MacroScope

The first quarter winds to a close and, for most investors, it must have been a profitable one with stocks climbing and peripheral euro zone bond yields falling largely on the back of the European Central Bank’s efforts to pump prime the financial sector with a trillion new euros. Reuters’ asset allocation polls on Tuesday will look at whether there has been a significant pull-back from core government debt and the “risk on” trend can continue.

The second quarter may be much less straightforward (though let’s not forget at the turn of the year, no one thought the first quarter would be either) but let’s not get too far ahead of ourselves.

The coming week provides a number of chances to take the temperature of the euro zone debt saga. Spain, having ripped up its 2012 deficit target, will present its full budget a day after a general strike and EU finance ministers gather in Copenhagen where the still unresolved issue of how to structure the euro zone’s permanent rescue fund will be structured.

Many in the euro zone want the resources of the EFSF bailout fund to be rolled into its successor, the ESM, creating a 750 billion euros pool which may be enough to scare the markets off from attacking Italy and Spain, particularly if the IMF flexes its muscles too. A decision could be made in Copenhagen though Germany continues to resist. The most likely solution is the least ambitious one – an increase of the bailout capacity to 692 billion (500 billion from the ESM, to be reached gradually over four years + 192 bln of money already committed to the Greek, Irish and Portuguese programmes by the EFSF).

The other key ingredient is public willingness to tolerate years more economic pain. The Portuguese have held a strike and Spaniards will do so this week, with and Italian down-tools also looming. So far, protest has been sufficiently muted that politicians have not been deflected from their cuts and reforms programmes. Spain’s ruling PP is likely to win an Andalusian election over the weekend, a victory which may encourage it to extend its austerity drive.

The euro zone economy looks to have contracted at a faster pace in March, according to the latest purchasing managers’ data, hours after ECB President Mario Draghi declared the worst of the debt crisis to be over. A mild recession appears to be in prospect with the probable exception of Germany.

The two aren’t mutually exclusive. Even if the existential threat to the currency bloc has passed, many of its members face years of economic hardship yet. With China’s equivalent report also coming in weak, the short-term signs are not auspicous.

Italy’s largest trade union has called a strike for the near future over Prime Minister Mario Monti’s labour reforms which have been rehardened to make it easier to fire not just workers in new jobs but right across the labour force. The prime minister says he won’t negotiate further given he has the support of other unions as well as employers groups. However, there is room for “fine tuning” today and tomorrow. The CGIL union has called for an eight-hour general strike with more to follow.

The spotlight swings firmly on to Italy where Prime Minister Mario Monti is meeting trade unions and employers in an attempt to push through labour reforms which he hopes will galvanise the economy. The largest union has said a deal is “impossible” by an end-of-week deadline despite signs the government is watering down the  measures.

This is big stuff. A number of key factors have helped move the euro zone debt crisis on from critical to chronic; top of the list was the ECB’s creation of a trillion euros of three-year money but not far behind came the elevation of Monti and the hope invested in him that he can turn the Italian economy around. If the euro zone’s fourth largest economy fell over, the currency bloc really would be on the skids. He must convince markets – which remain becalmed for now – that he can raise Italy’s trend growth rate if its 120 percent of GDP debt pile is ever to be eaten into.

If faith in the technocrat premier wanes, it could have a significant effect on currently benign investor sentiment towards the euro zone.

Investors who bought Greek default insurance discover how much they will be paid today. Memories of the chaos that flowed from CDS payouts after the collapse of Lehmans mean there is a degree of nervousness but the signs are this will be nothing like as serious.

A  payout of around $2.5 billion to holders of the insurance contracts on Greek bonds will not cause the calamity once feared by euro zone politicians and the ECB as it represents a drop in the ocean of losses investors have already taken on money lent to Greece. That doesn’t mean, however,  that a few banks have not been foolish enough to write vast amounts of contracts on Greek debt which will now fall due.

There is a complex auction process to go through where bonds are bought and sold in order to determine a final price, or ‘recovery rate’. That will also give a more accurate guide to the market outlook for Greece since the new bonds issued as part of the bond swap are barely being traded so far. That view ain’t likely to be pretty.