MacroScope

A telling moment. Before pretty much every showdown EU summit since the debt crisis exploded into life, the leaders of France and Germany have got together beforehand to agree a common strategy. It is a truism that the European motor only works efficiently when its two biggest powers are in accord.

This time, following the election of Francois Hollande as French president, there has been no such meeting. Instead he will talk with Spanish premier Mariano Rajoy in Paris before they head to the Brussels summit.
There, Hollande will press for the currency bloc to start issuing joint euro zone bonds and will run into implacable German opposition that will squash the plan for now.
But the plates are shifting and German Chancellor Angela Merkel looks somewhat isolated.

On euro bonds, Hollande can call on the support of Italy’s Mario Monti and the European Commission among others.
Nonetheless, Angela holds the purse strings so while we will see some modest pro-growth measures agreed (and no doubt trumpeted), there will be no pump-priming that requires extra deficit spending, certainly no mutualising of debt and probably no hint that the likes of Greece and Spain will be given longer to make the cuts demanded of them (though that policy’s time could soon come, depending on how the June 17 Greek elections go).

Greek contagion aside, Spain remains the bloc’s biggest headache largely because of the weight of bad debts dragging its banking sector down. One idea is to allow the euro zone’s rescue funds to lend to banks direct, thereby removing the stigma of a government having to ask for aid. But Berlin is not keen on this one either.

Less controversial are plans to boost the capital of the European Investment Bank, use “project bonds” backed by the EU budget to invest in infrastructure and recalibrate some EU structural funds which has been used to help poorer EU members so that it is spent in other areas which might yield a quick growth dividend. None of that can hurt. But peashooters and elephants come to mind.

Spain’s borrowing costs are likely to soar at an auction of 12- and 18-month T-bills after its 10-year yields were pushed through the totemic 6 percent level on Monday. The history of the euro zone debt crisis shows that once above 6 percent the spiral accelerates and before you know it you’re at 7 percent – the level generally seen as unsustainable for state financing.

Worryingly, Spain is dragging Italy’s yields up in its wake. But in Spain’s case, there are strong reasons for caution about imminent disaster. The government cannily used ECB-created benign market conditions in the first part of the year to shift nearly half its annual debt issuance needs already and the banks – which look like they will need recapitalization at some point – are well funded for now having also loaded up on the European Central Bank’s three-year liquidity splurge.

We also know Europe’s banks, too scared to invest elsewhere, are depositing 700-800 billion euros back at the ECB daily. If Madrid could engender a shift in confidence, some of that money could flow back into its bonds, particularly by Spanish banks.

So the debt crisis is back (did it ever really go away?) but it’s not yet anything like as acute as it was late last year.

Spain is coming under real market pressure, and dragging Italy with it to an extent, but there are good reasons to think it won’t fall over; banks well funded for now and the government’s savvy move to take advantage of benign early year conditions to shift almost half its 2012 debt issuance in three months.

Madrid faces another key test with a Thursday bond auction. Two weeks ago, it suffered its first wobbly debt sale for some months. The turning point is pretty clear – Prime Minister Mariano Rajoy’s decision to rip up Spain’s agreed deficit target for 2012 without consulting his partners. Since then, Spanish borrowing costs have soared though given the amount of debt Madrid has already shifted, that might not be as damaging as it was.

A day for central bankers and maybe the hint of a row brewing within the ECB. After days of jitters, euro zone bond markets were calmed a little this week when ECB policymaker Benoit Coure said the central bank’s government bond-buying programme could be revived if Spain started teetering.

That is decidedly not what the orthodoxists in Frankfurt would have wanted to hear. They are already worried that the creation of more than a trillion euros of three-year money could be stoking future inflation and creating addicted banks and feel that the bond-buying programme crosses a red line — that the ECB should not fund governments.

We know Bundesbank chief Jens Weidmann has been leading the charge to at least talk about an exit strategy from the ECB’s extraordinary policy stance – something the top man, Mario Draghi, slapped down pretty bluntly last week — and Orphanides, the ECB man from Cyprus, was out last night saying individual central bankers should not be making any commitments about bond-buying, a clear swipe at Coure.

All eyes on Italy. After paying sharply higher yields to sell one-year paper on Wednesday, it faces the altogether trickier task of selling up to five billion euros of three-year bonds. Yields are expected to jump by a full percentage point from a month ago but, as with yesterday, demand will be there and the paper should get away.

German Bunds have opened flat and European stocks are set to edge up so the recent rush for the exits has at least temporarily abated.

After yesterday’s auction result, Italian officials were  quick to point the finger at “external factors” – code for Spain. That prompted Spain’s Mariano Rajoy to hit back, demanding European leaders choose their language with more care. The message from Madrid is that the government is doing everything asked of it on the austerity and structural reform front and needs stronger backing from its peers. It’s hard to argue with that. Italian premier Mario Monti has said similar about Italy. The difference is that he did not renege on an agreed deficit target without consulting Brussels.

Spanish 10-year bond yields are within a whisker of breaking above six percent for the first time since December and are dragging Italy’s up with them. The balmy days of first quarter calm are well and truly over. “Markets step up the attack”, El Pais blares from its front page this morning.

Spanish risk premiums have leapt since Prime Minister Mariano Rajoy defied Europe by unilaterally easing Madrid’s 2012 deficit target and investors seem to have lost faith again as the impact of the ECB’s massive liquidity injection begins to fade.

BUT, and there is a but, there are good reasons to believe Spain will not fall over in the way Greece and others have. One silver lining for Madrid is that it has taken advantage of the benign market conditions early in the year to clear almost half its 2012 debt issuance needs so rising secondary market yields may be less damaging than they were last year.
 
As usual, confidence is key. The ECB three-year money has not vanished. Look at the 800 billion or so euros deposited back at the ECB by banks every day and it’s clear that if sentiment improved some of that money could be put to use once again to buy Spanish and Italian bonds, though there’s no sign of that for now.
 
Markets are resolutely “risk off” although weak U.S. jobs data last week have a part to play here. European stock futures are flagging a further 0.5 percent loss following a 2.5 percent tumble on Tuesday. The most reliable euro zone barometer – the Bund future – has edged lower at the open, probably in anticipation of Germany auctioning a new 10-year bond later. Given the climate, it should be snapped up despite yields already at record lows: While Spain faces a 6 percent price to borrow for 10 years, Germany can do so for 1.6 percent.

After the Easter break, a bit of perspective — to paraphrase the immortal Spinal Tap, maybe too much perspective.

Over the past two weeks, Spanish and Italian borrowing costs have continued to rise – in the former’s case they have now relinquished more than half their fall since December and are heading back into the danger zone. Stocks have also appeared to have given up on their first quarter rally, presumably testament to the realization that the ECB and other top central banks are unlikely to be writing any more blank cheques for banks to reinvest.

Late last year, it was Italy that seemed to have the power to drag Spain into the debt crisis mire. Now, it’s the other way round and after the ECB anaesthesia  wears off, it’s clear the euro zone patient is still sickly.

Brace yourself for a blizzard of numbers.

EU finance ministers gathered in Copenhagen are poised to decide precisely how much firepower their new rescue fund – to be launched mid-year – will have. A draft communiqué suggests that as of mid-2013, presuming no new bailouts have been required in the interim, the combined lending ceiling of the future ESM and existing EFSF bailout funds will be set at 700 billion euros (500 billion pledged to the ESM plus the roughly 200 billion already committed to Greek, Irish and Portuguese rescue programmes).

Up to mid-2013, if 700 billion proves to be insufficient — i.e. someone else needs bailing out — euro zone leaders will be able to bolster it with the 240 billion euros as yet unused in the EFSF, according to the draft, although German Finance Minister Wolfgang Schaeuble said last night that 800 billion should be the absolute limit.

Sorry, there’s more. Because the ESM will not have its full 500 billion euros capacity on day one – it will build up over time – the real available figure for the next year is more like 640 billion euros.
Confused? You should be.

Big debt test for Italy which will sell 8 billion euros or more of longer-dated bonds. A short-term T-bill sale went okay on Wednesday but a day before, the secondary market reacted negatively to a sale of zero-coupon and inflation-linked bonds, pushing Italian yields higher.

The glut of ECB three-year money has ensured Italian and Spanish auctions have sailed out of the door so far this year but there will be no more largesse from the central bank so be on the look out for signs of that support fading. Analysts expect this sale to go well with Italian banks wading in again.

Euro zone money supply data on Wednesday showed Spanish and Italian banks stocked up on government bonds in February – and that was before the ECB’s second instalment of money creation to the tune of 500 billion euros. So bond sales should be underpinned for some time yet though it is clear that the central bank has bought policymakers time rather than solved the root problems.

Conflicting pressures for the euro zone bond market today – a strong signal from Germany that it is willing to increase the firewall built around the currency bloc but ongoing concerns that Spain is being dragged into the mire.

Litmus tests are provided by an auction of a mixture of Italian debt worth up to four billion euros and the sale of short-term Spanish t-bills. While Spanish yields on the secondary market have come under pressure there has been no sign yet that primary sales will have any difficulty, given the more than 1 trillion euros of three-year ECB money sloshing round the financial system.

Italian Prime Minister Mario Monti and Spain’s Mariano Rajoy are both in South Korea for a nuclear summit and could well break cover.