MacroScope

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.

Rajoy insisted on Monday he would press on with a tough budget on Friday despite only a pyrrhic victory in weekend elections in Andalusia but markets are on red alert since he ripped up a Brussels-agreed deficit target last month. Italy is getting more benefit of the doubt but for that to persist, Monti will have to push through labour reforms in the teeth of union opposition.

That makes it all the more vital that euro zone finance ministers, meeting in Copenhagen later this week, agree on a method of bolstering the crisis firewall by combining some of the resources left in the temporary EFSF bailout fund with the ESM, a 500-billion-euro facility that comes into force from July.

In euro zone terms, two themes will dominate the week: Spain and the size of the euro zone rescue fund (Italy’s labour reforms will play a supporting role).

Yesterday, Spanish Prime Minister Mariano Rajoy won a key regional election in Andalusia although not as handsomely as hoped, raising the possibility that the socialists could rule there if they find a coalition partner. The result could hamper the government’s plan to press the autonomous regions harder to cut public spending. Having ripped up the deficit target agreed with Brussels last month, Spanish borrowing costs are already on the rise. Any further sign of wobbling could be seized upon by the markets. Spain faces a general strike on Thursday and Rajoy’s administration will present its full 2012 budget on Friday.

Also at the back end of the week, EU finance ministers meet in Copenhagen with the thorny issue of how, and by how much, to increase the euro zone’s future ESM rescue fund top of the agenda, which comes into being at mid-year.

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.

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.

The Greek bailout is done and Spain and the EU have struck a face-saving compromise over what deficit Madrid should aim for this year, so all is well with the world. That certainly seems to be the market mood this morning with safe haven German Bund futures opening sharply lower and European stock futures pointing to further gains.
In fact, the tone is more to do with the Federal Reserve, which sounded somewhat more upbeat about the U.S. economic outlook last night and said most banks (with the exception of Citi!) had passed tough stress tests, though it’s also true that there is nothing on the euro zone horizon today to spoil the party.

Italy comes to market with its latest bond auction. Investors flush with cheap European Central Bank funds are expected to pile in, pushing three-year borrowing costs below 3 percent. Rome is taking advantage of the current benign conditions to try and sell up to six billion euros of debt.

More interesting may be tomorrow’s Spanish auction. Italian premier Mario Monti remains the euro zone’s austerity poster boy, in contrast to Mariano Rajoy. Although the new Spanish prime minister has successfully negotiated a looser deficit target with Brussels, the downside of that deal is that Madrid might come under more scrutiny, particularly if it looks like missing that softer target.

Top billing of the day probably goes to Germany’s Merkel and Italy’s Monti meeting in Rome, though it is quite late in the day.  The Italian premier remains the austerity poster boy, in contrast to Spain’s Rajoy who was partially let off the hook by Brussels last night for abandoning his deficit target, though he was told to split the difference between the first target and his new, looser goal.

While trying to avoid a blizzard of numbers, Spain was supposed to land a deficit of 6 percent of GDP last year and 4.4 this, en route to the main target of 3.0 percent in 2013. Rajoy’s new government announced that last year the deficit had in fact swelled to 8.5 percent of GDP and as such he would only aim for 5.8 percent this year while sticking to next year’s goal. The Eurogroup told him last night to aim for 5.3 this year, cutting some significant slack but, but by demanding more cuts than Rajoy wanted to deliver, probably avoiding serious market disquiet about Spain becoming the new Greece – forever missing its targets – and undermining the bloc’s new fiscal pact while the ink is barely dry.

Nonetheless, the net result is likely to be to drag Spain deeper into recession this year. Looking at bond yield spreads, the markets don’t smell blood yet.