MacroScope

Euro zone week ahead

Italy will continue to cast a long shadow and has clearly opened a chink in the euro zone’s armour. It looks like the best investors can expect is populist Beppe Grillo supporting some measures put forward by a minority, centre-left government but refusing any sort of formal alliance. That sounds like a recipe for the sort of instability that could have investors running a mile. The markets’ best case was for outgoing technocrat prime minister Monti to support the centre-left in coalition, thereby guaranteeing continuation of economic reforms. But he just didn’t get enough votes. Fresh elections are probably the nightmare scenario given the unpredictability of what could result.

The story of the last five months has been the bond-buying safety net cast by the European Central Bank which took the sting out of the currency bloc’s debt crisis. But now it has an Achilles’ Heel. The ECB has stated it will only buy the bonds of a country on certain policy conditions. An unwilling or unstable Italian government may be unable to meet those conditions so in theory the ECB should stand back. But what if the euro zone’s third biggest economy comes under serious market attack? Without ECB support the whole bloc would be thrown back into crisis and yet if it does intervene, some ECB policymakers and German lawmakers will throw their hands up in horror, potentially calling the whole programme in to question.

In other words, until or unless a durable government is formed in Italy which can credibly say and do the right things, the euro zone crisis is back although not yet in the way it was a year ago when break-up looked possible.

Because of all this, Thursday’s ECB policy meeting looms very large, not because a shift in policy is expected but because journalists will get an hour to quiz Mario Draghi on the Italy conundrum. The Bank of England meets the same day. Policy stasis will probably be the order of the day again but it’s a much closer call after Governor Mervyn King was outvoted in calling for more money printing last month. Our poll puts a 40 percent chance on it happening this time. When King has been outvoted in the past, he has more often than not got his way some time later.  It’s a big central bank week with Japan, Canada and Australia also holding interest rate meetings, so there may be something broader to be done.

The other big setpiece of the week is the monthly meeting of euro zone finance ministers today. They will discuss how to construct a bailout for Cyprus. Progress will be made, our sources say, with an end-March deal the aim. The big question is whether to hit Cypriot bank depositors as part of the deal. That could spark a bank run and set a nerve-jangling precedent for investors but the euro zone is determined taxpayers cannot forever be on the hook for this stuff. There appears to be a split on that question. ‘Twas ever thus. Italy of course will exercise the ministers although it’s hard to see what they can do with no government in prospect for a while.

Europe and the danger of soft-pedalling

No one really questions Angela Merkel’s supremacy in Germany but losing the key state of Lower Saxony in a Sunday election, albeit by the narrowest of margins, means we’ll have to put on ice proclamations that her re-election for a third term in the autumn is now merely a procession. The centre-left SPD and Greens won the state by a single seat. Merkel and others will speak about the result today. What it probably does affirm is that the Chancellor will be extremely cautious about agreeing to more euro zone crisis fighting measures before the national election is safely out of the way.

We’ve been here before. When the drumbeat of market pressure eases, euro zone policymakers have tended to lose their sense of urgency. Today’s meeting of euro zone finance ministers, the first of the year, could be a case in point. The agenda lists “progress” on Cyprus, Spain, Ireland, Portugal and Greece with no decisions expected.
The meeting is set to anoint Dutch Finance Minister Jeroen Dijsselbloem as its new chairman after France dropped its objections on Sunday. He will attend the final press conference so it will be interesting to hear his pitch.

The most important area of debate will be the euro zone’s rescue fund and its ability eventually to recapitalize struggling banks directly, thereby breaking the “doom loop” whereby weak governments drive themselves further into debt by propping up listing banks while the lenders are stuffed with that government’s bonds which are liable to lose value. EU leaders seemed pretty clear at last June’s summit that this would be done but there are now suggestions that governments will remain on the hook to at least some extent. That would be a very significant backward step.

Do they they think it’s all over?

Is everything falling into place to at least declare a moratorium in the euro zone debt crisis?

Well the ESM rescue fund getting a go-ahead from Germany’s consitutional court and the Dutch opting to vote for the two main pro-European parties, following Mario Draghi’s confirmation last week that the European Central Bank would buy Spanish and Italian bonds if required, means things are starting to look a little rosier.

The risks? Next spring’s Italian election, and what sort of government results, casts a long shadow and it is just about conceivable that Spain could baulk at asking for help, given the strings attached, although the sheer amount of debt it needs to shift by the end of the year will almost certainly force its hand. If the Bundesbank mounted a guerrilla war campaign against the ECB bond-buying programme it could well undermine its effectiveness. That is a big if given broad German political support for the scheme. Key countries remain deep in recession with little prospect of returning to growth because of the imperative to keep eating away at their debt mountains, which could eventually trigger a dramatic public reaction. France could well get dragged into that category.

Get me to the court on time

Another blockbuster chapter in the euro zone epic.

Top billing today goes to Germany’s constitutional court, which is expected to give a green light to the euro zone’s permanent rescue fund, the ESM, albeit with some conditions imposed in terms of parliamentary oversight. The ruling begins at 0800 GMT. If the court defied expectations and upheld complaints about the fund, it would lead to the mother of all market sell-offs and plunge the euro zone into its deepest crisis yet.

Without the ESM, the European Central Bank’s carefully constructed plan to backstop the euro zone would be in tatters. It has said it will only intervene to buy the bonds of the bloc’s strugglers if they first seek help from the rescue fund and sign up to the strings that will be attached. The first rescue fund, the EFSF, could perhaps fill this role for a while but its resources are now threadbare, so without the ESM, markets would scent blood.

The Dutch go to the polls but with the hard-left Socialists seemingly losing support, the ruling Liberal party and moderate centre-left Labour are  neck-and-neck and look likely to form a coalition government committed to tight debt control and, more importantly, to the euro zone. So unless voters are lying to pollsters, some of the drama has leached out of this particular saga although it could take some considerable time to put a coalition together.

Get me to the court on time

Markets were a little unnerved yesterday by concern that Germany’s top court may take a long time to rule on complaints lodged against the euro zone’s permanent bailout fund, the ESM, which was supposed to come into effect this week. Finance Minister Schaeuble urged the constitutional court to reach a speedy decision. The judges are not expected to block it but Germany’s president says he won’t sign it into law without the court’s go-ahead. A minor delay will pose no problem. A lengthier one could jolt investors.

The head of the court raised the possibility of a review taking take two to three months. That could create a dangerous vacuum though he stressed that was just one option. Schaeuble is just out again saying he hopes for a verdict before the autumn.

Bundesbank head Weidmann said even rapid ratification may not stop the crisis escalating further. With only a maximum 500 billion euros (100 billion of which is earmarked for Spain’s banks) at its disposal, the ESM looks ill-equipped to tackle the bond market head on. When the European Central Bank intervened last year to lower Italian borrowing costs it was spending 13/14 billion euros a week. And even then, it bought only temporary leeway.

EU summit aftermath

After the EU summit exceeded expectations the more considered verdict of the markets will dictate in the short-term, certainly until the European Central Bank’s policy meeting on Thursday. Previous summit deals crumbled pretty quickly buying only a few days or even hours of market relief.

After strong gains on Friday, Asian stocks are up modestly and European shares have edged higher. However, German Bund futures are nearly half a point higher, so something’s got to give and more often than not it’s the stock market that thinks again. So maybe Friday’s rally was a one-off.

For it to have any legs, the ECB may well have to come up with something on Thursday, and a quarter-point rate cut – widely priced in – may not be enough. ECB policymaker Asmussen is already out saying Greece must should not loosen its bailout programme, Spain can restore confidence with a bank recap plan that builds in a large margin for error and dismissing calls for the ESM rescue fund, which comes into being next week, to get a banking licence so it could draw on virtually unlimited ECB funds. That all sounds fairly uncompromising.

Euro gang of four – or three versus one?

The euro zone’s big four meet in Rome with Germany’s Angela Merkel likely to come under pressure from Italy’s Mario Monti, Spain’s Mariano Rajoy and France’s Francois Hollande to loosen her purse strings and principles.

Monti, with Hollande’s backing, has suggested using the euro zone rescue funds to buy Spanish and Italian bonds but Berlin is not keen and there are good reasons why it might not work, not least the ESM’s preferred creditor status which means that if it piled in, private investors may flee knowing they would be paid back last in the event of a default.

The Eurogroup may have skirted the same problem with regard to the Spanish banking bailout last night by deciding to start the loans via the existing EFSF, which does not have seniority, before switching to the ESM. The EFSF’s rules will persist throughout.

A curate’s egg — good in parts

An action-packed weekend with both good and bad news for the euro zone, which may — net — leave its prospects little clearer.

Item 1: The IMF came up with $430 billion in new firepower to contain the euro zone-led world economic crisis, although some of the money will only be delivered by the BRICS once they have more sway at the Fund. Nonetheless, the figure at least matches expectations and could give markets pause for thought. The official line is that it is for non-euro countries caught up in the maelstrom but no one really believes that. If a Spain is teetering, IMF funds will be there. Together with the 500 billion euros rescue fund set up by the euro zone, there is still barely enough to ringfence both Italy and Spain if it came to it. But will it come to it?

Item 2: Socialist Francois Hollande came out top in the first round of the French presidential election and is now a warm favourite to win. Some fear that could weaken the Franco-German motor which must be humming smoothly if further crisis-fighting measures are to be convincing. Others say he is essentially a centrist who, either way, will be constrained by the realities of the euro zone situation. Domestically, his focus on tax rises over spending cuts and a slower timetable for cuts could drive up French borrowing costs. Attempts by Hollande and President Nicola Sarkozy to woo the substantial votes that went to the far right and far left could lead to some nerve-jangling campaigning messages for the markets to swallow in the run-up to the May 6 second round.

Today in the euro zone – Bonds, strikes and firewalls

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.

Euro zone week ahead – Spain budgets and Italy labours

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.