MacroScope

Portugal crisis to test ECB´s strategy

Portuguese bond yields surged to more than 8 percent as a government crisis prompted investors to shun the bailed-out country, raising concerns about another flare-up in the euro zone debt saga.

The resignation this week of two key ministers, including Finance Minister Vitor Gaspar who was the architect of its austerity drive, tipped Portugal into a turmoil that could derail its plan to exit its bailout next year.

Portuguese bond yields surged to levels near which it was forced to seek international aid two years ago. The sell-off spread to Italian and Spanish debt markets, but was not as pronounced there.

According to Elwin de Groot, senior market economist at Rabobank:

This could quickly bring Portugal into a situation where there will have to be decisions about whether there is another extension of the support programme.

It will also bring back discussion on whether the ECB has any interest in trying to prevent further increases in Portuguese yields and whether or not it will be willing to do so.

There is no sovereign debt crisis in Europe

Evidence that Europe’s austerity policies are not working was in ample supply this morning. The euro zone as a whole is now in its longest recession since the start of monetary union. France has succumbed to the region’s retrenchment. Italy’s GDP slump is now the lengthiest on record. And Greece, still in depression, shrank another 5.3 percent in the first quarter.

To understand why this is happening, Brown University professor Mark Blyth says it is necessary to forget everything you think you know about the euro zone crisis. The monetary union’s troubles are not, as often depicted, the result of runaway spending by bloated, profligate states that are finally being forced to pay the piper. Instead, argues Blyth, it is merely a sequel to the U.S. financial meltdown that started, like its American counterpart, with dangerously-indebted risk-taking on the part of a super-sized banking sector.

In a new book entitled “Austerity: The history of a dangerous idea,” Blythe writes that sovereign budgets have come under strain primarily because taxpayers of various nations have been forced to shoulder the burden of failed banking systems.

Spanish downgrade threat averted, but for how long?

Moody’s refrained from cutting Spain’s sovereign rating to junk territory last week, easing immediate fears that Spanish bonds could become vulnerable to forced selling if they fell out of benchmark indices, tracked by bond funds, as a result of the grade reduction.

But that risk still looms large.

Moody’s kept Spain’s rating at Baa3 but assigned it a negative outlook, saying ”the risks to its baseline scenario are high and skewed to the downside.” It said it believed the combination of euro area and European Central Bank support, along with the Spanish government’s own efforts, should allow the government to maintain access to capital markets at reasonable rates.

But should certain factors lead the rating agency “to conclude that the Spanish government had either lost, or was very likely to lose, access to private markets, then Moody’s would most likely implement a downgrade, potentially of multiple notches.”

Europe’s reactive leadership

Spain doesn’t need financial help. That was the verdict from euro zone ministers on Monday – quickly followed by a selloff in Spanish stocks and bonds on Tuesday. The trouble with that line of thinking is that it again leaves policymakers behind the curve, reacting to events rather than preempting them, write currency strategists at Brown Brothers Harriman in a research note:

For several weeks now Germany Finance Minister Schaeuble has argued against the need for Spain to request aid. France and Italy, in contrast, have been reportedly encouraging Spain to ask for assistance, which they assume would ease financial pressures within the region as whole. The Eurogroup meeting of euro area finance ministers endorsed Schaeuble’s position. Spain is taking necessary measures to overhaul the economy, they said.  Spain is able to successfully fund itself in the capital markets. Aid is simply not needed now.

While there is a compelling logic to the argument, the problem is that it prevents officials from being proactive rather than continue to its reactive function. It means that whenSpaineventually requests assistance, it will be in a crisis and the cost of assistance will be greater. It is penny-wise but dollar foolish. By failing to find a preventative salve, officials are not maximizing the breathing space that the ECB has created (intentionally or otherwise).

Eurobonds key to financial stability: Nobel economist

There’s no other way. In order for Europe to hold together as a monetary union it must be able to issue a currency region-wide bond. That’s according to Christopher Sims, Nobel-prize winning economist and Princeton University professor, speaking on a panel at the IMF over the weekend:

My view is that the only way to preserve the usual manner of operation of monetary policy in Europe, and the usual operation of financial institutions is to deliver on the Eurobond, and not after years but soon. A Eurobond that could be used as the main instrument of monetary policy in Europe would go a long way to stabilizing the financial system.

This explains why Europe is in trouble while other industrialized nations that also face high debt levels are not seeing anywhere near the same market pressures, Sims said:

Risks from ECB debt drip

The abundance of European Central Bank liquidity in the euro zone financial system is making for smoother issuance of shorter-dated debt in the euro zone.

Case in point: Spain. This week the country sold double its previously announced target of three- and four-year government bonds amid solid demand.

But there are risks, particularly if the Treasuries of lower-rated countries get too comfortable issuing at the short-end of the curve. Michael Leister, strategist at DZ Bank, described the potential pitfalls in a telephone interview: