MacroScope

Taking stock

It’s May Day and most of Europe, barring Britain, is taking a holiday so maybe it’s a day to take stock.

But first, a nervous glance at little Slovenia. Last night Moody’s cut its debt rating to junk, forcing Ljubljana to abandon a planned bond issue which looked set to raise several billion dollars and making a fifth euro zone sovereign bailout much more likely. Given the ham-fisted effort to rescue Cyprus didn’t put markets into a spin, it’s unlikely Slovenia will upset the euro zone applecart but it’s a reminder that this crisis isn’t over and won’t be until the currency bloc gets serious about creating a banking union. Slovenia’s problems, like Cyprus’s, are rooted in the banking sector, which is stifled by about 7 billion euros in bad loans.

One bullet was dodged when the Cypriot parliament narrowly approved its bailout late yesterday, which will avert bankruptcy but at a painful cost.

Looking at the wider picture, Item One on the agenda is that after euro zone inflation plunged to 1.2 percent yesterday – way below the European Central Bank’s target of close to but below two percent – it now has the greenest of green lights to act at Thursday’s policy meeting.

We already had it on very good authority that a quarter-point interest rate cut is on the cards, which will take rates to a record low 0.5 percent. However, nobody is under any illusion that that alone is going to lift the currency bloc out of recession, one reason perhaps that a debate is now raging over the benefits of cutting debt versus going for growth at a governmental level.

No Let(ta) up for euro zone

Fresh from winning a vote of confidence in parliament, new Italian Prime Minister Enrico Letta heads to Berlin to meet Angela Merkel, pledging to shift the euro zone’s focus on austerity in favour of a drive to create jobs. He may be pushing at a partially open door. Even the German economy is struggling at the moment and the top brass in Brussels have declared either that debt-cutting has reached its limits and/or that now is the time to exercise flexibility. Letta will move on from Berlin to Brussels and Paris later in the week.

France, Spain and others will next month be given more time to meet their deficit targets and Berlin does not seem to object. Don’t expect Merkel to join the anti-austerity chorus but there are some hints of a shift even in Europe’s paymaster. Yesterday, it launched a bilateral plan with Spain to boost lending to smaller companies and said it could be rolled out elsewhere too. Details were very sketchy but something may be afoot. The European Central Bank, expected to cut interest rates on Thursday, is considering something similar although that is far from a done deal.

Forgotten about Cyprus, which only last month had financial markets in a lather and threatened to reignite the euro zone debt crisis? Today, Cypriot politicians vote on the terms of the bailout offered by the euro zone. It should pass but it could be tight. No single party has a majority in the 56-member parliament, and the government is counting on support from members of its three party centre-right coalition which have 30 seats in total.

Finally, an Italian government

A weekend packed with action to reflect on with more to come.

Top of the list was the formation (finally) of an Italian coalition government. Market reaction is likely to be positive, although Italian assets rallied last week, and today’s auction of up to 6 billion euros of five- and 10-year bonds should continue this year’s trend of being snapped up by investors. Italian bond futures have opened about a third of a point higher.

Prime Minister Enrico Letto will seek a vote of confidence in parliament at 1300 GMT, which presumably should go without a hitch. But a coalition with the centre-left and Silvio Berlusconi does not necessarily look like a recipe for smooth government. It is quite possible that the leftward part of the centre-left will find it too hard to stomach, eventually leading to a split. Letta is expected to try to pass at least a few basic reforms quickly including a change to Italy’s much criticised electoral laws and a cut in the size of parliament

As far as the markets are concerned, there shouldn’t be any nerve-jangling economic policy shocks although Letta has said debt-cutting is self-defeating. New economy minister Fabrizio Saccomanni said on Sunday he plans to cut taxes and public spending and lower borrowing costs. The rhetoric may have shifted but the reality for the euro zone’s high debtors is many more years of pain to come. But it’s probably true that more emphasis will now be placed on structural reforms.

Beware the Bundesbank

German newspaper Handelsblatt has got hold of a confidential Bundesbank report to Germany’s constitutional court, which sharply criticized the European Central Bank’s bond-buying plan. This could be very big or it could be nothing.

Bundesbank chief Jens Weidmann has made no secret of his opposition to the as yet unused programme and since the mere threat of massive ECB intervention has driven euro zone bond yields lower for months there is no urgency to put it into action. But the OMT, as it is known, is by far the single biggest reason that markets have become calmer about the euro zone, so anything that threatens it could be of huge importance.

The key point is not the Bundesbank’s stance but how the Constitutional Court responds. It is due to consider OMT in June. Through the three-year debt crisis, when Berlin has reluctantly crossed red lines it has had to get the court’s approval. So far, it has always been forthcoming, though sometimes with strings attached. But if it took the Bundesbank’s assertion that bond-buying could “compromise the independence of the central bank” at face value, it is almost certain to have a long hard look. We already know that the court is a potential stumbling block to banking union as it has ruled that any future euro mechanisms would only be in order if Germany’s maximum liability was clearly defined.

Austerity — the British test case

First quarter UK GDP figures will show whether Britain has succumbed to an unprecedented “triple dip” recession. Economically, the difference between 0.2 percent growth or contraction doesn’t amount to much, and the first GDP reading is nearly always revised at a later date. But politically it’s huge.

Finance minister George Osborne has already suffered the ignominy of downgrades by two ratings agencies – something he once vowed would not happen on his watch. And even more uncomfortably, he is looking increasingly isolated as the flag bearer for austerity. The IMF is urging a change of tack (and will deliver its annual report on the UK soon) and even euro zone policymakers are starting to talk that talk. It was very much the consensus at last week’s G20 meeting.

The government can argue that it hasn’t actually cut that hard – successive deficit targets have been missed – and that it does have pro-growth measures such as for the housing market and bank lending. But the inescapable political fact is that Osborne and his boss, David Cameron, have spent three years arguing that they would cut their way back to growth and that to borrow your way out of a debt crisis is madness. In fact, it’s arguably perfectly economically sane, given that if you get growth going, tax revenues rise and will eat away at the national debt pile.

The limits of austerity

With debate about the balance between growth and austerity well and truly breaking out into the open, flash euro zone PMIs – which have a strong correlation to future GDP — are likely to show why a bit of fiscal stimulus is sorely needed. Talk of a European Central Bank rate cut is growing, euro zone policymakers at the G20 last week began to ponder loosening up on debt-cutting in an attempt to foster some growth and European Commission President Jose Manuel Barroso added his voice to the debate yesterday, saying the austerity drive had reached its “natural limit”.

Crucially, we haven’t heard similar from Germany but something is afoot, starting with the certainty that the likes of Spain and France will get more time to meet their deficit targets when the Commission makes a ruling next month. Portugal has already been given more leeway and today its finance minister will spell out new spending cuts which are required after the constitutional court threw out Plan A.

It’s a coincidence, but an interesting one, that this debate – frequently voiced in private over many months – has gone public just as THE academic study from 2010 which asserted that as soon as debt exceeds 90 percent of GDP growth is crushed, has been called into question.

Why euro zone bond yield ‘convergence’ may be something to fear

 

Are European bond investors looking for love in all the wrong places?

The premium bankers demand to hold various types of euro zone debt over that of Germany has recently come down. In normal circumstances, this might suggest markets are no longer discriminating between the risks associated with different member countries’ bonds. But analysts say the recent convergence is based on a precarious belief of ECB action rather than any real improvement in economic fundamentals.

Spain and Italy still offer a comfortable premium over Germany. But a narrowing in yield spreads that is being driven by a fall in the funding costs of Spain and Italy, rather than by a rise in German yields, gives reason for pause.

According to Lyn Graham-Taylor, fixed income strategist at Rabobank:

The fact there is almost no movement from Germany and a huge movement in peripherals is indicative to us of this convergence for the wrong reason.

German ghost of inflations past haunting European stability: Posen

“Reality is sticky.” That was the core of Adam Posen’s message to German policymakers on their home turf, at a recent conference in Berlin.

What did the former UK Monetary Policy Committee member mean? Quite simply, that the types of structural economic changes that Germany has been pushing on the euro zone are not only destructive but also bound to fail, at least if history is any guide.

Posen, who now heads the Peterson Institute for International Economics in Washington, argued Germany’s imposition of austerity on Europe’s battered periphery is the product of an instinctive but misguided fear of an inflation “ghost” that has haunted the country since the hyperinflationary spurt of the Weimar Republic in the 1920s and 1930s. However, Posen offers a convincing account of modern economic history that shows inflation episodes are rather rare events associated with major political and institutional meltdown — and not always around the corner.

ECB eclipsed by BOJ

The European Central Bank takes centre stage. While others in the euro zone are saying the way Cyprus was bailed out – with bank bondholders and big depositors hit – could be repeated, the ECB insists it was a one-off.

Fearful of any signs of contagion it will continue to talk that talk and there’s no sign of it having to do more so far, with no bank run even in Cyprus let alone further afield. But the last two weeks has reignited debate about what the ECB might have to do in extremis. It’s no nearer deploying its bond-buying programme but it could flood the currency area’s financial system with long-term liquidity again if called upon.

Interest rates are expected to be held at a record low 0.75 percent. Hints of policy easing further out are not out of the question. As ever, Mario Draghi’s hour long press conference will be minutely parsed but there will be nothing to match the Bank of Japan which earlier announced a stunning revamp of its policymaking rules – setting a balance sheet target which will involve printing money faster and pledging to double its government bond holdings over two years.

Firefighting in the euro zone

Money markets largely braved Cyprus’s bailout saga last week, but figures showing liquidity conditions are tightening suggest sentiment may not be as resilient the next time around.

Data from CrossBorder Capital, an independent financial firm that specialises in analysing global liquidity flows, shows the euro zone saw its biggest capital outflow in March since late 2011 – around the time the ECB injected liquidity into the financial system.

Financial institutions and governments took a net $175 billion worth of bonds and stocks, on an annualised basis, out of the euro zone in March – the biggest outflow since $201.4 billion in December 2011, according to the data.