Europe Continues to Froth and Bubble, Toil and Trouble

Europe is still stumbling through a sovereign debt crisis, Greece is close to default, Portugal is in dire need of more cash yet, risk appetite so far this year has been a minor revelation. Some major equity markets such as the DAX and the Hang Seng are up more than 10%; BRIC equities are also motoring ahead with both the Sensex and Bovespa recording double-digit percentage gains so far in 2012; the gold price has jumped more than USD 150 and the Aussie is up almost 5%.

A number of explanations can be presented to account for this surge in optimism. Firstly, the US economy thus far is largely unaffected by Europe’s malaise, notwithstanding Bernanke’s suggestion that more QE may well be required.

Secondly, Mario Draghi’s bold gamble on providing Europe’s troubled banks with unlimited funds for three years has definitely helped to stabilise the situation.

Thirdly, both investors and traders feared almost financial Armageddon towards the end of last year and therefore some of the buying activity witnessed so far this year merely represents some normalisation of these extreme positions. How sustainable these gains are and whether they can continue remains to be seen.

It is still a relatively easy task to construct a terrifying bear case scenario, given the multifarious difficulties still left unresolved in Europe and the potential for China to face a similarly destructive debt dynamic at some point. For now, though, it is pointless to fight the tape.   

Commentary

The growing monetary policy divide. What was remarkable about Wednesday’s raft of policy announcements from the Fed (greater pre-commitment, hints of more QE, further extension of maturities of the Treasury portfolio) is that they came at a time when the US is on a stronger footing than the eurozone and the focus of the world is on the risks that the eurozone poses to financial stability, both in Europe and beyond.

The riposte is that the ECB is constrained by its mandate, unable to undertake QE in the same way as the US (or UK) and that it has been bold in its provision of liquidity to the banking sector, most recently via the offering of 3-yr repos to banks.  Naturally, this holds up to a degree but there is more that the ECB can do.  In monetary policy terms, by lowering rates from 1.50% to 1.00%, all Draghi has done so far is unwind the mistaken rate increases of last year, rather than respond to the current slowdown and greater downside risks of the sovereign situation.

This is why more interest rate-cuts are needed. Lowering the policy rate to the 0.50% level would effectively push overnight rates near to zero given the current liquidity overhang, but would also reduce the costs for banks borrowing from the ECB via repos (dependent on the average of the key rate), which is more important than market rates given that the ECB is rapidly becoming the market for inter-bank lending. But the Fed’s actions should also be a reminder that the ECB needs to do more and EU leaders need to explore other ways of allowing this to happen because the ECB is appearing ever more out of kilter with the economic realities it is currently facing and is deficient in its ability to catch up.

Frankfurt’s fury at the IMF. Not particularly reassuring at a time of still fragile market confidence is the sight of the IMF squabbling with the ECB. IMF Chief Lagarde this week threw a real spanner in the works by asserting that public sector creditors would need to participate in Greek debt-restructuring if the contribution from the private sector was not sufficient.

Unsurprisingly, the ECB remains firmly opposed to any restructuring of its debt, which it claims was acquired purely for monetary policy purposes (and in particular to make up for the inability of European politicians to agree on how to deal with Greece’s debt problems with sufficient urgency). The IMF attempted a belated retraction of Lagarde’s remarks later in the day by suggesting that, actually, the IMF “has no view on the relative contribution of private sector involvement and official sector support”, but by then it was too late.

Clearly, the IMF feels the ECB needs to take at least a partial write-down. It was apparent in its latest Greek debt-sustainability assessment last month that the IMF was much more concerned about the situation than it had been previously. This helps to explain Lagarde’s observation that the ECB may need to help out, and the tougher stance it is  now adopting.

Confirming the tenor of the IMF’s latest analysis on Greece, the Kiel Institute issued a report claiming that the debt load of Greece would remain “unbearably high” even if public sector creditors agreed to participate. For their part, private sector bondholders have welcomed the IMF’s intervention with open arms – on Tuesday, Charles Dallara, IIF head, also opined that both public and private sector bondholders should take pain. Of Greece’s EUR 350bln in debt, the private sector owns roughly 60%. Even the OECD supports the proposal for the ECB to accept losses. From the ECB’s perspective, it will be livid about the IMF’s stance.

Two former members of the ECB Governing Council, Weber and Stark, resigned because they fundamentally disagreed with the bond-buying program, and no doubt others in the ECB are just as uncomfortable. Buying the bonds of Europe’s fiscally miscreant sovereigns was something the ECB clearly did not want to do, but was forced to undertake in the interests of preserving market stability.

German politicians were quick to dismiss the IMF’s suggestion, with senior CDU lawmaker Michael Meister stating that he couldn’t “imagine that European politicians would allow third parties to make such an indecent claim on our central bank”. One can only imagine that Lagarde’s remarks will have generated fury in Frankfurt.

Positive progress in Spain. Although the economy is going backwards, there are reasons to cheer some of the recent developments in Spain. New PM Rajoy has given some of the embattled regional governments a liquidity lifeline, albeit with strong conditionality. His administration is also putting a lot of heat on Spanish banks to increase loss provisions on their deteriorating portfolio of real-estate loans during the upcoming reporting season.

Yesterday, major unions and employers agreed a landmark deal which limits wages growth in the current calendar year to 0.5%. Furthermore, the government hopes to pass a new budget stability law tomorrow which sets spending limits for all administrations (including regional governments) and puts in place measures to enforce compliance.

Budget Minister Montoro confirmed today that neither income nor property taxes will be raised further during the current phase of the recession. As a result, should Spain need to implement further austerity in order to achieve the 4.4% deficit target for this year, it will need to do so through additional spending cuts. It is a very tough road for Spain, but positive progress is being made. Little wonder that Spanish bond yields continue to decline.    

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