Four Paths Forward for the Euro

Monday, July 2nd, 2012

From what seemed like a very low bar on expectations, last week’s summit headlines surprised modestly on the upside, even if the details remain far from clear – and implementation even murkier. Political talk of wanting to break the link between sovereign and banking risk was well-received by markets – but we remind all that talk-is-cheap with these Euro-pols. As Goldman noted this weekend, “we do not see the outcome as a game changer”, rather can-kicking until one of four possible endgames are realized. The absence of any explicit commitment to plans for fiscal or political integration; the lack of reference to any pan-European deposit insurance; and Ms. Merkel’s limited concessions (to ensure passage of the growth compact) to the terms on which the existing pool of EFSF/ESM resources are offered leaves the underlying issue – the terms on which mutualisation of financial risk is offered by Germany in return for mutualization of control over fiscal decisions throughout the Euro area – remaining inharmonious. German tactical concessions at the summit do not change their basic position on this issue: that discipline, reform and consolidation must be achieved and cemented first before mutualization of financial obligations is possible. Looking to the future Goldman sees four paths for the Euro are from here – and short-term too many crucial issues are left unresolved.

Huw Pill, Goldman Sachs: European Views

Looking to the future, we see four paths (albeit ones that are connected by cross streets) for the Euro area from here, around which scenarios for the market outlook can be developed:

• The Cultural Revolution. While unlikely, it is possible that European politicians recognize the error of their previous ways and collectively jump to a more constructive approach, exploiting the strengths of the consolidated Euro area in pursuit of a solution, rather than focusing on the weakness in individual countries that represent obstacles to one. In short, the European leadership could start to ‘think continental’ (to use a phrase originated by Alexander Hamilton in not dissimilar circumstances). In principle, this would offer a rapid and effective resolution of the crisis. But the likelihood of this outcome is low. The European authorities are inevitably in thrall to their national political constituencies (which, after all, elect them): thinking national rather than continental is the therefore the most likely result.
• The Long March. More realistically, one can characterize the June EU summit as another step forward in the long and slow process of necessary adjustment and governance reform in the Euro area, bringing national constituencies along in a step-by-step manner. Announcement of plans for banking union can be seen (for good reason) as part of the development of the new institutional architecture needed to make the Euro area workable. But however necessary, these measures are far from sufficient. Only over time will successive summits, each resulting in individually modest forward steps, lead to an accumulation of institutional advances sufficient to underpin the Euro adequately. The slow cumulative construction of a workable governance structure has been (and will remain) initially under-appreciated by the markets, but eventually be recognized, leading the market to support convergence rather than divergence across economies within the Euro area. Of course, aside from the politics of institutional reform, this ‘long march’ is likely to prove economically challenging: economic activity in the periphery will be hamstrung by the lack of a more comprehensive resolution, especially as the underlying necessary adjustments to competitiveness, external imbalances and public finances will proceed slowly, if at all, in this environment.
• The Great Leap Forward. We are skeptical that either financial markets or domestic political constituencies will have the patience for a ‘long march’ lasting as long as a decade (as Ms. Merkel has repeatedly predicted). More realistically, intensifying market pressure is likely to short-circuit this process, forcing Europe to an earlier decision point. For example, should Spain be denied market access and be forced into an explicit external financing program, additional fiscal demands will be placed on the rest of the Euro area, weakening the public finances of Italy and, via a domino effect, France and ultimately Germany. Relying on a slow, cumulative improvement in governance is inadequate in these circumstances. The ‘Big 4’ countries will quickly be presented with the question of whether or not they are prepared to take the steps necessary to underpin the Euro. Measures will need to be taken quickly and aggressively: acting outside the existing institutional framework will be required. Germany and France will have to decide to whether they are prepared to take substantial steps forward in economic and political integration in order to preserve the Euro. Muddling through will no longer suffice. In these circumstances, we think such a ‘great leap forward’ is the most likely response.
• Disintegration. That said, we cannot rule out the possibility that, faced with an ‘existential threat’, the political process does not allow such a ‘great leap forward’ to be taken. At that point, Monetary Union would become untenable—and a rapid and costly unraveling of the Euro area would result.

Using these four paths as a framework, we see the most likely scenario going forward as follows:

the European authorities continue their ongoing ‘long march’ of cumulative reform until, at some point—probably not imminently, but over the coming one to three years—market and/or political dynamics force the choice of whether to make a ‘great leap forward’ on the key Franco-German axis that has driven European integration since the 1950s.

Sketching this baseline scenario raises two questions:

• When will the Euro area switch from the slow, cumulative path of the ‘long march’ to confronting the pressing question of whether to take a ‘great leap forward’? We believe Euro area can continue on its current ‘long march’ for some time yet. The institutional machinery of monetary union—notably the balance sheet of the ECB and the ability of its TARGET2 balances to accommodate intra-Euro area cross-border stresses elastically—has proved remarkably robust to market pressure: by its nature, monetary union has greater resilience than the fixed exchange rate systems with which it is often compared. Moreover, for different reasons, the key players are not facing immediate pressures: ample liquidity in the Euro area is keeping French government bond yields at close to historical lows, while the German economy continues to show resilience at the lowest level of unemployment seen n for a generation. And procrastination is the path of least resistance for European politicians, lending inertia to the process. This makes a continuation of slow, incremental reform—rather than a comprehensive and rapid resolution of the crisis—more likely. But this approach does not come without its own costs. Macroeconomic performance in the periphery is set to deteriorate further in 2012H2, as market dislocation continues to weigh on credit creation and economic activity. And market participants are losing patience with the slow pace of adjustment: this adds to the tensions in financial markets.
• When facing the existential choice of whether to take the ‘great leap forward’, will France and Germany be prepared to do so? Yet ultimately we doubt that the ‘long march’ can be pursued to a conclusion. Other forces—such as a fiscal policy mis-step in France that undermines investor confidence or a populist political shock in the Italian elections—would force an ‘existential crisis’ for the Euro. At that point, we believe Germany and France will demonstrate the courage and commitment to move forward. Failing to do so in those circumstances would not merely imply acquiescence with the status quo, but rather a disintegration of the Europe built over the past 60 years, something neither country is likely to countenance. Yet making this step will not be without its own political challenges, especially in Germany where taxpayers are understandably reluctant to take on yet greater burdens that such a leap forward would imply.

Viewed in this light, the decisions taken at last week’s EU summit are best seen as part of the cumulative and incremental process of institutional reform inherent to the ‘long march’. While elements were surprisingly positive and important in themselves, in our view these decisions do not represent the ‘great leap forward’ required to resolve the crisis. They leave too many crucial issues—not least, the central question of how mutualization of financial risk and the debt overhang is traded off against loss of national fiscal sovereignty to German-inspired Euro area-wide fiscal and regulatory institutions—still unresolved.

Source: Goldman Sachs

Tags: Concessions, Constructive Approach, Cross Streets, Cultural Revolution, Deposit Insurance, Endgames, European Politicians, Explicit Commitment, Financial Obligations, Financial Risk, Four Paths, Goldman Sachs, Looking To The Future, Market Outlook, Ms Merkel, Pan European, Political Integration, Pols, Scenarios, Sovereign
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Rosenberg Defines European Insanity

Wednesday, June 13th, 2012

The situation in Europe goes from bad to worse. Gluskin Sheff’s David Rosenberg is back to his bearish roots as he remind us that ‘throwing more debt after bad debts ends up meaning more debt‘. As he notes, the definition of insanity is (via Bloomberg TV):

When you realize that of the potential $100 billion to spend, 22% of that has to be provided by Italy and their lending to Spain is at 3% but Italy has to borrow at 6%. They have to lend to Spain $22bn at 3% – it is just madness. Everybody is getting worried again. The solution that they seem to have come up with seems to be worse than the problem in the first place.

As we have pointed out vociferously over the past few days, even though the assistance is being earmarked for the banks, the Spanish government assumes the responsibility and so this once ‘low national debt’ sovereign is following in Ireland’s footsteps as its debt/GDP takes a 10pt jump to 89% (based on the government’s data) and much higher in reality (when guarantees and contingencies are accounted for). As Rosie explains succinctly, this is right at the Reinhart-Rogoff limit of 90% at which debt begins to erode the nation’s economic fabric.

It is probably not long before this credit – two notches away from junk and having to raise money at 6.75% when its economy is contracting at nearly a 2% annual rate – is going to require external assistance as it follows Ireland onto the sidelines.

The situation in Europe indeed goes from bad to worse.

Tags: Bad Debts, Contingencies, David Rosenberg, Definition Of Insanity, Economic Fabric, External Assistance, Few Days, Footsteps, GDP, Gluskin Sheff, Guarantees, Madness, National Debt, Notches, Roots, Rosie, S David, Sidelines, Sovereign, Spanish Government
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National Acronym Day in Europe. Don’t Underestimate the ECB

Wednesday, May 30th, 2012

National Acronym Day in Europe – Don’t Underestimate the ECB

by Peter Tchir, TF Market Advisors

May 29, 2012

So the EC wants the ECB to bypass the EFSF and use the ESM to recap EU banks? That was the rumor that shifted global stock markets by 1% in a matter of minutes?

It has been awhile see we looked at the EFSF Flowchart or had a detailed look at the EFSF Guidelines but it looks like it is time to dig a bit deeper into what is possible and what is not.

The ESM is not yet up and running. There was talk that it would be done by June or July of this year, but in typical EU fashion I don’t think much progress has been made towards that promise. So right now the EU is stuck with EFSF and the potential to set up the ESM.

The EFSF actually has a lot of powers. I’m not sure exactly why it is such a big deal if the EFSF (or ESM) invests directly in banks or lends money to countries to invest in banks. In theory the countries could lose on their bank investment but pay back EFSF loans? That is a possibility but it would seem more and more likely that if the bank rescues fail the sovereign is dead anyways, so the market might be reacting too much to that distinction.

The bigger problem is that the EFSF is not well set up to leverage itself. The EFSF is technically the entity that could be buying bonds in the secondary market. It is supposed to have taken over that role from the ECB, yet it hasn’t done that. Why not? It is possible that they haven’t figured out a good way to leverage the EFSF and therefore would get minimal bang for the euro by buying bonds in the secondary market without leverage. The same issues apply to its role in the primary markets. Yes, the EFSF can intervene in the primary markets, but again, had very convoluted leverage schemes, which would never work.

The problem isn’t so much what the EFSF is allowed to do, it is how constrained it is in terms of leverage and access to funding. There is almost nothing that can be done about how EFSF is set up at this stage, nor should there be. That messed up entity should be put out of its misery.

Europe’s big hope is to actually launch ESM and launch it with a banking license. If ESM can be launched, and it can get a banking license, then the EU has a powerful tool. The ESM is allowed to do all the things the EFSF can do – participate in new issues and the secondary market and lend to countries for them to support their banks. Without a banking license its firepower is limited. With a banking license it can leverage itself to a very high degree and can tap all the cheap funding already in place and whatever new programs the ECB decides to launch.

So worry less about any “new” powers the ESM might have and worry about 1) the ESM actually getting funded, and 2) the ESM getting a banking license. Germany was very resistant to the idea of the banking license. I assume they still are, but they have already given the ESM all the powers it needs, and has endorsed leveraging the capital, so a banking license might not be out of the realm of possibility.

With a banking license, the ECB can do a lot to help the ESM. The LTRO deals did a lot for the banks. They really have reduced the pressure on European banks. In spite of the fact that Bankia is a total mess, we are not reading headline after headline about how BBVA or SocGen or even DB are in trouble. The banking system is in much better shape than last year because of LTRO.

The market got carried away with the promise of LTRO as a sovereign debt savior. The market, more than the ECB, created the idea of banks buying lots of sovereign debt. That was never going to work because the banks that would do it, already had too much exposure to their national sovereign debt. It created a potential death spiral. Taking the concept of the “carry” trade and LTRO out of the banking system and into the ESM might have more of an impact.

The market has lots to worry about, whether it is China, Facebook, Banking Regulations, Fiscal Cliff, whether American Idol is rigged, economic data, etc., but we are still very much at the mercy of policy intervention. Strong signals of new QE for the U.S. seem more likely by the day, and in Europe, there is likely to continue to be a lot of contradictory comments, but banking license for the ESM seems more plausible than many of the other rumors (like Eurobonds or Greek Exit) and would be a powerful catalyst for a bounce in European equities.

The credit markets and CDS in particular seem tired. They don’t seem to have the energy to compete with the swings in equities. So far IG18 has traded in about a 1 bp range in spite of the gaps in equity futures. Even MAIN, right in the center of it all, has traded between 173 and 175.5. The high yield market, and HYG and HY18 both had big days yesterday, with cash up as much as 1%. We will likely see some give back there, but there really is no evidence that retail is giving up on high yield and there isn’t as much leverage in the market as there was in 2011 as hedge funds have been cautious and banks have cut their exposures.

Spanish and Italian bonds are definitely getting crushed today, but with Spanish 10 years above 6.5% and Italian 10 year bonds nearing 6%, the potential for intervention rises. The secondary market is affecting the primary market, which is driving up the cost of funds, creating more pressure on the budget deficits. The countries are painfully aware of that, as is the ECB. One ongoing frustration for the ECB is their inability to translate their short term rate setting of 1% into the sovereign debt market. They are looking for ways to ensure that policy can impact all sovereigns because without that occurring it makes their job far harder than the Fed’s where treasuries instantly respond to the Fed rate decisions.

Tags: Acronym, Banks, Buying Bonds, Countries, Distinction, Ec, ECB, Efsf, Esm, Euro, Europe, Fashion, Flowchart, Global Stock Markets, Invest, Loans, Matter Of Minutes, Primary Markets, Sovereign, Tf
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What Analysts are Saying About LTRO

Wednesday, December 21st, 2011

Below are select knee jerk responses by Wall Street analysts, which as warned repeatedly, are broadly skeptical for one simple reason: by delaying much needed ECB intervention, which is the only “bazooka” in this case, the solvency crisis in Europe’s financial core will continue to escalate until the next time around it will require far greater stop gap measures. Bottom line – this solves nothing.

RICHARD DRIVER, CAXTON FX ANALYST

“The big figure was welcomed initially but huge demand for ECB loans is not exactly a massive positive and really just reflects the huge squeeze European banks are feeling at present.

“Certainly this will help ease liquidity, as will last month’s coordinated central bank action on dollar swaps, but it also highlights the gravity of the situation in the eurozone – so don’t expect sustained euro gains.

“The market will once again be left to conclude that EU officials are addressing the symptoms but not the cause of the current debt crisis.”

CHRIS WHEELER, BANK ANALYST AT MEDIOBANCA IN LONDON:

“It’s helpful. It’s more than a sticking plaster, although it’s by no means the solution longer term. The solution to the sovereign is essential to deal with the solvency and liquidity issues around banks in the longer term.

“But the liquidity issues are the most pressing and that’s being addressed through this three year money. It shows people have taken on board the encouragement to get in early, to make sure they are well balanced and positioned to both refinance and to continue lending.

“It will not just be the weaker banks, it will be the stronger banks too. They are being encouraged to do it and there’s no stigma in doing so, so you can get the cheaper money and fill the gap.”

CHRISTIAN SCHULZ, SENIOR ECONOMIST AT BERENBERG BANK

“This is of course good news for euro zone banks. The number beats the previous record of 442 billion euros (the ECB allotted) in June 2009. It is highly unlikely now that banks in the euro zone will go bust because of liquidity shortage.

“This is an invitation to buy government bonds especially for smaller, unlisted banks, which do not take part in the EBA stress tests. For large banks, which are listed and which will have to face another EBA stress test next year, the motivation to buy government bonds is lower, because they fear that EBA will require more capital for bank holdings of peripheral debt and that will dilute existing equity.”

JONATHAN LOYNES, CHIEF EUROPEAN ECONOMIST, CAPITAL ECONOMICS

“The very heavy take-up of the ECB’s three year long-term refinancing operation (LTRO) provides some encouragement that banks’ liquidity needs are being amply met.

“But while this might help to address recent signs of renewed tensions in credit markets and support bank lending, we remain sceptical of the idea that the operation will ease the sovereign debt crisis too as banks use the funds to purchase large volumes of peripheral government bonds.”

MARTIN VAN VLIET, SENIOR ECONOMIST AT ING

“The take-up of loans is massive, and even higher than in the ECB’s first 12-month longer-term refinancing operation (LTRO) of June 2009, which attracted demand of 442 billion euros.

“However, the lower number of participating banks (523 versus 1121 previously) suggests that the take-up is currently less widespread – and probably more concentrated in banking systems in peripheral euro zone countries. We will be keeping a close eye on national central bank data over the next few weeks for further clues on which countries’ banking systems tapped the three-year facility.

“Today’s allotment of three-year loans is equivalent to almost one and a half times Spain and Italy’s combined sovereign bond issuance in 2012. However, we doubt whether the money will be used extensively to fund purchases of peripheral debt, given concerns about mark-to-market risks and possible reputation risks.”

ANNALISA PIAZZA, NEWEDGE STRATEGY

“The take-up was a massive 489 billion euros, much higher than the expected 300 billion euros. Liquidity on the banking system has now increased considerably.

“In a nutshell, the three-year auction can been considered as successful in terms of adding liquidity to the banking sector. We believe most of the take up has come from EMU periphery’s banks which have more problems with long-term fundings. However, given the large number of banks participating at today’s auctions, we cannot rule out some core countries’ banks have started to put on some carry positions.”

ALINE SCHUILING, ECONOMIST ABN AMRO

“The result was well above the consensus expectation of around EUR 300 billion.

“It could also allow banks to engage in a carry trade, in which they would use the ECB funds to purchase higher yielding government bonds.

“This seems to partly explain the unexpectedly strong demand for recent Spanish bond auctions, as well as the sharp decline in Italian and Spanish bond yields over the past few days. Looking forward, the next three-year LTRO will be allotted by the ECB on 29 February 2012. Since banks have high refinancing needs in the first quarter of next year, demand for this LTRO might be strong as well.”

JAMES NIXON, SOCIETE GENERALE

“This is good. It’s a positive number, at the top end of expectations. You have to regard it as a positive result. This is at least a solid 240 billion euros (net) increase for banks. But it is still short of covering all of the banks’ financing for next year. So, it could ease fears of a credit crunch somewhat.”

Source: Reuters

Tags: Bazooka, Chris Wheeler, Christian Schulz, Debt Crisis, Encouragement, Euro Zone, European Banks, Eurozone, Financial Core, Gravity Of The Situation, liquidity, Mediobanca, Solvency, Sovereign, Squeeze, Sticking Plaster, Stigma, Stop Gap, Swaps, Wall Street Analysts
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Details Of EFSF Emerge, However It Is “Too Little, Too Late”

Thursday, October 20th, 2011

Finally some details of the mythical revised and most certainly Dead on Arrival EFSF program, to be fully announced on Friday, emerge with Retuers bringing the scoop. Here are the preliminary bullets:

• EFSF to be able to grant two types of precautionary credit lines, normal and enhanced, based on IMF instruments.
• Typical size of both types of EFSF precautionary credit lines for Euro-zone sovereigns could be between 2 and 10 % of GDP according to a document
• To be eligible for EFSF precautionary credit lines Euro-zone sovereign must respect EU budget rules, have sustainable debt, external position, no bank solvency problem and seek to reduce macroeconomic imbalances according to a document
• Both types of EFSF precautionary credit lines would be for 1 year, renewable for 6 months twice
• IMF involvement in design and implementation of EFSF precautionary credit lines will be sought in all cases according to guidelines

Of course, if bullet point 3 is actually enforced, nobody would be eligible. Which means the whole framework is a joke. Yet nothing here changes the fact that with €100 billion set aside for bank recaps, a woefully low number and one which will do nothing to assure investors that banks have sufficient capital, there is still not enough cash to “guarantee” all future issuance, as was described in great detail previously. Lastly, it is too late to do much if anything except spike the EURUSD by a few hundreds pips for a day or two.

More from Reuters:

“The European Financial Stability Facility (EFSF) will be able to buy bonds at primary auctions at market price and, as a general rule, no more than half of the issue on offer, guidelines for the EFSF obtained by Reuters showed. The EFSF will be able to participate in auctions of those sovereigns who are either already under an emergency loan programme or have an EFSF precautionary credit line. Money invested in the bonds will be part of the overall existing programme or credit line. “As a common point, the intervention of EFSF would be at market price,” the guidelines, to be discussed on Friday by euro zone finance ministers, said. “As already expressed, it seems more adequate to consider that participation in primary market programme would take place only if a reasonable participation of private investors at a rate not excessively above the EFSF funding rate as the Reference Funding Rate is possible,” the document said. “The analysis whether a rate is excessive should be based on an assessment of the financing needs and gap of a country in the context of the overall monitoring, as well as an assessment of current market conditions,” it said.”

And, at the end of the day, it is all irrelevant – As the “experts” says, it is “now too little too late” per Reuters.

Exhausted by two years of crisis, Europe and its trading partners are hoping Chancellor Angela Merkel will ditch her customary caution and sign up to a “big bang” solution at Sunday’s EU summit — but she is unlikely to deliver.

The German leader, accused by her critics of worsening the euro zone’s debt debacle with her hesitant approach, has tried to dampen expectations of the meeting.

“Government debts were built up over decades and that’s why they won’t be removed in one summit,” she warned this week, saying the meeting would be just one of several important steps.

French President Nicolas Sarkozy, however, has heaped pressure on Merkel by declaring that Europe’s fate would be determined in the days to come.

Share markets and the euro fell on Thursday due to doubts about the leaders’ ability to come up with a comprehensive plan to solve the debt crisis at Sunday’s meeting, the latest in a series billed as crucial for the euro zone’s future.

“It is again the week of all weeks, the summit of all summits. It is again crunch time in Brussels on Sunday,” wrote Carsten Brzeski, senior economist at ING.

EU leaders are set to tackle three questions — bank recapitalisation, a bigger writedown of Greek debt and a possible leveraging of the European Financial Stability Facility (EFSF) bailout fund to boost its effectiveness.

France and Germany are at odds on how the fund could be leveraged.

Sarkozy’s tough words, however, are unlikely to outweigh domestic pressure on Merkel, leader of Europe’s biggest economy and the biggest contributor to the EFSF, not to sign a blank cheque for struggling euro zone members.

“I don’t think they can meet expectations. The summit will fall well, well short of the kind of big bang needed to reassure the markets,” said Simon Tilford, chief economist at the Centre for European Reform in London.

Tilford fears markets will react badly next week. “By the time the Germans finally budge, it’ll be too late,” he said.

Tags: Bonds, Budget Rules, Bullet Point, Bullets, Dead On Arrival, Efsf, Emergency Loan, Euro Zone, Eurusd, External Position, Financial Stability, GDP, Imf Involvement, Issuance, Reuters, Solvency Problem, Sovereign, Sovereigns, Spike, Sustainable Debt, Typical Size
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