Yesterday’s bond auctions might have gone well enough, but unfortunately other issues are brewing in Europe and moreover they are getting progressively worse. In Italy, as the economy reverses more rapidly than expected, the fiscal dynamics look increasingly problematic.
Unsurprisingly, the IT/GER 10yr spread widened another 15bp to almost 400bp. Spain is in the doghouse as well, for similar reasons, with the 10yr yield not far short of 6.0% again. Also worth noting is the continued underperformance in France – the 10yr FR/GER yield spread was 15bp wider at 140bp at one point, compared with 100bp just a month back. Video:
Part of the explanation lies in the increasing likelihood that François Hollande will become France’s next President. Hollande has been threatening to renegotiate the fiscal compact if elected (little wonder Merkel wanted to campaign for Sarkozy), and he has vowed to raise the minimum wage; he also wants the ECB to be more active in resolving Europe’s sovereign debt crisis.
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Not to be outdone, New Democracy Party leader Samaras has pledged to push back implementation of the Greek bank recapitalisation plan until at least after the election. Just as well some of Europe’s finance ministers are gathered together in Washington – they might as well start discussing how to deal with Europe’s next financial tsunami. As the IMF’s latest Global Financial Stability Report made clear, European faces a huge credit crunch over the next 18 months as banks shed USD 2.6trln of assets. Strap yourself in, there is worse to come!
Commentary
Monti’s huge fiscal challenge. Quite apart from the extraordinary opposition Italian Prime Minister Mario Monti faces gaining acceptance for his labour market reforms, it is becoming rapidly apparent that he will soon face fresh challenges on the fiscal front as well. On Tuesday, the Italian government lifted its deficit/GDP target for 2012 just slightly, to 1.7% from 1.6% previously. Also, the debt/GDP target for 2012 was raised to 123.4%, from 119.5%. These new projections from Monti’s government reflect the worse than expected deficit outcome for the March quarter. Indeed, looking at these figures more closely, achieving the new (higher) deficit targets this year will be a huge challenge. The major reason for the fiscal slippage is that the economy is not even doing as well as previously forecast. Industrial orders for the year ended February collapsed by more than 13% whilst construction spending plunged by 20% over the same period. Italy’s government expects the economy to contract by 1.2% this year, more than twice its previous estimate. Unemployment is heading inexorably higher, with the IMF expecting that it could reach 9.9% this year. Back in June 2011 the figure was 8.2%. Yesterday, Monti confessed that achievement of a balanced budget would need to be pushed back by a year to 2014. Later on the IMF suggested that even this was too optimistic – it expects Italy may take another five years to balance its budget. As such, there is plenty of potential for bond investors to become concerned about the state of Italy’s finances over coming months.
Brazilian real carried out. The surprise yesterday was not that Brazil had cut its key rate, by a further 75bp to 9.00%, but that the central bank was seemingly so dovish regarding the outlook. It noted that risks to the inflation trajectory remained limited and that, on the basis of the fragile global economy, “the contribution of the external sector has been disinflationary”. This perceived dovishness was the main factor pressuring the real weaker, USD/BRL pushing the highs of the year at 1.8839. This represents a near 10% depreciation for the real since the end of February. More significantly, on a total return basis, the returns from investing in the real (funding from dollars) are now also negative, year to date. Inflation remains high in Brazil but the issue is the softer economy, with growth having stalled significantly in the second half of last year. But what’s interesting is fitting this into the wider context of carry currencies. Carry strategies worked well during the first two months of the year but started to turn before the change in risk appetite seen in equities and credit markets. Furthermore, this followed on from what was a very frustrating second half of 2011 for carry-based strategies, which overall (taking a broad basket of high-yielders) produced negative results. If the message from the Brazilian central bank is to be believed, then this frustrating trend for carry trades could continue for some time to come, especially with the Australian central bank also likely to cut rates next month. From the other side, the prospect of further QE from the US has also diminished, but this seems to be a secondary consideration to the less rosy developments in high-yielding currencies.
Lagarde rejoices at IMF largesse. Ahead of the G20 meeting of finance ministers and the spring semi-annual session of the IMF on Saturday, IMF Managing Director Lagarde was rejoicing yesterday at the extra USD 320bn of pledges she had received to fill the Fund’s coffers. Europe has already claimed it will provide an additional USD 200bn, Japan announced earlier this week that it was good for another USD 60bn, Switzerland has vowed to throw in ‘a substantial amount’ and Poland has committed to USD 8bn. The Scandi countries have also been generous – Sweden will put in USD 10bn, Denmark USD 7bn and Norway USD 9.3bn. Critically, neither the United States nor Canada has agreed to contribute extra funds – both believe that Europe could and should do more to shore up its own financial firewall. Against the backdrop of the IMF’s dire warning for European bank-deleveraging contained in its latest Global Financial Stability Report, clearly Lagarde recognises the urgency of stockpiling as much financial resources as possible should there be another damaging bout of contagion emanating from Europe.
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