A dim light at the end of the tunnel

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The sense pervading from yesterday’s meeting of eurozone finance ministers was that Europe has reached the limits of what it believes it is capable of doing to fight the sovereign crisis.  After weeks of negotiations, leaders have failed to set a target for the firepower of the EFSF (it will be “very substantial”), whilst there was a call for closer cooperation with the IMF and for the IMF to increase its lending capacity to cope.  The focus now turns to the EU meeting on December 9th where there may be more clarity. 

The opening of European markets is seeing some disappointment being reflected in overall risk appetite and also the euro as once again markets are left with the taste of half-measures and a fear of making the necessary decisions to start building a ring-fence around the fragile eurozone periphery.

Guest post by FxPro

Commentary
The UK economic reality. The UK Chancellor used his autumn statement to catch up with the economic reality. On Monday, we had a taste of this from the OECD.  Yesterday the independent Office for Budget Responsibility (OBR) did the same, putting growth at 0.7% for 2012 as a whole, a touch higher than the OECD’s forecast of 0.5%.  That said, the Chancellor is remaining (relatively) bullish on the borrowing outlook, seeing the structural deficit eliminated within 5 years and debt/GDP ratio falling by the end of the current parliament in 2015.  These expectations are perhaps a little more ambitious than was anticipated, but his predecessor also had a habit of being overly bullish on the fiscal side.  It seems to be in the DNA of Chancellors.  Whether this ends up being true mostly depends on the path of the economy, the forecasting of which he has outsourced to the OBR.  It remains hopeful that the economy will bounce back in 2013, growing by 2.1%.  In other words, the belief remains that the slowdown will be relatively modest.  But the growing fear is that the UK and others could be in for several years of subdued growth, constrained by continued high levels of debt.  Don’t forget that the UK remains one of the most indebted nations worldwide, taking household, corporate and government debt as a proportion of GDP. The banking sector and reliance on the financial sector plays a large part in this.  For all the headline measures and other initiatives, it’s the ability of the country to overcome the impact of such a debt burden where the fate of the economy and hence government borrowing lies.

The growing ECB bond-buying imbalance.  It was perhaps not wholly surprising to see the ECB fail to fully sterilise its bond purchases yesterday.  Indeed, we wrote about the risk ahead of the event, although not fully expecting it to come this week.  The reasons for it this time around appear to be three-fold.  Firstly, the amount outstanding is nearly three times that of this time last year. Secondly, the difference between the average rate in the 7-day sterilisation tenders and the rate at which deposits at the ECB are remunerated has narrowed and is currently only 10bp. The average has been 38bp this year, so there’s been a decent incentive to tie-up surplus cash and earn a few basis-points.  Finally, stresses in money markets are clearly higher and especially in cross-currency swaps. This is also likely to increase liquidity preference over the year-end. As yet, there’s probably no need to panic. It’s more likely to prove to a bump in the road, but if the ECB’s bond-buying program continues to expand (as is likely), then there could be a more permanent imbalance, as the amount to be sterilised increases and bank balance sheets decrease. This would amount to QE by accident, rather than design or intent.

Extraordinary times. On a critical day for Europe which included an Ecofin meeting in Brussels and the UK Chancellor’s Autumn Statement, it was yet another extraordinary day of price action. In Portugal, the 10yr yield reached a record euro-era high of 13.46%; in Italy, yields jumped right across the curve as the market continued to worry about the lack of fiscal urgency being displayed by Mario Monti; in the UK, real yields on linkers traded at negative yields right along the curve and the Journal of Commerce Index of Industrial Materials Prices fell another 1%, a loss of 21% over the past seven months. For its part, the single currency is remarkably resilient, despite increasing concerns amongst some commentators that the patient has only days to live. Yesterday, the currency popped higher after a reasonably successful Italian bond auction. There is growing evidence that retail depositors in banks in the likes of Greece, Italy and Portugal are rushing to get their money out but even though they are, not a lot of it is actually leaving the eurozone. Separately, retail spending plummeted in Italy and France this month, while in Spain retail sales dropped by 7% in the year ended October. There can surely be little doubt now that most of Europe is in the grip of recession.

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