All bear and no bull

The single currency has not yet reached its final destination, but very soon it will come into view. European finance ministers meeting in Brussels today must know that unless they can convince trader and investors that they have found real solutions to the crisis, then the euro project’s days are numbered. Europe’s bond markets have ceased to function – liquidity is dreadful, even in Bunds, bid/ask spreads are therefore incredibly wide, volume is dire, and sellers are surreptitiously piling up.

European bank funding is equally problematic and dysfunctional, throwing a cannonball into solvency and severely inflaming Europe’s already horrendous credit crunch. Investors are gradually abandoning Europe, while depositors are trying to get their money out. Trust in Europe is evaporating. Basically, something will give, and fast! However, trying to forecast how events will unfold is almost impossible. Although coming up with a comprehensive solution seems to be beyond the wit of Europe’s sclerotic leaders, there are still three major global actors (the IMF, the US and China) who could yet ride to the rescue and are probably already considering their options.

At times like these, with investors convinced the end of the world is nigh, it is dangerous to underestimate the ability of international leaders to come together. Witness yesterday’s extraordinary jump in European equities, on a day of very little concrete news. The problem for the bears is that there are plenty of them with their territory already marked out, while there are basically no bulls. It is just possibly a huge bear trap.

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Accounting for yesterday’s improved tone. Late in Monday’s morning session risk assets soared with Europe’s major bourses up variously between 2% and 4% and the single currency threatening 1.34 after falling below 1.3250 briefly overnight. Accounting for such a flurry in risk appetite after Friday’s doom and gloom is an important exercise, if only because there was remarkably little comment on it from those who believe that Armageddon is about to descend on Europe’s main currency. One of the explanations is that the IMF is clearly very heavily involved in negotiations with European leaders over how it can assist. The suggestion from an Italian newspaper that the IMF is considering a EUR 600bn financial assistance package for Italy might be a little far-fetched, but clearly Rome is in very close dialogue with the IMF. Separately, China and some other members from the developing world appear to back increased contributions, although their preference is that it is not specifically earmarked for Europe. Second, Berlin is pushing hard for accelerated acceptance of EU treaty changes in order to enforce eurozone fiscal probity and sanctions in what could justifiably be regarded as a fiscal union on Germany’s terms. Thirdly, Germany is apparently considering the issue of joint bonds with other AAA-rated sovereigns, according to a major German newspaper.
Finally, the jump in risk assets almost certainly reflects accelerated short-covering ahead of both month-end and financial year-end for some major US banks. Short positions in the likes of the euro and European stocks became extreme last week, and the surge yesterday suggests numerous buy stops were triggered on the way up in what was otherwise light volume. This type of price action – aggressive short-covering a day or so before a pivotal eurozone meeting – is becoming common-place these days. The key, however, is whether the markets can sustain these gains over the whole of the week. If they do, then that would be even more impressive.

The UK Chancellor’s different approach. The UK Chancellor will today present his autumn statement. What’s getting more attention in the run-up to what often ends up being a mini-budget are the Chancellor’s plans for both channelling more loans for small business and also gaining more support for infra-structure projects from overseas investors. The latest borrowing figures, released last week showed net investment down 40% vs. the same period last year. Naturally, this has helped counteract the increase in upward forces on borrowing from slower than expected growth and, at present, the Chancellor is on course to meet his borrowing projections for the current financial year. However, the fall in investment leaves a hole in infrastructure-spending that could impose a rising burden for future generations.  The advantage of the Chancellor’s intended approach is that investors may be enticed to invest in longer-term projects. Some would say that, with the government able to borrow at just over 2% for ten years, it should be the one investing at this point in time, content that the returns would be more than ample. But the Chancellor’s planned approach recognises that investors are becoming far more circumspect regarding government borrowing, and yields of just over 2% should not be used as a smoke-screen for it not facing up to this. There were positive noises from China on possible investments, in contrast to the reservations that many emerging nations – not just China – are having in investing in the eurozone. It also contrasts with the US, where low yields are one explanation for the complacency and in-fighting over longer-term budgetary reform.

German contingency planning. No doubt the German government is drawing up contingency plans amidst the alarmingly rapid deterioration in eurozone financial affairs over the last few weeks. The German Chancellor has firmly rejected Eurobonds (for the time being), she is dead against ECB money-printing and only accepted the expansion of the EFSF’s fire-power under strict conditions. What Angela Merkel has fully endorsed is proposals to strengthen fiscal probity within the eurozone – which will force all members to submit draft budgets to the EU before they are discussed in the local parliament – and empower the European Court of Justice to impose fines/sanctions on fiscal miscreants. This then is eurozone fiscal union, German-style. Interestingly, German newspaper Die Welt published a story yesterday claiming that Germany was looking into the issuance of so-called ‘elite’ bonds. Under this proposal, Europe’s top six sovereign credits (Germany, France, Finland, the Netherlands, Luxembourg and Austria) would jointly issue bonds to fund their own debts, but also potentially to provide financial aid to the likes of Spain and Italy. An intriguing proposition, although how much traction it gets remains to be seen. Given the deterioration in the financial standing of both France and Austria recently, a situation which is only likely to worsen over time, Germany may find that it is forced to narrow the list participants if this idea ever gets off the ground. That said it could be a baby-step on the road to Eurobonds.

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