All or nothing in Europe

European leaders finally thrashed out a comprehensive crisis response Wednesday night which culminated in a communiqué released yesterday morning in Brussels. Italy has ‘committed’ to both fiscal consolidation and meaningful structural reform to achieve a balanced budget by 2013 and to introduce a balanced budget rule by mid-2012.

This will include wildly unpopular legislation to increase the retirement age to 67 from 65 by 2026. Greece will have a full-time on-the-ground monitoring team from the EU/IMF/ECB troika stationed in Athens “to advise and offer assistance” and “ensure the timely and full implementation of the reforms”. On Greek-debt haircuts, private bondholders have apparently agreed to a “voluntary” bond exchange equivalent to 50% to enable a reduction in government debt/GDP of 120% by 2020.

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Eurozone members have pledged an extra EUR 30bn.For the EFSF, there will be two complementary approaches, the provision of credit enhancement for new issuances by member states and also additional funding from private and public institutions and investors, probably into some form of SPV. According to Sarkozy, the uncommitted portion of the EFSF (around EUR 250bn) could be leveraged four or five times (offering insurance of either 20% or 25%) to boost the firepower of the EFSF to over EUR 1trln excluding any funds from ‘rich donors’.

Regarding recapitalisation, banks’ capital ratio is be raised to 9% by mid-2012 meaning that up to 70 banks may need collectively to raise EUR 106bn with governments to supply guarantees to prevent significant deleveraging.

Armageddon avoided, for now. It still contained numerous ‘blank spaces’, as George Osborne succinctly opined, but there was enough encouragement in the EU Summit statement to further mollify investors and traders who just a few weeks ago feared Armageddon. In particular, risk assets responded quite positively yesterday, with the CAC-40 and the DAX up 5%; the latter was up 23% from the mid-September low. High-beta currencies such as the Aussie have soared -up more than 13% in less than four weeks. Helping the high-beta currencies have been a stellar run in base metal prices – the copper price for instance is up nearly 15% in just a week. The single currency is at 1.42 – in early October, it was looking like death down at 1.32. Bond yields for troubled sovereigns have plunged – the spread between 10yr Italian BTPs and German bunds has narrowed by more than 20bp, while the FR/GER 10yr spread has tightened significantly. For the dollar, which attracted so much buying interest last month from those eager to escape the euro, some further selling has been witnessed as those short of the single currency have been forced to cover. As we have remarked on numerous occasions recently, the short base in the euro amongst both traders and investors was extreme in the first half of this month, and so there was huge potential for at least a short-covering rally as long as European officials showed willing. This observation (an excessive short base) applied equally to equities, high-beta currencies and peripheral European sovereign bonds. It is entirely plausible that as traders square their books ahead of calendar year-end, we could see further short-covering of risk assets and the euro in the near term.

Are the storm clouds clearing in the US as well? Europe’s creditable crisis response has almost been matched by an encouraging report out of the US suggesting that the worst may be behind it, at least in the short term. Two months back, there was heightened anxiety that America’s economy was lurching back into recession, not helped of course by the uncertainty generated by Europe’s problems. However, the provisional estimate of third quarter GDP growth of 2.5% was comfortably above the 1.3% recorded in Q2 and the 0.4% increase of Q1. Also, the consumer was on reasonable form and business investment continues to do very well. Separately, continuing claims for unemployment benefits dropped almost 100K in the week ended October 15th, a three-year low. As always, there are important caveats with all good news stories. For instance, in the most recent quarter, real disposable income dropped by 1.7% at a seasonally adjusted annual rate, which resulted in a slump in the saving rate to just 4.1%. Also, the decline in continuing claims is likely, in part, to reflect a tightening of eligibility criteria. At times like these, it is hard to know if the glass is half-empty or half-full.

UK manufacturing pessimism deepens. Not one or two but three MPC members have offered a very downbeat assessment of UK economic prospects in recent days. Adam Posen, the most dovish member of the policy-making committee, stated on Thursday that the economy is “cratering” and that growth this year will be little more than 0.5%. Martin Weale claimed earlier this week that he would not be surprised if growth this quarter was negative. And to top off the negativity, Paul Fisher suggested that the GBP 75bn of asset purchases undertaken by the BOE earlier this month was the minimum required and that the economy may already be shrinking. His remarks imply that he could be convinced to undertake further asset purchases. There can be little to disagree with here – the UK economy is like a bird without wings right now. .

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