After Wednesday’s bloodbath, yesterday was a little more positive, with the credible Mario Monti emerging as the likely replacement for Silvio. The mood was aided by a suggestion that fresh elections may not be necessary, and confirmation that Greece’s political leaders had finally agreed on a new leader (former ECB member Papademos). US initial claims data also provided a boost, down a further 10K at 390K in the latest week.
In response, risk appetite tentatively returned, with the Italian 10yr yield falling below 6.8% at one stage, after reaching 7.45% on the previous day. The single currency was in slightly better form, finding buyers below 1.35. In contrast, it was another worrying day for the French, with the 10yr yield up a staggering 30bp at one point, now 3.45%. In turn, the spread to Bunds exploded to 167bp, a euro-area record.
Not helping the situation in France was the erroneous announcement by S&P that it was lowering the country’s credit rating. Earlier in the day, another ratings firm, Egan-Jones Ratings Co., suggested that it may well lower France’s rating. Both Belgian and Austrian bonds also suffered yesterday on concern that their banks will be vulnerable to the sovereign debt crisis afflicting the single currency’s southern members.
Guest post by FxPro
The Austrian 10yr yield jumped 27bp to 3.34%, reaching a euro-area record wide to Bunds of 158bp. Back in the middle of this year, the spread was below 40bp at one point. Europe’s cancerous southern members are now rapidly infecting some of the core countries. Only some heavy-duty financial chemotherapy will prevent the cancer from spreading.
Commentary
Italy’s window of hope. The crux of the matter in Italy is the degree to which this is a fiscal or a political crisis. The question is valid because the fiscal and economic backdrop is different and in many ways not as extreme as for the recently bailed-out nations. At the same time, the politics of Italy is more fractured than for pretty much any other eurozone nation. The last point is illustrated by the fact that since the Republican Constitution of 1948, Italy has averaged nearly a government a year, which does not make for stable policy-making or allow the tough choices to be made that require time to reap rewards. Dealing with the economic/fiscal side first, there’s no doubt that current yield levels are at unsustainable levels. Back-of-the-envelope calculations show that Italy would need to run a primary budget surplus (i.e. excluding interest payments) of nearly 4% of GDP to stabilise interest payments. Yields need to be near to 5% (i.e. early Sept. levels) for Italy to breathe a little easier and within this, the curve needs to steepen, removing the punishing shift higher in short-dated paper seen in recent days. But growth is the other issue. It is true that Italy was not centre-stage during the credit boom, but equally, growth averaged only 1.5% between 1999 and 2007 and had been comfortably below 1% per year 1999 to date. At 120% of GDP, Italy’s government debt is potentially sustainable, but it needs some tough action, much of which should have been taken in the past ten years, but wasn’t. But can a fractured political system bring this about? The current moves towards a unity government, possibly under former EU commissioner Mario Monti, is the more likely way that this will be achieved. For Italy to call an election would cripple the finances, not least because there is over EUR 40bn of bond redemptions to be rolled-over in the first quarter of 2012 and austerity measures would grind to a halt. Furthermore, merely passing the austerity measures that proved to be Berlusconi’s undoing will not be enough. Any new administration will need to go further in implementing further spending reforms – including privatisations – and taking heed of IMF advice. This being the case, the ECB could well be convinced to buy Italian debt in greater volume than we have seen to date. Despite calls for the ECB to act as lender of last resort, this is just not going to happen (owing to legal, political and ideological barriers), so budgetary reform is currently the best hope for Italy to claw itself out of the current hole. Ireland is testament to the fact that it can be done, where yields have nearly halved over the past four months. The alternative will be some sort of fracture of the euro, given there is no viable hope of an EFSF rescue. Merkel and Sarkozy acknowledged this possibility in the heat of the Greek referendum debate early last week. So far, this is the more likely path than one of fiscal union in the true unfettered sense, which Germany and the ECB have shown no interest in undertaking.
The euro-split debate finally commences. Eventually, European leaders had to start to confront the inevitability that at least one of its members would be forced to leave the single currency. Over recent days, it is encouraging that some policy-makers are at least acknowledging such a development as a possibility, having denied it for so long. According to Handelsblatt, Angela Merkel’s CDU Party is expected to publish a paper imminently which examines the question of how members of the eurozone could leave in an orderly fashion. This paper may then permit the adoption of a motion at the CDU’s annual party congress next week which would make it possible for a country to depart the euro but remain within the EU. It is at least a start. Before Germany could support the possible departure of a eurozone member, it would require acceptance from the whole of Angela Merkel’s coalition, something which looks a formality. Afterwards, it would need the unanimous agreement of all members of the European Union to alter the treaty. Not permitted under current rules, both Angela Merkel and Nicolas Sarkozy implicitly accepted last week that Greece may be forced to leave the single currency. Yesterday, the latter even suggested that a ‘two-speed’ Europe could be a model for the future. Reuters claimed yesterday that discussions between Berlin and Paris had already commenced regarding a more tightly integrated euro-core group. Increasingly, European bond markets are making the same judgement. The ‘outs’ will likely consist of Greece, Portugal, Ireland, Italy and Spain, while the ‘ins’ would definitely be Germany, the Netherlands and Finland. France would be aghast at not being an automatic inclusion in this ‘in’ group, but the way their bond yields are headed, membership is definitely not guaranteed. Likewise, Belgium is also in danger of being cast adrift.
SNB – what are you waiting for? Repeated verbal warnings from various SNB officials over the past week regarding their undying determination to prevent further Swissie strength have been mildly effective, but need to be followed up with action soon or else the market will start to call their bluff. The case for lifting the EUR/CHF cap to at least 1.30 has strengthened significantly – the economy is being buffeted by headwinds blowing in from Europe, exports (which constitute one half of the economy) are also being adversely affected by the very strong currency, and now there is the very real danger of the economy sliding into deflation. The Swiss government is holding the blowtorch to the SNB, with the Economy Minister yesterday claiming that the currency was still “massively overvalued”. Retailers across Switzerland are slashing prices, both because demand is soft and because they can afford to do so. The clear deterioration in the Swiss economy begs the question – what is the SNB waiting for? It could be that it is in the midst of conducting its quarterly review (due to be released next month), and will be more decisive once that is released. As has been learned repeatedly during the euro-crisis, there is no mileage in waiting once the case for action becomes compelling. Companies in Switzerland are still screaming that the currency is killing them, resulting in a reduction in employment and active plans to move operations elsewhere. In the SNB’s defence, it may well be concerned that raising the ceiling at a time when Europe is melting down might not be successful. Safe-haven flows are still a very powerful force in foreign exchange markets right now, and this continues to make life extremely difficult for the SNB. Ultimately, however, it would be very surprising if the cap was not lifted to at least 1.30 within the next couple of months.
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