A Few Observations about Europe on Hump Day

Two main forces seem to be at work in the global capital markets.  The first is the month-end and quarter-end portfolio adjustments.  The second is a new deterioration of the situation in Europe, led by Spain and Greece.  These forces are combining and weighing on risk-assets in general and European peripheral bonds in paticular.

This is not to minimize the lack of confidence in the effectiveness of the Federal Reserve's new QE program, but as we saw after the November 2010 announcement of QE2, and has been experienced in other countries pursuing quantitative easing, the negative implication for the local currency can be overshadowed by other considerations.

The situation in Europe is deteriorating to such a point that even the Financial Times' Martin Wolf re-examines the case for a German exit, which he, like ourselves, does not place high odds on.  Nevertheless, in our conversations with asset managers, hedge funds and policy makers, this scenario seems to have, can we say, gained currency, since the Bundesbank was outvoted at the ECB on Draghi's plan (OMT).  Trichet's SMP program triggered the resignation of the two German representatives on the ECB.  Draghi's plan split the German vote at the ECB, but there is a sense that the largest country and most important country financially cannot be consistently out-voted and its interests overridden.  

Today, however, it is Spain and Greece gripping the market.  The latter has its first general strike today since February.  The government coalition has yet to agree on the roughly 11.5 bln euros, which are still not seen to be sufficient, as the IMF's Lagarde has acknowledged a larger financing gap.  

Spain appears to be coming apart at the seems.  Bad loans are rising.  The government's revenues are weaker than expected and expenditures larger.  The largest region has called for an election at the end of November that ostensibly will be seen as a referendum on seeking sovereignty.  

And this week's big events still lie ahead.  There include, a package of structural reforms that is designed to anticipate the conditionality that may be demanded should when it seeks assistance, the results of the bottom-up bank audit, and possibly a resolution to Moody's review of Spain's credit worthiness.  Spain's (generic) 10-year yield is poking back above 6% for the first time since early this month.  

Three of the FANG (Finland, Austria, Netherlands and Germany) creditor countries met yesterday (not Austria) and seemed to close potential loopholes that the debtors were looking to exploit. Most importantly, they claimed that the moving of bad bank assets from sovereign's responsibility to the ESM cannot apply to legacy assets and even then cannot be done until a single bank supervisor is up and running and effectively so.   Most immediately, this would have implications for that 100 bln euro bank backstop that Spain has been granted. 

The ECB's OMT scheme is offering only modest support to the short-end of the peripheral curve as quarter-end adjustments and the souring of sentiment take their toll.  In Spain, at pixel time, benchmark 2-year yields are up 20 bp, while the 10-year is up 25 bp.  In Italy, the 10-year yield is up a more modest 7 bp, but the 2-year yield is up 12 bp.  Portugal, which is thought to be a candidate for OMT,  has seen its 10-year yield rise 11 bp, but its 2-year yield is down 2 bp.  

There are still many observers who think Spain may formally request assistance by the end of the week.  We remain skeptical and still think a more likely time frame is next month if not November for largely political considerations.  However, when that request comes, we are concerned that attention turns to Italy.   While under Monti, Italy has taken a number of important steps, many are concerned that his program has been diluted and are even more concerned about the post-Monti era which is likely to begin by the middle of next year.  

At that point, we think France's membership in the core may also come under greater scrutiny.  Both Italy and France are continuing to see their unit labor costs rise, meaning a continued loss of competitiveness.  France's Hollande, elected, at least in part on an anti-austerity platform will be delivering the 2013 budget, which needs to show a 3% deficit rather than the 4.5% target this year (which it is likely to overshoot).   The public sector reforms in the periphery appear to be the key to the drop in their unit labor costs.  France has not even begun this process.  If it is really to offer a balance to Germany, it needs to get its own fiscal and economic house in order.