More On Spain, Swtizerland, UK, and Fallacy of Composition

Once the Spanish bond auction event risk passed, the euro’s recovery was extended. While Spain was able to place its paper, it came at a price and that is higher yields. The 10-year bond sale produced a bid-cover of 1.88 (vs 2.03 last time), while the yield rose to 4.84% from 4.04%. The 30-year bond had a better bid cover (2.44 vs 1.4 last) but the yield rose to 5.91% from 4.76%.

Nevertheless, the auction illustrates that the Spanish government has not been frozen out of the capital markets and its yields, even with the recent rise, are well below Greece. While the EU finance ministers meeting, beginning today, will no doubt discuss the situation, the recent slew of reports suggesting that Spain needed financial assistance, are likely wide of the mark. Meanwhile, Spain is insisting on publishing the results of the stress test on its banks and reports suggest it is prepared to release results on an individual bank basis. There had been some objection, especially from Germany on grounds that it posed unnecessary risks, but it looks like Spain’s position will carry the day. Recall that the results of the US bank stress test, despite the criticisms at the time, corresponded to a bottoming of that sector and also led to some banks raising more capital.

There seems to be nearly universal opinion that Europe needs to regain control of fiscal policy. However, slowly there seems to be a recognition of the cost of austerity in terms of the growth impact on fragile economies. This seems to be the essence of the op-ed signed by 100 Italian economists in Il Sole today as well as an op-ed in the UK Telegraph.

The austerity drive may be guilty of the fallacy of composition—which happens when what is good a part is interpolated to the whole. For example, an export oriented approach may work for a country, or even some countries, but cannot be adopted by all countries. Fiscal tightening by some countries is one thing, but when all EU members pursue the same strategy at the same time, may have much different economic consequences. The German model is not simply based on austere fiscal policy but also on exporting to other countries that traditionally have budget deficits and current account deficit. The EU finance ministers meet today and tomorrow ahead of the G20 meeting at the end of the month. While there are competing or at least parallel EU institutions, note that EU presidency will rotate from Spain to Belgium. Following the recent election, Belgium has a caretaker government, which could last for several months.

The Swiss National Bank did not alter its policy rate (0.25% 3-month LIBOR), but it did raise its growth and inflation forecasts and this was understood as a clear indication that the heavy intervention seen last month is unlikely to persist. And this in turn was seen as a greenlight to buy Swiss francs. Growth was revised to 2.0% from 1.5%. This puts its above the government’s forecast of 1.8%. Inflation was forecast to rise 0.9% this year, up from the previous forecast of 0.7%. Next year CPI is forecast to rise to 1.2% and than 2.2% in 2012.

The SNB implicitly and explicitly indicated that deflation risks had eased and this was the justification for the QE that included the SNB’s sales of francs. The euro, which flirted with the CHF1.40 level two days ago fell to CHF1.3760 today, spitting distance of the record low set on 9 June near CHF1.3735. It is hard to talk about support in unchartered territory, but the CHF1.35 area represents a reasonable objective.

UK retail sales surprised on the upside. The 0.6% increase contrasts with consensus expectations of a 0.1-0.2% increase, and was only partly blunted by the downward revision to the April series to flat from 0.3%.

However, sterling benefited from the general heavier US dollar tone even in the fact of a disappointing June CBI manufacturing trends survey. Late yesterday BOE’s King stuck with his assessment that recent price pressures are temporary in nature, strongly suggesting resistance to tighter monetary policy.