The Long and Short of It

The most important take away from this week's developments is that there will be no European joint bond and no substantial change in the ECB's sovereign bond purchase program AND that the euro and monetary union will survive.

The ECB opened the liquidity spigots in a significant way, with the unexpected reserve cut alone worth an estimated 100 bln euros, three year facility, liberalized collateral rules. This is on top of a 25 bp rate cut that brings the key rate to its record low of 1% and the dollar auction that provided a bit more than $50 bln.

This has been followed by new agreements that will enhance fiscal coordination and tighten the fiscal discipline. Make no mistake this is well shy of a fiscal union and more summits will ultimately be necessary. However, as we have argued, Europe is building the scaffolding of a closer fiscal union that will treat, even if not cure, the birth defect of EMU (monetary union without fiscal union).

Cognizant that is an oversimplification to think of a scorecard between France and Germany, it may be helpful to gauge the outcome. In general, it looks like Merkel, the persistent and determined German Chancellor got most of what she was seeking, including new unanticipated agreement that structural deficits should be kept to less than 0.5% of GDP. Once adopted, countries must need "automatic" measures to address overshoots and Merkel secured recourse to the European Court of Justice.

She also secured an agreement of automatic penalties for violations of the 3% deficit/GDP cap, but also Members also agreed to enshrine austerity into the national law.  Merkel also succeeded in preventing the ESM from getting a banking license which would allow it to borrow from the ECB (in theory).

A concession to France was on the private sector participation in future sovereign restructurings. France and several other countries wanted to eliminate the clauses that allow for private sector participation. Germany had been insisting that there is "burden sharing". The compromise is to rely on IMF rules for this which are more on a case-by-case basis. Thus it is not so much a German capitulation as an agreement to delay the debate until the relevant, i.e., when faced with a (next) sovereign restructuring.

Germany also appears to have succeeded in protecting the ECB's independence. There is not the overt pressure that existed previously and reports suggest there was no talk about the central bank at the summit, except that it would help execute the EFSF/ESM operations. The 17 euro zone central banks will loan 150 bln euros to the IMF and the other EU countries are expected to loan 50 bln euros. These funds are reportedly going to the IMF's general resources. They will be available should a euro zone country ask, but as of now neither Italy nor Spain appear to be on the verge of requesting assistance. It is not clear how the 150 bln euro loan will be funded among the euro zone members.

It is difficult to imagine the Greece, Portugal or Ireland contributing, for example. It is hoped that other countries, like China, Brazil and Russia, will also boost contributions/loans to the IMF.

Although our understanding is that many sovereign bonds already have collective action clauses (CAC), the summit appears to have agreed to harmonize the details and extend their use. This may help in governance and restructuring issues going forward. It also appears that the CACs will be embedded in the new intergovernmental treaty. The intergovernmental treaty also appears to be a victory for Merkel as she had wanted to give the agreement greater heft than an executive agreement.

Many investors will be disappointed insofar as the measures are not the "bazooka" that many wanted. However, the European treaties and the constitutions (e.g. Germany) are designed in such a way to prevent bold action. Yet there are important steps taken that will cede more fiscal sovereignty that has been ceded previously. This is an important accomplishment.

The ECB's liquidity provisions will help European banks. There is still much work that needs to be done, in terms of strengthening balance sheets, raising capital and next year's large refunding needs. The steps toward fiscal union are important as well and over time, more progress in this direction is necessary. It is the beginning of a process not the end of it.

At the same time, it does not change our view of the euro's outlook. Our stance is bearish the euro on macro fundamental grounds, but believe that EMU more than survives. Eventually it will emerge stronger than when the crisis began.

Lost in part because the urgency of the European developments, the US has put together a string of good economic reports, including employment, retail sales and manufacturing. Yesterday's report showed the lowest weekly initial jobless claims since March. Continuing claims fell to their lowest level since late 2008. Q3 GDP may be revised lower next week when the final estimate is made, but Q4 GDP appears to be tracking closer to 3%. The Fed may tweak its communication substantively and stylistically, but the monetary policy proper is on hold. Much of the rest of the world is easing.

China recently cut reserve requirements and further easing is anticipated. Brazil cut recently and will do more in the coming months. Australia cut rates and may cuts rates again early next year. The market is positioned for a Swedish and Norwegian rate cut next week. The ECB delivered the much anticipated 25 bp rate cut and we look for one or two more cuts in H1 2012. We expect the UK to extend its asset purchase program in February. There is also some risk that the BOJ also extends its asset purchase program.