The Changing Winds

Policy makers are taking new measures to address the financial and economic crisis.  The ECB's OMT, the Federal Reserve QE3+ and the BOJ's increase in its asset purchase program is the monetary response.  To this we expect to be added a new round of gilt purchases by the Bank of England.  Australia and Sweden, which have room to cut interest rates have recently done so and are expected to do so again in the coming weeks.  The Bank of Canada signaled a shift back to a more neutral stance that will formally be announced next week.  

These monetary measures are being complimented by new fiscal measures.  Merkel has expressed some sympathy for tax cuts in Germany.  Italy surprised many with a 1 percentage point cut in the tax rate for the lowest brackets (and raising the VAT next year by 1 percentage point rather than by 2).  Japan's Noda has indicated support for new stimulus spending.  Press reports suggest Noda wants to draw on some JPY900 bln set aside in the current budget to support the economy, which his government has downgraded for three consecutive months. Government spending is also supporting the Chinese economy.

At the same time, there has been a complimentary shift in the way European officials are conceptualizing the challenges.  One of the most important shifts has been regarding a Greek exit.  Six months ago, officials were still openly suggesting it as a possibility.  Not only has this talk been largely (even if not completely) extinguished, but the IMF appears to be endorsing giving Greece more time.  Can the Troika's report, now likely next month, or the finance ministers refuse to make a new tranche payment when the managing director of the IMF has affirmed that Greece has a reliable government committed to stability and growth?  This may have emboldened the junior coalition partners in the Greek government to reject new labor market reform demands from the Troika.  

In any event, the fact the ECB and ECM's support was cited by Moody's for affirming Spain's sovereign rating at the lowest of investment grades.  The risk of a Moody's downgrade to junk has hung over the markets in recent weeks and may help explain the under-performance of Spanish debt (relative to Italy).  Moody's also cited Spain's commitment to fiscal and structural reforms and the restructuring of its banking sector.  It maintained a negative outlook, given the grave challenges that still lie ahead.    

Last week S&P adjusted its rating for Spain last week, bringing it also to the lowest investment grade status, and maintained a negative outlook. In follow-up moves it has cut the rating of Spanish banks, including the two largest.  Fitch appears to be the one out of step now and is one notch above Moody's and S&P. 

Meanwhile, speculation continues that Spain is on the verge of asking for additional assistance on top of the 100 bln euros that has already been earmarked for it.   Many have thought that the large redemptions at the end of the month would force its hand, but our understanding is that the government has ample cash on hand to cover the maturing bonds.  Some apparently had thought that the recent Eurogroup meeting of finance ministers would be the forum for the formal request.  

Now the focus is shifting to the EU summit that begins tomorrow.  We remain skeptical.  Spain appears to have indicated two conditions for a formal request and neither are being satisfied.  First, there needs to be a consensus of support among the euro area governments.   Since Spain is able to fund itself in the capital markets and interest rates have fallen considerably, some countries do not see the need for more aid.  On the other than, Italy and France appear to want Spain to request aid, partly in the hope that it would help further stabilize the markets.  

Second, Spain wants more details on the conditions that will be required and what the ECB will actually do. The Rajoy government seems to think that it should have access to funds without conditions.  At the same time, in order to enhance the likelihood of success, the ECB needs to maintain a degree of strategic ambiguity, which means not telegraphing precise targets, levels, amounts and timing.