Weekend Developments: Signal and Noise

The weekend has produced five talking points. The leaked French Socialist draft document that was critical of Germany (and the UK) and the Bundesbank's letter to the German Constitutional Court objecting to the ECB's Outright Market Transactions do not really reveal anything new and we do not expect them to influence trading in the new week.

The Iceland election and the formation of a new Italian government are important. An Austrian weekly is claiming that national central bank estimates that to wind down a nationalized bank by the end of this year as the EU is demanding would cost the government 14 bln euros or ~4.5% of GDP. We recognize this as potentially important, but not immediately a market factor.

That in private moments the French Socialists are critical of Germany and Merkel is a dog bites man story, even if the Financial Times thought it worthy of front page coverage over the weekend.   The tensions between the French Socialists and the conservatives are not new or unilateral.  No where in the FT's coverage, for example, is one reminded that Merkel campaigned, as much as a German Chancellor could, for Hollande's rival, Sarkozy.  Nor is there any reference to the recent German criticism of the weakness of the French government, with claims among other things that French finance minister had to be woken at a recent crisis gathering.

The fact of the matter is that Germany is acting like a creditor and France is acting like a debtor.  When the situation was reverse, France acted like a creditor and Germany a debtor.  It was France that Germany was critical off for "selfish intransigence" and only thinking about French savers, which is the French Socialists accusation of Merkel.

France wants to blame Merkel on one hand, and UK's Cameron, on the other hand, for the strains in the "European project".  There is enough blame to go around, but Hollande and the French Socialists should recognize the responsibility of France as well.  Hollande has failed to articulate a clear and viable alternative to Germany's vision.  A large part of the reason for this is France's failure to enact structural reforms to ensure the continued competitiveness of its economy.

While we have often warned of the tragedy of France--that it is being squeezed from Germany above and now from the reforms and falling unit labor costs in the periphery form below--we recognize that French bonds continue to trade like slightly higher yielding German bunds.    This removes some  sense of urgency, though rise to record levels of French unemployment, may become a more explosive political force.    

That the Bundesbank is opposed to the ECB's Outright Market Transaction has been known since the OMT was first unveiled over the German ECB members objections.  OMT requires an agreement on conditionality  with the EU, means that OMT is not a unilateral tool of the ECB.

Moreover, interest rates in the periphery, especially Spain and Italy, have subsequently fallen more than one would have imagined they might should OMT have been triggered.  Indeed, with the EU signaling that it will 1) give some countries, including Spain, more time to reach the fiscal goals and 2) that it will place more emphasis on structural rather than cyclical deficits, there is a good chances that OMT is not triggered.  

The BBK's objections have formally been presented to the German Constitutional Court.  The Court is scheduled to make a ruling on the legality of OMT on June 12.  This is the most recent issue on the broader issue of European integration that has been brought before the court.  The Constitutional Court walks a fine line, allowing for the integration but at the same time preserving an important role for the German parliament.

This is what happened last September.  The court ruled in favor of the European Stabilization Mechanism, but limited German participation to 200 bln euros and required German parliamentary consent of any distribution of funds (which is why the German parliament voted on the package for Cyprus, though the Cypriot parliament did not).

The weekend election in Iceland result in a resounding defeat for the Social Democratic Alliance that has led the country over the past four years.  The Independent Party and the Progressive Party, which oversaw the overreach of the banking sector and the crisis have been returned to office on a populist agenda of cutting taxes, writing down mortgage debt and opposition to EU membership.

Monetary sovereignty and the ability to devalue has not been the panacea that many those advocating that one or more of Greece, Cyprus, Portugal, Spain or Italy should leave EMU and devalue have seemed to suggest.  This might also be one of the take-aways from the UK's experience.  Though its economy did surprise on the upside last week, with a 0.3% expansion in Q1, the ability to pursue an independent monetary policy does not appear produced superior economic results or even stronger exports.  

An estimated 80% of Iceland's household debt it linked to inflation.  This means that the higher inflation that the country has experienced has not helped the debtors.  Moreover, unemployment is twice what it was prior to the crisis.   Capital controls, instituted in 2008, remain in place.   Perhaps the most telling sin of the outgoing government was in its choice of friends.  The IMF supported the Social Democratic Alliance.  

The Icelandic election is a cautionary tale and is consistent with the swing in the pendulum away from the austerian agenda.  It warns other European countries that they must deliver better economic conditions or face the wrath of voters.   It is a reminder that there are no easy answers, like simply exiting from the EMU.  

After nearly two months since the election, Italy has a new government.  Not just any government, but a coalition government with the center-right, center-left, centrists and a couple of technocrats.  Grillo's 5-Star Movement is where it is most comfortable, in opposition, and is joined there by the far right and far left.  

The government is bolder than anyone anticipated.  It is younger and more female.  The average age of the cabinet fell a full decade to 53 years and a record 7 ministries will be run by women.  There is the first African in the cabinet, as well.  

The new cabinet will have two technocrats and 3 centrists.  Berlusconi's center-right will be represented in 5 ministries and the center-left in 9.  Although Berlusconi's ally, Alfano will be the deputy prime minister, as had previously been tipped, he did not get the Justice ministry as Berlusconi had insisted upon.  Instead, Alfano got the interior ministry portfolio.  Draghi's ally and Director General of the Bank of Italy, Saccomanni will be the Economic and Finance Minister.  Emma Bonino will be the new Foreign Minister.  

Many observes quickly judged Berlusconi to be the big winner.  If this is true, it is largely because, once again, his opposition shot themselves in the foot.  Bersani ran a poor campaign to begin with and then dismally failed to rally his own party behind not one but two presidential candidate.  The fissures in the center-left are the primary reason that the tenure of the Letta government rests largely in the hands of the center right.  

There are two important agenda items, which, once they are implemented, puts the government at the mercy of Berlusconi's political calculations as was the Monti government.  First, is to get rid of the terribly unpopular tax imposed by Monti on primary residence.   Berlusconi's demand that past tax payments be returned is not practical or very likely, but the elimination of this tax could help household finances and may underpin consumption.  If this were to happen, a decline in revenues from the property tax may be blunted by an increase in VAT collection.  

The second issue is electoral reform.  There is nearly universal recognition of the need for reform, the disagreement is over the shape of the reform.  It is a tricky issue and partisan interests will run high.  Polls show if an election were held today, Berlusconi's center-right would win.  With the left in disarray, Berlusconi appears as the only force that can check Grillio and the 5-Star Movement.   The center-left has at least a few months to try to heal its wounds, otherwise they risk Berlusconi picking their bones.  

Contrary to the numerous and repeated claims of the demise of the political elite in Italy, it seems very much alive.    Grillo dismissed the new government as an elite coup d'etat.  It is not coincidence that Letta's uncle is a close advisor to Berlusconi.  The broader, younger and more representative cabinet speaks to the elite's ability to draw new blood and ideas.  Saccomanni at the finance ministry will soothe some anxiety Europe and the EC.    

  

An Austrian weekly paper will reported reveal tomorrow that according to the Austrian central bank the cost of winding down the nationalized Hyper-Alpe Adria Bank International would cost the government as much as 4.5% of GDP.  The implication is that this amount could force Austria to see assistance from the ESM.   The EU may be persuaded to give the government more time to sell off the viable parts of the bank, but even then the central bank estimates that it could cost 5 bln euros or 1.6% of GDP.  

We have recognized that the crisis has bled into the core from the periphery in Europe.  France, the Netherlands, and Luxembourg  have come under scrutiny.  Austria's bonds trade as a smaller premium than French over Germany.  It five-year CDS finished last week below 40 bp, the third lowest in the monetary union after Finland and Germany.    While the situation is surely worth monitoring, we do not think the report will spark much of a market reaction.