Wednesday, May 12, 2010
The ECB Bond Desk plans it's next moves...
Ok, so the markets have had a few days to digest the EU’s newly erected defences against the speculative attack on the Euro that has been launched. What has happened?
On Monday the Euro popped, sovereign CDS spreads tightened a lot indicating that the risks of sovereign default had lessened substantially, and finally the European equity markets screamed higher and took the rest of the world with them though not as aggressively. Yesterday the Euro sold off and the European equities markets came off their highs but the sovereign credit markets continued to tighten. Today the Euro is a little higher but still near the lows, the equity markets are catching a bid on some good earnings news, and the credit spreads continue to come in.
So what does all this mean?
The EU has won a tactical victory and regained the initiative but is still in very serious trouble at the theatre and strategic levels. The delivery of the EU-IMF package to Greece combined with the outright purchase of Spanish and Portuguese bonds by the ECB has blunted the immediate speculative attack its’ main routes of contagion. It is true that this has not brought a bid to the Euro but the proper way to judge the success of this program is through the sovereign CDS markets all of which have tightened every day regardless of the direction of the Euro or the equity markets. One could even consider that the declines in the Euro are an expression of confidence that the ECB bond purchase program will be robust enough to function as quantitative easing despite the ECB pledges to withdraw liquidity elsewhere.
This tactical success has enabled the EU to regain the initiative and will buy time for the EU governments to pass the remainder of the package. The main problem is that neither the package nor the bond purchases address the intermediate or strategic issues which plague the EU. The theory is that the existence of a EUR 750 billion fund for the stabilization of the government finances of the weaker countries will deter any other speculative attacks on the EU. For the time being this seems to be working.
At the intermediate level there remain two very serious problems. The first is that the economies of Southern Europe remain weak and globally uncompetitive. Think about how freaked out Americans are about the rise of Chinese manufacturing and Indian service outsourcing. The marginal productivity of an American worker is almost 1.5 times that of a Spanish worker and more than twice that of a Portuguese worker. If Americans are in trouble, Iberians are doomed. Keep in mind that the governments are all committed to austerity measures to reduce their budget deficits even if the stabilization facilities are not draw upon. In all these countries the government share of GDP is 40%, if you embark on a massive program of reducing that, you are going to harm the non-government sector as well. All these countries have serious recessions on the way.
The second problem they have is that there does not seem to be a political consensus in these countries that the austerity measures are even necessary. The Eurozone as a whole had a near death experience this weekend and the Greek unions are already calling for more strikes. I can imagine that the Spanish and the Portuguese unions may feel the same when the time comes for their salaries and pensions to be on the block. I think the mere existence of the EU rescue package will exacerbate these tensions. Since the worst possible outcome now is not bankruptcy but a drawdown of the EU facility the unions have even less reason to compromise. They should basically press the government for a slightly better deal than they would get under the EU conditions but they have a lot more room to play chicken because they know that in the worst case scenario they don’t have to ask the markets for funds, they have to ask the EU which has already promised them.
The EU governments are hoping that the existence of the EUR 750 package means that it is unlikely to be used. I think the opposite is true, its existence guarantees that there will be more resistance to local government austerity measures which will force its deployment. Once that happens the balance sheets of the governments of Southern and Northern Europe will be linked and then the speculative attack will move North. Then the crisis of willpower will be not that of the Spaniards to take wage cuts but of the German taxpayers to finance them. This will be an even harder test, and the markets know that.
The photo at the top of this was taken during the battle of Kursk, this was an attempt by the German Army to encircle an extended Soviet Army in Central Russia in 1943 after the battle of Stalingrad. It was a bold and expansive plan which, if successful would have trapped and destroyed 20% of the Soviet Army and restored the initiative to the Germans. The Germans underestimated the size of forces opposite them, and had their best units chewed up in the largest tank battle in history. Afterwards the Russians were on the offensive until they reached Berlin. In the end no amount of tactical brilliance was enough to overcome the strategic dilemma the Germans had undertaken.