Europe has now followed the Fed in its all in move to prevent the disintegration of the euro and of Europe. As we expected, the EU was leaking various rumors to gauge market interest, and as speculated earlier, the final cost ended up being just short of one trillion. Here are the key summaries:
- EU Crafts $962 billion show of force to halt crisis
- Full blown monetization: ECB will buy public and private bonds
- Fed reactivates swap lines with Bank of Canada, BOE, ECB, BOJ, and the SNB
In other words, total and unprecedented monetary lunacy, as every cental bank, under the orchestration of the Federal Reserve, will throw money at the problem until it goes away, which it won't. As we have long expected, Bernanke is now willing to sacrifice the dollar at any cost to prevent the euro unwind. This is nothing than a very short-term fix, whose half life will be shorter still than all previous ones.
The race to the currency devaluation bottom is now in its final lap. And gold is the only alternative to the now imminent collapse of the fiat system: the world had a chance to take writedowns on losses, punish those who took risk and failed, and refused to do so. There is now no risk left, but it only means that eventually all the risk will come back and lead all capital markets to zero. The result will be the end of Keynesian economics as we know it. Do not trade in this broken market, do not hold your money in a bank as they are all now one hour away from a terminal bank run - buy and hold real, FASB mark-to-myth independent assets.
Here is Goldman's take on the reaction:
In reaction to escalating pressures on Euro area government bond markets this past week, and their broader repercussions on financial stability, European policymakers have announced tonight an impressive set of new policy initiatives, as Erik Nielsen flagged earlier this evening as they began to emerge.
The centerpiece is a EUR 500bn conditional mutual financial support scheme for EU sovereign states, boosted by further assistance from the IMF. To put this number into perspective, consider that it is slightly higher than Italy’s 2007-09 average gross issuance of public debt and that it could cover Spain’s and Portugal’s combined gross borrowing requirements for two-three years. These conditional contingent liabilities tying EMU sovereigns will not appear under the Maastricht deficit and debt measures. They require no additional funding-raising, for now.
The fiscal agreement will be subject to closer scrutiny in the days ahead, when more details will be made available. In particular, the EUR 440bn of bilateral loans will be no doubt at the centre of more political discussions. But, together with the promise by euro area governments to ‘take all measures to meet their fiscal targets’, such display of fiscal ‘solidarity’ and the institution of a fast-track EMU/IMF funding backstop have been instrumental in convincing the ECB to step in, invoking a financial stability role. In the coming days, the ECB – presumably through the national central banks - will conduct ‘interventions’ in those ‘public and private’ markets of the euro area it deems ‘dysfunctional’ and therefore impairing the transmission of monetary policy.
We provide more details of the measures below, touching also on some of the issues still pending. Our overall take is positive. The Eurozone fiscal crisis spread beyond Greece to countries with much better fiscal profiles due to a lack of confidence, in turn amplifying debt roll-over risks and hurting domestic banks. Short of fiscal federalism, the mutual support plan launched tonight goes to the heart of the matter, and fortifies Eurozone institutions, endowing them more flexibility tools to deal with future crises.
But the true ‘circuit-breaker’ when the European markets open tomorrow will no doubt be the ECB’s unprecedented involvement in the secondary markets. Banking on the ‘best practices’ accumulated over the crisis, the ECB is not saying which securities it will buy, and in what size. This makes the ‘announcement effect’ even more powerful. The interventions will be over time sterilized (i.e., the cash injected will be mopped up), limiting the interference with monetary.
In terms of markets, there are clearly a few areas that are more directly linked to tonight’s announcements and others that have been caught in the general cross-fire. We would make the following broad observations.
1. EMU peripheral sovereign spreads should tighten back, particularly at the front-end of yield curves. The move should be reinforced by the further tightening of fiscal policy in Spain and Portugal to be announced later this week, and the ongoing conservative fiscal stance in Italy. At the 2-yr maturity, Portugal closed on Friday at 550bp over Germany, Spain at 237bp and Italy at 181bp. Our relative preference goes at this juncture for Portugal, because of the higher risk premium. We think spreads should come back to the 250bp area, and quite possibly further. In Italy and Spain, spreads should halve (although we continue to think that Spain will trade weaker than Italy reflecting the two countries’ relative funding requirements). Meanwhile, German 2-yr benchmark bonds closed at 76bp through swaps. This spread is at least 20bp too high (it averaged 50bp up to March), considering that Germany’s contingent liabilities as a result of these actions have increased.
2. The impact all this should have on the level of rates is unclear. The ECB is in the near term injecting more liquidity, and this should keep rates low over the coming months. Sterilizations will presumably entail a steeper money market than currently is the case. Against the backdrop of falling risk premium and better growth numbers, as we expressed already in our Bond Snapshot last Friday, our inclination would be to fade the bond rally now. Among our recommended exposures is a trade to be long 10-yr UST vs. Bunds, for a target in the 40-50bp area.
3. On currencies, the impact on the trade-weighed EUR of a more restrictive fiscal policy and easy monetary stance is unclear. As the risk premium erodes, the currency may extend gains against the Dollar, returning towards our 1.35 3- and 6-mth forecasts (from Friday’s 1.27 close). Our main focus in coming days will be on several fundamentally sound opportunities that have been rocked by the generalized de-risking. Among these, at this stage we highlight PLN, TRY against the EUR, and MXN against the USD, which we added on Friday already as a tactical recommendation. Asian FX weakened last week on the increasing risk aversion, and should stage a come back. Earlier tonight, we recommended going long a basket of MYR, PHP and IDR against the JPY.
4. The story in equity space is similar: Given the higher co-variance between financial and sovereign risk, the main underperformer of late has been the European banking sector. In the near term, it will probably lead the market bounce. But tighter fiscal policy in the European periphery will in our view continue to weigh on the local financial institutions. Our interest goes more towards opportunities where we judge the macro underpinnings to be stronger. We have been recently stopped out of long positions in US consumer stocks, but that remains an area of interest, for example. And we have highlighted the merit of ‘core Europe’ (through the German DAX index), which we are likely to elaborate on in the coming days. Unlike during the credit crisis of 2008, these policy announcements take place against a much more favorable macro backdrop.
Turning to the measures, these involve:
On the fiscal side, the establishment of a ‘European stabilization mechanism’, under the legal umbrella of article 122.2 of the Maastricht Treaty. This envisages financial assistance from the Union to member states ‘seriously threatened with severe difficulties caused by exceptional occurrences beyond their control’. The overall ‘stabilization mechanism’, which overall will not require approval by the national parliaments, will revolve around three funding avenues, all operating on a conditional basis (meaning that the sovereign will have to agree to a fiscal adjustment plan to access the funds, ‘on terms and conditions similar to the IMF’s’).
To begin with, the EU Commission will set up and run a permanent ‘rapid-fire’ facility funded by the issuance of Eurobonds guaranteed by the single member states. The framework piggy-backs on the one used for the balance of payment support to non-EU countries, which is also run by the Commission. The new facility should be endowed with around EUR 60bn, and provide for the quick response that was lacking in the case of Greece. It is unclear whether the facility will be pre-funded. The balance-of-payment program is not, and the Commission taps markets upon need. Whether the guarantees will be ‘joint and several’, like is the case of existing EU Commission bonds, is also unclear. If so, the issuance may compete with existing EIB and KFW programs, which is less senior. We plan to flesh out some of these issues when more technical details are available.
Moreover, EMU member states have pledged up to an additional EUR 440bn in bilateral loans to support each other. As in the case of Greece, we think that they will be allocated along the same proportions as those holding for the ECB’s capital shares. The loans will be collected in an SPV ‘expiring after three years’. It is unclear whether non-EMU countries have signed up (the UK has not). The disbursement of the loans will require parliamentary approval.
Finally, according to European sources, the IMF will contribute to the deal with an amount up to EUR 250bn, presumably providing assistance in the formulation of the fiscal restructuring plan, as has been the case for Greece. We would notice that the higher the amount pledged by the IMF, presumably the greater the influence of its main shareholders over the disbursement.
On the monetary side, the ECB has announced it will conduct interventions in the euro area public and private debt securities markets ‘to ensure depth and liquidity in those market segments which are dysfunctional’. The ECB plans to sterilize these purchases. Further, to support banks, the ECB will conduct 3-mth fixed rate tenders around the end of this month, when the first 1-yr LTRO expires, and a 6-mth operation this Wednesday. And finally, the ECB will reactivate together with other major central banks temporary but unlimited Dollar swap lines with the Federal Reserve.
Last, but not least:
- The first tranche of the joint EMU/IMF 110bn package for Greece will be disbursed in the coming days. Earlier today, the IMF Board has approved the EUR 30bn Stand-by arrangement with Greece. Both these news were widely expected.
- On May 12, the European Commission will present proposals on how to improve the governance of the Euro area, including ‘strengthening’ the Stability and Growth Pact (involving a discussion on the introduction of more effective sanctions). This is the natural and necessary complement to a system of fiscal relationships involving greater risk-sharing, and will be the focus of many discussions in the weeks and months to come.
Francesco U. Garzarelli