On Europe's Apparent Utopia

With EURUSD hitting one-month highs and Greek and Spanish government bonds pushing higher day after day, one could be forgiven for thinking all is well across the pond. Tail-risks removed, firewalls in place, and everything ticking along nicely. The reality, of course, is a rather different picture. This week alone, 36bps compression in Spanish sovereign bond spreads, 100bps in Portugal...


European stocks are up over 5%!!!


and yet - under the surface - a harsher reality is coming into view...

Via Credit Suisse:

As we head into year-end, European storm clouds are building. In a week of considerable European news, the most significant in our view is the mass of headlines coming out on Greece. The inability, yet again, of the Eurogroup to reach an agreement in the absence of market stress we don’t think bodes well for the ECB-backed positive market environment to be sustained into 2013.


Greek headlines are negative – for Greece and Europe


It is hard to construe the newsflow out of Greece as anything other than negative. As we outlined last week, in our view the hard stance being taken by the IMF looked likely to lead to a better near-term outcome for Greece’s financial situation than if the IMF wasn’t involved. This is no longer clear.


Greece’s debt load is patently unsustainable, in our view, and it is necessary to cut it again. Which requires the euro area to put its money where its mouth is, and act to show their commitment to keeping Greece in the euro area by cutting Greece’s official sector debt.


It’s not a sufficient condition to put Greece on a sustainable economic path by any means, but it helps – not least because of the commitment it shows. And at the broader level, the fact that it would show that the euro area can take a decisive, pre-emptive action is positive when looking across to the situation in Spain. But instead, we believe the euro area again looks likely just to fudge the issue. We continue to expect funding for Greece to be forthcoming – although an agreement on Monday is far from certain – but a meaningful reduction in the country’s debtload is looking increasingly unlikely despite the IMF’s wishes.


With so many conflicting headlines emanating from this week’s Eurogroup meeting on Greece, the clearest conclusion is that there is complete disagreement not only on what needs to be done to support Greece, and when, but also how to go about it. The potential for anything meaningful therefore looks remote. Particularly since at Wednesday’s German Bundestag meeting on the 2013 budget, Merkel only discussed a cut in interest rates on the bilateral loans and a €10 billion EFSF-financed bond buyback programme. While not impossible, it is hard to see how she can agree to something greater than this next week given it wasn’t discussed in parliament.


So anything but the softest form of OSI still seems to be ruled out by Germany, and if, as reported by the FT, the Bundesbank isn’t willing to disburse its profits, it’s hard to see why other central banks would be willing to do so.


As for the debt buyback plan – on paper it may sound great: Greek bonds have been trading at around 25% of face value so spend €10 billion and buy back €40 billion face value, reducing the nominal debtload by €30 billion or 14% of GDP. Which would be a good start (although not decisive given debt levels in our opinion), but skips over a few minor details – one of which being the fact that bonds no longer trade at 25. Oddly enough, they’ve staged a rather decent rally since the buyback plan was announced… and what’s the incentive to sell? Or are we now talking about coerced bond purchases for 25% of notional, in EFSF bonds again maybe? It seems a small step from current rhetoric to a second private sector debt restructuring – at which point, maybe the 25% also comes into debate. Greece may well be the “exception” a second time sooner rather than later on current trends…


Indecision costs the whole of the euro area


The apparent inability of the euro area to reach any sort of decision on how best to address Greece’s debtload is far more negative in our view than just its impact on Greece. It speaks, once again, in our view, of the inability for progress at the euro area level in the absence of market pressure. The ECB’s (unactivated) OMT backstop has worked extremely well until now, but the ability of it to continue to do so without progress on the political side is limited in our opinion.


As we head into year-end, European storm clouds are building. We still expect Greece to get its funding, but Europe looks increasingly unlikely to grasp the opportunity to take Greek funding issues decisively off the European agenda for 2013. A decision on banking union looks more bogged-down by the day, with the EU budget at risk of going in the same direction, and then there’s Spain...


This week’s election in Catalonia is likely to create further political noise rather than a real risk of secession as outlined by our economists: Catalonia’s choice, 19 Nov 2012.


Our view (hope?) that Spain might ask for support in November, in advance of year-end, looks destined to be incorrect. Since we believe that a Spanish request for support is inevitable, we see little market-positive reason for Rajoy to not to be pre-emptive in asking.


If it really is Spain’s decision when to ask, then market pressure does look increasingly necessary – which based on developments of the last few months could take some time.


This week Spain did another private placement, this time €3.27 billion bought by its social security reserve fund (the last few we believe were primarily bought by the banks). Sovereigns as we’ve often said, are sovereign, and have many means at their disposal to ensure buyers for their debt. The cost, however, is to further increase the correlation in the Spanish system, and hence systemic risk. If, on the other hand, and as we suspect is at least partially the case, the timing of a Spanish bailout request is a decision for the Eurogroup more generally, this begs the question of the advantage to the Eurogroup of a delay. If all countries are on board, there seems to be little to gain from waiting – particularly given the risks to a deterioration in the situation in Greece. And if not all countries are in agreement on the best approach for Spain (which given the situation with Greece, is a depressing possibility), this is clearly market-negative in our view. There is only so much the ECB can do without political support – as Draghi has frequently made clear.


Meanwhile, as illustrated in Exhibits 6 and 7, the private sector is voting with its feet:


German exposure to the periphery continues to fall (down 56% from the peak to the end of September), with exposures to Italy and Spain in particular lower this year. As we highlighted in our publication on the negative sovereign-bank feedback loop, buying time, particularly when done through indecision, comes at a substantial cost. Without certainty or confidence in the likely path ahead, business has to act in accordance with the risks, and cross-border exposures to the periphery will continue to decline, with the resultant negative implications for growth and lending-market fragmentation. As Santander’s CEO said this week: while the Treasury may not need the Spanish bailout, the Spanish economy and firms do.


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