It appears that these days a EUR1 trillion hot liquidity injection (such as that from the ECB's LTRO 1+2) will buy you about 3 months of breathing room. Then the ostriches have no choice but to pull their head out of the sand, especially in Europe, where after three months of spread tightening, and hence the belief that "all is fixed", things are starting to turn ugly again: sovereign government spreads are beginning to widen, Europe is demanding more money from the IMF (i.e. America, even as the BRIC countries are starting to consider a world without the USD as a reserve currency, and are now forming their own bank) to boost its firewall, strikes are promptly converting to riots, Italian bank stocks are being halted due to rapid moves lower, the LTRO stigma trade is at 2012 wides, in short everything we grew to know and love in Q3 and Q4 of 2011. Ironically, having papered over the symptoms courtesy of fresh new money, the underlying causes were never addressed, and only got worse as the deteriorating European economic data suggests. What is scary, as UBS shows, is that this is just the delayed carryover from 2011! Just like the US which had the benefit of abnormally warm weather to mask a "bounce" in the economy which was never structural, so Europe had a relatively quiet quarter in terms of newsflow. Things are about to change: read the following for why the eye of the hurricane is about to pass over Europe and why this time around there is $1.3 trillion less in firepower to delay the onset of reality.
The crisis in the European sovereign debt markets has seen a dramatic turnaround over this quarter. However, in our view, it would be wrong to extrapolate an end to the crisis from that, as many risks remain.
While we think that the current benign phase in the European markets could continue for some weeks more, we believe that volatility and wider spreads will probably return to sovereign bond markets in the future. In this note, we study some of the known event risks in Europe in an attempt to map some of the possible pitfalls for markets. Before doing so, however, it is worth pointing out that much of the risk in Europe would not normally be characterised as “event risk”, or still less tied to specific dates.
In particular, and as we have written in the past, we believe that there is a structural and near-permanent deficit in demand for peripheral government bonds compared to that in the pre-crisis years, while peripheral governments continue to issue bonds at a near-record pace. We expect that this imbalance of supply and demand – the mechanics of the sovereign debt crisis- will reestablish itself at some point this year, after the current phase of covering tactical underweight positions of peripheral bonds is completed by some investors. In addition, changes in expectations for economic growth are an important driver of sovereign spreads in Europe, and have helped determine many of the turning points of the crisis.
Selected event risks by country
The ability of Greece to implement spending cuts, and indeed to commit to them, presents a major risk to European bond markets. The prospect of Greek default (or, more accurately, further default) is probably no longer capable of causing upsets in other peripheral markets in the way it has in the past.
However, the possibility that EU funds for Greece might be cut off at some point - while the country is still running a primary public deficit - could be very destabilising. In that event, the government of Greece might need to resort to paying for government expenditure in IOUs (in effect printing its own currency) or even abandon the euro in a formal sense.
While we do not see such a development as the most likely outcome, a rise in brinkmanship between the EU and the Greek government can be easily envisaged in the event that Greece continues to miss its targets for spending cuts and deficit reduction. As this would make it seem that a discontinuation of the Greek aid plan had become more probable, we could in this case expect the structural deficiency in demand for Spanish and Italian bonds to deepen and deposit flight from some peripheral countries to increase.
Frustration in other euro area member states with Greece’s incomplete implementation of planned austerity has evidently risen in recent months. This is especially true in Germany where finance minister Wolfgang Schaeuble recently referred to the need for Greece to close its “bottomless pit”, adding that “the promises from Greece are not enough for us any more”.
Focus should be on late June or July, when the troika will conduct its first quarterly review of the second Greek aid programme. At that point, missed targets by Greece could become much more apparent.
A continuing lack of implementation of austerity measures is not the only way in which Greece’s relations with other member states could worsen. Another could be any lack of commitment to austerity in Greece. The heads of the two main political parties (PASOK and New Democracy) have signed letters committing themselves personally to the deficit reduction plan of the second aid programme. But support for political parties in Greece has appeared to become more fractional ahead of the elections, which are now likely to be held on 6 May (with the other possible date being 13 May).
According to recent opinion polls, there is a chance that even a coalition of PASOK and New Democracy might not be able to command a parliamentary majority after elections, despite the 50 extra seats automatically given to the largest party in parliament. Other political parties, most of them opposed to the planned path of austerity, have gained ground in opinion polls (including a splinter party formed by expelled members of New Democracy) as has the communist party KKE, which advocates leaving the single currency altogether.
Just after the publication of this note, the Spanish budget is due to be presented to parliament.
Spain has become increasingly the focus of negative sentiment in bond markets, with a number of factors causing concern among investors. Chief among these, perhaps, has been Spanish government’s unilateral change of Spain’s 2012 deficit target from the 4.4% of GDP agreed with the European Commission to 5.8%.
While a compromise 5.3% target has now been reached with the Commission, we are yet to see how the Spanish government will attempt to implement fiscal policy to achieve it. A fiscal adjustment of 3.5% of GDP in a single year from the current 2011 estimate of 8.5% will be very challenging, especially in the light of 2012 growth estimated at -2.0% by UBS Economics (-1.7% by the Spanish government). Spain is still committed to the 3% deficit target agreed for 2013, making the two-year planned deficit adjustment 5.5%.
The fourth quarterly review of the Portuguese aid programme is due to take place in mid-June. The risk is that at some point - either then or in the following review – the troika declares that Portugal is not likely to be able to issue the €9.4bn bonds according to plan in late 2013. In that case, the IMF would likely ask for a change to the current Portuguese aid package or perhaps a new one altogether.
While this was the pattern which led to Greek PSI, we would not expect a PSI process to emerge for Portugal in the near term, even if events were to develop along these lines. As we have written in the past, European policy makers are
very keen to portray Greece as an isolated case in the European periphery and as long as the Portuguese government carries out promised spending cuts, it is likely that other member states show flexibility towards it. This we believe would happen even in the case that deficit targets were missed as a result of unexpectedly low tax receipts (probably themselves the result of unexpectedly low economic growth).
The IMF’s rules state that it cannot continue to fund a programme if other planned sources of cash flow do not materialise. We would expect more EU funds to be available to cover this shortfall if Portugal seems unable to issue bonds next year.
At the time of writing, the Dutch government is facing on-going difficulties in gathering a parliamentary consensus behind measures to reduce the country’s deficit to 3% of GDP by 2013. There is a risk in the short term that the minority coalition government of Prime Minister Mark Rutte’s Liberal party and the Christian Democrat party, holding only 52 seats are unable to pass the budget through the 150-seat parliament. Negotiations are taking place with Geert Wilders’ Freedom party (24 seats) in order to secure passage, but if enough votes cannot be found, it is possible that the government falls in the near term.
This would have the potential not only of risking further weakness in Netherlands bonds, but also – with Netherlands a core country insisting on deficit adjustment in the European periphery - of undermining the credibility of deficit reduction as policy response to the crisis.
Under the rules of Excessive Deficit Procedure of the European Union, countries must submit their budgets to the European Commission for approval by 30 April.
Despite much market focus on recent statements by French presidential candidate Francois Hollande, we do not believe that there is a high risk to markets arising from the French presidential and parliamentary election process, or indeed subsequently to it.
UBS Economics has argued that some of these campaign declarations by Mr. Hollande should be taken with a grain of salt. For example, we do not think that a Hollande administration would seriously attempt to renegotiate the ‘fiscal compact’, particularly as the French Socialists appear isolated in this regard among European centre-left parties. In the end, Mr. Hollande might seek to develop growth-friendly strategies alongside the fiscal compact (as has recently been proposed by the German SPD) or even be content with declarations of the kind made by the German government that economic growth is important and that further investigation is needed into how to generate more of it in the euro
In any case, as our economists point out, the race between President Sarkozy and Mr. Hollande might be closer than many think in the elections scheduled for 22 April and 6 May. While opinion polls might still point to a Hollande win, it is important to note that Mr. Sarkozy continues to score quite highly in terms of ‘credibility’, and that the reliability of opinion polls in the two-round modus of French elections is historically inferior to that in other electoral systems.
Complications might arise however out of the parliamentary elections which will follow the presidential ones on 10 and 17 June, especially if the majority political party in parliament differs from that of the presidency.
But it is possible that as uncertainty is perceived to increase ahead of the elections, the market will become more nervous vis-à-vis France. In our view though, the problems in France arise not so much from the elections, but from some fragile underlying fundamentals – a subject for another day.
At the time of writing, it appears that the Eurogroup meeting (of euro area finance ministers) this Friday, will approve an increase in the size of the European “firewall”. German finance minister Wolfgang Schaeuble has indicated that his government supports the idea of amounts already committed to EFSF programmes (roughly €200bn) running alongside a €500bn ESM when it comes into existence in July.
The proportionate increase in potential German liability over the two facilities would probably have to be signed off by a full session of the Bundestag in the near future. While we would expect any vote to be passed (opposition groups are likely to be in favour), further divisions between Mrs.Merkel’s CDU and the Free Democrat Party (FDP - the junior coalition partner) might be manifested as might divisions within the CDU itself.
Either way, we see an increased “firewall” as a side-issue for European government bond markets, for three reasons: 1) the idea of a “bazooka” (a vehicle so large it does not need to be used) in European crisis is no longer valid, if indeed it ever was; 2) a €500bn facility might be enough to fund Spain for a few years, but would need to be increased immediately were a country of that size to request aid, to show other states could be funded and 3) an increased facility of this size probably would not be able to fund itself effectively in periods of stress anyway. Instead, we see the increased firewall as a necessary step for Europe ahead of the IMF/World Bank Spring meeting next month, which might allow the G20 to respond by pledging some (though probably limited) additional resources for the IMF.
On 6 and 13 May, the German states of Schleswig-Holstein and North Rhine-Westphalia go to the polls. In recent months, Mrs. Merkel’s policies have moved increasingly towards further European integration, deepening a rift between her policies and those of the FDP which has positioned itself as the anti-bailout party of mainstream German politics. As a result, the potential for an early reformatting of the German government coalition has increased.