Tuesday, December 14, 2010

Merry XMas and a Happy New Year

This is my last blog post for the year as I will be hitting the slopes in Switzerland from this weekend onwards.

In my blog post Finally some good news dated December 1, a day ahead of the last ECB meeting, I wrote: "we are likely to get a timid response by the ECB, just enough to improve sentiment towards risky assets in general in the short term but not enough to provide a real lasting solution."In the meantime the amounts the ECB bought during that period have been published. In the week up to Dec 3, EUR1.965bn of bond purchases have been settled and EUR2.667bn during the last week. While this constitutes a clear pick-up in terms of ECB bond purchases compared to the previous weeks/months, it remains too small and far away from what would be needed to provide more than just a very short term pause in the peripheral's downward spiral.
Given that market liquidity is usually drying up in the period leading to XMas and New Year, theses small ECB purchases seem to have been enough to fuel a short covering rally by some dealers in bonds and even more so in peripheral equity markets where for example the Spanish IBEX was able to rally by more than 10%.
However, the underlying problems for the peripheral economies (an unsustainable debt path coupled with a lack of competitiveness) remain. Additionally, the purchases are not large enough to break the adverse feedback loop. The high yields the peripheral countries have to pay render the debt situation even worse - be it for the sovereign as well as for its banks and corporates/households - leading to higher deficit and slowing down growth even more. Furthermore, given the huge volatility in market yields, sticking to peripheral bond positions becomes more difficult even for investors who think that current spreads adequately reflect fundamental risks. As realised volatility rises, the value-at-risk of the peripheral bond positions increases and hence to keep risks in check, the nominal positions has to be reduced nonethless, leading to even higher yields and higher volatility.
I argued previously that a significant increase in ECB bond purchases could help a lot to break this adverse feedback loop. It would for one lower yields (and with that reduce costs for the sovereigns/its banks/corporates/households) and it could also - if done in a more transparent manner than at present - lower market volatility and hence value-at-risk for investors in respective bonds. Both would help to lure investors back into the market.
However, the ECB seems very reluctant to go down that route and seems to keep its buying as low as possible. This is enough to cause some stability in a thin pre-holiday trading environment, but not enough to get through the funding heavy first months of the new year.
As a result, the peripheral downward spiral remains intact and 2011 promises to see Portugal and then Spain to have to revert to the EFSF before the end of Q2. I expect that at that stage a more lasting solution will be found (probably some kind of E-Bond or bond buying programme, however, judging from recent political rhetoric, it will be called differently). If that would still not happen, then Belgium and later Italy promise to be next.
So, for the time being, enjoy the crisis pause the ECB has provided to celebrate XMas and New Year but get ready for the showdown in 2011!

Wednesday, December 8, 2010

Just Blame Germany

It has become fashionable to blame Germany for the current crisis in the Eurozone. Most arguments encompass one or more of the following: Germans don't consume enough, Germany has a large current account surplus which hurts the rest of the Eurozone, Germany has conducted a beggar-they-neighbour policy over the past decade via internal devaluation and wage restraint, Germany exerts pressure on the peripheral countries to engage in way too strong deflationary austerity measures which renders their situation even worse, Germany refuses to pay for the periphery via more financial help be it in the form of a substantially larger EFSF or the introduction of EuroBonds, Germany is pushing ahead with its plans to introduce a sovereign default mechanism from 2013 onwards which leads investors to sell their peripheral debt now.
First, the arguments which blame Germany on the basis of their economic behaviour over the past decade seem mostly wrong: yes, Germany has a current account surplus, a relatively high savings ratio/low consumption, a highly competitive economy and it engaged in substantial internal devaluation via wage restraint. What we should not forget though is that a) just as the peripheral countries were profiting from very low real yields during the past decade amid the German economic malaise, Germany suffered from too high real yields amid the periphery's boom which rendered its economic weakness even worse and most importantly b) if Germany would not have done the corporate restructuring/budget consolidation/structural reforms, the German economy would be in a much worse shape at present. It would not be competitive (and therefore not have a current account surplus) and it would have a much larger fiscal deficit. As a result, if Germany would currently not have a current account surplus it could as well not be a net exporter of capital. Furthermore, if it would have a significantly higher fiscal deficit, it would as well suffer from the risk of rating downgrades amid an unsustainable debt path. Given that the German economy constitutes close to 30% of Eurozone GDP, the health of the German economy and the German sovereign is vital for the survival of the overall Eurozone. Would Germany still be economically sick, then approx. 50% of the Eurozone would be mired in deep depression with no one being able to help. It is great news that Germany could overcome its chronic weakness and is now in a state where it can provide stability to the Eurozone periphery.
Looking ahead, it remains my expectation that Germany will continue to outperform in economic terms as domestic consumption can pick up again. The low level of unemployment should lead to increasing real wage gains. Furthermore, the low level of unemployment coupled with the end of the structural reform period leads to an improvement in household sentiment and as a result an increase in the willingness to consume/a reduction in the willingness to save. This is further strengthened by the historically low level of real yields. The combination of a rising sum of wages and a lower savings rate should significantly fuel consumption growth over the next 2-3 years. This will lead to an improving internal balance within the Euorozone and eases the pressure on the periphery to restore competitiveness via significant deflation.
If there is one sensible argument to blame Germany relating to the past decade, then it is that they did not bring their banking system in order. The German domestic banking sector remains highly fragmented and barely profitable, a key reason why German banks have engaged in such massive investments in Eurozone peripheral debts. Would there have been more private banking mergers and would politicians have forced a consolidation of the Landesbanks and a change in their business model, the German banking sector could be much more resilient now. But it is not and that remains the key weak point of the German economy!

Additionally, I also think that to blame Germany for the latest surge in peripheral yields misses the point somewhat. Germany wants to introduce a default mechanism for states from 2013 onwards. Some observers suggest that this is the reason why investors have started to dump their peripheral bond holdings and blame Germany for talking about potential default. However, it is mostly the same obsevers who have been suggesting that there is no way around the perihperal countries defaulting anyway (and maybe leave the euro). The only thing which the German proposal changes is that they want to have an institutional set-up for the limits of Eurozone sovereign solidarity.

Overall, one should also not forget that if Germany does not demand any austerity measures/reforms in exchange for financial support, then nobody will. It seems that the smaller core countries (for example the Netherlands, Austria, Finland) have a similar line as Germany but in the current negotiations dont have the same power. As a result, if Germany were just to bail-out the rest of the periphery then yes, the peripheral debt crisis would be solved for the time being. But the prize to pay would be a massive rise in moral hazard issues, risking an even bigger debt crisis further down the road where no-one would be able to lend support.

Finally, I remain in favour of some sort of Eurobond (I suggested earlier joint issuance for the part of debt being within the Maastricht Treaty criteria) and do hope that Germany will give in on this. But also here, it matters a great deal that incentives to conduct a sustainable fiscal policy and to remain economically competitive become stronger and are not weakened further.

But to repeat: the biggest mistake by Germany is that it did not restructure its German banking sector. Germany is the voice of the fiscally sustainable and economically competitive countries. If these countries do not have this strong voice anymore, then the door to a fiscal union with much higher moral hazard issues as well as a higher propensity towards inflation and a lower propensity towards innovation and productivity is open. Germany has shown that they are able to negotiate, stand back from their toughest demands and support the common currency project if need be and so far it does not look likey they are deviating from that course.

Wednesday, December 1, 2010

Finally some good news

Some days ago Mr. Weber, the arch-hawk and president of the German Bundesbank, hinted that the European Financial Stability Facility could be increased in size in order to combat the woes in the Eurozone periphery. Furthermore Mr. Trichet, the president of the ECB, stated yesterday at a hearing in the European Parliament that "We will see what we decide" when referring to the ECB's bond buying program. Additionally, he suggested that markets would be underestimating EU government's determination to safeguard the Eurozone.
The statements by both, Mr. Weber and Mr. Trichet, are important. They suggest that the ECB now sees the need for more action in order to stabilise peripheral bond markets/economies, even though they will likely continue to disagree on the means to use. Mr. Weber seems to be preferring actions by the EU (i.e. an increase in the EFSF) while keeping the ECB out of this area whereas Mr. Trichet understands that the ECB has to and can provide significant support for financial stability.
I mentioned previously that I favor a significant quantitative easing program by the ECB (see Monetary easing in the wrong places or will the real ECB please stand up dated 17th November) - which could be put into practice straight away - and should be followed later on by joint Eurobond issuance for parts of the sovereign debt (i.e. up to 60% of GDP and up to a 3% deficit per year for each country) as mentioned in the last blog post.
A massive buying of peripheral bonds by the ECB would a) directly reduce peripheral bond yields and with that help to keep fiscal deficits in check and promote debt sustainability b) provide an effective floor for bond prices and hence increase incentives for investors to buy these bonds as well which renders financing of maturing debts/deficits for the peripheral countries easier. Given the prohibitively high interest rates on peripheral bonds, the monetary environment in the affected countries is currently very restrictive. Coupled with the ongoing fiscal tightening programs, this means that deflationary pressures have been rising. A significant reduction in these yields would just render the monetary environment less restrictive without causing inflationary risks.
Judging from Mr. Webers and Mr. Trichets comments, the discussion within the ECB about larger bond buying programme seems to be taking place at the moment and there is a good chance we will see some announcements being made at tomorrow's press conference. I expect some new measures (i.e. increased buying of peripheral bonds) but not to the extent which will really turn things around for good. Rather we are likely to get a timid response by the ECB, just enough to improve sentiment towards risky assets in general in the short term but not enough to provide a real lasting solution.

Still, in conjunction with an improving macro-environment in the US (the next weeks/months promise to see a slight growth rebound), the stage might be set for a year-end rally in equities.