3 Main Market Drivers for the Week Ahead: EU Debt, Deflation and U.S Bank Investigations

by: Cliff Wachtel


  1. EU Debt Crisis: Scheduled, Potential Events, Ramifications
    1. EU Finance Ministers Meetings May 17th-18th: Sovereignty Or The Euro?
    2. Needed EU Control Over National Budgets = End of National Sovereignty
    3. Indicators of PIIGS Bond Sentiment
    4. Major EU Stock Exchanges and Financial Stocks
    5. ECB Bond Sterilization Plans
    6. Ramifications Of EU Actions This Week
  2. Growing Deflation Story EU, China, US, Japan And Ramifications
  3. US Banking Investigations

Longer Term Technical Perspective

EU Debt Crisis: Scheduled, Potential Events, Ramifications

EU Finance Ministers Meetings May 17th-18th: Sovereignty Or The Euro?

The EU’s crisis is primarily due to its unworkable combination of a unified currency with independent national spending. That has permitted the unaffordable spending of Greece and the other PIIGS to threaten the EU’s existence. That brings us to the big choice the gathering needs to make – the Euro or continued full national sovereignty.

Problem: Needed EU Control Over National Budgets = End of National Sovereignty

The European Commission has already published recommendations that essentially subject national budgets to EU approval to prevent a repeat of the current problem of member state mismanagement threatening all. Germany has not objected, despite Merkel’s previous policy that the Bundestag, not the EC, set German budgets. As numerous commentators have noted, the ability to tax and spend is the essence of national independence.

Are EU members ready for this? and if not, how does the EU convince markets that it can avoid a similar crisis?

Watch for news on this topic from the meeting. Without movement towards EU supervision over national budgets, the EU won’t rebuild confidence that it can avoid a similar crisis.

Indicators of PIIGS Bond Sentiment

Like its predecessors, the real goal of the latest EU/IMF aid plan is to calm markets enough so that PIIGS bond rates fall enough so that they don’t need any aid and can borrow on the open bond market. The test of this will be how upcoming PIIGS bond sales fare.

PIIGS Bond Sales: Encouraging Thus Far, More This Week

Results thus far have been encouraging, as Italy and Portugal were able to sell bonds at roughly the same or lower yields with respectable demand.

This coming Tuesday, May 18th: Ireland will sell 4 and 10 year bonds totaling around €1.5 bln. Markets have thus far shown faith in Ireland’s commitment to fiscal reform

This coming Thursday, May 20th: More important will be Spain’s planned 10 year bond sale of around € 3bln to test market sentiment on Spain’s latest spending cuts. Last week Spain announced new deficit reductions by an additional 0.5% of GDP for 2010 and 1% of GDP for 2011. These included cuts to civil servants pay, and may not be legal under Spanish law.

Late last week PIMCO’s CEO warned that the ECB’s purchase of PIIGS bonds on the secondary market may be backfiring because it provides a chance to sell these bonds for those that would otherwise have held them and thus supported their value.

Major EU Stock Exchanges and Financial Stocks

  • Watch the French CAC. Per IMF estimates, Southern Europe bonds comprise about 22% of all French bank assets. Anxiety about PIIGS bonds will show up fast here.
  • Watch banking stocks (Santander (STD) -6%, Soc Gen (OTCPK:SCGLY) Credit Agricole (OTCPK:CRARY) among others that took big hits last week because of their vast exposure to PIIGS bonds are taking a hit as the various European Central Banks have ceased buying PIIGS government bonds in the secondary market.
  • Per Morgan Stanley (via businessinsider.com), a number of major EU insurance companies have significant PIIGS exposure. Watch their stock prices as another measure of confidence/anxiety about PIIGS default risk.

Insurance: Potential contagion risks for giants

13 May 16

ECB Bond Sterilization Plans

In the coming days the ECB is expected to announce details of how it will prevent its bond purchases from stoking inflation. The ECB’s Stark has hinted the ECB may hold the debt until it matures.

Greek Default = Portugal Default?

Portuguese banks hold more Greek bonds as a proportion of their capital, 23%, more than any other EU country. This implies that Portugal would be the next likely domino should Greece need to default or restructure.

Ramifications Of EU Actions This Week

If the EU succeeds in calming markets, risk assets stabilize or recover. In particular, the EUR/USD holds support around 1.2400. If not, more downside near term to 1.1600.

Growing Deflation Story EU, China, US, Japan And Ramifications

As numerous market analysts have been warning over the past months, including Charles Nenner (Nenner Research Center) and David Rosenberg (Gluskin-Sheff), deflation and shrinking GDPs are more of a concern than inflation.

The plunge in oil prices is a clear sign of fear that investors are de-risking ahead of a possible slowdown and protracted deflation: Oil is now below $72. Less than 2 weeks ago it was near $90.


Watch CPI and PPI data. Deflation and its drag on GDP threatens to bring a continued Euro decline if not outright EU dissolution.

Spain’s underlying inflation rate just turned negative in April for the first time in at least 25 years and this is likely just the beginning, as we have yet to see the full brunt of fiscal austerity hit aggregate demand.

Given that none of the EZ nations come close to meeting the Maastricht budgetary targets, all could be facing severe deflation pressure in the future based on the amount of slack in their economies and need to cut spending.

Deflation Threatens The EZ ‘s Existence And/Or The Value of the Euro

Businessinsider.com’s Joe Weisenthal here correctly notes what this ultimately means:

A choice between Euro devaluation or EZ shrinkage (if not outright dissolution):

Even with the recently announced austerity measures for Spain and Portugal, these countries may have trouble improving their fiscal ratios, if deflation sets in and GDP falls (as it has in Ireland). It’s otherwise known as the ‘catch 22’ — and the future of the Euro zone project, as it currently stands, is more in doubt than many are willing to believe at the current time. Either the Euro plunges or several of the EMU members will inevitably opt for their own currency of yesteryear to ease the deflationary pressure on their economies.


China – China’s stock markets have for some time been a leading indicator for US markets and risk assets in general. The Shanghai Index is down 20% from the highs of the year.

As the most prominent economic growth engine given its combined size growth rate, recent measures by China’s central bank to tighten liquidity is a challenge for a world drowning in debt and slow growth or contracting GDPs from austerity measures. The recent increase in consumer prices of 2.8% in China exacerbates the problem as it encourages further tightening.


Dollar Strength, EU and China Slowdown Bring Deflationary Pressure to US

A slowing EU and China, as well as an appreciating USD would hurt US growth by themselves. However the US is already feeling deflationary pressures. Per David Rosenberg as reported by Joe Weisenthal here:

The U.S. implicit GDP price deflator receded to its slowest rate in 60 years in Q1 (+0.4% from +2% a year ago) in a sign that this profits recovery is still being underpinned by cost cuts, tax relief and accounting shifts than by anything exciting on the pricing front.

The latest Case-Shiller house price index confirmed that we are into a renewed leg down in home prices…

...which adds to the deflationary brew.


The Bank of Japan is actively continuing stimulus and has long openly expressed its prime concern is fighting deflation.

US Banking Investigations

US Bank Investigations: In addition to Federal probes and coming regulations, new troubles for critical US banking sector. This week New York Attorney General Andrew Cuomo ‘s investigation of eight banks has gathered momentum.

So far no charges, and the likelihood of the banks being actually sentenced to make huge compensation payments is small unless additional evidence comes to light or Cuomo can prove that banks deliberately deceived ratings agencies like Moody’s & Co (NYSE:MCO).

Government scrutiny of the financial sector is intensifying and will only get worse as senators fight for re- election this November. A debt downgrade for Goldman Sachs (NYSE:GS) could be in the offing which would in turn send financial shares tumbling.

This past week the Senate Finance Committee decided to create a new ratings agency. The congressionally approved ratings body will likely remove the conflict of interest inherent in the current private rating agencies business model. Expect to see Moody/Fitch/S&P make a preemptive downgrade of various banks like GS.

Remember that the financial sector has typically been a leading indicator for overall market direction. If GS drags the group down the rest of the market will suffer.

Disclosure: No Positions