EU Summit deal doesn’t solve debt crisis
The much-anticipated EU Summit delivered on the basics of establishing new fiscal rules to prevent a future debt crisis, but has failed to resolve the near-term debt crisis, namely how will troubled European governments maintain their debt service if credit markets turn on them again? The EU agreed to provide an additional EUR 200 bio to the IMF in the form of bilateral loans, providing a bit more of a back-stop to the under-powered EFSF and ESM. Proposals to increase the size of the ESM were put off until March.
On Thursday, ECB Pres. Draghi shocked markets by indicating the ECB had no plans to increase its government debt purchases even if the EU fiscal compact was strengthened. Government bonds of Spain and Italy, in particular, sold-off sharply in response to Draghi’s reversal, sending yields sharply higher and back into unsustainable territory. Italian and Spanish yields surged higher again early on Friday as the results of the EU Summit emerged and were deemed insufficient to counter a credit market backlash. Only subsequent ECB buying of those bonds as part of their minimal SMP program brought those government bond yields back down. We will be paying close attention to European debt markets next week for signs of further stress.
And it’s not just the government debt crisis that remains at risk of relapse. The European banking sector remains in jeopardy as investors remain reluctant to fund some of the continent’s largest banks. EU banks were found to be in need of EUR 115 bio in new capital following stress tests by the EBA, and three of the largest French banks had their long-term ratings cut one notch by Moody’s.
In short, the EU Summit might look good on paper, but it comes up short in convincing investors that funds will be there to prevent a sovereign borrowing collapse. EU leaders provided no new initiatives to promote growth and simply recommitted to austerity programs, which keep the growth trajectory tilted south, increasing the debt burden even further. Next week will see the December ZEW and PMI surveys for France, Germany and the eurozone, where further declines are likely to reinforce the view Europe is heading for a recession if not already in one.
Market reaction is puzzling
Despite the disappointment over the EU Summit felt by most market observers, risk markets managed to rebound on Friday. For the week, EUR/USD was essentially unchanged, not the result one would expect given the risks still facing the single currency. Other risk assets (e.g. AUD/USD, EUR/AUD, NZD/USD, S&P 500, and crude oil) finished the week either unchanged or nearly so, suggesting that risk sentiment remains uncertain and still undecided. Italian and Spanish government bonds, however, show clearer indications of a rejection of the past week’s attempts to rally, suggesting prices may fall again and yields may surge higher.
It may be that we’re facing another Wile E. Coyote moment, where markets have gone off the cliff, but haven’t looked down yet. There may also be a growing resignation that the worst case scenario of a eurozone break-up will not ultimately come to pass, or that the hodgepodge of lending facilities the EU/IMF has come up with will together be enough to prevent a sovereign debt collapse. Or that they have bought themselves some more time, postponing the day of reckoning once again. Word on Friday that China has initiated a new $300 bio investment vehicle, with half destined for Europe/half for the US, was the proximate catalyst for the risk rebound on Friday, which may not prove sustainable. For the EUR in particular, the ECB’s refusal to commit to using its balance sheet on a larger scale (turning on the printing presses) to support EU debt markets is certainly helping to limit the downside.
Whichever flavor one chooses, there is a growing risk of a capitulation in risk-off positioning, meaning a potentially sharp rebound in EUR and risk/sell-off in USD, likely exacerbated by lower year-end liquidity and market interest. We would highlight the 1.3500/3600 area in EUR/USD as a potential trigger to a short-squeeze higher. Alternatively, a drop below 1.3150/200 would suggest markets are experiencing more intense risk aversion on deteriorating fundamentals and may see risk assets decline into the end of the year. In the meantime, inertia within recent ranges should continue to prevail.
Plenty of risks remain
We already highlighted the Dec. ZEW/PMI gauges as potential stumbling blocks to a further rebound in risk and EUR. Turning back to the EU Summit result, we would expect to hear word from S&P and other ratings agencies early next week on the possibility of sovereign downgrades. The Summit result does not look sufficient to prevent at least some ratings’ cuts, as S&P cited high household/government indebtedness and weak growth outlooks, which the Summit pact does nothing to address, as grounds for a lower rating. Still, it’s a close call and we would note the increasing numbness with which markets view ratings agencies’ opinions. Italy, Spain, and Portugal will all be auctioning debt of various terms next week, and the results will be critical. Greece has talks with the Troika on Monday to ensure funding is available to cover about EUR 7 bio of debt issues maturing next week.