Three events took place last week that will shape the general investment climate in the weeks and months ahead.
Pump it Up
The ECB significantly increased its liquidity provisions. Some observers seem to be disappointed that the ECB did not flout its own legal mandate and indicate it would buy an unlimited amount of peripheral bonds. This should not interfere with an appreciation of what the ECB is doing. It is willing to lend to member banks as much money as they want (and have collateral for, whose definition was also broadened) for three years.
Moreover, this money, like other repo operations, continues to be conducted on a full allotment basis—a bank that gets as much as it asks for—and at a fixed rate, rather than an auction process. This underscores the willingness of the ECB to backstop the banks with liquidity.
The unorthodox measures were complimented with other more traditional measures. The cut in reserves was unanticipated by market observers and investors. It alone frees up 100 billion euros for banks, which the European Banking Authority says that European banks needs to boost their capital by about 114 billion euro to meet the capital requirements that come into effect at the end of H1 2012.
Draghi has hit the ground running and has led the ECB to decisive action in his first two meetings, which have seen the April and July rate hikes completely unwound. At the same time, he seems just as adamant to defend the ECB’s independence and, while arguably stretching the rules regarding sovereign bond purchases, refuses as much as Trichet, to break the rules outright.
Summit or Plain?
The ECB’s actions will help address the most pressing issues. It will give officials more time to win the confidence back of investors. It extends the life expectancy of the euro beyond the few weeks suggested by some observers that would be the case if there were no stepped up bond purchases or a common European bond.
Important steps toward tightening fiscal coordination were taken at the last European summit of the year. Germany’s agenda appears to have carried the day. There will be strict limits on budget deficits and nearly automatic sanctions on violators. The European Commission will be involved in approving budgets and the European Court of Justice will be the final arbiter on violations. A European bond is not on the agenda.
These steps compliment the ECB’s measures. The ECB told investors that it is prepared to flood the market with liquidity and the EU Summit told investors of new and improved efforts to adopt fiscal discipline and a regime of austerity going forward. These make a potent one-two punch.
While recognizing the importance of the ECB and EU summit measures, we realize that neither will do much to avoid or mitigate the coming economic downturn or substantially ease anxiety over the concentration of maturing sovereign and bank bonds in the first part of next year (and hence our negative euro outlook). Additional easing by the ECB and more work by the new monthly EU summits will be needed.
Changes come as grinds, like the climate and demographics, or bumps, like 9/11 or the fall of the Berlin Wall. The ECB and EU summit were strong grinds, but the U.K.’s refusal to participate may be a bump. The U.K. decision to exclude itself from the other 26 countries in the European Union that have agreed (pending national parliament/referendum approval) was an unexpected development.
U.K. Prime Minister Cameron heads a coalition government that itself is divided. The Tories are considerably more for the European project on the whole than the Liberal-Democrats. Cameron’s decision will increase the strain on the coalition, but is unlikely to break it. Moreover, the initial polls suggest the government’s decision has a popular majority.
This is a considerable break from the past. The U.K., through various governments over the years, has tended to participate so that it could shape the outcome and be better positioned to defend the nation’s interest. It was the Tories that historically have led the U.K. to joining EU institutions, like Heath and the EU and Thatcher and the ERM. One of the consequences of Cameron’s decision is that it opens a new can of worms: What is the U.K.’s relationship to Europe? Rather than addressing the new economic contraction that the OECD warns is beginning this quarter, this will dominate the discussions and official attention.
Cameron’s decision, which apparently was not discussed with others and sprung on the summiteers as a surprise, will likely strengthen those who want the U.K. to pullout of the EU altogether. This seems to be the general drift, unless Cameron makes clear that the U.K. is still relevant for Europe. At the same time, some, including the next European Parliament President, may encourage efforts to further marginalize it.
It could turn out to be like the French leaving the unified command of NATO in 1958. There were various agreements that operationally mitigated the impact, including the then-secret agreement that French forces would be reintegrated in NATO should the Soviet Union attack. Cameron could seek to soften the apparent strident stance, though domestic political considerations do not provide much incentive. That might be too optimistic of a historical precedent.
Cameron’s objections were not over the summit’s agenda or the steps toward greater fiscal discipline. Looking over numerous accounts, it appears Cameron wanted to revert back to unanimity in decision-making in a number of areas regulation that have been decided by qualified majority voting since the mid-1980s.
This was not over the proposed financial transaction tax. It already was recognized as an issue to be decided by a unanimous agreement and the U.K. would have surely vetoed it, or diluted it by demanding an opt-out clause.
Moreover, despite the heated rhetoric, the U.K. has hardly been outvoted in the EU on issues related to financial services. Even without agreeing to participate in the new fiscal treaty, the U.K. will still be impacted by the EU’s financial regulations though its jurisdiction over non-U.K. banks.
It is a mistake to see this as simply a case of U.K. resisting stiffer regulation from Brussels. For example, the U.K. wants to impose higher levels of capital requirements than the European Commission. Changing procedures, like going from a qualified majority to unanimity, enhances the power of an individual country to be obstructionist, not just the U.K. It does make decision-making more difficult and this would reinforce the perception of Europe being analog in a digital world.
In the short-term, the U.K.’s role as a safe haven of sorts during the intense phases of the European crisis may be strengthened by Cameron’s decision. Over the last 3 months, the U.K.’s 10-year bench mark yield has fallen 10 bp, while Germany’s has risen 37 bp, Japan’s has risen 2 bp and the U.S. yield has risen 5 bp.
At the start of the year, the U.K. paid a premium of 42 bp on top of Germany for 10-year money. Now it pays no premium. Part of the outperformance may be related to the BOE’s purchases and the weakness of the domestic economy, but some residual may be owed to its “not the euro” status.
Over the past three months, sterling is the second best performing currency behind the yen, losing only 1.3% against the greenback and gained a bit more than 0.5% against the euro. The euro is flirting with a significant support area in the GBP0.8400-GBP0.8500. A break of this area could see the euro losses extend toward GBP0.8000.
Disclosure: No positions