Based on reports from journalists who have seen a copy of a draft of Europe’s budget-stability treaty, it appears that the compact may be tougher and more binding on its signatories than previously thought. According to Bloomberg, a country faces sanctions if it fails to reduce its public debt/GDP by five percentage points per year should this ratio be above 60%.
This is in addition to automatic fines for those which fail to maintain a budget deficit below 3% of GDP. These provisions appear to have the hand of German involvement. Recently, Angela Merkel’s coalition partners in Bavaria wanted automaticity on sanctions for fiscal miscreants, and for sustained violations the possibility of being tossed out.
Just last week, we saw how much power the EC now has under this new regime – Belgium’s new government was told that substantial fines would be imposed if it did not re-submit a budget draft after the EC found that it was unlikely to meet the 3% of GDP budget deficit target for this year. Europe desperately needs a tough fiscal treaty, together with some of the structural reform initiatives discussed by Merkel and Sarkozy on Monday in order to encourage growth. Investors will reward Europe if it can implement and enforce a stronger fiscal treaty, because in the past it has failed.
Italian desperation. Truly frightening is the only way to describe it. Buffeted by a surge in withdrawals by retail depositors and a complete inability to raise funds from the wholesale market, Italian banks raised their usage of ECB loans to a staggering EUR 210bn at the end of last month, up EUR 57bn from the month before. By the end of 2011, Italy’s banks accounted for nearly a quarter of the liquidity provided by Europe’s central bank. Unfortunately, very little of the liquidity raised has been recycled back into Italian government bonds, and nor is it likely to be – the 10yr yield, for instance, remains above the critical 7% level. Friday’s 5yr BTP auction looms as a critical test of underlying demand for Italian paper, and will be closely watched by the forex market. At the same time as Italian banks are being forced to access emergency ECB loans, their share prices are collapsing. Unicredit shares closed yesterday at its lowest prices since the late 1980s – in the past four trading sessions alone, it has fallen by 45%, on heavy volume. In the second quarter of 2007, Unicredit shares traded above 40 euros – now, they are worth just 2.4 euros. The trigger for the recent collapse is the dreadful response to the announcement of a heavily discounted rights issue. For the management of Europe’s banks trying to raise fresh capital from the markets in order to satisfy the EBA’s new capital adequacy requirements, this is an absolutely terrifying market reaction, one that will no doubt scupper any plans to go to market in the near future. The conclusion is even more inevitable than before – banks will be forced to accelerate plans to shrink the size of their balance sheets, thereby intensifying Europe’s incredibly damaging credit crunch still further. Undoubtedly, Italy’s Prime Minister Mario Monti is watching the situation unfold very closely. At the same time, his options are very limited, given the mountain of sovereign debt Italy already has. One possibility is for Monti to approach the EBA and ask for more time to meet the 9% capital requirement. Even if this were granted, banks in other countries would want the same extension. However, market response to any such measure may well be negative. Italy is still on the edge. If retail depositors continue to abandon Italian banks (and frankly, why would you risk leaving your deposits there?), the situation will become unsustainable. There are no easy answers for Italy. It can only get harder.
The inefficacy of QE2 in the UK. Looking at the latest round of asset purchases, started in October of last year, there are few signs that the impact has been felt beyond the immediate vicinity of the Gilt market. Looking at equities, we have seen the FTSE All Share Index move up nearly 10% over the past three months, the pace (3.1% per month) very similar to that seen during the first round of QE (3.3% per month). But UK equities have not really broken away from the pack. Versus the DJ Stoxx 600 and S&P 500, UK equities are some 1% lower and flat respectively over the period since the QE2 announcement back on 6th October last year. There’s a similar picture for corporate borrowing costs, as measured by both investment-grade and high-yield markets. Both have seen yields rise modestly since early October, as measured by yields on the iBoxx AAA and BBB non-gilt series. The big proviso here is that QE1 was started at a time of considerable overshoot in both the investment-grade and high-yield markets, so it’s more than likely that yields would have rallied, even without QE. But if we compare with euro-denominated counterparts, UK investment-grade bonds have underperformed both euro and dollar counterparts, after only briefly outperforming during the first two weeks of QE2. The picture from financial markets is also complemented by that of last week’s credit conditions survey from the BoE, which showed borrowing costs (as set by banks rather than the corporate bond market) having risen and expectations of further increases ahead. In summary, so far at least, whilst QE may have benefitted the Gilt market and held down government borrowing costs, the impact elsewhere appears to have been limited.
Aussie and Kiwi on top. Both the Aussie and the Kiwi have attracted significant buying interest this week, with the former again flirting with the 1.03 level and the latter at 0.7950. Improved risk appetite, strong US consumer credit figures and a larger-than-expected Chinese trade surplus last month encouraged both currencies. For the year-to-date, the New Zealand dollar is the best-performing major currency, followed by the Brazilian real and then the Aussie. The Antipodean currencies continue to reach new heights against the major European currencies – AUD/GBP is back at 1.50, while both EUR/AUD and EUR/NZD are at new record lows. Notwithstanding this latest burst of currency strength in Australia, some headwinds loom in the near term. After cutting official interest rates in both November and December, there is a strong likelihood that the RBA will continue to ease monetary policy further in the current quarter. For the Australian central bank, the arguments in favour of additional action remain fairly compelling. The domestic economy was relatively weak throughout last year, with the consumer preferring to save, house prices under downward pressure, and the labour market generating very few jobs. Monday’s soft retail sales figures for November provided further confirmation that household spending remains tentative. Also, the current federal government is intent on returning the budget to surplus in the next fiscal year, and as such has implemented a significant program of fiscal consolidation which will curtail growth in the economy. International factors are also weighing on the Australian economy, with the pace of expansion in China (Australia’s major export destination) definitely slowing. Currently, the front end of the curve expects the RBA to lower the key cash rate by a further 75bp by the middle of the year, including a 25bp reduction at the next meeting in early February. This looks a perfectly reasonable expectation.