Photo: Mark Douwe Decker via Flickr
Here is an under-appreciated irony: One of the underlying themes of the European summit is the erosion of sovereignty for the sake of integration. In the US today, the Supreme Court decision on President Obama’s national health care program, reinforces if not strengthens the power of the sovereign (in this case, to tax). The US state may have gotten stronger, while the European state is set to weaken. The first day of the European summit contained a few surprises. First, many understood Germany’s Schaueble’s comments about being about to accept some mutualization of euro zone debt and would support short-term measures to deal with the financing problems effecting some governments (Spain and Italy), to be a shift in policy. It was not.
Schaueble set the conditions upon which Germany could agree on some shared liability for euro zone debt: if it was convinced that the path toward establishing centralized controls over national fiscal policy was irreversible. The Wall Street Journal quoted him as saying, “There will be no jointly guaranteed bonds without a common fiscal policy.”
The second surprise was the willingness of Spain and Italy to cut their nose to spite their face, as it were. They say they will not support a 120-130 bln euro growth measures if there do not get support for their bond markets. Monti too separately made a gesture intended to demonstrate his resolve: He will not return to Rome, he says, without an agreement to support Italian bonds.
Yet what they did was raise the stakes. France’s Hollande is doing his part. He can’t exactly not support the growth measures since this was the agreement he struck with Merkel, but he seem to threaten not to endorse the fiscal compact (which the Socialists have been quite cool to in any event).
Here’s a potential third surprise: These gambits may succeed. Finland, which has often been more demanding than Germany (insisting on collateral for example from Greece and Cyprus), has proposed what may be the basis of a compromise. Its proposal is for the EFSF/ESM to buy collateralized government debt in the primary market.
The EU is also working on a potential compromise, with a step toward what some call a banking union. It is to set up a single bank supervisor. Currently, bank supervision is done on the national level and the EBA is largely dependent on the national bank supervisors. Once a single supervisor is operating, the EU’s draft argues, the ESM could lend directly to banks.
This of course is going to take some time. There needs to be some short-term salve. Enter ECB stage left. In exchange for getting these new supervisory powers, the ECB would be expected to support Spanish and Italian bonds.
While in many countries, including the US, the UK and Japan, the central bank and the government (finance ministry or Treasury) work close together, especially during the crisis. It is yet to be seen whether this is simply actions in a crisis or the erosion of central bank independence. The issue itself may turn on whether the central bank’s balance sheet becomes a more orthodox policy tool, like the government’s balance sheet after the Great Depression.
In any event, the central bank without a country, the ECB jealously guards its independence. Earlier in the crisis, former ECB President, Trichet backed down a few times, capitulating to government’s pressures, either directly or through their central banks that are represented on the ECB board.
Draghi seems reluctant, but knows that financial pressures are building. The ECB’s balance sheet, we learned earlier this week is at new record highs as banks have stepped up their borrowings at weekly 7-day refi operation. Consider that in the first four auctions in May, the average weekly take down was around 38 bln euros. It has risen now for five consecutive weeks to reach this week 180.4 bln euros.
In addition, the ECB is also gradually increasing its use of the Fed’s swap lines. In the week ending June 27, the net new borrowings rose about $2.8 bln for a total of about $26.56 bln. Overll use of Fed swap lines stand at $27.06 bln, which includes a $50 mln previous use by the BOJ.
Some argue that this increase will lead to a new LTRO. Instead, it seems the ECB responded by easing the collateral rules, which go into effect this period. I had recently argued against expecting another LTRO or resumption of the bond purchase scheme. Of the two, I suspect the latter is more likely, but it would still not be my base case. I would think that a rate cut is still the first line of defence.
The ECB is sufficiently independent that even the heads of state cannot pre-commit it. Nor can the idea of automatic intervention at a certain yield or spread level that some have proposed be taken seriously. It would in effect fix interest rates and require an nearly unlimited commitment. It would likely not be deemed credible. That assessment of the earlier purchases may have explained the lack of sustained market reaction.
The market anxiety has risen considerably. One way to see it is looking at 1-week euro volatility. The idea here, even if you don’t follow the option market, is that volatility will rise in the current environment if participants anxious and seek to protect themselves. On the eve of the Greek election earlier this month, 1-week euro volatility rose above 16.5%. It fell afterwards and in the middle of this week had traded below 10% for the first time in a month. Early Friday in Asia, it is quoted near 12.4%.
Trading can become more treacherous given a wider range of possibilities with Italy and Spain attempting to play a trump card out of a weak hand. Short-term market participants may consider tightening up stops. A now above $1.2525 may test the intestinal fortitude and money management skills of the late shorts.
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