Thursday, November 24, 2011

Buying a First-Class Ticket on the Titanic?

Daniel Flynn of Reuters reports, Sarkozy, Merkel agree to stop sniping on ECB crisis:

France and Germany agreed on Thursday to stop arguing in public over whether the European Central Bank should do more to rescue the euro zone from a deepening sovereign debt crisis.

President Nicolas Sarkozy and Chancellor Angela Merkel said after talks with Italian Prime Minister Mario Monti that they trusted the independent central bank and would not touch its inflation-fighting mandate when they propose changes of the European Union's treaty to achieve closer fiscal union.

They also demonstrated their confidence in Monti, an unelected technocrat, to surmount Italy's daunting economic challenges, in contrast to the barely concealed disdain they showed for his predecessor, media billionaire Silvio Berlusconi.

"We all stated our confidence in the ECB and its leaders and stated that in respect of the independence of this essential institution we must refrain from making positive or negative demands of it," Sarkozy told a joint news conference in the eastern French city of Strasbourg.

French ministers have called repeatedly for the central bank to intervene decisively to counter a market stampede out of euro zone government bonds, while Merkel and her ministers have said the EU treaty bars it from acting as a lender of last resort.

Sarkozy said Paris and Berlin would circulate joint proposals before a December 9 EU summit for treaty amendments to entrench tougher budget discipline in the 17-nation euro area.

Merkel said the proposals for more intrusive powers to enforce EU budget rules, including the right to take delinquent governments to the European Court of Justice, were a first step toward deeper fiscal union.

But she said they would not modify the statute and mission of the central bank, nor soften her opposition to issuing joint euro zone bonds, except perhaps at the end of a long process of fiscal integration.

French aides had hoped Berlin would relent in its opposition to a bigger crisis-fighting role for the ECB after Germany itself suffered a failed bond auction on Wednesday, highlighting how investors are wary even of Europe's safest haven.

"There is urgency (for ECB intervention)," Foreign Minister Alain Juppe told France Inter radio before the meeting.

Sarkozy took a step toward Merkel this week by agreeing to amend the treaty to insert powers to change national budgets in euro area countries that go off the rails. Juppe cautioned that treaty change could take years because of the need for 27 national parliaments to ratify it.

With contagion spreading fast, a majority of 20 leading economists polled by Reuters predicted that the euro zone was unlikely to survive the crisis in its current form, with some envisaging a "core" group that would exclude Greece.

Analysts believe that sense of crisis will in the end force dramatic action. "I think we are moving closer to a policy response probably, which could be either more aggressive ECB action or the idea of euro bonds could gain some traction," said Rainer Guntermann, strategist at Commerzbank.


In signs of public resistance to austerity in two southern states under EU/IMF bailout programs, riot police clashed with workers at Greece's biggest power producer protesting against a new property tax, and Portuguese workers staged a 24-hour general strike.

Credit ratings agency Fitch downgraded Portugal's rating to junk status, saying a deepening recession made it "much more challenging" for the government to cut the budget deficit, highlighting a vicious circle facing Europe's debtors.

German bonds fell to their lowest level in nearly a month after Wednesday's auction, in which the German debt agency found no buyers for half of a 6 billion euro 10-year bond offering at a record low 2.0 percent interest rate.

The shortage of bids drove Germany's cost of borrowing over 10 years to 2.2 percent, above the 1.88 percent markets charge the United States and the 2.18 percent that heavily indebted Britain has to pay.

Bond investors are effectively on strike in the euro zone, interbank lending to euro area banks is freezing up, ever more banks are dependent on the ECB for funding, and depositors are withdrawing increasing amounts from southern European banks.

In one possible response, people familiar with the matter said the ECB is looking at extending the term of loans it offers banks to two or even three years to try to prevent a credit crunch that chokes the bloc's economy.

Monti repeated Italy's goal of achieving a balanced budget by 2013 but said there was room for a broader discussion about how fiscal targets could be adjusted in a worse-than-expected recession.

Italian bond yields' jumped this month to levels above 7 percent widely seen as unbearable in the long term, despite stop-go intervention by the ECB to buy limited quantities, triggering Berlusconi's fall.

Keeping Italy solvent and able to borrow on capital markets is vital to the sustainability of the euro zone. Key Italian bond auctions early next week will test market confidence.


German officials said the failed auction did not mean the government had refinancing problems and several analysts said Berlin just needed to offer a more attractive yield.

But it was a sign that, as the bloc's paymaster, Germany may face creeping pressure as the crisis deepens that may cause it to re-examine its refusal to embrace a broader solution.

Economy Minister Philipp Roesler of the Free Democratic junior coalition partner called for parliament to reject euro zone bonds "because we don't want German interest rates to rise dramatically."

But some market analysts are convinced joint debt issuance will eventually have to be part of a political solution to hold the euro zone together.

"Although it is not easy to see how the region will get to a fiscal union with Eurobonds, we believe that this is the path that will be chosen," JP Morgan economist David Mackie said in a research note.

With time running out for politicians to forge a crisis plan that is seen as credible by the markets, the European Commission presented a study on Wednesday of joint euro zone bonds as a medium-term way to stabilize debt markets alongside tougher fiscal rules for member states.

The borrowing costs of almost all euro zone states, even those previously seen as safe such as France, Austria and the Netherlands, have spiked in the last two weeks as panicky investors dumped paper no longer seen as risk-free.

Outside the euro zone, a top British financial regulator said British banks should make contingency plans for a potentially disorderly break-up of the currency area, or the exit of some countries, as the sovereign debt crisis rages on.

"Good risk management means planning for unlikely but severe scenarios and this means that we must not ignore the prospect of a disorderly departure of some countries from the euro zone," Andrew Bailey, deputy head of the Prudential Business Unit at the UK's Financial Services Authority, told a conference.

In a Reuters poll conducted over the last 10 days, 14 out of 20 prominent academics, former policymakers and independent thinkers agreed the euro zone's make-up would change.

A new "core" euro zone with fewer members received qualified backing from 10 economists as a possible solution, with seven of them saying Greece should be excluded from it.

I'm not a proponent of a new "core" eurozone. In fact, if you kick out the weakest members, you might as well break up the whole eurozone because it will unravel faster than you can say "Nein! Nein! Nein!," leaving nothing but a much weakened France and Germany. (Read Andreas Koutras' latest on developments in Greece).

Unfortunately, Ms. Merkel is adamantly opposing selling joint euro bonds:

German Chancellor Angela Merkel said that joint euro bonds would send a “completely wrong signal” in part because they would immediately lead to a convergence of interest rates in the euro region.

“This would take us back to where we were before the crisis,” Merkel said in comments today at a press conference with Italian Prime Minister Mario Monti and French President Nicolas Sarkozy in Strasbourg, France.

As I wrote in my last comment on German bunds, the easy trade now is to continue shorting German debt until the bond market breaks Merkel. And trust me, the bond market will break Merkel.

Spoke with a senior bond trader at the Caisse who told me that it's tough trading bonds in this environment because of the "politics" which seems to change every day. He told me that the market will bring Germany to the "precipice" and pointed out a Bloomberg article which stated that Germany is buying itself a first-class ticket on the Titanic:

When the Titanic sank in 1912, even its first-class passengers ended up in the sea. Germany's failure to attract bids for all the bonds it wanted to sell yesterday suggests investors are growing wary of lending to even the euro region's most creditworthy nation.

Germany's 10-year borrowing cost dropped to a record 1.64 percent on Sept. 23 as bunds offered a refuge from the debt crisis. The rate now exceeds 2 percent, driving the gap with U.S. Treasuries to a 30-month high, after bids at the sale of securities repayable in January 2022 fell 35 percent short of the 6 billion euros ($8 billion) offered yesterday.

Bunds are losing the haven status they share with Treasuries as Germany rules out common bond sales to solve the debt crisis, and argues against the European Central Bank becoming the lender of last resort. As recently as Nov. 10, bunds yielded 28 basis points less than the American debt. Ten- year yields advanced to a four-week high of 2.24 percent today in London.

"The Titanic and the single currency cannot continue in its current form," said Stuart Thomson, who helps oversee about $121 billion at Ignis Asset Management in Glasgow. "Safety lies in another ship, RMS Political Union, which is just over the horizon. It remains to be seen whether the third-class passengers of the peripheral economies and the second-class passengers of the semi-core will be willing to decamp from their current luxury liner to this cramped tramp steamer."

October Accord

An all-night summit of European leaders in October failed to calm investors after producing a pledge to write down Greece's debt, recapitalize banks and strengthen the region's rescue fund. Former Greek Prime Minister George Papandreou spooked markets by calling for a national vote on the agreement to rescue the country, a proposal he later withdrew.

Germany opposes a plan that would raise money for indebted nations by issuing joint euro-region bonds because it would probably lose its top AAA rating under such a program. It also wants to have a more integrated budget to police spending across the region to prevent future debt crises.

Michael Meister, finance spokesman for German Chancellor Angela Merkel's Christian Democratic bloc, rejected calls this week for Europe's largest economy to do more to counter market turmoil. Germany doesn't possess a "new bazooka," he said on Nov. 22.

Bunds also yield more than 10-year U.K. government bonds for the first time since March 2009. Investors demanded 3 extra basis points to hold 10-year bunds rather than benchmark gilts today. That compares with an average yield difference, or spread, of 40 basis points in Germany's favor over the past year.

New Commitment?

"Up until a few weeks ago, it was fairly easy for clients to justify an investment in bunds," said Jim Reid, a global investment strategist at Deutsche Bank AG in London. "We're getting to the point where either Germany has to make a huge commitment or they won't. The market may not be prepared to take that risk at these yields."

Germany's Finance Agency sees no risk in financing the government's budget, Joerg Mueller, a Frankfurt-based spokesman, said in an interview yesterday. The agency allotted 3.644 billion euros of the securities, leaving the Bundesbank to retain 2.356 billion euros, or 39 percent of the supply.

"It's a wakeup call for Germany," said Nick Stamenkovic, a fixed-income strategist at RIA Capital Markets Ltd. in Edinburgh. "Investors are starting to turn more cautious on Germany, which has been the hallmark of stability."

Selling Out

Yields are rising as failure to end the crisis fuels speculation the 12-year old monetary union will collapse under the weight of austerity and recession.

European industrial orders declined by the most in three years during September, led by Germany and France, the European Union's statistics office in Luxembourg said yesterday.

"It seems as if international investors, mainly from Asia and the U.S., are selling out of euro-region assets all together," said Nicola Marinelli, who oversees $153 million at Glendevon King Asset Management in London. "In all this mess, the bund isn't rallying, so that shows there may be a full blown divestment of euro-region assets."

Almost half of 984 clients surveyed by Barclays Capital expect at least one country to leave the euro in 2012, double the proportion two months ago, a report published yesterday showed. About a quarter said they expect the euro to break up.

"It's becoming increasingly difficult to see how we get through this without some sort of restructuring of the euro, which we hope will only sacrifice Greece," Bill Dinning, head of strategy at Kames Capital in Edinburgh, said on Nov. 18.

U.S. Budget

It's too early to say that Germany has lost its safe-haven status, with yields close to record lows in the secondary market and U.S. lawmakers at odds over that country's fiscal problems, according to Orlando Green, a fixed-income strategist at Credit Agricole Corporate & Investment Bank in London.

"If you take into account global assets, where do you go?" Green said by telephone. "You've got other leading economies that have their own issues."

German bonds gained 0.2 percent this month as of yesterday, while U.S. Treasuries returned 1.2 percent, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. Austrian, French, Dutch and Finnish securities lost between 0.9 percent and 5 percent.

"The crisis has had a short-term positive effect for Germany in that it has lowered the borrowing costs because people are willing to pay a premium for the security of German bonds," said Gianluca Ziglio, a London-based interest-rate strategist at UBS AG.

"But the medium- and long-term costs dwarf the short-term advantage of lower yields. The cost of a break-up of the euro-region would be massive for Germany."

That is precisely the point, Germany has to choose between two evils and bite the bullet or it too will succumb to the forces of the bond market. A breakup of the eurozone in any form is simply not an option. The market will continue punishing Germany as it adopts a hard stance against expanded ECB powers and a credible eurozone bond market.

Another senior bond analyst at the Caisse shared this comment with me:
Bund auctions do “fail” fairly regularly, so to a certain extent, this is just the market just seizing on whatever reason they can find to panic. (The Bundesbank takes down a portion of the auction, then they offload it later; their treasury does not do a particularly good job of preparing market makers ahead of auctions.) But right now, the European bond markets appear to be in full panic mode, which won’t be helped by the U.S. markets being shut down for the Turkey and football extravaganza. Time for emergency summit #15 (and I believe that’s the real number, not an exaggeration…).
The endless political posturing in Europe is indeed a sad spectacle and it demonstrates how utterly despondent some European leaders are when it comes to handling this crisis. Michael Lambrianos, Head of Analysis & Investment Strategy at Eurobank EFG Mututal Funds in Athens spelled it out clearly:
Yesterday's bund auction was an early sign indication that the contagion is becoming full- blown...Merkel will have to backtrack or her political career is at stake...If she continues this hardline I expect that she will be overthrown.
I agree, if Merkel doesn't backtrack, her days are numbered. The Financial Post reports that Credit Suisse economists warned Monday that market pressure on the eurozone means that EU leaders need to act by mid-January if they intend on saving the continent’s common currency, the euro. I do not think we have "entered the last days of the euro" (Credit Suisse must be in terrible shape if it's publishing this rubbish), but one way or another, we need leadership and decisive action, not Germany buying a first-class ticket on the Titanic.

Below, watch an excellent Bloomberg interview with Steven Major, global head of fixed-income research at HSBC Holdings Plc, discussing Germany's sovereign-debt contagion risk and proposals for a common euro-area bond. He speaks with Bloomberg's Manus Cranny in London. Happy U.S. Thanksgiving, enjoy your holiday weekend.

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