Fasten Your Seatbelts: A Week that Can Rock your World
Starting today and running through next week, there is a key event nearly every day.
Today Sarkozy is to give a speech in France that will outline proposal to increase fiscal coordination and convergence in Europe. Friday Merkel’s speech to the German parliament is to cover the same issues as Sarkozy.
On Monday, Dec 5, Italian PM Monti will unveil an austerity and growth package, and as argued here yesterday, it will also likely embrace many of the reforms that Germany, among others have pressed for.
On a slightly different note, on Dec 6 Switzerland will report Nov CPI figures.This is potentially important as it will be recalled that the SNB adopted its current policy, a cap on the franc in September following the CPI report. Since then the threat of deflation has grown. The year-over-year rate on headline Swiss CPI was 0.2% in August, which was reported in mid-Sept.
In October the headline rate had fallen to -0.1% and in Nov, deflation’s grip tightened and is expected to be -0.4%. This is important because many participants suspect that the SNB may look to lower the franc’s cap and the CPI release would be such an opportunity. We continue to doubt this but recognize the possibility. A lower cap, could spark broader euro gains and increase upside pressure on the Japanese yen, tempered somewhat perhaps by the risk of BOJ intervention. In late Oct, the BOJ intervened to the tune of at least $100 bln in a single day.
There are three key events on December 7.
Second, on December 7, the Greek parliament is expected to approve the 2012 budget cuts that are necessary to ensure the next tranche of aid gets paid. We expect IMF to approve the payment.
Third, prior to the EU summit, the conservative leaders in Europe will meet. Headline risk can be great.
Before the EU heads of state dine in the evening of December 8, the ECB will meet. We expect the ECB to cut at least 25 bp and see an economic case for 50. The ECB is also likely to provide longer term repo operations and may liberalize the collateral rules. The latter seems more likely after ECB President Draghi noted today that officials recognized the shortage of collateral. We do not expect the ECB to announce a major increase in bond buying, but do note that by its own guidelines, it can buy more sovereign bonds, if needed.
December 9 is the EU summit.
It is hard to square the circle if officials limit themselves to the ECB and EFSF. European officials recognize this and appear to be seeking a new and larger role for the IMF. Germany’s finance minister indicated willingness to talk about beefing up the IMF and is even willing to discuss SDRs. While this sounds promising, one of the potential drawback is that, as we have noted before, many large countries, include the US, Germany and China have yet secure domestic approval for it.
Also, while some large developing countries appear open to bilateral loans to the IMF, they are reluctant to earmark the money for Europe, which we still argue has the wealth and resources to deal with the problems, but lack sufficient will. There is some point where foreign money cannot make up for the absence of will.
After being repeatedly disappointed with EU Summits and promises of comprehensive packages, investors are duly skeptical and wary. However, we should expect broad strokes of the road map toward addressing the EMU birth defect–monetary union without political union. One way to fix the defect is infanticide, and that is what many seem to be calling for, the disintegration of the EMU.
Instead, we see occupational therapy as the more likely direction and this is establishing the scaffolding of a fiscal union. We have identified three key elements. Ex ante input (or veto), surveillance mechanism (like the one that Italy has agreed to with the IMF, which seems to be unprecedented in nature) and an ex post stick to create disincentives to missing targets/violating agreements.
While pressures on Germany and the ECB to do more have increased, we argue the pressure for ceding fiscal authority is also increasing. The market talk and media focus has been on the former, but the risk is that it shifts to the latter in the period ahead. First, it will be the first dollar auction by the ECB under the new and lower rates. It is not just the Fed that cut in half the punitive rate, but also the ECB cut its associated fees and this means that new "savings" to banks is more than the 50 bp that has been widely touted in the media. Given the drop in the 3-month cross currency swap by nearly a third (from 162 bp below 3-month Euribor yesterday to 118 bp today), if sustained, may see soft demand at the dollar auction. This will include constitutional change embracing a balanced budget, something that France has found politically impossible to adopt itself. It will also include a independent agency to forecast, monitor and measure fiscal position. Monti has already shown the broad outlines to other EU governments, which is also a step toward the enhanced coordination sought. The reports suggesting that the EU may sanction bank bond guarantees through next year is also indicative of the kind of headline risk that will exist as Europe officials grapple with the crisis. This is also an important element that can help banks secure their funding for next year. European banks reportedly have about 800 bln euros of bonds maturing in 2012.