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Banking

Bond Outlook by bridport & cie, December 7 2011

Much of what we write today has to be provisional, because the results of the European summit are not yet known, let alone analysed and digested. Already, however, Merkel and Sarkozy are pre-empting the summit (and, it would seem, the democratic input of other European leaders) by announcing, for example, that “Eurobonds” are off the agenda, and that the private sector need not suffer from lending to wayward governments. Quite how markets interpret these pronouncements, and how, ultimately they are tested in the real world, we must wait and see. “Merkozy” must however be aware that they are continuing to tread a very fine line between further market opprobrium, and placating domestic political concerns.

 

What seems to be emerging is an inexorable move towards a federal structure for the euro zone, which we and many others believe to be the only route to long-term success of the single currency. Only last week we suggested that the summit might echo the events of 1790 in the USA, when the federal structure was basically put in place. The single central bank for the USA emerged much later, but that would be less an example to follow than an error to avoid.

 

Apart from setting overnight interest rates, the ECB has at present the strange role of acting as a clearing house for euro zone loans from surplus countries to deficit countries. Germany, the Netherlands, Finland and Luxembourg have effectively become the ‘creditor’ nations to the other ‘debtors’. This system (known as “Target”) means that increased credit from national central banks to their country’s commercial banks does not increase the money supply in the zone as whole. The system cannot last. The creditor countries are running out of assets to sell to raise funds to lend. Moreover, as voters gradually realise that, like it or not, they are lending to the profligates, the level of protests, and civil unrest, can only grow.

 

This raises the whole issue of the “democratic deficit” in the EU in general, and the euro zone in particular. The “Target” system can only be fully understood by specialists, but if the popular press starts explaining how it is that deficit countries can effectively borrow as much as they like via the ECB, (and in most cases, the country signing the cheques will be Germany), it is unlikely to survive for long.

 

Likewise, the whole concept of centralised control of budgets, which will eventually lead to a fully constituted Ministry of Finance (with the right to dictate fiscal policy, and, despite current rhetoric, issues bonds!), will be an interesting ‘democratic’ experiment. Merkel wants the central entity to report to the EU parliament. However, when it is Germans who will have to provide the bulk of funding, it is difficult to see how they would accede to relinquishing majority control of decision making.

 

Germany has the strong economy and the deep pockets needed to hold the euro zone together. It is also in the country’s interests to keep the weaker members in the zone, both to maintain Germany’s export markets, and to prevent the currency used in Germany from becoming uncompetitive. The commitment of all members of the euro zone, with the possible exception of Greece, to keep the euro is so strong that the fear of German dominance, and the power of unelected EU officials, will be tolerated, at least in the short term. Major countries within Europe, but outside the euro zone, most notably the UK, may look upon the whole undemocratic process with disdain. Nevertheless, our guess is that they would rather see an undemocratic but functioning euro zone, than a euro collapse, even as they reinforce their own determination to stay out the single currency.

 

These sentiments may also be echoed in Switzerland, where the central bank’s stated intent of a weaker Franc appears to have become self sustaining.

 


Macro Focus

Global: on Friday, the central banks’ of America, Canada, the UK, Japan, the Eurozone and Switzerland reduced the interest rate on dollar liquidity swap lines by 50bps and extended their authorisation until February 2013. That same day, China said it would cut the reserve requirement ratios for banks by 50bps, starting from 5th December

 

Euro zone: prior to the summit of 8-9 December, the French and German governments proposed a plan for EU treaty change, in which countries that exceed deficit limits will be subjected to sanctions by the European Court of Justice. The case for Eurobonds was abandoned. That evening though, S&P placed fifteen of the euro zone’s 17 countries, including France and Germany, on negative watch pending the result of the EU summit on Friday: the EFSF was also marked for possible downgrade. Markit’s composite PMI Index rose to 47 in November, up from 46.5

 

ECB: the ECB is issuing far more emergency overnight funding than is normal. On Monday night, for example, 7.764bn EUR was doled out: typically this figure is around 1bn EUR

 

USA: the Institute for Supply Management's factory index rose from to 52.7 in November from 50.8 in October – the largest increase in five months. However, the non-manufacturing index unexpectedly fell to from 52.9 to 52.0

 

UK: the Markit PMI for services rose to 52.1 in November from 51.3 in October. The index for manufacturing fell from 47.8 to 47.6

 

Switzerland: CPI fell 0.5% YoY in November, following on from October’s 0.1% decline; GDP grew 0.2% QoQ in Q3, the slowest rate for more than two years. Exports fell 1.2% and investment 1.0%. The Procure.ch PMI fell from 46.9 in October to 44.8 in November, the largest contraction in more than two years

 

Credit: American Airlines and its affiliates filed for Chapter 11 bankruptcy last Wednesday. The same day, S&P cut ratings on debt issued by Goldman Sachs, Bank of America, UBS, Barclays and HSBC

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