Bond Outlook by bridport & cie, May 23 2012

From the very beginning of the euro crisis, we have argued that only a federalist solution for the euro zone can stop the whole project falling apart. With this as a starting point, we discuss below the likelihood of this solution happening.

A federalist structure, also called a “fiscal union”, implies centralisation of at least part of tax receipts, approval of spending, and the issuing of euro zone bonds with joint and several responsibility. The latter, at the present time, immediately encounters Merkel’s veto, despite OECD, IMF and US support for what can also be called “mutualisation” of euro zone sovereign debt.

The majority view within the euro zone, both of political leaders and the people, appears to be that the euro should continue, and that no country should leave. In Greece, over 70% of the population, and even the party opposed to austerity (Syriza), wish to stay in the euro. Germany says, “No bail-out if you renege on your commitments”; Greece says “Let us off the hook and bail us out anyway”. That looks very much like an irresistible force meeting an immovable object!

If neither side yields, Greece will default and the chaos created throughout the euro zone, and its banking sector, will dwarf the Lehman Brothers saga. Banks throughout the euro zone (including Germany), would lose billions, the EUR would fall, and the whole European economy could go into depression. If the zone ultimately splits up, Germany would no longer benefit from (some might argue, artificially) competitive currency. Decades of progress towards a federal Europe, originally seen as a long-term objective towards which monetary union was but a step, would be undone.

That must be a sobering assessment, even to the recalcitrant Frau Merkel – and more so for her Germany than for Greece. Of the two, we see Germany blinking first because it has more to lose; the Greeks are already in such a terrible state that they will wonder how things could get worse.

A federal structure would put Germany more or less in the driver’s seat. Whilst this might not appeal to their continental neighbours, one might imagine that it would suit the Germans themselves. It seems not to be the case, however, for reasons which can scarcely be discussed, but must go back to the 1930/40’s. Politically it is quite wise of Merkel at least to appear reluctant to dominate the euro zone; better to let the others do the begging!

Saving the euro via federalisation is the scenario we see as the most likely, but only because the alternatives are all so much worse,

There is also of course the small matter of the “democratic deficit”. The EU is already widely perceived as anti-democratic. If euro zone countries choose to hand more sovereignty to a fiscal union, it will appear to be even more so. Does that matter, given the disillusionment throughout Europe with established parties? We think it does, and some system will have to be devised to allow for voters’ influence. We cannot propose a simple solution, but affirm that without either a real, or even perceived, level of democratic influence, the fiscal union will not work.

To fiscal harmonisation and debt mutualisation must therefore added democratic considerations if the embryonic federal structure, and ultimately the euro, is to succeed.

For fixed income investors, diversification of currencies is an obvious step, while still trusting that too much is at stake for the euro to fail.

Macro Focus

USA: mixed signals this week: industrial production climbed, but manufacturing in the Philadelphia region fell to the lowest reading since September. This was reinforced by declines in the leading indicators index in April. Housing data confirmed that the residential real estate industry is stabilizing. The mortgage delinquency rate declined in the first quarter to the lowest level since 2008 as an improving job market and low interest rates helped more borrowers pay their bills

Fed: asset purchases reduced yields on securities beyond the government and mortgage bonds targeted by the central bank, as it pumped record stimulus into the economy. Further monetary easing remains an option to protect the economy from the danger that lawmakers will fail to reach agreement on the budget or Europe’s debt woes worsen

EU: inflation slowed last month and exports dropped as the euro region’s spreading fiscal crisis undermined the economy and consumer demand. Construction output unexpectedly rebounded 12.4% in March, led by surging activity in Germany and France. The ECB paused lending to some Greek banks

UK: inflation slowed: consumer prices rose 3.0% YoY. Jobless claims fell by 13,700 from March, the biggest drop since July 2010 and the unemployment rate dropped to 8.2%, providing further evidence of stability in the labor market. Cameron said he will not swerve from his austerity plan

Switzerland: while the SECO consumer confidence increased to the highest in a year in April, investor confidence, measured by the ZEW, fell for the first time since December