Are we really supposed to believe the news released today that German Prime Minister Angela Merkel and French Prime Minister Nicolas Sarkozy favor a meaningful change in the Maastricht Treaty which serves as the basis for the European Union?
Seriously, how many times have we gone down the road hearing that the European heads of state and central bankers have struck a deal to save the EU and the euro?
Didn’t we just hear news of that sort merely a month ago and now once again all eyes and ears are on the next major European summit to be held later this week. In typical political fashion, the markets and ministers are front running the summit in an attempt to convey an air of equanimity while pretending that they are about to pull the proverbial rabbit out of the hat.
Are we supposed to believe that this time something meaningful and longstanding will truly come to pass?
Let’s navigate and review what JP Morgan’s Michael Cembalest has to say on this topic,
This will be brief, since there’s only so much we will know before the EU summit on December 9th. Europe needs an alternative to traditional debt markets before Q1 2012, when Italy’s sovereign borrowing needs jump from 70 billion to 120 billion. Even with lower issuance in Q4 and ECB purchases, Italian yields rose anyway. Let’s not waste time wondering about multiple outcomes, and cut to the chase.
In all probability, the EU summit will result in ambiguous, unenforceable commitments to lower deficits and debt levels, which countries involved may or may not adhere to, making
Maastricht 2.0 not that different from Maastricht 1.0. However, the ECB (headed by Italian Mario Draghi) is likely to greet summit pronouncements as if they were a combination of the Magna Carta and the Declaration of the Rights of Man, and proclaim that the era of European fiscal integration and soundness is upon us.
After doing so, one can easily envision the ECB increasing purchases of peripheral sovereign debt, and/or lending a few hundred billion to the IMF (still run by Europe/France despite claims of neo-colonialism by China) so the IMF can support Italy and Spain.
Financial markets would probably like debt monetization by the ECB, as it avoids for now all the unpleasantness of having sovereign debt markets clear at levels based only on private sector demand. Takeaway #1: don’t sell your gold here.
It’s hard to believe France would really commit to 3% deficit limits (such as those proposed by former ECB chief economist Jurgen Stark). France (like many countries) often relies on counter-cyclical fiscal policy, and would have found it hard to stick to 3% deficits in the past. But again, the ECB is probably just looking for a fig leaf to allow member countries to raid the temple granaries. German ECB members would stamp their feet like the boy in Die Geschichte vom Suppen-Kaspar and complain about debt monetization and moral hazard, but probably not do much to stop it.
As a reminder, sovereign debt is only part of the problem; there are also banking sector funding challenges. There has been a sharp rise in the ECB deposit facility used by EU banks to park extra cash when they are reluctant to lend to each other.
The latest data show a modest rise in retail bank deposit outflows in Spain, continued reductions to EU bank exposure by US money market funds, falling economic activity in Spain and Italy, and most EU banks intending to de-lever instead of raising more capital. To reiterate, markets would probably react favorably to debt monetization (if it happened) to counter these negative trends.
Furthermore, there are signs that investors are very short; last week there was a 4% rally when the Fed reduced the cost of a dollar swap facility for EU banks that no one is even using. But I am reluctant to commit capital now to European debt and equity markets simply based on rumors of debt monetization, out of concern of not knowing what would happen after the fact, and the concern that it may happen too late.
So in regard to my title and the question as to what will really happen in Europe, I would concur with Cembalest in that we really do not know what will happen after this summit …or the next one…or the one after that….so let’s just keep kicking the can down the road.