Europe’s long road away from ruin

The next EU summit takes place on 28/29th of June in Brussels. The leaders of the European Union will discuss everything from financial cohesion and potential fiscal union to the growth pact and then to EU expansion and the potential for Montenegro to join the currency bloc.

Unlike other summits there are expectations that this summit will do two things: 1, reach agreement on the roadmap that leads to fiscal, banking and political union in the currency bloc 2, enacts some shorter-term measures to help ease pressure on Europe’s peripheral bond markets.

So what is at stake?

Although at the summit back in December Italian and Spanish bond yields were higher than they are today, back then the markets could be calmed with long-term cheap money from the ECB to bolster Europe’s banking sector. This time the action can’t be palmed off to the ECB. After more than 2 years of this crisis there is a feeling in the financial markets that this summit is a seminal event and it either changes the course of the currency union, or it fails to take the necessary action to foster a closer union and thus sows the seeds of its destruction.

Italian PM Mario Monti said last week that Europe’s leaders have one week to save the Eurozone, and if bold action is not agreed upon in the next few days then there may not even be a euro for Montenegro to join.

Breaking down the issues

The summit is due to start early on Thursday 28th June, and we expect a press conference at approximately 1630CET/ 1730 BST once it has concluded on Friday, (although these summits can run into the early hours of the morning).

The markets want two things to happen: 1, agreement on closer fiscal/ banking and political union, 2, understanding what sacrifice this entails on behalf of the Eurozone members themselves. For example, does greater fiscal union mean that debt is pooled and Europe’s periphery can piggy-back on Germany’s strong credit rating (even after the Egan Jones downgrade on Tuesday night). Some may argue that countries did this in the first decade of the currency bloc, although the markets weren’t so scrupulous back then and did not require fiscal union to deem peripheral nations credit-worthy.

However, underwriting debt is only one half of the fiscal union equation. The other half is fiscal regulation and oversight. Will there be a centralised financial Treasury who oversees all debt and spend programmes? Will budgets need to be agreed by all currency bloc members? Will countries issue their own debt, as has been the case since the introduction of the euro, or will it be issued by Brussels? Will the end game for fiscal union be jointly issued debt? These are the questions that the markets, analysts, media and citizens of Europe want answered.

The problems

Germany ‘s opposition to joint debt liability was expressed by Merkel herself who was quoted on Tuesday as saying that there will not be “total” liability sharing in her life time. Other German officials have also spoken out openly against Eurobonds. In recent days Berlin has sounded particularly concerned that the European authorities will try to slip debt-sharing through the back door without the appropriate risk controls in place first. Thus, Germany is on its guard and is likely to fight for strict centralised budget controls.

But Berlin is not the only sticking point, some members seem adverse to ceding control of their national budgets to centralised authorities. Although from an outsider’s perspective this may suggest they have something to hide, the Eurozone was set up as a currency bloc that respected and maintained sovereign rights. Thus some countries including France and Italy have balked at the prospect that this summit could erode their sovereignty.

The third problem is political. In the past when big decisions have had to be taken at EU summits France and Germany tended to lead the drive for change. However, Hollande doesn’t have the same “special relationship” with Merkel as his predecessor Sarkozy did, which complicates the political dynamics of this summit. Merkel appears fairly isolated with only the Northern European bloc of Finland, Austria etc to watch her back, while France, Italy and Spain seem to be singing from the same hymn sheet. Getting four countries to agree to an agenda and then persuading other members to hop on board is a lot tougher with four members to please then it was with two.

Why there won’t be a satisfactory outcome from the summit

Throughout this crisis we have heard how the markets move quicker than politicians. Markets work in milliseconds while politicians work in terms of years and decades. Hence, we have been prepped that the most this meeting can deliver is a blue print towards fiscal union. The markets are not naive enough to think that Europe’s politicians will solve this crisis by the end of this week; hence markets have failed to rally into this summit. This compares with other summits when markets tended to be cheered during the lead-up of the event only to be disappointed by the outcome. This week the markets are preparing to be disappointed, which, for the optimists out there, always leaves open the chance of being positively surprised.

So what would constitute a positive surprise? The first thing would be a detailed road map that laid out specific milestones over the next few years and ultimately ended with a centralised Treasury and Eurobonds. Europe’s leaders have said that a fully integrated union could take 10-years, and as long as the transition is managed properly that may be greeted with relief by the markets. However, in the long-run the road to the United States of Europe is unlikely to be smooth and there may be event risks and bouts of risk aversion along the way.

There would also need to be broad agreement between all members about what the road map would look like and this is where we think there is a potential hurdle. With a little over a day left until the start of the summit there appears to be no agreement on the balance between joint fiscal liability and ceding sovereign powers to centralised authorities. The markets are notoriously bad at pricing political risk, which makes me wonder whether the outcome of the summit could cause an even deeper bout of risk aversion.

There is a chance that banking union could be easier to reach an agreement on, and we may see some form of centralised banking authority with a beefed up mandate. However, a central guarantee for all Eurozone bank deposits is unlikely at this stage.

The impact on the markets

We see two potential scenarios playing out:

1, The markets rally on broad outlines for future fiscal integration and on signs of closer banking union, but the lack of detail causes the rally to fade and risk assets soon start to meander lower. In this scenario we would look to sell any rallies in EURUSD at 1.2650 first then to sell again if the rally extends to 1.2750 (the high post the Greek election). However, we could then see the single currency turn lower and head back towards the 1.2250 lows from this year. If we get down there then a potential breach of 1.20 is possible and we may see 1.18 by the end of Q3. We don’t anticipate a return to parity because the market is already short the euro and if the Eurozone crisis deteriorates further the Fed may do more QE, which could keep a lid on dollar strength.

2,The markets are disappointed by the summit. In this scenario the euro could miss out the move higher and head directly for 1.20. Although we think a move to 1.15 and below is hard to see at this stage.

The ECB’s crucial role

I’ll finish on the ECB. Although this summit is dominated by the politicians, the ECB still has a hefty job to do. It needs to build the bridge between where we are today and the land of fiscal union where the sovereign debt crisis is a distant memory. This means we could see the SMP programme re-started if Spanish bonds react badly to the outcome of this summit. The ECB is also like to continue to support the periphery’s weakest banks, although hurry to lower its collateral requirements further after doing so last week, especially if this summit delivers a disappointment.

Our base case is that the ECB does not cut rates, as we don’t think lower borrowing costs are the problem in the currency bloc right now – growth is. While austerity and fiscal consolidation are the orders of the day then lower rates are unlikely to make too much difference, especially when real rates adjusted for inflation are negative already. However, we will find out the Bank’s appetite for rate cuts next Thursday when it next meets

Источник: Forex.com

27.06.2012