The ECB’s bond market intervention did its job for Italy and Spain last night, but as I expected we also saw some risk shipping. While periphery bonds fell off, French bonds started wearing the risk and we saw French sovereign credit default swaps hit a record high of 160 basis points overnight.
As I have stated previously, France is in no better position than any of the PIIGS and simply cannot bear the burden of carrying higher priced funding. As a contributor to the EFSF it risks blowing itself up under its obligations. More importantly Germany is likely to balk at carrying the rest of Europe, so if we see a less than short term deterioration in the French position then I think we are going to see a full-blown crisis in Europe with the real threat of a break up.
The short term question obviously is whether Trichet’s bazooka can hold off the markets long enough for Europe parliaments to get the extended EFSF in place. The trouble on US markets last night , the ongoing downgrade of the US debt complex and now a pending bank collapse is putting further pressure on Europe and there is the distinct possibility that the ECB’s firepower will not be enough to hold Spanish and Italian bonds below sustainable levels.
But it is not just economic pressure flowing across the Atlantic, the political pressure is also mounting. The US themselves have obviously decided that the best thing for them is a fiscally integrated Europe. Geithner spelt that out yesterday:
U.S. Treasury Secretary Timothy Geithner said Europe needs to boost the size of its emergency bailout facility to stem a sovereign-debt crisis threatening to engulf two of its largest economies and push the global economy back into a recession.
The Treasury secretary, in an interview with CNBC television on Sunday, said that Europe needs an “unequivocal financial backstop…so there is no doubt in anyone’s mind that those countries across Europe have the ability and the will to meet their obligations.”
Mr. Geithner said he is confident that European officials will “step up and provide more forceful support for the countries under so much pressure,” according to a transcript of the CNBC interview.
In a flurry of conference calls over the weekend, world financial leaders have scrambled to figure out how best to solve Europe’s debt crisis.
As the European Central Bank moved to provide liquidity to Italian and Spanish banks, some of Europe’s leaders have called for expanding the size of the €500 billion bailout ($714 billion) facility to at least €1 trillion, and possibly more.
Germany, however, has been reluctant to endorse such a plan. Its domestic politics are already presenting a hurdle to approving existing plans to make the fund more flexible.
Mr. Geithner said that European “governments are getting their fiscal house in order.”
In particular, U.S. officials are concerned that if Italy and Spain don’t cut their bloated budgets faster and encourage growth more quickly, they could push the debt crisis into a more damaging stage.
So far Germany’s Merkel and Schäuble are still insisting that Italy and Spain sort themselves out via increased austerity but I doubt Europe has much more time left to finally make a pivotal decision. We are already starting to see an encroachment into the credit markets, with the inter-bank market beginning to show worrying signs that it is creeping towards a credit crunch.
Signs of stress in the interbank funding market are worsening. The difference between the three-month euro interbank offered rate, or Euribor, and the overnight indexed swap rate, a gauge of banks’ willingness to lend, climbed to 0.558 percentage point yesterday, the widest spread since June 2009. It was at 0.548 percentage point today and was at 0.360 a week ago. A wider spread indicates greater reluctance.
Firms are wary of lending to each other and are increasing the amount they deposit with the European Central Bank. Europe’s lenders deposited 12.2 billion euros in the ECB’s overnight deposit facility on Aug. 3, the most since February.
The cost of insuring European bank debt against default surged to a record today. The Markit iTraxx Financial Index linked to senior debt of 25 European banks and insurers rose to 211 basis points today.
“At some point this does start feeding back into the real economy if it goes on for too long,” John Raymond, an analyst at CreditSights in London, said in a telephone interview.
There have also been some unconfirmed rumours printed in the UK press that two of the largest European banks are under threat of collapse.
Fears are growing this weekend that two of Europe’s largest banks may require a bailout, having been hugely damaged by the worsening crisis across the eurozone.
In France, President Nicolas Sarkozy is having to confront the possibility that the country’s second-biggest bank, Societe Generale -commonly known as SocGen – is on the brink of disaster after huge losses over loans made to Greece.
The chilling possibility of the largest bank in Italy, UniCredit Banca, suffering a similar collapse if a bailout is not implemented comes as Silvio Berlusconi already faces an increasingly dangerous national economic situation.
In Britain, a senior Government source described the position of the two banks as ‘perilous’
Given that equity value makes up a large part of capital requirements that really isn’t much of a surprise. But what it means is that the ECB looks as if it is now going to be holding up both the sovereign bond market and private sector liquidity. This will require a massive expansion of its balance sheet which will once again upset its Governor, who will once again apply pressure to the Euro-elite to find themselves a meaningful resolution.
Either the euro zone accept that they require a integrated fiscal union including a financial transfer facility and a centralised bond issuing instrument, or one group of countries must depart the union leaving them all to clean up the huge mess that will be left over. The longer Europe lets the problems linger the more likely it is that the functional economies will become tainted.