European Roundup

You’ll have to forgive me for this week’s effort on Europe. I had some non-blogging work that I needed to concentrate on, so I didn’t manage to get my usual flow of daily posts out this week. Due to this I thought I would provide a supplemental piece for over the weekend.

The week ended with a couple of important events. Firstly we appear to be getting an answer to the question of whether or not the 3-year LTRO is creating a “Sarkozy” trade. If the auctions on Thursday are anything to go by then the answer is yes.

The yield on Italian 12-month bills fell to 2.735 percent, from the near 6 percent yield Italy paid to sell one-year paper at a mid-December auction. It was the lowest since June 2011.

Italian and Spanish bonds rallied on Thursday boosted by a well-received Spanish bond sale which also saw yields fall. The 10-year yield spread between Italian and German bonds fell below 500 basis points for the first time this year.

Italy sold 8.5 billion euros ($10.78 billion) of 12-month BOT bills and 3.5 billion euros of bills maturing at the end of May.

The 12-month sale was covered 1.5 times, versus a bid-to-cover ratio of 1.9 at the slightly smaller sale in mid-December.

The excitment of Thursday didn’t quite stretch into Friday however. Italy did manage to sell the maximum planned amount of 4.75 billion euros of 3-yr bonds with lower yields (4.83% from 5.62%) the bid to cover was quite low ( 1.2 vs. prev 1.364 ).

This is certainly a better result than could have been expected in early December, but there is a long way to go. Fortunately, at this stage, both Italy and Spain’s yields appear to be falling even at the higher end of the curve. I am wonder exactly what happens after March 1, when there is no new 3-year LTRO to look forward to, but as I said there is a long way to go so we can’t start worrying about that in a month or two.

So is Europe fixed ? Well no.

We have seen some lowering of sovereign yields and banking liquidity problems have abated, although I still note that even with nearly half a trillion euro parked at the ECB the discount windows is still be used suggesting there are still problems. However against that good news is the reality that there are still massive problems with some national economies and the larger issue of imbalances remains un-checked to this day. So although we are seeing some positives signs in the inter-bank markets and some flow-on effects for government issuances, there is little evidence these non-standard monetary solutions are helping the real economy.

For example from Spain

Banco Espanol de Credito SA (BTO)’s dwindling loan book is symptomatic of the risk that Spain’s economy will slump into a recession.

The bank, which is known as Banesto and is a unit of Banco Santander SA (SAN), the nation’s biggest financial firm, cut lending by 8.6 percent last year, according to its fourth-quarter earnings report published yesterday. The pullback at the first Spanish bank to report 2011 results accelerated from 7 percent in the nine months through September.

“This will continue,” Jose Antonio Garcia Cantera, Banesto’s Chief Executive Officer, told a news conference in Madrid yesterday. “The decline in lending is associated with the natural process of deleveraging of the Spanish economy.”

With nearly 22% unemployment it is hard to be surprised that banks can’t find willing recipients of credit, which means it is a surprise to see news like this.

Spain’s underlying inflation rate slowed in December as the economy edged closer to a second recession in two years.

Core consumer prices, which exclude energy and fresh food, gained 1.5 percent from a year earlier, slowing from 1.7 percent in November, the National Statistics Institute in Madrid said today. Headline inflation, based on European Union calculations, was 2.4 percent, compared with an initial estimate of 2.3 percent on Dec. 30.

Spain’s economy is on the “edge of a recession,” Budget Minister Cristobal Montoro said on Jan. 11 after the Bank of Spain estimated the economy shrank in the last three months of the year.

So the private sector is obviously de-leveraging, members of the banking system are openly admitting that the demand and/or desire for new credit is falling and the government itself is stating that the economy is going backwards. The response from the new government ?

Spain’s Parliament approved the new conservative government’s first austerity measures Wednesday, which aim to rein in the country’s swollen deficit with €8.9 billion ($11.5 billion) in spending cuts.

The measures, which also include income and property tax hikes.

And that is the real issue with Europe. In many of the periphery nations there just isn’t a credible plan as to how they are going to move past their current economic slumps within the framework of the new “fiscal compact” without either massive external help and/or write-offs of their existing debts.

On Friday morning I watched the press conference of the ECB president, Mario Draghi, in which he announced a rate hold. I have included a video of his statements at the end of the post. As usual the most interesting information was in the Q&A session which runs for about 45 minutes after the presentation. If you have a spare hour you can see it here .

The thing that struck me during the Q&A, once again, was how Mr Draghi was able to give credible answers on monetary policy, but when it came to broader questions of Europe’s near-term financial stability he stumbled badly. For instance he stated a number of key things:

• The economy was weak with real GDP at 0.1% QoQ within the Euro area because of weak demand, both internal and external due to balance sheet adjustments of the public and private sectors.
• That he expected inflation to fall because of weak global growth and subdued internal demand.
• M3 growth was slowing, loans to the private sector were down 1.9% from 3.0% in Dec.
• The interbank market weren’t functioning although unsecured bond markets have re-opened in some areas.
• He wasn’t sure whether the private sector was see a flow-through effect from the LTRO, because there are visible parts of the Euro economy where credit is contracting
• The Greek PSI was a mistake, and should never happen again.
• The ECB saw a weakening economy with downside risks and high level of uncertainty.

So given all of those items and the fact that it has been known for almost 2 years that Europe has had growing economic issues you would expect some form of creditable plan to have emerged as to how poor performing nations were going to make the transition into the efficient export competitive powerhouses that EC and ECB constantly talk about.

However when asked a number of specific questions about this particularly important topic all he could come up with was:

• Euro area government’s need to sign up to the fiscal compact as soon as possible.
• The fiscal compact should be binding and unambiguous
• The stabilisation facility needs to be a priority
• Employment should be at the primary objective of government policy in the Euro area, but only by structural reforms.
• That austerity will cause a short-term contraction, but once structural reforms are in place the economies of Europe will start to grow again.

Standard & Poor’s is set to downgrade the credit ratings of France and Austria by one notch each, the Financial Times reported on Friday, citing an unnamed official.

France and Austria would be set at AA-plus, the next rung down, the report said.