Ireland’s decision to hold a referendum on the ‘fiscal compact’ will most likely end up as a storm in a pint of Guinness, rather than a major stumbling block in the path of the successful implementation of the new fiscal rules. The pact can come into force with ratification from 12 of the 17 eurozone members and Ireland does has a history of creating a fuss but then falling into line with such referenda. The euro’s initial wobble and subsequent recovery on the news was therefore an understandable reaction. More immediate focus today will be on the results of the ECB’s auction of 3Y funds (see below).
Entering into the unknown. Over the past week, the market has come round to our view that it doesn’t truly know the implications of today’s 3Y auction of funds from the ECB. This has been evident in some of the commentary on the wires and elsewhere, but also in the markets themselves. What was interesting about Tuesday’s session was the tentative bullishness seen on EUR/USD, in contrast to the reticence of the Aussie and Kiwi. Participation in the first LTRO was strongly correlated with the re-financing needs of participating banks. The ECB wants to see more of this tranche feeding through to the real economy, but that’s a tall order when banks are facing pressure to reduce the size of their balance sheets in the face of limited recapitalisation options. For all the talk, we are entering into the unknown today.
The need for a German re-think. Germany’s position on increasing the bail-out capacity of the eurozone rescue vehicles is turning into another collection of contradictions that often drives its approach towards crisis management. This is becoming even more pertinent after the (not unexpected) rebuff by G20 finance ministers and central bank heads over the weekend to demands that they do more to help the eurozone. There are two strands of thinking about the increase. Some see it as providing a more credible backstop to prevent contagion spreading to other countries, especially if Greece needs either further support or another (forced) restructuring. Others take the view that building such a firewall will be both tempt markets to test it but also reduce the incentive for peripheral nations to undertake the necessary reforms and fiscal austerity measures required to ensure they either maintain market access (Italy and Spain) or comply with the current lending programmes (Portugal and Ireland). In our view however, this period of declining bond yields in the periphery (Spain and Italy) offers the best opportunity to boost the rescue vehicles because waiting for the next crisis risks doing too little, too late. Furthermore, the ECB’s position as assumed preferred creditor with respect to its holdings of peripheral debt makes its bond-buying programme less effective at holding yields down because the more the ECB’s holdings increase (in proportion to the private sector’s), the greater the risk that the remaining private sector holders are pummelled in any eventual restructuring (despite assurances that the Greek deal was a one-off). The best outcome from this week’s summit of EU leaders would be a softening of Germany’s stance and the drawing up of a roadmap for the merging of the EFSF (approx EUR 250bln remaining) into the permanent European Stability Mechanism (eventual EUR 500bln capacity). Of course, this would not be sufficient to backstop Spain and Italy, but it would be a step in the right direction and would be one not overtly forced by markets.