This has been an extremely turbulent week. It began with the USA debt ceiling agreement and ended with slightly higher than expected USA Non Farm Payrolls figures followed by a credit rating downgrade of the USA, from AAA to AA+ with a negative outlook, by S&P. Along the way the Eurozone made news with Mr Berlusconi’s appearance before the Italian Parliament, the meeting of the Governing Council of the ECB (Video and transcript), a public statement by President Barroso, a letter to the Member states, a press conference by the Economic and Financial Affairs Commissioner Olli Rehn (Transcript of the speech), yet another acrimonious joint public appearance between Berlusconi and Tremonti and a phone conversation between Mrs Merkel, Mr Sarkozy, Mr Zapatero and Mr Berlusconi. At the end $2.5 trillion were wiped out of the stock markets.
The sovereign debt crisis that has been affecting the Eurozone (check just about any post on this blog), unnecessarily found a parallel in the USA, where irresponsible politics, bad policy and unfortunate economic fundamentals dragged the country downwards. It wasn’t contagion. It was just plain irresponsible.These economic fundamentals in turn spread fear of a global spillover from low growth in the states, particularly to an already slow and austerity aflicted Euro-zone. On top of this, poor communication skills, a lack of understanding of the situation in the USA and wishful thinking allied with denial all conspired to escalate an already fragile situation.
But I’m moving too fast. Let’s start from the beginning and have a closer look at the situation. The graph below is organised in the same manner as last week’s graph.
To begin with, it should be mentioned that in the middle of all of this Japan intervened in the markets to weaken the Yen and that the National Bank of Switzerland unexpectedly decreased its interest rate to zero, also in order to depreciate its currency. Both moves were meant to stem the embrace that their currencies had experienced as markets flew to safety, which would have rendered both countries’ exports less competitive.
Portugal’s and Ireland’s Yields
Portugal and Ireland enjoyed a turbulent week, although it ended well with yields falling across all maturities from Thursday after rising throughout the week. This is at least partly due to the diligent austerity followed by those countries’ governments which must at some point appease the bond vigilantes. However, it is mostly due to the rumoured intervention of the ECB in the markets on Thursday. The intervention didn’t come as a surprise. Paul de Grauwe, the Belgian European Economist, argued for it on the eve of the meeting. What was surprising was its focus.
ECB’s intervention and rate Decision
This led to what must have been one of the most interesting hours this week, as Mr Trichet went from discreetly hinting that something might have happened in the markets by the time he’d be done with the press conference to admiting something was actually happening in the markets and finally refusing to explain why the ECB was purchasing Portuguese and Irish bonds rather than Spanish and Italian ones (53 minutes and 28 seconds into the press conference ). Markets did not appreciate it.
The markets spent the rest of Thursday cursing Trichet and trying to make sense of the intervention. Was the ECB ignoring Spain and Italy because it can’t actually intervene or because it doesn’t want to intervene just yet. The consensus seemed to be that it was because things hadn’t gotten bad enough, rather than because things were too bad.
Italy and Spain yields
Italy and Spain continue to be the main focus of the European Crisis. Their sluggish growth and exposed banking sectors scare the markets and the European political leaders who must find a solution to this problem. In Spain, looming elections and fiscally underperforming regional authorities seem to be the main problem. In Italy, the problems are low growth, high levels of government debt and political uncertainty due to Berlusconi’s many legal dramas, his fading power and to his several (here and here for the latest) public feuds with his highly respected finance minister, Giulio Tremonti. Unfortunately I do not have the graphs, but it was quite a sight to behold to see what happened to Italian and Spanish yields on Thursday. They started the day climbing, took a little dive when rumours started to spread that the ECB SMP was on the groud and then jumped right back up as it became clear that Spain and Italy were not the focus of the intervention. But, looking back at the graph and the week,what was the actual final effect. Well, the lack of an intervention on Italian and Spanish markets kept the increase in the yields on track with their previous trend. However the week ended with yields dropping on Friday.
The Periphery – Portugal & Ireland V. Spain & Italy … and Greece
Nonetheless, in an interdependent Europe, some argue that regardless of their efforts Portugal and Ireland’s yields are completely dependent on the situation in Spain and Ireland. Is this what this week’s and last week’s data suggest? The answer seems to be “no” if the problem is contained to the Eurozone (see last week) and “yes” if the fears stem from the United States (as was the case this week). The main difference seems to be in the timing of the Yield drop. Portugal and Ireland’s yields decreased on Thrusday, whereas Italy and Spain only fell after the good US’ NFP data came out. The drop in Portuguese and Irish yields was driven by the Eurozone, where the ECB had an active and leading role. The drop in Spain and Italy was passive and part of a global calm down following the American data release. However, European interdependences precede the transatlantic ones. The truth is that for as long as the problems in Spain and Italy will remain unattended, Portugal and Ireland will indeed remain at the mercy of the fears of the markets and of outside events. It seems that some officials are becoming more and more creative in their approach to dealing with the crisis and accepting “defaults”. But I’m getting ahead of myself. Last week looked good. Until the Greek PSI is clearer, yield movements similar to the ones this week will remain. Up, up, up!
The Core – France and Germany remain a Haven but Concerns over Belgium
As the graph above shows, rates in France and in Germany remain very low, on occasion even below the ECB rate. This is interesting in light of recent concerns over the actual safety of France. Regarding Belgium, the charts above seem to suggest that there is a concern over long run sustainability, with 5 and 10 years maturities climbing in a markedly different manner than their 2 years homologue.
European leaders must do something to stem this crisis, rather than to just consider it a nuisance to their holidaying, created by irrational markets who do not understand the size of the achievement of the July 21 EU decision. This clearly did not seem to help. In my view it signaled a total misunderstanding of the situation. This in turn scared markets even further. As a result, they now seem to have at least decided to think and talk about this problem. Even so, a mix of condescending pedagogy and understatement seem to characterise an approach aimed at allowing markets to take stock of the good US job number published on Friday.
Update(Sunday 01:00AM): What now? - The week of 06/08/2011 to 13/08/2011
Just in case however, France and Germany have issued a joint statement saying that all will be well and that Europe remains solidair with itself. In the mean time, the ECB has been understood to be preparing itself to buy Spanish and Italian debt as a result of commitments from Italy and Spain to speed up Fiscal adjustments.
Tomorrow morning the markets will have to digest these new bits of information, together with the rating cut. However the problem still remains. Our growth prospects in the middle of this mess are not very bright, the EFSF is too small, and everyone is on holidays, so that the July 21 changes won’t come into place until September. Or are they coming in earlier?
So I ask: Will markets wake up in 3 or 4 hours happy or mad? – When in doubt, collective madness is where my money’s at.