Greece plans to propose a two-year deferral for the harshest austerity measures in its bailout package

In this week’s bulletin:

  • Fears of a global economic slowdown outweighed optimism over European progress.
  • Moody’s downgrade several major global banks.
  • A meeting between the main eurozone leaders, which was designed to demonstrate unity, does not deliver the intended result.
  • Concerns remain over the severity of the problem in Spanish banks.
  • Greece plans to propose a two-year deferral for the harshest austerity measures in its bailout package.
  • Further Quantitative Easing looks likely in the UK after the release of the latest minutes of the Monetary Policy Committee.

Twists and turns dominate markets

  • Fears of a global economic slowdown outweighed optimism over European progress
  • Moody’s downgrades major global banks yet again

It was a rare week in which economics dominated politics. Equities, government bonds and currencies experienced yet another volatile period as fears of a global slowdown cast a shadow over policymakers’ efforts to ease the eurozone debt crisis and boost the US economy. The early positivity arising from the Greek election results lasted only a matter of hours, fading once investors realised there would be few developments from the G20 meeting in Mexico. Market anxiety was also heightened by weak manufacturing data in China, Europe and the US, as well as poor US housing and employment numbers. Analysts had expected these indicators to speed up the arrival of further Federal Reserve stimulus, but the announcement of an extension to its ‘Operation Twist’ programme disappointed those who wanted a more aggressive response to support the US economy.

Away from central bank issues, equity markets reacted to Moody’s downgrade of 15 major global banks including Morgan Stanley, Credit Suisse, Goldman Sachs and Deutsche Bank. The re-rating was not unexpected as stocks fell in anticipation; so when the announcement was formally made, the reaction was one of indifference. Morgan Stanley was perhaps the best example of the impact the ratings downgrades had on share prices: having fallen sharply on expectation of a severe three-notch downgrade, when Moody’s dropped the bank’s rating by only two levels, shares jumped by 3%.

As to the wider impact of these downgrades, the move originally raised fears that the banks’ additional cost of borrowing from wholesale markets would be passed on to customers in the form of increased mortgage rates. However, over recent weeks fixed-rate deals have fallen, while Lloyds and RBS both insisted the downgrades would have a “limited impact on funding costs”.


Investors still concerned about Europe

  • The meeting designed to demonstrate the unity of eurozone leaders did not deliver the intended result
  • Concerns remain over the severity of the problem in Spanish banks
  • Greece plans to propose a ‘bailout holiday’ to defer the harshest austerity measures for two years

“The €440 billion European Stability Fund could ease the very severe strain being felt by Spain and Italy”

Benoît Cœuré, board member of the European Central Bank

Bond yields in Spain and Italy fluctuated throughout the week amid speculation over whether Europe’s rescue funds would intervene in their secondary debt markets. Although the comment of Benoît Cœuré, the European Central Bank (ECB) board member in charge of financial market operations, was likely to have been motivated by a desire to ease pressure on the ECB, optimism succeeded in reducing yields in both stricken nations. The ten-year yields in each country reduced by the weekend to 6.41% in Italy and 5.74% in Spain, some way below the perceived crisis rate of 7%. Such support is likely to be a short-term fix to a long-term problem but buys Spain, Italy and the ECB some additional time to find solutions.

In Greece, reports emerged over the weekend suggesting the newly elected coalition government is to seek a two-year ‘bailout holiday’ from some of the harshest elements of the European Union (EU) and International Monetary Fund (IMF) package. Proposals are being drawn up to safeguard the country’s economic future while retaining the financial support from international bodies. The core of the proposal is to defer tax rises and spending cuts until 2014; but it will contain a ten-year plan designed to lead Greece out of the crisis which has lead to 22% unemployment and falling living standards. While the EU, ECB and IMF are all keen to meet with the new Greek government as soon as possible, any meetings have been postponed until at least 2 July due to the ill health of Antonis Samaras, Prime Minister of Greece, who had surgery last week on a detached retina, and Vassilis Rapanos, Finance Minister of Greece, who collapsed on Friday complaining of dizziness and nausea.

Overall, much remains unclear. For example, does the eurozone’s rescue fund have the firepower to combat a sell-off in Spanish and Italian debt? The overall amounts involved in the European Stability Mechanism are yet to be ratified, even by Germany, and the original €440 billion in the European Financial Stability Fund has been depleted over time by loans to Portugal, Ireland and Greece. There is estimated to be around €250 billion left, including the €100 billion recently pledged to Spanish banks, but it will be interesting to see how negotiations proceed as the pressure on Angela Merkel and colleagues intensifies.

Last week, the leaders of the four largest eurozone economies met in Rome, pledging to boost growth and defend the common currency, although Germany continues to resist proposals to issue common debt and use bailout funds to stabilise financial markets. The summit was intended to demonstrate the unity of authorities ahead of a wider meeting on 28–29 June, but ended in disagreement over the need for short-term intervention in the markets and how to achieve political union. At a joint press conference, Angela Merkel was clearly on a different page to François Hollande, Mariano Rajoy, the Spanish Prime Minister, and Mario Monti of Italy, as she declined to endorse the need to use bailout funds to calm markets.

“We need to use all existing mechanisms to stabilise markets, to give confidence… This would be an important step… The bailout fund should be used to buy the debt of ‘virtuous’ countries.”

François Hollande, French President

“Europe needs to respect existing rules and must work towards common structures to regulate the euro, rather than have policies from 17 parliaments each with national sovereignty. If I am giving money to Spanish banks… I am the German chancellor but I cannot say what these banks can do.”

Angela Merkel, German Chancellor

Three months ago, the media perception seemed to be that inactivity of the peripheral nations was the problem, yet more recently opinion seems to have shifted to a belief that Angela Merkel is hindering progress. This view seems short-sighted. Since Germany joined the euro in 1999, with no referendum, there has never been an opinion poll showing a majority in favour of the eurozone. Recent reports show that in excess of 50% of the population would be happy to depart the single currency immediately. With elections due in 2013, and sentiment towards her within the country delicately balanced, Ms Merkel cannot afford to ignore such signals. German citizens feel they have a lot to lose, while printing money and bailout funds go against the very culture of the nation. The German chancellor can or will not agree to anything unless given more influence over the policies of other governments, emphasised by her insistence that the Spanish bailout money go to the government rather than the banks directly.

This week’s summit needs to lay out a long-term picture of where the eurozone leaders see their countries in the coming years, as well as the steps needed along the way. Only then will markets have more certainty on which to base their future direction. We agree with Dominic O’Connell, Business Editor of the Sunday Times who wrote, “If Mariano Rajoy thinks the markets will buy into ruses or trickery, he needs to wake up. The markets will not give Spain a break until they think the banks’ problems have been addressed. Half measures will only make things worse. The €100 billion figure for Spanish banks may be right, but until that final figure is known, markets will remain jumpy and will struggle to finance its debts while the eurozone crisis drifts on.”


QE3 debate rumbles on

  • Further quantitative easing looks more likely after the release of the latest minutes of the Monetary Policy Committee

The Bank of England needs to pump at least another £50 billion into the stalled UK economy, according to David Miles, member of the Monetary Policy Committee (MPC). In an interview with the Financial Times, he warned that only a substantial round of bond-buying would kick-start recovery. Mr Miles, who voted with three others, including Sir Mervyn King, for additional quantitative easing at this month’s meeting of the MPC, said:

“Do we need a more expansionary monetary policy? Yes.

Should it be a substantial change in asset purchases? Yes.

Could one know in advance what is exactly the right amount? Absolutely not.”

David Miles, member of the Monetary Policy Committee

It seems inevitable that further stimulus will be forthcoming and it’s just a matter of when. Vicky Redwood, Chief UK Economist at Capital Economics, agrees with this view. “The minutes of June’s MPC meeting provide yet further evidence that more QE is just around the corner… those who voted for no change simply wanted to wait to see how the eurozone crisis unfolded and to check that inflation would fall as expected. [Recent] figures should provide reassurance on the latter… The Committee discussed cutting interest rates further but, while it will keep the option open, thought that it would have no advantage over just doing more QE. More stimulus looks close, and for now, the Committee still seems to think more QE is the best way to go. We’re sticking with our forecast of another £50bn of gilt purchases at July’s meeting.”

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