The market continues eagerly to anticipate the European summit. According to Reuters, Merkel and Sarkozy yesterday agreed the following:
  • Treaty change, ideally for all 27 EU members but could be just for the Eurozone 17.
  • 3% deficit target with automatic sanctions to be written into national laws.
  • European Stability Mechanism to be brought forward to 2012.
  • European bonds are not a solution.
  • The European Court of Justice will check that debt brakes have been implemented in national law but will not have oversight of fiscal policy.
  • The private sector will not be involved in future bailouts (The Economist reports that Merkel feels the private sector first said that losses on Greek debt were inevitable, and then said that a Pandora’s Box had been opened with regard to the fiscal position of other countries). 
This all represents a continuation towards the fiscal-transfer solution. The treaty changes are all about convincing the German public and global investors that Europe is on a path to debt-sustainability. The EFSF/ESM provides a vehicle for fiscal transfers within Europe; politicians are apparently also exploring the idea of using the IMF for this purpose. Naturally the process of treaty change will rumble on and on, but that may not be a huge problem — its purpose is to convince Germany to accept fiscal transfers and the ECB that politicians are moving in the right direction on the same subject.

The market has finally caught up with my view that the crisis can only get as bad as the ECB allows, and is now watching for any hint of ECB action. Since the ECB will want to maintain the pressure for a fiscal solution, it seems reasonable to expect that it will not announce a massive programme in response to the latest moves, but will instead continue its existing programme, which is justified in terms of keeping the monetary-policy transmission mechanism operating properly. It may signal a willingness to keep the programme in operation and step up its purchases somewhat. In the view of the ECB, there is a distinction between monetary policy, which is conducted through the interest rate, and liquidity policy, which is the realm of the ECB’s other tools. It would be consistent with this view for the ECB to cut rates in response to the worsening economic situation but not to engage in large-scale asset purchases unless sovereign spreads remain, in its judgement, excessively high. In other words, the latest moves hardly change anything with regard to the ECB’s likely actions. They have, however, brought the market closer to an understanding of the situation, and may thus allow a risk rally. I do not intend to attempt to trade this change, because a rally is far from certain and because timing will be extremely difficult. My protection against this kind of short-term vacillation is a good entry price.

An issue facing the ECB is the collateral crunch faced by European banks. Banks are still buying peripheral bonds in auctions because, although they will not accept them as collateral, the ECB will. If the ECB buys up more peripheral bonds, it reduces the pool of available collateral and thus the ability of Eurozone banks to borrow from the ECB. I am not sure whether this effect will be large enough to limit the ECB’s freedom of action when it comes to peripheral bond purchases; but it may do so.

What about the effects of further fiscal transfers? We are yet to see any detail, but a combination of a strong fiscal transfer plan and commitment in the European periphery to further austerity may mean that peripheral spreads continue to fall (as they have done for the past couple of days). That would reduce the need for ECB action and might alleviate the collateral crunch that is presently going on in Europe by improving the perceived credit quality of peripheral bonds. However, to be effective, any fiscal transfer plan needs to be large enough to create a credible firewall. The last few have not been and I see no reason for optimism about the latest one. The market may be setting itself up for disappointment on this score. If the plan is big enough, peripheral spreads should fall.

But does any of this present a solution to the fundamental problem, which is the internal balance-of-payments situation in the Eurozone? No. Europe will still have a bad recession as the periphery attempts deflation via the mechanism of austerity. The ECB will have to cut rates further, and the EUR should fall. This is the story that has kept me short the EUR for some months, and nothing is presently happening to change it.

Talking of the European recession, the economist Tim Duy has produced some charts that show US and Eurozone industrial new orders. They are highly correlated, and the Eurozone series had a big fall in the latest month. Correlation is not causation, I know, but this point serves as a reminder that developed-world economies are highly interconnected and that the US is unlikely to be immune to the situation in Europe.

The FT has a piece on the expiry of the US’s payroll tax cut. It reports that the Republicans want to extend the measure, and finance it by cutting the pay, and number, of federal government employees. The Democrats first countered by suggesting it should be funded by a tax on income above $1m (the Republicans love millionaires), and have now suggested a combination of such a tax and some spending cuts. The crucial point here is that both parties appear committed to funding the measure. The important question is: out of which year’s budget? If it is 2012, then government net spending will fall as if the tax cut had expired (although the effect will be offset somewhat by unemployment benefits paid to any federal employees who are fired), and the net effect on the economy will be the result only of differing multiplier effects. If it is after 2012, then the measure will prevent a contraction of fiscal policy as a result of the expiry of the measure. I await more detail on this point.

The RBA has cut interest rates again in response to funding stresses, especially in Europe. AUD remains high — I wonder whether there is an opportunity for a trade. AUD is high because interest rates remain relatively high, and they are likely to remain high relative to other developed-world economies. And AUD has been highly correlated with risk assets in general. Nevertheless, I should remain alive to the potential for a trade here.


ISM Non-manufacturing PMI fell to 52, d.e. Finally a disappointing US data point!
Factory orders -0.4% d.e. Oct.
UK BRC retail sales -1.6% Nov.
UK Halifax HPI -0.9% Nov.
Swiss CPI -0.2% d.e. Nov.
Eurozone revised GDP 0.2% a.e. Q3.
German factory orders 5.2% b.e. Oct. A very strong, and perplexing, number. 

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