European Deal

Markets have responded very positively to the statement released by Eurozone heads of government this morning. The statement itself does not actually say very much. It announces:

  • Single bank supervisor to be worked on.
  • ESM could recapitalise banks directly ONCE there was a single supervisor IF such a decision were taken AND with appropriate conditionality.
  • Loans to Spain to recapitalise its banks will come from the EFSF and later be moved to the ESM, without becoming senior as a result of the move.
  • Ireland and other countries will have their bailout terms reviewed so that similar cases are treated in similar ways.
  • The EFSF/ESM will be used in a “flexible and efficient” manner to stabilise markets for countries respecting their various obligations.

If this doesn’t seem like a massive breakthrough, that is because it isn’t. The aim is to have an agreement on the single bank supervisor by the end of 2012, although the implementation will probably take much longer because bank regulation is a fiendishly complicated subject. The idea that the ESM could be used to recapitalise banks directly is new, and a concession by Germany, but of course its practical application, on the foregoing argument, will be some time away. The absence of de jure seniority in European lending will not change its de facto seniority (as seen in the Greek restructuring). And the ESM can already be used in a “flexible and efficient” manner — it has always had the ability to buy sovereign bonds directly.

So why have the markets rallied? Well, you have to know what the politicians have been doing and read between the lines. This agreement was reached only after Mr. Hollande put his support for the fiscal treaty on hold and Messrs. Monti and Rajoy said that they would refuse to support the previously-agreed growth package that is about to pass through the German parliament. They put a gun to Mrs. Merkel’s head and in consequence she made some concessions. What were they? Mr. Monti said after the meeting that sovereign bond purchases by the ESM would now be approved without the countries concerned having to submit to full Troika oversight, although Mrs. Merkel said that countries would still have to fulfil the existing conditions — criteria of European virtue, if you like — and that the Troika would check this. The argument seems to have been about how intrusive the Troika could be, in terms of new conditions and monitoring, in the economic policies of countries whose bonds are bought by the ESM. Mr. Monti seems successfully to have forced an agreement, in principle, that it will not be as intrusive as it might have been. The details of this agreement are to be worked out (or at least, are to be started to be worked out) today, on the second day of the summit. This means that there is still room for the markets to be disappointed if the details do not live up to expectations.

Is this an important agreement? Yes, for two reasons. First, it confirms that political integration remains the long-term solution to Europe’s current problems in the minds of the Eurozone’s politicians. Europe is moving in the direction of a permanent solution, and that should cheer the markets up (after all, it is better than moving in the opposite direction, as many have recently feared). Second, it would not have been worth Mr. Monti’s effort to make such a fuss if he did not think that Spain and Italy might actually ask the ESM to purchase their countries’ bonds — i.e. that the relatively relaxed conditions attached to such purchases would make a request for them politically acceptable. This, I think, is what has really cheered the markets up. My point about the details, above, is that the devil may prove to be in them if the ground Mr. Monti thinks he has gained is reclaimed by Mrs. Merkel in today’s discussions.

Will secondary-market purchases of Spanish and Italian bonds make a difference?

Just the fact that they are there should be helpful. I talked yesterday about the reasonable fear, in the domestic markets for these governments’ bonds, of mark-to-market losses. ESM purchases should ameliorate that fear, and hence should be of some help. I fear, however, that the direct effect may not be large: a market price is set by the marginal buyer, and if a large, non-price-sensitive buyer enters a market, its effect is to change who the marginal buyer is; thus the size of the price effect of the new buyer’s entry on the market price will depend on the dispersion of prices that people in the middle of the buyer-distribution are prepared to pay. Unless the dispersion is very large, or the new buyer is prepared to buy as many bonds as necessary in order to hit a price target, potential buyers’ (correlated) views on the value of the bonds are likely to remain the major determinant of bond prices.

To the extent that the general worries about Spain are reduced by this move, and hence that deposits return to the Spanish banking system, the banks may feel able to return to the government bond market and that could really reduce Spanish bond yields; I find it hard to predict the strength of this effect in advance, however. Spanish yields are down sharply today, but on the basis of my analysis yesterday I think that they will only reverse their rising trend if Spanish banks are able to feel more secure in their stable funding. The agreement will not make that happen directly, but it might continue to have a positive effect on market sentiment.

Everything Has Shot Up

Risk assets have all shot upwards today. EUR, GBP and AUD have all risen, as have global equities, oil, copper and precious metals. At the same time, risk-off assets have fallen. USD and JPY are down, as are Treasuries and Bunds.

This is just a dramatic illustration of something traders have had to deal with every day in the past few years — everything is correlated. Markets are largely driven by the One Great Variable, also know as risk-on/risk-off. It makes me think of various figures in Hinduism who are all manifestations of Vishnu. All the different markets that people like to talk about, and perhaps trade quite separately, have of late been manifestations of the OGV.

This makes the job of a trader quite difficult. One has to try to make money by predicting the OGV, but one would also like to be able to diversify by trading something else. The search for assets that are not avatars of the OGV has been one of my themes. But it is hard to predict when an asset will switch and become a god in its own right — for example, AUD rallied with risk assets in Q1 despite the RBA having started to cut rates, then seemed to fall for its own idiosyncratic reasons, and now has once again revealed its true nature as an aspect of the OGV.


  • Japan retail sales 3.6% b.e. May.
  • UK Nationwide house price index -0.6% d.e. June.
  • German unemployment change 7k d.e. May.
  • UK current account deficit remained quite wide, d.e., Q1.
  • UK final GDP -0.3% QOQ a.e.
  • UK revised business investment 1.9% QOQ d.e.
  • US initial claims 386k a.e. and roughly flat on last week.
  • US final GDP 1.9% QOQ a.e.
  • UK GfK consumer confidence -29 b.e. but remains very low.
  • Japan manufacturing PMI 49.9
  • Japan household spending 4% YOY b.e. May.
  • Japan national core CPI -0.1% YOY d.e. May.
  • Japan unemployment 4.4% b.e. May.
  • Japan prelim. IP -3.1% MOM d.e. May.
  • Japan housing starts 9.3% YOY b.e. May.
  • German retail sales -0.3% d.e. May.
  • French consumer spending 0.4% b.e. May.
  • Eurozone M3 2.9% YOY b.e. May.
  • Eurozone private loans -0.1% YOY d.e. May. This series has been trending down for a while but this is the first time it has been negative on a YOY basis since early 2011.
  • Eurozone CPI flash estimate 2.4% YOY a.e. June.

Coming Up

  • US Personal Income and Outlays report.
  • Chicago PMI
  • Revised Michigan sentiment
  • Global PMI’s (Sun and Mon)