We just might be there – Europe finally gets a plan that can work

July 22, 2011

Global Macro

Political will to keep the Eurozone together was never lacking but political capital to get the job done was. So in many ways the fact that markets have taken the very existence of the Eurozone union and the Euro as a currency to the precipice has in a large part likely created the sort of urgency that imbues political leaders with political capital. So there is some good in the recent volatility.

So we got good news for a change and a big night offshore as the prospect of a Greek default seemed to move closer toward resolution. At the end of trade the Dow Jones was up 1.21% to 12,724 with the S&P up slightly more than that. The Bourses of Europe were not quite so ebullient but they too closed at the highest levels in a couple of weeks with the average rise around 0.8%. Clearly it is going to be a better day in Asia today – good news for a change.

The interesting thing about last night was that earlier in the session Jean-Claude Juncker had said that Greece will probably default and European manufacturing data was on the weak side. But it seems that the proximity to the abyss has seen Europe’s politicians and Central Bankers find some middle ground in their approach. This looks like the start of some sort of formal fiscal integration with other countries back stopping Greek debt according to ECB President Jean-Claude Trichet. We’ll see if they can hold this plan together but throwing €160 billion at the problem gives it a chance.

But let’s have a quick look at the plan and see if it’s sustainable both in terms of the positive impact on markets but more particularly once this plan gets back into the home parliaments of the leaders who have agreed it.

The Economist Newspaper summarises the key points below

The new bail-out will add another €109 billion ($157 billion) in official help to the first bail-out, worth €110 billion, which is still being disbursed. Moreover, interest rates on new lending from the European Financial Stability Facility (EFSF), the euro area’s rescue fund, will be more lenient (interest rate roughly 3.5%) while the maturity of the loans will be doubled from the current 7.5 years to 15 years.

On top of this, private-sector holders of Greek government bonds will contribute a net €37 billion. The statement does not specify the measures, referring instead to “a menu of options further strengthening overall sustainability”. One might be an exchange of existing bonds for new ones worth less than the old ones on paper because they will pay lower interest and stretch out longer. But the mooted reduction in their net present value (ie, the sum of their discounted cashflows) was reportedly only 20%: for a haircut, bald this will not be.

Apparently we are still going to see a default call from the ratings agencies point of view the article also says but it seems the market might be less concerned about it this time around. Who knows, I’m skeptical.

But the key point for me that gets the whole thing over the line is the fact that Greece is going to be backstop by other Euro-area Governments. As I noted above this is a slide toward fiscal transfer – granted only on default but it is back stopped nonetheless. Bloomberg reported  ECB President Jean-Claude Trichet saying,

We have to lend to sound counterparties, and we will have the backing for our own refinancing operations,” Trichet said. “I can tell you that the amount of capital that has been accepted by heads of state and governments is 35 billion euros.

I’m guessing that with a number that large European leaders are trying a bit of shock and awe in the plan’s size but, to quote Westpac’s Head of Rates Strategy, Russell Jones,

While these measures are clearly a step in the right direction for near-term risk appetite, there does remain implementation risk.

That’s a nice way to put it. While we don’t want to always focus on the negative and are genuinely hopeful that we might finally be getting there and hope the spread of contagion can be stopped there are legitimate questions about whether this compromise solution is going to be acceptable to the individual sovereign parliaments of Europe.

And to quote Mr Jones again, who has a very nice turn of phrase,

 There is still the threat that the eye-watering fiscal austerity required to address these debt burdens around the periphery keeps these economies depressed and proves socially and politically unsustainable. Sustained growth remains a priority. The Eurozone is slowing (see yesterday’s PMIs) and the ECB is tightening!

So we may be able to breathe a sign of relief for now but weak economic growth and a working through of the debt bomb looks here to stay. I’ve written on this blog a couple of times that I didn’t think Greece would be the thing that takes the market down but that the data eventually would.

I still holds that view but a relief rally, if that’s what we are getting now, could be sizable. There are clear short-term upside risks to markets if things settle down. That offers trading opportunities for the nimble but the overall macro economic backdrop is changing – a European solution means it’s just not going to get worse. 

greg@lighthousesecurities.com.au

www.twitter.com/gregorymckenna

This blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If you do need economic, investment or financial advice we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au

 

 

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