EU/ECB and EUR credibility on the decline

What a difference a weekend makes… or not. Naturally, the short end of the Greek yield curve collapsed over the weekend, but 30-year Greek sovereigns are still trading below 65! In the eyes of the bond market, Greece is just as troubled long-term as it was perceived on the 4^th of May. The 5-year Greek sovereigns are just back to the April 22^nd level (a tad higher than 90). In other words, the 750B EUR bail-out package agreed upon over the weekend was a “quick and dirty” fix to a big and very current problem. But the package raises a number of questions for the long-term effect on the EUR and Euro-Zone growth – not to mention the political union.

1. Growth. We have already been pessimistic on the long-term growth outlook of the Euro-Zone, which even before the crisis was saddled with debt, suffering from Euro-Sclerosis, huge tax burdens and a political class hating private enterprise and free markets. When the crisis hit Europe, the private sector engaged in much needed full-scale deleveraging, but the governments took over and now continue to run extreme budget deficits at further detriment of the long-term growth outlook. Alarmingly, the overall Euro-Zone debt burden is allowed to continue its uncontrolled growth and this will happen in an environment with already low investment/GDP ratios. Long-term E-Z growth with the current political institutions looks capped at 1.5% at max.
2. The EUR. The single currency rallied as a first reaction after details on the package hit the market Monday morning, but this is the kind of rally that is induced by a really big and fundamentally justified short position. Everybody wants to get out, the EUR advances in short-covering and then resumes the downtrend. Why? Because nothing has been done to lower the debt burdens. The populations of Europe can still look forward to decades of sub-par growth, huge tax burdens and a deteriorating demographics. The ECB will now begin buying sovereign debt and extends the unlimited 3-month funding facility. Low rates are guaranteed for the rest of the year and probably most of 2011. We maintain our end-of-year target of 1.22 in EURUSD. And it might very well go lower beyond 2010.
3. EU/ECB credibility. Is there any left? Last week, Trichet said that the ECB had not even discussed the possibility of buying sovereign debt. Then, only a weekend later, they are now ready! The French FinMin, Christine Lagarde even said: “The message has gotten through: the euro zone will defend its money”. We know that the French politicians have zero understanding of even simple market concepts, but this is beyond ridiculous. One does not defend ones money by printing loads of it and weakening fiscal discipline within the Euro-Zone. If European politicians and the ECB were at all interested in EUR strength, they would implement harsh austerity measures and hiking rates. Furthermore, with French and German debt/GDP ratios at 78% and 73% respectively, this bail-out package is actually a case of the indebted bailing out the indebted. Yes, Germany and France will have no problems servicing their debt for the next five years, but are they really in a position to guarantee the PIIGS countries’ debt (PIIGS countries are a third of E-Z GDP)? Within the next twelve months, the bond market will begin to seriously question the credibility of the bail-out package. Get out of PIIGS bonds with maturity of more than 2 years, while you can at present yields.
4. Germany. Furthermore, what happened to the “no bail-out clause” in the Lisbon Treaty (Article 125)? Germans are clearly against this initiative (the social democrats are for once having the right opinion) and German law professors are already rattling with the Vervassungs-sabers. What I hear, though, indicates that they don’t have a case, since bail-out happens as a multi-lateral effort. Well, if that is the case, what exactly does the “no bail-out clause” mean and what value does it have? Could one imagine any situation at all where it is relevant? I think not. The article 125 has gone the same way as the Maastricht Criteria and by the way, Eurostat now reports that the combined Euro-Area government deficit is 6.3% and the government debt/GDP stands at 78.7%. Both figures are five months old and the last figure is probably 83% by now. Germany has no place in such a union of lackadaisy, French attitude and while one can hardly come up with a scenario of PIIGS depegging and devaluation, it is much easier to find a case of German depegging and revalutation. Watch out for a lot of political noise from inside the union, that will further serve to weaken the EUR.