This Can’t Continue Much Longer - Something’s Got to Give

EU authorities are stirring once again and some new forceful action must be forthcoming  - but what and when? Meanwhile, GBP fairly steady despite very dovish quarterly BoE inflation report.

Latest EU Developments:

After false starts yesterday, the new Italian Prime Minister Monti announced his cabinet of ministers today, a move that failed to sustain the rally in European bond markets, where yields had dropped early in the day on news of ECB bond buying. The Italian 10-year benchmark opened above 7.0%, then fell to 6.75% only to rally back north of 7% as of this writing. Spanish and other EU nations’ spreads to German yields were likewise back close to or beyond recent extremes.  We mentioned yesterday that the stress levels are clearly a Euro negative development, as are the lower yields at the front end of the Euro yield curve, but this ZH post looking at a recent Deutsche research piece points out the possibility that repatriation flows back into Europe from asset liquidation may be a key drive and reason for the Euro’s relative resilience.

In general, the very odd thing here is that global risk appetite hasn’t taken even more of a hit around the world than it has on this continuing Euro Zone debacle. We’ve already crossed the Rubicon here on yields and there is no relief in sight and the US S&P500 is 3% from recent highs? The situation is severely destabilizing and at this point has become a self-fulfilling prophecy (assuming no intervention) due to the leveraged nature of the European banking system. Higher yields quickly lead to margin calls and/or de facto insolvency for the most leveraged banks. Witness rumours today that Italy’s biggest bank Unicredit is in trouble and asking the ECB to recognize other collateral.

We can expect that EU authorities are scrambling once again, as some kind of response is no doubt taking shape behind the scenes. It is clear that the solution won’t immediately involve giving the ECB new powers – the ECB’s Mersch was out late yesterday speaking on the limits of ECB efforts and Merkel today said that the ECB doesn’t have the option to solve Euro problems. Merkel also said, however, that “Germany … wants a 17-member Euro Zone … that inspires confidence. We are prepared to give up a piece of national sovereignty to achieve that”.  She added that an EU treaty change would send a signal to markets. For their part, European Commission president Barroso and Van Rompuy were also out making noises on the possibility of the European Commission receiving new powers on the one hand and on the other, the creation of a new central EU body that is given the authority to intervene in national budget matters. Considering the “proud” tradition of maximum intervention, we should expect something soon – perhaps this weekend? This can’t continue much longer. So the risk remains very much of the two-way variety (short term further aggravation of the current circumstances extending the move one way, while a kneejerk reaction when “Something, anything!” is finally done to address the problem could give the market whiplash.

Odds and ends

The BoE inflation report was very dovish on growth and inflation, particularly given the very elevated recent CPI readings out of the UK. The BoE’s King revised growth estimates for 2012 down to 1% and said that inflation would begin falling sharply early next year. He also said that the financial sector is not completely out of the woods yet, though UK banks are in better shape that EU counterparts. It is rather clear that the BoE will continue to act (via QE) as long as the economy remains vulnerable and will countenance painfully wrong inflation forecasts if necessary to support growth. On this news (and better than expected jobless claims figures as well) the pound at first lost ground versus the Euro before gaining a good portion of the losses back. GBPUSD has corrected considerably lower today and poked through the 55-day moving average intraday. (about 1.5825).

The Bank of Japan came and went with no fanfare, and USDJPY is back just below the 77.00 level, which was about the mid-point of the range through the August and September time frame. This will likely soon testing the MoF’s resolve again soon and we should all be the lookout for the next round of intervention and the short term distortions it creates. Consider that the last round of USDJPY intervention pushed EURJPY all the way to 111.50 and that EURJPY is now trading 8 figures lower.

Looking ahead

It’s all about the Euro Zone as ever, with headline risk growing with every bp wider that EU peripheral spreads run. The next intervention can’t lie far ahead if the situation remains this bad, much less worsens. Italian 10-year yields might be able to fiddle around above the 7.0% level for a few days or more, but it doesn’t seem possible that we head to 10% there and/or in Spain without the banks grinding to a halt. The stakes are enormous here – so stay very careful out there.