Europe Exceeds Low Expectations…

The clearest result from the latest EU summit was that EFSF/ESM funds can be used directly to support banks, a positive move toward breaking the destabilising bank/sovereign linkage which was exacerbated by the ECB’s LTROs.  However, that can’t happen until we have a new pan euro zone regulator in place, and in the interim the ECB will have to step in via a longer duration LTRO or SMP peripheral debt purchases. I moved in the strategy note in mid-June to add portfolio beta and on my recent Asian tour, it was clear that expectations were extremely low, and well managed by euro zone politicians for once. The sharp risk rally in recent days partly reflected short-covering, but there are as ever plenty of loose ends in this deal. The new agreement implies that in the future, banks will be bailed out by the collective effort of euro zone countries. At the very least, disintegration has been postponed a while longer, although true fiscal union via Eurobonds etc will have to wait until after the September 2013 German election.

Germany’s position had softened in the run-up to the summit, from seemingly ruling out any further help for Italy or Spain to insisting that any assistance must be through the tools already in place, a shift that investors largely ignored. However, Germany remains adamant that new aid requires more conditions and EU oversight. The plummeting yield on Irish sovereign debt was significant as the burden of its banking rescue looks set to be lifted alongside action on Spain, allowing a return to the bond markets in 2013, and indeed the country is set to return to the bill market this week with a €500m sale. Whether the rescue fund will be used to buy Italian bonds is still unclear, and we have 1.6trn in Spanish and Italian bonds to absorb between now and end 2014, which requires either a dramatic resurgence in private sector appetite or an unprecedented scale of ECB purchases. The key is to cap peripheral yields at a level which private sector investors perceive as sustainable and therefore an attractive entry level, probably about 4-4.5% for Italy and Spain.

While the move on seniority for official capital injections from the ESM will comfort private investors, senior bondholders are ultimately very likely to be made to absorb losses for the first time in this on-going crisis; the numbers simply don’t add up otherwise, given total EFSF/ESM resources of only 500bn, and no leverage to be applied to these funds apparently. The direct capital injection arrangement is linked to the establishment of a “single supervisory mechanism involving the ECB”.  This could be a single regulator inside the ECB (similar to the new UK model), which would go a long way to correcting the absence of a joint regulation and restitution regime for banks. The point of having a single supervisor trusted/ controlled by the ECB is to make it possible for the ECB to at long last act as a lender of last resort, and that’s the most bullish implication of the whole deal. The summit also agreed on a growth pact adding up to a total of some 1% of EU GDP via a ragbag of initiatives (SMEs, energy and broadband infrastructure etc.) that will do little to boost trend growth but is a sop to the new French President.

Overall, despite a host of details such as the timescale for the new bank regulator to appear (and the equity injections require that oversight in place, which is unlikely before next year), this was a milestone next step toward a fiscally integrated euro zone. A grand European bargain between Germany and other euro members is taking shape, requiring countries to give up a large degree of sovereignty over their budgets. While Berlin continues to insist that European leaders take concrete steps toward a fiscal union, Germany is open to a level of mutual financial support between euro members that has so far been taboo, so long as joint EU fiscal policy comes before joint debt liability. Italy and Spain will have an easier time qualifying for aid from the ESM; countries that comply with existing economic-policy recommendations will be eligible for aid without having to fulfil any extra conditions.

That’s less onerous than the conditions which Greece, Portugal, and Ireland had to meet to get bailouts. By until now claiming preferred status, official lenders have effectively subordinated private bondholders, driving private bondholders to demand even higher yields as compensation. However, for now, at least, official lenders like the ESM will still have preferred creditor status on loans to countries other than Spain. The ECB is likely to follow through on the summit progress with a rate cut this week of at least 25bps, and a longer dated LTRO scheme is likely soon. A move to allow the ESM to borrow €1trn plus from the ECB would bring the intervention fund to a credible scale versus looming peripheral bond issuance.