When a broad and unspecific deal is so hard come by- and some have used blackmail- it is much harder to negotiate and fill in the details.
This looks like a political deal to keep Monti in power.
A long-term road map towards a fiscal union, so no sign of common Eurobonds ” in Merkel’s lifetime”, and a short-term fix for banking union.
The big deal, and a very positive development for the Euro zone, is if by the end of July there will be a single supervisory mechanism for Euro are banks, headed by the ECB. This will then allow the ECB to use the ESM, if it comes into existence after the German’s have voted on it and their constitutional court ruled on it, to inject capital directly into failing banks and take over those banks. So the ECB, a non-democratic Euro institution, would take over and run banks in sovereign countries ahead of the democratically elected governments. But this does stop the fear that weak banks could bring down individual sovereign countries, like it did in Ireland.
The deal with Spain is that the EFSF is used initially to recapitalise the Spanish banks, by directly lending to the Spanish government. If the Banking Union is put in place, and if the ESM is ratified, then the ESM will take over the loans. That surely should also allow other countries, such as Ireland and Greece, to repay loans to the EFSF and use the ESM as well. For Ireland that seems a huge win. This means that any loans to the Spanish will supposedly stay the same creditor ranking as current bondholders.
On the use of the ESM to buy sovereign debt directly. This is not new news, The ESM, once established, was always able to buy Sovereign Debt. This was Monti’s demand to reduce the borrowing costs of sovereign nations, especially Italy’s. It is not surprising therefore that he is touting this as his success. The ESM debt buying will not lead immediately to any supervision, by the Troika of the EU/IMF and ECB. However, the country requesting debt purchases, will only be eligible if it is complying with the Euro zone fiscal rules. It requires a memorandum of understanding though and is subject to a majority vote by the member countries. If they are following the Euro zone fiscal rules, it would be pretty unlikely that the yields on the debt will be worrisomely high. The reason that Spanish yields are so high is that the Spanish are unable to abide by the EU fiscal pact. And the reason that Italian yields are so high is that the market doesn’t expect the Italians to be able to abide by them.
So Monti does at least win politically here. If he can convince the Italian parliament to put in place long-term structural reforms that will keep the EU fiscal rules, then Italian bond yields should fall, and there is at least a carrot for the Italian parliament to do so. But if non-domestic investors believed that the Italians were capable of putting in place these credible reforms then the yields would not have been rising in the first place.
This is a deal reliant on growth- and that doesn’t seem to be coming. The Italians and Spanish need economic growth to be able to comply with the EU Fiscal pact, or they will not be able to ask the ESM for debt purchases without applying for a fully supervised debt bailout.
Market reaction- I suppose that with little expected the risk markets are not surprisingly taking the results out of the 19th Euro zone crisis summit very positively. Italian 10yr bonds traded as low as 5.75% this morning, from 6.18% last night, but are starting to rise again and currently stand at 5.90%.
Spanish 10yr yields have fallen the most, down almost 55bp to 6.35% earlier. But it is the front-end that has seen yields fall even more. 3yr Spanish bonds were 80bp lower at 5.13% but have risen back to 5.30%.
But both Spanish and Italian bond yields remain at unsustainable levels!! 10yr Yields have to be sub 5%. Otherwise the increase to the Budget deficits is too great for any chance to maintain abeyance of the Fiscal Pact.
Risk markets are better with European equities higher by around 2.5%, commodities are similarly higher with Copper up 2.25%.
German Bunds have taken the most pain, 10yr Bunds are down 1.2% and 30yr Bunds are down 3%.
10yr German Bund yields are now yielding 1.66%, 2bp more than US 10yr Treasuries.
As always the market risk over shooting on this optimism. There are too many ifs and too many declarations of “in principle”. And the time scale is too long to save the Spanish and probably Italian debt markets. The Spanish will receive the Bank capital required from the EFSF, it may never receive them from the ESM. The Banking supervisory board will not be operational until 2013 at the earliest, and probably significantly later as they do not have the staffing currently.
And now Merkel is clarifying that nothing new has really changed. However I would say that the way that the Italians and Spanish blackmailed the German politicians by refusing to sign the “growth” pact until the statement was written the way they wanted it then the antagonism caused will mean that the negotiations over the details will be very tough.
Volatility is set to rise even more.
I will send out some more specific market commentary later.
