After good housing data yesterday, today’s crop of US data is not likely to be so sunny. We get durables (expected up a measly 0.5%), pending home sales (expected up 1.5%), and the usual Wednesday Energy Dept oil inventories.
As will be the case all week, eyes are on Europe. We continue to think Germany has the correct stance and the stance that will prevail, if only because it’s the only one supported by legal contracts. Weidmann is right— confidence in the eurozone experiment would be irreparably damaged if the members somehow succeeded in ganging up on Germany and were able to impose other members’ liabilities on Germany without Germany’s agreement. It would be despotic (“no taxes without representation” should sound familiar to American ears). Besides, it wouldn’t work. No one really believes Greece or other southern tier country would clean up its act and reverse centuries of cultural norms to become fiscally responsible within ten years. They have already had 121⁄2 years and failed.
Still, a massive new commitment to federalism is on the table. This particular version seems doomed and yet Germany’s commitment to the eurozone concept is not merely rhetorical. So we should expect a series of additional initiatives, including revival of the Wise Men proposal. The van Rompuy report is not a game- changer but it marks the beginning of a new phase of EMU governance. It may appear that the eurozone is tottering along with the same old muddling-through mentality, but that’s not accurate. Something big did happen with the van Rompuy report and bigger things are ahead. The question is whether the bigger things can be implemented before Greece is forced to default (again) and exit the eurozone, and Spain goes bankrupt and defaults.
Without some glimmer of hope of new support for peripheral bonds, Spain and Italy will reach unacceptable costs this year. If they were to seek sovereign bailouts, the existing resources of the EFSF and ESM would not be enough to get the job done. Investors smell blood in the water. We continue to wonder if there is not some off-Treaty emergency action that can be taken, like US presidents do with executive privilege.
But if not, we will be talking about haircuts for Spanish investors before the year is out. Not to be cruel, but isn’t this the way private credit markets are supposed to work? Those who put too much faith in bad sovereigns get the chop. Fiscal mismanagement leads to bankruptcy whether public or private. Anyone who believed in Argentina after the 1992 default deserves everything they got—pennies on the dollar. Anyone who believed the EMU would rescue a big member because it rescued small members was not counting the amount of money in the coffers. Analysts have said for months that the ESM was not a bazooka and insufficient for Spain and Italy. Therefore, those who have been out buying Spanish and Italian notes over 12-18 months at juicy yields are failing to evaluate the sovereign credit risk accurately. We don’t need to go so far as to say they are “greedy.” It was always thus, and should be.
A lot of ink has been spilled over the past two years about the eurozone “failing” and breaking up. We say the eurozone has already failed—banks won’t lend to one another and some sovereigns cannot access the private credit markets. But breakup is unthinkable. A partial breakup, maybe—namely Greece. But we do not question the German and French commitment to the eurozone idea. And we have yet to hear from the ECB, the only institution standing. The consensus is building that it will cut rates next week (July 5). We doubt it will do the trick of goosing banks to make loans into contracting economies, but never mind.
We see no alternative to the euro slipping further to the June 1 low at 1.2286 and then beyond. But remember, rabbits and hats. Traders worry that sentiment can turn pro-euro on the slightest pretext, and on recent history, they are right to worry.
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