Lets-Talk Finance

Can Super Merkel save the Euro? - Market update

Nothing really happening recently on financial markets that have been quite snoozy lately. No news is good news? It seems like it. Despite the lack of any update on ECB's (European Central Bank) intervention on markets or any good economic figures, European markets are rallying (Friday : IBEX 35 = +1.94% - FTSE 100 = +0,31% -  DAX = 0.64%) - supported by the financial sector dynamism (Bankia went up  50% two weeks ago due to the fact that the financial aid it needed is to be completed in a very near future). The spanish 10 yr bond dipped from 6.84% to 6.54%, as well as the Italian 10yr bond even though its decrease hasn't been as sharp as the Spanish'.

The main underlying question laying behind this flitting momentum is the following : Will Merkel and Germany allow and proceed to purchases on the secondary bond market by European institutions to lower bond yields. It appears that this option is pretty much the last one that could save the Euro if uncertainty and poor confidence still characterise the market over the next few weeks. In fact, analysts believe that the euro bailout funds would not be sufficient to provide a full bail out to both Spain/Italy, which would cost at least  € 1 trillion  (bail out funds amounts to approximatively  €700 millions.

Hence in this scenario, the only safety net is the possibility of the creation of a banking license to the ESF (European Stability Fund) , which would enable it to create and pump in money in Euro distressed bond markets to lower yields. This is of course a very well-intended proposal despite the risks of inflation - increasing the monetary base would enable the ESF to lower yields in peripheral euro countries  and give them time to reduce their structural deficits (as opposed to cyclical deficits). Sounds nice in theory, and the only thing really left to us is to hope that it will be "enough".

Unfortunately, there is quite a large room of concerns on this ECB "Quantitative Easing for Southern European Countries"

The Bundesbank, Germany and Northern European countries except France are quite strongly opposed to ECB's possible intervention. They consider that those kind of actions should be decided by parlements and not by central banks, and are worried it may become an 'addictive drug' without solving the roots of the problem.

And that's the core of the problem. There is no doubt that bond yields will go down if ECB decides to intervene in the market - at least in the first place.

Markets will even respond positively and rally for a bit. 

But over the long-term many concerns will remain, and risk mitigation is highly unlikely. Why?  :

1.  Will a real fiscal and bank union will take place? This sounds really doomed as both sides stand their ground and do not seem keen on a compromise. Germany and Northern European countries are not willing to increase inflation in their countries (pay rise or any other minimum wage) and the rest of Europe leaders are having a hard time cutting down on social benefits and other public bodies. No compromise = No union = Higher perceived risk by markets. 

2. Lower bond yields are likely to be only a fad. Why? Many hedge funds and other participants in the bond market sell their holdings after public intervention in the market. In fact, if the ECB buys bonds it will be a preferential creditor of Spain. In other words it will be repaid first and before any other creditor (ie : hedge funds, banks..). This creates an additional risk and this result in bonds sell-off, more information here : http://www.businessinsider.com/the-basic-arithmetic-behind-investors-biggest-fear-in-europe-2012-8

Lower yield means a higher bond value - hence many bond holders leave the market after public intervention. Except if growth expectations improve in the long run, nothing will really prevent bond yields to spike up again.

3. ECB buying bonds is likely to spark up some tensions amid distressed Euro countries (Portugal,Ireland..). Those countries have even higher borrowing costs than Spain or Italy (9.45% for the Portuguese 10Y - 8.2% in Ireland and more than 20 in Greece). Their reasoning is the following : Why would this country get the help of the ECB to have lower borrowing rates when mine does not? The role of the ECB is meant to be impartial and not to favour any country specifically - which is particularly opposed to a such intervention.