The answer to this is anyone's guess. Europe is perhaps the most dangerous and increasingly deteriorating macro issue out there right now, with huge and far-reaching consequences likely if the worst-case scenarios play out.
This is while the US is showing signs of entering a recession, China is growing at a slower rate, and traders want defensive assets in droves.
Lack of leadership and cohesion from European officials
We have argued for some time that it is simply impossible to run a 16-member union with:
- one central bank directing monetary policy
- the ECB setting interest rate policy, and
- each member country applying its own fiscal controls.
There needs to be some sort fiscal unity (i.e. one government's fiscal policy applying to all), and some member countries are warming to this idea, while Germany is not. There is a consensus amongst almost all member nations, except Germany, that a Eurobond will have to be created. It is clear that the bail-out process has been just a band-aid solution, and it cannot be sustained. However, it's the process of voting through these bailouts that has been the source of frustration - uncertainty with political posturing has been causing massive headwinds for risk assets.
Key vote in Germany
One just has to look at the recent regional election in Germany to see that Angela Merkel is losing her grip. The public has vented its anger at continually having to use tax payer money for years of massive overspending in Southern Europe, when Germany spent the decade after the inception of the euro restoring its competitiveness with textbook-like discipline. Chancellor Merkel knows her every move could be political suicide, and is therefore treading carefully when Europe ultimately needs bold and decisive action. September 29 is key as Germany votes on the expanded European Financial Stability Fund (EFSF) - a rejection of this would be taken very negatively.
Will Greece's aid payments be cut?
It is clear the tough austerity measures are causing massive social unrest, with a Greek cabinet minister recently saying 'no more austerity, it's killing us'. Greece's economy is expected to contract around 5% this year.
Germany's stance
A recent investigation into whether Greece is on track to meet these financial targets by the ECB, EU and IMF (Troika) caused panic when it was cancelled due to what officials said were compliance issues. Germany's response was that Greece will not receive aid payments this month if the conditions of the rescue package are not met. Tough talking indeed, but given the public discontent, it is completely understandable. This week:
- The bailout funds are expected to be delivered; however, what is clear is that markets don't believe Greece will keep to the measures in the future.
- Greek two-year bond yields are above 50%, which shows that investors don't have any confidence in them to ever come back into the private markets to fund their deficit (debt burden).
- Talk has revealed that Greece will perhaps always need continuous bailouts, and any signs that it will not meet the pre-determined budget targets will see risk assets suffer.
At some stage something will have to give, and it increasingly looks like Greece may be forced out of the euro and left to fend for itself.
Neighbouring worries: Italy
Italy has clearly gone above and beyond expectations with the proposed 45 billion euro austerity measures and a balanced budget by 2013:
- All it has really done is appease the ECB enough to step in and buy Italian bonds.
- The market remains thoroughly unconvinced that it will meet these measures, and has started selling Italian bonds, which in turn has begun driving up yields (making debt refinancing more expensive).
- There is speculation that ratings agency Moody's may even downgrade Italian debt in the near term, and traders are questioning the effects on yields when the ECB stops buying (which will happen soon). Will yields sky rocket? This is key and could be a major issue.
- The EFSF was set up to help out Portugal, Ireland and Greece, and with potentially $440 billion to use, it is in no way big enough to help Italy.
- The question then is, will we see Germany, France, etc step up and dramatically increase the fund? If so, will we see credit downgrades from the agencies as they use more money to pay for it?
What we see in the short term
Essentially we are seeing share prices of European financial institutions getting smashed as banks lose confidence to lend to other banks.
- Last week, bank deposits at the ECB surged to 166.85 billion euro, the highest level in a year, while credit markets are starting to freeze as banks find it increasingly difficult to get USD funding.
- If we see a default of Greek debt, what will the potential losses be as banks try to market their assets? There is rumour of consolidation in French banks; we have seen it happen already in Greece.
- It is clear that the price action in sovereign yields and European banks are running the show in global markets, and this should continue in the short term until something major is announced.
Unfortunately, given the lack of political will, this doesn't seem likely; the probable course of action, it seems, is one of negativity.
Have a view on the future of the European economies? Why not take a CFD position?
Forex trading is very popular at the moment, as markets are heavily affected by only the slightest news. IG Markets offers tight spreads on a full range of currency pairs, including the EUR/USD, starting from just 1 pip.
We have also recently reduced the minimum spreads on some of our most popular stock indices, including the Germany 30 cash, from just 1 point. Plus spot gold is available from 0.5 points.
Visit our extensive market analysis section, including The Week Ahead and Economic Indicators, to keep in touch with major economic releases.
If you do not already have an account with IG Markets, simply apply for one online, and you could be trading within minutes.
Updated: 08/09/2011
Disclaimer: IG Markets provides an execution-only service. The material above does not contain (and should not be construed as containing) personal financial or investment advice or other recommendations, or an offer of, or solicitation for, a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of the above information. Consequently any person acting on it does so entirely at his or her own risk. The research does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.