AMSTERDAM—Economic data in Europe was mixed at best, but markets were lifted on positive economic data.
Retail sales disappointed, shrinking 0.4 percent in December where a 0.3 percent gain had been expected. Germany was the big driver in the disappointment as sales dropped 1.4 percent compared to an expected gain of 0.8 percent. Unemployment in the eurozone also moved up slightly to 10.4 percent in December from 10.3 percent in November with unemployment in Italy rising to 8.9 percent from 8.6 on expectations of 8.7.
Spanish GDP came in at 0.3 percent year on year for the fourth quarter, even a bit better than expected; but the Spanish housing market remains an absolute disaster. Housing permits crashed 31.5 percent in November compared to a year earlier. Nonetheless, the country managed to auction off 6.5 billion euros ($8.54 billion) in debt at moderately lower yields without any disruptions. So far the auctions are going well and Spain has covered already 25 percent of the targeted issuance for 2012.
Markets Up on US Payroll
The euro had quite a volatile week, probably reflecting daily changes in the Greek negotiations. The currency had a total of 7 rallies and crashes of more than 1 percent during the week. And this despite the fact that the headline change was only -0.27 percent from $1.3174 the week before.
Probably anticipating very good headline payroll data out of the United States and celebrating a higher than expected Chinese manufacturing PMI, the Eurostoxx equity index rallied 4.91 percent from a low on Monday to close at 2,515 for the week, along with also upbeat U.S. equity markets. This time stocks from all countries participated with Italian bank Unicredit up 12.8 percent for the week and German carmaker BMW more than 8 percent.
LTRO Part of the Explanation for Bullish Markets
Many market observers noted, however, that the current rally feels like when the Federal Reserve’s quantitative easing program was still in place.
Stocks just go up disregarding slowing global trade or a complete collapse in the Baltic Dry Index, which measures freight rates for dry bulk shipping and is considered to be a leading indicator of global economic activity.
The Citigroup economics team provides another angle to the now infamous long-term refinancing operation (LTRO) by the European Central Bank (ECB). In a recently issued note, they argue that while individual banks are not likely to directly reinvest cash from the ECB into risky assets, the banking system does so on aggregate and then gets rid of the excess liquidity at the ECB after the process.
Michael Saunders writes: “The circulation of the excess liquidity can’t be assessed through the deposit facility. Individual banks are able to reduce their excess liquidity through transactions not involving the ECB (e.g. sovereign bond purchases, replacement of other sources of own funding, or loan provision). But, the euro area banking system on aggregate is only able to use the ECB to offload excess liquidity.”
If a bank posts collateral at the ECB and then uses the cash to pay back a maturing bond issue for example, then the cash does not become extinct, but instead changes hands to a party who is more willing and able to take risks. This leads to higher risk prices at the margin, but excess cash will end up at a party that does not have anything to do with it but deposit it at the ECB. During this process, risk is taken out of the market, which helps equities and sovereign bonds. This is similar to the excess reserves that are deposited at the Federal Reserve by U.S. banks.
Greek Situation Still in Deadlock
In our recent pieces, we have highlighted the difficult incentive structure surrounding Greece. Banks need to accept a haircut but know that they have some sway over the public sector institutions such as the ECB, which do not want to take any losses. But in a forced restructuring, that is precisely what would happen.
Greece on the other hand knows that neither the public nor the private sector wants to take the 75 percent haircut that the market is pricing in and is therefore also making demands, knowing full well that it is dependent on future EU, IMF, and ECB funding.
This week saw a marked escalation in the “war of words” with German Finance Minister Schäuble alluding to the fact that Germany is not willing to keep Greece in the euro at any price. He said he “hoped” that the euro would still have the same membership roster at the end of 2012 and made it clear that there was not going to be any official sector involvement (OSI). He also demanded that Greece comply with all the budgetary restrictions before the next tranche of the second bailout package announced last year would be paid out.
On the other hand, Greek Finance Minister Evangelos Venizelos thinks there should be an OSI: “[There] must be negotiations for the official sector involvement (OSI)” and this “means that the ECB must be mobilized.” It comes to no surprise that Eurogroup President Jean-Claude Juncker described the talks as “ultra difficult” and said, “The possibility of a sovereign default by Greece cannot be ruled out.”
Greece’s guaranteed compliance on budget reform, however, is needed to even restart the talks about the private sector involvement in the alleviation of the debt burden.
The Week Ahead
We will have an ECB meeting in Frankfurt this week, where the central bank determines the rate for its refinancing operations, akin to the Federal Funds Rate in the United States. Given mildly positive PMI data and the upcoming renewed LTRO at the end of February, the Nomura economics team expects the central bank to keep rates at 1 percent, which reflects consensus expectations on Bloomberg.
An extraordinary meeting in the eurozone occurred over the weekend. Greek Prime Minister Lucas Papademos was able to secure agreement between the political parties on certain measures demanded by foreign creditors, including additional budget cuts equaling 1.5 percent of the nation’s GDP. Alas, the time for Greece is running out as any kind of restructuring deal needs some time to be finalized and put into law, with some estimates ranging to as long as six weeks. The critical 14.5 billion euros ($19.05 billion) bond payment is due on March 20. If the European leaders stick to their ultimatum, markets should brace themselves for the prelude of a disorderly Greek default.
