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Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. I do make mistakes, but I try hard to do my analysis thoroughly, and to make sure my data are correct. Remember: the unexpected sometimes happens. The expected does too, but all too often it takes longer than you thought it would.

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Sunday, August 5, 2012

Shock and awe



Well, maybe not.  But heaps better than previous attempts to solve the crisis.

Question:  why does the US, owing more than 100% of GDP, and with pollies and a political system apparently incapable of walking and chewing gum at the same time, have nominal long bond yields just a whisker over 1%?  One reason, the key reason, is that the US has its own currency and its own central bank.  Now, the currency of the Euro area is, well, the Euro.  And the Central Bank of the Euro area is the ECB.  And if you are a true believer in the Euro project, then buying the bonds issued by Spain or Italy or Germany should in principle (for the Central Bank)  be no different to buying bonds from Germany.  And rescuing Spanish banks should be no different to rescuing German banks.  After all, the Fed doesn't refuse to help banks in Alabama, the RBA to help banks in Tasmania.  But this the ECB refused to do.

This inexplicable unwillingness to act like a Central Bank (henceforth called a CB, to save typing) strongly suggested to the market that the ECB and the Germans and all the others running the show didn't really believe in the Euro project.  And the market responded accordingly driving down the prices (and up the yields) of Spanish and Italian bonds, thus making default more likely, as I've discussed ad nauseam.

On Friday, it began to look as if this obvious truth has finally percolated through the thick dolomite of the European Authorities' skulls, as this article by James G Neuger discusses: 
After 2 1/2 years of incremental crisis management and false starts, a bargain is beginning to emerge between Europe’s politicians and central bankers over how to calm bond markets and end the debt tumult that threatens the euro’s survival.
 The European Central Bank sketched out its side of the deal yesterday, offering to buy Italy’s and Spain’s bonds on the market as long as the euro governments’ bailout fund makes purchases directly from the two countries’ treasuries and ties them to tough conditions. 
“The ECB’s decision is important,” French President Francois Hollande told reporters in Paris. “It allows the ECB to intervene when it’s necessary.” German Chancellor Angela Merkel, who is on vacation, didn’t air any immediate qualms; on July 27, she and Hollande made a joint pledge “to do everything to safeguard” the euro. 
Draghi’s offer to join forces with governments contrasted with the maneuvering in August 2011 by his predecessor, Jean- Claude Trichet. With Europe’s rescue fund not yet empowered to intervene on bond markets, Trichet ended up going solo in starting the purchases of Italian and Spanish debt. Italy’s then-government, led by Silvio Berlusconi, chafed at the ECB’s insistence on budget cuts, and the central bank had no way of enforcing its writ. Opposition from the two Germans on the ECB’s policy council limited the size of the bond purchases and led to their suspension six months later. 
Draghi is operating in a different political constellation. Berlusconi is gone, replaced by the non-partisan Mario Monti, now in the midst of enacting 26 billion euros of spending cuts. In Spain, Prime Minister Mariano Rajoy has delivered three rounds of austerity since taking office last December. Moreover, Europe’s political establishment has courted the ECB by giving Draghi a lead role in fixing the birth defects of the monetary union that go back to the 1991 Maastricht Treaty. Along with European Union President Herman Van Rompuy, European Commission President Jose Barroso and Luxembourg Prime Minister Jean-Claude Juncker, the central banker is co-drafting proposals for a closer fiscal union and more integrated banking system.
Sounds like the real thing.

There are caveats (aren't there always?).  It requires legislation; the German Constitutional Court has to rule on aspects underpinning this reform, and that won't happen until September 12th; the Spanish and Italian governments haven't yet asked for aid.

It used to be said of the British Cabinet that nothing concentrated their mind so much as a fall in the pound.  What's concentrating the minds of the Euro big-wigs is that Spain and Italy together are between a quarter and a third of the Euro zone, and moreover, if they fall, who will be safe?   So, prolly, this time the Euro elites will come up with a workable solution.

Markets clearly think so.

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