Is Recent EU Activity Enough?

Friday 29 June was a trading day of pure euphoria on commodity and stock markets. One day gains for oil in Nymex trading reached 9.3% for the WTI contract, with large or massive gains for cotton, coffee, orange juice, copper, gold and silver. Some European stock markets, like the Italian MIB jumped by more than 6% on the day with Spain's IBEX close behind. The euro currency gained.

Headlines not only in the financial press, but in all media hailed the news that the euro zone seems a step closer to solving its 30-month-long debt crisis and stimulating both economic growth and employment with an apparent no-wriggle-room agreement to find and 'inject' 120 billion euros into Europe's failing economy. European leaders specifically agreed to expand their effort to stem the debt crisis by easing repayment rules for emergency loans to Spain’s banks and relaxing their conditions on potential near-term help for Italy.

The basic question is however simple: Are these agreements and the flamboyant rally they triggered strong enough to take scrutiny and testing longer than one weekend?

HOW FAR IS ENOUGH?
The S&P 500 and the Nasdaq posted their best daily percentage gains since December 2011 on Friday after the agreement by European leaders, also pushing up the euro, but the next 7 days will need to avoid any major push back or negative headline news that suggest the deal is not going to happen. The first doubts are the most logical: the claimed new 'growth pact' defended by France's Francois Hollande, Mario Monti of Italy and Spain's Mariano Rajoy basically and firstly seeks to push down borrowing costs for Spain and Italy, and to prevent them growing for France. Exactly how the 120 billion euro headline figure will stimulate growth is not specified, but major and classic 'Keynesian type' infrastructure spending appears unlikely, firstly because costs in this sector are high and new infrastructures outside the "green" sector are scarcely needed, and secondly because costs-per-job are also high.

The three-man attack by Hollande, Monti and Rajoy on Angela Merkel's fiscal rectitude was the meat of hundreds of editorials, in a context presented as exposed to imminent threat of the Eurozone card castle collapsing with a catastrophic breakup of its single currency, unless a new rescue fund could inject aid directly into Europe's stricken banks, starting next year, and intervene in bond markets to support troubled member-state debt servicing.

This one year delay may itself be fatal for market sentiment, which will not be mollycoddled by pledges to create a single Eurozone banking supervisor for the zone, based around the European Central Bank, and possibly leading on toward a European banking union of 27 members, which would be able to shore up struggling members like Spain, Italy and other PIIGS, most recently joined by Cyprus.

In a sure sign of rippling and spreading worry that the European crisis is a strong and real threat to the global economy, Wall Street's previous reaction to euro-zone bailout packages and plans were somewhat muted, until 29 June. Initial commodity and equity gains quickly disappeared, usually by the day's end, as investors realized that no quick fix had been thrown together for the region's problems.

On Friday 29 June, the story was different. US commodity market prices spiraled upward and the three major US equity indexes jumped by 2 to 3 percent from the opening bell and held their gains through the day, on news of the Eurozone agreement. Showing the dire need for positive sentiment, these gains enabled trading on the Dow to return a weekly rise of 1.9 percent, 2 percent for the S&P 500, and 1.5 percent for the Nasdaq. Looking at this on a monthly basis, for June the Dow added 3.9 percent, the S&P 500 rose by 4 percent and the Nasdaq climbed 3.8 percent, but three-month Q2 performance was negative for all of them.

HOW BIG IS TOO BIG?
Logical questions abound: will the ESM/EFSF state debt and private bank bailout funds have enough capital, in the sure and certain context of extreme weak economic growth in Europe? Assuming they don't, will the ECB chip in, after some highly complex and politically charged "modification" of its status and powers, and enable the bailout funds to act like a bank, able to leverage their assets? French-German fencing and sabre rattling has almost obsessionally focused this subject - but with no result.

Adding further complexity, sovereign debt growth and debt servicing needs for the EU27, as well as the financing of their national budgets, is a subject producing a huge range of forecasts and estimates which because of their complexity helps buy time, aided by glitzy summits, but debt-and-deficit crisis also gets worse, as no real cash is ever made available. The underlying disease of excessive debt and lack of growth stays like an iceberg fixed in the European Titanic's one-way track to economic armageddon.

The leaders of the 17 Eurozone countries are long on prose announcing what look like big plans, but what is delivered, each time, are a series of short-term steps to shore up their dysfunctional monetary union, and bring down the borrowing costs of Spain and Italy, simply because the borrowing needs of these two countries are so immense that, unlike Greece they are too big to bail out. The existing but temporary EFSF (European Financial Stability Facility), and the proposed and planned but not operational ESM (European Stability Mechanism) are both emergency rescue funds. Their basic (or even only) role is to act "to stabilize markets" by supplying funding support to countries that comply with EU budget policy recommendations, which will take months to be drafted, circulated, modified and approved by all member states.

Their ability to "spearhead economic growth" is at best hard to identify, but the June 29 Eurozone summit papered over that crack by claiming that if debt growth is stabilized, and borrowing costs for national treasuries of the most affected countries are held down, "growth can only return".

HOW LOW IS LOW?
Market sentiment in the week starting 2 July will focus very simple key data, starting with how the euro performs and ECB interest rates. The European Central Bank has no political - rather than monetary, economic or other - choice but to cut interest rates when it meets on July 5. Markets can easily apply their form of "persuasion" by heftily trimming the 29 June gains, through July 4, but without Wall Street's aid due to the Independence Day closure of markets, which carries its own risks of easily manipulated market moves in thin trading. Put another way, if the ECB does not cut borrowing costs on July 5, the chance of a new and large plunge in the euro's value, and equity and commodity prices, and further growth of Spanish and Italian borrowing costsm is very high.

ECB watchers, like Fed watchers have multiple sources of information, comment and rumor to weight the ECB's internal resistance to the bank reviving its bond-buying programme, or further loosening its collateral rules to ease the plight of banks in Spain through accessing its funds. Making it easier for the ECB to cut rates however, the US Federal Reserve has extended its "Operation Twist" of buying longer-term securities and selling short-term ones to keep borrowing costs down. ECB action to cut interest rates in the Eurozone, and later openly buy Spanish and possibly Italian bonds, could have a dramatic positive impact on sentiment, through the clear signal that more easy money will be available for equities and commodities markets.

Far more than the US Fed, the ECB in its short life has massively bought bad debt. Over a quarter of the ECB's balance sheet, of more than 3 trillion euros is PIIGS debt, with no clear mechanism (like the ESM) yet in place to enable the ECB to dump this debt on whatever Eurozone central banks and national economies - that is Germany - which could or might absorb the losses. By further cutting interest rates, the ECB creates more and further financing and leverage problems - for itself.

The outlook is therefore as murky as ever, but simply because European and Eurozone political leaders have a horror of taking real decisions, they have set themselves a range of short term key-number tests with potentially fast and massive market reaction to any further refusal to decide.