Originally published at http://www.europeaninstitute.org/EA-September-2013/perspectives-choppy-atlantic-waters-ahead.html. Reposted with permission of the author.

THE EUROPEAN INSTITUTE

European Affairs

Perspectives: Choppy Atlantic Waters Ahead?  [1]
By J. Paul Horne

Following Germany’s federal election on Sunday, September 22, there may be a growing risk of another chapter in the Euro crisis saga that began in late 2009.  Causes could be Germany’s new coalition government’s reaction to new international bond market stresses; Euro member governments’ political problems; unfinished business such as reform of Euro institutions and a Euro banking union; plus U.S. financial and fiscal stresses that may trigger new strains in Euro financial markets.

While we do not expect this autumn’s turbulence to pose an existential threat to the Euro zone, it will generate enough pressure on European bond and stock markets to revive fears about structural flaws in the Euro zone’s government policies and banks. European politicians have grown complacent and too focused on domestic political squabbles during the truce afforded by the long German election campaign and the European Central Bank’s (ECB) guarantee to protect the euro. Renewed market turbulence this autumn will force them to agree, we hope, on yet more institutional reforms needed to protect the euro currency and the Euro zone banking system.

On the surface, the Euro zone appears to have been improving since the resolution of the Cypriot chapter of the Euro crisis last March. Green shoots of economic growth and confidence have appeared in Germany, France and other northern Euro countries. Government bond yields (the best early indicators of Euro crises) are significantly below their crisis levels of summer 2012; and Euro zone blue chip equity indices are up 12%-to-15% in the past year. The euro has yet again confounded euro-skeptics by being stronger than expected. At $1.35 US today, it is above its $1.325 average since the Euro crisis began in late 2009. Recent surveys of consumer and business confidence show improvement in the northern tier of Euro states since spring.

There are reasons, however, why this apparently positive environment may be only a truce after the German election results and new international stresses, notably in the U.S., start this autumn. If so, we could be in for another round of financial uncertainty and economic difficulty, forcing additional corrective action by Euro zone leaders.

European Pressures

Even though German Chancellor Angela Merkel led her CDU-CSU parties to a major victory with 311 of the 630 seats in the Bundestag for a third mandate, her coalition partner, the FDP failed to win the 5% necessary to be in the Bundestag. Merkel is thus forced to negotiate another “grand coalition” with the opposition center-left SPD party (with 192 seats), as was the case in her first government from 2005-2009. If this proves impossible, then she would have to govern with the Greens (63 seats).

A grand coalition of the CDU-CSU and SPD could alter her capacity for negotiating with Euro zone governments in trouble again this autumn. During the election campaign, German voters’ vocal resentment about bailing out “Club Med” countries became a powerful new political factor for all parties. A grand coalition might be less likely to compromise on austerity measures to deal with peripheral countries’ deficit and debt problems and under-capitalized Euro zone banks.

The SPD shifted leftward since leaving the grand coalition in 2009, notably resisting the painful structural, tax and labor reforms Germany needs. A recent OECD analysis put Germany’s long-term economic growth potential among Europe’s lowest because of bad demographics, low productivity growth and excessive dependence on exports.  The SPD could, however, be more pro-active in a new Euro crisis after criticizing Mrs. Merkel’s insistence on “austerian” policies for Southern European. Today, the SPD would insist on more economic stimulus and debt re-scheduling for Club Med, in return for which, it would insist on more domestic concessions from Mrs. Merkel. The SPD might also resist European Commission supervision of fiscal policies under the “fiscal union” program pushed by Merkel. And it would be even more reluctant than the CDU to submit all German banks to ECB supervision in the new Euro-wide banking union.

Other Euro zone politics could increase autumnal tensions, notably in Italy where former PM Berlusconi’s supporters threaten to quit PM Enrico Letta’s fragile coalition if Berlusconi is expelled from the Senate following his recent court convictions. The government has already backed off from significant tax reforms pushed through by his predecessor, Mario Monti.  An Italian government crisis this autumn would revive worries about Europe’s biggest debtor country. While France’s economy appears to be picking up slowly, President Francois Hollande’s popularity is very low and his ability to persuade his parliamentary majority to legislate much-needed structural reforms to improve export competitiveness is impaired.

Span’s government also faces renewed popular resistance to the austerity program which pushed unemployment to record levels. But austerity improved the fiscal balance enough to cut Spain’s yield spread over the bund to less than Italy’s for first time in a year. Portugal, after a political crisis in July when two senior ministers quit, is demanding that the “Troika” of the European Commission, ECB and the IMF ease fiscal targets in the final phase of its consolidation program. Greece, where the Euro political crisis first flamed up, is undergoing its regular economic review by the Troika. A slowing rate of economic decline and joblessness, plus a growing primary budget surplus, are signs of some success for austerity policies that produced six years of recession misery for Greeks.

Yield Spreads and The Draghi Guarantee

The spread between government bond yields is the most sensitive sensor of Europe’s debt crisis, notably peripheral countries’ spread over the benchmark German bund yield. These have narrowed dramatically since European Central Bank (ECB) President Mario Draghi defused the Euro debt crisis in July 2012 when he promised the ECB would “do whatever it takes to preserve the euro.” The day after the German election, he reiterated that the ECB would assure liquidity with its Long-Term Refinancing Operations (LTRO). The ECB commitment to use its theoretically unlimited monetary powers to prevent the bankruptcy of a Euro-zone country and the Euro banking system has so far reassured bond markets, as yield spreads are today well down from crisis levels. Today (Sept. 27), Greece’s yield spread vs. the bund is about 8% (800 basis points – bps) compared with 35% in late 2011; Italy’s is 250 bps, compared with a high of 480 bps; and Spain’s is 252 bps (vs. 587 bps). The yield gap for France, the Euro zone’s second core country, is about 55 bps, versus 148 bps in 2012, but far above the 20 bps spread prior to the crisis.

Today’s yield spreads are relatively good, compared with spring 2012 when political instability was a reality in those countries implementing draconian fiscal policies: Greece, Spain, Italy and Portugal. Bond markets perceived an existential threat to the Euro zone and ratcheted up those countries’ borrowing costs, effectively cutting them off from capital markets and threatening the Euro zone banking system, which suffered massive losses on its large government bond holdings.

There was more good news for the proposed new Euro zone banking union two weeks ago when the European Parliament approved, overwhelmingly, the Single Supervisory Mechanism (SSM). This gives the ECB primary responsibility for supervising the Euro zone’s 130-odd largest banks, including resolution of a Too-Big-To-Fail bank in trouble.

U.S. Pressures

A serious threat to the Euro zone is the high correlation of European bond markets with that of the U.S. . Jorg Asmussen, of the ECB’s executive board, recently recalled in Brussels that the Fed’s tightening of monetary policy in 1994 severely impacted Europe. “If spill-overs were large in 1994,” he said, “we can expect them to be even larger today in an even more deeply interconnected world.” This Transatlantic correlation may be evident during upcoming U.S. fiscal crunches. Political paralysis on Congressional funding of government operations after the U.S. Fiscal Year 2013 ends on Sept. 30 is the first problem. A government shut-down in October could be negative for economic growth, especially if “sequestration”, the $85 billion across-the-board reduction of federal government defense and non-defense spending, continues in FY 2014 if Congress fails to act.

A more urgent deadline occurs on October 17 when the U.S. Treasury announced national debt ceiling will be reached and it will not have enough cash to pay U.S. obligations. If Congress refuses to raise the debt ceiling, the U.S. might renege on existing debts. House Republicans’ determination not to raise the ceiling unless the Obama administrations makes major concessions means there will be a stressful period. We assume a last-minute compromise will be worked out, as occurred in summer 2011. At that time, however, the U.S. crisis coincided with the Euro debt crisis, perversely causing international capital to seek refuge in U.S. Treasury securities, which exacerbated the Euro crisis. If this scenario is not repeated, however, rising U.S. yields could push up Euro yields, increasing peripherals’ spreads over the bund yield.

U.S. monetary policy will, eventually, be a potential problem for the Euro zone. When the Federal Reserve finally deems economic growth to be adequate and it starts reducing its $85 billion-a-month purchases of Treasury and mortgage-backed securities, U.S. yields will rise back toward normal levels and push up Euro yields, and widening Euro zone yield spreads. This would again pressure under-capitalized Euro zone banks and test the “Draghi guarantee” to protect governments and banks.

These U.S. threats could trigger profit-taking on U.S. and Euro zone equity markets. The Wilshire 5000 index, which measures about 98% of all listed equities in the U.S., is at an all-time high making it ripe for correction; as are some Euro stock markets, notably Germany’s DAX and France’s CAC indices. Sharp weakening of stock markets would cause loss of business and consumer confidence, slowing Euro economic growth.

A political source of tension could well be U.S.-Russian negotiations to eliminate Syrian chemical weapons. Should these drag on, or fail, and exacerbate Middle East tensions, oil prices are certain to rise, thereby penalizing economic growth and volatile bond yields, putting more stress on the Euro system.

Conclusion

Although Euro zone developments since the Cypriot crisis early this year appear relatively positive, we are concerned that there are potential triggers for renewed Euro zone stress, notably  fromU.S. fiscal and monetary developments. Rising U.S. yields will push up Euro yields and spreads, slow economic growth, delay fiscal consolidation programs and cause further popular resistance to continued austerity and unemployment. Germany’s new government and Mrs. Merkel will, once again, have to lead the Euro zone response.

But we are optimistic that, as previous episodes demonstrated, new Euro strains will force political leaders to defend the euro currency and banking system, by pushing ahead with the institutional reforms that the Euro zone needs. As European Commission President Jose Manuel Barroso warned recently, progress to date is imperiled by “political complacency…. We must not,” he insisted, “come back to the old normal. We have seen that anything that casts doubt on governments’ commitment to reform is instantly punished.” He also warned against the intra-Euro blame game: “When you are in the same boat, one cannot say: “Your end of the boat is sinking.”

J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris , France, where he was chief international economist for Smith Barney for 24 years. He retired as a Managing Director of Salomon Smith Barney/Citigroup in 2001 but remains active with the National Association for Business Economics, the Global Interdependence Center and the Société d’Economie Politique in Paris.

Speaker / Author

J. Paul Horne

Independent International Economist & GIC Board Member

Paul Horne is an active independent international market economist since retiring as a managing director and European equity market economist at Salomon Smith Barney/Citigroup in London. He is on the boards of the Global Interdependence Center in Philadelphia; the Committee for the Republic in Washington, DC; and the American Library of Paris Foundation. He writes for The European Institute (supported by the University of Maryland and the Bertelsmann Foundation) and is on the forecasting and editorial panels of the National Association for Business Economics. Previous positions: Smith Barney’s chief international economist and Investment Policy Committee member based in Paris 1975-1998; the ... Read More