ECB Preview – Scope For Disappointment?

Thursday’s ECB meeting is important in the context of recent market moves and statements regarding the level of the euro. Citi notes that the rise in short-dated vol indicates considerable investor focus on the meeting. Expectations have been building that ECB President Draghi may offer a more cautious tone to ‘talk down’ the moves seen in the short-term rates and FX. In light of President Hollande’s advocation of an exchange rate policy aimed at ‘safeguarding competitiveness’, Draghi will likely face further questioning on FX. However, Citi does not believe that he will reverse his position and explicitly talk the currency down. Goldman also notes that while ‘Taylor-Rule’ users might infer a 30-50bps lowering of rates (thanks to growth, FX, and inflation) the improvement in ‘fiscal risk premium’ balances that dovishness leaving Draghi likely on hold. However, he is unlikely to stand ‘idly by’ without some comment on the ensuing currency wars.

Short-term, the LTRO repayment (and Fed QE4EVA) leaves EURUSD biased upwards on balance sheet basis…as the ratio of Fed/ECB balance sheets has now round-tripped to the start of LTRO2

though medium-term perhaps EURUSD is discounting the Fed’s expansion and ECB stability…


but EURUSD has a bearish bias based on spread differentials…

Via Citi,

In the January press conference, Draghi stated that “[he] never comments on exchange rates”. While the EUR NEER has appreciated significantly in January, the current levels are not ‘excessive’ when compared to historical averages. The proximity to “historical averages” is something which Draghi highlighted in the January press conference. Furthermore, Hollande’s comments met opposition from German Government Spokesperson Steffan Seibert who suggested “exchange-rate policies shouldn’t be an instrument to strengthen competitiveness,’’ and viewed the euro’s rise as an indication that “confidence is returning to the euro area”. We expect Draghi to largely echo these thoughts, while stressing that the exchange rate is merely an input variable into their monetary analysis.


As our economists have written, Draghi may adopt a more dovish tone to convince market participants that monetary conditions will remain loose, but we view any specific ‘talking down’ of the EUR as unlikely. Based on the check-list of indicators from the ECB’s January press conference (CDS prices, stock market indices, realised volatility, capital inflows, Target 2 imbalances, confidence indices, current account balances), market developments are likely to be viewed as broadly positive by the ECB more than offsetting any negative impact from EUR strength. Therefore, given expectations of a dovish statement, we think risk-reward favours some short-term upside as expectations that Draghi will talk down the euro are re-priced. Over the medium term we hold a bearish EURUSD view, largely as a function of relative growth prospects versus the US but believe expectations for ECB action are slightly overdone.

There are two other important events that will likely grab Draghi’s attention:

LTRO impact

Another important area of focus will be Draghi’s views on the impact of the first LTRO repayment. If he suggests that large initial repayment in January is a positive sign indicating stabilization, market expectations of the amount to be paid back from LTRO2 are likely to increase, which will support the EUR. Alternatively he may caution banks about returning cash too early, since the design of the operations was to provide cheap funds in case they are needed at some point in the future and the ECB will be keen to avoid another LTRO unless absolutely necessary. A reduction in market expectations of the amount of LTRO2 borrowing to be paid back will weigh on the EUR.

Spanish auction

Another major risk event sees Spain returning to the bond market for the first time since negative headlines over Mariano Rajoy emerged last weekend. Widening periphery spreads to Germany were a driver of euro weakness on Monday and the close relationship should hold once more today. The treasury will auction €3.5-4.5bn of the SPGB Mar ’15, SPGB Jan ’18 and SPGB Jan ’29.

Via Goldman Sachs,

So how is the ECB likely to react to the recent exchange rate appreciation? Since the December ECB Governing Council meeting, the Euro has appreciated by about 3.5% on a real trade-weighted basis. Our ‘real time’ Taylor rule implies that a 3.5% appreciation would lead to a 15bp-20bp lower ECB policy rate. Combining this effect with that implied indirectly via the impact on growth and inflation, our results imply lowering policy rates by between 30bp and 50bp, depending on how much of the recent Euro appreciation reflects exogenous factors. On our current forecasts, we expect the Euro trade-weighted index to appreciate by a further 1.5% over the next quarter (with the EUR / USD cross reaching 1.40). Accounting for this further appreciation, the total downward impact on ECB rates, according to our ‘real time’ Taylor rule estimates and subject to the degree of exogenous factors driving the exchange rate appreciation, is between 45bp and 75bp.

However, we cannot hold all other determinants of the policy rate constant in this exercise. In particular, the fiscal risk premium has also moved sharply since December. And our empirical results suggest that we need to control for this effect if we are to rely on our estimated direct impact of the exchange rate on rates. Our ‘real time’ Taylor rule estimates imply that the 250bp decline in the fiscal risk premium would equate to a rise in ECB rates of around 80bp-90bp. Thus, the decline in fiscal risk would more than counter the effect of recent Euro exchange rate appreciation on ECB rates.

Hence, on our ‘real time’ Taylor rule estimates, we think the Euro exchange rate appreciation has not been sufficient to warrant a cut by the ECB, so far. Even if the Euro were to appreciate further to our forecast level of EUR / USD at 1.40, our results suggest rates would be on hold.

For all the recent talk of ‘currency wars’ and the vulnerability of the Euro area economy should the ECB ‘stand idly by’ while the other advanced economies engage in competitive devaluation, our empirical work suggests that we are still some way from an ECB policy rate cut driven by concerns about Euro appreciation.

This has the potential to be a mixed blessing:

  • On the one hand, it has been widely argued that, while competitive devaluations are self-defeating (since it is a logical impossibility for all countries to depreciate simultaneously), the implied monetary easing in each jurisdiction – and thereby in the world as a whole – is ultimately what is required to reflate the global economy. Via the pressure exerted by Euro appreciation, even a more independent and conservative central bank like the ECB will eventually be compelled to make a contribution in this direction.
  • On the other hand, by undermining international economic cooperation, competitive devaluations threaten to weaken the global economic system and institutions. Protectionist pressures may re-emerge. Capital controls and financial repression may re-segment global financial markets. Having benefited over the past two decades from the favorable supply-side effects of globalization, such setbacks would threaten global growth.

Source: Citi and Goldman Sachs

The Good, The Bad, And The Ugly Six Charts Of Europe

We would assume that tomorrow’s ECB meeting will be the usual smug gloating by Draghi of how the market has turned around so exuberantly and implicitly that means all is well. While Willem Buiter just took that complacent perspective to task, we thought the following six simple charts of Good (well not terrible), Bad, and Ugly macro-economic data would simplify reality…


The Good (ish)

Well, it’s a stretch to say that sub-50 PMIs are good but they have shown a turn-up in recent months. Also, the positivity enlightened by a rising EUR relative to the USD has been indicated by some as a ‘good’ thing – though obviously (as Mr. Hollande recently noted) not for all as exports hurt…


The Bad

The price of energy (in EUR) is high, very high, and wearing on spending and margins. This margin pressure is even more intensified as the region gets close to deflation in asset prices – not good… and sure enough, the EUR strength (that was apparently a good thing) is crushing export growth rapidly…


The Ugly

Domestic Demand and GDP growth is decidedly negative and while second derivatives are heralded as green shoots, they are most certainly not taking the euro-area out of recession any time soon. This is weighing increasingly on the population as consumers see their general economic situation and household financial situation as very weak over the next 12 months


All-in-all, it seems, as we have seen elsewhere, that equity markets are pricing in a miracle as fundamentals reflect anything but. Though perhaps, the fact that European stocks and credit are now down in price on the year reflects an awakening to the solemn realities…


Source: BNP

Guest Post: The Next Secular Bull Market Is Still A Few Years Away

Via Lance Roberts of Street Talk Live,

There have been several articles as of late discussing that the next great secular bull market has arrived.  Historically, secular bear markets have averaged about 14 years, and considering that we began writing about the current secular bear market cycle in early 2000, that would put the current cycle about 2 years away from it historic average.  However, the reality is that this cycle is currently unlike anything that we have potentially witnessed in the past.  With massive central bank interventions, artificially suppressed interest rates, sub-par economic growth, high unemployment and elevated stock market prices it is likely that the current secular bear market may be longer than the historical average.  In either event we are likely closer to the end than the beginning and the next major stock market correction will likely be the last for this cycle.

There are several fundamental reasons from valuations to the current level of interest rates that support this viewpoint.  The first chart shows the inflation adjusted, or “real”, ratio of the stock market to the economy as measured by GDP. With the economic recovery, such as it is, currently in its fourth year, the market to GDP ratio is beginning to push levels that are normally consistent with cyclical bull market peaks rather than where secular bear markets have ended.


Furthermore, secular bull markets do not begin when prices are already stretched well above their long term growth trend. I often use the “rubber ball” analogy to express the movement of prices relative to their trends. Like throwing a rubber ball into the air – the momentum of the throw can make it seem like it is temporarily defying the laws of gravity. However, the effect of momentum will fade as the pull from gravity increases on the ball until it reaches its maximum height. The ball will then quickly revert back to earth. The same goes for the financial markets.

The chart below shows, very importantly, that secular BULL markets do not begin when prices are already trading well above their long term growth trend. Very much like past secular bear markets – prices can remain above their long term growth trend for quite some time until they eventually “mean revert.”


These reversions take prices to a position that is an equal distance below the long term growth trend. As the chart shows – if you had moved out of the market in early 2000 and gone into bonds you will still be well ahead of those that had stayed in the stock market.

Not surprisingly, when prices are elevated well beyond their long term trends, valuations are at levels that are normally associated with secular bull market peaks rather than the troughs where secular bull markets are usually born.

The chart below uses the Shiller Cyclically Adjusted P/E (price to earnings) ratio which has been inflation adjusted. The immediate argument to this analysis is that some analyst on television stated the “valuations are cheap based on ‘forward earnings expectations’ which are below the long term average.” There are two huge flaws in that statement:

1) The long term median P/E as shown below is based on TRAILING REPORTED earnings. Not forward operating earnings which are full of accounting issues. This is an “apples to oranges” comparison.

2) More importantly, forward earnings are ALWAYS overly optimistic by as much as 33% historically. Therefore, the valuation argument is generally wrong at the outset.


This brings us to the “stocks are cheap based on interest rates” argument. Despite the fact that prices and valuations are stretched well above their historic norms this does not deter the media from finding some other flawed argument to try and lure “suckers”… um…I mean…investors into the Wall Street casino.

The chart below is the “Fed Model” which is the basis for the “stocks are cheap because earnings yield is higher than bond yields.”


Following this model would have kept you out of stocks primarily when you should have been in and vice versa. This is due to the intervention by the Fed to suppress interest rates to support economic growth. These suppressions have driven interest rates consistently lower over time and have been the primary factor in the creation of one bubble after the next. Subsequently, when the Fed raises interest rates, it causes a dislocation in the markets.

The fallacy of the model is quite simple. THERE IS NO SUCH THING AS EARNINGS YIELD. The earnings yield is simply the inverse of the P/E ratio whereby corporate earnings are divided by the price of the market. However, as an investor in a stock you do not receive the earnings yield in the form of a cash payment.   However, YOU DO receive the interest yield from bonds.

This is a very, very flawed analysis and one that should be forever stricken from your investment valuation models.

Nothing Organic About It

No matter how you slice the data – the simple fact is that we are still years away from the end of the current secular bear market. The mistake that analysts, economists and the media continue to make is that the current ebbs and flows of the economy are part of a natural, and organic, economic cycle. If this was the case then there would be no need for continued injections of liquidity into the system in an ongoing attempt to artificially suppress interest rates, boost housing or inflate asset markets.

Nothing shows this more clearly than the amount of excess bank reserves, which is the direct byproduct of QE programs, which exploded higher last week by $46.4 billion.


These liquidity pushes directly correlate with market ramp ups – not improving economics or fundamentals.

Of course, this is also why each time these programs come to an end the financial markets face steep corrections and economic growth plunges.

Into The Danger Zone

It is with this background that we continue to harp upon the dangers that are currently building in the markets. While no two market cycles are ever the same – they generally behave similarly over time. I have posted the following chart several times lately showing the high degree of correlation between the market bubble prior to 2007 and currently.

I expect that the chart will begin to decouple somewhat in the months ahead as there is not a relative crisis immediately available.   However, come May when the debt ceiling issue resurfaces, or there is a resurgence of the Eurozone crisis, or some other exogenous event crops up – stock prices are likely to correct very sharply.


Using a weekly analysis, to slow down the day to day volatility of the market – the market currently cannot achieve a higher level of its overbought status. It is “pegged out”, “maxed,” or whatever other term you want to use to describe the extreme nature of the overbought condition that currently exists.


The chart on the next page overlays this overbought/oversold long term weekly indicator with a weekly chart of the S&P 500.


See the potential problem here?

The next chart shows the STA Risk Ratio indicator which is a composite index of the rate of change in the S&P 500, bullish versus bearish sentiment, the volatility index, and a ratio of new highs to new lows.   Currently, that index is approaching levels normally only seen at very significant market tops.


I could show you chart after chart after chart. They all say the same thing – the market is extremely overbought and is currently pushing the limits of the current upside advance.

What I Am NOT Saying

The bulk of the mainstream media’s, and analyst’s, blathering is more akin to a parade of idiots rather than something you should actually spend your time paying attention to. Pay attention to the data.

While I have spilled an exorbitant amount of ink this week on all the reasons why the market is getting extremely overbought and into very dangerous territory – I am not saying that you should sell everything and hide in cash.

This may sound very counter-intuitive but the markets are being driven by the expansion of the Fed’s balance sheet. Therefore, due to this artificial influence, the market can move higher, for longer, than you can possibly fathom. It will end, eventually, and it will end badly.

However, in the meantime, this is how to approach the current market.

1) Do not add to equity exposure at this time no matter how emotionally conflicted you become. Emotions lead to bad investment decisions – always.

2) Sell some, not all, of positions that are speculative in nature and have a lot of volatility. When the correction comes these will be hit the hardest.

3) Increasing stock markets suppress bond prices. Therefore, rotate some money into bonds which will benefit from a stock market correction – “Buy where the money ain’t goin’.”

4) Hoard cash – you can’t be a buyer when things get “cheap” when you don’t have any cash to buy with.

5) Rotate from very aggressive equity exposure to more defensive positions that have an income stream. (ie utilities, staples, and healthcare) However, these positions WILL lose money when the market corrects – just not as much.

6) Beware of high-dividend plays particularly REITS and MLP’s. The majority of these positions are GROSSLY overbought and overvalued and a correction of magnitude will lead to larger losses than you can currently comprehend.

7) Fundamental valuations HAVE NO bearing on a stock market correction. No matter how fundamentally strong you think your investments are they will generally correct as much, or more, than the market. Fundamental value is only effective for eliminating bankruptcy risk. In a market environment driven primarily by programmed trading it is only PRICE ANALYSIS that matters.

8) Did I mention hoarding cash?

9) Pay attention to the trend. The trend is currently positive and we want to mindful of that. It will require a VERY substantial price correction at this point before a SELL signal is issued. This is why profit taking, and keeping new savings in cash, is the best way to stay invested but reduce overall portfolio risk.

10) Just because you take profits, or sell a position today, DOES NOT mean that you can’t buy it back after it corrects.   That is just a good portfolio management practice. There IS NO successful investor – ever in history – that only “bought and held.”

There will be corrections which are buying opportunities and there will be corrections that aren’t.  Unfortunately, you will never know which is which until it is too late.  This is why employing rudimentary rebalancing processes, or even basic risk management tools, to your investment portfolio will work to protect your investment principal overtime.  Are you going to get out at the tops and in at the bottoms? No.  Are you going to be the next great market timer?  No.  Will you keep from setting yourself back years from reaching your retirement goals?  Definitely.

Sacre Bleu! France Collapses Right as Spain, Italy and Greece Become Embroiled in Corruption Scandals


The following is a excerpt from a recent client letter.


The house of cards that is Europe is close to collapsing as those widely held responsible for solving the Crisis (Prime Ministers, Treasurers and ECB head Mario Draghi) have all been recently implicated in corruption scandals.


Those EU leaders who have yet to be implicated in scandals are not faring much better than their more corrupt counterparts. In France, socialist Prime Minister Francois Hollande, has proven yet again that socialism doesn’t work by chasing after the wealthy and trying to grow France’s public sector… when the public sector already accounts for 56% of French employment.


France was already suffering from a lack of competitiveness. Now that wealthy businesspeople are fleeing the country (meaning investment will dry up), the economy has begun to positively implode.


The first sign of this came actually came from Germany. As we noted a few months ago, Germany had prepared a working group to examine the impact of an economic collapse in France.


German Finance Minister Wolfgang Schaeuble has asked a panel of advisers to look into reform proposals for France, concerned that weakness in the euro zone’s second largest economy could come back to haunt Germany and the broader currency bloc.


Two officials, speaking on condition of anonymity, told Reuters this week that Schaeuble asked the council of economic advisers to the German government, known as the “wise men”, to consider drafting a report on what France should do…


The biggest problem at the moment in the euro zone is no longer Greece, Spain or Italy, instead it is France, because it has not undertaken anything in order to truly re-establish its competitiveness, and is even heading in the opposite direction,” Feld said on Wednesday.


“France needs labour market reforms, it is the country among euro zone countries that works the least each year, so how do you expect any results from that? Things won’t work unless more efforts are made.”


This German concern has proven to be well founded, as the recent spate of French economic data has been truly horrific.


Auto sales for 2012 fell 13% from those of 2011. Sales of existing homes outside of Paris fell 20% year over year for the third quarter of 2012. New home sales fell 25%. Even the high-end real estate markets are collapsing with sales for apartments in Paris that cost over €2 million collapsing an incredible 42% in 2012.




Since the EU Crisis began in 2008, France and Germany have been the two key countries backstopping the implosion. The fact that France is now facing an economic implosion does not bode well for the future of the Euro or the EU.


The other sovereign backdrop for the EU, Germany, is also experiencing an economic slowdown.


The German economy was hit hard by the euro zone crisis in the final quarter of last year, shrinking more than at any point in nearly three years as traditionally strong exports and investment slowed, the Statistics Office said on Tuesday…


Gross domestic product shrank by 0.5 percent in the final three months of 2012, the worst quarterly performance since Germany fell into a recession during the global financial crisis in 2008/2009 and only the second contraction since it ended.


The parlous fourth quarter pushed overall growth for the year down to 0.7 percent, a sharp slowdown from the 3.0 percent registered in 2011 and a post-reunification record of 4.2 percent in 2010. The 2012 figure was a tad below a Reuters consensus forecast for growth of 0.8 percent.


Thus, we find that Europe’s primary political market props (EU leaders including ECB head Mario Draghi) are coming unraveled at the precise time that EU banks are showing warning signs and the most important EU economies are heading sharply south.


2013 is going to be a very interesting year for Europe.


We have produced a FREE Special Report available to all investors titled What Europe’s Collapse Means For You and Your Savings.

This report features ten pages of material outlining our independent analysis real debt situation in Europe (numbers far worse than is publicly admitted), the true nature of the EU banking system, and the systemic risks Europe poses to investors around the world.

It also outlines a number of investments to profit from this; investments that anyone can use to take advantage of the European Debt Crisis.

Best of all, this report is 100% FREE. You can pick up a copy today at:


Phoenix Capital Research





'Europe's A Fragile Bubble', Citi's Buiter Warns Of Unrealistic Complacency

Citi’s Willem Buiter sums it all up: “…the improvement in sentiment appears to have long overshot its fundamental basis and was driven in part by unrealistic policy and growth expectations, an abundance of liquidity and an increasingly frantic search for yield. The key word in the recovery globally, and in particular in Europe, growth is fragile. To us the key word about the post summer 2012 Euro Area asset boom is that most of it is a bubble, and one which will burst at a time of its own choosing, even though we concede that ample liquidity can often keep bubbles afloat for a long time.” His conclusion is self-evident, “markets materially underestimate these risks,” and the post-Draghi european performance has “gone well beyond the point of possible self-validation and therefore looks fragile.”


Excerpted from ‘New and Old Risks in the Euro Area’, Citi’s Willem Buiter

Then Buiter rips apart the Central Banker’s meme of ‘markets’ as policy tools...

We recognise that, in a decentralised market economy where expectations of the future, moods, hopes and fears drive private (and sometimes also government) behaviour directly and through their effect on the prices of real and financial assets, today’s subjective expectations and other psychological characteristics in part determine what tomorrow’s fundamentals will be.


Irreversible or costly-to-reverse decisions like capital expenditure, human capital formation, resource extraction etc, are driven by subjective expectations and moods, making the distinction between a fundamentally warranted asset boom and a bubble slightly fuzzy at the edges.


But this indeterminacy, bootstrapping, self-validating characteristic of complex dynamic economic systems inhabited by partially forward-looking households, firms and policy makers – called reflexivity by George Soros – can be taken too far.


Mere optimism and confidence will not permit the authors of this note to bootstrap themselves into winning the men’s doubles at Wimbledon 2013. The fact that financial markets have radically reduced their implied estimates of the likelihood of sovereign default in the periphery of the EA (other than in Greece) and of senior unsecured bank debt restructuring throughout the EA, core as well as periphery, should not stop us from continuing to analyse carefully the fundamental drivers of both sovereign credit risk and senior unsecured bank debt credit risk. When we do this, the conclusion that the markets materially underestimate these risks is, in our view, unavoidable.

Eliminating or mitigating some risks of disaster does not create an engine for sustained growth…

Let us recall the major headwinds for the world economy and Europe in particular. Private sector debt has hardly fallen in many EA countries to date and remains much above the levels at the beginning of the last decade (Figure 4).




Fiscal deficits have fallen in most EA countries, but general government gross debt continues to rise and remain close to all-time highs outside of war periods for many advanced economies (AEs, Figure 5).



Continued fiscal austerity thus remains all but certain in many AEs.


Many banks (both in the core and the periphery of the EA) remain weak despite a substantial amount of operational restructuring and selective recapitalizations and deleveraging. In many EA and in a number of non-EA member states of the EU, the entire national banking systems remain weak, fragile and unable or unwilling to provide funding to the real economy on a scale sufficient to support a sustained recovery.

The path to economic recovery, let alone sustained growth at an attractive growth rate of potential output remains an arduous and long one.

Euro area policy actions or announcements have also been misinterpreted or at best over-interpreted.

The ECB now provides a selective safety net for the banking sector through the LTROs (ring-fencing banking activity against a systemic collapse) and through the OMT. The OMT ring-fences sovereigns against convertibility or break-up risk, but not against the risk of sovereign debt restructuring through official sector involvement, OSI, through concessions by official creditors, or through private sector involvement, PSI, through concessions by private creditors. These measures effectively rule out the key tail risk of a break-up of the Eurozone through an involuntary forced exit of the fiscally and competitively weak member states.


It is key to recognise the fact that neither the ECB nor the ESM, nor any foreseeable evolution in their scope and resources, eliminate the risk of bail-in of unsecured bank creditors (including senior unsecured creditors, up to unsecured bank bondholders and non-guaranteed/uninsured depositors) in Cyprus, Portugal, Spain, Italy, Slovenia and indeed, unless the sovereigns in the core really are willing and able to open their pockets to support their own banks’ unsecured creditors, in Belgium, France, the Netherlands and Germany.

In addition, a number of risks have in fact increased recently.

1) Political risks in Italy and Spain

First, there are renewed political risks. In Italy, the Monte dei Paschi di Siena (MPS) bail-out is providing further support to the growing momentum former PM Berlusconi‘s party enjoys in the most recent polls, raising risks of a hung parliament in the upcoming election on February 24. The fact that ECB President Draghi was Governor of the Bank of Italy at the time when it was the supervisor of MPS when MPS is alleged to have engaged in a number of dubious financial operations creates the risk of reputational damage for the ECB President.


More significant than the individual reputations at risk is the risk that the MPS issue reinforces concerns about the potential for reputational damage to the ECB once it takes on the role of the main EA bank supervisor under the new Single Supervisory Mechanism (SSM), a concern voiced in general (rather than specific to the MPS issue) by ECB Executive Board Member Constancio recently.


Even before the MPS issue, the near-term prospects for further near-progress on banking union were dimmed by two other factors. First, the German general election, due to be held in September 2013, has reduced Chancellor Merkel’s appetite for policy actions that could be controversial domestically. This might preclude any major concessions to Germany’s EA neighbours as regards the timing and phasing of fiscal austerity, and the early introduction of key elements of banking union.


Meanwhile, in Spain, allegations about financial malpractice in the ruling Partido Popular party have further hurt the party’s popularity. They are likely to limit government effectiveness in taking unpopular further reform measures and have increased – otherwise modest – risks of government instability, should these allegations be found to be true.


These developments will in particular make it harder for the Spanish government to impose substantial additional fiscal austerity. Additional fiscal tightening would be needed to meet deficit targets following a likely diagnosis of deficit overshoots in the spring. This is despite the new, softer (and IMF-induced) conventional wisdom towards fiscal tightening in response to deficit overshoots: make up bad faith deficit overshoots within the original time frame but permit bad luck deficit overshoots to be corrected over a longer horizon. Unless there is a Keynesian Laffer curve (fiscal tightening depresses activity to such an extent that the deficit increases) the new conventional wisdom will raise the risk of future debt unsustainability.

In Greece, the government announced a primary surplus for 2012 on the basis of preliminary budget figures, but government officials also noted that the final figure is likely to be revised to a deficit of 1.2-1.3% of GDP. The domestic political situation remains tense, as evidenced by the civil mobilization orders that the Greek government has issued to metro and maritime workers. Political tensions and the risk of political instability translate in a direct and somewhat disconcerting manner into economic and financial uncertainty, the likelihood of an earlier recourse to further sovereign debt restructuring and the risk of dysfunctional politics leading to Grexit.

2) Excessive contagious optimism among policymakers

Second, the rally in asset prices and in particular the reduction in funding stress for both sovereigns and banks in the EA periphery has also lessened the perception of many policymakers of the need for major further support measures in the near-term, a perception that is evident by various remarks to the effect that ‘the worst of the crisis is over’ (see e.g. Euro Area: Sovereign Debt Crisis Update 23 Jan 2013).


Notably, ECB President Draghi neglected these dynamics when he spoke of ‘positive contagion’ at the last ECB policy meeting. In our view, there is no such thing as ‘positive contagion’ if the term ‘positive’ refers to the real economic impact of the contagion. Excessive contagious optimism, detached from fundamentals, usually ends up hurting more than it helps, even though the improvement in financial conditions that resulted from the recent rally has probably eased some of the pain in fiscally and financially weak EA countries.

3) Bail-ins of bank creditors (junior and senior) are undoubtedly coming closer.

The combination of the likely further capital needs of EA banks, the limited financial resources of the EA sovereigns (even in the core) and political opposition to bailing in tax payers to avoid bailing in senior unsecured bond creditors make it likely that bail-ins of senior unsecured bank creditors in the EA will start before 2015.

The economic and financial risks facing the EA are not only driven by governments and politics.

4) The recent appreciation of the euro and the effective monetary tightening implied by the increase in money market rates (driven by the large repayments of the first 3Y-LTRO on Jan 30) are most unwelcome from the point of view of EA domestic demand.

Summing up, in our view, the EA sovereign debt and banking crisis is far from over. If anything, recent developments, notably policy complacency bred by market complacency, combined with higher political risks in a number of EA countries highlight the risks of sovereign debt restructuring and bank debt restructuring in the EA down the line.

Source: Citi

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