This is going to be the last briefing before our summer break. It is shorter than usual, as the news flow is falling off. We will be back on Monday, August 13.

You know it must be the summer break if a comment by Austria central bank governor moves markets. When Ewald Nowotny told Bloomberg that the ESM needed a banking licence, Spanish bond yields fell for the first time in 10 days, and the euro recovered after having fallen below $1.21.

Suedeutsche Zeitung writes this morning that the eurogroup is considering help for Spain in the form of bond purchases. The plan is for the EFSF to purchase government bonds from financial institutions, but this requires a formal application by the Spanish government. The article quotes an official as saying that this, together with the loan for the Spanish banks, would solve the problem (are the kidding? It might alleviate the pressure, but how could this solve the problem?) The article says Germany is not in principal opposed to bond purchases, but warns that the Bundestag’s special committee may not agree given the faltering support for any further rescue operations. The article says, procedurally, Spain needs to apply for help, the ECB would then have to write a recommendation.

El Pais writes that the ECB, too, was currently looking at a number of options of strengthening the system, including changes to collateral rules, or an ESM banking licence. It quotes a senior European official as saying that the next ECB meeting will be very important, but cautions that any attempts to open up the ESM to direct funding from the ECB may run into severe opposition from the Bundesbank and other northern central banks. The article says the European Commission believes the most likely option would be for the ESM to buy debt directly.

In a comment in Reuters, Neal Kimberley says that Nowotny’s comments gave currency traders a pretext to buy euros, thus forcing Asian intraday players, running short of euros against the dollar, to scramble to cover positions.  But he says many traders had taken out barrier options at $1.2050 on Tuesday, which means that the markets may soon test those lower levels. He makes the point that a banking licence would effectively increase the size of the ESM, stranding it with greater contingent liabilities that ultimately fall disproportionately on Germany.

(Which is why we do not think it is going to happen, also in view of the ruling of the Constitutional Court, which at a minimum will try to close any avenues to raise Germany’s liabilities.)

 

Ifo index tanks

Germany has always been a late cycle economy, and there is now mounting evidence that the downturn is hitting home. The Ifo index dropped to 103.3, the lowest since March 2010, much below what was expected. The drop in the index is a reflection of the crisis itself, and the slowdown in the global economy, which is hitting German exporters. Moody’s downgrade threat clearly has not helped (which may lead to a further fall in the index). Among the sub-indices, the expectation is particularly weak.  Reuters says the purchasing managers’ index showed that the private sector has now contracted for the third month running, which may point to an overall economic contraction in the second and third quarters.

 

Noyer: We need banking union to address failing policy transmission

ECB rate cuts are not filtering through to borrowers across the continent and a banking union is needed to address this, ECB Governing Council member Christian Noyer said in Dublin on Wednesday. A banking union with a unified supervisor, a deposit guarantee scheme and a banking resolution fund would strengthen banks in peripheral states and allow them to pass on rate cuts, which some are failing to do now, Reuters quotes Noyer. While a typical German bank is able to cut its rates in line with ECB rate cuts, a weak bank in a peripheral member state like Italy might actually increase its much higher rates if a cut in its credit rating increased its cost of borrowing, he exemplified.

 

Gene Frieda says a much larger and more credible firewall is needed

Gene Frieda writes in the Financial Times that with the decision of the summit, the ESM now has the multiple tasks of ensuring against sovereign default, bank runs, and currency redenomination risk. He argues that deposit insurance would be a very effective way of dealing with the bank, the focus on recapitalisation will be less so, since the banks’ assets will remain highly geared to the sovereign and the local economy. This affects the robustness of collateral that can be used to borrow from the ECB. The link between sovereigns and banks thus remains, and is made worse by the fact that 40% of the ESM is guaranteed by the stressed periphery. He says two measures need to be taken urgently: first, there must be framework for additional capital injections if the first does not suffice. Otherwise, the tail risk will remain with the sovereign. And second, there needs to be a much larger firewall. The best way would be through common deposit insurance and bank recap funds, rather than through an increase in the unfunded ESM. He also writes that broader private sector burden sharing, including of unsecured senior creditor, should be seen as complement, rather than an alternative.

 

10-Y Spreads, Forex, ZC Swaps and Euribor-Ois
10-year spreads
	Previous day	Yesterday	This Morning
France	1.036	1.017	1.040
Italy	5.379	5.329	5.326
Spain	6.404	6.132	6.226
Portugal	9.489	10.055	10.414
Greece	26.770	26.182	#VALUE!
Ireland	5.052	5.021	5.446
Belgium	1.573	1.548	1.624
Bund Yield	1.235	1.267	1.27
Euro Bilateral Exchange Rate
	Previous	This morning
Dollar	1.209	1.2143
Yen	94.510	94.94
Pound	0.779	0.7841
Swiss Franc	1.201	1.2009
ZC Inflation Swaps
	previous	last close
1 yr	1.52	1.54
2 yr	1.48	1.49
5 yr	1.47	1.56
10 yr	1.81	1.92
Euribor-OIS Spread
	previous	last close
1 Week	-7.714	-6.714
1 Month	-0.800	-0.9
3 Months	18.493	19.593
1 Year	84.379	84.079
Source: Reuters