The euro unravelling

The end of the beginning could very well be the beginning of the end..

Although all eyes were on the jobs report Friday, and the figures were pretty bad, it’s nothing compared what is going on in Europe. As we argued extensively (see here), unless there is a drastic change of policy, we think Europe is inexorably heading towards a big euro crisis.

At present, Germany is stopping all possible solutions to the euro crisis, like:

  • European Central Bank (ECB) purchases of bonds of the weak euro members, especially Italy and Spain
  • Increase in the EFSF fund, the European rescue fund
  • The introduction of euro bonds.

As of now, the only thing that is standing in the way of us and a crisis of epic proportions are the ECB interventions in the Italian and Spanish bond markets.

The ESFS has been authorized to take over from the ECB, but that has to be confirmed by the parliaments of all euro member countries, this could take a while still.

Even then one can wonder whether the fund will be big enough as half of its 440 billion euro is already pledged in various support packages for Greece, Ireland and Portugal.

In the mean-time, the ECB seems to be losing its battle with the Italian bond vigilantes, and this is a terrifying prospect.

One-Year Chart for ITALY 10 - GERMANY 10 SPREAD (.ITAGER10:IND)

Friday especially has been a very bad day with the difference rising well above 300 basis points.

Other possible crisis triggers we identified in the article aren’t going particularly well either. Austerity is affecting economic growth, and by extension public finances:

The International Monetary Fund, which has generally encouraged “fiscal consolidation” in euro-zone countries, has noted that budget cutting undermines growth and employment. The impact is even more pronounced if many countries are cutting at once and central bank policies are not geared toward growth — just the path Europe is following, according to the IMF.

We must live in some kind of alternate universe if the head of the IMF starts warning against overdoing it on the austerity front:

support for growth in the near term is vital to the credibility of any agreement on consolidation. After all, who will believe that commitments to cuts are going to survive a lengthy stagnation with prolonged high unemployment and social dissatisfaction?
We should remember that markets can be of two minds: while they dislike high public debt – and may applaud sharp fiscal consolidation – as we saw last week they dislike low or negative growth even more.

Growth in Greece is especially hard hit, causing it to miss budget targets and even leading to a break-off in talks with the IMF.

Meanwhile, deposits keep on fleeing the Greek banking system at a rate of 18 billion euro a quarter, funny enough leading to increased profitability of Greek banks as the deposits are replaced by cheaper emergency financing from the ECB.

The only line of defense is the ECB. But how long it will keep up buying bonds left, right, and center, is anyone’s guess. The markets seem hell-bent on finding out.