Once more unto the breach, dear friends, once more...

Yawn and stretch... Mmmwoahh. That’s better. Now then, what's been going on?

Middle East Soccer has seen the revolution ball passed from Egypt to Bahrain and it is now in Libya, all in a week. At this rate we will have seen the formation of the “New People’s Ottoman Empire” completed by teatime. But today’s TV is coming live from Libya and you have to think that the Gadaffis have politically gone “all in”. You can hardly shoot 300 - 500 of your own people and then back down and expect a healthy retirement that doesn’t involve lampposts and 1 inch 3-ply.

BoE – ho hum. We almost give up on commenting on the Swerve and his Mervynflation, but at least the rest of the market is waking up to what has to happen.

G20 – zzzzzzzzzzzz

We have a fair amount of catching up to do, but let's start by having a look at Europe.

The STFU policy has managed to gag most bad news and dissent so far this year, but over the last week we have been picking up more odd rumbles on our seismometers.

- Hamburg has said “Nein” to Mangler and the incoming party is expected to be less euro-friendly
- Portugal borrowing levels hit new highs and the ECB jumped in again (though Portuguese Jan budget deficit fell 58.6% y/y)
- Concerns over the German banking system raised its head again with WestLB back in the limelight
- A large exodus from North African turmoil is not exactly what Spain and Italy need at the moment
- And finally the ongoing debate about what is going on in the Euro funding markets

It is this last point we are actually going to take a look at, as this weekend the latest great mystery plaguing the European money mkts was finally resolved.


According to some knowledgeable insiders, the €16 yards borrowed from the ECB marginal lending facility (see above for a historical perspective) was a by-product of the ongoing wind-down of the two particularly nasty pieces of the Irish toxic waste pile, namely ANGIRI and IRNWID. In TMM’s view, this invites all sorts of puzzlement and questions, like a) couldn’t this all have been coordinated just a tiny bit better; b) who foots the roughly €3mm/week bill. However, TMM have resolved to stop sweating the small stuff in 2011 and want to use this opportunity to dwell on the big picture, namely the state of affairs in Euroland.

So let’s start with the first piece of the puzzle. The rolling off of the €16 yard Irish technicality (probably some time next week) is likely to reduce excess liquidity in the Eurosystem to around €20bn (please treat this number with caution, as there’s a lot of room for interpretation). In itself, this isn’t likely to cause a repeat of the sharp EONIA squeeze we saw in January (see below), which was, at least partly, due to a variety of technical factors. However, it’s entirely clear which way the wind is blowing. Barring any unforeseen calamities, EONIA is likely to continue its gradual move higher, towards the main refi rate of 1%. This is a culmination of painstaking efforts on behalf of the ECB, designed to “cleanse” its interbank mkt and wean the addicted banks off the mother’s milk of ECB liquidity (of course, all it means is that the little buggers are now firmly latched on the teat conveniently provided by their respective national govts).


The second piece of the puzzle is, of course, the ongoing saber-rattling rhetoric of the ECB Big Cheeses, who continue to threaten hikes (e.g. Bini-Smaghi on Friday; Trichet in his French radio interview this past w/e; Darth Weber at the G20). While it’s not clear just how much of this is intended for the specific ears of the union leaders in Germany, the mkt has certainly been reading the message loud and clear. Consider, for example, that new bold ECB call from Barclays, who now expect the first hike in Sep 2011, rather than Jun 2012.

The net result of both developments (i.e. tighter liquidity conditions and expectations of monetary policy actions) is the move in 1y EONIA rate seen this year (below).


So the main question for TMM is what all this “sturm und drang” actually means. Assuming that the ECB rhetoric is reflective of their actual thinking and, more importantly, translates into action, it is TMM’s considered opinion that the Eurozone is heading for a painful accident. Allow us to look at this in a bit more detail.

It’s abundantly clear that the EMU is experiencing a “many-speed recovery” (see below for a comparison of industrial production YoY averages), in the face of which the ECB is resorting yet again to their favorite Eurostrich policy framework.


Specifically, they claim, with much ardor, that it’s simply not their problem and that the national governments should just get their acts together and sort things out (the fact that the national govts can’t seem to be able to do just that is, yet again, not the ECB’s problem). While such a view is undoubtedly justified as far as the letter of the law goes, it clearly doesn’t contribute to a long-term solution.

The issue that’s been raised by a number of pessimistic pundits is that the Eurozone, with its multitude of disjoint policies and regimes, isn’t a viable construct in the long run. Efforts at strengthening the fiscal union, while ongoing, have so far yielded no meaningful results. At any rate, such herculean harmonization effort is likely to take years, if not decades. While this is ongoing, the Eurozone remains stuck with divergent growth rates and a central bank that’s unwilling to make allowances for this. Will it survive such an ordeal? The last time the ECB closed its eyes to peripheral developments during the 90s (focusing on Germany which was in the throes of re-unification), we all know what happened. Now, in the aftermath of the bursting of the peripheral bubble of partly their own creation, the ECB is facing a divergent dynamic of a different sort and getting ready to commit the same grave error. Plus ça change, plus c'est la même chose, indeed.

While thinking about all these weighty matters, TMM did a wee bit of scenario analyzing. The idea has some merit, in spite of some rather aggressive simplifying assumptions. Let’s take a hypothetical Eurozone sovereign with a lot of public and banking sector debt, a moderate GDP growth rate (held constant) and a healthy desire to get its fiscal house in order, reflected in a negative primary budget balance. We look at the trajectory of the said sovereign’s debt/GDP ratio under different rate regimes (each 100 basis points higher).


Now, quite clearly, this is not rocket engineering and is precisely the sort of thing the pundits look at when talking about countries not able to deal with unsustainable refinancing rates. We invite readers to consider that tighter ECB policy, accompanied by low growth in the periphery, has PRECISELY the same effect on peripheral debt sustainability as soaring mkt yields. And all this before we even take the effective exchange rates into account.

We have had March billed in our diaries for the showing of “Eurowoes 3” since December. Are we being shown the trailers?

EDIT: apologies for the miscalculation of the cost of the Irish debacle in the original. It's been corrected (thanks to the peeps who caught this).