Notwithstanding the worsening financial calamity that is southern Europe, noticeable over the last couple of weeks is that both Angela Merkel and her Finance Minister Schaeuble have been less prominent than might have been expected. In part, this reflects Germany’s increasing isolation within Europe – the Latin-bloc are demanding a growth agenda rather than perma-austerity, politicians around the globe are demanding that Europe (that is, Germany) do whatever it takes from a financial perspective to put a firewall around the banking sector, and Europe is fracturing away from the centre towards more radical political solutions. Particularly striking this week was the aggressive push by EC President Barroso for a fully-fledged European banking union, a proposal that has a measure of support in Europe and one that is essentially a prelude to a much more integrated fiscal union. For their part, Germany’s current leaders remain opposed to this latest grand master plan from Brussels; they do not like eurobonds, they do not want the ECB to recommence secondary market bond-buying, and they are incredibly uncomfortable with the notion of a Europe-wide deposit guarantee scheme. At the same time, Germany may well be calculating that the cost of the euro collapsing is simply too great and as such perhaps they have no choice but to play along with Brussels and the ECB while attempting to limit Germany’s liabilities as best as possible. For the supposed powerhouse of Europe, Germany is in an invidious and incredibly vulnerable position.
Changing market dynamics. Over the last couple of trading sessions, rather striking has been some market developments that are out of kilter with recent norms and correlations. For instance, the single currency was one of the better performing currencies yesterday, climbing above the 1.26 level briefly despite continuing nervousness regarding the situation in both Spain and Greece. At the same time, German Bund yields rose further, with the 10yr touching 1.50%, while both Spanish and Italian yields were little changed. Looking back over the past year, this is also a fairly rare phenomenon, normally symptomatic of a fairly major “risk-on” move. The euro price action appears to be in part owing to positioning, with the market still vulnerable to a bout of short-covering given the extent of short positions (as seen in latest CFTC data). Furthermore, there are reports in the German press that EU leaders may relax the austerity measures on Greece after the weekend election. It’s certainly true that the election result is far less binary than is often made out. The price action is also further confirmation (if needed) that the strong “risk-on, risk-off” dynamics that have characterised much of the past 3 years have altered fairly dramatically, both in FX markets and beyond. This has implications for investors but also central banks, with the impact on asset markets of further quantitative easing biased towards being less dramatic than before. This was reflected in remarks from the Bank of England deputy governor (Tucker) earlier this week, who challenged the conventional thinking that QE should be limited to buying gilts. Governments and EU leaders in particular should take note, as the ability of central banks to do the heavy lifting is diminishing fast.
Shot across the bows for Aussie bears. Moody’s effectively issued a warning for Aussie bears yesterday. In their latest annual assessment, Moody’s claimed that Australia’s financial position is one of the best amongst the top-tier (AAA-rated) sovereigns. According to the rating agency, Australia recorded very high readings for economic strength, government financial strength and institutional strength. In addition, Moody’s suggest that Australia has very low susceptibility to event risk. In a statement bordering on the bleeding obvious, Moody’s wrote that external factors such as global and East Asian growth represented the biggest risk to this scenario. In a glowing report, Moody’s noted that government debt remains extremely low by global standards, and that the current government expects to record a further decline in outstanding debt in the next fiscal year. Australia’s supposed financial strength compares with the deterioration being experienced by most of the world’s advanced economies. As a result, notwithstanding the fact that the currency is overvalued, from a fundamental perspective Aussie bears need to be extremely careful. In a world where the number of healthy AAA-rated sovereigns is rapidly diminishing, many investors will be almost compelled (by their mandates) to allocate capital down under.