MERKEL’S HUGE IN-TRAY

by **Cals** Mon 13 Aug 2012, 17:59

MERKEL’S HUGE IN-TRAY

13/08/12 @ 07:38 GMT by Michael Derks, Chief Strategist

Germany’s Chancellor returns to her desk after her summer vacation with a very full agenda. Her government, indeed the rest of Europe, eagerly awaits the decision of the German Constitutional Court next month on the legality of the permanent rescue scheme (ESM). In addition, Merkel is an important participant in the discussion of under what conditions (if any) the ECB could purchase the bonds of troubled sovereigns such as Spain and Italy. On Saturday, Governing Council member Luc Coene fanned the flames of what is already an acrimonious debate by declaring that it “makes no sense for the ECB to start financing” sovereigns. In the meantime, there is ongoing anxiety over whether the troika will release further funds to Greece – it is due back in Athens early next month to examine progress on implementation of previous agreements.

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Commentary

Japan catches the global economic tide. Second-quarter growth in Japan was weaker than expected, up just 0.3% QoQ, although this followed a creditable 1.3% jump in the previous quarter, aided by reconstruction spending. Apart from the anticipated slowing of export growth, consumers were more cautious than they have been since the March 2011 earthquake. With the currency still stronger than the MoF would like, and consumers still hesitant, the pressure is mounting for a stimulatory supplementary budget. Deflation remains an ongoing concern for Tokyo – the GDP deflator fell by 1.1% in the year ended June. To put this into perspective, apart from a very brief period of just two quarters in 2009, Japan has endured deflation for the past fourteen years, testimony to the impotence of monetary policy once an economy enters the debt vortex.

Accounting for the weaker euro. The single currency was one of the weaker performers last week. Previously, the euro was supported by the belief that the ECB was shifting its stance and planning to buy bonds in a more sustained fashion and at the shorter end of the yield curve. From a position above 6.5% earlier in June, yields on 2yr Spanish bonds were below 3.5% earlier last week, but ended back just below 4% level. It is shorter-dated yields (2yr) rather than 10yr yields that tend to correlate better with currency movements. Our (GDP-weighted) measure of 2yr spreads over Germany in the peripheral eurozone has shown a stronger correlation with EUR/USD (-0.69) even than for 2Y German yields vs. 2Y US yields more recently. In other words, the market is showing greater sensitivity to peripheral risk than to the relative returns in core eurozone or US bonds. Yields in Spain are creeping higher however on the belief that nothing is going to change anytime soon. The ECB has indicated that it’s going to have to wait for the German Constitutional Court’s decision on the ESM (the permanent rescue fund) before the next stage can be considered. Furthermore, the ECB itself has said it would address the issue of seniority (the ECB being ranked higher than private sector creditors) but has offered no further details. As such, bond markets are still living off hope and promises, rather than hard facts, and so the rise higher in yields is understandable. The single currency could be vulnerable to more of this should we fail to get further clarity in the coming weeks which, during the holiday season, seems a likely scenario.