Orlando, FL 4/25/12 (StreetBeat) -- So the Euro Zone has a problem with debt; you know all about it. Great efforts have been expended by the countries that use the euro, the broader EU, the ECB, and others, in an attempt to make the trouble go away. Despite it all the problem persists. Try as they might Greece is now the home of the largest sovereign default in history. But Greece is small potatoes when compared to Spain, the current poster child for European debt woes. Almost two years removed from the first rescue plan it is now possible to have a polite discussion about a reduction of the single currency membership list; not something that was acceptable at the onset of the process. Will a country abandon the euro? Maybe not, but possibly so; in any case it is part of the conversation. But if so; who?
The solution to Europe’s debt problem is not clear; if it was then it is likely it would have been found by now. Then again it could depend on who you ask as to whether or not there is a solution in plain sight and whether or not it is just the will to enact it that has been elusive. In a speech delivered late last month, Bundesbank President Jens Weidmann suggested that the time for dithering is over and the time for real decisions on the future path of the Euro Zone has arrived; “The time has come to move from containing the crisis to resolving it. If we have the will to make the right choices, we will be able to rebalance Europe and lay the foundation for a stronger, more stable monetary union.” In order to resolve its deficit problem, says Weidmann, Europe is in need of stricter rules, rigorously applied. Of course Bundesbankers have long believed that monetary union cannot survive without a political union; either members go all in, with union interests above national interests, or the odds of success are greatly reduced. In his speech Weidmann acknowledged that “member states have made it clear that they want to retain their autonomy in fiscal policy,” so therefore, he says, rules must be stiffened in an attempt to make a less than optimum solution effective.
But there is clearly resistance, throughout the continent, periphery to core, on signing up to a vision that has the Bundesbank as its chief architect; the French election results and Dutch budget squabble reinforce the existence of that reluctance. Therefore, it appears the Bundesbank will get even less than their reduced expectations in regards to fiscal rectitude. Right or wrong; pro growth or favoring austerity, it is fair to say that the Bundesbank will not get what it wants. While Weidmann may not yet have developed a nervous tick over the prospects for Euro Zone fiscal sobriety in the long term, there may be a way to measure the likelihood that he will eventually be inflicted with one. The TARGET2 imbalance at the Bundesbank is up to EU615 billion as of the end of March, up more than ninety percent from last year and up EU152 billion in the first three months of 2012. Yeah, we all know this is collateralized and not solely the responsibility of the Bundesbank, even if things go badly for the Zone; there is not yet any official sweat on the brow over the situation. But what will be the mood in Frankfurt if this imbalance hits EU1 trillion? Does the Bundesbank have a TARGET2 stop in mind, while also keeping in mind that collective will to reverse the imbalance is less than Teutonic? Is there a point at which this arcane data point captures the imagination of the German street and forces the hand of Berlin? The key question; is it possible that Germany is the first to bail out of the single currency? Maybe not, but possibly so; it is, in any case a topic that can be brought up in polite conversation and that, in and of itself is important.
You can trade Euro Zone sovereign debt, but aside from Germany, you can’t invest in it. The Financial Times reports that “bankers estimate that EU100 billion has been taken out of French, Italian and Spanish government debt markets in the past two years as many investors have lost faith in the single currency zone.” I would add that not only has there been a divestment of this debt but there is no fresh buying, except from banks that are beholden to their national central banks for their continued existence. For institutional investors, the natural buyers of fixed income such as insurance companies, pension funds or banks, there is nowhere else to turn but the German debt market and the US Treasuries. It is not a matter of fundamentals, such as the spread above or below inflation; it is a matter of what is available to purchase that can pass the mustard of an investment committee review. There is even a hoarding instinct at work. Reliable, well rated collateral is at a premium. This is made all the more acute by the increased use of covered bonds, which prohibit the reuse of the pledged securities, and because of an unintended consequence of the LTRO. While this ECB strategy may have ensured that banks will not run out of liquidity, the collateral that has been pledged to the central bank to secure those funds could mean that banks will run dry on collateral the next time push comes to shove.
The bid in German and US debt that has driven the yields down to, or close to, record lows, is not a matter of chasing what you want, it is just a matter of securing what you need. And until the question of the Euro Zone’s future can be confidently answered, it is hard to imagine the situation changing.
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