This week’s edition of The Economist got a bit of publicity at the weekend for a prediction that the euro crisis could see Australian house prices down 25%, a prediction that brought a chorus of oohs and ahhs from the usual crowd of housing jeremiahs. But they missed an even grimmer prediction in the opening editorial of the same magazine.
“This cannot go on for much longer. Without a dramatic change of heart by the ECB and by European leaders, the single currency could break up within weeks. Any number of events, from the failure of a big bank to the collapse of a government to more dud bond auctions, could cause its demise. In the last week of January, Italy must refinance more than €30 billion ($40 billion) of bonds. If the markets baulk, and the ECB refuses to blink, the world’s third-biggest sovereign borrower could be pushed into default.”
If that’s the case, then if you are travelling to Europe in the next month or two, take some US dollars, it could be the short-term currency of choice if the euro collapses.
Well, there’s an opportunity for the situation to be tested this week. Italy, Spain, France and Belgium will each attempt to borrow billions of euros through a string of debt auctions in the face of growing reluctance by investors to hold even the safest European debt. In fact Belgium, Italy, Spain and France are on course to issue up to €19.5 billion ($US26 billion) in nominal and index-linked bonds next week, as well as another €9 billion to €9.5 billion in short-term bills, according to analysts.
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So it’s no wonder that there are media reports this morning that the International Monetary Fund is looking at linking with the European Central Bank in a €600 billion backstop for Italy.
The La Stampa newspaper reported that such a move would give the new Italian government, led by Mario Monti, a window of 12-18 months to implement urgent budget cuts and growth-boosting reforms “by removing the necessity of having to refinance the debt”. The paper said the fund would guarantee rates of 4% or 5% on the loan — lower than current borrowing costs of more than 7% for two- and five-year Italian debt.
Italy needs to refinance about €400 billion in debt next year, but first it has to get 2011’s financing finished. The question now is whether the markets will give it time to do that. Seeing investors baulked at fully funding last week’s €6 billion issue of 10-year bonds by Germany, we could see what the bond market calls a “market event”, something that absolutely floors confidence. “After the recent hiccups in the primary market arena, all auctions have to be regarded as event risks,” wrote strategists at Commerzbank last week
After the surge in yields on Italian debt to more than 8% on Friday, Belgium’s downgrade by Standard & Poor’s also on Friday and the jump in German yields after that auction last Wednesday, confidence has gone from the market and a credit freeze and recession beckons. And if that happens, then France’s AAA rating will come under pressure.
Italy was forced to pay a record 6.5% for six months bills on Friday. Yields at the 2-, 5- and 10-year levels soaring above 7% as a result. Yields on two-year bonds jumped past 8% in the secondary market on Friday, meaning the Italian yield curve has inverted even more dramatically. (An inverted yield curve is where short-term yields are above longer-term rates and signal the rising prospect of a recession). Germany’s 10-year bond yield ended the week at 2.26%, up from 1.96% last Friday.
Italy is set to sell €500 million to €750 million of index-linked bonds tonight, our time and tomorrow night will see it try to sell between €5 billion and €8 billion of bonds, including a new three-year benchmark, 10-year bonds and a 2020 bond. These issues on Tuesday will test the market’s interest in Italian debt.
Belgium tonight will also try and sell €1 billion to €2 billion of 2018 bonds as well as its 10-year benchmark and other issues. Belgium will have to pay more after Friday’s downgrade to a AA credit rating. Spain is expected to try and sell €3 billion to €4 billion in various bonds on Thursday, while France is set to auction up to €4.5 billion of bonds on the same day.
Tuesday sees a meeting of the 17-member Eurogroup of finance ministers in Brussels. Just what they can now do to halt the slide is problematic. Everything they have tried in the past has failed. The economies of the eurozone and outsiders such as Britain, are is sliding towards recession and the financial system is freezing over.
London will be gloom and doom all week. The mid-term budget review this week is being overshadowed by the realisation the economy is on its way to a recession. Weekend media reports said the Organisation for Economic Development and Co-operation (OECD) will tonight warn that the UK economy will shrink over the first half of 2012.
The forecast will be followed by the mid-term review from the government, new forecast from the independent budget office and then the latest financial stability report from the Bank of England on Thursday, all of which will paint a very pessimistic outlook for the UK.
But let’s return to The Economist’s editorial: “Mrs Merkel and the ECB cannot continue to threaten feckless economies with exclusion from the euro in one breath and reassure markets by promising the euro’s salvation with the next. Unless she chooses soon, Germany’s chancellor will find that the choice has been made for her.” The time to do something conclusive is disappearing by the day.