The Last Days of the Euro

Why France and Germany are likely to strike a momentous deal on fiscal union sooner than anyone thinks.

 

By Jonathan Wilmot.

We seem to have entered the last days of the euro as we currently know it.

That doesn’t make a break-up very likely, but it does mean some extraordinary things will almost certainly need to happen – probably by mid-January – to prevent the progressive closure of all the euro zone sovereign bond markets, potentially accompanied by escalating runs on even the strongest banks.

That may sound overdramatic, but it reflects the inexorable logic of investors realizing that – as things currently stand – they simply cannot be sure what exactly they are holding or buying in the euro zone sovereign bond markets.

In the short run, this cannot be fixed by the ECB or by new governments in Greece, Italy or Spain: it’s about markets needing credible signals on the shape of fiscal and political union long before final treaty changes can take place. We suspect this spells the death of “muddle-through” as market pressures effectively force France and Germany to strike a momentous deal on fiscal union much sooner than currently seems possible, or than either would like. Then and only then do we think the ECB will agree to provide the bridge finance needed to prevent systemic collapse.

We think the debate on fiscal union will really heat up from this week when the Commission publishes a new paper on three different options for mutually guaranteed “Eurobonds”, continue at the summit on 9 December and through a key speech by President Sarkozy to the French nation scheduled for the 20th anniversary of the Maastricht Treaty (11 December).

While these discussions may give some short-term relief to markets, it seems likely that the process of reaching agreement will involve some high stakes brinkmanship and market turmoil in subsequent weeks. (Not unlike the US debt ceiling debate this summer, or the messy passage of TARP in 2008.)

One paradox is that pressure on Italian and Spanish bond yields may get quite a lot worse even as their new governments start to deliver reforms – 10-year yields spiking above 9% for a short period is not something one could rule out. For that matter, it’s quite possible that we will see French yields above 5%, and even Bund yields rise during this critical fiscal union debate.

Moreover, this could happen even as the ECB moves more aggressively to lower rates and introduce extra measures to provide banks with longer-term funding. And US bond yields may fall – or at least not rise – despite improving US growth data through end-year. Equally, global equity markets and world wealth could follow a more muted version of their early Q1:2009 sell-off until the political brinkmanship is resolved – see exhibits below.

In short, the fate of the euro is about to be decided. And the pressure for the necessary political breakthroughs will likely come from investors seeking to protect themselves from the utterly catastrophic consequences of a break-up – a scenario that their own fears should ultimately help to prevent.