This week had a surreal quality. The buildup for the week was the European summit in Brussels that started Thursday afternoon and went into Friday. The talk was of impending catastrophe and/or a financial Armageddon unless some kind of significant consensus was not formalized by the weekend.
On Thursday, in front of the summit, Mario Draghi’s ECB announced it was lowering its central rate by 25 bps back to a record low of 1%. Perhaps more importantly, the ECB announced it would extend loans against collateral for up to three years and relax the ratings criteria for that collateral to single “A” for any banks in need of moneys to finance themselves. In essence the ECB announced it would more aggressively assume a role of lender of last resort.
These announcements, although somewhat discounted, should have been positive for the markets. Somehow, though, “it” was decided that the markets were looking for something more; that the markets were disappointed, perhaps that the ECB was not going to write a blank check to purchase some of the more suspect European sovereign credits. The reality is no one knows for sure why the markets were disappointed but disappointed they were and European and US equities sold off 2% to 3%.
Friday’s market action started off ominously. Asian markets had sold off overnight and most European markets opened up down more than 1%. By 10AM on the continent, the bourses had more or less recaptured their losses and proceeded to tread water until around lunchtime. At this point, the markets gapped higher. By the end of the day, markets had more or less reversed the previous day's losses. Victory was ours; an agreement had been reached. Chaos had been averted and Western Civilization had survived, at least for now.
So what, you might ask, was agreed to? First, a consensus has emerged among the 17 Euro-Zone members that each country would submit their domestic budgetary process to a supra-national, EU oversight. This is in general what is meant when people speak of Fiscal Union. In practical terms, this means that each member will be unable to run deficits that exceed 3% of their GDP. The second noteworthy item is that the same 17 Euro-zone countries will contribute 150 billion Euro’s to the IMF to somehow support the more challenged sovereign credits, with an additional 50 billion Euro coming from "other" European Union countries. The details of who pays what and how the support is implemented still need to be worked out but presumably Germany and France will lead the charge.
Skeptics might be reminded of the famous French dictum, “Plus ca change, plus ca reste la meme chose”. In this case, we would be referring to the Maastrict Treaty of December 9, 1991, enacted exactly 20 years ago to the day. Among other criteria, the Treaty required that members not have annual deficits exceeding 3% of GDP and that outstanding Government debt could not exceed 60% of GDP. Without belaboring the point, most Euro zone countries have consistently missed these criteria, and by more than a nose. But apparently, this time, we’re serious….
Perhaps, the biggest irony about all this are some of the post-mortem headlines. The summit has been declared a success and Britain has been declared the big loser by not signing up for membership in this open-ended, opaque agreement which still doesn’t substantively deal with how next year’s $1.5 trillion of European sovereign debt will be refinanced.
And this is where the surreal quality enters in. It would seem that by declaring a loser, by definition there must have been a winner and therefore something substantive must have been accomplished. But, how is the UK a loser unless it means David Cameron won’t be invited to dine at Comme Chez Soi with Merkozy any more? And if there isn’t a loser, was there a winner?
Over the past six months, since the European sovereign crisis has taken center stage, the UK has outperformed most European countries as measured both by their currency and their domestic interest rates. Specifically, the GBP/Euro cross rate (see graph 1 below) has appreciated by 3.5% since June from 1.13 to 1.17 (1 British Pound is now worth close to 1.2 Euros).
British Pound/Euro Cross Rate
(source: Bloomberg)
Perhaps more importantly, UK long term interest rates have declined significantly relative to most Euro-zone countries (see graph 2 below comparing UK vs. France 10 year yields). So the UK has arguably been able to stimulate its economy at a time of broad global vulnerability while most Euro-zone countries have essentially abdicated their ability to implement domestic policy stimulus. In fact, most countries will embark upon the opposite, austerity programs in order to maintain their club membership.
10 year Gilt (UK) vs. 10 year OAT (France) Yields
(source: Bloomberg)
The point is that the current economic circumstances are exactly the reasons that a country might not want to sacrifice it's monetary independence. Further, the markets are rewarding the UK with good grades and not with the hourly gyrations currently being experienced by many Euro-Zone countries. So despite calumnious charges of "Perfidious Albion" and meteorological forecasts of "Fog in Channel, Britain isolated", Conservative Prime Minister Cameron would do well to heed Marx’s famous dictum, “I don't care to belong to any club that will have me as a member”. Groucho Marx that is.
