Email of the day (1)
Comment of the Day

December 12 2011

Commentary by David Fuller

Email of the day (1)

More on risks of a Eurozone disaster:
"Your estimation, in Friday's Comments, of a 25% probability of a Eurozone disaster outcome doesn't seem unreasonable on the face of it. And as you've mentioned on a number of occasions recently, Italian BTP yields appear to have displayed trend ending characteristics of at least medium-term significance.

"However, a 20 year chart of Italian BTP yields highlights what may be a more disturbing picture: yields have potentially formed a 12 year base from which they've recently broken out, and are currently retesting that breakout.

"Without a full and complete Euro Zone fiscal union in place, the ECB will be unable to embark on a full QE program in the manner of the BoE and Fed; to attempt to do so, without that fiscal union established, would be signalling a clear departure away from monetary policy and into fiscal policy, and a step into the realm of debt monetization and monetary financing, which the currency and bond vigilantes would likely soon test to destruction.

"Even with full fiscal union, it's probable that the ECB would at most only follow a policy of "lender of last resort" in the classical Bagehot style - ie. responding solely to liquidity issues, not solvency issues. Mervyn King recently made this very same point in response to The Telegraph's Jeremy Warner at the recent Inflation Report press conference.

"Without the ECB able to cap Euro Zone government bond yields on anything other than a short term basis, real buyers - with real money - will be required to transform these medium term peaks in yields into longer term peaks. With the world experiencing a lengthy period of deleveraging, and with regulatory pressures within the Euro Zone ensuring that their banks are on an accelerated course of balance sheet contraction, one must wonder where these real buyers with cash in sufficient size will come from.

"If they don't emerge, perhaps we'll see that yields on government debt are experiencing a broad secular change in terms of risk perception, that the pullback in Italian BTP yields is just temporary, and that a far more dangerous financial climate lies ahead of us. Let us hope it's not so, but to consider this outcome as entirely possible seems prudent currently."

David Fuller's view Thank you for a very clear and concise summary of risks currently faced by the Eurozone.

I agree with your point that longer-term risks still exist. The accelerated peak which I first pointed out in Italian 10-year bond yields on 9th November as it was occurring, and also on 10th November as they fell back, could only cover the short-term outlook at that time.

Over a month later the peak near 7.5 percent (weekly & daily) cannot be accurately described as more than of short-term and possibly medium-term significance at this time. Therefore, you are right to point out that longer-term risks are still apparent on the 20-year chart shown in your email above. After all, they have been much higher in the past, albeit in the days before the euro was created.

The "real buyers" to which you refer, whether they are Italian citizens, Chinese or anyone else will require some convincing. After all, many of us prefer to view asset selection from the perspective of judges at an international beauty contest. On that basis, I would want to see a credible austerity plan in Italy, further fiscal union within Euroland to bring the ECB more fully onboard, and a credible growth plan for both Italy and the Eurozone.

Clearly, we are not there yet but Eurozone officials and corporate leaders keep reaffirming their determination to save their currency union. If they are to be believed, they should have every incentive to do so sooner rather than later.

(See also Eoin's detailed assessments to similar emails below.)

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