This Is A Historic Moment In Time

While most  EU  officials are packing their bags for summer holidays, the global financial crisis are approaching its climax, with a real possibility that the worlds greatest nation – United States of America – may default on its debt, and an even more real possibility that the oldest societies in the world – Europe – once again  will be thrown into chaos and disaster. What happens  over the next few weeks will in many ways determine our future. This is truly a historic moment in time.

“The financial markets are not going on holiday … so I hope EU officials have not bought non-returnable flight tickets.”

Michael Emerson

In spite of  the obvious risk of seismic events in both the US, the euro zone and the Arab world over the next six weeks, EU institutions will drop to staff levels of just 20 percent as officials go on holiday, limiting their capacity to respond to any situation. On the financial side, eurocrats can fly to Tuscany – a favored location – happy in the knowledge that some of the biggest events will fall either side of their break.

According to the EUobserver, member states have already designed “backstop” measures of public and private sector support which they can put into play this week.

If something truly worrisome should happen, they might meet in a summit next Thursday or Friday.

If such a summit is to take place, the markets will be looking for leaders to say that only public money will be used in the second Greek bailout and that the EU will boost the size of emergency funding mechanisms to cover potential problems in Italy and Spain.

Much will depend on Germany, which has been unwilling to move quickly.

The other risky event – an EU-IMF assessment of whether Greece is doing enough to secure its next tranche of aid – will come in late August, when many officials are back from their vacation.

“The financial markets are not going on holiday … so I hope EU officials have not bought non-returnable flight tickets,” Michael Emerson, an expert at the Centre for European Policy Studies, a Brussels-based think-tank, says.

Economist Christoph Weil at Commerzbank do not rule out a spontaneous market event, such as one or two top private investors moving out of Ireland, Italy, Portugal or Spain and causing wider panic.

“It’s a clear risk,” Weil says:

“The ratings agencies already point to a threat of defaults or the need for second bailouts. But if you look at bond spreads at the moment, they are very high – the ratings agencies are behind the curve [compared to the markets].”

Despite the common perception that the EU sleeps in August, institutions will have four major crisis-monitoring centres running 24/7.

The biggest one, the Joint Situation Centre, keeps half its  staff of about 100 persons in place during the holidays.

If the EU needs to make a serious statement, the time-lapse between foreign relations chief Catherine Ashton sending a draft to the 27 capitals on the secure Coreu network and getting the green light is about six hours.

If it needs to take action, foreign ministers can be called to Brussels on 48 hours’ notice and leaders in three to 10 days’ time.

“Things have changed over the past 10 years. We’re more flexible. It’s no longer like a car factory shutdown,” one senior official notes.

The Strange Part

The behavior in CDS spreads for US debt, much like the debate to raise the debt ceiling, has been kinda peculiar.

One year CDS spreads are being quoted about 10 basis points wider than five-year levels intraday.

That is strange because curve inversion in the short end of CDS curves is typically only seen for risky credits with spreads that are greatly elevated and have the heightened possibility of a default in the short-term, director Otis Casey at Markit Credit Research explains.

So to see it for a credit that trades at levels this tight is remarkable.

“It reflects to some degree the anxiety and growing sense of urgency around raising the debt ceiling sooner rather than later,” Casey comments.

Late Wednesday, Moody’s carried out its earlier threat of putting the US on review for downgrade citing the lack of progress in the negotiations.

Earlier in the week, out of a growing sense of frustration, Senate Minority Leader Mitch McConnell offered a proposal that would allow the President the authority to raise the debt ceiling without Congressional approval.

On the face of it, the proposal is a reversal of the Republican tactic to try to match future spending growth against any raises in the ceiling.

Political pundits wondered aloud if it was simply a tactic designed to pin the blame for ballooning deficits on the President in order to gain an advantage in next year’s presidential elections.

Absent any new progress on a compromise though, it seems to be gaining some traction as the primary backup plan should a deal not be reached.

“Based on Moody’s announcement regarding the debt ceiling limit, the result of such legislation would be that it would avoid a downgrade while leaving the outlook negative; this is precisely what the markets have now.  Putting aside the question of whether such legislation would pass constitutional muster (some doubt that the Legislative branch can cede that much of its constitutional authority on budgets to the Executive), members of both parties find it lacking for a variety of reasons,” Otis Casey says.

It is thought that the beginning of the end game in all of this will come next week as many believe that some sort of deal or understanding needs to be completed by July 22 in order for Congress to write legislation and get it approved by the August 2 deadline.

“Adding to the sense that this is a historical moment will be House GOP led efforts to vote on a balanced budget amendment,” Casey points out.

The Week Ahead – Day by Day

The initial driver of the markets on Monday will likely be the results of the European bank stress tests and ongoing talks regarding sovereign debt over the weekend, as well as US budget discussions.

The euro zone will remain in focus over the week, with a slew of economic data published, including the Markit Flash Eurozone PMI  surveys for July.

PMI data last month showed worrying slowdowns in Germany and France, as well as renewed weakening in the periphery.

A noticeable downturn in the Italian PMI data was a key factor bringing the country’s debt servicing problems into the foreground, while the headline numbers for the euro zone raised concerns that recent interest rate hikes by the European Central Bank have come at a time when growth is already slowing.

UK policymaking will also come under the spotlights with the publication of the Minutes from the July Bank of England Monetary Policy Committee Meeting.

Recent weak economic data, including a fall in inflation from 4.5% to 4.2%, are expected to have led to increased discussions about the need for further quantitative easing if further weakness is seen in coming months.

The markets are now not pricing in a full 25 basis point rise until the final quarter of 2012, according to Markit Financial Information.

Retail sales and government borrowing for June are also likely to add to the policy debate, with the former likely to show high street sales struggling and the latter closely watched to see if the improvement seen in May can be repeated.

The US focus will be on the housing market, with the NAHB index plus housing starts and home sales data published.

Monday
The US kicks off the week with the release of the Treasury International Capital (TIC) Flows data.

Viewed as a key resource for offsetting the US trade deficit, total net TIC flows were lower in April.

This release is closely followed by US NAHB housing data.
Tuesday
July’s ZEW Economic Sentiment will reveal if recent developments in the euro zone have further hit German investor confidence.

Another highlight of the day will be the Bank of Canada’s interest rate decision.
Wednesday
Wednesday’s key releases are German PPI and the UK Bank of England Minutes.

On 7 July, the MPC voted to maintain the official Bank Rate at 0.5% and the stock of asset purchases at £200billion.

The minutes will reveal the reasoning behind the latest decisions and who voted for them.

The Bank of Canada Monetary Policy Report will end the day.

Thursday
Flash releases of Chinese manufacturing, French, German and euro zone PMI’s will be some of the most closely watched data on Thursday.

These will be followed by several important releases, including Japanese all-industry activity and the merchandise trade balance total, UK retail sales, as well as US jobless claims and leading indicators.

Friday
The week ends with German IFO data, which will give updates of the current and expected business climate in Germany.

The current conditions index showed an improvement for the first time since February in June, but the expectations index dropped further.

Euro zone industrial new orders and Canadian CPI data follow.

See also:

Fitch Ratings. Italy Special Report: Risks to Italy’s Public Finances

Markit Economoic Research. Global Economy, July 2011: Global economic growth weakest for almost two years.

Markit Eurozone Composite PMI – final data: Euro zone growth slides to 20-month low in June

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