WISE MONEY

The pound strengthened to 1.22 against the Euro yesterday for the first time since November 2008.

Sterling continues to benefit from the UK budget announced earlier this week and the news that one MPC member voted for a rate hike this month. A strong response from the credit agencies took away fears that the UK’s AAA rating could be downgraded.

Concerns over the European debt crisis were on the rise again yesterday with Greek credit default swaps hitting a record high.

ECB president Trichet said he is “pleased” with Germany’s decision to concentrate on fiscal discipline, he also commented that the idea that austerity measures could trigger economic stagnation is “incorrect” and he does not think the risks around deflation will materialise.

Another cause for concern in the Eurozone is the requirement for European banks to repay the $540bn of ‘special’ 1-year loans that they borrowed from the ECB.

The added problem here is that a number of the banks used the loans to buy up bonds in Greece, Spain and Portugal – fixing in a healthy interest margin in the process. Now they have to repay their ECB loans, the banks may decide to offload some of these bonds, which could reignite tensions in European financial markets.

Investor George Soros has warned Germany to leave the euro unless it is willing to embrace a growth strategy, calling Berlin’s current austerity plans  a threat to democracy and political stability in Europe.
“German policy is becoming a danger that could destroy the European Project. A collapse of the euro cannot be excluded,” he told the German weekly Die Zeit.

“Unless Germany changes policy, its withdrawal from the currency union would be helpful for the rest of Europe. At the moment Germany is pushing its neighbours into deflation: this threatens a long phase of stagnation, leading to nationalism, social unrest, and zenophobia. It endangers democracy,” he said.

Mr Soros saw the political effects of wage cuts first-hand during the Great Depression, and narrowly survived the Holocaust as a Jewish boy in Nazi-controlled Budapest. He has since dedicated much of his wealth to philanthropic works promoting freedom and pluralism across the globe, mostly through Open Society institutes.

His comments reflect growing alarm in influential circles on both sides of the Atlantic over the 1930s-style policies of wage cuts and debt-deflation being imposed up the Club Med bloc, Ireland, and parts of Eastern Europe by the EU authorities, at the behest of Berlin.

President Barack Obama clearly had Germany in mind when he wrote a letter to fellow leaders before the G20 summit in Canada this week that surplus countries should do more to shore up global demand. “Our highest priority must be to safeguard and strengthen the recovery: we cannot let it falter or lose strength now. Should confidence in the strength of our recoveries diminish, we should be prepared to respond again as quickly and as forcefully as needed,” he wrote.

China has deflected G20 criticism by starting to free the yuan, leaving Germany facing the full wrath of Washington.

While the German economy is not in itself large enough to shape global events, US officials fear that Berlin’s dominant influence over the European Central Bank and the fiscal machinery of monetary union is dragging most of Europe into an economic swamp. Germany has raised the bar for every eurozone country by announcing €80bn of belt-tightening from next year.

Nobel laureate Paul Krugman told the German press earlier this week that the country was committing the same error as the United States in 1936-1937, or Japan in the 1990s, by withdrawing stimulus before recovery has taken root.

“I don’t have a problem with trying to balance the budget in five or 10 years. The question is whether one should start when the economy is at 7 or 8 percent below its normal capacity and interest rates are at zero. Now is not the time to be worried about deficits.”

Professor Krugman said there was a risk of a “domino effect” reaching Spain and Italy if Bundesbank chief Axel Weber takes over as head of the ECB and fails to offer enough monetary stimulus to keep these countries afloat.

One analyst said that Mr Weber faces an impossible task. “Either they do more QE (quantitative easing), in which case it will set off inflation in Germany and cause Germany to leave EMU: or they don’t do more QE, in which case it will lead to deflation in Southern Europe and force them out of EMU,” he said.

Mr Soros said Germany was treating the deeply-flawed Maastricht Treaty as it were a “sacred text”, warning that monetary union cannot endure for long as a narrow construct based on debt and deficit ceilings.

He said wage rises in Germany are imperative to help lift the whole eurozone, allowing peripheral economies to claw their way out of trouble without fighting the extra headwinds of deflation.

“The truth is that what we have in Europe is not a currency or sovereign debt crisis as many people think, but a banking crisis,” he said.Mr Soros argued that the weaker states cannot easily fund their deficits any longer because some banks are purchasing fewer bonds as a result of damaged balance sheets.

European debt markets remain under high stress on persistent reports that Spain is in secret talks with EU officials and the International Monetary Fund for a support package of up to €250bn (£208bn), the largest rescue in history.The spreads on 10 year Spanish bonds jumped to a post EMU high of 224 basis points above German Bunds as traders brace for a crucial auction by Madrid.

The relentless rise in bond yields replicates the pattern seen in Greece at the onset of crisis. Spain must raise €25bn of debt in a cluster of auctions in July.

Elena Salgado, Spain’s finance minister, reacted angrily to a report in the Spanish daily El Economista claiming that the support plans are well advanced.

“It has been denied by the Spanish government, by the European Commission, and by the IMF. How much more can we deny it?” she said.

The story refuses to die, however. Three German newspapers have run similar stories over recent days, citing German sources. The markets are convinced that some form of contingency planning is underway.

El Economista said officials from the EU, the IMF, and the US Treasury had been discussing a credit line of €200bn to €250bn, dwarfing the €110bn package for Greece. Dominique Strauss-Kahn, the IMF’s managing director, reportedly called a secret meeting of the IMF’s Board of Directors to tackle the crisis.

The loan terms would be softer than the draconian budget cuts imposed on Greece, with the lion’s share of the money coming from eurozone states under their €750bn shield.

It is unclear how the EU would finance a full rescue for Spain. Under the Greek formula, the EU-IMF ratio of aid is 8:3, implying an EU share of around €180bn – with a risk that the sums will escalate. The number of eurozone states available to fund the package is shrinking.

The original hope behind the EU’s €750bn “shock and awe” headline was that the announcement of such sums would end all doubts about the political solidarity behind the euro project, but nationalist body-language from EU capitals and daily spats between France and Germany have sapped confidence.

What haunts markets is fear that Spain may be the last line of defence. There can be no easy rescues after that because the money will run out. If investors ever start to question Italy’s public debt – the world’s third largest – they may face a sovereign version of the Credit Anstalt crisis of 1931.

The Spanish government’s cost of borrowing has hit a new record hign amid renewed concerns over the state of its economy and public finances.
The interest rate Spain is being asked to pay by investors is now 2.23 percentage points higher than that being demanded of Germany.

This widening gap in the bond market marks a drop in confidence in Spain’s ability to repay its debts.

The Spanish cabinet has also approved unpopular changes to labour rules. The changes, which include a cut in the level of severence pay, have prompted a call for a general strike in September.

Spain, which is emerging from a two-year long recession is now pursuing austerity measures. These include a 5% cut to public sector pay in an effort to bring down its borrowing and help restore its credibility among international lenders.
IMF speculation

Its budget deficit is currently running at over 11% of GDP – way above the 3% limit imposed by the EU.

This week the Spanish government has also been forced to deny newspaper reports that it is in talks with the IMF over a Greek-style bail-out package to help it manage its debts.

The Spanish Prime Minister Jose Luis Rodriguez Zapatero is scheduled to meet IMF chief Dominique Strauss-Kahn on Friday, but Spanish officials say the talks are unconnected to the press speculation.

Investors remain concerned about the underlying strength of Spain’s economy.

There are also worries that spending will hamper its recovery from recession, with its unemployment rate of 20% – the highest in the eurozone – a significant concern.

The government has approved long-awaited labour market reforms, which it says will encourage firms to hire more people, easing the jobs crisis.

But the plans have met with demonstrations from unions, who fear the changes will hurt workers’ rights.

Analysts at the French financial group AXA see a serious likelihood that the eurozone will break in half or disintegrate, dismissing Europe’s £623bn rescue package for Club Med debtors as a stop gap measure that misdiagnoses the problem.
“The markets are very nervous because they can see that there is a fatal flaw in the system and no clear way out,” said Theodora Zemek, head of global fixed income at AXA Investment Managers.

“We are in a very major crisis that has even broader implications than the credit crisis two years ago. The politicians have not yet twigged to this.”

Ms Zemek said the rescue had bought a “maximum” of 18 months respite before deeper structural damage hits home, with a “probable” default by Greece setting off a chain reaction across Southern Europe.

“It would be the end of the euro as we know it. The long-term implications are at best a split in the eurozone, at worst the destruction of the euro. It is not going to end happily however you slice it,” she said.

The warning came as Spain’s authorities were forced to shoot down German media reports that Madrid was preparing to tap the rescue facility after ructions in the inter-bank market.

Carlos Ocampa, Spain’s treasury secretary, said smaller Spanish banks are struggling to roll over debts but denied that the country is seeking outside help. “The rumour is false,” he said.

Spanish banks increased reliance on funds from the European Central Bank to a record €86bn in May.

Greece’s woes increased further as Moody’s downgraded Greek debt to junk status, saying the “macroeconomic and implementation risks associated with the programme are substantial”. The move is largely symbolic at this point since the European Central Bank has suspended its rating requirements for use of Greek debt as collateral for loans.

Greece is almost entirely shut out of the capital markets. Private investors are believed to have offloaded €25bn of Greek debt on to the ECB as it steps in to shore up the market, shifting the credit risk on to tax payers.

Axa said there was “no chance” that the EU’s €750bn “shock and awe” shield will succeed since it treats Club Med’s debt trap as a short-term liquidity crisis.

In the case of Greece the joint IMF-EU policy will increase Greek public debt from 120pc to 150pc of GDP by 2014, arguably making matters worse.

A number of ex-IMF officials have said the policy is doomed to failure since there is no devaluation or debt relief to offset the ferocious fiscal squeeze, and may endanger the credibility of the Fund itself. The IMF had floated the idea of a debt restructuring but this was blocked by the Brussels.

The strategy assumes that voters in Greece and other Club Med democracies will endure years of pain for the sake of foreign creditors. “It’s a pipedream,” said Ms Zemek.

Contagion from a Greek default would be harder to control than fallout from the Lehman collapse. “This has huge implications for banks. These bonds didn’t just disappear; they went somewhere, allegedly into French money markets and insurance companies, or on to French balance sheets,” she said.

The Bank for International Settlements said French and German lenders have £650bn in exposure to Greece, Ireland, Portugal and Spain, mostly in mortgage and company debt rather than sovereign debt.

The distinction has become meaningless in Greece. The ECB has lent Greek banks €85bn, mostly in exchange for collateral in the form of Greek government bonds.

This has kept Greek lenders alive as they suffer a slow bank run, losing 7pc of their deposit base since last June as wealthy Greeks shift their funds abroad. The ECB support is equal to 20pc of their non-equity funding, according to Lombard Street Research.

Axa said the America’s currency union is successful because Washington has over-riding legal powers over the 50 states.

“It is a precondition for the system to work but it doesn’t exist in Europe and the bond markets are starting to figure this out. We are looking at a noble experiment on the brink of failure,” said Ms Zemek.

Investors are placing bets on a Black Monday size crash in the British stock market at the fastest rate since the collapse of Lehman Brothers bank in 2008, the Bank of England has warned.
In a survey of markets, the Bank warned that widespread fear over the possible collapse of a sovereign debtor, including Greece and Portugal, had sparked a mass of bets on a 20 per cent fall in the FTSE 100.

The warning coincides with calculations from the Bank for International Settlements (BIS) showing that Britain has major exposure to the Irish and Spanish banking systems, which many fear could be at risk in the next round of the financial crisis.

The Bank of England used its Quarterly Bulletin to warn that markets were under increased strain following the International Monetary Fund and European Commission’s bail-out of Greece.

It said that investors had fled into safe haven assets, including Treasury bonds, gold and, to some surprise, UK government bonds.

However, it pointed out that the number of investors betting on a 20 per cent fall in the FTSE 100 index, based on their purchase of options connected to such a scenario, had risen from below 5 per cent to about 13 per cent in the past month alone.

Although this is below the 25 per cent level around the time of the Lehman implosion, the rate of increase is similar.

Some analysts fear problems surrounding government bonds could trigger a repeat of Lehman-style events.

The BIS used its own Quarterly Report to point out that, although the strain had worsened throughout the international banking system, banks’ balance sheets were slightly healthier than in the early stages of the subprime mortgage crisis that led to the Lehman collapse.

However, it also pointed out that various countries in the euro area were particularly exposed to each other – both in terms of sovereign and private debt.

Banks headquartered in Britain had larger claims on Ireland £158 billion than banks based in any other country. Britain has a £103 billion exposure to Spain.

Deutsche Bank- Germany’s largest bank has revealed it is currently shorting Spanish and Portuguese government bonds- despite the country’s ban on holding short positions in the debt of other European governments.
Deutsche Bank has admitted that it has a net £900m short position on Spanish government debt and a £660m short on the Portuguese sovereign, as the German government attempts to ban all short sales in European sovereign debt.

The position will be doubly embarrassing for the German government, as Deutsche Bank’s own shares are currently the subject of a short trading ban imposed by the country’s authorities at the same time as sovereign ban.

Details of Deutsche Bank’s shorting came in a presentation given in at the Goldman Sachs European financials conference in Madrid by the company’s chief risk officer Dr Hugo Banzinger.

Dr Banziger described the bank’s overall exposure to Southern European government debt as “relatively small, except Italy”. Deutsche Bank’s net sovereign exposure to Italy is £2.6bn, based on a gross position of about £23bn.

Germany’s unilateral ban last month on the naked short selling of euro-denominated government bonds, credit default swaps based on those bonds, and shares in the country’s 10 leading financial institutions initially surprised other Eurozone governments, but has since gained support.

Deutsche Bank’s revelation of its short position in European government debt shows how easy sophisticated financial institutions with trading operations located around the world have found it circumvent national bans.

Sterling held steady yesterday as the reintroduction of a star chamber to quiz ministers on spending decisions marked the start of the Government’s formidable challenge of reducing its £156 billion budget deficit.The last time a star chamber was in use was under Margaret Thatcher, but even she did not face cuts of the scale that now face George Osborne.

To maintain a triple A rating, Britain must cut £92 Billion (or roughly the annual NHS budget) over the next five years according to the credit rating agency Fitch, and Mr Osborne made it clear to MP’s yesterday that the role of the State is about to change significantly.

Social security payments, tax credits and public sector pensions are likely to bear the brunt of any cuts, which may end up being as high as 20 per cent. Mr Osborne cited the example of Canada, which faced similar difficulties to the UK in the 1990’s, but successfully turned a large budget deficit into surplus by strongly challenging ministerial spending decisions.

What he failed to point out was the Canadian restructuring was achieved in a period of strong world growth with foreign demand able to replace government spending. We are certainly not in this situation now, and we are far from a consensus over whether current fiscal tightening will put Britain back on the long term path to growth or tip the economy back into recession.

This uncertainty is reflected in the markets; Sterling is treading water in the run up to the Bank of England meeting tomorrow and the Emergency budget on the 22 of June.

The Euro broke the physiologically important 1.20 level against the Dollar on Monday and continues to trade weakly against all the major currencies.

This morning there are reports that Spanish banks are having difficulty accessing funding in the European interbank markets, an ominous sign if true.

The contagion from Eurozone members to periphery nations continues to spread with Hungarian Ministers stating their economy was left in a perilous state by the previous government, sparking significant price action in the Florint-Swiss pair.

The euro will have broken up before the end of this Parliamentary term, according to the bulk of economists taking part in a wide-ranging economic survey for The Sunday Telegraph.
The euro is facing its worst crisis since it was founded with the survey’s findings underline suspicions that the new Chancellor, George Osborne, will have to firefight a full blown crisis in Britain’s biggest trading partner in his first years in office.

The single currency is in its death throes and may not survive in its current membership for a week, let alone the next five years, according to a selection of responses to the survey – the first major wide-ranging litmus test of economic opinion in the City since the election.

The findings underline suspicions that the new Chancellor, George Osborne, will have to firefight a full-blown crisis in Britain’s biggest trading partner in his first years in office.

Of the 25 leading City economists who took part in the Telegraph survey, 12 predicted that the euro would not survive in its current form this Parliamentary term, compared with eight who suspected it would. Five declared themselves undecided. The finding is only one of a number of remarkable conclusions, including that:
• The economy will grow by well over a percentage point less next year than the Budget predicted in March.
• The Government will borrow almost £10bn less next year than the Treasury previously forecast, despite this weaker growth.
• Just as many economists think the Bank of England will not raise rates until 2012 or later as think it will lift borrowing costs this year.

But the conclusion on the euro is perhaps the most remarkable finding. A year ago or less, few within the City would have confidently predicted the currency’s demise.

But the travails of Greece, Spain and Portugal in recent weeks, plus German Chancellor Angela Merkel’s acknowledgement that the currency is facing an “existential crisis”, have radically shifted opinion.

Four of the economists said that despite the wider suspicion that Greece or some of the weaker economies may be forced out of the currency, the most likely country to leave would be Germany.

The recent worries about the euro’s fate followed the creation last month of a £691 billion bail out fund to prevent future collapses. Although the fund boosted confidence initially, investors abandoned the euro after politicians showed reluctance to support it wholeheartedly.

After the money markets closed on Friday, Spain’s debt rating was downgraded by the ratings agency Fitch from AAA to AA plus with outlook stable.

The move seemed to have been priced into the market with very little movement in the price of the Euro over the extended weekend, but as the European trading session got underway on Tuesday, the Euro has come under renewed pressured and is now trading below 1.22.

On EUR/USD and over 1.18 against Sterling. The Spanish PM is facing mounting pressure to push through long awaited labour reform laws, with unemployment running at over 20% and huge amounts of pressure being applied by Spanish labour unions, we are entering a critical phase for Spain.

The recent ECB stability report has forecast further write-downs for European banks.

Sovereign debt contagion will spark a second wave of loan losses of greater magnitude than the £200 billion already written off up to December 2009 according to the report.

The ECB has also continued in its purchase of government debt, Portuguese, Spanish and Greek bonds have all been soaked up in the continuing effort to alleviate some of the fiscal strains affecting them.

David Laws, newly appointed Chief Secretary to the Treasury, resigned over the weekend over fresh MP expenses irregularities. Mr Laws has been replaced by Danny Alexander, a key member of Mr. Clegg’s negotiating team.

The news has caused concern in the markets because of the timing of the announcement and the nature of Mr Laws role in implementing the Governments policy of reducing the Budget deficit, temporarily at least putting downward pressure on Sterling.

The Reserve Bank of Australia kept interest rates on hold, a decision widely expected and already priced into the market. But the Aussie is coming under further pressure since the big move a couple of weeks back.

As continuing fears over the 40% super levy on mining companies gather momentum, it is still unclear if the large miners, widely expected to gain at least some concession in the deal, will get anything at and will have to bite the bullet and pay up.

Data revealing China’s housing market continues to overheat has also increased the downside pressure on the Aussie, since China is the main buyer of the raw materials that Australia produces.