France and Germany to the rescue

All eyes are now on Europe’s Franco-German summit that takes place later today. The leaders of Europe’s two largest economies will have a tete-a-tete at 1300 BST, with a news conference scheduled for 1500 BST. The market action so far suggests that there are low expectations a credible solution to the Eurozone’s problems, in particular the spread of the sovereign crisis to the core economies, will be found today.

But after some weak GDP figures released this morning the need for a decisive solution is becoming urgent. The EU debt deal last month is now looking like an inadequate solution since it didn’t extend the size of the European Financial Stability Facility (EFSF) fund and only negotiated a small portion of Greek debt to be written off by the private sector. There is a growing consensus in the markets and also in the wider political arena that closer fiscal unity is the answer.

The constant round of bailouts (instead of fiscal unity) is starting to cause its own problems. The enlargement of the EFSF to deal with the debt problems of Spain and Italy could top €1 trillion. This would impact the public finances of the contributor members, most worryingly France, and Parisian bond spreads with Germany reached multi-year highs last week. If France was to get sucked into the debt crisis it would most certainly mean the end of the Eurozone.

The EU needs to take radical action. If bailouts only make things worse in the long-run then common Eurobonds might well be the solution. However, both France and Germany have said that this will not be on today’s agenda (although since there is much talk of these bonds it seems odd that Angela Merkel and Nicolas Sarkozy wouldn’t at least bring it up). So that leaves the Eurozone in limbo yet again.

But investors are probably right to think that today’s meeting won’t provide the panacea to Europe’s problems. Fiscal union and euro bonds are a massive step for the Eurozone and would require dramatic treaty changes. Even if common bonds were implemented they would take months, if not years to come to the market as Europe deals with difficult questions like what would happen to the debt already issued by the individual nations? How much debt would each nation be allowed to issue? What would happen if a nation defaults? Considering the snail’s pace the EU moved when arranging bailouts for Ireland, Portugal and Greece, one can imagine fiscal union would be a slow, drawn out process.

Worryingly, a slowdown in growth is now becoming the biggest problem for the Eurozone. German GDP in the second quarter slowed sharply, expanding at just a 0.1 per cent rate, below expectations of 0.5 per cent. Combined with France where growth last quarter was flat, overall Eurozone GDP moderated to a 1.7 per cent annual pace, down from the 2.5 per cent rate in the first quarter. Although growth was probably overstated in first quarter due to a bounce back in activity after extremely poor weather at the end of 2010, this rate of growth won’t help heal the desperate public finances of some of Europe’s weakest economies.

Germany’s data caused the biggest effect on the markets. Stocks are lower across Europe and the single currency is also broadly down. Germany was the West’s best hope for growth this year, but now it looks like even this exporting powerhouse is coming under pressure. The negative sentiment may well persist for the rest of the day.

Although we won’t know the detail of the GDP reports until later releases growth has dominated market sentiment today. Although Spain held a fairly successful debt auction earlier its yields have inched back above 5 per cent. Italy’s yields are also around the 5 per cent mark. Although this is below the danger zone, the European Central Bank won’t be happy about any 'rate creep' after it spent €22 billion (more than the €15 billion expected) on purchasing Italian and Spanish debt last week.

Elsewhere, inflation in the UK resumed its march higher in July after a brief respite in June. CPI was flat on the month, but the annual rate rose to 4.4 per cent from 4.3 per cent. The upward pressures came from processed foods and utility prices and there was less evidence of retailers discounting during the summer sales season. Last week the Bank of England said it expected inflation to return to target next year, and if commodity prices continue to fall this may well happen. While the Bank of England’s credibility might be taking a hit right now, UK Gilt yields don’t highlight any concerns that longer-term inflation expectations are running out of control. After the release the pound was broadly stronger.

The minutes from the last Reserve Bank of Australia meeting suggested that the Australian central bank is unlikely to raise rates in the near term. Since the meeting took place prior to the latest outbreak of market turmoil, it is likely the Reserve Bank of Australia is now even further from hiking rates at least through to the end of this year. While it noted that inflation pressures persist, it also noted that the downside risks to demand had increased and that previous rate hikes and a strong exchange rate were “already exerting a reasonable degree of restraint” on the economy. This may well erode the Aussie’s yield differential, although in the current environment the Aussie is being moved according to investors’ risk appetite. It’s correlation with stocks has surged since the start of this month, which has put claims that the Pacific currencies were turning into safe havens firmly to bed.

Kathleen Brooks is research director at Forex.com

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