The much-anticipated EU Summit delivered on the basics of establishing new fiscal rules to prevent a future debt crisis, but has failed to resolve the near-term debt crisis, namely how will troubled European governments maintain their debt service if credit markets turn on them again? The EU agreed to provide an additional EUR 200 bio to the IMF in the form of bilateral loans, providing a bit more of a back-stop to the under-powered EFSF and ESM. Proposals to increase the size of the ESM were put off until March.
On Thursday, ECB Pres. Draghi shocked markets by indicating the ECB had no plans to increase its government debt purchases even if the EU fiscal compact was strengthened. Government bonds of Spain and Italy, in particular, sold-off sharply in response to Draghi’s reversal, sending yields sharply higher and back into unsustainable territory. Italian and Spanish yields surged higher again early on Friday as the results of the EU Summit emerged and were deemed insufficient to counter a credit market backlash. Only subsequent ECB buying of those bonds as part of their minimal SMP program brought those government bond yields back down. We will be paying close attention to European debt markets next week for signs of further stress.
And it’s not just the government debt crisis that remains at risk of relapse. The European banking sector remains in jeopardy as investors remain reluctant to fund some of the continent’s largest banks. EU banks were found to be in need of EUR 115 bio in new capital following stress tests by the EBA, and three of the largest French banks had their long-term ratings cut one notch by Moody’s.
In short, the EU Summit might look good on paper, but it comes up short in convincing investors that funds will be there to prevent a sovereign borrowing collapse. EU leaders provided no new initiatives to promote growth and simply recommitted to austerity programs, which keep the growth trajectory tilted south, increasing the debt burden even further. Next week will see the December ZEW and PMI surveys for France, Germany and the Eurozone, where further declines are likely to reinforce the view Europe is heading for a recession if not already in one.
Next page: Analyzing the market reaction