European Affairs


While we do not expect this autumn’s turbulence to pose an existential threat to the Euro zone, it will generate enough pressure on European bond and stock markets to revive fears about structural flaws in the Euro zone’s government policies and banks. European politicians have grown complacent and too focused on domestic political squabbles during the truce afforded by the long German election campaign and the European Central Bank’s (ECB) guarantee to protect the euro. Renewed market turbulence this autumn will force them to agree, we hope, on yet more institutional reforms needed to protect the euro currency and the Euro zone banking system.

On the surface, the Euro zone appears to have been improving since the resolution of the Cypriot chapter of the Euro crisis last March. Green shoots of economic growth and confidence have appeared in Germany, France and other northern Euro countries. Government bond yields (the best early indicators of Euro crises) are significantly below their crisis levels of summer 2012; and Euro zone blue chip equity indices are up 12%-to-15% in the past year. The euro has yet again confounded euro-skeptics by being stronger than expected. At $1.335 US today, it is near its $1.325 average since the Euro crisis began in late 2009. Recent surveys of consumer and business confidence show improvement in the northern tier of Euro states since spring.

There are reasons, however, why this apparently positive environment may be only a truce before the German election results and new international stresses, notably in the U.S., start this autumn. If so, we could be in for another round of financial uncertainty and economic difficulty, forcing additional corrective action by Euro zone leaders.

European Pressures

In the run-up to this weekend’s German elections, it seems likely Chancellor Angela Merkel’s CDU party will win the largest share of the popular vote. But it is not clear that her existing coalition--FDP and CSU--can be stitched back together. While the CSU, the CDU’s conservative sister party, won an absolute majority on Sept. 15 in Bavaria; her other coalition party, the FDP, failed to win the 5% necessary to be in the Bavarian state parliament. If the FDP fails to win 5% at the federal level, the FDP would be out of Parliament, forcing  Mrs. Merkel’s CDU-CSU into another “grand coalition” with the opposition center-left SPD party, as was the case in her first government from 2005-2009.

As head of the CDU, Mrs. Merkel would remain Chancellor, but her capacity for negotiating with Euro zone governments in trouble again this autumn could be more constrained than during the past four years of Euro crisis. During the electoral campaign, German voters’ vocal resentment about bailing out “Club Med” countries became a powerful new political factor for both conservative and liberal parties. As a result, a grand coalition government might be less likely to compromise on austerity measures to deal with peripheral countries’ deficit and debt problems. It would certainly be more problematic to agree to further German taxpayer bailouts for those over-indebted governments and under-capitalized Euro zone banks.

The SPD has shifted leftward since it left the grand coalition in 2009, notably on domestic policies such as structural, tax and labor reforms, of the sort that Germany increasingly needs. The SPD’s resistance to reform is significant in view of the OECD’s recent analysis putting Germany’s long-term economic growth potential among Europe’s lowest because of bad demographics, low productivity growth and excessive dependence on exports.  The SPD could, however, be more pro-active in another Euro crisis. It was highly critical of Mrs. Merkel’s insistence on the “austerian” policies for Southern European. The SPD would insist on more economic stimulus and debt re-scheduling for the peripherals, in return for which, it would insist on more domestic concessions from Mrs. Merkel. The SPD might resist European Commission supervision of fiscal policies under the “fiscal union” program pushed by Merkel. And it would be even more reluctant than the CDU to submit all German banks to ECB supervision in the new Euro-wide banking union.

Other Euro zone politics could increase autumnal tensions, notably in Italy where former PM Berlusconi appears bent on causing problems for PM Enrico Letta’s increasing fragile coalition. Such pressures have already forced his government to back off from significant tax reforms pushed through by his predecessor, Mario Monti.  An Italian government crisis this autumn would revive worries about Europe’s biggest debtor country. While France’s economy appears to be picking up slowly, President Francois Hollande’s popularity is very low and his ability to persuade his parliamentary majority to legislate much-needed structural reforms to improve export competitiveness is impaired. His recently announced ten-year plans for industrial renaissance may also slow progress in reducing France’s deficit rate, a key indicator watched by bond market vigilantes.

The Spanish government also faces renewed popular resistance to the austerity program which pushed unemployment to record levels. But austerity improved the fiscal balance enough to cut Spain’s yield spread over the bund to less than Italy’s for first time in a year,  and Madrid is considering a 50-year bond issue. After a political crisis in July, when two senior ministers quit, Lisbon is demanding that the “Troika” of the European Commission, ECB and the IMF ease fiscal targets in the final phase of its consolidation program. Portugal’s bond yield gap over the bund yield immediately jumped. Greece, where the Euro political crisis first flamed up, will have its current economic situation reviewed by the Troika this month. A slowing rate of economic decline and joblessness, plus a growing primary budget surplus, point to some success for austerity policies which led to six years of recession misery for Greeks.

The spread between government bond yields is the most sensitive sensor of Europe’s debt crisis, notably peripheral countries’ government bond yields spread over the benchmark German bund yield. These have narrowed dramatically since European Central Bank (ECB) President Mario Draghi defused the Euro debt crisis in July 2012 when he promised the ECB would “do whatever it takes to preserve the euro.” The ECB commitment to use its theoretically unlimited monetary powers to prevent the bankruptcy of a Euro-zone country and the Euro banking system reassured bond markets. The yield spreads declined to today’s relatively manageable levels – even though the ECB has not yet had to use its printing presses to save the system.

Currently (as of Friday, the 13th of September), Italy’s spread is about 260 basis points (bps), compared with 480 during the worst of the summer 2012 crisis; Spain 252 bps (vs. 587 bps), Portugal 545 bps (644 bps) and Greece 840 bps, compared with an extraordinary 3500 bps during the worst of the Greek crisis. The yield gap for France, the Euro zone’s second core country, is about 60 bps, down from a high of 148 bps in 2012 but still far above the 20 bps spread prior to the crisis.

Today’s yield spreads are relatively good, compared with spring 2012 when political instability was a reality in those countries implementing draconian fiscal policies: Greece, Spain, Italy and Portugal. At that point, bond markets perceived an existential threat to the Euro zone and ratcheted up those countries’ borrowing costs, effectively cutting them off from capital markets and, significantly, threatening the Euro zone banking system, which was suffering serious losses on its large holdings of government bonds. There was good news for the crucial new Euro zone banking union last week. The European Parliament approved, over-whelmingly, the Single Supervisory Mechanism (SSM), with the ECB having primary responsibility for supervising the 130-odd largest banks in the Euro zone, including a resolution function in the event of a Too-Big-To-Fail bank running into problems.

The Draghi guarantee that halted this most serious threat to the Euro zone last year, could be put to the test this autumn if developments beyond the ECB’s control push Euro bond yields higher, causing the peripheral countries’ yield spreads to widen further.

U.S. Pressures

The simple fact is that the Euro debt market is highly correlated with the U.S. bond market. Any developments affecting U.S. yields, even those having nothing to do with the Euro zone, immediately influence Euro yields. Jorg Asmussen, a German member of the ECB’s executive board, recalled in Brussels last week that the Fed’s tightening of monetary policy in 1994 has a severe impact on Europe. “If spill-overs were large in 1994,” he said, “we can expect them to be even larger today in an even more deeply interconnected world.” This Transatlantic correlation could have a direct impact for Euro yields and spreads because of the U.S. fiscal and monetary calendar this autumn. The U.S. Fiscal Year 2013 ends on Sept. 30 and with it two critical issues confront politicians and markets: the real threat of a government shutdown and the continued effects of sequestration (the across-the-board cuts legislated by Congress and explained below.)  

If the U.S. federal government is to continuing functioning, it must do with funds appropriated by Congress. But the Republican-controlled House of Representatives has already indicated that it will not approve such operating funds unless the Obama administration cuts entitlements and other non-defense federal spending, and has tied the release of operating funds to defunding the signature Affordable Care Act, key elements of which are poised to take effect on October 1st.   The President has indicated that such cuts are unacceptable. So financial markets, as well as the economy, face the possibility of a government shutdown in October.

“Sequestration” is the $85 billion across-the-board reduction of federal government defense and non-defense spending (Social Security, Medicaid, federal pensions and veteran's benefits are exempt) in effect since March 1, 2013 after Congress failed to compromise on spending cuts and tax reforms. Sequestration at the same rate will continue in FY 2014 and each subsequent year until FY 2021 unless Congress acts – which the House appears unwilling to do. Sequestration’s cumulative direct and indirect impact on economic growth will be increasingly evident from late this year. Tensions over sequestration will exacerbate bond and equity market worries over the funding of the government.

An even more urgent deadline will occur in the second half of October when the U.S. national debt ceiling will be reached. If Congress refuses to raise this ceiling, the U.S. could be obliged to renege on its existing debts. Since House Republicans have already announced that they will block an increase in the debt ceiling unless the Obama administrations cuts federal spending in return, there will almost certainly be a stressful period before a compromise is worked out, as occurred in summer 2011. At that time, the U.S. crisis coincided with the Euro debt crisis but perversely caused international investors to seek refuge in the U.S. Treasury debt market. Their flight from euro securities exacerbated the Euro crisis, as the up-coming U.S. debt ceiling debate could do again.

An equally important U.S. threat to the Euro zone is “tapering”, the curious term for the Federal Reserve starting to unwind its quantitative easing (QE) of monetary policy that has kept U.S. interest rates very low since the financial crisis began. Fed Chairman Ben Bernanke stated last May that the current QE program of Fed purchases of $85 billion per month (equally divided between Treasury debt securities and mortgage-related securities) would be reduced gradually (hence “tapering” off) as the unemployment rate approached 7%.  

Shocked that the Fed might end its “free money” policy, bond markets pushed yields on the benchmark ten-year U.S. Treasury note sharply higher: From 1.6% in May to almost 3% in early September, the sharpest rise in any three-month period. The Fed’s upcoming FOMC meeting will analyze the current state of the economy, notably jobs data, including the number of people dropping out of the labor force. The Fed is extending its economic forecasts into 2016, suggesting that it will take into account medium-term trends as well to decide how and when to taper off QE. Current U.S. economic and jobs data point to a gradually improving rate of private consumption, even as consumers reduce their debt; corporate profits remain good and jobs are being created at a reasonable rate.

Rising bond yields and slower-than-expected economic and profits growth are also likely to trigger profit-taking in equity markets. The Wilshire 5000 index, which measures about 98% of all listed equities in the U.S., is at an all-time high making it ripe for correction; as are some Euro stock markets, notably Germany’s DAX and France’s CAC indices.

Another possible source of stress could be the outcome of U.S.-Russian negotiations over elimination of Syrian chemical weapons. To the extent that these drag on and/or fail to produce any practical results except to exacerbate the Syrian civil war, Middle East (and world) oil prices are likely to remain high or go higher if the U.S. decides to ratchet up military pressure on Damascus. Higher energy costs would be reflected in higher bond yields and more stress on the Euro system.


Although Euro zone developments since the Cypriot crisis early this year appear positive, there are concerns that the political, economic and financial truce prior to the German election campaign may fray soon after the results are announced. While political tensions are growing in Euro countries, the trigger for renewed Euro zone stress is likely to come from bond market pressures caused by U.S. fiscal and monetary developments. Rising U.S. yields will push up Euro yields and spreads, delaying fiscal consolidation programs and causing further popular resistance to continued austerity and unemployment. Germany’s new government and Mrs. Merkel will, once again, have to lead the Euro zone response.

But as previous episodes have demonstrated, new Euro strains will force political leaders to defend the euro currency and banking system, and to push ahead on institutional reforms that were initiated in response to earlier crises. As European Commission President Jose Manuel Barroso warned recently, progress to date is being imperiled by “political complacency…. We must not,” he insisted, “come back to the old normal. We have seen that anything that casts doubt on governments’ commitment to reform is instantly punished.” He also warned against the intra-Euro blame game: “When you are in the same boat, one cannot say: “Your end of the boat is sinking.”

J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris , France, where he was chief international economist for Smith Barney for 24 years. He retired as a Managing Director of Salomon Smith Barney/Citigroup in 2001 but remains active with the National Association for Business Economics, the Global Interdependence Center and the Société d’Economie Politique in Paris.