Germany to Directly Supervise Spain's Budget Reforms

We have long maintained that the ongoing sovereign debt crisis in Southern Europe will precipitate further European integration. (See Another Step Forward in the Creation of the United States of Europe). With the second Greek bailout a done deal, the market's attention has again shifted to Spain. Last week yields on Spanish government bonds were once again up at 5.5%.

Today Dow Jones Newswires reported that a German government delegation will fly to Madrid to

corroborate first hand the government's reforms and assess the true risk of the new deficit target

Reading between the lines this means that representatives of the German government will have a direct

Greek Talks Break Down

Equity markets and the Euro have rallied hard last week in anticipation of a deal to be reached between Greece and its private creditors during negotiations in Athens. However the negotiators on the creditors' side left Athens on Saturday without an agreement having been announced. It appears that the talks have hit a snag yet again. The Institute of International Finance was quick to deny it but that rings hollow. If Dallara and Lemierre had really planned to leave on Saturday, the reduced time frame should have been taken into account during the talks. Sometimes there is no better confirmation than an official denial!

Negative Yield on German Bills Indicates Maximum Level of Panic

Today's auction of German 6 month bills resulted in investors paying a negative yield (see Reuters article). Of course this does not make sense logically, but it has happened before - 3m US Treasury bills were in such high demand in the middle of the financial crisis in late 2008 that the winning bids were so high that yields went negative. In both cases investors are afraid to keep their money in the bank in case it goes bankrupt and would rather pay a fraction of a percentage point for the peace of mind. So either the Eurozone is coming to an end sometime very soon or the panic has reached such proportions that a bounce (in the Euro, as well as Eurozone sovereigns) is coming very soon. I would be tempted to bet on the latter.

Hungary Takes the Euro Hostage, But Watch Out for Short Covering

Most people were probably unaware that lawmakers in Hungary had recently re-written its entire constitution. The new so-called Basic Law took effect Jan 1st and now has everyone up in arms. Tens of thousands protested against it in Budapest on Jan 2nd (see Reuters article) and many EU and US leaders have officially expressed concern. The controversial law appears to limit the independence of the judiciary, the media and the central bank. The concern that the central bank will have to do the government's bidding is what caused talks for an IMF bailout to break down last month and is making sovereign default a realistic possibility. The uncertainty has caused a near collapse of the domestic economy, with the Forint dropping to multi-year lows against the Euro and the most recent government bond auction requiring a yield of 2% higher than the one in December and still remaining undersubscribed.

Hungary is not even part of the Eurozone, but that has not stopped the fear of contagion from making investors dump EU government bonds and the Euro itself. The constant string of bad news coming out of the EU has made everyone nervous to the point of selling first and asking questions later - somewhat similar to the way the Asian Crisis of 1997 engulfed good and bad economies alike. This panic has taken EURUSD down to levels last seen in Sep 2010. At the same time the speculative futures positioning on the pair is at an extremely bearish level, so a short covering may be overdue.

The Flip Side of Germany's European Bailouts

Among all the political noise coming out of Europe the main theme seems to be that Germany may have to bail everyone else out and is not too happy about that. While factually true, we should not forget that Germany has been the main beneficiary of the currency union. The estimates of how much stronger the Deutschemark would have been compared to the Euro if it still existed vary between 50% and 100% depending on who is running the models. Either way that would have been terrible news for Germany's economy, which is very dependent on export of capital goods - just take a look at Japan. So given that it has been enjoying all the benefits, Berlin should be more willing to spread the love. In fact it has to do that, or risk an end to its export-lead boom if Europe ever reverts to local currencies.

Has the Euro Become Radioactive?

More and more countries are distancing themselves from the Euro. First were non-Eurozone EU members like Poland pushing off the already agreed-upon adoption. Then Greece was toying with the idea of re-introducing the drachma, and now a politician in Iceland is suggesting that they should scrap their application for joining the Euro and opt for the Canadian dollar instead (read CNBC article here).

It is more of a psychological process than a purely financial one. Eur/Usd is only down 13% from the high of just under 1.50 reached on the day before the ECB failed to raise rates again in early May (what were we thinking??). However the more the crisis drags on, the more psychological capital the common currency loses. Companies are considering contingency plans for pricing their products; central banks are dusting off the printing presses for legacy currencies; brokers and banks are conducting "war games" to make sure they can quote and settle should those currencies come back. With every passing day it appears that the Euro is unlikely to survive in its present form.