BMO Capital Markets’ Stephen Gallo sees need for EMU ‘survivability curve

Stephen Gallo, European head of FX Strategy at BMO Capital Markets, does not see a weakening in the broader risk of a breakup in European monetary union, and believes a shift is needed in investor psychology.

We need to develop an EMU “survivability curve” so that markets can do their jobs properly

• Asset prices drive investor psychology for too long after they have undergone a substantial adjustment

• Longer-term EMU break-up risks still climbing despite decline in “break-up premia”

• There are important short-term political links to EUR weakness at present, particularly in Germany

• The current EMU “survivability curve” appears to be substantially inverted

I thought it was important to flush these thoughts out today, despite the fact that the markets tend to focus themselves, broadly, on a “one theme at time basis”. If they are to be of any use, at most, they probably just need to be “shelved” for the time being, or perhaps “dusted off” as developments change the underlying picture inside of EMU over time.

I don’t agree with Blankfein’s comments, as reported by Bloomberg over the weekend, that euro area break-up risks are “lower now than they were a year ago”. If anything, my view is that this is the first time in a very long time, that EUR break-up risks are still rising despite the fact that break-up risk premia are not being factored “into the price” in any major way: be it the CDS market, the bond market, the EUR, or the share prices of European financial institutions. This is a major problem for investors and perhaps even policy makers too: the fact that asset prices (rather than the underlying longer-term picture) drive investor behaviour, judgement and psychology for far too long after they have adjusted to some new piece of fundamental news. Back in early July of last year, asset prices did not reflect the presence OMTs. They have since adjusted – quite appropriately – but, we have already started to let their levels influence our overall judgement about the workability of EMU in its current state: asset prices have adjusted because short-term risks of an EMU break-up have declined, but further adjustments in asset prices won’t spur a greater degree of EMU survival. Time and time again, asset price fluctuations in a persistent “state” or direction tend to obfuscate all sorts of matters related to investor attitudes and perceptions, relative to underlying fundamentals.

Blankfein’s comment, in my opinion, essentially stems from the conventional wisdom, which is that with bond yields falling and OMTs essentially “in place” EMU break-up risks are declining. But market participants in particular have a habit of interpreting or, better yet, deriving “underlying” or “structural” judgements from asset prices themselves, just as we did when EUR/USD traded to $1.6000 during the last decade. In this case, doing so also risks creating misunderstandings about how EMU should function (politically and monetarily, for instance), particularly when we talk about the increased chances of EMU survivability based on aggressive ECB easing or sharp spread compression: “if the ECB prints enough, the euro zone can survive” or, “if Spanish bond yields are low enough, break-up probabilities are essentially nil”. This is wrong and, quite dangerous for a whole host of important reasons in my view. The more policy makers aggressively paper over the cracks in the short-run, the less likely EMU is to survive in the long-run.

The fact of the matter and irony of the current situation is that narrower spreads and the presence of OMTs are keeping euro break-up risks low in the short-run, but in the long-run, delays to adjustment in the periphery, and in France and Italy, are actually increasing the chances of a euro break-up at the same time. Germany simply cannot survive inside of an economic union with countries that refuse to undergo a substantial adjustment – otherwise, the penchant for accumulating debt will forever be a recurring theme. Politically, this is a dismal yet also inescapable fact. Moreover, it also brings new meaning to the importance of having a weak level for the euro at present: with Germany virtually the only major EMU economy where there is currently any policy traction, easier-than-warranted monetary conditions can, for a time, help keep political tolerance to being inside of EMU reasonably high. But yet again, this is still only a short-run outcome, and one that is not necessarily able to produce a better long-term result for EMU as a whole. The euro area is therefore still on a break-up trajectory, but the market seems unable or willing to trade this trajectory at present.

Perhaps for the sake of efficiency and being prepared we should devise and even “price” a way to quantify euro break-up probabilities in both the short-run and the long run in a similar manner to which we view dynamic, real-time fluctuations in the yield curve. At the bottom or on the extreme left of our “curve” we have the short-term probability of EMU survival, and on the extreme right we have the long-term probability. At the moment, the EMU survivability curve would appear to be heavily inverted, with short-term probabilities of a survival much greater than the longer-term ones. But, we mustn’t fail to view this curve from a dynamic aspect: with each move higher in short-term survivability – particularly as a result of fluctuations in asset prices – the longer-term survivability shifts lower. We, or more appropriately European policy makers, are paying for a higher probability of short-term survival by selling some longer-term probability. The question remains then: what do policy makers do with the time they have as the short-run gradually becomes the long-run?


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