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Wall Street Steward Blog

Eurobonds: A Potential Positive Not Lost in Translation

Last week,  Federal  Reserve chairman, Ben Bernanke delivered his speech from the Fed’s Jackson Hole conference, the event that helped to turn around last summer’s fear of recession. While people along the eastern seaboard lined up at stores on Friday, August 26, to buy batteries and bottled water in anticipation of the unknown ravages of hurricane Irene, gentle Ben provided no surprises to disturb the markets. Instead he provided a review of the Fed’s economic outlook and policy options already well known to market participants. The attention on the Fed was misplaced. While market participants have been demanding a response by policy makers, they are looking for that response in Europe more  than in the United States.

Last week’s gain was the first in five weeks for the U.S. and European stock markets. Indications that the European Central Bank (ECB) was leaning towards reversing rate hikes they implemented earlier this year and signs that a proposal for so-called Eurobonds was gaining acceptance as a longer-term solution to Europe’s debt  problems boosted investor confidence. In recent months, the U.S. S&P 500 stock market has been driven in no small part by the unfolding events in Europe. European  economies, policy makers, debt markets, and the banks that hold the troubled debt  have been acting and reacting  to the worsening sovereign debt  problem, and rising likelihood of a sovereign default. Markets are demanding a policy response that goes beyond bailouts and they may soon get it.

Translating and interpreting some of the European  events and parties involved into terms more  common to U.S. investors may be helpful to explain why investors are catching on to the idea that so-called Eurobonds are the most likely long-term solution to Europe’s debt  problems.

The European  Commission, unlike the often  temporary and powerless commissions of the U.S. Congress (where the answer to every thorny political issue is to avoid the tough  questions by putting together yet another  commission — remember how the president backed away from his own bi-partisan deficit commission when they finally reported their results), is actually the ruling body of the European  Union. It is the executive branch, so think “White House” when we refer to the European  Commission.
 
European Commission regulators are pushing for Eurobonds. The European  Parliament (think “Congress”) needs to see a proposal for Eurobonds and vote to pass rules allowing them. Most of the European Parliament appears to now be on board with Eurobonds as an end game (even France). The European  Commission is writing up the Eurobond proposal now and, as it prepares to present it to Parliament, is seeking to get Germany  (think “Tea Party”) on board.

In September, the European  Parliament will ratify the flexible mandate of the European  Financial Stability Facility (EFSF) (think “TARP”). The EFSF will be able to buy the debt  of any country or business or inject capital into any bank in Europe and make  it a collective obligation of the Eurozone. The European  Central Bank (think “Fed”) is acting in this capacity now, but is limited by what  it can buy. The EFSF is a step towards a common European  obligation, but is limited by its size. Accompanying the EFSF ratification is the enactment of laws to strengthen Europe’s deficit-limits to keep budget  imbalances among Eurozone members from developing in the first place.

The Eurobond (think “Treasuries”) proposal due out before the end of the year may be released just after the EFSF is ratified by the end of September. The European  Commission President indicated that draft legislation for Eurobonds will be presented in the near future,  but is unlikely to unveil it until after the EFSF vote.  The proposal, which is already well developed, is likely to be a plan where 60% of a country’s GDP would be financed by Eurobonds (or special sovereign bonds guaranteed by the Eurozone) at a common low interest rate and be backed by the credit of the entire Eurozone and the remainder of the country’s debt  would be supported by their own issuance backed by their own sovereign credit. For example, Greece has about 150% debt  to GDP so 60% would be financed by low rate Eurobonds, while the remainder would be financed at higher rates unique to Greece providing an incentive to keep  debt  ratios low. This would be a huge benefit  to countries such as Greece now facing unaffordable high interest rates on all of their debt  coming due.

Why would Germany  go along with the introduction of Eurobonds when it would clearly mean  a higher interest rate for Germans to help guarantee nearly about $7 trillion in collective European debt? Because creating a European government bond market of about $7 trillion would result in the world’s second largest after U.S. Treasuries ($10 trillion). It would provide markets with a highly liquid, well-rated alternative to U.S. Treasuries, just as the United States has seen its credit rating downgraded by Standard  and Poor’s. Six of the members of the Eurozone are A A A-rated (Austria, Finland, France,  Germany,  Luxembourg, Netherlands). Also, the deficit-to-GDP for the Eurozone is a much  better 6% (according to Eurostat) compared to 9% for the United States (according to The Congressional Budget Office). The liquidity boost provided by an alternative to U.S. Treasuries may lower collective yields for the Eurozone members, even  for Germany.

If enacted, Eurobonds may likely be a big plus for European  stocks and bonds. It would likely be a negative for Treasuries and the dollar given the creation  of a competing market for the world’s liquid capital. The potential rise in interest rates in the U.S. could put further  pressure on economic growth and housing — perhaps this is part of the reason Bernanke  pledged to keep rates low at least through the middle of 2013 and may use maturing short-term debt  holdings to buy long-term bonds to try to keep rates down. A weaker dollar does have a silver lining in that it is good for U.S. exports and good for commodity prices.

Eurobonds are likely to be the ultimate direction in which European policymakers will go, or will be forced  to go, but it may be a while before they get there. In the meantime, even  Eurobond draft legislation, which may be unveiled soon, may be helpful in providing market participants with

Eurobonds are likely to be the ultimate direction in which European policymakers will go, or will be forced  to go, but it may be a while before they get there. In the meantime, even  Eurobond draft legislation, which may be unveiled soon, may be helpful in providing market participants with a glimpse of a long-term solution they have been demanding even  if the implementation is not imminent. Merely hinting at Eurobonds as a potential  solution can create a powerful  turnaround in sentiment as a shift begins from a monetary union that markets view as no stronger than its weakest link to a massive economic zone that is stronger than the sum of its parts. This could spark the return of investor confidence and begin to lower yields.

Confidence is most important right now, as it was back in 2009 for the stock market. Perhaps not surprisingly, the yields on some of the troubled debt of European  nations appear  to be tracking the pattern of the S&P 500 during the 2008 – 2009 financial crisis and recovery [Chart 1]. As I stated last week: the stock market climbs a wall of worry not when risks go away,  but when the confidence that they will be overcome returns.

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