Another critical week ahead for the euro zone

• The Chart of the Week shows 5-year government bond spreads of Italy, Spain, Ireland, Portugal and Greece versus Germany. Bond investors implicitly assumed that sovereign debt risks were equal for all countries within the euro zone in the pre-crisis period. This resulted in macroeconomic imbalances that ultimately manifested itself in the current sovereign debt crisis. This week's EU summit will be about fiscal integration and the possible introduction of euro common bonds. So far, three countries oppose such a step as it could result in higher funding costs for them and as such bonds will subsidise countries that behave(d) fiscally irresponsible. In fact, euro bonds may even result in the same situation as was experienced before the crisis: too low interest rates for riskier countries. Accordingly, the EU summit will try to address the problem that countries may not play according to the rules. This will unlikely be accepted without resistance as it will mean giving up sovereignty.

United States

• Whereas the world is looking anxiously to Europe, US macroeconomic data was encouraging last week. The Conference Board's consumer confidence index jumped to 56.0 in November from 40.9, which was the biggest monthly increase since 2003. We continue to expect a sort of muddle through/growth stagnation scenario for the US economy for the coming few quarters. Average GDP growth is expected at 1.7% for 2011 and 1.3% for 2012. Noteworthy, the improvement in confidence seemed to be driven by an improvement in labour market conditions and income expectations. The unemployment rate fell indeed 0.4% to 8.6% in November due to a decline of unemployed people by 594k, while the labour force shrank by 487k. Meanwhile, non-farm payrolls jumped 120k in November after it picked-up 100k in October.
• Apart from consumer confidence, also the ISM manufacturing index improved. The index rose 1.9 points to 52.7 in November, driven by an increase in the new orders and production indices. This is in contrast to movements of the PMIs in the euro zone, which are in recessionary territory already. And also the Chinese manufacturing PMI came in at 49.0 in November, suggesting that growth in China may slow sharply in the coming months.
• On a more skeptical note, the consumer confidence index remained well below its historical average of about 94, while the expectations index is at levels that only suggests very modest consumer spending growth. Also labour market conditions are far from good. For example, the average duration of unemployment in weeks rose to a record and the participation rate fell to 64.0%, the lowest rate since the mid-1980s.
• Accordingly, after decent GDP growth in the fourth quarter, also US economic growth may slow thereafter given that world economic growth is slowing and consumer spending fundamentals are still weak.

Euro zone

• No dull moment for financial markets! Whereas EU finance ministers approved the distribution of the sixth loan to Greece of almost EUR 6bn (the IMF is expected to approve their share this week), concerns about the effectiveness of the 'new' levered EFSF picked-up again. The EU summit at the end of this week should bring confidence back about the effectiveness of the bail-out package by providing more details, but we fear that concerns will increase again after the release of the details. For example, the potential size of the rescue package will probably be smaller than the previously intended EUR 1,000bn (that was likely already too small to convince financial market participants that contagion risks have been reduced to acceptable levels).
• Ongoing concerns about sovereign debt had also an effect on the costs for swapping euros into US dollars, which rose sharply to the widest levels since late 2008. One of the explanations for that development was that investors have become hesitant to lend US dollars to European financial institutions. Last Wednesday, the EUR/USD 3-month cross currency basis moved out to more than 160bps. This was unacceptable for central banks and, consequently, the Bank of Canada, Bank of England, Bank of Japan, ECB, SNB and the Fed said in a statement in the afternoon that the interest rate on dollar liquidity swap facilities will be reduced by 50bps (today) and that their authorisation of the swap arrangements will be extended through February 2013. The EUR-USD basis swap narrowed following the announcement, although costs to swap euros into dollars remain very elevated (3 month EUR-USD cross currency basis swap spread was at 126.33bps on Friday).
• The decision by the People's Bank of China to cut the reserve ratio by 50bps and especially the coordinated announcement provided again hope for some that policy makers are ready to take further steps to ease the debt crisis. More specifically, hope was lifted for some that euro common bonds or unlimited printing by the ECB is a step closer. As regards common bonds, Germany, the Netherlands and Finland are strongly against the issuance of such bonds. We don't expect to see such bonds in the foreseeable future.
• Furthermore, the ECB faces strong political pressures, but several central bank policy makers have so far emphasised that the ECB will only stick to its mandate of ensuring price stability. Admittedly, the ECB failed to sterilise its government bond purchases last week, which effectively means that the ECB 'printed money'. This was certainly not the first time this happened, and past experience shows that the amounts will be sterilised in the week thereafter. Yet, it was interesting to see that the euro started to depreciate after the announcement, which may be a signal about what might happen if the ECB engages in QE. That said, Draghi suggested last week that the ECB may take bolder steps, but that this would come after a new "fiscal compact". Although Draghi didn't comment on which kind of steps the ECB might take, markets interpreted these words as if QE might be a step closer.
• As regards the recession, the final manufacturing PMI was at a 28-month low in November (46.4) and the index indicated that the economic activity in this sector weakened further. The index confirms that economic weakness is spreading from the south to the north and that even core countries might not escape a recession in the coming quarters.
• In this week's ECB meeting, Draghi may announce again that the refi rate will be cut by 25bps to 1.00%, but the rate cut isn't a 100% 'done deal' as inflation was again more than 1% above the target inflation rate in November. Furthermore, the ECB is expected to announce an extension of the full allotment procedure at all its refinancing operations, including an announcement on more unlimited longer-term loans (the next 13 month tender will be on 20 December) given rising tensions in financial markets. Even an announcement on the availability of loans for longer than one year or changes in the collateral framework are within the realms of possibilities (the planned tightening in some of the rules is expected to be delayed). On quantitative easing, Draghi will likely continue to make clear that the bond purchase programme is limited and temporary.
• Furthermore, the world will focus on any news from the EU summit at the end of this week, especially regarding comments about Treaty changes and the EFSF package. Unsurprisingly, the euro zone's leaders do not agree with each other about Treaty changes, so there is a risk that nothing concrete will be announced on this subject on Friday.

United Kingdom

• There were enough reasons to continue to expect that the BoE will engage in further QE in the coming months.
• For example, the manufacturing PMI fell 0.2 points to 47.6 in November and the new orders index was at 46.0 (although it rose 1.1 points). Output was falling due to deteriorating domestic and foreign demand and weak economic activity is thus not only caused by the crisis in the euro zone, as has been suggested by some politicians over the last few months.
• This was also confirmed by the GfK consumer confidence survey. Whereas the confidence survey rose 1 point to -31 in November, this seemed to be mainly due to past developments. On the contrary, expectations about the economic situation in the next 12 months declined 2 points to -33, the lowest level since early 2009. In addition, current consumer confidence index levels are typically consistent with a contraction in consumer spending. Accordingly, prospects for consumer spending remain bleak and we expect negative consumer spending growth in the fourth quarter after spending has been flat (in Q3) or falling in the past 5 quarters.
• We continue to expand another round of asset purchases of GBP 50-75bn in the first quarter of next year, which would effectively mean that the UK is monetising its government debt. Past experience shows that persistent high deficits that are financed by the 'printing press' often ends in a drama. Hopefully the UK will not become new evidence of this theory, but we are far from convinced that the country can escape this faith if it continues with current fiscal and monetary policies.
• As regards the deficit plan, the Office for Budget Responsibility (OBR) significantly reduced its GDP forecasts to 0.7% in 2012 compared to 2.5% in their March forecasts (and 2.1% in 2013 after 2.9%). As a result, also public borrowing forecasts were raised significantly and the debt/GDP ratio is now expected to peak at 78% in 2014-2015. Worrisome, we expect that the revised projections are even now too rosy. We already argued several times before that the UK is certainly one of the weakest AAA-rated countries based on its fiscal and economic fundamentals.

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