Bond Outlook by bridport & cie, June 13 2012

The Spanish bank bail-out can be interpreted in two ways:

• just another sticking plaster for a system which is slowly falling apart
• a step towards the banking union which we identified last week as one of the seven Merkel “neins” most likely to become a “ja” on the way to a federal system

In keeping with our moderate optimism, based admittedly mainly on the assumption that Germany will not allow the euro to break lest it lose its international competitiveness, we continue to lean towards the second of these interpretations.

The Spanish rescue, coupled with some comments by hedge fund manager, John Hussman, prompts us to ask the question, “Just what is the objective of a bank bail-out operation?” There are plenty of examples to go on in the USA, the UK, France, Sweden, etc, even in Switzerland.

We would define the objective as: to ensure that depositors are protected and that the financial system continues to function.

Even that definition begs a question about what aspects of the financial system must be maintained. On this we would like to answer in the most general way: to assist in allowing financial resources to flow to the areas of the economy most likely to create wealth.

In general, the first of these objectives has always been met in modern times, even in a case like Northern Rock, where there really was an old-fashioned run on the bank. Likewise, government loans and equity participation, along with forced mergers, have kept the financial system running – not necessarily running well in certain cases, witness the repetitive hesitation of banks to lend to each other and the dearth of bank lending to industry -- but the system by and large soldiers on.

The problems arise with the allocation of financial resources. A basic principle of a market economy is that risk and reward go hand in hand. Shareholders do best when their company does well, but are the first to lose when it fails. Likewise bondholders are exposed to “haircuts” in the event of restructuring, and this is right and proper -- except that they too are often given protection, as if they were depositors.

There is a powerful argument that, because bondholders were given so much protection in the USA in 2008, and are benefitting in a similar way in Europe in 2012, that the whole process of Schumpeter’s creative destruction has been interfered with, seriously damaging the proper allocation of financial resources, and condemning the economy to a return to recession.

Unfortunately the terms of the Spanish bank bail-out are not sufficiently transparent to make it clear whether restructuring is properly (in the sense we describe above) taking place or not. That is another pointer to opacity of the EU and euro zone negotiations. If understanding a EUR 100 billion Spanish bail-out is hard enough, think how difficult it is come to grips with the true position of Germany on Merkel’s seven “neins”. We can but hope that European leaders must be doing more than is publically announced, and that “more” is a move towards a federalised euro zone, with perhaps a contingency plan for the case of Greece choosing the exit.

For many months we have cautioned readers about bank debt, and that caution must remain at least until the “banking union” is truly established.

Macro Focus

USA: the productivity of workers fell more than initially estimated in the first quarter as labour costs climbed 1.3%. The trade deficit narrowed in April by 4.9% to $50.1 billion as a drop in imports exceeded the first decline in exports in five months

Euro zone: German exports declined (-1.7% MoM) and production fell 2.2% from March. French manufacturing production dropped 0.7% in April and sentiment among factory executives fell from a revised 94 in April to 93. About 10% of the French population were unemployed, up from 9.8 in the previous three months. Italy’s economy shrank 0.8% in the first quarter and industrial production dropped 1.9% in April from March. Portugal’s economy contracted for a sixth quarter with a 0.1% GDP decline from Q4

Ireland: treasury bills are likely to be sold within weeks, heralding a return to international debt markets after almost two years

ECB: the bank held its benchmark interest rate at a record low and Mario Draghi said officials are ready to add more stimulus to the euro region’s economy, while dampening expectations that another round of three-year funding for banks is imminent

UK: shop-price inflation quickened in May as retailers struggled to maintain the discounts they used to attract cash-strapped consumers. However, factory-output prices unexpectedly fell in May as petroleum prices dropped 0.2% from April, the most since the depths of the financial crisis in 2009. Service industries unexpectedly maintained their pace of growth in May and employment rose as demand increased. Construction growth slowed for a second month in May, but house prices rose by 0.5% from April

BOE: the bank left its stimulus plan on hold as the threat from above-target inflation overrode policy makers’ concerns about the risk to the U.K. from Europe’s debt crisis

Switzerland: CPI declined 1.0% from a year ago in the eighth monthly decline. The jobless rate held at 3.2% from April, revised from 3.1%. The central bank’s foreign- currency reserves surged from CHF 237.6 billion in April to a record CHF 303.8 billion in May as the euro region’s turmoil forced policy makers to step up their defence of the franc ceiling

Cyprus: a bail-out for the government and/or the banks is on the cards against a background of strategic rivalry with Russia (which has already provided one bail-out to Cyprus)