In Plain English: EU Summit

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The Europeans did it! Early this morning, European Council President Van Rompuy stepped onto the podium and announced a breakthrough agreement with a clear outline to provide short term support for peripheral countries such as Spain, Ireland, Greece, Portugal and Italy. In other words, the Germans caved and it was a double whammy because Germany lost the semi-finals of the European Football Championship to Italy hours before Merkel was forced to make more concessions than she initially wanted.

Expectations were extremely low going into the Summit with investors expecting nothing more than a growth pact and the formation of a single banking supervisor. When Van Rompuy delivered more, the EUR/USD soared in approval. These gains have extended into the North American trading session with all the major currencies trading sharply higher against the greenback. U.S. equity futures are up significantly while Spanish and Italian bonds have declined sharply in a full risk on move.

None of this enthusiasm can be attributed to this morning’s U.S. data, which were right in line with expectations. Personal incomes grew 0.2 percent in May, the same pace as the previous month while spending remained flat. The PCE, a measure of inflation dropped 0.2 percent while core prices rose a mere 0.1 percent. Manufacturing activity in the Chicago region accelerated slightly. As with most of this week’s U.S. economic reports, the changes are not significant enough to alter the Federal Reserve’s outlook for monetary policy.

As for the EU Summit, we attempt to explain to you in plain English what was delivered and what is still missing. An official statement will be released later this afternoon but 4 key announcements have been made.

Four Key Announcements:

1. EUR120 billion Growth Pact – While the growth pact was preannounced on Thursday, it was the bargaining chip used by the Spanish and Italian Prime Minister to get Merkel to cave on debt issues. The money will come from existing EU funds and will be used for short term growth boosting measures such as building highways, railways and air links in the same spirit as the Franklin D Roosevelt’s economic programs to promote growth during the Great Depression.

2. Quasi Banking Union and Direct Rescue of Banks – A banking union is one of the core solutions to Europe’s debt crisis that the market did not expect so quickly from Europeans Leaders. However the Italians got the Germans to relent on allowing the European Stability Mechanism (ESM = Europe’s rescue fund) to give money to banks directly without adding to the debt burden of individual governments. What is wonderful about this is that it helps to cap the rise in European bond yields and hopefully prevent further downgrades by providing a bailout for banks without adding to the total debt sovereign owed by countries like Spain and Ireland. U Leaders aim to start allowing direct rescues of banks as quickly as year end instead of 3 years from now, when the crisis will probably be behind us. This is the short term rescue that the market desperately wanted and the main catalyst for the EUR/USD rally. The ECB will also become the sole supervisor of banks and any loans will be attached with strict rules.

3. Give Spanish Bondholders Seniority Over the EU – EU Leaders promised to not subordinate Spanish bondholders, giving creditors the confidence that they will not lose their place in the debt restructuring line to the ESM. As the second groundbreaking announcement from European Leaders this morning, loans from the rescue fund will now be on equal footing with loans from private investors, giving them the reassurance they need to buy Spanish bonds again.

4. Allow EFSF/ESM To Buy Bonds Directly – Allowing the EFSF/ESM to buy bonds in the secondary market is also a big deal because it is an aggressive and quick way to prevent the crisis from worsening by allowing the EFSF/ESM to control bond yield.

What was missing however are guaranteed deposit insurance and a roadmap for a fiscal union, which EU Leaders have tasked EC President Van Rompuy with delivering by the October summit. While there is no question that EU Leaders have announced more aggressive measures today than investors had anticipated, without fiscal changes or anything directly targeted at Italy, everything now rests on the hope of lower bond yields. In light of this, we are skeptical about whether steps taken today are enough to turn things around for Europe and end the crisis.

Kathy Lien
Managing Director

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