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Is Europe's Financial Crisis Over?

20 September 2012 in Trading Ideas

Thank goodness that whole mess in Europe has blown over, right? Right?

Under the heading of investor perception creating reality, one could be forgiven for thinking so.

Indeed, for the first time in 18 months, investors are now more concerned with economic events in the US than the Eurozone crisis, according to a survey from Bank of America Merrill Lynch.

The proportion of the panel responding to the survey that cited the Eurozone as the biggest investment threat fell to 33% in September from 48% in August. According to Merrill’s chief investment strategist, Michael Hartnett, the “fiscal cliff” looming in the US – the scheduled combination of federal tax increases and lower spending that will take effect on Jan. 1, 2013, if not averted by Congress – is now a bigger concern.

While one could argue the shift in focus hasn’t exactly hurt US stocks yet – the S&P 500 is up 14% since the beginning of June – it does seem plausible that abated fears in Europe have helped rally stocks there.

The Eurozone Rebound motif is up 11.5% in the past month, compared to the Dow Jones Stoxx Europe 600 Index’s rise of just under 1%.

A key contributor to investors’ collective relaxation was the recent news that the European Central Bank has agreed to something called Outright Monetary Transactions (“OMT”), which allows the ECB to buy sovereign bonds of countries that have agreed to reform their economies.

As the theory goes, the ECB could buy unlimited amounts of Italian and Spanish debt, which would put an emphatic end to European debt strains and ensure the future unity of the euro once and for all.

Or will it?

As Gene Frieda, a global strategist for Moore Europe Capital Management, contends in a recent article, without the ECB’s plan the Eurozone would have been doomed more episodes of fiscal stress. “The OMT program breaks the volatile liquidity cycle that stems from chronic shortages of bank collateral and a limited fiscal transfer mechanism.”

On the other hand, Frieda argues, the ECB also has raised the stakes. If the central bank doesn’t back its pledge to cut off countries that don’t reform, it’s a “free lunch.” But cracking down on such countries also brings problems – namely, the fleeing of investors who may begin to sense the ECB is preparing to stop buying any individual country’s debt.

In this sense, he says, while the region’s credit conditions will ease, its financial balkanization of the last three years lives on.

Another potentially troubling wrinkle was recently mentioned by economist John Hussman, who pointed out that every euro of Spanish or Italian bonds bought by the ECB (creating new euros) will drain euros by selling something else – most likely, the bonds of Germany and other stronger European countries.

That means an existing stock of euros will have been created to provide fiscal support to Europe’s troubled countries while the stronger nations theoretically get no benefit at all.

It may be worth wondering how long that arrangement will remain palatable.

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