Europe’s debt problems could again rile markets, as investors recognize that the European Central Bank’s (ECB) long-term refinancing operation (LTRO), a much welcomed source of financing for European banks, is doing nothing to address the region’s underlying solvency problems.
-Thomas D. Higgins, global macro strategist, Standish Mellon Asset Management
May 7, 2012
Risk of Further Financial Market Volatility
Given this backdrop, we worry that Europe will continue to be a source of global financial market volatility in the coming months. Although we believe the ECB will step in with a third round of the LTRO if strains resurface in bank funding markets, the bank’s track record suggests it will be reactive rather than proactive due to the opposing viewpoints on the Governing Council. This implies that sovereign spreads in Spain and Italy might have to approach the previous highs before the ECB feels compelled to act. We expect this to be accompanied by a deterioration in European credit and a weaker euro.
Even with another round of the LTRO, it is becoming clear that European leaders need to lay out a plan for addressing the structural flaws in the common currency and the need for a true pan-European euro bond issuance program. This would entail lifting restrictions on the free flow of capital and labor across borders, harmonizing tax and entitlement programs, and developing a true pan-European budget that allows for transfer payments from stronger to weaker regions in the currency area. It would take years to implement such measures, but investors would likely take comfort that Europe was working toward a common goal. Perhaps most importantly of all, for the euro to be successful, citizens and government leaders across Europe will have to stop putting their national interests before the needs of the eurozone as a whole.