The American sharemarket rose sharply last night in response to the latest European solution because traders reckon that it is now much less likely that we will face a European meltdown.
And there were celebrations in the French and German camps because by inserting a money market tax in the agreement, they ensured that Britain stayed out. That means the European future will be led by France and Germany – exactly what French President Nicolas Sarkozy and German Chancellor Angela Merkel carefully planned.
The European Financial Stability Facility bailout fund plans to raise as much as €2 billion over three months from its first sale of bills next week – another important milestone. Despite this, the European spending cutbacks plus those in the US mean that the Western world will not enjoy high levels of economic activity in the medium-term – recessions are likely in Europe.
There are two obvious weaknesses in the agreement; the first is that it requires very unpleasant actions by nation states, which will not be easy to achieve. On the other hand, the penalties of bankruptcy for those nation states that do not toe the line will probably stiffen the resolve of politicians.
The second weakness is the most serious – there are inadequate measures to handle the existing debt. The agreement is about the future. Europe plans to set up the permanent rescue fund, known as the European Stability Mechanism, in July 2012. While that’s a year ahead of schedule, a lot will need to be done in the interim period.
However, enormous efforts were made to bring the European Central Bank into line. The ECB earlier this week indicated it was not going to go on a massive money printing exercise to bail out the existing debts. But last night ECB President Mario Draghi welcomed the accord and more importantly, was in there buying Italian and Spanish government securities so that their prices rose, providing a favourable backdrop to the agreement.
The first real test of the agreement comes on December 14 when Italy is due to sell 2016 bonds. A day later Spain will auction securities due in 2016, 2020 and 2021.
Last night, Italian two-year yields were 24 basis points lower at 5.99 per cent, while 10-year Italian yields dropped 10 basis points to 6.36 per cent, according to Bloomberg. Spanish two-year rates declined 25 basis points to 4.66 per cent, while the 10-year Spanish yield slid eight basis points to 5.73 per cent. These yields are well down on their peaks but still high.
In contrast, Portuguese two-year notes climbed 15 basis points to 17.09 per cent – it will need a major rescue. However, reports indicate that Mario Draghi and the ECB have been buying them.
For Australia, the key is what our banks will have to pay to get wholesale money, because that will govern our interest rates.