Fresh woes on several fronts fuel market alarm

ECONOMICS: Bond trader pessimism reflects urgent need for both euro debt crisis and political difficulties to be contained

ECONOMICS:Bond trader pessimism reflects urgent need for both euro debt crisis and political difficulties to be contained

ASSESSING THE state of the economy is never easy. In the past week, a blizzard of data, surveys, reports, announcements and financial market data have made it more difficult than usual.

The domestic real economy is profoundly weak and recent developments serve only to emphasise this. Monday’s survey of purchasing managers in the services sector suggested that the largest part of the economy expanded in August, but at a slowing rate and with new orders (an indicator of future activity) moving deeper into negative territory.

Wednesday’s announcement of large job losses in Waterford was depressing not only because of the numbers involved and the effect it will have on the local economy, but also because it serves to remind that even sectors not dependent on the domestic economy are vulnerable to shake-out.

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Yesterday’s inflation figures also suggest weak domestic demand (that said, inflation is exactly where it should be – not in deflation territory, but below the rate in peer economies, thus helping in the long haul to regain competitiveness).

What of outside perceptions of Ireland, which are crucial if the State and the banking system are to return to sustainable funding positions? An upbeat appraisal of the economy's prospects in an editorial last Friday in the influential Financial Timesnewspaper was followed on Wednesday by the IMF's strongly positive quarterly assessment of progress on implementing the bailout terms.

That assessment was echoed yesterday by Jean Claude Trichet at his penultimate press conference as president of the European Central Bank. But while it can only be helpful that opinion formers in London, economists in Washington and central bankers in Frankfurt say nice things about the situation here, it would be wrong to overstate their influence.

The people who matter more are bond traders. Their view of Ireland turned this week, marking what looks like the end of an extraordinary six-week rally in Irish government bonds.

As of market close yesterday, yields were up on the start of the week across all maturities, with shorter-dated paper performing worst. Yields on the two-year almost touched 10 per cent yesterday, from 7.5 per cent last Friday.

The partial reversal in yield developments reflects a worsening of the sovereign debt crisis in the wider euro zone. Yields on all the other weak peripherals rose this week, and they did so despite buying of bonds by the ECB to the tune of tens of billions of euro.

Political factors have played an important role in the rise of peripherals’ yields. Last Friday, the EU-IMF troika abruptly left Athens 10 days earlier than scheduled as talks broke down. The unwillingness of the Greek government to implement its bailout plan and the scale of Greece’s problems make it increasingly difficult to see how the situation in that country can be stabilised.

In Greece’s case, trust has been obliterated. In Italy’s case, Silvio Berlusconi appears to be intent on destroying whatever trust others have in him and his country. Despite promising to implement a new budgetary adjustment package a month ago in return for ECB purchases of Italian bonds, he started backsliding almost immediately. A package belatedly made it through parliament on Wednesday night.

The vicious circle of cross-contamination that has long been evident between banks and sovereigns is now increasingly prevalent between the economics and the politics of the crisis. On Monday, Germany’s finance minister, Wolfgang Schäuble, categorically ruled out the issuance of euro bonds and urged all euro zone countries to embrace Germany’s austere ways. This was a hardening of Germany’s position and followed yet another defeat in regional elections on Sunday for Germany’s federal coalition.

While the German constitutional court did not torpedo the euro on Wednesday, popular opinion is increasingly hostile. So are some pockets of elite opinion.

This, and the strength of feeling on the subject, were to be seen at the ECB press conference yesterday. A journalist prefacing a question to Trichet said some German economists advocate going back to the deutschmark and accuse the ECB of monetary debasement. Trichet furiously rejected the charges but it is unlikely that he changed the minds of those who believe such things.

And it is not only in Germany where the hostility to bailing out the peripherals is limiting the scope of politicians to act. The same is true elsewhere in the solvent north. Yesterday, the Dutch prime minister and finance minister publicly called for a mechanism to allow errant countries to be ejected from the euro. It is yet another sign of the widening North-South rift in Europe and comes on top of Finland’s continuing to make impossible demands of Greece and doubts about whether the Slovakian parliament will ratify the euro leaders’ July 21st deal designed to contain the crisis.

With Europe’s real economy weakening, its financial system teetering and its politics increasingly strained, there is much to be concerned about and limited cause for optimism. Nor is there is upside for Ireland from a deepening of the crisis, as some people seem to believe. One commentator this week even made the absurd claim that a “meltdown” of the French and German banking systems would be good for Ireland. This could not be more wrong. By far the worst thing that could happen to Ireland now is for the crisis to spin out of control. That would guarantee a return to recession for the region’s real economy, thereby extinguishing the Irish export engine. And if the Franco-German banking system were to go into meltdown, those countries would no longer be in a position to provide this State’s bailout funds. That, in turn, would lead to cuts of a previously unimagined size.

It is in everyone’s interests that the euro crisis be contained.