THE BLOG

The EU Has Found a Compassionate Side

03/06/2013 13:32 BST | Updated 31/07/2013 10:12 BST

The EU seems finally to have got it. 'Austerity Infinite' was only ever going to succeed in taking us to very bad places indeed. At the best (and I'm afraid we're going to see this anyway), violent unrest on Southern European streets. At the worst, well, goodness knows where things might have gone; one can certainly envisage desperate populations demanding that their governments take them out of the Euro, and maybe even the EU, as populist rhetoric whipped up anti-German fever.

Thankfully, therefore, the EU bigwigs used this week's summit to agree on various relaxations. France, Italy, Spain, The Netherlands and Belgium from within the Eurozone were given more time to reach the 3% deficit target. Poland and Hungary from the wider EU were also given some reprieve. Somewhat disturbingly for the 'hair-shirt' contingent at the ECB, rules were flouted and penalties waived, left, right and centre. Belgium, for instance, should have been fined for failing to meet deficit reduction targets, but wasn't.

As I think I may have observed in this blog previously, it's all a game of politics and the delicate balance between carrot and stick required to persuade no cats to separate from the herd, including the ECB, with its pesky conscience, the Bundesbank.

The game enters a particularly interesting phase later this summer, with elections in Germany. The good news for the Euro is that there is no actual probability of this leading to an 'anti-Euro' Government. Hardly surprising since a hefty proportion of German voters say they want the Euro to survive and for Germany to stay within it. (A much smaller percentage of respondents say they want to make the payments to the periphery to enable the thing to survive!)

The smart money is on a 'Grand Coalition' between Chancellor Merkel's centre-right CDU/CSU and the centre-left SPD. Failing that, it'll surely be a repeat of the current coalition between the CDU/CSU and the liberal FDP. The highly unlikely left-wing or 'red-green' coalitions would be even more Euro friendly, opening the way to the issuance of Eurobonds, with each nation jointly liable for the borrowing. Mainstream politicians, reflecting the public mood, have always rejected this possibility, but give me some mildly attractive odds and I'll have a small bet that a relaxed, re-elected Merkel will start adopting a softer line on this by this time next year.

Everyone knows two things. One, the Euro is highly unlikely to survive another five years, say, without a fiscal union. Two, the Euro has, and continues to be, great news for Germany. The obvious conclusion is, to borrow M.Draghi's phrase, 'whatever it takes'.

So what of the ECB and negative rates? I'd expect the ECB governing council to spurn the introduction of any new measures on June 6, whether unconventional conventional or conventional unconventional, as there are just a few glimmers of an uptick in the numbers (e.g. PMI's), and the ECB staff forecast is for a 'gradual recovery' in H2. Why use what little remaining ammo you have left when it's not absolutely necessary?The same could probably be said of the UK and one begins to wonder whether it's the US economic 'locomotive' which we must thank for this.

Turning to the US, I'd say yields are now on pretty much a straight path higher, with the market's reaction to economic data likely to be quite asymmetric now. The Fed has told us to watch unemployment and inflation data. If data is weak, then given that it's now unlikely to be awful, as we've successfully moved past the key major obstacles-the fiscal cliff, payroll tax rises, the debt ceiling and even the sequester, the market will be prone to say "oh well, let's just wait for next month's key releases and they're bound to be stronger, taking rates higher, so we're sure as hell not going to take them lower now".

Of course, I oversimplify and there could well be a dip in yields as stock markets take fright at this prospect and swoon, but the health of the economy will hopefully prevent a protracted fall in equities.

This is a recipe for continued US Dollar outperformance, as rates are certainly not going up anywhere else, in the G7 world at least, anytime soon.