The dukes of moral hazard — the European Central Bank (ECB) and European policy makers — are at it again. By opening up the balance sheet to lend against virtually any collateral, the ECB has eased the source of market fears: European bank funding strains. In turn, we expect risk appetite should return for all risk assets lead by European bank and debt shares.

An old joke goes...

In Heaven...
the mechanics are German
the chefs are French
the police are British
the lovers are Italian
and everything is organized by the Swiss.

In Hell...
the mechanics are French
the police are German
the chefs are British
the lovers are Swiss
and everything is organized by the Italians.

That old joke summarizes the cultural difficulties in finding a solution in Europe. For the eurozone to stay together, members will need to give up sovereignty in moving towards closer fiscal union. But progress towards fiscal union will be measured in years and even decades, not in a moment following the conclusion of any one meeting of eurozone leaders. The European sovereign debt crisis continues to dominate the outlook for financial markets, and in 2012 we expect this again to be the case with at least a positive twist to start the year. The actions of the European Central Bank to greatly expand liquidity support for financials by accepting a wider range of collateral should contribute to easing the strains in bank funding. Ebbing European risk should lead to better performance from risk assets (stocks and fixed income credit) but higher interest rates in US Treasuries.

"The Dukes of Moral Hazard" — European policymakers — appear to be forming the next steps in addressing the Eurozone crisis. The ECB provides the financial equivalent of a warm blanket over the impact of a painfully slow and politically perilous journey towards greater fiscal union. There is no magic bullet for Europe and no "TARP" moment where clarity on policy allows confidence to return and risk asset prices to definitively rise. Europe stands at a crossroads between strengthening the bonds of union or disintegration.

 

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