After last year’s big tax and real disposable income squeeze, where the next fiscal tightening was £31bn, the pre-planned tightening is £18bn. This represents 1.1% of GDP and will be split between £3bn tax increases and £15bn spending cuts. Just 12% of the planned spending cuts have taken place. This share is expected to rise to 80% of the total 2009/2010 to 2016/2017 fiscal austerity program over the next few years. This squeeze on spending is more efficient and does less damage to the private sector economy than tax hikes, but it is politically awkward for the Conservatives and their Liberal Democrat allies. The spending squeeze will be all the more painful because of the weak growth environment.

We expect real GDP to grow by 0.7% during 2012, in line with the Office of Budget Responsibilities (OBR) revised December growth target, helped by the substantial stimulus from the Bank’s QE program.

We believe that 2012 growth is likely to be in line with expectations, a change from the last three years where growth has undershot the government’s expectations. This suggests that the budget outcome will be smaller than the revised target of £120bn for the forthcoming fiscal year as the mix of government revenues once again surpasses the Treasury’s cautious expectations.

The current fiscal year is tracking a £7bn undershoot of December’s revised target of £127bn and we expect a further undershoot of £3bn to the FY2012/13 target of £120bn, which will imply a deficit to GDP outcome of 7.4%. We doubt that the Chancellor will announce a lower 2012/13 target on Wednesday, preferring instead to include a margin of error into his calculations to take account of the risks to global growth. The European Sovereign Debt crisis has received a temporary stay of execution thanks to massive liquidity from the ECB. However, liquidity delays rather than solves solvency problems and we continue to expect renewed concerns over peripheral debt during the second half of the year.

Increasingly budgets are not just for March, they are planned to incorporate the future with decisions affecting future financial years. This week’s Budget will be no different with weekend press leaks promising an easing of Gordon Brown’s parting poison pill, the 50% tax band, down to 45% in April 2013. April 2013 is also likely to represent the target date for the Liberal Democrats’ cherished target of raising income tax allowances to £10,000. This will provide an important boost for those on low incomes and together with other welfare initiatives will provide a supply side boost to the UK economy.

The Government’s hope is that these politically important initiatives for their respective parties will be funded by improved growth over the next few years. It is effectively taking a down payment on this growth by pre-announcing the moves in the hope that it will boost consumer confidence. For the current fiscal year any spending initiatives must be balanced by higher revenues. The main source of revenue gains will be a crackdown on tax avoidance. This is a time honoured ploy of governments desperate for revenues to attack tax avoidance. The plan for a general anti-avoidance rule aims to ensure a minimum level of taxation on high earners. These funds will be used to increase income tax allowances to £9,000 and to further delay the fuel escalator.

The Chancellor is expected to present two further initiatives to great fanfare and little economic effect. The first is the credit guarantee scheme for lending to small and medium sized companies. These guarantees are contingent liabilities and do not count towards sovereign debt to GDP. This is convenient, but we do not expect the initiative to contribute materially to easing of financial conditions for the sector. UK financial sector balance sheets are still highly leveraged and while the government and indeed the Bank hope that the bulk of this deleveraging will be achieved in overseas markets, further deleveraging of domestic balance sheets is required over the next few years.

The second initiative is the apparent privatisation of a portion of the roads network. This portion is likely to be small, (3-5%) of the network, and is part of the incentive for domestic institutions to finance infrastructure projects. However, details of this plan are sketchy and will need to be fleshed out in considerably more detail before it represents anything more than a deflection to disguise the lack of more substantial business friendly initiatives. They will not be enough, but the lack of fiscal manoeuvrability means that the Government is likely to borrow further from future growth to pre-announce more cuts in corporate tax for 2013 and 2014. They in turn are likely to be financed by presumed revenues from the partial privatisation of the roads network.

The funding implications of this largely neutral budget should be equally neutral for the gilt market, but the government has a cunning accounting trick up its sleeve. It will assume the assets and liabilities of the Royal Mail pension fund, which has assets of £28bn and liabilities of £37bn. The liabilities will disappear from view into the mass of unfunded future liabilities, which the rating agencies conveniently do not take into account because they presume that governments can always renege on their promises. However, the Government can use the proceeds of the assets to lower borrowing next year. We have assumed that the government will spread these proceeds over the next two years with the bulk of the assets, £18bn, being sold in the forthcoming fiscal year.

Together with the £7bn undershoot for 2011/2012, this suggests that the gross funding requirement will be £25bn lower than the Debt Management Office’s December assumption of £189bn at £164bn. The distribution of this funding requirement will be the most intriguing aspect of the budget presentation. The DMO will be grateful for the opportunity to lower the funding requirement from the current year total of £178.9bn and ease the exhausting treadmill of auctions. Having successfully persuaded the Bank of England to crunch the purchase bands of its QE program to bring them in line with the DMO’s own maturity categories, it seems reasonable to assume that the agency will weight its issuance towards short and medium conventional. Issuance in these two sectors will be maintained at last year’s gross amounts of £60.6bn and 39.8bn respectively.

This leaves the £14.9bn savings to be split between long conventionals and index linked bonds. A substantial proportion of the Royal Mail pension fund consists of £10bn index linked bonds. These will be sold onto the secondary market which should help to satisfy pension funds craving for linkers. This provides the DMO with the opportunity to reduce new linker issuance by £5bn to £34bn, which in turn provides the DMO with the opportunity to reduce long dated conventional issuance by £9.9bn to £29.6bn.

The main advantage of this substantial reduction of long-dated issuance is that it creates room for the new ultralong bond. Press reports last week suggested that this could be as much as a 100yr bond. While this has the wow factor for the government, it is likely to be a maturity too far for the perennially risk averse DMO and we expect the maturity to be a more palatable 70-80yrs. However, the 100yr bond speculation is more likely to be a red herring, with the DMO using it as cover to reduce issuance of long conventionals. We expect the DMO to conduct a consultation on the issue first and it may quietly drop the idea in time. More importantly, speculation is based on the low level of average long conventional rates. But these average spot rates are misleading and the forward curve is generally upward sloping at this portion of the curve making it relatively expensive for the government to raise funds in this new sector.

Indeed, the speculation over the 100yr bond may be a cover for the Chancellor to gather further positive coverage for his budget by declaring an end to the War. By retiring the War loan, the Chancellor can finally repay First World War debt and re-issue a new perpetual bond to better serve the longevity requirements of the pension industry.

The improvement in sentiment and data since this meeting has increased the proportion of economists and market participants who believe that this will be the last in the current round of quantitative easing. We disagree and expect the MPC to execute additional conventional gilt purchases in May as the methadone rush of 3yr LTRO gives way to new concerns over the European Sovereign Debt Crisis in the second quarter. We also expect the seasonal improvement in global activity over the past four months to give way to slower global economic conditions. Moreover, while the UK economy is expected to avoid a double dip recession in the first quarter the pace of activity is likely to remain subdued through the first half of the year.

Moreover, it is important to determine the trigger sensitivities around additional quantitative easing. Is it the threat of a double dip that motivates the central bank or the likelihood that growth in real activity will be less than 1% versus estimates of long-term productive potential of 2.5%. We believe that it is the latter and more quantitative easing is required.

Indeed, while the Bank can bask in the success of quantitative easing in reducing banks’ wholesale funding costs from 362bps at the start of the year, the current level of 304bps has been sufficient to force banks into raising their variable rate mortgages, which is likely to cool the nascent improvement in the housing market over the next few months and produce another year of negative real returns for residential housing.

More importantly, the mechanics of this second tranche have been materially altered from previous rounds by the Bank’s decision to follow the advice of the Debt Management Office to mirror its bands for the purchase program. The effect of this change has been to crunch the purchase bands from the previous, 3y-10y, 10y-25yr and over 25yr to new compressed ranges of 3y-7y, 7yr-15y and over 15y. The most charitable explanation has been that it has evened out the free float in these bands enabling the central bank to pursue further rounds of quantitative easing in the months ahead.

However, the net effect of the Bank’s actions have been to produce a pronounced hump in the yield curve. This was not a deliberate aim of the policy. Indeed, the Governor was visibly embarrassed at the Inflation Report press conference when the subject was broached and immediately passed on the question to Paul Fisher, the MPC member in charge of the operational implementation of QE, who explained; “this was a purely operational decision, although made in consultation with the MPC, designed to make sure that we can deliver on the MPC’s objective, which was, as stated back in October, buying along the curve. We are still buying along the curve and in quite large size. We don’t target any particular maturity, but the average maturity we would expect over the next three months is broadly in line with the average maturity in gilts, if anything slightly higher”. As Shakespeare might have responded, “methinks he doth protest too much”.

There are those who will welcome the consequences of this policy as a means of forcing increased bank lending, partially shielding the pension funds from the consequences of QE and putting downward pressure on Sterling, but this represents a fallacy of composition since the sum of the parts is less than the overall result and as the famously monetary purist Sir Mervyn King would undoubtedly note, the function of quantitative easing in springing the liquidity trap is to lower the term structure of interest rates to encourage risk appetite. The rise in medium term forwards militates against this policy and ultimately increases the requirement for more QE.

It is highly unlikely that the Bank will now restore the previous purchase bands for the next round of QE and the most that can be expected is that the Bank alters the amounts that it is willing to purchase in each particular segment to smooth the yield curve and maximise the impact of policy. In the meantime, the curve is likely to become more pronounced until consensus expectations once again discount more quantitative easing in the second and third quarters.

The citation for Mr King’s 2011 award has been taken from his own speech to the Institute of Directors at St George’s Hall in Liverpool on October 18th; “from the beginning of the crisis there has been a reluctance by governments to face up to the underlying solvency problems generated by the apparent unending trade deficits with no mechanism, whether flexible exchange rates or some other means, for correcting these disequilibria. Those solvency problems have shown up on country and bank balance sheets. The initial reaction has always been to provide liquidity; through central bank or an extension of official lending by governments. Providing liquidity to buy time to devise and put in place a coherent response to the underlying problem can be not only valuable but necessary. But liquidity can never be an answer in itself. And if the time bought is not used then the size of the debt problem becomes larger and the cost is gradually transferred from private sector creditors to taxpayers.

The main impediment to the strategy of rebalancing our economy is markedly slower growth in our major export markets, especially in the rest of Europe. This is why we are treading a fine line between stimulus to demand in the short run, and a rebalancing away from private and public consumption towards exports and import substitution in the longer run. Without monetary stimulus, low interest rates and large asset purchases, there is a risk that growth would stall and inflation fall below our symmetric 2% target. But easy monetary policy, by bringing forward spending from the future to the present, means that the ultimate adjustment of borrowing and spending will be even greater. That is our dilemma and that of other deficit countries. The best way to escape this dilemma would be higher spending by surplus countries, to make possible rebalancing by the deficit countries, and supply side reforms in the deficit countries, to raise expected future incomes and to ease the burden of debt repayments. Each country can put itself in a position to rebalance, as we have done in the UK. But in the absence of rebalancing, globally and especially in the €uro area, we could be facing a recovery that is not merely reluctant but recalcitrant”.

Sir Mervyn’s wise words shows how policy is working in harmony with fiscal policy, but also emphasises the seemingly intractable problems in Europe and explains why massive liquidity from a central bank is a temporary panacea rather than a solution. This argument neatly skewers those who would anoint the new ECB President as central banker of the year.  The miniscule time gained is not enough to reach the political union that is necessary to bind together this dysfunctional group into permanent. Mario Draghi is correct in describing the fiscal compact as the first step toward fiscal union but as Confucius said “a journey of a thousand miles begins with a single step” and it will take hundreds of thousands of more steps before this dream becomes reality, something we doubt.

More importantly, we believe that Senior Draghi’s task will be complicated by the perennial bailouts of Greece and demands of other countries for similar debt relief. The new President has already compromised several cherished principles of pure central bank theory and will undoubtedly compromise more during 2012 as French politics add further stresses to an already impossible task.

The non-voting members of the awards committee provided very vocal support for Fed Chairman Ben Bernanke citing prediction that if economic conditions remained weak the central bank was likely to maintain its record low interest rates until the middle of 2013 (subsequently he extended this presumption until end 2014), which in turn was followed by Operation Twist, which switched $400bn of short dated treasuries into medium and longer dated treasuries following the textbook prescription for evading the liquidity trap. However, he just failed to achieve top spot because of the parsimonious scale of his unconventional monetary policy and continued verbal support fiscal easing. The $600bn QE2 program and the $400bn Operation Twist are small versus the $14tr US economy.

Nevertheless, Ben Bernanke is one of the early contenders for the 2012 award. He remains committed to further QE and while current economic data is too strong to allow additional stimulus, we believe that he will react quickly to any signs of weakness. However, this will not unfortunately be more traditional treasury purchases and is more likely to be additional credit easing in the form of MBS purchases, blurring the lines between fiscal and monetary policy.

Inevitably, Sir Mervyn King is also a leading contender for CBOY having delivered another £50bn stimulus for the economy and largely dismissing the exaggerated increases in the purchasing managers’ indices. However, the operations department has succumbed to intense lobbying and shortened the buckets in which the central bank will carry out these purchases. There are understandable reasons why this has been done, but they contravene the core belief of quantitative easing to flatten the term structure of interest rates in order to encourage investors’ animal spirits.  We believe that this black mark is temporary and that the Governor is likely to redeem his reputation by carrying forward the MPC to an additional £50bn in May.

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The ECB’s balance sheet now represents 29% of €urozone GDP and is a similar size to the Bank of Japan’s ratio, although it has taken more than thirteen years for the BoJ to achieve the same level. The ECB’s balance sheet will expand further in February when the central bank conducts a second 3yr LTRO. By contrast the Fed and MPC’s balance sheets are equivalent to around 20% of GDP although we expect both balance sheets to expand substantially over the next twelve months. In theory there is no limit to the size of the central bank’s balance sheet, the Swiss National Bank’s balance sheet is more than 60% of GDP and is likely to rise even further to constrain the Franc against safe haven flows from the €urozone. We expect the €uro to fall to $1.15 against the Dollar by the middle of the year.

Moreover, it is logical for the ECB to have a substantially larger balance sheet as a percentage of GDP because of the size and importance of banking in Europe relative to the US. However, logic and politics are strange bedfellows and we believe that the Northern European members of the ECB’s governing council will become increasingly uncomfortable with the scale of the central bank’s liquidity provision. After February, 3y LTRO’s will be reserved for emergencies, which will undoubtedly arise during 2012. The ECB has not completely exhausted other avenues of stimulus, we believe that the ECB has further room to cut its benchmark two week repurchase rate further from the current 1.0% rate down to 0.5% by the end of the summer. However, we view 50bps as the lower limit for rates in Europe because of the impact on money market funds and t-bill rates. These interest rate cuts will contribute to further €uro depreciation and we expect the currency to drop to $1.15 against the US Dollar.

The ECB’s additional liquidity measures have prevented systemic failure of the European banking system. Banks will have sufficient funding to cover their refinancing needs during 2012. Sentiment amongst peripheral government bond markets has gained additional confidence from the sudden and sharp improvement in business sentiment over the past two months. Citibank’s Eurozone economic surprise index has risen from -60 in mid-November (itself an improvement on the -104 in early September) to the current level of 27.  We believe that these positive surprises relative to market expectations could continue for another couple of months, raising the surprise index to 60-65 level. This will be driven almost entirely by special and temporary factors caused by the mild winter weather and increased economic volatility in the wake of the credit crunch, although there has undoubtedly been some positive lagged impact from the weaker €uro since last summer.  Both of these temporary factors are extremely difficult for statisticians to accommodate in the monthly data and will have the effect of optically boosting activity in the first quarter and depressing it in the second and third quarters. This pattern will be extremely important for European economies since the initial relieved euphoria gives way to heightened pessimism in the spring and summer.

This combination of generous ECB liquidity and temporary seasonal boost has solved the liquidity crisis in the short-term, but it has not liquidated the solvency crisis in the longer term. Europe has a balance of payments crisis that has been aggravated by fixed exchange rates within the single currency. The German solution to this balance of payments crisis has been severe and rapid fiscal austerity, which has fostered the paradox of thrift within the region. This is forcing deep recessions on the peripheral economies, which are ultimately self-defeating as the following summaries of the PIIGS.

Greece: Greece is bankrupt and will have to default. Debt to GDP is 165% and is expected to rise to 180% by the end of the year. We expect the budget deficit to remain close to 10% of GDP as growth contracts by an additional 5% (on top of the 12% contraction over the past three years) as the persistent recession and sluggish reform process fails to provide any material fiscal improvement. We do not believe that there is an acceptable level of voluntary private sector net present value debt reduction that returns Greece to a sustainable growth path. More money is required either from the ECB, European Governments or private sector investors. All of these participants are reluctant to send good money after bad.  The first opportunity to default is the March 20th redemption, and while it is possible for either the ECB or more likely the politicians to provide more money to jump this hurdle, the combination of elections in April and further economic weakness will force default by the summer. In the wake of this expected default, it remains to be seen whether the Eurozone will continue funding Greece, but if it does not, Greece will be forced to leave, enduring the resulting chaos.

Portugal: Is the next domino to fall. The Government missed last year’s deficit target of 4.5% by 1.4%, this means that it now has to halve the budget deficit to meet the Troika’s target of 3.0%. This will be impossible with another substantial contraction of growth. We expect growth to contract by 4.5% during 2012, with the official data contracting by even more as tax evasion follows the same route as Greece. Portugal is poorer than Greece, per capita income of $21,000 versus $26,000 and more indebted, with total debt equivalent to 479% of GDP, compared to 296% in Greece, although government debt is lower at 110% of GDP. There is no doubt that Portugal will need another package. This package will have to be agreed before the country is scheduled to return to the markets in May 2013. From May 2012, the IMF will have to provide an assessment of the forward funding ability. The second package needs to be at least as large as the €79bn provided in May 2011. This will be funded by the ESM, which in turn will include a collective action clause and suggests that even if the European authorities decide not to force private sector debt holders to share the burden through PSI, they will eventually have to be expropriated because the debt is too high for Portugal to repay.

Ireland: A second Portuguese package will also focus attention on Ireland. Ireland is the poster child of austerity even carrying out a debt swap. Irish government bond yields have more than halved since last July when the agreement to provide a second Greek bailout package also reduced substantially the interest rate that Ireland paid for its bailout.  Irish government bonds have also been helped by the fact that prior to the crisis, the outstanding level of Irish bonds was relatively low and over the past six months, when there has been no new issuance there has been strong demand for the paper from domestic pension funds and banks. So far so good, but Ireland debts are still too high and there is pressure in the government to repudiate the bank debt that it acquired in 2010. The economy is crucial, domestic demand remains very weak and growth has been driven by exports, this is reflected in quarterly GDP last year which rose by 2% in the first and second quarters and contracted by 2.0% in the third quarter and over the previous four quarters, GDP contracted by 0.1%. Nevertheless, the Government is confident that the economy will grow by 1.3% during 2012 despite the latest IMF forecast of 0.5%. We believe that weak global growth will cause GDP to contract by 1.3%, consistent with the cyclically adjusted fiscal tightening of 1.3% of GDP and this will provide the catalyst for Ireland to “renegotiate” its guarantee of bank debt and seek substantial haircuts on these bonds.

Spain: Spain has already funded 20% of borrowing requirement this year encouraging its banks to borrow as much liquidity from the ECB to reinvest in government bonds. However, beyond the February LTRO, there is a limit to how much Spanish banks can increase their holdings without raising concerns amongst investors. More importantly, the government’s recent package increased the cyclically adjusted tightening of policy to 1.9% during 2012, with an additional tightening of 0.6% due in 2013. The IMF has responded to this additional austerity by lowering its forecast for 2012 from growth of 0.9% to expecting a contraction of 1.7% in just four months.  The contraction in growth will lead to a further increase in unemployment from the current 22.3% to more than 25% over the next couple of years. Rising unemployment will put further downward pressure on property prices. The budget deficit exceeded its 2011 target of 6% by 2% and it will be impossible to meet the 2012 target of 4.4%.  Spanish banks are exposed to domestic property, over-leveraged corporate sector and Portugal. The government has acknowledged the need to recapitalise the banks by €50bn, but we believe that the requirement will be at least three times this level. This cannot be achieved through domestic resources and we believe that this will require recourse to the ESM to fund this bank bailout. Use of the ESM will result in further sovereign credit downgrades.

Italy: The IMF has just downgraded its outlook for Italian GDP to predict a contraction of 2.2% during 2012 noting “overdoing fiscal adjustment in the short-term to counter cyclical revenue losses will further undermine activity, diminish popular support for adjustment and undermine market confidence”.  Policy tightening will be equivalent of 2.1%, with half of the austerity caused by tax hikes. These counter-productive policies will reduce growth and damage support for the technocratic government. However, Italy is too big to fail and too big to bail. Debt to GDP is equivalent to 120% of GDP and the growth and policy outlook suggests that this will rise to 130% by 2015.  If Germany refuses to allow common Eurobonds and unlimited ECB bond buying, and we believe that they will be because they are illegal under current treaties; then Italy’s excessive debt burden will have to be reduced. This debt devaluation is likely to take place within the euro, because of the scale of Italy’s $1.9tr government bond market, but the cost of this devaluation will require further bank recapitalisation by the ESM.

In conclusion, we expect the single currency to eventually break up, but it is likely to be a long, slow, lingering death rather than a rapid collapse. The single currency is likely to lose at least one member during 2012. The most likely candidate is Greece and this is likely to be followed by Portugal within the following twelve months, which in turn will put pressure on Ireland. The European authorities will be forced to ring fence both Spain and Italy, but this will require a substantial transfer of resources from the richer northern European economies. We believe that voters in these economies will eventually rebel against this implicit taxation without representation and one of these countries will leave the single currency. This analysis may seem unnecessarily pessimistic, particularly to those who believe that the history of Europe is one in which the business elites drag politicians towards greater federalism, and therefore by hook or by crook the €uro will survive, either unlimited purchases of peripheral government bonds by the ECB or through issuance of common Eurobonds. Proponents of the latter solution note that German politicians are not opposed to Eurobonds and would be willing to offer support provided there is greater central control over the new fiscal compact. However, the German Constitutional Court has made it clear that it would require a referendum to allow Eurobonds and unlimited purchases of peripheral government bonds that are contrary to the ECB’s treaty. More importantly the fiscal compact creates pro-cyclical policies in a region that has too much debt, government, financial, consumer and corporate.  This is not sustainable in the medium term.