Draghi disappoints--yesterday's non-action by the European Central Bank doesn't mean anything good for the markets in August

08/03/2012 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

The euro is irreversible. High yields are unacceptable. And, yes, the European Central Bank will resume buying Spanish and Italian government bonds as soon as it can work out which bond holders will be get paid back first in the case of a default.

Yep, that was the sum total of the August 2 action from the European Central Bank. After tantalizing the financial markets with hints of another interest rate cut or another round of bank lending and a proposal to give the European bailout fund a banking license so it could borrow directly from the central bank, this very limited package is what European Central Bank   President Mario Draghi delivered.

European stock markets that had been up as Draghi’s press conference began slowly moved into negative territory. An hour after Draghi’s remarks the German DAX Index was down 0.66%. Before the open futures on U.S. stocks had moved into the red.

In the short-term financial markets, having been led to expect something dramatic, were left disappointed.

But that’s the short-term.

In the long-term I think the bank’s non-action leads to serious negative consequences.

The simplest way to characterize the action, or non-action, of the European Central Bank on August 2 is that the bank has moved to defend the Italian and Spanish bond markets and left the rest of the EuroZone to hang in the wind. Or to wait for the politicians to come up with a solution, if you prefer that formulation.

By saying that the bank will resume buying Italian and Spanish government bonds—over the strenuous objections of the Bundesbank, Draghi not too subtly hinted in his press conference—the ECB has signaled traders that they don’t have the field to themselves. Think about the risk that the bank will buy and drive prices back up and yields back down before you short these bond markets. The bank didn’t draw a specific line in the sand, as some economists had suggested, so the markets don’t know what yield the central bank will defend. But I think it’s a good bet that Draghi wants to drive yields on Spanish 10-year debt significantly below the 7% mark that the Spanish government has repeatedly called unsustainable.

Bond markets haven’t been especially impressed. In the hour after Draghi spoke the yield on Spanish 10-year debt moved up to 6.78% from 6.68% and the yield on the Italian 10-year bond increased to 6.1% from 5.81%. U.S. Treasuries rallied as those markets opened with the yield on the 10-year Treasury falling as buyers stepped up in their search for safety.

The bond market’s reaction is completely understandable. Draghi didn’t give any indication that the central bank was about to undertake a big intervention. Past moves have been too small to really change the trend in the bond market for long and with Draghi noting Bundesbank opposition to a resumption of bond buying, it’s only reasonable to assume that this effort too will be too small to matter.

Some more details might have helped the central bank’s credibility. Saying that the bond buying program will start once the bank has worked out the problem of whether or not the ECB will jump to the front of the line of creditors if Spain or Italy default is like saying that the EuroZone will have unified deposit insurance when it can convince Germany to back deposits for savers in Spain and Italy.

And there’s also a technical question of where the bank will intervene on the yield curve. Spain has been selling short-term debt by the cart load recently because long-term rates are punitively high. That’s had the effect of gradually driving up short-term yields. So will the central bank buy the long end of the yield curve or intervene at the short-end? That’s important to traders trying to decide what to sell short and what short bets to cover. And it illustrates exactly how big the task ahead of the European Central Bank is right now.

But enough about what the bank did. Let’s look at the much longer list of what the bank didn’t do and the problems that are likely to get worse because the bank punted on them today.

First, because the bank didn’t cut its benchmark interest rate again, it didn’t throw even a bone to struggling European economies. It’s certainly clear to almost anyone who doesn’t lead Germany, Finland, and the Netherlands that the EuroZone can’t produce necessary growth through a regimen of budget cuts and tax increases. I’m not sure that in the current economy lower interest rates would do much to increase domestic spending inside the EuroZone, but by weakening the euro further cuts in interest rates could stimulate exports in the Spanish and Italian economies. Non-action here doesn’t offer those countries any help or hope in that direction.

I’d also note that from a global view the failure of the bank of reduce interest rates makes it just a little bit harder for the Federal Reserve and the People’s Bank to pursue their own stimulus programs. That’s not good news at a time when the global economy is in danger of stalling from the drag created by the euro debt crisis.

Second, by giving the impression, accurate as it probably is, that the Bundesbank put the kibosh on any more ambitious plan of action, today’s non-move by the central bank just reinforces the view that the EuroZone has no effective plan—still—for coping with the euro debt crisis and that the EuroZone’s leaders are hopelessly divided on how to proceed.

Third, by doing so little the bank left big and growing problems unaddressed in even its own narrowly defined competency of stabilizing the monetary system. For example, in recent weeks cross-border lending between, say, a bank in Germany and a bank in Slovenia or Italy has just about dried up. This kind of inter-bank lending is crucial to the ability of European companies to conduct business inside the EuroZone: If you can’t get your accounts settled when your Italian company gets an order from Germany because the German company’s bank won’t risk increasing its exposure to its Italian counterparts, then trade grinds to a halt. Nothing in today’s program addresses this loss of confidence in EuroZone partners.

So where do we go from here?

Chaos in Greece as the Greek government proves unable or unwilling to meet promised budget cuts and tax increases in order to get its next installment of rescue money and the troika of the International Monetary Fund, the European Central Bank, and the European Commission refuse to sign the next check. At best, the game of chicken gets more unsettling to financial markets as Greece finds a way to bridge its finances in August and then all parties work out a deal in September to avoid a Greek default in October. At worst, there is no deal and Greece defaults in October. Either way the turmoil will push up yields in Italy and Spain (and push them down in Germany and the United States) and hang over global financial markets like a decaying corpse.

The Italian and Spanish governments continue to unravel. In Italy the question is can Mario Monti’s government of technocrats hang on until elections in April 2013. Pressure from the opposition in Parliament is rising; the government faces a near-insurrection from a regional government in Sicily that, while broke, continues to spend; and momentum toward economic reform has just about stalled. An early election is likely to result in the return of a government led by Silvio Berlusconi’s People of Freedom party. And that would just about end the willingness of the International Monetary Fund and other EuroZone countries to help dig Italy out of its hole. In Spain it is only the lack of a viable alternative that keeps the Popular Party of Mariano Rajoy in power. Rajoy, who led his party to the biggest election victory in Spain in 30 years, has seen his disapproval rating double from January to hit 43% in June. Madrid’s attempt to control the budgets of Spain’s deeply indebted regional government is floundering with even regional governments controlled by Rajoy’s own party telling the central government to take a hike. With Spaniards unwilling to put the Socialists back in power, opposition is now centered on mass demonstrations in the streets. Rajoy’s credibility with other EuroZone governments isn’t much higher than his popularity back home. His inability to call a rescue a rescue and his desire to avoid outside controls at all costs has left Spain’s EuroZone supporters increasingly frustrated. The outside audit on Spain’s banks due for September delivery is critical. No one has any confidence in the Spanish government’s latest take on the balance sheets at the countries banks. The outside audit could restore some credibility to Madrid and some confidence to Spain’s banks. Or it could torch the last shreds of faith in Madrid’s ability to manage this crisis.

The EuroZone is left twisting slowly in the wind without a viable backup plan. The permanent European Stability Mechanism, which was supposed to replace the temporary European Financial Stability Facility in July remains in limbo until the Germany constitutional court rules in September. And meanwhile there’s a curious lack of visible activity on essential reforms such as joint deposit insurance. European leaders continue to move at a pace that suggests there is no real crisis.

Is there a way out of this? Sure. The United States and China can stimulate their economies so that global growth picks up and slowly begins to drag Europe out of recession. Of course, Germany would be the first to benefit and that would just exacerbate the divide between efficient exporters such as Germany and Finland and the other EuroZone economies. And the recovery in those economies would still be so slow that it would remain a drag on global growth. (And certainty on prices in global financial markets.) In other words even this fix wouldn’t solve the basic problems with the euro.

Does depending on the kindness of strangers constitute a sound economic policy? You bet your Stanley Kowalski souvenir T-shirt it doesn’t.

All this adds up to another reason—or set of reasons—to think that August will be a down month for global stocks. How down will depend on how nasty the Greek crisis gets and how quickly. You can also expect to see the dollar and the yen and other safe haven currencies continue to move up—with negative effects of company profits in strong currency economies. (And with negative implications for gold and other commodities.) August, in this scenario, is likely to yield even deeper stock market bargains than currently and I’d expect that any company that disappoints will see its stock punished hard. If you’re been waiting to buy, I think you can keep waiting unless you get a really stunning sell off in a stock that you have always wanted to own. Even then don’t buy with the expectations of a quick recovery.

I think the catalyst for any, even temporary, turn will be the Kansas City Federal Reserve’s late Jackson Hole retreat and the September 13 meeting of the Federal Reserve that is, after today, even more likely to produce another round of quantitative easing. The Europeans will also gear up their summit machinery sometime this fall in my estimate. (Everybody in Europe goes on vacation in August. I don’t think this crisis will change that.)

That leaves us all waiting for October-November-December for a rally. And if that kind of groupthink doesn’t make you nervous, especially with the looming U.S. fiscal cliff, it certainly should.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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