The Cost of the Latest Euro Stall
08/03/2012 9:00 am EST
The European Central Bank has disappointed anyone hoping for serious action to resolve the Eurozone's woes. That has short-term and long-term implications for investors, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
The euro can't be undone. 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 bondholders would be repaid first in the event of a default.
That was the sum total of today's action from the European Central Bank. After tantalizing the financial markets with hints of another interest-rate cut or another round of bank lending, along with a proposal to give the European bailout fund a banking license so it could borrow directly from the central bank, ECB President Mario Draghi delivered only this very limited package.
European stock markets that had been up as Draghi's news conference began slowly moved into negative territory. An hour after Draghi's remarks, the German Dax was down 0.66%. Futures on US stocks moved into the red before the open, and the S&P 500 ended down more than 10 points on the day.
In the short term, financial markets were left disappointed, after having been led to expect something dramatic. But that's the short term.
In the long term, I think the bank's failure to act leads to serious negative consequences. Here's why.
The simplest way to characterize the action, or perhaps the inaction, of the ECB 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 continue waiting for 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 Germany's Bundesbank, Draghi not too subtly hinted—the ECB has signaled to bond traders that they don't have the field to themselves.
The traders will have to think about the risk that the bank will buy—driving prices back up and yields back down—before they short these bond markets.
The bank didn't draw a line in the sand, as some economists had suggested, so the markets don't know when the central bank will decide to step in. But I think it's a good bet that Draghi wants to drive yields on Spanish ten-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 ten-year debt moved up to 6.78% from 6.68%, and the yield on the Italian ten-year bond increased to 6.1% from 5.81%. US Treasuries rallied as those markets opened, with the yield on the ten-year Treasury falling as buyers stepped up in their search for safety.
The bond market's reaction is completely understandable. Draghi gave no indication that the central bank was about to undertake a big intervention. Past moves have been too small to 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.|pagebreak|
Details might have helped the central bank's credibility. Saying that the bond-buying program will start—once the bank has decided whether the European Central Bank can jump to the front of the line of creditors if Spain or Italy defaults—is like saying that the Eurozone will have unified deposit insurance when it can persuade Germany to back deposits for savers in Spain and Italy. Neither is likely to happen.
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 cartload recently, because long-term rates are punitively high. That has gradually driven up short-term yields, the amount Spain has to pay the bond buyers.
So will the central bank buy long-term or short-term bonds when it decides to intervene? That's important to traders trying to decide which bonds to sell short, betting they'll fall in value, and which short bets to shy away from. And it illustrates exactly how big the task ahead of the European Central Bank is right now.
The Costs of Not Acting
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 worsen because the bank punted on them:
- Because the bank didn't cut its benchmark interest rate, it didn't throw even a bone to struggling European economies.
It's clear to almost anyone who doesn't lead Germany, Finland, or the Netherlands that the Eurozone can't produce the growth it needs under 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. Inaction 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 bit harder for the US Federal Reserve and China's 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 Eurozone debt crisis.
- By giving the impression—accurate though it probably is—that the Bundesbank put the kibosh on any more ambitious plan of action, today's non-move by the central bank reinforces the view that the Eurozone still has no effective plan for coping with the debt crisis, and that the zone's leaders are hopelessly divided on how to proceed.
- 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 interbank lending is crucial to the ability of European companies to conduct business inside the Eurozone.
It makes sense: 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, trade grinds to a halt.
Nothing in today's program addresses this loss of confidence in Eurozone partners.
And Now, the Fallout
So where do we go from here?
Chaos in Greece. The government proves unable or unwilling to carry out 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.|pagebreak|
The Italian and Spanish governments continue to unravel. In Italy, the question is whether Prime Minister Mario Monti's government of technocrats can 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 other Eurozone countries and the IMF to help dig Italy out of its hole.
In Spain, only a lack of alternatives keeps the Popular Party of Mariano Rajoy in power. Rajoy, who led his party to the biggest election victory in Spain in 30 years, saw his disapproval rating double to 43% from January to June.
Madrid's attempt to control the budgets of Spain's deeply indebted regional governments is floundering; even regional governments controlled by Rajoy's own party are 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 have left Spain's Eurozone supporters increasingly frustrated.
An outside audit of 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 country's 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 in the wind without a viable backup plan. The permanent European Stability Mechanism, the bailout fund that was supposed to replace the temporary European Financial Stability Facility in July, remains in limbo until Germany's constitutional court rules in September.
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 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 certainly on equity prices in 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.
A Gloomy August
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, the yen, and other safe-haven currencies continue moving up, with negative effects on company profits in strong-currency economies. (This also has negative implications for gold and other commodities.)
August, in this scenario, is likely to yield even deeper stock-market bargains than we have now, and I'd expect that any company that disappoints will see its stock punished harshly. If you're been waiting to buy, I think you can keep waiting unless you get a really stunning sell-off in a stock you've always wanted to own. Even then, don't buy with the expectation of a quick recovery.
I think the catalysts for any turn, even temporary, will be the Kansas City Federal Reserve's late August 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 waiting for October, November, or December for a rally. And if that kind of groupthink doesn't make you nervous, especially with the looming US fiscal cliff, it certainly should.