Is Draghi fiddling while Rome burns?

Outlook

A falling euro is just what the doctor ordered for near-deflation conditions in the eurozone, although many FX analysts continue to speak of a trading range of roughly 1.3500-1.3700. A dip to 1.3500, which we have nearly reached already, is not enough. The ECB is a bit laggardly, not starting the new LTRO until September and completing the bank capital adequacy/stress tests as late as mid-Oct, with the ECB taking over the regulatory role on November 4. The banks get a big two weeks to fix things before the ECB takes over, a threat in its own right. Many of the 128 banks under the microscope have already raised capital.

Some analysts suggest Draghi is fiddling while Rome burns, but at a guess, the bank examinations are taking up more time than we know. Nobody ever likes to admit it, but banks are the pivot upon which the economy swings. For all we know, a bunch of banks will fail and the ECB is beavering away to figure out how to maintain interbank liquidity, among other worries (like a disastrous announcement effect). The mid-Oct release of the bank examinations is the biggest thing on the longer-term calendar.

The US data calendar today includes housing starts, the usual Thursday jobless claims, the Philly Fed, money and supply and the Fed’s balance sheet, and a speech by the St. Louis Fed’s Bullard, the most hawkish of the hawks who openly says the Fed is behind the inflation curve. Yesterday fellow hawk Fisher complained that "At some point you cross the line from reviving markets to becoming.

The bellows fanning the flames [of asset price bubbles]. I believe we have crossed that line. I believe we need an adjustment to the stance of monetary policy." Fisher sees “financial excess of our own making” and expects higher rates early next year “or sooner.” Market News homes in on a key factor—not only ending tapering in Oct, but halting the reinvestment of interest.

Market News notes “There are no reinvestments coming due in Treasuries until 2016, but in the current month reinvestments in the agency mortgage-backed securities market will total $21 billion. That is quite a hefty amount when you consider the fact that MBS QE3 buys are likely to be reduced to $10 billion at the July meeting.” Remember that NY Fed Dudley has his knickers in a twist over liquidity and his own special repo system. The Economist reports an increas-ing shortage of paper that results in the occasional failure to deliver—a sure sign of distress.

We are having a hard time reconciling FX moves with the rest of the markets, which are over-reacting in an unexpected way to the sanctions on Russia. Maybe it’s the summer doldrums, but the FT says European bourses are following US equity index futures downward and US equity index futures are down on the Russia story. Really? It’s the European economy that takes the biggest hit from sanctions on Russian companies. Exports to Russia (reported yesterday) are al-ready down 13% in the first 4 months of the year. If there is an economic reason for the euro to be falling, there it is. But if the world is fearful of the geopolitical situation, why isn’t the yen stronger? The yen is supposed to be a canary in the coalmine, rising on repatriation at any whiff of global troubles. But the dollar/yen is still ranging around a little under 101.50 but seeming headed up at 8 am.

We always advise to respect breakouts and we do have a breakout in the euro and Swiss franc, but in the absence of a compelling reason, we have to suspect its staying power. US yields are flattening but if theer is a geopolitical crisis, the 10-year should be under 2.50% again. Yes, there are solid economic and institutional reasons for the euro to slide, but they have not worked before. The one thing that does push the euro down is bank failures and sovereign debt crises, and we don’t have that, either. So we must suspect the breakout could be false.