The power of a central bank was in force today. Mario Draghi, speaking at the Global Investment Forum in London, chose a strange platform to announce to the world’s financial community that the ECB would do “everything it takes” to save the euro. The Global Investment Forum is an Olympics-based initiative designed to boost trade and investment to the UK economy…
So what exactly did Draghi say and what can we now expect from next week’s ECB meeting? The key thing to note is that Draghi said the Bank would do whatever it could within its mandate to preserve the euro. The problem is that the ECB’s mandate is fairly narrow and it basically focuses on inflation. Draghi pre-empted the markets’ disappointment by finding a loop hole in the mandate, saying that rising sovereign borrowing costs for Spain and Italy can disrupt the effectiveness of the ECB’s monetary policy measures, thus he hinted that the ECB can get involved in depressing sovereign premia (read bond yields) by the back door.
In effect Draghi was saying that the ECB can’t work in the current conditions in Europe’s sovereign bond markets, thus it has to do something to save Spain and Italy to allow monetary policy, including historically low interest rates and a 0% deposit rate, to work their magic.
So what can he do?
1, Re-start the SMP programme, so that the central bank starts buying up Spanish and Italian bonds and acting as a lender of last resort to the third and fourth largest economies in the currency bloc. There is are a few problems with this 1, the ECB is not allowed to act as a direct lender to sovereigns, 2, the Bundesbank is against the SMP programme and 4, when it has bought government debt in the past it bought in such small size (approx. EU200bn) that it is unlikely to impact the deep credit markets of Madrid and Rome.
2, Re-start the LTRO programme. This pumps money into the banks at an extremely cheap rate, which is designed to entice banks into buying sovereign debt. This is a risky strategy for the ECB because 1, it deepens the toxic link between the banks and the sovereigns and 2, the Bundesbank is also against LTRO.
3, Cut rates: while a rate cut may do little to spur economies or reduce risk premiums in Spain and Italy, by cutting the deposit rate (the rate at which banks get paid interest for storing money with the ECB) to below 0% it could boost lending to the wider economy, which may have a knock -n impact on growth. The problem with this is that 1, there is no guarantee that demand for debt is there and 2, if there was it would take a while to be reflected in economic growth and thus have a positive effect on credit risk.
4, Collateral requirements: By further reducing the quality of collateral banks can use to get cash from the ECB, Draghi and co. may hope that the banks extend more loans to the wider economy and thus create new collateral to get fresh central bank cash. This has the same problems as above, but also reduces the quality of the ECB’s balance sheet.
5, QE: If the ECB started up the printing presses and pumped money directly into the real economy it could have two effects: 1, boost growth through reducing the value of the euro even further and 2, shock the markets into believing Draghi was serious that the Bank will not let the Eurozone fail. However, rounds of QE have done little to help the UK or US economies and the ECB’s balance sheet is already enormous, which makes pure QE a less attractive option for them, in our view.
Overall, we think the markets may be slightly disappointed by any fresh ECB action announced next week. Obviously Draghi has been extremely frank during his speech and thus needs to deliver something to preserve his credibility, but if you think he’s about to launch a big bazooka (in the words of David Cameron) think again – that is definitely not in the ECB’s mandate.
Working in these narrow confines, we believe Draghi could cut deposit rates to below zero; he could also re-start the SMP programme but with a strict limit on the amount of future purchases and also reduce collateral requirements for banks.
But this is not to say that Thursday’s speech was not a momentous event for the Eurozone. Draghi has broken ranks with other ECB officials, most noticeably the Bundesbank, and he has ushered in a new, more pro-active stance from the ECB. The former President Trichet was much more measured and stuck closely to the no-inflation mantra pedalled by the Bank. Draghi has shown he has the guts to stand up to powerful Germany and also to politicians. He won’t do more if they don’t.
The markets reacted with undulated glee to Draghi’s remarks. EURUSD climbed more than 200 bps at one stage and Spanish and Italian bond yields have declined, Spain’s 10-year yields are now below the critical 7% level. But could the markets be overreacting? Probably. The markets like to buy the rumour before selling the fact, so they could be pricing in for a big bazooka while the ECB is planning more of a medium size missile.
Added to this, the ECB doesn’t tackle the real issue at the heart of this crisis: mountains of debt. It can’t deal with welfare states that cost more than the tax revenue a country generates and it can’t enact much-needed to reform to get these economies on the fiscal straight and narrow for the long-run.
Instead, the ECB can only act like a bridge getting us from where we are now to the land of fiscal union that lies across the water. Thus, the ECB is only one part of the equation and without government action it’s hard to see bond yields in Spain and Italy fall on a sustainable basis.
So what could happen to asset prices in the coming week?
If we get some comments from the Bundesbank that temper expectations of ECB action then we could see markets turn around. Support for EURUSD lies at 1.2110 then 1.2040. However, if Germany remains quiet then the next hurdle risky assets need to pass is 1.2330 in EURUSD. If this can be overcome then 1.25 comes back into view.
For that to happen we need to see a further decline in credit risk. The 10-year – 2-year Spanish yield spread was at an extremely stressed level earlier this week but pulled back sharply on Thursday as 2-year yields declined at a faster rate than 10-year yields.
Spanish 10-year yield – 2-year yield
If the ECB can deliver something that amounts to a big bazooka then expect risk to be back on into the end of the summer and peripheral bond markets to surge (yields to fall).
We are also looking closely at gold. It has been in a range for the last two months, and we don’t think it will break out to the upside without some central bank action to calm this crisis. If the ECB (the BOE and FOMC meet next week but all eyes are on Draghi) delivers the goods then we expect a swift reaction in gold. If it can break above $1,640 then it opens the way to re-test $1,700 and potentially even $1,800. If the ECB doesn’t seal the deal we could go back to range-trading with $1,550 acting as major support and $1,615 capping the upside.
Interestingly, gold had started to move before Draghi even spoke, suggesting that investors have a demand for risk. However, for it to remain sustained we need to hear from the ECB next Thursday.
Gold – daily chart with moving averages