The commentary from economists and financiers on the summit last week is among the most interesting we have seen for years. LSE professor DeGrauwe told the NYT that the bank recapitalization plan is wildly insufficient, even if it manages to put a cap on yields temporarily. Spain and Italy together have €2.5 trillion in outstanding sovereign debt. The EFSF has €248 billion left and the ESM will have €500 billion, of which €100 billion has already been promised to Spain. It’s a credibility problem. Recapitalizing banks at this low level (so they can continue to buy sovereign paper) doesn’t solve the problem of too much paper out there and private buying having dried up. He says far better would be to have the ECB buy bonds when their spread over Bunds or an average reaches some number like 300 points. Unless leaders give the ECB this power (and PDQ), investors, especially newcomers, will call the bluff. DeGrauwe is an expert on expectations and how they rule market prices, and this is an impressive comment. We will get more information on July 9 when the ESM comes into existence. As for what the ECB will be able or willing to do, stay tuned. We haven’t heard from Draghi on this front since the summit. He speaks at the policy press conference on Thursday and again at a conference on Friday.
Now that risk appetite has gone through the roof, it’s hard to see why we would not get a rally in just about everything—the euro, emerging market currencies, commodities, equities. Germany is certainly going to start talking about "conditionality" but never mind—we can worry about conditionality later, as the October bank recapitalization system is forged. In fact, conditionality will continue to be a major feature of bailouts of all stripes—it would be silly to think otherwise. But in the meanwhile, we will get the "Angela rally." Remember, crummy economic data doesn't look so bad when stock markets are rallying, and in fact, stock market rallies can change the economic behavior that in turn is measured by the next set of data. The really interesting part is that a renewed European optimism can join the British euphoria in the build-up to the London Olympics and jump the pond. The Fed may be able to avoid QE3 because more hopeful business owners and consumers will go back to their high-spending ways.
The risk to the European peripherals and to the overall risk-on rally is that someone will figure out what economist DeGrauwe is saying—the bailout funds are insufficient and we lack a mechanism why which the ECB is allowed in intervene in day-to-day bond trading to hold fear in check. A new bank supervisor is a slender reed to stabilize expectations. Market News quotes an unknown bond market trader who summarized doubts: "A decisive solution using a fund that doesn't exist to buy debt that won't be repaid via a mechanism that hasn't been agreed." We don’t imagine Mr. Draghi or others read the quips of American bond traders, but let’s not underrate him. Talk of breaking the bad feedback loop of banks and sovereign debt has hardly been achieved by allowing joint recapitalization of banks. It’s probably not going too far to say that unless the ECB needs to become the lender of last resort and not only buy sovereign bonds but also leverage up the buying and possibly jigger maturities, like the Fed.
It remains to be seen how quickly the markets come to this conclusion and start acting on it. As noted above, the market can ignore an elephant in the room for a long time.
As for the US, the calendar includes the June ISM today, with the Russell indices having been rebalanced. Tomorrow it’s construction spending and Thursday, chain store sales and the ADP private sector estimate. Friday brings the IMF’s report on the US economy and the HSBC China service sector PMI as well as July payrolls. Bloomberg has an estimate of 90,000, the first sub-100,000 estimate since Nov 2011.
This week is the July 4th holiday on Wednesday but many, many people will take the full week off. We don’t yet know if trading will be thinner because of it, but it’s probably a good bet. For some reason, the dollar tends to rise a few days ahead of payrolls and then spike both ways on the release, so in a thin market this “normal” behavior could become exaggerated. We should also factor in the heat wave, huge swathes of the mid-Atlantic (including Washington DC) with no power and no cable in Connecticut. On the whole, after some jitters and pullbacks today, we think the markets will embrace the summit surprise with both arms and rally its head off for
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