STOCK MARKET WATCH -- Tuesday, 31 July 2012

[Demeter]

21. The Euromess Continues

http://economistsview.typepad.com/timduy/2012/07/the-euromess-continues.html

Excitement is almost guaranteed this week, with both the Federal Reserve and the European Central Bank pondering their next moves. At the moment, I am more fascinated with the latter, as it represents the more fast moving policy failure for the moment. In response to that disaster to date, it is now widely expected that the ECB will deliver a significant policy expansion, possibly accepting its responsibility of lender of last resort for sovereign debt in the Eurozone. I think it is widely believed that this will be the turning point in Europe. In some ways, yes, as it would keep the threat of imminent dissolution at bay. But the Eurozone will still be fundamentally hobbled by a devotion to re-balancing via austerity-driven internal devaluation. This does not offer a promising long-run outcome.

The sequence of events of last week is becoming clearer. Last Monday, Spanish Economy Minister Luis de Guindos met with his German counterpart. Initial reports indicated no new initiatives were in the works. Subsequent reports suggest otherwise. Friday we learned, via Reuters:

Spain has at last conceded it may need a state bailout and policymakers are considering writing down Greek debt to their central banks, European officials said on Friday, as markets anticipated radical new action to pull the continent out of its debt maelstrom...

...A euro zone official said Economy Minister Luis de Guindos had brought up the prospect of a 300 billion euro bailout this week at a meeting with Germany's Finance Minister Wolfgang Schaeuble. The official spoke on condition of anonymity because he was not authorized to brief

"De Guindos was talking about 300 billion euros for a full program, but Germany was not comfortable with the idea of a bailout now," the official said.

He said the question would be put off until the euro zone's new, permanent bailout fund, the European Stability Mechanism, is up and running. He also said that Germany appeared to be softening its opposition to giving the ESM a banking license, which would allow it to borrow money and deploy more firepower if called upon to rescue an economy as big as Spain's.

So it sounds like de Guindos went to Schaeble with hat in hand, only to be told that at best Spain would need to wait its turn. Meanwhile, market participants, sensing Spain is teetering on the brink, were pummeling the nation's stock and bond markets, sending yields soaring, thus ensuring a bailout was necessary (Interesting aside - at what interest rate does Spain not need a bailout, and would that rate become an ECB target? Sounds like a good project for an investment bank research team.) ECB President Mario Draghi, smelling disaster in the wind, breaks down and delivers some now famous remarks in London, including this line:

To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.

This indicates Draghi has finally found away around the mandate prohibiting monetizing sovereign debt, laying out the justification for bond purchases as necessary to implement appropriate monetary policy. This generates a massive global relief rally, as everyone and their brother, expect of course apparently everyone at the ECB, knows that only the ECB has the firepower to stop the repeated cycle of panic endured by Europe. It seems like a real, promising plan is in the works. Via Bloomberg:

Draghi’s proposal involves Europe’s rescue funds buying government bonds on the primary market, flanked by ECB purchases on the secondary market to ensure transmission of its record low interest rates, the officials said. Further ECB rate cuts and long-term loans to banks are also up for discussion, one of the officials said.

I don't think Draghi has publicly stated this as a proposal, but instead reporters have pieced this together from contacts within the Eurozone. In any event, to the extent that their exists any substantial opposition to such a plan, that opposition rests with - caution, spoiler alert! - Germany. But you guessed that already, didn't you? Via Reuters:

Germany's Finance Minister dismissed reports Spain is about to ask the euro zone bailout fund to purchase its bonds, and talked down fears about its spiralling borrowing costs in an interview with Welt am Sonntag newspaper made available on Saturday.

"Spain's financing needs in the short-term are not so high. High interest rates are painful and they create a lot of uncertainty, but it is not the end of the world, if you have to pay a few percent more at a few bond auctions," Wolfgang Schaeuble said.

Asked if there was any truth to speculation that Spain would shortly ask the euro zone rescue fund for help via buying its bonds, Schaeuble answered: "No. There is nothing to these speculations."

And from the FT:

Germany’s powerful Bundesbank issued a reminder that it still opposed sovereign bond purchases by the European Central Bank, dampening market optimism after ECB president Mario Draghi hinted he could act more decisively in the eurozone debt crisis.

This, I think, is the state of play heading into Monday morning. Basically, Spain is in all-likelihood on the brink of disaster, threatening to drag the rest of the Eurozone with it, Draghi sees this and has made some very, very big promises to deliver imminent action to keep the ship afloat, but he may face internal resistance that necessitates watering down his plans. Now, at what levels will such a plan work? The short-game here is pretty obvious. It is tough to bet against Spanish or Italian debt if you think the ECB is set to cap borrowing rates. Now think about the long-game. Does it, by itself or in concert with other plans floated in Europe, put the Eurozone economy on firm footing? In my opinion, no. To understand why, one needs to read the full text of Draghi's market-moving remarks. I struggled with the remarks, and was happy to see that I was not alone. Paul Krugman describes them as strange. I found them downright incomprehensible. Draghi begins with the analogy that Europe is like a bumblebee. No one believes it should be able to fly, but it did. Then people stopped asking the question of why it should be able to fly until the financial crisis. Now the job is too restore confidence in the Eurozone so that is become a bee, which everyone believes flies.

No, it is not an easy analogy to decipher. But the bottom line seems to be this: There is not anything fundamentally wrong in the Eurozone that prevents a fully functioning economy, it is only a crisis of confidence.

It's not me, it's you.

LET LOOSE THE CONFIDENCE FAIRY!

SO MUCH MORE AT LINK