Many central bankers in the past have made solemn pledges stating “we will do what it takes to preserve the integrity of [name your currency]”. Such a statement usually sparks off a short covering rally amongst the “speculative” community, but inevitably ends up with lower prices. Recall the efforts made by the Bank of Japan to keep USD strong vs. JPY over the years. It currently fetches just JPY 79 to USD 1, a breath away from its all-time low.
In short, these pledges rarely work. Draghi also added the immortal words, “believe me, it will be enough”, words that may come to haunt him soon enough. However, as the statement was made, the equity markets shot up, sovereign bond yields for the peripheral countries fell and the Euro moved from 1.20 to 1.23 in a matter of minutes.
Now, there are only two plausible measures to slow down the Euro crisis – fiscal integration amongst the sovereign nations in the EU (i.e. all for one and one for all) or monetisation (i.e. print Euros to buy sovereign debt). Since the first is not in the ECB’s mandate, the Draghi statement was interpreted as suggesting the imminent commencement of a large scale bond purchase operation, backed by printing Euros, if necessary. The markets have also been goosed by apparently leaked statements by members of the Fed that this week’s meeting will see the re-commencement of QE in the US.
There are certain obstacles that the central banks will have to contend with. Although the politicians have supported Draghi, the German Bundesbank was quick to denounce the statement. After all, bond purchases will sit on the ECB balance sheet, most of which is owed to the Germans. In other words, Germany ends up with a greater burden of risk of Italian and Spanish defaults. Without German consent, it’s hard to see a large scale buying operation taking place. On a secondary point, the greater the volume of ECB purchases, the greater the risk of subordination for existing bondholders. This will creep in soon enough after such purchases commence.
In the US, the economic numbers have been dismal with unemployment persistently up. At the same time, sales, GDP, manufacturing and servicing indicators are all down. As the chart below shows, the earnings season in the US has also been a major disappointment. Many pundits have therefore suggested the Fed will start QE3 this week.
However, this is election season in the US and the Fed may not want to be seen as helping the incumbent party. Furthermore, there is growing evidence that inflation is ticking up. If an easing is perceived by the $16 trillion odd creditors of the US bonds as being “slack on inflation”, we could see long term rates spiking up in the US, which is not what the Fed wants. Finally, you have to ask yourself this question, “will the fed embark upon QE3 when the S&P equity index is close to 1400 or will they use that bullet when the markets are much lower”?
What has so far been an extremely technical game of chess between the markets and central banks has been transformed into a poker match. The market will now call “show” and it is up to the central banks to deliver. If their hand falls short “buy will become bye bye”.
The answers will be with us soon enough! << Collapse