European Psychological Cycle Repeating
As in July and October, the market has rallied in anticipation of monetary and fiscal policy shifts that could be more accommodative towards the economy and credit markets – what I like to call a “hope rally”. As I mentioned in a quick note on Monday, we have three potential catalyst events that could shift investor psychology: the ECB meeting (today), the EU summit (Thursday and Friday), and the Federal Reserve meeting (next Tuesday). The ECB today was the primary catalyst due to its ability to buy sovereign bonds using its Securities Markets Program (SMP), initiated on August 7th. Given Mario Draghi’s speech to the European parliament last week, there was speculation that a “bazooka” was finally being developed to put a floor in European sovereign bond prices. Draghi said:
"A credible signal is needed to give ultimate assurance over the short term…What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made…We might be asked whether a new fiscal compact would be enough to stabilize markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility…Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right.” European Parliament Hearing, December 1.
Investors took “other elements” to mean a larger monetization plan for buying sovereign bonds but I think it was taken out of context with the point he was making and with past comments.
Recall that back in October, the hope was for the EFSF’s leverage to shore up sovereign bonds, then when no details were released on how the facility would be leveraged and when France’s triple “A” rating was called into question (and to an extent, the EFSF bond rating), hope was passed to the IMF and the ECB. Since Trichet reopened the facility on August 7th, the SMP has been instrumental in keeping yields “controlled” – and I use the term loosely. Without it, we’d be looking at 2010 Ireland-like yield spikes for Italy and Spain. The administrative change at the ECB when Mario Draghi took over as President opened a psychological vacuum as we didn’t know what Mario’s stance on an increased ECB role in rescuing bond yields was. There was some speculation and even some interpretation by Trichet, but in the end we received very hawkish comments in November from Mario on an increased role of the ECB:
“The Securities Markets Programme always has had, and was meant to have – as it has been stated since the very beginning – three characteristics. First of all, it is temporary. Second, it is limited in its amount and, third, it is justified on the basis of restoring the functioning of monetary policy transmission channels. So we should keep this in mind because this in a sense answers all the questions that one might have. The relationship with conditionality should be viewed from this perspective. We want our monetary policy to function. And I think that is where the main justification for the SMP lies.” ECB Press Conference, November 3rd
He was asked about yields on ten-year Italian bonds rising above 6% despite ECB intervention. Draghi had this to say from the same press conference:
“No, we have not really been focusing on this and similar situations in our discussions today and yesterday. However, it is clear that – as I have said many times – the responsibility for maintaining financial stability and orderly financial conditions lies first and foremost with national economic policies. It is really pointless to think that sovereign bond rates could be stably brought down for a protracted period of time by external interventions.”
There should have been no confusion regarding Draghi’s comments last week in the context of his parliament speech and his first ECB press release in November. Mario is trying to get investors and politicians to stop thinking short-term. Quantitative easing by the Federal Reserve in the U.S. has inflated assets and confidence, which has allowed us to have two “good” years in the financial markets and stemmed job losses, but structural problems remain with over $15 trillion in debt and little political will to change (there’s no motive). Draghi is forcing Italy and other nations to take action at the fiscal level because if rescued by a SMP band-aid in a greater capacity, budget inefficiencies, pension liabilities, and wages would not be adjusted to increase the Eurozone’s competitiveness.
SMP Hardline, Dovish Policy
Despite the seemingly hawkish comments from Mario regarding the SMP, the ECB’s policy shifts have been anything but. Since Mario has taken seat as president we have:
- Two rate cuts (down 50 basis points to 1 percent currently)
- Generous liquidity tenders (announcing 36-month today)
- Reduced the bank reserve ratio to 1%
- Reducing the rating threshold for certain asset-backed securities (ABS) allowing central banks to accept as collateral specific securities that might otherwise be rejected under current criteria
- ECB’s SMP will help facilitate bond purchases for the European Financial Stability Facility (EFSF)
Even though the ECB’s policy has been accommodative, investors sold the news release on three bottom line factors:
- Mario denied that a fiscal compact would automatically see a support of more bond purchases.
- No lending to the IMF. While technically legal, Draghi said he didn’t want to violate the spirit of EU treaties and engage in outright fiscal deficit monetization (what the U.S. is doing).
- The rate cut today wasn’t unanimous.
Investors want a bazooka to take out the sovereign debt crisis, but the ECB has explicitly stated now in two meetings that it's not an option. Draghi stated he was surprised the market had interpreted his “other elements” comment last week as a “if you build it (fiscal compact) we will come (monetizing deficits)”. Possibly chalk that up as a freshman in his new role as ECB president or chalk it up as hope-seeking journalism by the financial community.
The Chart and Catalysts
The S&P 500 was able to break a key short-term support level when it dropped below 1244 today. The market attempted to get back above that level towards the end of the day by a Reuters article that the ESM bail-out was to be given a banking license, giving it the ability to directly recapitalize banks. However, that was squashed in the last 20 minutes by a German official who said they were rejecting the idea. The S&P 500 closed at 1234, down 26.66 points as we check off the first of three potential catalysts, and probably the most important catalyst in dealing with market jitters.
Tomorrow is the final day of the EU summit. I’m not expecting anything major here, except for possible news on political unification of which Mario Draghi emphasized last week. I still think the market is searching for more details on IMF involvement and ESM introduction, but I don’t think this meeting will take care of those details. Finally, we have the Federal Reserve meeting next Tuesday, but they’re likely only going to make a communications shift as one could glean from the last meeting’s minutes. Current U.S. economic announcements have been showing recovery statistics with the jobless claims firmly below 400,000 now.
Remember that the S&P 500 is ready to do some downgrading on 15 nations soon after these catalysts have come and gone. Unless they see some fiscal reform, European economics continue to warrant the credit agency's downgrade of European bonds. Eurozone stress test results hit at 12pm ET today and the aggregate capital shortfall is now €114.7B versus the last test that showed €106B. Banks need to submit plans by January 20th to plug any capital deficit and have until June 12th to execute on those plans. That means more sovereign bond sales are likely to come as a result of these tests.
The hope rally leading up to a central bank or EU summit has taken place as it did leading up to the July 21st and October 27th meeting. As those two meetings disappointed, a large vacuum opened under the market sucking liquidity as investors de-risked. To me, this already looks to be in motion as risk-on assets took a big hit today with financials down 3.8%, materials down 3.0%, energy down 2.9%, and industrials down 2.4%. The ECB disappointed the market today despite huge accommodation shifts in a rate cut, longer-term liquidity facility to banks, lower reserve ratio, and easier collateral credentials. The market will move on headlines (specifically Eurozone headlines), economics, and technical analysis after these three catalyst events (ECB, Summit, Fed) take place until the next earnings season.
The S&P has about-faced from a confluence of resistance today on the ECB bazooka shut-down talk and has triggered a short-term sell-signal with the break below 1244 in combination with a breadth breakdown as now only 61% of stocks within the S&P 500 (down from 84% on Monday) are above the 50-day moving average. In addition, this was the first major downside volume day I’ve seen since November 23rd as sellers re-enter and de-risk. Friday and Tuesday are wildcards, but I think investors will be disappointed because past comments from the central banks do not show the likelihood of a bazooka being produced. Technical breakdowns today are confirming those thoughts.
However, this is no doomsday proclamation. Central banks have obviously shown they’re willing to be accommodative with the loosest monetary policy I’ve ever heard of existing in the financial markets. Even the PBOC is involved now with a lower reserve ratio. While central banks may not be providing a bazooka to the sovereign debt crisis, they are certainly showing they’re perfectly capable of acting (as on November 30th) in coordination to prevent economic collapse with appropriate monetary policy shifts. In all likelihood, the markets will continue to be extremely volatile as fund managers actively manage in a risk-on/risk-off mode to headline risk. Most of the recent rally happened over two days! So stay nimble, invest in quality companies that can weather the environment with solid fundamentals, or stay out because with an 80% correlation the market is very susceptible to headline risk.
About Ryan Puplava CMT
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