Had you gone on holiday last Wednesday night to a remote blackberry/Bloomberg free desert island and landed back just before the ECB meeting yesterday then you may have been pleasantly surprised by what they offered up. However expectations are everything and they couldn’t live up to the elevated hopes that originated from Draghi’s speech last week.
It was a crazy afternoon of trading with the Euro spanning four big figure handles in less than 30 minutes as the market tried to digest the implications of the meeting. By the close Spain’s 10yr yields had spiked 43bp which is the biggest one day rise since the daily data starts on Bloomberg in January 1993. The 10yr closed at 7.165%, just about 20bp off levels seen before Draghi’s London speech last Thursday as it unwound most of the past week’s gains. The Spanish curve steepened though given the ECB’s focus on the front end in any potential market intervention. Indeed Draghi yesterday hinted that it was the recent spike in the short end peripheral yields that prompted his bold statement last Thursday. The Italian curve moved in similar fashion with the 10yr (+40bp) recording its biggest single day spike since December last year to close at 6.327%. BTP 2yr yields fell 3bp to 3.118%. The reaction away from peripheral fixed bond markets was equally violent. The euro saw its biggest single day range (1.2134 – 1.2405) for the year. Xover and Main closed +24bp and +11bp wider. Spanish and Italian equities were off -5.16% and -4.64% respectively. The lack of specific announcements from the Rajoy-Monti meeting yesterday also disappointed the markets.
Overall it makes you consider whether central banks should always use surprise as a tactic or whether they should slowly guide the market of their expectations? Whatever the right thing to do is one could argue that Mr Draghi fired his surprise bullet too early and even then was probably guilty of subconsciously guiding expectations too high. To be fair to him how the media and financial pundits
interpret what he’s says is not his responsibility. If we re-read his speech from last week there wasn’t a smoking gun as we argued at the time but one can easily see how expectations got ahead of themselves. The two key quotes were “within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” and “To the extent that the size of these sovereign
premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.”
The “within our mandate” should probably have raised alarms that the ECB weren’t going to break rank and absolve countries of their responsibilities and needed commitment of Government action first. However his “whatever it takes” comment was always going to overshadow the mandate part. Overall the basic message from yesterday was a more sober we’re happy to intervene but only if
countries activate support from the EFSF/ESM. As we suggested at the top, had last week’s speech not taken place then yesterday’s strong hints that the ECB would buy bonds alongside Governments when a program had been activated would have likely created better momentum for the market coming out of the meeting.
So where are we left? The good news is that the ECB does seem prepared to intervene in the secondary market. The bad news is that they won’t do this until Spain and/or Italy request official support and they enter a MoU. So we now enter a waiting game for Spain in particular to decide that the only option is to request the external aid. It seems likely that if they don’t decide this soon the market will force the issue pretty quickly. So we’re back to where we were 7-10 days ago.
However one would have to say that the tail risk is probably lower than it was back then as we now know that the ECB will act alongside Government intervention. This will postpone any worst case scenario for a while at least and perhaps the last 3-4 months of the year is
going to be the start of the moment of truth for all things Euro related. We may find out how the rescue mechanisms so far set up can cope with Spain and Italy potentially requiring help. We might well find it might not cope particularly well and there’s a decent chance much more stressful times could easily come further down the road but as a minimum we know that the ECB will likely be involved which gives Europe more time than if they weren’t going to intervene.
The seniority issue received some air time yesterday with the ECB saying that it is ready to address the “market concerns with seniority”. While Draghi didn’t tell us the specifics on how this would be addressed, our economists thought the fact that he chose to explicitly mention this goes beyond their expectations given prevailing market concerns. The ESM banking license issue seems to be also off the table as Draghi repeated a legal opinion last year that such a construct is illegal and the ESM (in its current form) would not be a suitable counterparty for the ECB.
So what are the things to watch out from here? Clearly all eyes will be on when/if Spain requests for a full programme. One of the biggest pending question marks for timing of aid is perhaps Germany’s Constitutional Court’s approval of the ESM on the 12 September. Also important is Moody’s potential downgrade of Spain’s rating to HY. Another hurdle is Greece’s Troika review which will be out in September. So clearly there are plenty of potential risks still ahead.
Back to markets, equities and credit markets continue to weaken overnight with the Nikkei, KOSPI, and the Australia iTraxx -1.1%, -1.0% and +7bp on the day. It’s worth noting that the S&P 500 (-0.74%) managed to close off its intraday lows though as it recovered somewhat post the European close. Indeed the S&P 500 Futures are in the green as we type. Chinese equities (+0.4%) are higher on the day though. The non-manufacturing PMI in China fell only modestly to 55.6 in July from 56.7 in June.
Looking at the day ahead, US non-farm payroll is the key release and has been overshadowed a bit by the ECB. DB’s Joe LaVorgna is expecting a headline/private payroll increase of 75k/80k respectively. The market is looking for 100k/110k. Unemployment is expected to hold at 8.2%. Remember in recent months we’ve shown that seasonally July’s reading tends to be the low point for the year. That aside Eurozone and UK services PMIs and the US nonmanufacturing ISM are also due today.
Finally as we reach the end of week 1 of London 2018 our 1-man crusade to see Spandau Ballet’s Gold re-enter the top 10 got a boost with a wonderful triple Olympic Team GB Gold celebration yesterday. The Song is now at a mighty 147 in the iTunes UK charts. Come on folks, make my year!
Colin Tan, CFA