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Deutsche Bank Early Morning Reid – July 30

Deutsche Bank Early Morning Reid – July 30

This week we’ll probably see the start of a butterfly effect which will shape the rest of the year one way or another. Will the ECB embark on a significant change in direction or will they fail to reach a consensus and risk the rally of the last few days and throw the market back into turmoil?

Our view at the start of last week was that it was likely that the market would start to price in action from the ECB and the Fed as the week progressed but that after the meetings markets would end up disappointed as the action was likely to be limited. Well it’s fair to say that we weren’t expecting Draghi’s speech on Friday and although we still thought that the market would continue to price in action
from the ECB we didn’t think the speech was a game changer. However on reflection we probably made a mistake and under-estimated the language used and now think there are compelling signs that Draghi is clearly prepared to aggressively act if he can build a consensus.

What was also supportive were the comments on Friday from the German Finance Minister that suggested Germany will, like the ECB, do all in its power to save the Euro. This could be seen as an endorsement of Draghi’s speech by the German Government which is important. The biggest hurdle is likely to be the Bundesbank and Mr Weidmann in particular. Any headlines from the likely talks
between these two need to be closely watched for early this week.

So what can Draghi drive through ahead of Thursday’s meeting? Bloomberg news noted that Draghi’s likely proposals involve primary market bond purchases by the EFSF/ESM flanked by ECB purchases in the secondary market. It is said that LTROs on top of ECB rate cuts are also up for discussions. The Bundesbank on Friday said that it remains opposed to restarting government bond purchases and
its also worth remembering that in a “leaked” letter four months ago Weidmann urged Draghi to tighten collateral rules and warned of the growing TARGET 2 imbalances.

So if the press is to be believed it will be a week where Draghi will be trying to build a consensus. How far he can get will have a huge impact on markets through August. So unless the headlines turn more negative in the meantime it seems likely that the markets will
remain fairly buoyant ahead of Thursday’s meeting and we’ll then wait for the results. At the end of the day intervention is likely to make a huge difference if a country is perceived to be on the right side of being solvent. If a country’s solvency continues to get questioned then intervention is incredibly difficult to sustain if growth doesn’t recover. So whatever happens this week from the ECB, growth will continue to be the key. Intervention alone is unlikely to save the periphery. Remember this time last year Trichet suggested that speculating on a Greece default was “a sure-fire way of losing money given decisions taken last Thursday”.

Greece’s economy was squeezed into the ground to a point that intervention had its limits unless the authorities wanted to own all the debt which as it transpired they didn’t. With this in mind this week’s PMIs will be another important pointer as to how successful any
intervention in Spain and Italy might be. Such growth pointers hold the key to the Sovereign crisis in these countries in the months and quarters ahead.

We’ll review the rest of the week ahead at the end of the EMR but note that it includes a rare second fiddle Fed meeting, the ISM and other global PMIs, non-farm payrolls, Spanish and Italian auctions, and over 200 company results from both sides of the pond.

At the start of this busy week Asian markets are continuing to rally as Draghi’s “do-whateverit-takes” mantra reverberates around the globe. Except for China, Asian equities are up across the board led by the Hang Seng (+1.5%). This follows on from gains in European and US markets on Friday with the IBEX, FTSE MIB and S&P 500 up +3.91%, +2.93% and +1.91% on the day. This strong finish also helped the IBEX and FTSEMIB post their first weekly gain in since the end of June. Back to Asia, the Shanghai Composite (-0.1%) is down slightly as we type not helped by some earnings concerns. Credit spreads are tighter with the Australia iTraxx around 9bp tighter on the day.

Recapping some of the main weekend stories, German Finance Minister Schaeuble denied that Spain plans to ask the EFSF to buy bonds but also added that while rising interest rates are painful for Spain the country will be able to manage them. EU’s Juncker told Germany’s Sueddeutsche Zeitung and France’s Le Figaro on Sunday that leaders would decide in the next few days what measures to take to tackle Spain’s bond yields and added that they had “no time to lose”. He also added that “We will work in close agreement with the ECB, and we will, as Mario Draghi said, see results. I don’t want to drive expectations, but I must say, we have reached a decisive phase”.

Elsewhere Moody’s highlighted that the ECB can do no more than buy time and its actions alone will not resolve the debt crisis. The rating agency added that resolution will ultimately rest on achievement of fundamental changes to member states’ budgetary positions and debt stocks, on structural economic changes required to stimulate growth, and on institutional reform to the economic and fiscal governance of the euro area. Each of which will take years to accomplish, and support from the ECB will be essential to the preservation of the euro in the meantime. Whilst there is nothing new in this, it reminds us of Spain’s review for downgrade and the implication of a non-IG sovereign rating on the Spanish fixed income complex.

This could still be a big event in the coming week whatever happens on Thursday.

Moving on to today, Spain’s Q2 GDP and Italy’s bond auction (EU5.5bn across 2015, 2017, 2022) are the main highlights in Europe. Its worth noting that Geithner will also meet with Schaeuble and Draghi in separate sessions today. The meeting with Schauble will take place on the northern German island of Sylt on Monday afternoon and the meeting with Draghi will be held in Frankfurt the same evening.

Looking beyond today and to the rest of the week the FOMC will begin its two day meeting tomorrow. Data wise we have the Conference Board Consumer Confidence, Chicago PMI and Personal Spending/Income in the US tomorrow. In Europe, we have a scheduled EFSF bond sale, euroland July inflation estimates and unemployment stats from Italy and Germany. Wednesday will be global PMI day with manufacturing surveys out in the US (ISM) and China as well as the first taste of the Italian and Spanish PMIs. In China the market is looking for another modest improvement (50.4 from 50.2 last month) but Italian and Spanish readings are expected to remain very depressed (Spain’s forecast 40.3, Italy at 44.1). The ISM in the US is expected to rebound back to 50.2 from a surprise 49.7 reading last month. All these will nicely coincide with FOMC’s rate decision but given recent data hasn’t been as bad as feared we’d be surprised if we get any major Fed action this week. There will be no post-meeting press conference by Bernanke this time round. We then move on to the ECB and BOE meetings on Thursday with the ECB now having to deliver to avoid a market disappointment. Interestingly we have a Spanish bond auction a few hours prior to the ECB verdict on Thursday where the government plans to sell bonds across 2014, 2016 and 2022 maturities. Rajoy will also host a crisis meeting with Monti on Thursday. Last but not least we then arrive at Payrolls Friday where the market is looking for a headline/private payroll of +100k/110k this
month versus the disappointing +80k/84k last month. The unemployment rate is expected to hold at 8.2%. Payrolls aside its also worth noting the release of service sector ISM in the US and the equivalents across Europe on Friday. All before the weekend’s 100m Olympic final. A fitting end to a hectic week.

Jim Reid

Colin Tan, CFA
Research Analyst

Deutsche Bank