Markets and euro cheer the ECB decision to backstop sovereign debt
10/Sep/2012 • Currency Updates•
Draghi’s announcement last Thursday that it will intervene without limit to support sovereign bonds of countries under bailout programs brought about a massive rally in financial markets generally, and particularly in the euro. Markets correctly view this step as removing the short-term risk of a complete euro breakup, and the removal of this critical downside risk brought about a serious bout of euphoria in financial markets.
Additional bullish news came out of China, which announced another infrastructure stimulus project accounting to about 2% of GDP and triggered a massive rally in Chinese equities. In FX markets, the euro rally was supported not only by the ECB policy change, but also by yet another lacklustre payroll report out of the United States that pretty much guarantees additional unconventional monetary easing from the Fed as early as next week’s meeting.
As we and the consensus expected, the Bank of England announced no change in policy at its September meeting last week. More importantly, a surprisingly strong set of PMI reports buoyed optimism that the UK economy may finally have grown moderately this quarter, after three straight quarters of contraction. The composite PMI at 52.6 is consistent with a moderate economic expansion, particularly when combined with the temporary factors that depressed output in the second quarter. We will wait for further data (particularly in consumer spending) before releasing our forecast for GDP growth in the third quarter. Sterling, however, did not react strongly either to the PMI data or the Bank of England announcement, and continued its recent pattern of behaving like a low-beta version of the euro, rising 0.7% against the dollar for the week, but dropping 1.2% against the euro.
Draghi’s decision to announce unlimited intervention in support of sovereign bonds for those countries that have requested a bailout was widely expected. However, the terms were somewhat more structural than the consensus had been expecting. First, it refused to set explicit yield caps, which will tempt markets to test the ECB results and risks periodic bouts of market instability. Second, no country will receive this assistance unless it has requested and received a full bailout program, with the conditionality and austerity that it entails. Third, the widely expected intervention in Portugal’s sovereign debt did not materialize. Overall, we would consider Draghi’s intervention to be a mild disappointment. The market, however, reacted euphorically, sending the euro upwards to close above the 1.27 level for the first time in many months. As for macroeconomic data, moderately positive industrial production out of Germany was overshadowed by more disastrous data out of Spain. The payroll report there for August confirmed that job destruction continues at an alarming pace. While the economic sentiment index, which had hovered around 90 for a long time, broke sharply down to 83, we maintain our view that ECB intervention has removed the short-term risk of a euro breakup but done little or nothing to support the medium-term viability of the common currency. Hence the path of least resistance for the euro will continue to be down.
The all-important monthly payroll report delivered a jolt to the market. In addition to a disappointing headline of just 96,000 jobs created in August (barely sufficient to keep up with growth in the labour force), the internal details of the number were, if anything, even weaker. Wage growth was flat, and unemployment only dropped to 8.1% because of a decline in labour force participation. This report all but guarantees further unconventional policy easing out of the Fed when it meets next week. We continue to expect some sort of a surprise in the modality of such easing, and think the market is overlooking the possibility of a direct lending scheme modelled in that of the Bank of England.
Last week’s report, while disappointing, is still consistent with our forecast of 1.5-2.5% growth in the US economy for the remainder of the year.