Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Saturday, 4 August 2012

ECB Declares Silly Season Open


The silly season is clearly upon us. It is the best explanation for Friday’s rally. Just like medieval priests interpreting holy texts to accord with their own worldview, the market has found a more appealing and convenient interpretation on re-reading Draghi’s remarks. Therefore equivocation is yet again greeted by jubilation. The plot is becoming tired having been repeated since the beginning of 2010: 
1. Panic as inevitable collapse looms; 
2. A few off-the-cuff remarks to instill hope; 
3. Panic abates, hope rises; 
4. Some summit/meeting/press-conference occurs; 
5. An equivocal and ambiguous statement of “solidarity”, “policy makers realise concerns”, “new and improved bazooka”; 
6. Sharp rally as fools rush in.

There is not much on offer looking at Draghi’s statement. Ignoring the “Euro is irreversible” rhetoric which is meant to calm the masses (“Peace for our time” anyone?) the critical two paragraphs which the high priests of optimism have interpreted to hail Draghi as the saviour are as below: [emphasis mine]

“The adherence of governments to their commitments and the fulfillment by the EFSF/ESM of their role are necessary conditions - not sufficient, necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective.

In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.”

Once again the market assumes that the statement “We may do something” is equivalent to the statement “We will do something”. It further assumes that “concerns about seniority will be addressed” means “We will consider ourselves pari-passu with other private holders”. The latter is a reasonable assumption considering that not even the ECB is that stupid to declare itself a senior creditor. However, someone (read governments) will have to underwrite all that credit risk unless ECB feels brave enough to operate on negative capital. Now the governments which have the ability to underwrite the credit risk are also the ones unwilling to underwrite it. Of course, Italy and Spain can once again guarantee SMP purchases like they have guaranteed EFSF and ESM but only a lobotomised optimist would find it credible.

And yet again the promise of future action, “over the coming weeks…” seems to have lulled the optimists into somnambulistic buying. What has been ignored is Draghi's emphasis on official request for aid and the conditionalities that go along with it before any action by the ECB (which may or may not happen). The relevant paragraphs are below [emphasis mine]:

“In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination.

As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist - with strict and effective conditionality in line with the established guidelines.”

This is a nice back-heel pass to the Eurozone governments. FT reports that Spain wants aid but in typical fashion without many (any?) conditions. The chances of that are slim unless Rajoy again manages to ambush Merkel at the next summit (which by the way is going to decisively solve all problems).

The importance of ECB awaiting government measures is being ignored. The high-priests of optimism have interpreted “must stand ready to activate EFSF/ESM in the bond market” as “will activate EFSF/ESM in the bond market”.

Leave aside the fact that EFSF/ESM do not have sufficient firepower to stop a Spanish/Italian meltdown unless ECB monetises copiously. The bigger immediate problem is that Draghi has clearly isolated the Bundesbank with his “The voting was…basically unanimous with one – with one reservation” (Orwell would have loved this – ‘unanimous with one reservation’). In the question and answer session he dismissed Weidmann’s concerns “…the endorsement to do whatever it takes to preserve the euro as a stable currency has been unanimous. But it’s clear and it’s known that Mr. Weidmann and the Bundesbank…we should never forget that they have their reservations about programs that you see buying bonds”.

He seems to suggest that the Bundesbank is going to be voted down and its sound money policies are going to be replaced by policies undertaken by the French and Italian central banks in the 70s and 80s. If this is the case then the Germans are going to be even harsher in setting aid terms. That is assuming they countenance the impertinence of relegating their beloved BuBa to the fringes of monetary policymaking. In the words of Weidmann “We are the largest and most important central bank in the Eurosystem and we have a greater say than many other central banks in the Eurosystem.” 

Riding roughshod over Weidmann's objectives may not only have repercussions on German policy on Eurozone bailouts but may also lead to his resignation. To have lost two German representatives from the Board may be carelessness but to lose three will be a calamity. The credibility of the Euro and its current strength derive from the assumption that the Bundesbank is firmly in charge. But if this is not the case then the Euro should make the transition from trading like, an albeit weakened, Deutsche Mark to the Italian Lira. The market is practicing doublethink when it pushes the Euro up on news of potential monetisation. 

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