So Mr. D spoke and said nothing at all. Those that expected a “big stick” from the boss at the ECB are very disappointed. The initial market reaction to this dud is a down move in equities and the Euro while Italian and Spanish yields soar. Given the high expectations Draghi set the market up for, I can’t imagine a worse outcome.
I read through the (very carefully worded) press release looking for something. There are few sentences that have me wondering. The first comes from the summary section where Draghi says:
decisive and urgent steps need to be taken to improve competitiveness
Okay, that sounds nice. But what does Draghi mean when he says “competitiveness”? Does he mean between Spain and Germany? Maybe.
One way to achieve the competitiveness that Draghi seeks, is to further punish the Spanish economy, and push unemployment higher (it’s now 24%) in a desperate attempt to push unit labor costs down. That would be an insane approach. Spain is already on its knees. Pushing the economy further into depression is not going to help at all. Also, a process like this would take years before the pain is converted into some gain.
Draghi used the word “decisive”. To me, this word implies something that might be considered a “game changer”. A multi year depression is not decisive, It is slow death. It is also politically unacceptable. Spain (and Italy) are not going to accept that they must have a depression to save France and the rest of northern Europe.
A step that would be “decisive” would have to be on the currency front. This gets us back to the talk of bringing back the Peseta (and the Lire), or some form of two tiered Euro. But I don’t think Draghi was suggesting that there would be a Euro breakup at this time in history. He was very clear on this when he said:
The euro is irreversible.
He also confirmed (to me) that there ways no “Euro breakup” in his mind when he made clear that the ECB/SMP would be buying more Spanish bonds at some point in the future. If there were a two-tiered Euro, the portfolio losses at the ECB/SMP would be enormous. The losses would be larger still if more purchases are made.
I conclude from all this that the probability of some kind of currency reshuffle within the Euro Zone is not in the cards at this time. But I’m still confused how Draghi thinks he can achieve the “urgent” improvement in competitiveness. There might be a clue from Draghi in the press release. I thought these words were odd:
Downside risks (to the economy) also relate to possible renewed increases in energy prices
Huh? What’s this about? Does Draghi know something about energy prices that I don’t?
In the statement, Draghi makes it clear that the Euro area is slowing. He also is no dope, he knows full well that the USA, S. America, India and most of Asia are also slowing down. There is nothing in the global economic mix today that would suggest that energy prices are going to rise anytime soon. So why would he make a point about it? Even more curious is why he would repeat his warning in the next paragraph when he speaks about the risk of rising inflation:
Upside risks pertain to further increases in indirect taxes, owing to the need for fiscal consolidation, and higher than expected energy prices over the medium term.
What is the one thing that Draghi could do that would cause energy prices within the Euro Zone to rise?The answer is he could cheapen the Euro versus the dollar. Absent a global increase in the price of crude, the only thing that would cause energy prices to rise in the EU would be a significant depreciation of Euro versus the dollar (and the Yen).
If Draghi was really serious about the “competitiveness” issue, then he would certainly be looking for a cheaper Euro that would “decisively” and “urgently” address a fundamental flaw of the Euro. It is dramatically overvalued.
We know that the Germans hate all the monetary options that Draghi would like to use in his war with the bond markets. Things like more bond buying, LSAPs and QE are not going to happen because of German opposition. However, the titans of German industry would jump for joy at the prospect of a 20% devaluation of the Euro. Merkel is up for reelection and she desperately needs those titans on her side. She also needs to have some improvement in the domestic economy. More workers making BMWs and VWs are just the ticket for Angela.
There is one other piece in this puzzle. What would the USA have to say about a plan that would cheapen the Euro versus the buck? On that score, I do wonder about the meeting last week that Timmy Geithner had on an island in the middle of the North Sea with those EU “deciders.”
If the Euro were to weaken it would be a body blow to the US economy. It would be exactly the type of situation where the US Fed would act. A “decisive” effort to depreciate the Euro would give Bernanke the excuse he needs to put a big QE package on the table.
I was very surprised that Ben chose to “do nothing” yesterday. I wonder if this is not all being orchestrated behind closed doors. Ben needs the ECB to act first, and then he will quickly follow suit with an action plan of his own. This could happen between the scheduled meetings.
Is this far-fetched? I admit it is, but I don’t see any other options on the table. A significant change in the EURUSD rate is not out of the question.
I would not be long the Euro for a bit, just in case. And yes, I’m talking my book. From a week ago (Link):
I bet all of my recent FX gains on a short EURUSD option strategy. I missed a big blip that got the Euro above 1.2400, and ended up with a fill a bit over 1.2300.
Images: Flickr (licence attribution)
About The Author – Bruce Krasting
I worked on Wall Street for twenty five years. This blog is my take on the financial issues of the day. I was an FX trader during the early days of the ‘snake’ and the EMS. Derivatives on currencies were new then. I was part of that. That was with Citi. Later I worked for Drexel and got to understand a bit about balance sheet structure and corporate bonds from Mike Milken. I was involved with a Macro hedge fund later. That worked out all right, but it is not an easy road. There was one tough week and I thought, “Maybe I should do something else for a year or two.” That was fifteen years ago. I love the markets. How they weave together. For twenty five years I woke up thinking, “What am I going to do today to make some money in the market”. I don’t do that any longer. But I miss it.