Draghi: Call Me Maybe

ECB President Draghi appears to have gotten as much as he can get with his word play.  He has been fairly successful.  The pressures that were threatening Europe via Spain and Italy in late July were reduced and summer holidays were still enjoyed by his well placed suggestive comments.  

Spanish 2-year yields fell from over 7% before Draghi to about 3.35% last week.  Italian 2-year yields fell from about 5.25% to just below 2.90% last week.  In recent days, the yields have consolidated 15-20 bp above those lows.  

While Spanish and Italian bonds remain firm, though without any more upside momentum, we note that the price of insurance is beginning to rise.  The 5-year credit-default swap in Spain is just below 500 bp and is at its highest level in two weeks.  Italy's 5-year CDS is near 455 bp, which is approaching a 3-week high.  

A new, improved bond buying scheme by the ECB does not appear likely to be forthcoming at next week's ECB meeting.  There are three main parts that are missing.  

First, an ECB plan that works in conjunction with the EFSF and ESM cannot be fully developed until the German Constitutional Court makes its preliminary ruling on the ESM itself.   The decision is likely to recognize that the measure has already been approved by parliament, but the Court may look to more fully secure German parliamentary support when the institution is up and running.  

This in an of itself may not have an insurmountable obstacle and the second obstacle is even more potent.  The precise "modality" has not been fully worked out yet because it is such a contentious issue.  In part, that is one important take-away from the more ardent opposition by BBK's Weidmann in recent days, comparing bond purchases to a drug addiction.  Bond purchases do not simply violate the ECB's mandate, Weidmann suggests, but it is also morally problematic.  

Yet it is the third missing piece that poses both the necessary and sufficient cause for the ECB's inaction:  No one has formally requested its assistance.  Spain says it wants to know the terms and conditions first, which sounds proper enough, but then, recall that that is not the way the 100 bln euro bank backstop seemed to arise.  And in back channels, it appears Spain, or at least some officials, want to use part of those funds to support the sovereign bond market.  

The road is about to turn more treacherous for Spain, and yet tomorrow's 3- and 6-month bill sales should not be a problem.  Consider that on Sept 1, Spain's VAT is hiked 3 percentage points to 21%.  This can only be another weight on the leaden economy.  Industrial action and protests are likely to intensify in the coming weeks as people resist measures that will surely erode the quality of their lives and their children's lives.  Only now do the official forecasts recognize that the contraction is going to be deep and long.  Some time in September, Moody's is expected to revise Spain's credit ratings.  It could lose its investment grade status, which would also have negative implications for the banks' ratings.  

In terms of the net financing needs in the remainder of the year, Italy seems to be in a considerably better position that Spain.  Italian banks also appear to have greater capacity to buy government bonds than do Spanish banks.  Italy's 10-year bond auction later this week (Aug 30) should be easily absorbed.  

Italy's economy is weaker and the budget deficit bigger than officials recognized earlier. However, the more pressing challenge may be more political than economic.  One of the virtues of Monti's technocrat government is that strides were made toward injecting a bit more flexibility into the economy.  The bulk of what he can accomplish is done.  He has ruled often by decree and this raises questions over the sustainability of his accomplishments.  

After years of Berlusconi rule, Monti represents the old elite (bourgeoisie?) regaining the reins of government.  However, to firmly re-establish its interests it requires more than a year, no matter how talented and experienced Monti may be.  Moreover, perhaps because Berlusconi was largely pushed out by foreign adversaries  rather than domestic opposition, Italian democracy has further languished under Monti (in word and deed).

Draghi's comments in late July also sparked a recovery in the euro, which has appreciated about 5.5 cents.  As we argued about interest rates, we think the bulk of what can be accomplished by the his words has largely been achieved.  We continue to look for signs of a potential reversal in the euro's price action.   

We noted here that sterling and the Australian dollar, which generally led the euro's advance, appeared to have posted potential reversal patterns.  The modest pullback the euro has seen at the end of last week and today appears corrective in nature.  The market cannot feel comfortable in buying dollars ahead of Bernanke at the end of the week, even though it will likely learn that personal consumption expenditures rose more in July than they did in Q2.   

Draghi is scheduled to speak on Saturday at Jackson Hole.  This too may keep the dollar buying and euro selling in check in the coming days.  Draghi, even more than Bernanke, is unlikely to be very revealing.   It would not seem proper for the head of the ECB to provide some new information to a monetary policy wonks in a foreign country.  

Dollar bulls need to be patient, but another opportunity is near.