Trichet's Feint Works for the Moment

The ECB must be pleased with itself.   The strategic ambiguity card that Trichet played yesterday is succeeding in supporting the peripheral bond markets and a relaxation of prices in the credit default swaps market.  Because the ECB never indicated a amount of sovereign bonds it would buy, an increase, as we have saw last week and this week, does not require an announcement or change of stance.  The ECB's Nowotny acknowledged that purchases were "energetic" this week. 

Recall that in the first week of the sovereign bond purchases back in May, 16 bln euros purchases were made.  Last week, the ECB purchased around 1 bln euros of sovereign bonds.  Estimates for this week's purchases are around 5 bln euros.  The market learns of the size of the purchases primarily through the size of the sterilization effort.  This is indicated late Mondays in Europe and will be a key focus for investors in the coming weeks. 

However, I remain skeptical that this will stem the tide for very long.  First, it does not address the funding for banks, such as those in Portugal and Ireland that have been locked out of the wholesale funding market since April/May.  With the ECB extending its emergency liquidity provisions through Q1, this enables continued dependency, which is really unsustainable.  

Second, it will not stop the rot from growing.  Specifically, Moody's placed six top rated Irish mortgage bonds on negative watch and S&P announced that it was placing Greece's sovereign BB+ rating on negative watch.  S&P also placed Portuguese bank on credit watch for possible downgrade (currently A1 long-term and A2 short-term).

Third, the political fallout from the crisis will continue.  The ruling Fianna Fail party in Ireland has seen its public support fall to new lows and this underscores the risks that new week, the Irish parliament fails to approve the 2011 budget, which is ostensibly part of the basis for the aid package.   The pricing of credit-default swaps on Italian banks have risen this week.  Prime Minister Berlusconi faces a confidence vote on December 14 and many expect his government to fall. 

It is Belgium that has the dubious honor of having the worst performing bond market in the euro zone this week.  It is among the most indebted euro zone member and, although its economy is expanding and it enjoys a current account surplus, it has been unable to form a government several months after the national election.  The government has to roll-over 75 bln euro of debt next year, and like Spain and Italy it is front loaded, concentrated in Q1 11.  Like several peripheral countries, banking assets in Belgium are a multiple (3.5X) the size of the economy.

In terms of the euro itself, the recovery in peripheral bonds have sparked a short-covering rally in the euro.  The euro approached the $1.3280 area.  A convincing break of this area could spur as much as another 2 cent advance from a technical perspective.  However, we think that participants will be reluctant chase the euro there ahead of the Irish budget vote.  Also, the 2-year US-German interest rate differential, which has tracked the euro-dollar exchange rate so well, is still moving in a dollar-supportive direction.  

Other news from Europe today seems largely irrelevant, but to note the service sector PMIs were generally on the first side as were euro zone retail sales in October (0.5%, more than twice the gain the market had expected).   

Look for a decent Canadian employment report (maybe the best in 3 months) and a respectable US employment report.  My own guesstimate is for an above consensus read and would not be surprised to see something close to 200k on the nonfarm payrolls.  Note that it would be the eleventh month of private sector job gains, i.e., every month this year has seen private sector payrolls grow.