BOJ, ECB Surprises, Makes for Treacherous Markets

The failure of euro zone and US officials to give the markets any sense of meaningful closure to their policy challenges is eliciting a response by central bankers.  Switzerland got the ball rolling yesterday, with a new attempt at quantitative easing and symbolic rate cut.  It has been joined by the BOJ, which announced an increase in its asset purchases plan and intervened directly in the foreign exchange market.  This in turn has now been followed by the ECB.  It has confirmed that it was re-opening the 6-month refi facility and was going to resume its bond purchases.  At the same time, ahead of tomorrow US employment report, there is much speculation about increased risks of a renewed economic downturn in the world's largest economy and potential for QEIII. 

For investors these are treacherous waters.  The euro has dropped more than 1% and has reached its lowest level since July 19th.  It has traded on both sides of yesterday's ranges.  A close today below $1.4144, yesterday's low would further weaken the technical tone.  Support is seen near $1.4100 and then $1.4060.  German 2-year yields have collapsed (while US 2-year yield has simply drifted lower) and the net consequence is for the 2-year rate differential to move another 10 bp in US favor.  The US discount to Germany now stands near 60 bp.  

When the euro peaked earlier this year the spread was just above 130 bp. It would seem as if the US debt debate, the risk of a technical default and the risk of a downgrade, has softened the linkage with the euro-dollar exchange rate, but it is still evident.  

The BOJ's intervention caught the market wrong footed and me included.  I had thought that volatility was not very high, international support would be lacking, the economy was recovering from the earlier tragedy, and that these considerations would keep the intervention in the oral phase.  Wrong.  

It is a bit of a mug's game to estimate the size of intervention, but it did manage to briefly push the dollar above JPY80 from around JPY77.  However good offers were encountered--including, according to market talk, Japanese exporters.  The underlying driver of yen (and Swiss franc) demand remain, namely US and euro zone political economy challenges.    In retrospect, I did not appreciate how the Swiss actions yesterday increased the pressure on Japan to act.  

Moreover, if my sense that a weak US jobs number tomorrow, coupled with the increased fiscal drag next year for an economy that appears to have all but stalled in H1, could intensify QE3 prospects, a preemptive strike in the foreign exchange market may be reasonable.  Better the dollar comes off from JPY80 than JPY77 or JPY76.  

The ECB is being forced to re-enter the fray because the European political class is acting at its usual technocrat speed, while the markets and investors occupy the instantaneous world of modern capital.  It will take several weeks still for the EFSF to be made new through parliaments endorsing the recent and even then it may be too small for the tasks given--pre-cautionary lines of credit, bond purchases and loans.  

The resumption of ECB bond purchases was not a unanimous decision.  Last time Weber and Stark objected.  It will be interesting to see if Weber's replacement and Stark (i.e., Germany) were again the holdouts.  Market talk suggests ECB bond purchases were limited to Ireland and Portugal.  If the
ECB is not buying Italian bonds, why should investors, seems to be the thinking as Italian bonds succumb to more selling pressure.   Italy has about 237 bln euros of debt maturing and needs to be rolled over here in H2.  Spain has about 150 bln euros.    Italy's 2 and 5 year yield is above Spain's, though the 10-year Italian yield is about 10 bp below Spain's.  Both Spain and Italy's 10-year yields are establishing a foothold on a the 6% handle.  There is an "inside baseball" debate among economists precisely where the Rubicon lies.  Most seem to place it between 6.70% and 7.0%.    

As highlighted here yesterday, the French 10-year premium to Germany is widening and by another 5 bp today.  The spread is at a record and the more Italy comes under pressure, the more France will.  Trichet was specifically asked if Italy would opt out of the second aid package for Greece.  Trichet's answer was not very revealing.  Yet I would continue to argue that if Italy does opt out, to save its funds for its own needs, French bonds were under-perform and its triple-A rating would likely be put at risk.