Draghi Means Dragon

As European leaders take leave for their summer holiday's, ECB President Draghi has again stepped into the vacuum and has helped spark a recovery in the global capital markets.  Not only has the euro rallied to the highest level in a week, but Spanish and Italian yields have fallen sharply and the short-end has fallen more than the long-end.  

European equities have rallied and the financials are fully participating.  In Spain, at pixel time, the IBEX is up 2.8%, while financials are up 5%.   More broadly, the Dow Jones Stoxx 600 is up1.5%, and the financials are the strongest sector, up nearly 2.4%.  

What did Draghi say?   There are two elements that are important.  First, he said the ECB was prepared to do whatever it takes to preserve the euro, within its mandate.  This hints at new policy action and the ECB meets next week.  Second, he suggested that if the premium on government borrowing damages the monetary policy transmission mechanism, it is within the ECB's mandate to address it.  This suggests the resumption of the sovereign bond purchases program (SMP), which was the rationale for it in the first place, over German objections (led to two resignations, Weber and Stark).

Separately, but potentially related, the Spanish newspaper El Pais reported that the ECB may consider to relaxation of collateral rules.  This is more about liquidity than the transmission mechanism of monetary policy, but it fits into today's theme by underscoring potential ECB actions. 

This is different that Nowotny's comments yesterday, which we argued the market misunderstood.   By qualifying his willingness to do whatever it takes with a reference to the ECB's mandate, Draghi is not signalling giving the ESM, which does not exist now and will not for at least another six weeks or so, a banking license, as he has previously argued this is against the EU Treaties.  The fact that the European Investment Bank can borrow from the ECB is a different issue.  It is, after all, a bank.  Moreover, EIB borrowing from the ECB would not conflate monetary and fiscal policies.   

There is little doubt the transmission mechanism is broken.  That is a characteristic of the crisis.  Data reported by the ECB today have also underscored the sense of urgency.  The ECB reported with its money supply figures that Greece has seen a 4% drop in private sector deposits in June and deposits at at their lowest level since October '05.  Spain saw a 0.5% drop in private sector deposits, which now stand at their lowest level since before the crisis.  Deposits in Portugal fell 3.5% and 1.8% in Ireland.  Breaking the pattern, Italy reported a 2% rise in deposits and France and Germany reported a 0.4% increase.  

Separately, French Finance Minister Moscovici made some parallel comments.  He suggested that the use of EFSF funds to buy sovereign bonds has not been ruled out.  He also said that market intervention should not be still born.   This is not a new position for France, but coming on the heels of Draghi's comments and it also points to a resumption of the SMP operations.  

This is unlikely to be the "spread shield" that Italy's Monti has advocated, which is some kind of automatic effort triggered when the sovereign spreads widen beyond levels officials agree with.   There is little chance of this happening.  Interest rate spreads cannot be targeted.  

While we have been anticipating an upside correction in the euro and other major currencies in the second half of the week, the recovery has extended beyond what we had projected.   In part, our expectation of a bounce was that conditions had reached a point that in the past elicited a policy response.  

Previous resistance in the $1.2160-70 area should now offer initial support for the euro.  On the upside, as the $1.2300-30 area is approached, look for bears to make a stand.  Sterling has completely shrugged off the unexpectedly large contraction in Q2 GDP reported yesterday and is more than 2 cents off the lows recorded in response.  The $1.5680 area offers initial resistance now, but there is potential toward $1.5740.  Support is now seen near $1.5550.  

The greenback has support near CHF0.9760 and then CHF0.9720.  A convincing break could spur a move toward CHF0.9660-80.   The dollar is also set to test support against the Canadian dollar in the CAD1.0050-65 area.  The Australian dollar is trying to establish a foothold above $1.04.  Near-term potential extends to $1.0440 and then $1.0470.