What Nowotny Did Not Say

There seems to be some confusion in the markets.  Many think that the head of the Austrian central bank and ECB member Nowotny raised the likelihood that the ESM could get a banking license.  This would allow it to borrow from the ECB to supplement its funds and make for a practically unlimited war chest. 

It would help address concerns that the current funding plan is insufficient to meet the potential need, especially if Spain needs a full package and Italy needs assistance.   Moreover, it appears Portugal may need more aid and there is Cyprus and Slovenia in the wings.  

In fact, Nowotny did no such thing and revealed little new.  He said that while there were arguments in favor of it, there were also counter-arguments.  On one hand he said that it was the subject of ongoing discussions and then seemed to have quickly added that he was “not aware of specific discussions within the ECB at this point.”  

There are good reasons not to expect the ESM to get a banking license any time soon.  First, the ESM does not exist at the moment.  It cannot be established without Germany and Germany is waiting on ruling from its Constitutional Court.  As a defender of German sovereignty, the Court may be reluctant to rule against something that parliament has already approved, but may put more limits on what can be done without parliament's approval.

Second, there are profound arguments against granting the ESM a banking license.  The ECB President Draghi it as recently as two months ago on grounds that it would violate the EU treaties that prohibit the central bank from financing government deficits.  The blurring of the line between monetary and fiscal policy is problematic.

Thirdly, it is not clear what kind of controls could be put into place.  Unlimited ESM borrowings could, without parliamentary approval increase German (and other creditors more generally) contingent liabilities.

The euro's bounce today is more understandable from a technical perspective.  The euro had finished the NY session lower for the past five sessions and although there was a longer losing streak in the second half of May, this streak and levels left prices stretched.  Moreover, as argued previously, the magnitude of the moves, especially in Spain and Italian debt markets, had in the past sparked some policy response.  In addition, there string of disappointing US economic data has continued and the FOMC meets next week and there is no prize for guessing the direction of its guidance and/or policy response.  

Yet the technical bounce in the euro cannot be sustained for long.  The situation in Europe is getting worse and European officials are more or less on holiday.     The porch light is on, but no one's home and this gives the market forces, which none less than the German finance minister has said is wrong for driving up Spanish yields, freer rein.    Over the next few sessions consolidative price action is likely with the ranges seen Mon-Tues--roughly $1.2040-$1.2180--likely to confine the bulk of the action.