Europe Drives Capital Markets

There is one overriding driving force in the capital markets today, and it is Europe.  The data, preliminary inflation, M3, and sentiment surveys are all read with an eye toward next week's ECB meeting.  In addition, Russian troops, tanks and weapons appear to be entering Ukraine under the guise of the insurgence.  This is like a rolling start to a war, and Lithuania officials have called it such.  This will be the key focus of next week's important NATO meeting.

Euro area money supply and preliminary inflation readings from Germany and Spain are better than anticipated.  However, the initial positive impact on the euro, which had carried the single currency back up to last week's lows, ran out of steam ostensibly on the back of the developments in Ukraine, though month end flows may be playing a role. 

Money supply, M3 rose to 1.8% in July from a revised 1.6% pace in June.  This represents the third consecutive monthly increase in the year-over-year rate.  Lending is still contracting but at a slower pace.  In fact, the pace slowed for the fifth consecutive month in July.   Lending to businesses was unchanged at -2.2% year-over-year.  Lending to households was unchanged at 0.5%.  It was mortgage lending, which is not included in the TLTRO calculations, improved from -0.4% to -0.1%.  

The German states that have reported inflation figures suggest that the national estimate may come in at 0.9% up from 0.8%.  The consensus expected an unchanged reading.  Spain's CPI moved deeper into negative territory, but not as much as had been feared.  The preliminary August rate stands at -0.5% after -0.3% in July.  The consensus was for -0.6%.  This may suggest that tomorrow's preliminary EMU reading may come in above the consensus 0.3% pace.  

There has been much speculation that the ECB could announce an asset-backed securities  purchase program at next week's meeting.  We suspect those investment banks that have been pushing this line are exaggerating the likelihood, and under-estimating the difficulties.  There are many hurdles that the BOE and ECB joint study highlighted, and these issues, including regulatory issues, have not been addressed yet.  

Draghi did say at Jackson Hole that the potential ABS purchase program was "fast-moving forward", but to take that to mean that it is ready, seems to be confused.  News yesterday that the ECB hired Blackrock to help advise also suggests that a purchase program is not imminent.     

Recall that just yesterday, ECB's Coeure indicated that for the ABS purchase program to reach its full potential, government's must guarantee at least some of the debt.  It is not clear whether this is an economic or political need.  According to S&P, of the outstanding ABS in Europe in mid-2007, only 1.6% defaulted.  In the US, the figure was closer to 19% (see subprime MBS).  The point is that Coeure's comment suggests additional hurdles to an ABS purchase program.  Existing ABS securities appear to be concentrated in a few countries, especially Italy and the Netherlands. 

Rather than an ABS purchase scheme, we suspect the risks are more aligned with a further rate cut by the ECB.    Now that the zero boundary has been crossed with the deposit rates, an additional cut is not as earth shattering.    It is almost as if going through Alice in Wonderland's looking glass the first time was a big deal.  Staying in it is less traumatic.   

The collapse of inflation expectations is significant and Draghi acknowledged it.  Some response is required and the large rally in European bonds, and the heaviness of the euro reflects this anticipation.  We are concerned that those looking for an ABS program will be disappointed.  There is also some risk of "buy the rumor, sell the fact" type of activity.  That said, the ECB meeting is still a week away.  

The North American session features weekly initial jobless claims and the second look at Q2 GDP.  Given the events in Europe, including Ukraine, next week's national jobs report and the historic nature of Q2 GDP, we suspect that today's US data will not distract participants.