Not So Super Mario
By Benjamin Streed
August 06, 2012
Last week’s FOMC announcement was greeted with mixed feelings; the market abruptly pushed Treasury yields lower and then steadily reversed-course after it had time to properly digest the news. The committee maintained an accommodative stance by stating that it, “will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability”. The equity markets weren’t thrilled with the release and stocks fell on the disappointment that Chairman Bernanke refrained from adding additional measures to its monetary policy. The FOMC has indicated that it intends to continue to review economic data despite weakening consumer spending, stubbornly high unemployment, slowing manufacturing and weak payrolls growth. Until its next meeting in September the committee will have a chance to review unemployment data from both July and August to get a clearer picture of the unemployment situation before making any policy decisions. To summarize the release, the Fed is taking no action but will “wait and see” how things shape up in the next few months before it pulls the trigger on any new monetary policies.
On the exact opposite front, European Central Bank (ECB) President Mario Draghi chose not to take a “wait and see” approach as his central bank decides how it intends to save the euro. Policy makers meeting in Frankfurt on Thursday kept the benchmark lending rate at 0.75%, a record low, which was generally expected by the markets. Similar to the FOMC’s release the prior day, much of the focus was on the ECB’s “signaling” provided by the press-conference whereby Draghi indicated that the central bank will undertake outright open market operations to help lower borrowing costs on the short-end of the yield curve. Many market participants have been demanding that the ECB enact powerful measures to help stem the seemingly unending European financial crisis that has plagued the region for years. The real feat for Draghi and the ECB will be convincing the ever-stubborn Germans that any proposed measures would not be considered direct bailouts of member countries, a practice currently prohibited under European Union law. Draghi previously stated that he was willing to do, “whatever it takes to preserve the euro” but it appears that his plan has done little to convince the markets that it will be enough to fix the embattled currency. The ECB’s Fed-like bond purchasing program is being called his “bazooka” although many details remain unclear and questions abound as to whether this will be enough to stop the ongoing fiscal turmoil in the region. Any action could be weeks, or even months, away and there are still considerable hurdles regarding EU law and proper implementation. The rough explanation of the plan is as follows: the ECB will directly purchase the sovereign debt of both Spain and Italy from their respective treasuries while simultaneously implementing austerity measures. The plan will likely be implemented in September when the European Stability Mechanism (ESM) takes effect with is massive €500 billion in bailout funds. This mechanism is currently tied-up in Germany’s highest court as to its legitimacy and is expected to have a court ruling on September 12th. Until then, the ECB would only have the paltry European Financial Stability Facility (EFSF) totaling €148 billion that are left over after last month’s Spanish bank bailouts. Unfortunately, much is being left to the imagination when it comes to the proposed plan as Draghi chose to provide limited concrete evidence of how the plan will actually work. Spanish and Italian bond yields showed a very temperate reaction to the ECB’s “bazooka”; Spanish 10-yr yields fell to 6.84% after being as high as 7.17% earlier in the week and Italian yields dropped to 6.05% after being as high 6.33%. Both yields are near their all-time highs and are only slightly lower now that the ECB has made its commitment to help ease borrowing costs in the two countries. According to the markets’ reaction, it appears that Mario’s weapon may have backfired. Looking ahead; between the FOMC rate decision scheduled for the 13th and the German court ruling on the validity of the ESM, September could be one of the most important months of the year.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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