Notes From Underground: RUMOR OF THE WEEKEND–ECB WILL CAP RATES ON PERIPHERAL DEBT

There are several stories making the rounds this weekend that the ECB is planning to announce that it will CAP interest rates on Spanish and Italian DEBT. It seems that the ECB is floating an idea to see how the market responds to the idea of aggressive action by the ECB. Some are even calling it “THE BIG BAZOOKA.”

I personally detest the phrase as it is an atavistic remnant from the small mind of Hank Paulson. If Mario Draghi knows anything, it is that when you call attention to a price level, the market will test your ability and desire to defend that level. The highly regarded Swiss National Bank (SNB) has drawn the proverbial line in the sand on the EUR/CHF CROSS and it has led to a massive build up in the foreign reserves of the SNB and could prove calamitous for the Swiss financial system.

Some media sources are reporting that the way the CAP WOULD WORK IS THAT THE ECB WOULD CHOOSE A RATE DIFFERENTIAL BETWEEN ITALIAN 2-YEAR NOTES AND GERMAN 2-YEAR NOTES AND MOVE TO BUY ITALIAN DEBT WHENEVER THE SPREAD DIFFERENTIAL WIDENED BEYOND THE PRE DETERMINED LEVEL. THE SAME PRINCIPLE WOULD APPLY TO OTHER PERIPHERAL DEBT. The article originally appeared in Der Spiegel but the reference I cite is from the Business Insider article by Joe Wiesenthal.

Again, several media sources are running with the story but my inclination is to view it as a trial balloon. If this story had merit, my first inclination would be to get LONG GOLD because the market will press the ECB to test how serious it will be in defending some price level. Price targets are not a POLICY and the mere levels will not dissuade the markets from exacting its toll on any ill-conceived plan from Brussels and Frankfurt. The logical outcome is that the ECB would be forced to pump more liquidity into the system, thus creating a demand for assets that hold value. Draghi may hope that low rates on short-term debt force investors to invest further down the curve, but as we have seen the 2/10s steepen due to a lack of buying of the 10s, it would take an enormous amount of intervention for the ECB to be successful.

Until the clouds of uncertainty begin to lift over the EU, investors will keep sovereign debt risk to as short duration as prudent–defined by the size of LTRO.

An interesting article from Der Spiegel Online, “Attraction and Repulsion Define French-German Relations,” in which French intellectuals discuss the Franco-German axis of the European Union. The article raises the concerns about the recent fragility of the axis of the EU, which has been a concern of NOTES FROM UNDERGROUND. One view is that, “each of the leading powers,possess a key, and the keys can only be used together to liberate Europe from its tower of debt and the fetters of the financial markets. If Berlin is willing to cooperate, that is. But the German government’s intentions are mysterious. There is an unspoken suspicion that German Chancellor Angela Merkel … could be pursuing a hidden agenda and that her secret goal is to prepare Germany, the world’s third-largest exporter, for the fight for survival in the age of globalization.”

This view is significant as it means that France wants to maintain its present status and protect the French workers from the pains of global competition. President Hollande’s first order of business was to roll back the Sarkozy reforms of the 35 hour work week and the pension reforms on age and retirement. This denotes the major problem going forward: Germany wants to be competitive in the age of globalization and the French and others wish to maintain the status quo and have it financed by the German economic locomotive. Until there is some resolution to this philosophic chasm President Draghi can buy all the debt he wishes at a capped price but it is a mere band-aid on a huge wound.

As the historian Emmanuel Todd sums it up: “Merkel’s ‘austerity mandate’ and her ‘pact for eternal austerity’ in the European Union as a form of ‘fiscal fascism.’ Todd believes that two opposing cultures are colliding in the Euro zone: The German culture of free competition and the French culture of fraternal equality.” As the question of history always arises, Mario Draghi, what is to be done?

***An award goes to Ireland as it has been able to get its 2-YEAR NOTE down to a 2.013 % YIELD. The Irish 2/10 curve is a very steep 383.2 basis points, but this is an amazing feat for the Irish. It has taken an enormous toll on the Irish people as the economy has been in severe contraction, but it seems that the market is giving the Irish a short-term vote of confidence. This is a positive for Draghi as it momentarily relieves one problem and allows the ECB to concentrate on Spain and Italy.

Portugal has also seen a sizable drop in its 2-YEAR NOTE, which is currently yielding 4.47%. There’s still much work to be done but have to acknowledge the positives that have occurred.

 

 

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