QE2 in the EMU – Not Likely

The US dollar rally continued to soften as the market prepares for the ECB rate announcement. The market expects the ECB to announce additional liquidity provisions to attempt to quell the fears emanating from Europe’s liquidity/solvency crisis, though we suspect that the ECB is unlikely to announce a massive extension of bond purchases.  We feel, however, the ECB will continue to provide liquidity through its MFI operation, which may leave the market disappointed and stoke a rise in volatility in the sovereign market, unraveling some of the euro’s recent gains.  Yet the euro continues to maintain yesterday’s trading range and will need to get above the August 62% retracement level of $1.3235 to garner further support. Meanwhile, sterling rallied on the back of the positive European news and continued to rally, moving into $1.566 highs, following the strong construction PMI numbers yesterday.  And the combination of strong global PMI’s and the rise in risk appetite eased demand for safe haven currencies, thus weakening the yen.  Elsewhere, a plunge Australian retail sales came after yesterday’s softer-than-expected GDP clip, which added further fuel to market expectations of a steady RBA and continued weakness in the Australian dollar falling to lows not seen since late September, despite the marginal recovery in risk appetite. 

Global equity markets are solidly higher, boosted by strong risk appetite, following the host of better-than-expected global PMIs and a possible liquidity extension from the ECB.  Namely, Asian stocks shifted higher once again with the MSCI Asia index up 1.4%.  Meanwhile, the Nikkei is up 1.8%, led by solid gains in technology and industrials.  At the same time, the Shanghai Composite is up 0.7% with a 1% gain in financials.  European bourses were up, after hitting an eight-week low, with the Euro Stoxx 600 up nearly 0.5% led by a gain in financials.  Meanwhile, the FTSE and Dax were both up as well with the FTSE outperforming, up by 0.8%, led by a gain in materials.  The Dax is up 0.1% led by a 1.7% rally in consumer service with the S&P futures up 0.2%.

European sovereign bonds yields continued to decline with Spain and Italy leading the decline as Spanish and French bond sales saw healthy demand.  Spain’s 10-year yields, for instance, are down 12bp followed by a 6bp decrease in Italy’s yields.  At the same time, Spanish 3-year yields plunged 16bp after the nation drew stronger demand for three-year notes than at a previous auction in October.  Spain raised €2.5bln with an average yield of 3.717% from 2.527% in October.  Elsewhere in the periphery, 10-year Greek yields are down 1bp, Portugal’s 10-year yield is down 2bp with Belgium 10-year yields down 3bp. Meanwhile, 10-year German yields are up 2bp with the 10-year US Treasury up 1bp, increasing the Germany’s yield advantage and aiding euro strength.

Currency Markets

Today is the most important ECB meeting in several months.  Nervousness ahead of it has encouraged some modest position adjusting across asset classes.  Given that the Irish aid package failed to stabilize the markets, many are looking at the ECB step into the breach and mitigate the risks of contagion spreading into the core of Europe.  To us it seems that there are only four potential courses of action.  The first is simply not to take any new initiative and continue with its plan to continue to normalize operations. Currently the ECB provides unlimited amount of 3-month funds at a fixed rate of 1%.  The next step would be to auction the three-month money, which if done in sufficient size could still be fairly generous in terms of liquidity.  This would like see a strong against the euro and European bonds.  Second, the ECB could signal that market conditions do not yet allow it finish the normalization process.  This also risks a negative market reaction on disappointment.  Third, the ECB could re-introduce a longer-term repo, like a 6-month or 12-month repo.   Although this would provide extra liquidity, the market likely see it as a subsidy for insolvent institutions.  However, what would banks do with that extra liquidity?  Likely buy their sovereign bonds, like they did before.  Fourth, the ECB could buy more sovereign bonds.  Reports indicate that Spain, Portugal and Italy have been pressing this case.

Some comments suggest the French are sympathetic.  German officials clearly are not while Trichet does not seem to be and his reference to it recently probably needs to be understood in the context over what happened in May, when he said it was not discussed, only to reverse himself shortly afterward.  His citation of the size of the broad governing board could be read as a note that more than Germany decides ECB policy or that Trichet did not want to stick his head out.  The latter seems more likely.   In the absence of a fiscal transfer, which is politically untenable, especially given the German constitutional court challenges, QE has certain merits.  However, we are concerned that it would not solve the real problem. Banks in some peripheral countries have not access to funding outside of the ECB.   Recall what Portugal’s central bank reported within 48 hours of the Irish package:  sovereign difficulties had forced banks into a "permanent and large scale" dependence on ECB funding that is not sustainable.   If the ECB were to buy more Portuguese bonds, for example, would Portugal banks be more welcome in the wholesale funding market?  Large-scale ECB bond purchases would also look a lot like a fiscal subsidy (which is part of Germany’s objections).  Spain–federal government, regional government and banks need to roll over €253bln of debt next year and likely raise a €60bln more.  Italy–government and banks–have to roll over more than €300bln next year (concentrated in Q1).  Meanwhile, other potential courses, like increasing the EFSF or issuing euro bonds, like Junker has suggested is not in the ECB’s domain.

Upcoming Economic Releases

At 8:30 EST / 12:30 GMT US reports initial jobless claims for the week of November 27. The one-month moving average hit a two year low last week (436k) and the consensus for the claims to fall below that again (424k).  October’s Pending home sales are expected to rise to -0.9% from -1.8% in September.  Events: A host of Fed speakers schedule to appear including Plosser (non-voter), Bullard (voter), Duke (voter) along with the Treasury’s Warren.  In Canada Toronto-Dominion Bank/Canadian Imperial Bank release 4th quarter results.

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