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Jens Weidmann, president of the German central bank, called the European markets "calm" this week. The euro (NYSEARCA:FXE) has shown short-term strength, European sovereign bonds rallied and European equities are holding up. All this is happening despite economic weakness across the eurozone, Italy's inability to form a government and a very awkward solution to the Cyprus crisis. The European calmness is aided by global liquidity and search for yield (thanks, in part, to Japan), but also reflects some positive steps taken by the ECB. An ECB rate cut seems likely in the next few months, but the ECB is largely sitting on the sidelines while the Federal Reserve and the Bank of Japan increase their balance sheets. This environment seems largely supportive of the euro. In this article I will examine recent comments by ECB President, Mario Draghi, and Jens Weidmann as well as the performance of the euro and other European asset classes.

The Next Step For The ECB

Last week I discussed the fact that the ECB is falling behind the Bank of Japan and the Federal Reserve in terms of money printing (Euro Strength Continues...).

The ECB will likely act at some point to confront economic weakness and low inflation, but the next move by the ECB will probably be a rate cut (maybe at the next meeting, but I am not sure it will happen so soon).

On April 15, Mario Draghi delivered a speech titled, "The role of monetary policy in addressing the crisis in the euro area." His main point was that the ECB has done a lot to deal with the crisis in Europe, but going forward the heavy lifting needs to be done by the politicians, not the ECB:

"The way out is to restore competitiveness. And the way to do this in the context of a monetary union is to pursue with determination an ambitious structural reform agenda. Such an agenda comprises a number of national measures to make sure that the functioning of product and labour markets is fully compatible with participation in monetary union. One specific aspect is to fight vested interests that hamper competition, structural weaknesses of productivity and to allow, where needed, the nominal adjustments to play out...

And let me be clear: undertaking structural reforms, budget consolidation and restoring bank balance sheet health is neither the responsibility nor the mandate of monetary policy. Monetary policy can only avert an abrupt deleveraging that would have been conducted in an environment of panic and fire sales. And this is what we have done in order to avoid deflationary downward spirals that would have prevented us from delivering on our mandate of preserving price stability in the euro area."

Draghi does not seem to have much appetite for another large scale program by the ECB.

One factor that could prompt some action from the ECB sooner rather than later is the threat of deflation. Last week, three members of the FOMC mentioned concerns about inflation not meeting the 2% target and the possibility of additional monetary policy accommodation to push up inflation.

The causes of low inflation in the U.S. are the same in Europe: high unemployment prevents wage inflation and falling commodity prices will bring down the price of many goods. The ECB may use below-target inflation as an excuse to cut rates.

The euro would likely weaken if the ECB cuts interest rates. However, the ECB would still be far behind the Fed and Bank of Japan in the race at the printing press, so the effect of a rate cut may be limited.

Jens Weidmann's comments last week were initially interpreted as favoring a rate cut, which caused a sharp drop in the euro. The Wall Street Journal reported:

"In an interview with The Wall Street Journal, Bundesbank President Jens Weidmann signaled that the ECB could reduce interest rates if incoming data suggest it is warranted. But he warned such a move wouldn't turn around the euro bloc's economic fortunes." (source: WSJ)

Like Draghi, Weidmann thinks that the ECB does not have the main responsibility for fixing the problems in Europe. The ECB is doing its part, but the structural problems need to be addressed by others.

The comments by Draghi and Weidmann did not add a lot of new information to the debate about the ECB's next move and the future direction of the euro. There is increasing chatter about an upcoming rate cut by the ECB, but it seems like there is no imminent large scale quantitative easing program.

Euro Price Action

The euro has been strong since the Cyprus crisis. It experienced some volatility following Weidmann's comments and closed the week at $1.3049, down a bit from the previous Friday. Importantly, the euro stayed above a few important technical levels, though it has been trading around the 200-day moving average for a few days.

(click to enlarge)

(Source: FreeStockCharts.com)

European Sovereign Bonds

Like the euro, the European sovereign bond prices have been strong since the Cyprus crisis.

Last week bond yields dropped across the board and spreads tightened for the peripheral countries.

Italy still has not established a new government, but there may be some progress (Italian Lawmakers, After Stalemate, Re-elect President to Second Term).

I thought that the Cyprus crisis would end the rally in Italian and Spanish bonds, but they have continued to perform well. Importantly, the Italy-German spread for 10 year bonds fell below 300 bps last week for the first time in a while.

(click to enlarge)

(Source: Bloomberg.com)

The Japanese QE program and the global hunt for yield are likely attracting global investors to European bonds. If capital is flowing to the European markets, the euro is likely benefiting as well.

European Equity Markets

The European equity markets had a mixed week, but Italy rallied.

The following chart shows the five-day price action for the iShares MSCI Germany Index Fund (NYSEARCA:EWG), iShares MSCI Italy Index Fund (NYSEARCA:EWI), and iShares MSCI Spain Capped Index Fund (NYSEARCA:EWP), and the SPDR EURO STOXX 50 ETF (NYSEARCA:FEZ).

EWG Chart

EWG data by YCharts

The financial sector closed the week on the downside.

The following compares the iShares MSCI Europe Financials ETF (NASDAQ:EUFN) with the iShares MSCI EMU ETF (NYSEARCA:EZU).

EUFN Chart

EUFN data by YCharts

I have been following Banco Santander (NYSE:SAN) as a possible play on strength in the European markets. I have not invested yet, but continue to follow the stock. Last week, Banco Santander was mostly flat, but did better than the broader financial sector.

EUFN Chart

EUFN data by YCharts

This chart shows the key levels for Banco Santander in more detail.

(click to enlarge) (Source: FreeStockCharts.com)

Impact of European Equity Markets on U.S. Equity Markets

Unlike last summer, the weakness in European equities is not a catalyst for the U.S. markets.

The following compares the S&P 500 (NYSEARCA:SPY) and the Financial Select Sector SPDR ETF (NYSEARCA:XLF) with their European counterparts, the EZU ETF and the EUFN ETF.

SPY Chart

SPY data by YCharts

Conclusions

European markets continue to be resilient. European sovereign bonds have been especially strong, likely attracting foreign investors in the hunt for yield. This dynamic would also be a positive for the euro.

The ECB will likely cut interest rates at some point, but a larger scale QE program does not seem imminent. Therefore, the ECB will likely continue to lag the Bank of Japan and the Federal Reserve in balance sheet expansion. It is important to note that the ECB's primary mandate is to maintain price stability and does not have a dual mandate like the Federal Reserve.

The euro may weaken if the ECB cuts rates, but the ECB's relative inaction may support the euro until other central banks dial back quantitative easing.

Europe faces a lot of challenges for the long term, but there are some factors that are supporting the euro and European assets in the short term.

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Source: Europe Is Calm: The ECB's Next Move And Impact On The Euro

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