Last week, stocks rallied on what was, for all intents and purposes, a rumor that the ECB would begin buying Spanish and Italian debt. The interesting thing about the rumor is that it was perpetuated by the ECB itself, as Mario Draghi said the following about the crisis (emphasis mine):
"To the extent that the size of these sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate...Within our mandate, the ECB is ready to do whatever it takes to preserve the euro…believe me, it will be enough."
Note that what Draghi has done is tie high periphery sovereign debt yields to the central bank's broken monetary policy transmission channel. Draghi is referring to the fact that retail interest rates have decoupled from official rates in Spain and Italy. In fact, as I noted last week, the periphery is experiencing "transmission reveresal," meaning that retail interest rates are moving in the opposite direction of the official rate.
It was critical that Draghi made the connection between the two and I certainly doubt it's a coincidence that the research report which showed that retail rates in the periphery were increasingly dependent upon sovereign spreads came from Goldman Sachs where Draghi was once vice chairman and managing director. Now that Draghi has connected sovereign debt yields with the monetary policy transmission channel, he can justify the purchase of sovereign debt by reference to the latter's deleterious effect on the central bank's monetary policy, and, by extension, monetary stability. Just like that, Goldman's research serves as a justification for the ECB to buy sovereign debt.
In any case, setting aside the fact that sovereign debt purchases will likely not work because they will trigger subordination fear selling by private creditors, Germany is unlikely to go along with the idea. Germany's finance minister Wolfgang Schaeuble has already said that rumors of ECB bond buying were "speculation" and "not true." Worse still, according to Reuters, Joerg-Uwe Hahn, an FDP leader in Germany's centre right coalition actually suggested that Germany sue the ECB over last week's rumor:
"The European treaties allow member states to sue the ECB..."It's time to open the toolbox of the (EU's) Lisbon Treaty and see how one can ensure that the ECB is brought into line to focus on its original task: monetary stability"
Meanwhile, the crisis is speeding toward a potential trainwreck in September when Germany's high court will decide whether the European Stability Mechanism (ESM) is permissible under the German constitution. If the result of that decision is negative, the ESM will not have the firepower necessary to support Spain and Italy. Of course, the ESM is already deficient in terms of firepower:
"... even when you include the EFSF's 200 billion euros and a hypothetical 150 billion from the IMF, the amount available is not even close to sufficient to cover what has already been disbursed, the remaining commitments, new aid packages for Greece and Portugal, and Spain and Italy's 3 year funding needs."
The additional funds required to plug the gap: around a half trillion euros.
In the grand scheme of things, it doesn't really matter what the ECB decides to do or how big the ESM turns out to be. The problem is structural and cannot be fixed by throwing money at it, as emphasized today by Robert Zoellick, former president of the World Bank:
"Monetary policy fundamentally buys time. It doesn't deal with the fundamentals ... They have to make reforms. The Germans are right, they (Spain and Italy) have to fix their fiscal situation, but also structural reforms for competitiveness."
This is a dicey prospect at the current juncture as the people of the eurozone's indebted nations are literally protesting in the streets. For investors, this week may mark the perfect opportunity to exit at the top. Though I'm not one for market timing, the fact that the ECB and the Fed could announce new policy initiatives and juice the stimulus-hungry market could prove quite fortuitous considering what may be coming in August and September as the crisis comes to a boiling point. Look to exit long positions on strength this week, then, short S&P 500 (SPY), short European stocks (FEZ), and long volatility and gold (GLD).