The US dollar has surrendered yesterday's post-FOMC gains as the market churns within recent ranges ahead of today's ECB meeting, the key event risk of the week. The euro is back to levels seen near this time yesterday. Stronger than expected Australian retail sales (1.4% vs 0.9% consensus) and an unexpected trade surplus (A$9 million vs A$347 million deficit expected has lifted the Australian dollar back through $1.05 as odds of a rate cut next week diminish. The UK reported a stronger than expected construction PMI (50.9 from 48.2 in June and consensus of 48.0). As expected, the BOE did not do anything at the MPC meeting. Spain's bond auction went off without a hitch, and largely what one would expect: higher yields and stronger interest for shorter-dated paper.
These developments, coupled with a belief that the ECB will deliver, after the strong statements, have helped underpin the foreign currencies and Spanish and Italian bonds. The MSCI Asia Pacific Index was down marginally, though China failed to build on yesterday's recovery. European shares are faring better; most bourses are up around 0.3% ahead of the ECB meeting. Financials are the strongest sector in the Dow Jones Stoxx 600, up twice the overall market.
The spotlight is on the ECB. Draghi's comments last week have seen 2-year Spanish yields drop 230 bp and the 10-year yield to drop about half as much. These are dramatic moves. The market anticipates some balance sheet expansion by the ECB, especially a resumption of the SMP program. Some suspect that Draghi will take a page from Trichet's playbook and begin buying bonds during the press conference.
A 25 bp cut in the refi rate (but not cutting the deposit rate below zero) and/or some tweaks in the collateral framework will not be enough to diminish the risk of "buy the rumor, sell the fact", which we are inclined to see. To truly "shock and awe" the ECB officials show an unlimited commitment of funds either to cap yields, as some have suggested for "virtuous countries" or through unsterilized QE itself.
Yesterday we argued that the higher rates in the European periphery and low (and even negative) rates in the core are a sign not that the transmission mechanism of monetary policy is not working, but rather that it is the transmission mechanism by which the surplus countries funded the deficit countries that has broken down. We suggest that the ECB cannot do much to repair this.
There is something else that has been broken that the ECB cannot fix. Draghi called it "convertibility" and we have been calling it "redenomination risk", that is the risk one or more countries leave EMU and introduce new currencies. Draghi has said that EMU is "irreversible" but this is not the same thing. German officials, but others as well, continue to discuss conditions of a Greek exit. The mere talk encourages the financial disintegration - the reversal of cross border movement of capital and recycling of surpluses. We continue to suspect that a Greek exit would increase rather than diminish redenomination risk.
There are three take away points for investors from the FOMC statement. First, the Federal Reserve lowered the bar to additional action. The subtle shift is found in the phrase "will provide additional accommodation as needed", rather than "is prepared to take further action", as it said in June. In fact, this is very similar to the wording of the September 2010 FOMC statement before announcing QE2 in early November.
Second, the somber economic assessment, except for "further signs of improvement in housing", also suggests that the burden of evidence has shifted. Previously, we argued that the Fed needed to see a marked deterioration in the economy to take new action. Now, if there is not marked improvement, the Fed will likely act.
Third, the Fed will update its forecasts in September. It is important that changes in guidance reflect changes in economic outlooks. Adhering to this discipline will help increase the Fed's transparency. Clearly, the odds favor new measures and guidance in September and while a new round of asset purchases would be the odds on favorite action, we remain intrigued by Bernanke's admission that the Fed is looking for other tools.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.