The week before last, ECB President, Mario Draghi, had sparked hope that the ECB would ride to the rescue at its August 2nd policy meeting. We were doubtful that a solution would be reached at that time. For one, the ECB had no mandate to act unilaterally to purchase sovereign debt. Secondly, the Germans remain resistant to direct debt purchases. Lastly, a change to the ECB's mandate and extension of its powers would probably involve a lengthy debate among European leaders. With Europe going on holiday this week, the deck was stacked against Mr. Draghi.
However, Mr. Draghi is a persistent sort. During his post-meeting press conference, Mr. Draghi stated that, buying short-term sovereign debt was within its single mandate of price stability. There is some credence to this. Monetary policy is usually conducted by adjusted short-term interest rates. If the ECB purchased short-term sovereign debt, it would surely affect (lower) short-term interest rates. Although purchases of short-term sovereign debt would lower short-term interest rates in the affected nations, Mr. Draghi is clearly exploiting a loophole in (or side effect of) his mandate of price stability.
Mr. Draghi knows that he is exploiting a loophole. He also knows that asset purchases alone will not solve the problems of the European periphery. In his press conference, Mr. Draghi stressed that structural reforms were necessary to the Spanish and Italian economies to put an end to the sovereign debt crisis. He also stated that bond buying would come with "strings attached" and that Spain and Italy would have to first ask for official bailouts before the ECB would begin bond buying. This did not please Italian Prime Minister, Mario Monti, and left Spanish Premier, Mariano Rajoy, speechless. Market participants were dismayed that money would not simply be thrown at the periphery and responded by sending equity prices lower and prices of U.S. Treasuries higher.
The markets reversed on Friday, as the possibility that Spain will ask for a bailout and that the Germans were softening their resistance to bond purchases cheered market participants. Spanish Premier, Mariano Rajoy, stated that he would consider asking for a bailout, if it was in the best interest of the Spanish people. He told reporters at a Friday news conference:
"I will do what I always do, act in the best interest of Spaniards."
In our opinion, this does not necessarily increase the likelihood of a bailout and bond purchases. If one asks economists: "Are a bailout, asset purchases and structural economic reforms in the best interest of Spain?" Most would probably answer yes. However, if the average Spaniard is asked the same question, he or she may not agree. It is clearly in the best interest of many (if not most) Spaniards that the status quo is maintained. Unfortunately, unless Spain receives permanent subsidies from core Europe (Germany), maintaining the status quo would be virtually impossible.
We have not changed our opinion that either Europe has to become more united from a fiscal standpoint (which would likely involve near-term, but temporary, economic hardships) or it will fragment, which could have similar results. The worst alternative is to try to maintain the status quo. Doing so could doom the European Union to a zombie-like state.
If throwing money blindly at the sovereign debt problem would solve little in the long-term health of Spain and Italy, why are the markets comforted by the possibility? The markets do not care whether it exhibits sustainable growth. They do not care whether or not businesses and sovereigns are fundamentally strong. The markets only care that their securities will pay off and they do not care who is doing the paying. In the minds of market participants, it does not matter if Spain pays its debt with money sourced in Madrid or with money sourced in Berlin, as long as it pays. The same can be said of bank debt and preferreds. However, it does matter in the long run. Money is finite and patience limited. At some point, citizens of core nations will become weary of supporting those who can seemingly do as they please and have their bills paid by others.
Readers would be advised not to confuse market optimism regarding asset values as reflecting improving economic fortunes, be they here or abroad. Higher assets prices merely reflect more optimistic sentiment regarding those assets. Bailouts and monetary policy accommodation tend to improve asset prices when fundamentals would dictate otherwise.
Last Wednesday, the FOMC left policy unchanged and did not extend the guidance for policy accommodation beyond late 2014. The news left the "monetary policy cures all economic ills" crowd disappointed. However, they soon found cause for cheer in the text of the FOMC statement which read:
"The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability."
The key word in the paragraph is "will." The Fed made it clear that, unless conditions improve, the Fed will act. This was considered to be good news by the equity markets. This is because it is probably good news for the equity markets. Whether or not another around of extraordinary monetary policy accommodation would be beneficial to the U.S. economy is debatable.
Further policy accommodation would help equities by creating resistance against rising rates. QE3 (if the Fed went that route) could help to weaken the dollar, but with major exporting countries already hurting, it is unlikely that foreign central banks would sit idly-by as their currencies appreciate versus the dollar. The real benefit comes to the equity market by driving investors looking for returns from bonds into stocks. Exceptional policy accommodation drives capital to areas of the market in which it has not traditionally gone. This is the stuff of which bubbles are made. Bubble or not, conditions appear ripe for a rally in equities, at least in the near-term. As we said in our European commentary, assets price valuations do not always reflect fundamentals. Technical factors, such as the expectation of renewed monetary stimulus, can push asset prices above their fundamental value.