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ECB tonic or toxic???

 

Friday the 11th November 2011 at 11 pm was a date to remember for most people as they gathered to do something special, well not for “Wall Streeters”, as at 11 pm when the market’s closing bell rang, relief took over as the week finished with no new surprises and with a positive outlook.
Last week, the Greek saga ended with the inauguration of a new coalition government headed by former ECB Vice President Lucas Papademos; positioned to swiftly ratify the EU bailout package.
More importantly, Italy’s Senate approved economic reforms needed to bring back confidence into markets.
Berlusconi is out looking for his friend Ghaddafi, and technocrat Mario Monti will be in replacing him.
The most relieving news was the collapse of the Italian yields to 6.4-6.5% away from the danger of getting caught in the spiral of borrowing cost above 7%.
However, this does not remove the political risk, or even the resurgence of the yields above 7%. Some serious action from the ECB this week is expected, and markets have already bet on it. Markets are not expecting a normal nibbling of Italian bonds on the secondary market, but an intervention!!! An intervention to explicitly suppress the yields at least to the area near 5%.
Such action is crucial because it will prove that the ECB is willing to support and take action with major leadership changes occurring in the Euro zone.
But a one time action to lower the yields on any of the disrupted economies in the EU will not be sufficient to silence the Violinists of the Titanic, a more active role of the ECB as lender of last resort is required.
However, such role is being opposed to by Germans, but with increasing calls for more money to leverage the EFSF to 1 trillion , not to mention the failed EFSF bond auction last week, they are limiting their options while, quite frankly, they have very few. 
How will the ECB role as lender of last resort will look like, if it was to happen:
The ECB will put an interest rate cap for various countries, by explicitly informing the market that if the yields of a certain country’s bonds reached a certain level, they will intervene, or they could use a spread to the bunds by intervening every time the spread widen to 300 basis points.
The one time, nibbling like intervention is not useful. Let us consider the currency market as an example, the Swiss franc, and the Japanese Yen.
During 2011, the BoJ intervened 3 times to weaken the Yen, first time when it reached 82, then when it reached mid and lower 75 against the dollar. Currently the yen is trading at 77, nearly the same level before their intervention, which proves that such interventions will not work.
 
However, if we consider another example, the Swiss franc, and within the same time frame, the SNB explicitly informed the market they are going to put a floor under the euro against the Franc at 1.20. Since, the EUR/CHF has never dropped below that level, and is currently trading at 1.24. This strategy has been both effective and cheaper.
It has proved to be effective, and it is cheaper because it is not the SNB that is pushing the rate from 1.20 every time it nears it, but the private sector, market participants, because of the language.

On the other hand, such solution could have its weaknesses since it could take off the pressure off European countries to proceed with the reforms and austerity measures, not to mention ending up with huge loads of Italian and Spanish debt if the situation deteriorates further.
Furthermore, unlike the Fed who is the lender of last resort pursuant to its statutory mandate, the ECB, by contrast, is expressly forbidden by the treaty from taking on financial risk from any country, it is independent. When we refer to the independence of the ECB, this means that it cannot favor one nation or group of nations in the euro zone.

Well, good for me I am not the head of the ECB, Draghi is, and he better find a solution because the ECB has a crossroad of either being tonic for the markets or toxic otherwise.
 


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.