Home > Uncategorized > 2012/01/12: ECB Supports the Reflation Trade

2012/01/12: ECB Supports the Reflation Trade

© 2012 ROHR International, Inc. All International rights reserved.

It is no doubt just a bit presumptive to take the communication from one monthly ECB press conference and infer there has been a significant policy shift. There were certainly many interesting aspects to president Draghi’s Q&A session today. However there was one focal point he revisited on several occasions that seemed to point toward the ECB becoming more Fed-like in its approach to the European Sovereign Debt Crisis and economy than anything that might have been attempted by his predecessor. And that is showing up in the markets in the form of the risk-on ‘reflation trade’ seeming to return over the past few days. On several fronts this would seem to be another example of the markets exhibiting technical trend decisions where the reasons only become apparent once the further information driving the psychology is available.

We are referring to his response to repeated questions on an issue where we (among many others) have had concerns: the efficacy of straight austerity as an effective manner in which to address the European Sovereign Debt Crisis. There have been rightful serious doubts about whether a nation as small as Greece that lacks a significant manufacturing base could actually shrink its way out of its Brobdingnagian debt load. Of course, while less so for other major profligate European southern sisters, there was also a question of the economics and political dimension for Portugal, Spain and Italy as well.

Calls for some mechanism to stimulate growth at the same time that the longer-term austerity measures are implemented are both reasonable and necessary. Vox populi in all these countries is already expressing a major degree of austerity fatigue, and further extreme measures might lead to outright rejection, along with the fact they are not likely to achieve the desired fiscal results.

So it was not necessarily a total shock when President Draghi repeatedly expressed the notion that “job creation” is a primary goal alongside the overall austerity push toward fiscal rebalancing. However, it is the first time anyone has heard it from the head of the ECB. And it must be noted that allowing that sort of focus formally moves the ECB much closer to the Fed’s “dual mandate” than anything which anyone might’ve expected prior to today’s press conference.

Under the circumstances that is likely no bad thing. It also demonstrates that Signore Draghi is quickly moving the agenda well beyond anything that would have been remotely considered by Monsieur Trichet. Some will consider this a fulfillment of all the fears of weakened ECB inflation control credentials. However, much has changed since the more rigid and doctrinaire approach of Draghi’s predecessor was allowed to exacerbate the weakening economic tendencies in Europe. The most prominent of these is what’s been tried, and failed: serial austerity measures in Greece have not produced anything approaching the desired fiscal rebalancing. And significant weakening of the economy (which looks to continue into this year) has had the predictable effect of diminishing tax revenues to the point of neutering any of the cost-cutting measures.

And indeed there is another aspect of recent ECB action reviewed during the press conference which works hand in glove with that focus on growth as opposed to pure inflation mitigation. That is the steps the ECB has taken to underwrite the stressed European banks with the extension of three-year loans at attractive rates under the Long Term Refinancing Operation (LTRO.) The significant lowering of collateral standards is enlightened to the degree it is going to prevent a pure liquidity crunch at the over-leveraged European banks. In that regard it is enlightened.

However, along with the major liquidity operations underway by the Federal Reserve, Bank of England and other central banks, the ECB was the last stalwart not engaging in wholesale liquidity expansion. Now that they have joined the “do what is necessary” to prevent another banking crisis club, there is at least temporarily a return of the risk-on ‘reflation trade’.

That is showing up in various ways in the markets (more below.) Yet, we are already seeing at this early juncture where (much as with the Fed’s QE efforts) it is not necessarily a panacea for the equity markets. Strength in precious metals and energy are already seen as an inflation harbinger is to a goodly degree, which is not necessarily constructive for stock markets.

Aside from all that there was much else that was interesting at the ECB press conference today. Most especially the comments on the once again fraught Greek Debt Deal negotiations over Private Sector Involvement (PSI). Pressed repeatedly over the question of whether the ECB would accept any haircut (reduction in the principal value) of its Greek sovereign debt holdings, he finally deferred to ECB Vice President Constancio. The Veep was very concise and pointed in his observation that the PSI being all about the private sector holdings had nothing at all to do with the ECB. And that’s that.

Signore Draghi was also very pointed that the whole PSI episode was “a mistake” that had what he called unintended and unforeseeable consequences. He allowed that it was nothing more than a political response driven by the mentality of the successful northern tier European countries. While he did not say so in so many words, our view (and that of many others) is that only folks with their head in the sand would’ve missed the point that forcing private sector haircuts and eviscerating the euro sovereign debt Credit Default Swap (CDS) market was a huge error.

We first began covering what a mess that was going to make back in our June 30th post On the Menu This Week? Looks Like Both French Toast and Greek Toast! And that whole area has been an ongoing fiasco ever since the PSI was first proposed, to the point that fear of government reprisal meant that no banks were willing to offer CDS on the bonds of the European Financial Stability Facility (EFSF.) And subsequent there were failed auctions, which we believe were in part due to the lack of any ability to take out an effective insurance policy against the failure of those bonds.

The only surety anybody has now that a 60%-70% reduction of principal value and Greek bonds is being fudged as not being a “credit event” (which would trigger those sovereign CDS payments) is that the European governments will ultimately stand behind the value of the bonds. Which is why Signore Draghi has been adamant previous and again today in expressing the view that both EFSF and its soon-to-be incarnated sister European Stability Mechanism (ESM) must be “operational and fully equipped.” And in this case the ‘equipment‘ is money.

And while they all haggle over the fine points during the next phase of the endless recurrence of the Greek Debt Deal negotiations, it seems like something we thought was already upon us some time ago is becoming the reality at present. Barring any further effective ability to kick the can down the road that seems to have run out, the Germans and other successful northern tier economies that have the ability to fund the EFSF and ESM are facing another ‘Jerry Maguire’ moment… “Show me the money.”

General Market Observations

It is certainly possible in the equities might improve further as the session proceeds. However, on current form they are sagging in a manner that is disconcerting in light of what seemed to be confirmation of a much looser approach by the ECB. Perhaps that is on the back of the surprisingly weaker than expected US Retail Sales and Weekly Initial Jobless Claims this morning. Those are especially disconcerting to the bulls who are relying upon the US and other economies to hold the line while Europe sinks into what is likely to be at least a mild recession (if they and all the rest of us are lucky.)

That the US might be weakening is especially disconcerting in light of this morning’s release of OECD Composite Leading Indicators (CLI), which still showed general global weakening in spite of some mitigation for the US and Russia. As such, any sign that the US is in fact reverting back to the sort of weakness that would make it a global softening would be a real problem for an already stressed Europe. Once again, as we pointed out on Tuesday some of our very short-term momentum indications have not returned to the potential UPside ‘runaway’ condition that fizzled after the gap higher Tuesday morning and again today. And it will be interesting to see if the March S&P500 future might actually sag back below the key near term 1,280.90-1,275.60 (Monday’s Close) gap support for the weekly Close this week.


Along the way it is very interesting that the February Gold future is managing to extend its recovery above its key 1,615-30 resistance. That is pushing it back above its weekly MA-41 and Negating its mid-December DOWN Break. Holding out any retest of the low end of that range will keep it constructive in the near-term, with a likely test of the 1,680 or even the 1,700 area possible. That is also consistent with the March Copper future pushing above its 3.50-3.55 resistance once again, for a test of its significant downward channel resistance and congestion in the 3.67 area. Much above that it could easily be on its way back toward at least the next incremental resistance in the mid-upper 3.80 area.

At least for now the prospect of lower short-term rates along with the prospect that the equities might still weaken is allowing both the primary government bond markets and the US dollar to be very contained within their downside reactions. Kind of perverse insofar as any sort of reflation trade should favor the commodity currencies over the US dollar, and represent a problem for the govvies. However, all of that likely will have more to do with whether the equities do indeed weaken significantly from current levels than any temporary bulge in the precious and industrial metals.

The energy market also remains strong in spite of today’s current weakness in equities. However, February Crude Oil future pushing back up into its 102.00-103.39 area resistance might also still be under the influence of the unsettled Middle East situation. Yet, whatever the drivers might be, stronger precious metals, industrial metals and energy that are obviously not driven by an upbeat mentality in the equities are not good for the latter.

We hope you find this useful.

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