ECB - A Program To Nowhere
The markets have languished for weeks now awaiting news from the Fed and the ECB on further programs to support their respective economies. Both have failed to deliver. We wrote yesterday in "Draghi To Announce Sterilized Bond Purchase Program" that: "The details of the plan will likely NOT be the 'bazooka' that the markets have been hoping for. The most likely announcement tomorrow, considering that Draghi has absolutely no support from Angela Merkel or Bundesbank, is a regurgitation of the SMP (Securities Market Program) from last year. The problem with the SMP is that it had absolutely no effect on stemming the problems facing the Eurozone." I detailed the problems with the expected announcement yesterday but will focus on a couple of points today.
The announcement today uses proceeds from maturing assets to buy short dated (3 Years or Less) secondary market issues. Furthermore, any bonds purchased will not hold seniority and bond purchases will only be made when conditions are met. Finally, and most importantly, these new bond purchases will ONLY HAPPEN in concert with the EFSF and the ESM bailout funds. The problem remains that Germany still has not ratified the ESM fund, and likely will not this month as expected, and will allow a referendum to take place first. This could postpone ratification of the ESM fund for months.
While the announcement by the ECB sent short sellers running for cover today - the sustainability of the rally remains in question as market participants start to digest the announcement. While the announcement was very much in line with what we expected yesterday there are a couple of very important points to be added.
First, the ECB's decision to not have seniority in its bond purchasing plan will increase the liabilities of core Euro countries equivalent to that of Spain. Furthermore, the attack on the short end of the yield curve is potentially problematic. As we stated yesterday: "...with a focus bonds with maturities of three years of less in duration, this program will do little to solve the credit crisis of the banks that are loaded with much longer dated toxic assets (real estate, corporate and government) that will still need to be dealt with."
The seniority point is important. Since "Pari passu" will not apply to existing SMP holdings this makes dealing with Greece much more of an issue. There has been a precedent set in Greece, as they have not yet accepted a haircut on their bonds, so why should other investors believe that Greece will be ranked accordingly. This is very likely to deter investment in the future.
Finally, the "conditionality" is the real wrinkle to the program. Nothing can be activated until countries, such as Spain or Italy, request a bailout. However, therein lays the biggest problem. With the ECB now "doing everything in its power," which is keeping yields artificially low and markets artificially high, the ECB has removed any urgency for Spain, Italy, or any other country with unsustainable primary and other deficits, to fix their problems. Therefore, the experimental treatment for the cancer will never be tried because the patient currently feels just fine even as the cancer continues to spread.
However, the politicians, at least for now, do not have to risk their careers with socially unacceptable austerity programs when they can just continue down the same destructive path they have been on. As long as the ECB will continue to bail them out – why should they change? This, of course, will not end well - but in Europe what doesn’t need to be dealt with today can be postponed until never. This is the whole problem with Eurozone – it was put together with no underlying structure, just a grandiose idea. The structure was supposed to be designed and implemented later – it never was. That lack of structure, a constitutional agreement, is the overarching problem today.
In the next six to twelve months the economic data will worsen in Europe due to the existing problems that are not being addressed. Just today the ECB revised GDP forecast for Europe downward to a -0.6% growth rate from -0.5% - the reality is that it will be worse than even that estimate. As the economic deterioration continues the debts, deficits and economic viability will continue to swell into larger problems than they are today.
Today's action, as stated yesterday, has achieved nothing in solving the long term problems that are the Eurozone. Just as the previous SMP failed in 2011 - this program too shall ultimately fail. As my friend Tyler Durden noted today: "It is this that the Bundesbank is lamenting: the ever greater trade off of meaningless short-term market gains in exchange for long-term broad collapse and potentially hyperinflation. Sadly, nobody else is, or will be until not even all the world's central banks can control the fate of the bond and stock markets any longer."
Market Hits 4 Year Highs
Regardless of the logic and realities that are the Eurozone crisis – the markets are rallying which are pushing short sellers to cover positions. The market has been in a holding pattern for the last several weeks and the announcement was enough to initially send risk assets higher. The question now becomes sustainability. The snap reaction has been decent, volume light, but the breadth of the rally has been good. I think there is a strong possibility that within the next few days as the markets digest the ECB announcement, and the reality of its potentially limited success, that there could be a bit of disappointment.
The markets are on buy signals as we have reiterated many times in recent weeks. The breakout today, if sustained, will require additional risk exposure to be added to the markets. However, the rule in uptrends is to "buy dips" - therefore, any declines to support will provide better opportunities to increase additional exposure.
As we discussed in this past weekend's newsletter - there are many indications that we are closer to a market top than the beginning of a new bull market cycle. The market is clearly overbought on many levels and more corrective action is needed to provide a better risk/reward dynamic.
I will update allocation models in this weekend's newsletter (click to subscribe for free delivery) and post the updates here on Monday. Stay tuned.