Monetary Policy

Following David Einhorn's take-down of the great and glorious Oz Larry Meyer eighteen months ago, the latter has been in training - readying his counterfactual counter-punches and controlling his ire. The king of Keynesianism just had his bell rung once again by a market realist and pragmatist as Stephen Roach destroyed the "if-we-don't-have-models-we-are-making-it-all-up" maestro and his constant diatribe of counterfactual crap. "Where's the beef, Larry?" Roach asked on CNBC this morning, which was followed up with a rabbit punch from Kiernan, "and what about Christina Romer's stimulus-employment model?" The visibly shaken (seriously watch the clip) Meyer falls back once again to a defensive pose - and while practically admitting that the Fed is impotent - as he pulls out the ultimate "but without our models we would not be able to tell you how much worse it would be without the Fed interventions". Roach takes this weak cross to the chin and comes over the top with a devastating "mark your models to market in light of what the economy has done over the four and a half years, the traction from monetary policy has been the major disappointment of this so-called post-crisis recovery." TKO.

A Fed decision to launch QE3 would increase the yellow metal’s appeal as an inflation hedge and bolster prices.  US house prices increased for their 4th month in a row suggesting that the US housing market recovery may be underway which dampened further hopes of any immediate easing in the US Fed’s monetary policy. The markets are playing a waiting game and investors are cautious.  Thursday’s ECB policy meeting will determine if President Mario Draghi will have the backing he needs to embark on significant policy changes to rescue the region’s financial woes.  Yesterday, German Finance Minister Schauble said in an email response to a newspaper, “The rules of the European Stability Mechanism don’t foresee a banking license to allow refinancing at the European Central Bank”.  Schauble’s comments fell like a penny in a wishing well that rippled to curb the market’s enthusiasm. Since Draghi’s initial comments to “do anything it takes” gold has increased by nearly $50/oz.

The Hilsenrath-Haggle Federal Open Market Committee (FOMC) is likely to ease monetary policy at the July 31-August 1 meeting in response to the continued weakness of the economic data and the persistent downside risks from the crisis in Europe. While we expect nothing more exciting than an extension of the current “late 2014” interest rate guidance to "mid-2015", Goldman adds in their preview of the decision that although a new Fed asset purchase program is a possibility in the near term if the data continue to disappoint, their central expectation is for a return to QE in December or early 2013.

The catalyst for the major turnaround in markets last week was comments from ECB President Draghi that he was prepared to do whatever it takes to preserve the Euro and ensure monetary policy transmission. While this is nothing more than stating his mandate (and that water is wet), the focus on 'transmission' caught the attention of many and Barclays provides a succinct flowchart of just where those transmission channels are broken. However, with SMP empirically a losing proposition for sovereign spreads, LTROs having had no impact on loans to non-financial corporates, and rate cuts not reaching the peripheral economies (and in fact signaling further divergence); it seems that short of full-scale LSAP (which JPM thinks will need to be a minimum EUR600bn to be in any way effective), whatever Draghi says will be a disappointment and perhaps that explains the weakness in European sovereigns this week as exuberance fades (or is the game to implicitly weaken the EUR to regain competitiveness).

Minutes ago French socialist president Hollande once again climbed on top of Cloud Nine, fully hopeful that Draghi's bluff would be enough:

• HOLLANDE CITES `STRONG WORDS' BY ECB'S DRAGHI ON EURO
• HOLLANDE SAYS ALL WILL BE DONE TO `DEFEND, PRESERVE' EURO

This led to a brief spike in the EURUSD until moments later, CNBC's Steve Liesman, by way of the Bundesbank, just converted Cloud Nine into Cloud Nein, which in turn was promptly pulled from under Hollande:

• BUNDESBANK TELLS LIESMAN MONETARY POLICY SHOULD FOCUS SOLELY ON PRICE STABILITY, STATES NEED FISCAL INTERVENTION

This means the Bundesbank does not give its blessing to SMP reactivation, and does not all "all" to be done to defend the Euroe.

While it is probably not surprising that so many decided to focus on those few words of relevance to an implicitly self-aggrandizing crowd of long-only risk-takers and commission-makers; the truth is that, as UBS notes, "Draghi was stating a fact, not changing a policy". Putting the fateful sentence in the context of the rest of his speech/interview is critical and most importantly, we agree with UBS' Justin Knight's opinion that Draghi did nothing more than make a technical observation on an impairment in monetary policy transmission (as we discussed here). Regardless, if our interpretation is correct, then the rally in peripheral bonds should unwind quickly. The size of the move probably has knocked many shorts out of the market.

It's all about the central banks this week.

Goldman's ex-employee Mario Draghi is in a box: he knows he has to do something, but he also knows his options are very limited politically and financially. Yet he has no choice but to escalate and must surprise markets with a forceful intervention as per his words last week or else. What does that leave him? Well, according to Goldman's Huw Pill, nothing short of pulling a BOJ and announcing on Thursday that he will proceed with monetization of private assets, an event which so far only the Bank of Japan has publicly engaged in, and one which will confirm the world's relentless Japanization. From Pill: "Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed." Why would the ECB do this: "A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations." In other words, the only thing better than a little global central banker put is a whole lot global central banker put, and when every central planner is now all in, there is no longer any downside to putting in even more taxpayer risk on the table. Or so the thinking goes.

• Schäuble View on Eurozone at Odds With US (FT)
• Juncker: Euro zone leaders, ECB to act on Euro (Reuters)
• German Banks Cut Back Periphery Lending (FT)
• Monetary Policy Role in EU Debt Crisis Limited: Zoellick (CNBC)
• Bond Trading Loses Some Swagger Amid Upheaval (NYT)
• As first reported on ZH, Deflation Dismissed by Bond Measure Amid QE3 Anticipation (Bloomberg)
• Record Cash Collides With Yen as Topix Valuation Nearing Low (Bloomberg) - but, but, all the cash on the sidelines...
• Greek Leaders Agree Most Cuts, Lenders Stay On – Source (Reuters)
• Chinese Investment in US 'set for record year' (China Daily)

There are only three words that send a chill down the spine of Ben Bernanke - Ron, Paul, and Deflation. His life's work is devoted to the avoidance-at-all-costs of the latter (and probably the former in reality). As we discussed here two weeks ago, his actions in extreme monetary policy have all occurred at periods when the market's expectations of future rapid de- or dis-inflation have increased rapidly. As we noted then: without inflation break-evens dropping, the Bernanke put will not arrive; but the market in its infinitely efficient wisdom has created a self-defeating spiral of BTFD reflexive front-running on any rapid spike down in future inflation expectations - which implicitly sparks a non-dis-inflationary reaction and removes Bernanke's punchbowl for another day. This has occurred 4 times this year - with this week's early plunge being caught by Draghi and Hilsenrath - and with inflation break-evens almost at their highest in 10 months, it would appear the 'desperate-not-to-miss-the-life-giving-rally' market just removed its own blood supply.

"September will undoubtedly be the crunch time," one senior euro zone policymaker said. "In nearly 20 years of dealing with EU issues, I've never known a state of affairs like we are in now," one euro zone diplomat said this week. "It really is a very, very difficult fix and it's far from certain that we'll be able to find the right way out of it."

“If the ECB continues like this, it will soon even buy old bicycles.”

We discussed the use of Game Theory as a useful tool for analyzing Europe's predicament in February and noted that it was far from optimal for any (peripheral or core) sovereign to pre-emptively 'agree' to austerity or Eurobonds respectively (even though that would make both better off). This Prisoner's Dilemma left the ugly Nash-Equilibrium game swinging from a catastrophic break-up to a long, painful (and volatile) continuation of the crisis. Recent work by BofAML's FX team takes this a step further and in assigning incentives and from a 'do-not-cooperate' Nash-equilibrium between Greece and Germany (no Greek austerity and no Eurobonds) they extend the single-period game across the entire group of European nations - with an ugly outcome. Analyzing the costs and benefits of a voluntary exit from the euro-area for the core and periphery countries, the admittedly over-simplified results are worrying. Italy and Ireland (not Greece) are expected to exit first (with Italy having a decent chance of an orderly exit) and while Germany is the most likely to achieve an orderly exit, it has the lowest incentive to exit the euro-zone - since growth, borrowing costs, and a weakening balance sheet would cause more pain. Ultimately, they play the game out and find while Germany could 'bribe' Italy to stay, they will not accept and Italy will optimally exit first - suggesting a very dark future ahead for the Eurozone and with EUR tail-risk so cheap, it seems an optimal trade - as only a weaker EUR can save the Euro.

A lot of desk chatter about this move in risk-assets - and the entire reversion to red on the day in EURUSD - as a WSJ report now circulating suggests that ECB members are not backing reported proposals by President Draghi. Specifically, the statement referenced is the following: "Many ECB Members Surprised By Draghi's Comments Suggesting New Bond Buys, Source Tells WSJ". The bottom line here is that Draghi most likely pulled a Mario Monti (and his hanger on Mariano Rajoy), and spoke up before pre-clearing with Buba's Weidmann. Draghi thinks that, like Monti with Merkel at the June 29 summit, he can bluff the Bundesbank into submission, and Germany will agree to monetization, especially if markets have risen enough where nothing out of the ECB next week leads to a market plunge (as the WSJ explains below). The problem is that as we patiently explained, Monti got absolutely no concessions our of Merkel, as was seen in the bond yields of Spain after the June 29 summit, which hit record wides a few weeks later. Expect the same this time around too: i.e., Germany will hardly cave in to the European beggars.

Confirming what we described in detail in March, Bridgewater's Ray Dalio notes in his Daily Observations that "Spanish banks' collateral is running out in a way that could force them into an ELA." The manager of the largest hedge fund in the world - so not some self-perpetuating political mouthpiece - estimates that the Spanish banking system has only a few hundred billion euros left in eligible collateral and that some of the weaker banks are likely already getting close to a point where their collateral is exhausted. Critically, if this occurs, then Spanish banks will need to turn to its own Emergency Liquidity Assistance (ELA) program. An ELA for Spanish banks would likely be several times the size of those in place for Greece and Ireland, further fracturing the uniformity of central bank standards across the eurozone, and the magnitude of funding coming through the national central banks could accelerate rapidly. This increasing Balkanization of European central banks and funding capabilities only entrenches the impossible task of fiscal union as 'more' sovereign control transfer will be required in return for any core backstopping. Furthermore, those who are hoping for LTRO3: no collateral, no deal! Which the IMF just confirmed is a flashing red warning:

• IMF: COLLATERAL AT ECB VULNERABLE TO DOWNGRADES, MARGIN CALLS

The attempt to manage the imbalances among the Euroland economies is an extremely dangerous highwire act, and to the extent that monetary policies diverge to serve individual countries' needs, the further capital flows will likely go in the opposite direction.