Monetary Policy

There are many channels through which changes in the monetary policy stance are transmitted to the real economy. Recent statements by Draghi and Noyer (and a dropped word by Nowotny) suggest that the ECB is concerned about the uneven transmission of its July interest rate cut to bank lending rates across the Euro area. Goldman finds this empirically true, noting that the influence of official ECB rates on retail interest rates in Italy and Spain has diminished, while it has increased in Germany and France and in fact there is a ‘reversal of policy transmission’ in Spain and Italy, whereby ECB rate cuts are now associated with an increase, rather than a fall, in retail rates (as the rapid deterioration in peripheral banking systems has more than offset any impact of lower rates). This 'failure' of standard monetary policy to ease conditions has led to the non-standard measures being discussed now. We see three points from this: rate cuts are less likely than the market believes; while SMP is now being priced in, it doesn't specifically address the transmission-mechanism; and just as Draghi hinted at in his last conference, we suspect he will reiterate his reduced collateral standards and increased eligibility to private-sector loans directly (an LTRO 2.5) - which, however, will necessarily encumber bank balance sheets even more (if Zee Germans will even agree to it).

Will the Fed then just keep printing forever and ever? As an aside, financial markets are already trained to adjust their expectations regarding central bank policy according to their perceptions about economic conditions. There is a feedback loop between central bank policy and market behavior. This can easily be seen in the behavior of the US stock market: recent evidence of economic conditions worsening at a fairly fast pace has not led to a big decline in stock prices, as people already speculate on the next 'QE' type bailout. This strategy is of course self-defeating, as it is politically difficult for the Fed to justify more money printing while the stock market remains at a lofty level. Of course the stock market's level is officially not part of the Fed's mandate, but the central bank clearly keeps a close eye on market conditions. Besides, the 'success' of 'QE2' according to Ben Bernanke was inter alia proved by a big rally in stocks. But what does printing money do? And how does the self-defeating idea of perpetual QE fit with the Credit Cycle relative to Government Directed Inflation (or inability to direct inflation where they want it in the case of the ECB and BoE)?

While Dos Equis has its most-interesting-man, we think we have found the 'most hypocritical'. Until today we thought Sandy Weill was the undisputed champion in this category, but after seeing this clip we think he has strong competition. At around 40 seconds into this lengthy diatribe, everyone's favorite Libertarian Las Vegan utters the most two-faced hypocritical words that he could possible have uttered: "I think we should audit the Federal Reserve". Between Harry Reid's recent vehement anti-Paul behavior and the whip-order that Democrats received on Ron Paul's bill yesterday, this is stunning. While the sell-out nature of this kind of politician does not surprise us, we thought it prudent for all US citizens to understand the true nature of the political class that decides an increasing amount of our day to day lives.

Given the anticipation that is now built-in for next week's ECB meeting, we hope that Draghi has a little more up his sleeve than reviving the Treaty-testing, bondholder-subordinating SMP. Presented with little comment is the market's reaction during the last two periods of buying as it seems that Italian and Spanish bondholders are more than happy to know that there will always be a buyer no matter how much they keep selling their exposure down.

Wondering what Draghi really meant this morning when he spoke at an informal Investment Conference? Apparently nothing just as we said first thing this morning: IMF SAYS DRAGHI'S REMARKS ARE A WELCOME REITERATION OF ECB'S WELL-KNOWN COMMITMENT TO DO WHAT IS NECESSARY. So now the talking down of expectations, or in this case today's iteration of "baffle with bullshit" begins. Yet surely there is some additional agenda. For the best interpretation of what the ECB head said, we go to his former employer, Goldman Sachs, which is always ready to tell its clients to do the opposite of what its own prop desk is doing.

While some have talked of the 'credit-easing' possibility a la Bank of England (which Goldman notes is unlikely due to low costs of funding for banks already, significant current backing for mortgage lending, and bank aversion to holding hands with the government again), there remains a plethora of options available for the Fed. From ZIRP extensions, lower IOER, direct monetization of fiscal policy needs, all the way to explicit USD devaluation (relative to Gold); BofAML lays out the choices, impacts, and probabilities in this handy pocket-size cheat-sheet that every FOMC member will be carrying with them next week.

European markets started off on a quiet note with thin volumes as equities drifted lower and fixed income gradually made gains, however newsflow rapidly picked up as commentary from the ECB President Draghi picked up wide attention. The ECB President was very upbeat on the Eurozone’s future, commenting that the bank will do whatever is needed to preserve the Euro, fuelling the asset classes with risk appetite across the board. European equities as well as the single currency erased all losses and the Bund moved solidly into negative territory. As such, EUR/USD is seen comfortably back above 1.2200, with both the core and peripheral bourses making progress. In the wake of the moves, attention is particularly being paid to Draghi’s comment that if monetary policy transmission is affected by government borrowing, it would come within the bank’s policy mandate. As such, much of the focus now lies firmly on next week’s policy decision from the ECB.

For those stunned that the market is reacting as euphorically as it is to remarks which are basically a rehash of prior Draghi statements and are nothing new, or that bond yields are ripping in on the implicit threat that Draghi may reactivate the SMP, in the process further subordinating bondholders and cramming them down forcing even more selling, here is a sampling of previous Draghi statements explaining what he can do, and more importantly, what he is allowed to do under the existing European framework. Which is why we find it not very surprising that Draghi waited until all usual German suspects are on vacation and are thus unable to immediately issue a press release as to the structural limitations of what Draghi can do. Because when in doubt, ask this: does export-heavy Germany want a strong or a weak euro?

When you can't act, you talk. Sure enough, here we go again:

• DRAGHI SAYS ECB WILL DO WHATEVER NEEDED TO PRESERVE THE EURO
• DRAGHI SAYS THE EURO IS IRREVERSIBLE
• DRAGHI SAYS YIELD DISRUPTING POLICY TRANSMISSION ARE IN ECB REMIT
• DRAGHI SAYS SHARING SOVEREIGNTY ON EU LEVEL TO COME
• DRAGHI SAYS LAST EU SUMMIT WAS MOMENT OF RECOGNITION

And of course the weak hands cover until they realize Draghi just said absolutely nothing, as at this point everything is  in Germany's hands. And not only has Germany not said anything, and won't until September when the constitutional court will approve or deny the ESM, but in fact they have been saying overnight that Spanish bonds are not eligible for EFSF purchases. In the meantime, Europe has devolved from a continent of coordinated action to coordinated jawboning.

When Paul first introduced his bill a decade ago, it was written off as another piece of his far-flung libertarian worldview is how Politico juxtaposes today's (now successful) vote on Ron Paul's Fed Transparency Bill. "I want to appreciate and congratulate Dr. Ron Paul for his tireless pursuit of openness and transparency," said Rep. Jason Chaffetz (R-Utah). "Without his leadership, we wouldn’t be at this point today." Via Bloomberg:

• *FED AUDIT BILL OPPOSED BY BERNANKE GAINS APPROVAL BY U.S. HOUSE
• *FED AUDIT BILL NEEDS SENATE APPROVAL, PRESIDENT'S SIGNATURE
• *FED AUDIT BILL SPONSORED BY REPRESENTATIVE RON PAUL OF TEXAS

"I’m pleased. It’s something I’ve worked on for a long time, and it’s a good first step," Paul told POLITICO. "It’s coming to the floor as a response to the American people, because I don’t have a whole lot of clout around here." Never mind that the Fed audit is dead in the Senate — Majority Leader Harry Reid’s office has said he won’t bring it up.

"The global growth picture is, as per our long-term contention, weak and deteriorating, pretty much everywhere – in the US, in the eurozone and in the emerging markets/BRICs.... We in the Global Macro Strategy team still think the market consensus is far too optimistic on policy expectations both in terms of the likelihood of seeing more (timely) fiscal and/or monetary policy assistance (globally), and in terms of any meaningful and/or lasting success of any such policy moves. In particular, we think that the period August through to November (inclusive) represents a major global policy and political vacuum. Based on the reasons set out earlier and also covered in my two prior notes, over the August to November period I am looking for the S&P500 to trade off down from around 1400 to 1100/1000 – in other words, I expect over the next four months to see global equity markets fall by 20% to 25% from current levels and to trade at or below the lows of 2011! US equity markets, along with parts of the EM spectrum, will I think underperform eurozone equity markets, where already very little hope resides. For iTraxx crossover, this equates to a spread wide for 2012 of – in my view – 800/1000bp.... And of course I still see a very clear path to 800 on the S&P500 at some point in 2013/2014, driven by market revulsion against pump-priming money printing central bankers, but this discussion is also for nearer the time."

Independent from Congress … or from the American People?

"This market isn't real. The two percent on the ten-year, the ninety basis points on the five-year, thirty basis points on a one-year – those are medicated, pegged rates created by the Fed and which fast-money traders trade against as long as they are confident the Fed can keep the whole market rigged. Nobody in their right mind wants to own the ten-year bond at a two percent interest rate. But they're doing it because they can borrow overnight money for free, ten basis points, put it on repo, collect 190 basis points a spread, and laugh all the way to the bank. And they will keep laughing all the way to the bank on Wall Street until they lose confidence in the Fed's ability to keep the yield curve pegged where it is today. If the bond ever starts falling in price, they unwind the carry trade. Then you get a message, "Do not pass go." Sell your bonds, unwind your overnight debt, your repo positions. And the system then begins to contract... The Fed has destroyed the money market. It has destroyed the capital markets. They have something that you can see on the screen called an "interest rate." That isn't a market price of money or a market price of five-year debt capital. That is an administered price that the Fed has set and that every trader watches by the minute to make sure that he's still in a positive spread. And you can't have capitalism if the capital markets are dead, if the capital markets are simply a branch office – branch casino – of the central bank. That's essentially what we have today."

The three "de's:" deregulation, desupervision, and de facto decriminalization.

The importance of the negative credit outlook from Moody’s lies less in the realm of financial markets, given how little investors seem to value the views of the credit rating agencies. Rather the major importance lies in the policy and political reactions to the rating actions. As UBS notes, there is a risk of popular (not political leadership) adverse reaction. The media in Germany (where there is a tradition of media hostility to the Euro periphery) or in the Netherlands (approaching a general election in September) may portray this as "we are being dragged down by the Euro periphery". If that does transpire it could easily fan the flames of populist resentment of the Euro still further. Critically, if the media attribute (or mis-attribute) the blame to the periphery, there could be obstacles to that integrationist momentum. The reality of a common monetary policy and the necessity of some kind of communalized fiscal responsibility are being brought to bear on the Euro area polity - but markets seem confused. CDS markets are pricing Germany's risk as if it was becoming increasingly encumbered to the periphery and yet the FX market is dragging EURUSD lower on expectations of massive upheaval and potential SPexit with no German 'unlimited' support. CDS appears to fit with raters, FX more with haters - or as UBS points out, perhaps all is not well in Germany as it "has demonstrably failed to grow its way out of debt."