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).
The transmission policy channels of central bank largesse are failing...
[7]
as giving free money to banks is not reaching the economy...
[8]
and cutting rates didn't reach the areas it needed...
[9]
and the SMP may have an initial reaction but does nothing short-term to reduce sovereign spreads which are now even more interlinked with banking systems...
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so maybe, just maybe (as JPMorgan notes) the game is to weaken the Euro to aid in competitiveness broadly - but be careful what you wish for...
So if currency weakness is an implicit ECB policy objective, the quickest path toward that end is to foster persistent sovereign stress by delaying approval of banking union, reviving the EMU exit debate, or pressuring the ECB to avoid further LTROs or direct asset purchases. Such delays and constraints could easily push EUR/USD to 1.15 or below. Of course such malign neglect would mark a pyrrhic victory since overall financial conditions will tighten through wider credit spreads and lower equity prices. Conversely, the policies that are most helpful to sovereigns, such as the SMP and LTRO, risk arresting the euro’s decline unless the Fed is on hold (possible) or tightening (impossible). So as obvious as the normative argument seems, it isn’t so helpful in thinking through the range of factors in play as the ECB moves into uncharted territory.
Source: Barclays, JPMorgan