"So What Can Go Wrong"

Despite economic miss after miss, the momentum players in the market continue unfazed, dodectupling down on Bernanke Put Double Zero, pushing stocks to new highs simply on continued hopes that something in Europe may have changed with Merkel's so-called defeat last week, even as Merkel's key CSU coalition partners voiced an open threat earlier today to no longer support Eurozone aid if there is no conditionality - supposedly Mario Monti's biggest victory (ignoring that the German constitutional court is also faced with a barrage of demands to undo the ESM), and on hopes that tomorrow the ECB will announce something more drastic than the now widely expected 25 basis point cut. In other words a hope rally, even as bonds, and FX have now diverged dramatically with the hope gripping the global stock market. And hope is good, however if it becomes an investing "strategy" total loss is virtually guaranteed. That said, perhaps for the first time ever, bonds are wrong, and stocks are right, and all the bad news has been priced in (unlike all those other times when everyone said the same, and when everyone was certain they would sell first ahead of the herd). Which brings us to the question that Citi's Steven Englander has just asked himself: "So what can go wrong?" Here is his answer (in five parts).

  1. Finland and the Netherlands seem to be saying that they will not approve the use of EFSF or ESM funds in the secondary market. Finland also wants collateral on any loans to Spanish banks
  2. The line-up of countries seeking similar terms to Italy and Spain keeps growing
  3. IMF’s Lagarde says with respect to Greece “I am not in a negotiation or renegotiation mood at all
  4. Investors seem increasingly to be counting on ECB action beyond the policy/deposit rates to ease the soveregin debt market
  5. There is a gap between indicators of economic conditions and market appetite for risk. The average of US, China and euro zone economic surprises is at its lowest level ever, other than in the immediate aftermath of the Lehman bankruptcy (see Figure 1 below).  investors either believe additional stimulus will be coming or that positive sentiment is right and economic data are wrong. Additional stimulus means the Fed doing QE3, the ECB doing something more effective than cutting short-term rates and China taking a much more aggressive policy stance than it has so far. It is possible but there are hurdles, especially if the policy tools are not as potent as they were earlier in the rebound.

And while we have discussed four of the five topics above previously, #4 is still open, and will be fully answered early tomorrow when the US is sleeping during its national holiday. Here is what Englander thinks will happen:

ECB – What is enough?


The strong expectation in markets is that the ECB will do a refit cut and some reduction in deposit rates, but if this is all they do we think investors will walk away disappointed and sell the euro.


Our economists are expecting the ECB to cut the refi rate by 25 bps and move the deposit rate down to 10bps.The Bloomberg consensus has 46 forecasters expecting a refi move to 75bps, 5  to 50bps and 11 staying flat at 100bps. Of the forecasts time-stamped after the summit 30 expect a move to 75bps, 1 to 50bps and 6 for the ECB to stay flat. Money market rates have come down both since the Summit and over the last month but the moves have been modest, reflecting the low effective overnight EONIA rate (around 34bps) that have been in place for some months (Figure 1).  So while the BBG forecasts may point to a slightly more hawkish post-Summit distribution of outcomes, we would go with the market pricing that points to some further easing.


The tightening of euro zone GDP-weighted average CDS (SOVCDS) and run-up in euro zone bank stocks (SX&E) also point to a continuation of the post-Summit optimism (Figure 2). If anything, the EUR is lagging the tightening of CDS and the bank stock gains.


With effective rates trading well below the policy rate it is very difficult to gauge exactly what the market is expecting from the ECB. Clearly the cut to 75bps is a strong consensus view and there probably is some deposit rate cut also expected. In practice these would amount to little more than showing the flag – were the euro zone’s sovereign debt issues solvable via policy rate cuts, those would have been put in place long ago.

Finally for all those who say nothing bad can happen (in the now generic bipolar phase shift from two short weeks ago when the market could not catch a bid) all of a sudden, we leave you off with the following Englander quote referencing Coolidge, and his own post script.

Calvin Coolidge said  “If you see ten troubles coming down the road, you can be sure that nine will run into the ditch before they reach you.” and he was probably right but he didn’t give any advice on what to do about the tenth.


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