Will Draghi Deliver or More about Modalities ?

What promises to be an eventful period, and one in which the implied volatility, either in VIX or currencies seem low, has already had a couple of surprises.  The session began with soft Australian employment numbers.  Rather than grow 5k jobs, it lost 8.8k.  These were concentrated in part-time jobs, but the full-time positions gained only 600 and the July figure was cut by 1.6k.  

That said, the Aussie, which had made new multi-week lows yesterday failed to extend its losses, which precipitated a short-covering bounce.  Some of its gains were linked to speculation that China will ease policy imminently.  Given the economic and financial weakness, many participants have been surprised by the lack of response yet by the PBOC.  

The other surprise today has been the Sweden's Riksbank's decision to cut rates 25 bp to 1.25%.   While most observers recognized the possibility, most expected it to wait for greater clarification.  However, there have been soft PMI readings and the domestic economy has under-performed both the government and central bank expectations, while the krona is been stronger than expected.   

The euro spiked up to SEK8.55, a multi-week high, and then yielded everything to return to levels seen late in NY yesterday (~SEK8.48).    Many observers will anticipate another rate cut by the end of the year, given the weakness in the euro area economy and China, while the krona may continue to draw investment flows. 

The Bank of England did not surprise the market by taking any action; but it is expected to expand its gilt purchase program either in Oct or Nov.  A rate cut also is possible later this year to early next. 

Ahead of the ECB meeting, Spain managed to raise the upper of the desired 2.5 bln-3.5 bln euros.  Despite the lower yields (solid even if lower coverage), there has been some unwinding of the big bull steepeners (bond market rally led by the short-end).  There is some suspicion that the ECB could signal its intent by buying short-term Portuguese bonds today.  The 2-year yield is above 4%, the most in the euro zone and more than twice as high as Ireland's.  It continues to receive high marks from the Troika, but is struggling to make its targets.  

Yet the focus is more on Spain and the reports that the buying could be unlimited, even if sterilized (which overtime may pose a technical challenge especially given the zero deposit rate).  It may be better to think about the "unlimited" as simply unspecified.  There is a limit.  

Here is a back of the envelop calculation.  According to central bank figures, as of the end of July, Spain had about 128 bln euros of debt maturing between 1 and 3 years.  This is incidentally equivalent to a little more than a fifth Spain's debt.  In addition to this Spain has funding needs for the remainder of the year, which could be an estimated 4-15 bln euros, depending on if the original funding program is adhered to, or if it is increased to recognize the deficit overshoot.  Then, for the sake of the exercise, consider that next year Spain's funding needs could be about 120 bln euros (half to cover maturing debt and the other half for the deficit and regions).  

Since the maturing debt has already been accounted for in the 128 bln, a maximum estimate is  that the ECB can buy no more than around 200 bln euro of Spanish 1-3 year bonds by the end of next year.  Our concern is simply this:  as fast as the ECB may put money in, the private sector may take it out.  Last month alone, official figures suggest Spain lost about 74 bln euros in deposits and for a total of some 233 bln since 2011.  

Many observers seem to think that the ECB will begin buying Spanish and Italian bonds shortly.  This still does not seem likely to us.  Spain is not yet in a position to make a formal request.  It seems to be at least another month off.  Although, the Financial Times suggests Italy may need to formally request bond support, we think the technocrat prime minister is loath to do so under his watch.  

With much details of Draghi's plan already leaked, the US economic data will also attract market interest.  Tomorrow's national employment data is still widely understood to be pivotal to the FOMC's decision next week.  While the ADP data has tracked the official figures, there have been some notable discrepancies.  However, because it was a good gauge  last month, players will be biased to give it the benefit of the doubt this time.  The Bloomberg consensus which continues to creep up now stands at 138k for the August nonfarm private payrolls while the estimate for the ADP is 140k.  The weekly jobless claims are really immaterial, leaving the non-manufacturing PMI (and its employment component) to be most important.