Should ECB Sell Bunds?

The US dollar is  mostly softer as the broad position adjustment phase continues.    Whatever momentum there was though eased in the European morning after the modest upside surprise in German and French Q2 GDP estimates failed to translate into a stronger euro area GDP figure.  The 0.2% contraction was spot on consensus.  The German economy expanded 0.3% in Q2, but as today's ZEW survey and the recent PMI surveys suggest, Q3 is off to a weak start.  France was flat in Q2 rather than have contracted slightly as the market expected.  The $1.2385-$1.2400 offers resistance now for the euro, while initial support is seen near $1.2320.

The first increase in UK CPI (2.6% in July from 2.4% in June) since March saw sterling spike to record the session high near $1.5730 before pulling back. Provided the $1.5670-80 support holds, sterling can continue to edge higher.  In six of the past seven sessions sterling has risen above the previous day's high. For its part, the dollar has been confined to a 15 tick range on either side of JPY78.15.  The market's attraction to the dollar-bloc currencies we have noted appears to have eased and appear to have entered a consolidative phase.

Equity markets are firmer in Asia and Europe.  Reports of short-covering of European positions by leveraged accounts and other reports of funds being amassed to buy distressed European assets may be helping buoy European equity markets.  The Dow Jones Stoxx 600 is up about 0.5% near midday in London to its best level in 5 months.  Financials are participating, but not leading the move.  That role is had by utilities, health care and telecoms today.  The MSCI Asia Pacific Index rose about 0.4%, led by the more than 1% advance in Hong Kong and Korea.  Foreign inflows have been particularly strong into Korean shares in recent weeks.  The debt markets are mostly quiet.

Spanish and Italian bonds are consolidating recent gains.  Arguably the reaction to the LCH Clearnet margin increase, which goes into effect at today's close, has been minimal at best.   Of note the large Greek T-bill auction went off without a hitch.  In fact raised almost a billion more euros than it had intended, paying "only" 15 bp more than it did at the July auction (4.43% vs 4.28%).   The August 20 payment to the ECB has been effectively covered now.   The US will reported July PPI and retail sales data.  There are downside risks to the former after softer importer prices.  An increase in retail sales will be part of the evidence we expect to accumulate that will indicate the US economy is not slowing further in Q3. 

Given the comments by ECB President Draghi, many market participants have rightly focused on the possibility of official purchases of Spanish and Italian bonds.  The 2- and 10-year yields in Spain and Italy are moving in lock step.  The 30 and 60 day rolling correlations are up end where they have been since the crisis began (0.84-0.87).  Prior to the crisis, the correlations were mostly above 0.90 and now only rarely and briefly do they rise above that threshold now.  This might explain the reports that suggested that Italy's Monti had joined the official pressure on Spain's Rajoy to formally request assistance.  He was hoping to break the linkage in the mind of investors.

Yet it is the President of Portugal that grasped the heart of the matter.  The ECB should be buying Portuguese and Irish bonds on the grounds that they meet the conditions Draghi has proposed.  They are operating under the conditionality embodied in the memorandum of understanding with the Troika and the assistance has been approved by all the members.  The Irish 2-year (generic)is now yielding around 2.75%. This is off from over 10% last November, and near the lowest level since 2010.  Yet it is still high relative to the current monetary stance of the ECB.  Portugal's 2-year (generic) yield is near 5.55%.  Last November and briefly in February the yield was near 22%.  As recently as late-May the yield was above 14.5%.

There are several advantages for the ECB to buy Irish and Portuguese short-term financial instruments. First, give the size of those markets, a small amount of funds can be effective.  Second, early success may help it when it comes to the heavier lifting that might be required for Spain and Italy.  Third, it will also put paid to Draghi's conditionality and underscore the spirit of desire to reward what some officials call "virtuous" countries.

The justification of ECB intervention in the sovereign bond market is that yields are not allowing the transmission of its monetary policy.  To demonstrate its point in the most convincing way possible is not to take an asymmetrical stance and only resist high yields.  It should also sell the 2-year notes of those countries, like Germany and Finland which have negative yields.   Surely a 0.75 bp refi rate does not justify a negative 2-year yield.  This would have the added advantage of reducing the impact on the ECB's balance sheet.  It would also demonstrate the ECB's resolve that the euro is indeed irreversible.  
Should ECB Sell Bunds? Should ECB Sell Bunds? Reviewed by Marc Chandler on August 14, 2012 Rating: 5
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