Draghi'ing the wool over our eyes? Thoughts on the ECB and euro

It seemed clear at the end of last week that there were a number of high level eurozone officials that had had enough of the relentless rise in Spanish bond yields, enough of the uncertainty surrounding the next steps for the crisis, enough of the unstable footing from which the embattled eurozone is striving to bounce back from.

Starting with ECB president Draghi’s comments on Thursday that the “ECB will do whatever needed to preserve the euro” intermingled with praise for the progress of the eurozone over the past six months and warning against underestimating “the political capital in the euro”. Mr Draghi went on to point out that firewalls are “ready to work much better than in the past” and then potentially risking his credibility (and that of the ECB) he said “believe me, it will be enough”.

On Friday, this boost to the expectation of action were raised further by the rhetoric following the meeting of Merkel and Hollande, who jointly pledged that they are “ready to do anything to protect the euro region”. Equities and risk assets reacted very positively and even the troubled EUR made up some lost ground in valuation against a number of currencies.

Disrupting the transmission mechanism

The core ‘hope’ of the markets, or alternatively the core ‘suggestion’ of Draghi et al is that the ECB either via the EFSF or in its own right will step in to the secondary markets to purchase the bonds of Spain (and perhaps others). Sceptics continue to point out that Germany remains opposed to the use of joint funds to purchase a country’s debt, as it continues to oppose mutual liability in any form. The issue as I see it, however, is slightly more technical than that and lies in whether the ECB determines that the current level of Spanish (or indeed any other nation’s) debt is disrupting the transmission mechanism for monetary policy. If the answer is ‘yes’ then the opposition of Germany is irrelevant.

In reality, however, any ECB purchases of Spanish bonds will not solve the ills of the eurozone. It is in no way a long term solution or replacement to the much needed structural rebalancing and painful debt reduction that will sap the energy out of the economy for years to come. The EUR, as I see things, will be under pressure for years to come. That does not mean that the EUR cannot make further ground back this week however!

Central bank action

Expectations of central bank policy action will likely dominate this week. While it is very unlikely that the Bank of England will sanction a further stimulatory measures this close to the re-invigoration of QE at last months meeting (and while it is still in full flow), expectations of further easing ahead, likely in the form of a rate cut (while I remain sceptical) are likely to grow in the broader market. In the US expectations of QE3 continue to grow, and data this week will be key in shaping these expectations, culminating in a potentially explosive employment report on Friday.

Actions speak louder than words

In the eurozone, Mr Draghi has now ‘set out his stall’ and the market expects action following on from the confident “believe me, it will be enough” rhetoric. Anything less than firm action, or further believable assurances will likely mean Mr Draghi finds out that actions speak louder than words.

For this week, therefore, I would expect volatility to pick up further. While the EUR has given back some ground since the highs of Friday afternoon, the macroeconomic supports of sharply lower Spanish (and Italian) bond yields, a more risk friendly equity backdrop and narrower spreads should provide some support for the EUR. Despite that fact, that it may seem like a very long week for a long EUR position. I would expect the embattled currency unit to have held its ground and even to have made some more headway by the end of the week.