07 August 2011 at 18:44 GMT
What the markets face at the start of the week is a 'bundled', i.e., a combination, of different risks into one event risk and it's important to keep perspective and deal with these risks individually.
The US downgrade in itself is not major news. I am sorry, it is logical and justified. A country going from AAA to AA+ is not the end of the world it will not force anyone to do major fire sales of bonds; it may over time, and in lack of new growth, create the demand for a higher yield.
It's more like the 'teachers pet' going to the principal's office to get a warning. It's not that the debt situation is not for real, but it's out of context to treat this as a new information. Further, the downgrade was widely leaked ahead of market close Friday as clearly proved on a number of newswire reports.
The second risk is the contagion in Italy - with Italy now yielding more than Spain, something 90 percent of market pundits would not have imagined less than one month ago - but here the issue is more serious.
Even if ECB gets a mandate tonight from the EU to intervene in Italian bonds tomorrow, it will be long-term futile as the combined debt of Spain and Italy is far beyond the present EFSF size - even with an enlarged version of EUR1.5 trl. Let me stress, I think, with 95 per cent certainty, that ECB will be buying Italian bonds by the open tomorrow - probably even sanctioned by Germany.
Germany holds the key to the EU debt crisis but their ability to operate is limited by their wish to stay inside the Maastrict agreement which stipulates a no bail-out clause!
But never underestimate the political will to save the EU. Never. And here lies the answer to the expected policy response later tonight.
If the JPY and CHF strengthen on the open, I expect intervention.
The G7 leaking statement which says they are working on support to the US dollar (it was out 1915 European time).
I fully expect ECB to intervene in BTP's and potentially in Bonos (Spain).
The key for the medium- and long-term is where Germany stands and what happens to France's credit rating (at risk too).
Finally using historic comparisons:
- When the market closed post 9/11 it reopened down 5 percent - on average the market opened down 5 percent on any historic closing.
- The Madrid bombing took the market down 2.5 per cent - this is NOT 9/11 or Madrid - it's not even a surprise and not an attack on any nation.
It is, however, the market telling the policymakers: enough of this buying time - we want to agenda of growth and jobs and a consolidation of debt.
The FX market will open at 5 a.m Sydney time (2100 CET) - it is going to be with weak liquidity and wide spreads - from midnight CET, Globex and the futures will start trading, getting us the first full picture of the risks.
Between now and the European open I expect, if needed: FX intervention, a mandate to ECB to buy bonds and strong rhetoric to support the EU, Italy, Spain and the US. (As I write this, news broke from Germany and France reiterating commitment to 21 July EU agreement).
By this time tomorrow we will have had session with full liquidity and I would expect things to have normalised. I do not foresee a Black Monday but I expect high volatility with huge trading ranges and poor liquidity.
This is Crisis 2.0, which is about paying for years of economic neglect, but the bill is not going to be paid up front and in one day, but through multi-years of low growth, low stock market returns and higher marginal costs.
That's what we should have learned from history.