We are having a pullback in the market after the new ECB head Mario Draghi quashed some hopes of ECB being involved in solving the Euro crisis by lending to the IMF. Last Thursday in a speech, Draghi had mentioned the words “other steps might follow” if the European nations agree on stringent fiscal rules. Those words were taken by the markets and the financial media as hint to a stronger ECB involvement in dealing with the Euro crisis.
There has been talk about a program of the ECB lending to the IMF which will in turn lend to European countries. The reason you have take this circular route is because by law the ECB cannot lend directly to sovereign countries. So this is a technicality to get around that law because the ECB is allowed to lend to the IMF, although in spirit it is going against the law. Today Draghi strongly suggested that he wants to stick to the spirit of the the European treaty and he expressed surprise at how his words were interpreted. Draghi is new on the job and I think it is a lesson for him that whenever he gives speeches he has to be pretty specific, unless he wants to achieve a policy end by being vague.
We are seeing some positive developments in Europe which could lead to a more sustainable solution to the European crisis.
The first positive indication came from the new ECB chief Mario Draghi last Thursday where he indicated that if there is a wide agreement on some stringent fiscal requirements among the EU nations, then the ECB could play a larger role in dealing with the European crisis.
The other positive development came today. It appears France and Germany the two most influential member of the EU are finally converging on how they want to handle the European crisis. Looks like they are calling for modifying the European treaty to include more stringent fiscal requirements which will limit the level of fiscal deficits a country is allowed to have. Till now France and Germany were on a different page with France calling for more ECB intervention without much constraints. It appears France is finally moving more towards the German position and setting up a system which closely resembles the one that Draghi wants in place for the ECB to play a larger role.
In response to these developments, you are seeing a strong pullback in most European bond yields, especially in those of Italy and Spain. The level of pullback is pretty large, which tells me the market is also thinking something more sustainable could happen. Also another positive development is that the new Italian government led by Mario Monti passed tough austerity measures.
The EU leaders have a summit on Dec 9th and we will find out more on how the proposal by Merkel and Sarkozy is received by everyone else.
The key thing now for the world equity markets over the next 6 months to a year is if this solution is too late. It appears Europe is heading into a recession, so are we going back into a negative feedback cycle where lower tax receipts make the fiscal situation worse.
In general over the last few weeks US economic data has been coming in better than expected. Unemployment claims for this week came in at 388K, which is one of the lowest reading this year. Leading indicators today came in at 0.9% vs expectations of 0.6%.
Although the US economy is doing better than expected, we are seeing tighter credit conditions in the global banking system. One measure of stress in the banking system is the LIBOR rate. LIBOR is what big banks charge each other for money. Even though central banks haven’t tightened monetary conditions you are seeing increase in LIBOR rates. That means banks are being more cautious and charging more to lend to each other as they worry about the solvency of their counter party. Here is a link to the chart of 3 month LIBOR and you can see that it has been steadily rising over the last few months.
3 month LIBOR
Over the last few weeks things have gotten worse in the European sovereign debt markets, yields for most Euro zone countries including France which is AAA have gone up. The EFSF which is the bailout fund is itself having trouble finding buyers. The situation seems to be getting out of control. Only some ECB intervention in the Italian markets has kept yields from going further higher. Over the last few weeks the S&P 500 has held up relatively well in light of these conditions. I think there are probably two main reasons for this.
1. A lot of active fund managers are sitting on cash and there are reports that many hedge funds are under performing the market this year. So in order to make up for performance before year-end some of this cash could be coming into the market and supporting the stock market.
2. I think the more important reason could be that the market is betting that ultimately Germany will give in and allow the ECB to announce a major bond buying program. At this stage it appears that the ECB is the only institution that has the resources to stop the crisis from getting worse. The ECB can potentially print unlimited amount of Euros and buy Euro debt, of course Europe will face potential of higher inflation. I think the recent divergence in the Euro and S&P 500 suggest that ECB intervention is what the market is counting on. ECB intervention would be bad for the Euro and good for equity markets. If you look at the chart below you can see that starting the first week of October the Euro has remained weak but the market has gone up.
I think the market might be getting too optimistic, I don’t think the ECB will come in with a major program until the situation gets much worse. The Germans are really paranoid about inflation and they will agree with this option only when things get really bad.
I have decided to venture into managing money and that is one reason blogging has been so sparse last couple of weeks. I have been busy getting registered with the Texas Securities Board as a Registered Investment Advisor. Finally I am done with registration.
The name of my company is Objective Investments LLC and you can download more detailed information at
I should have a post up about the market later today.
The markets are rejoicing on the European plan to deal with the credit crisis. Although many commentators are saying it is inadequate, I think European leaders still deserve some credit. It is not easy to get stuff done when you have 17 members to deal with. Getting 17 parliaments to unanimously approve the EFSF and getting private debt holders to agree to a voluntary 50% haircut on Greek debt are positive accomplishments.
The key measure of the success of this program will be if it avoids the debt problem from spreading to Spain and Italy. Unfortunately it doesn’t appear that is yet the case, at least for Italy. So Keep a close eye on the Italian and Spanish 10 year bond yields. If they go much above 6% then Europe would be in trouble again. Here are the links to see Italian and Spanish bond yields.
Italian 10 year yield
Spanish 10 year yield
The National Association of Home Builders came in at 18 versus expectations of 15. This index has been between 13 and 17 for the past 1 year. The index is a survey in which asks respondents about the condition of the housing market. This sharp jump is pretty surprising considering the weakness in the financial markets over the last few months. It might be an early indicator that the housing market may finally be in the early stages of healing. One of the main reason the current recovery has been so weak is because housing hasn’t contributed in this recovery at all. In all the previous recoveries, housing has been one of the biggest contributors in the early stages of the recovery. Housing stocks are rallying strongly on this data. Hopefully this data is not an anomaly and instead of a headwind we will finally get a small tail wind from housing.
I have been busy with some other work so haven’t been able to post frequently. Hopefully I will get back to posting about 2-3 times per week.