Draghi and Carney’s Reflections

Both Draghi and Carney reflected
Their policies weren’t connected
To Ben’s latest caper
The infamous ‘taper’
Instead low rates should be expected

It seems to me that the market may be moving to a new level of concern about Europe and its ability to address the myriad problems that exist within the Eurozone’s weaker members. Last week, the Greek governing coalition lost its junior member, as they could no longer support the government’s austerity measures. Two days ago it was Portugal that saw turmoil as two ministers, including FinMin Gaspar, resigned from the government calling into question the viability of the governing coalition in Lisbon. Again, the reason was they could no longer support the government’s austerity measures. Notice a pattern here? It took two months for Italy to form a coalition, which ultimately based its electoral legitimacy on its plans to unwind some of the previously implemented austerity measures. Spanish unemployment continues to climb, currently above 27%, and the pressure to find a solution there is intensifying. Through all this, Chancellor Merkel looks on and cares only about her re-election prospects in September, which means she cannot countenance any further German aid for the periphery.

It was back on June 14 when I commented that the euro would trade 1.25 before 1.35 as I felt the underlying structural problems in Europe combined with the idea that the Fed was seeing the light at the end of the free money tunnel would force market participants to reevaluate the euro’s future. Today, I am looking a lot better on that call as the euro is firmly below 1.30, ahead of the Payroll releases this morning, and quite frankly looking like it has nowhere to go but down. As the pressure intensifies on the peripheral nations’ governments to end austerity, the Troika is going to find itself with a real problem. If it condones any changes in policy, it will lose all legitimacy with respect to insisting on conditions for any future bailouts. If it holds the line on its austerity policies, the possibility of Greece or Portugal or Ireland or Cyprus exiting the euro grows dramatically. At some point, these countries are going to start to look more closely at the potential long-term benefits of getting out from under the ECB’s (and Germany’s) thumb.

All of this is the backdrop to yesterday’s unprecedented comments from both the ECB and the BOE. It started with new BOE Governor Carney releasing a statement after the MPC meeting despite not changing policy. The statement was basically, we don’t care what the Fed is doing, we see no reason to raise rates anytime soon. Shortly thereafter, it was Mario Draghi’s turn to step outside the traditional ECB framework and promise that rates would remain low for an extended period of time with a downward bias to boot. It certainly makes sense that the ECB will keep rates low as the recession there continues unabated. So it will be difficult for the euro to find support for a while, especially if US data points to better times ahead. The UK story is a bit tougher as the data there has shown modest growth and the forward looking surveys are actually looking up. My concern for the pound is that inflation starts to increase and the BOE finds itself unable to address the issue effectively.

When the Greek crisis began back in 2010, I had written that the best (only?) solution for the euro was for it to decline dramatically, to parity or below, as only then would the peripheral nations start to have their labor priced competitively in global markets. But that has not happened and that repricing of labor has come via direct cuts in wages and reduction in those nations’ workforces. This has been the recipe for disaster which is currently playing out. The euro has further to fall my friends, of that I am sure.

Today we are awaiting the US payroll story, with the market pretty bulled up on things. Expectations are for NFP at 165K, Private payrolls at 175K and the Unemployment Rate to fall to 7.5%. Equity futures are pointing higher after yesterday’s holiday though equity markets in Europe are generally lower. As I wrote Monday, I expect a good number today, something near 200K, which will simply confirm the differences between the US and the rest of the developed world in terms of economic prospects. This should help the dollar and hurt Treasuries, with the initial move being positive in equities. But the equity conundrum remains; stronger US growth will lead to a quicker taper in QE by the Fed, which means higher interest rates and equity market support will waver. Ultimately, I continue to believe that the US equity market is priced incorrectly and is very expensive. So alongside a strengthening dollar, look for weaker stocks.

Good luck