The intermission is over and now we get to the heart of the matter.
We will get some actual information this morning. The ECB will cut rates, 25 bps at a minimum and possibly 50 bps. That isn’t news and is priced in. Any pop on a 25 bp cut is likely to be retraced quickly. A 50 bp cut could have a more lasting impact.
The ECB may or may not announce new lending programs for banks. They probably will, but no one really cares. They are already clearly the lender of only resort for many banks and they aren’t going to cut those guys loose. Does it make a big difference that a bank has to constantly roll short maturity positions with the ECB rather than being able to get a longer loan? Not really since not once has the ECB not rolled or extended or grew a program that was being used. Some may say it is a big deal, but the reality is the short-term programs were already going to be constantly rolled so don’t get excited about more ways to let banks fund themselves at the ECB.
SMP. This is where all the focus will be. Will Draghi give the market the QE it is begging for? I would be shocked if we see any strong statement here. The best the market can hope for is indications that the ECB is reviewing its policy and is watching the treaty negotiations closely. If he talks down the possibility of intervention on a grander scale, expect the market to react very poorly. Ultimately, the market has pinned its hopes primarily on ECB throwing in the towel and printing. In the end, I expect his statements to be neutral on this. He won’t rule out the possibility, but will not commit to it at this time.
The leaders pretty much have to cobble together some form of agreement. If they don’t reach an “agreement” the market will likely sell off 5% or more pretty quickly. We were at 1150 2 weeks ago when Europe was back to no plan, so that would be a pretty obvious target if they can’t reach an agreement this week. If they reach an agreement, the market is likely to move up a bit (1-2%), the bulls will be dancing in the street shouting out that Europe is fixed and gets it. The bears will point out that the agreement is a long way from being implemented and is unlikely to ever actually be followed. In either case, it doesn’t make a difference.
The moment a treaty agreement is announced (assuming it is) the market will turn its attention to the ECB, IMF, and Fed. The market will be desperately hoping that the ECB immediately follows up the “successful” treaty summit with a new and fresh commitment to become lender of last resort for sovereigns. Expect disappointment. Draghi may be a dove, but he seems focused on banks (which is his primary mandate) and is unlikely to implement a new, and in Europe, revolutionary policy. The markets will test their resolve. Italian and Spanish bonds aren’t trading so well because anything has been fixed or because the market cares about treaties. The bonds rallied hard because the ECB was in the market and no one wanted to take a chance that a treaty agreement would be the excuse the ECB needed to ramp up its purchases. Without aggressive ECB action, Italian and Spanish bonds will decline in price, and renewed fears will hit all risk assets.
The market is looking to the IMF to play a bigger role. The IMF resources are limited. I thought their resources were under €400 billion, but it looks like they may have some provisions they can use to get to €600 billion in theory. Where they will actually get the money is a question. The EU members are really going to contribute money? The US is going to borrow money to make its payments? The IMF will try to borrow from the ECB? Without aggressive ECB action, the IMF will likely have a very limited response. The “save yourself” crowd will be more than justified in their reluctance to bail out a Europe that won’t help itself. China doesn’t want to spend their reserves on loans to Europe – they want companies and hard assets. The US can’t spend money on its own citizens but can borrow to save Europe. The IMF solution is again very likely to disappoint and will raise the question of how the IMF will get the funds. Can the ECB really lend to them without printing? How much money can the ECB come up with and pretend that it isn’t printing money? Will countries not honor their quotas?
The Fed will likely continue to play nice. The reality is that they need the European banks to have access to cheap dollars so that they don’t sell USD denominated assets as part of their ongoing balance sheet restructuring. The Fed is weighing various QE options (from all reports) but I think this is likely to get pushed to next year. If the ECB comes out strong, the Fed may accelerate their efforts to make it appear globally coordinated and in the hopes that the ECB and Fed programs would be synergistic and that together the benefits would be even greater than if enacted individually. Expect continued dovish comments from the Fed and some possibility that they surprise the market in a positive way.
EFSF – what happened to the €1 trillion? As far as I can tell it is largely gone. Plans to leverage it up seem to have failed. The EFSF may come alive again, but I’m doubtful that the actual size of the EFSF plus IMF programs will reach €1 trillion.