>GREED & FEAR: Front running Mr Flexible

Zurich
As the August stock market rally has proceeded in ever more desultory trading volumes, so the grinning talking heads appearing on CNBC have become increasingly bold in proclaiming that the Eurozone is finally getting its problems “sorted”. GREED & fear should make it clear that such is not the view here. Rather the base case is for renewed risk aversion heading into the fourth quarter.

The reason for the increasingly upbeat mood is clear and was discussed here at some length two weeks ago (see GREED & fear – The road to euro quanto easing, 9 August 2012). That is that Flexible Mario has set out a road map to quanto easing and Frau Merkel has not immediately disassociated herself from his comments. Still that does not mean that the ECB has already embraced quanto easing or, indeed, has already committed itself to purchase Spanish government debt, a development that might be assumed given the dramatic decline in two-year and 10-year Spanish bond yields in the last four weeks (see Figure 1). For such developments hinge critically on the key Berlin-dictated Eurozone concept of conditionality.


This week has seen the first stirrings of reality as European politicians return from holiday,
including Frau Merkel. Thus, the ECB felt it necessary to issue a statement on Monday denying
a Der Spiegel weekend report that the ECB was considering committing itself to capping yields on targeted purchases of specific Eurozone periphery bonds. While GREED & fear has little doubt that Ever Flexible Mario would love to perform that sort of manoeuvre such an ECB
approach, in GREED & fear’s view, would be anathema to Merkel since it would remove all
incentive on the relevant periphery country to get its affairs in order; be it in terms of meeting
fiscal targets or pursuing structuring reforms. True, Merkel does not seem to agree with the
Bundesbank approach which is to oppose ECB purchases of sovereign bonds on a point of
principle. But she will certainly demand a certain due process. This is also why Spanish pleas
for an open-ended commitment by the ECB to purchase Spanish debt would seem to have no
hope of being met right now, most particularly given the current lack of a market panic.

Indeed renewed market panic is probably required to apply the necessary pressure to give the
Spanish what they want. In the absence of such a panic the focus of policymakers will be on
conditionality and what the Spanish must agree to in return for a ECB commitment to purchase
their sovereign debt at the short end of the curve, which is what Draghi has indicated.

To read article: GREED & FEAR