Wednesday, December 1, 2010

Finally some good news

Some days ago Mr. Weber, the arch-hawk and president of the German Bundesbank, hinted that the European Financial Stability Facility could be increased in size in order to combat the woes in the Eurozone periphery. Furthermore Mr. Trichet, the president of the ECB, stated yesterday at a hearing in the European Parliament that "We will see what we decide" when referring to the ECB's bond buying program. Additionally, he suggested that markets would be underestimating EU government's determination to safeguard the Eurozone.
The statements by both, Mr. Weber and Mr. Trichet, are important. They suggest that the ECB now sees the need for more action in order to stabilise peripheral bond markets/economies, even though they will likely continue to disagree on the means to use. Mr. Weber seems to be preferring actions by the EU (i.e. an increase in the EFSF) while keeping the ECB out of this area whereas Mr. Trichet understands that the ECB has to and can provide significant support for financial stability.
I mentioned previously that I favor a significant quantitative easing program by the ECB (see Monetary easing in the wrong places or will the real ECB please stand up dated 17th November) - which could be put into practice straight away - and should be followed later on by joint Eurobond issuance for parts of the sovereign debt (i.e. up to 60% of GDP and up to a 3% deficit per year for each country) as mentioned in the last blog post.
A massive buying of peripheral bonds by the ECB would a) directly reduce peripheral bond yields and with that help to keep fiscal deficits in check and promote debt sustainability b) provide an effective floor for bond prices and hence increase incentives for investors to buy these bonds as well which renders financing of maturing debts/deficits for the peripheral countries easier. Given the prohibitively high interest rates on peripheral bonds, the monetary environment in the affected countries is currently very restrictive. Coupled with the ongoing fiscal tightening programs, this means that deflationary pressures have been rising. A significant reduction in these yields would just render the monetary environment less restrictive without causing inflationary risks.
Judging from Mr. Webers and Mr. Trichets comments, the discussion within the ECB about larger bond buying programme seems to be taking place at the moment and there is a good chance we will see some announcements being made at tomorrow's press conference. I expect some new measures (i.e. increased buying of peripheral bonds) but not to the extent which will really turn things around for good. Rather we are likely to get a timid response by the ECB, just enough to improve sentiment towards risky assets in general in the short term but not enough to provide a real lasting solution.

Still, in conjunction with an improving macro-environment in the US (the next weeks/months promise to see a slight growth rebound), the stage might be set for a year-end rally in equities.

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