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ECB Spurs Short-Covering Rally!

  • Written by Syndicated Publisher No Comments Comments
    July 27, 2012

    Overnight Mario Draghi, the head of the European Central Bank, spurred the financial markets by saying that the ECB would do whatever is necessary to save the Euro – or did he?  Let’s start with the rather confusing set of headlines from Bloomberg this morning:


    sp500-ecb-savestheday-072612-2These headlines immediately sent the shorts scurrying to cover and rocketed the global markets, and US stock futures, screaming higher.  This pattern of headline release, short covering run up and return to reality has been the hallmark of the June and July rally since the May sell off.  As you will notice each time there is a rumor induced rally the markets   As of yesterday, when we posted our warning that our major sell signal had been triggered, the markets were down nearly 2% for the week – however, Draghi’s “save” has cut that loss to just 0.5% for the week so far.

    From Zerohedge:  “The kneejerk short covering reaction to Draghi’s remark that he will do “anything to preserve the euro” (this must be news because yesterday the ECB would notdo anything to preserve the euro supposedly) is over. Now the analysis begins of what was actually said.

    The realization is… nothing. From Bloomberg:

    •  ‘Nothing Structural’ in Post-Draghi Bond Spread Moves: Credit Agricole
    • While selloff in bunds may extend further, it appears to be just “correction” of what is risk- averse bull rally, Credit Agricole fixed income strategist Peter Chatwell says in interview.
    • The inverse is still case for periphery; says “we’re still in a regime of elevated peripheral yields” and difficulty in those markets
    • Draghi remarks on ECB readiness to act “deliberately ambiguous,” clearly in response to market volatility and distress
    • In being so ambiguous, comments are “slightly threatening” for investors short the periphery; could be hinting at further easing, rate cuts, or something “much more bold”

    And now the countdown to the halflife begins. Typically cases such as this where the ECB leaves an open door without any actual hints of what it will do, have a several hour kneejerk lifetime. If and when Germany comes out and denies everything Draghi said, whatever it may have actually been, it will be minutes”

    From a technical standpoint the market must now wrestle with the break of the previous uptrend that started at the beginning of June. While there is support in the 1358 area the overhead resistance to further advances is equally daunting.  However, the key point here is that we have repeatedly seen these attempts to “save the markets” by both the Fed and the ECB before.  Whether it has been the Fed planting stories with the WSJ’s Jon Hilsenranth or continued promises from the ECB to save the EU – both have been long on talk and short on action.

    This announcement also comes at a time when the only person that matters is unavailable, Angela Merkel, the Chancellor of Germany, who is on vacation and unable to respond to Draghi’s comments as of yet.  As we know from recent history what Mario Draghi says, and what Germany will comply with, have been two very different things.

    Goldman Sach Dirk Schumacher commented:  “We have been of the view for a long time that the ECB is ultimately the only institution that can credibly backstop Italy and Spain should these countries no longer be able to refinance themselves in private markets. The existing bail-out funds are not large enough to cover both countries and any other form of debt mutualisation (Euro bonds, for example) that would provide relief for either Spain or Italy are not feasible any time soon.

    Mr Draghi’s comments, in our view, signal very clearly the ECB’s determination to use the ECB’s balance sheet in one form or another to support the Euro. While we think that the ECB wants first to see a similar commitment from governments – and the use of the existing tools as signalled by his comments – before it springs into action, we would not rule out that some action will be taken at short notice in order to dent the sharp rise in Spanish and Italian yields.

    The reference of Mr Draghi to the malfunctioning monetary policy transmission mechanism could be seen as a preference for a re-activation of the SMP. However, it is noteworthy that a damaged transmission mechanism has been the justification for all non-standard measures the ECB has taken.

    In any case, such measures would probably provide only short-term relief and a firmer commitment would be needed to have a lasting effect on peripheral bond markets. Some form of refinancing of the EFSF/ESM through the ECB would be a lasting solution,although there is some legal uncertainty about whether this is feasible.”

    In short this implies that, just as we have seen here domestically, is the continued reliance by the financial markets on artificial means of support as organic economic growth remains elusive.  As Schumacher referenced above the transmission systems of monetary policy are broken, not only in the Eurozone, but globally.  As Ben Bernanke has previously stated the effects of interventions are having a diminished rate of return and options are beginning to run dangerously thin.

    qe-actions-072612As we have stated previously another dilemma that Bernanke faces is the timing of additional stimulative actions into the markets.  When Bernanke instituted QE 2 in 2010 he stated that the purpose was to boost asset prices in order to spur consumer confidence.  The increase in consumer confidence would then likely transfer into an economic push staving off a potential recession.  It worked.

    However, at the time of QE 2 the markets had fallen from their peak of being up 9.6% for the year to being down 8.3%.  At the same time economy had slipped markedly.  The same  thing occurred in 2011 with the introduction of “Operation Twist” with the markets falling from an 8.43% gain to a -10.66 loss.  In both of the cases sharp declines of 14% and 19% in the markets from their respective peaks provided the negativity needed to make the programs effective in pushing asset prices higher.

    This is the problem that Bernanke faces today.  The reason that we highly suspect the Fed will take no action at the next FOMC meeting is that the “jawboning” is keeping the markets elevated.  Bernanke realizes that with the markets already within striking distance of their highs for the year any intervention he will engage in will have very limited effects.  Furthermore, he also knows, that Fed actions work best when they are not expected.  This allows announcements, and subsequent actions, to have the greatest “bang for the buck.”   That is not the case today.

    The conclusion here is that the Central Bankers will continue to “jawbone” the markets as long as possible while taking no direct actions.  Only when “talk” begins to fail would we expect to see central bankers spring into action.  The reason we say this is that a) talk is cheap but is working; and 2) there really are few options left to continue to bailout markets and economies.  My best guess is that the announcement from the ECB today will fade as short covering concludes and that we will get little action from either the ECB or the Fed before the end of August or September.  The question is whether the markets can hang in there for that long.

    With our major sell signal in place, although very early, we will have to wait and see how things play out.   It is unlikely that we will see the “swan dive” of last August but more likely, if the markets do decline further, it will be a slow grind lower.  While we may get some buying opportunities in the near future due to sector rotation, which we will want to take advantage of, it will still very likely pay to remain cautious for the time being.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of Streettalk Live

    lance robertsAfter having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.