Draghi "Rescues" the Euro

Dollar bulls are going are looking forward to this weekend also, as the US$ continued to slide yesterday after the ECB president “came through” on his promise to do what it takes to rescue the euro (EUR). The program announced by Draghi, named Outright Monetary Transactions, was identical to the one leaked out to the markets yesterday morning. The ECB policymakers agreed to an unlimited bond purchase program designed to regain control of interest rates in the euro region and assure the future of the euro. According to Draghi, the program “will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro.” So Draghi and the rest of the ECB proved to the “bond vigilantes” that they could and would mount a coordinated defense of the euro by bringing out the big gun of unlimited funding. “Under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area.”

I think Draghi’s statement really told the story of why the ECB felt they had to bring out the biggest gun they could find. Will the funding for bond buying really be limitless? Of course not! But Draghi and the rest of the ECB were fighting against a bunch of “what if” scenarios and had to try to put an end to all of the speculation that the euro was bound for destruction. With the announcement of limitless funding, the euro breakup that many were seeing as a sure thing is now a bit less likely. The policymakers of the ECB had to wrest back control of interest rates across the euro area, and now bond traders will have to think long and hard before trying to attack the sovereign debt markets, as they will be facing the substantial funds of a very determined and coordinated ECB.

And the best part of this announcement is that as of right now, there isn’t even a need for the bond purchases. Neither Spain nor Italy have requested aid from Europe’s rescue fund, and with rates moving lower in both countries, just the announcement of the program may be all that is needed. Draghi reiterated his call that any aid would come with strict and effective conditions — something which Germany’s chancellor had insisted on. Germany’s Bundesbank was still opposed to the plan, the only member on the 23-member Governing Council to vote against it. The Germans continue to be worried about the inflationary pressures this bond buying creates, and apparently, the Bundesbank isn’t buying all of the “sterilization” rhetoric. As readers of yesterday’s Pfennig know, I agree with the Bundesbank’s pessimistic view of the sterilization, and details of how this will be done weren’t given.

I am happy to see the ECB finally wrest control of the markets back from the bond and currency traders on Wall Street, but I’m still worried about the long-term inflationary impact of the bond purchase program. The ECB left the benchmark rate unchanged and the deposit rate steady at 0%, so the negative interest rates which would have pulled some funds out of the market didn’t materialize. Hopefully, the ECB won’t have to make many purchases, which would limit the inflationary impact, but that is something we will just have to wait and see about.

The ECB actions pushed the euro up above $1.27 as currency investors confirmed Draghi’s rescue plan. The euro was also helped by data that showed German exports and industrial production increased in July. German exports rose 0.5% in July, versus a revised decrease of 1.4% in June. Economists had forecast a 0.5% decline, so the positive number was a very good surprise for currency traders. Industrial production in Germany also increased, climbing 1.3% in July, when it fell a revised 0.4%.

The market’s focus will now move back across the pond to the U.S. Our own central bank will be meeting next week, and many are expecting Mr. Bernanke to announce his own version of the Outright Monetary Transactions plan. Yesterday’s weekly jobs numbers showed 365,000 workers filed for unemployment claims last week, down slightly from the prior week. The ADP employment change surprised on the upside, with 201,000 new jobs added in August, better than last month’s revised 173,000, and substantially better then economist’s predictions of a 140,000 increase. But the weekly numbers can be fairly volatile, and the Fed traditionally focuses on the monthly data, which are being released this morning.

American employers are expected to have hired an additional 130,000 workers during the month of August, slightly lower than the 163,000 jobs filled in July. But as last month proved, these small increases in the labor market will not have an impact on the unemployment rate, which is expected to remain at 8.3%. Chairman Bernanke pointed to the 8%-plus unemployment rate as a “continued drag” on our economic recovery, indicating that he would push the Fed to take action if we don’t see an improvement in the labor market sometime soon. Expectations of another round of QE (no matter what the Fed decides to call it) have put pressure on the U.S. dollar, which lost ground versus just about every major currency yesterday.

I had a Pfennig reader pose an excellent question yesterday. She asked why when the ECB announces stimulus, it helps the euro, but when the Fed announces stimulus, it drives the value of the dollar lower? The answer, as is common with questions on market movements, is complicated. First, the easy part; the Outright Monetary Transactions announced by the ECB yesterday was a rescue plan for the euro. The whole purpose of this plan was to stabilize the markets in order to ensure the future of the euro. Currency investors had real worries that the euro would not survive, and the ECB plan calmed some of those fears (for now). This is why the plan announced yesterday pushed the euro higher.

Now the complicated part. Why does the dollar lose value when the Fed announces stimulus? First there is the “safe haven” aspect of dollar buying. Investors who are worried about the future of the global economy have been moving money into short-term U.S. Treasuries, pushing U.S. yields lower and increasing demand for U.S. dollars. With the announcement of stimulus measures by the FOMC, these global investors no longer need the safety of the U.S. Treasuries and sell them and the dollar to invest the funds back into the global markets. The second factor that comes into play with another round of Quantitative Easing is the inflationary impact it will eventually have on the U.S. economy. In these programs, the Fed is pumping liquidity into the markets in order to keep rates down (or, in the case of Operation Twist, to adjust the shape of the yield curve). Simple supply and demand tells us that anytime you increase the supply of an item and leave demand unchanged, the value of that item will decrease. So by injecting U.S. dollars into the markets, the Fed is essentially driving the value of the U.S. dollar lower, given steady demand. (You can refer back to my first point regarding “safe haven” buying to understand how the dollar could rise even as the Fed is leaving all of this liquidity in the markets.) The ECB is going to try to offset the inflationary impact of this new liquidity by pulling liquidity out of other areas of the markets (sterilization), but Bernanke and the FOMC haven’t discussed sterilization of any of their stimulus plans.

And finally, there is the long-term impact that additional debt has on the underlying fundamentals of the U.S. economy. These bond buying programs have to be funded, and that funding comes in the form of new debt. Hopefully, you all enjoyed the big boss Frank Trotter’s weekend “Pfennig and Pfriends” piece on what drives a currency’s value. Underlying economic fundamentals, and specifically debt levels, have a lot to do with the long-term value of a country’s currency. The additional debt incurred during these stimulus programs puts long-term pressure on the value of the U.S. dollar. Ty Keough sent me the following regarding the U.S. debt yesterday: America’s total national debt, which includes government debt owed to businesses and foreign government, passed $16 trillion for the first time. It passed $15 trillion only 10 months ago.

As I mentioned earlier, the news out of Europe had the dollar backpedalling throughout the trading day. With confidence temporarily restored, currency investors moved back into “riskier” assets. The high-yielding commodity-driven currencies were some of the biggest benefactors of this risk-on day, with the South African rand (ZAR) and Australian dollar (AUD) leading gains versus the U.S. dollar. The New Zealand dollar (NZD) also moved higher. The South African rand rose to a two-week high on the news from Europe. The EU region is South Africa’s largest export market, so the rescue by Draghi was good news for the South African rand. The Aussie held above $1.03 for a second day. The rise in the Australian currency came in spite of a report which showed a wider-than-estimated trade deficit in July. Australia’s trade deficit was A$556 million, from a revised A$227 deficit in June. The median estimate was for a A$300 deficit, so the actual number was substantially higher than the estimates. The trade deficit is a real concern, and will likely weigh on the Aussie dollar going forward. The commodities rallied with the risk-on sentiment, and they brought along both the Canadian dollar (CAD) and Norwegian krone (NOK).

To recap: Draghi was able to rescue the euro with an unlimited bond buying program. The euro ran up above $1.27 and the dollar was down versus most of the major currencies. Focus will now shift back across the pond to the U.S. labor market, which is expected to show a slow increase in jobs. The unemployment rate is expected to remain at 8.3%, which should force some action by the FOMC. I attempted to answer an excellent question regarding the seemingly opposite effects of stimulus versus the euro and U.S. dollar. And it was a risk-on day on Thursday, which drove the commodity currencies higher across the board.

Chris Gaffney
for The Daily Reckoning