ECB Monetary Policy: When in Debt, Do as the Debtors Do

The euro-bailout stole the headlines yesterday, while cheering investors around the globe – especially those investors who own the stocks and bonds of bankrupt nations. Greek, Spanish, Portuguese and Italian stocks all soared more than 10% on the day, as yields on high-risk sovereign debt plummeted.

Greek 10-year yields tumbled nearly 500 basis points – from 12.47% to 7.77% – as buyers rushed back into the market. But one has to wonder what sort of buyers these might have been. Were they: 1) The sort of buyers who sensed a bona fide buying opportunity; 2) The sort who sensed a bona fide short squeeze or; 3) Traders for the European Central Bank? Our guess would be #3, followed closely behind by #2.

In other words, almost every aspect of yesterday’s trading looked like a great big short squeeze. Since investors around the world have been establishing hefty short positions in all things euro-related, the threat of a $1 trillion buyer for said assets was more than enough to send the shorts rushing for cover…or rather, TO cover.

“At the lightning speed that markets operate in today’s world,” says David Rosenberg, “this short squeeze could be over [already]…Recall the initial reaction to the TARP program [was]…a huge immediate relief rally of 11% that gave way to a 30% slide to the lows. The bottom was only turned more than four months later, once the kinks were worked out and the specifics of the stress tests were announced. Keep this in mind if anyone decides to extrapolate today’s short-covering rally into the future.

“In the final analysis,” Rosenberg concludes, “if the EU lends money to Greece or to any other problem country in the zone, debt ratios…in the region will only rise further. It will be interesting to see how the rating agencies handle this. It cannot be lost on them, or the global investment community, that while loans, guarantees and central bank provisioning can deal effectively with liquidity issues, they are ineffective in addressing what’s really at stake here, which are structural fiscal issues. So the deal over the weekend is only going to be successful and so far as it is backed up by meaningful reforms…

“What is clear is that any rally in the euro should be shorted, because the line between fiscal and monetary policy has just become blurred. The cost of the ECB helping drive long-term yields in the periphery [countries] lower is jeopardizing the sanctity of the Central Bank balance sheet…Of all the knee-jerk bounces today, the euro is the one most vulnerable to a reversal.”

Our only surprise here at The Daily Reckoning was that the trillion-dollar bailout announcement failed to resuscitate the euro or to suppress gold…even for one day. The short-covering rally in the euro produced very meager results. After jumping nearly 3% in early New York trading, the euro ended the day with a miniscule gain. Gold, on the other hand, dipped only slightly from the near-record highs it hit last Friday.

Apparently, investors deduce that the ECB’s bailout scheme is inflationary, at a minimum. Somehow, some way, the ECB will conjure euros into existence that do not exist today. Thus, much like the Federal Reserve’s activities during the last 18 months, the ECB will dramatically expand the supply of money and credit in an effort to “rescue” the euro.

Ironic, isn’t it? Trying to defend the value of a currency by producing more of it? In all of this, gold seems likely to benefit.

Eric Fry
for The Daily Reckoning