EUphoria as Draghi Unveils "Big Bazooka"

September 9^th, 2012

Nick Hays

Dhaka, Bangladesh

Today – on The Long and the Short

* Stocks jump as ECB announces major policy shift, warms up the printing press

* Economic picture worsens – global manufacturing now in contraction

* Liquidity versus fundamentals - central banks and the law of diminishing returns

After a muted response to Bernanke and the Fed at Jackson Hole, it was the turn of another central banker to give the markets a massive boost on Thursday as “Super” Mario Draghi announced that the ECB stands ready to purchase “unlimited” quantities of Eurozone sovereign bonds, subject to certain qualifications.

Though the move was widely telegraphed ahead of time, markets reacted strongly to the announcement with major European stock indeces rallying 2-3% and the European banks jumping 5%. Gold rallied 2.4% and the Euro gained 1.7% against the Dollar the following day.

(Click to enlarge)

The ECB, under pressure from German politicians and the Bundesbank in particular, has to date shyed away from direct purchases of sovereign debt, fearing this would undermine deficit-reduction commitments and stoke inflationary pressures.

Thursday’s announcement therefore marks a major change in ECB policy, essentially providing a ‘safety net’ for sovereign debt yields by paving the way for the central bank to directly purchase government bonds with newly printed Euros.

Meanwhile, the macroeconomic picture worsened with the August PMI showing that the manufacturing sector in almost every major economy is now in contraction. In addition it was announced that the US economy managed to create just 96,000 jobs in August, significantly missing the market expectations of 130,000 and fuelling concerns that the US is not growing enough to significantly reduce the unemployment rate.

Amidst this dismal backdrop, the strength of the market reaction to the ECB policy shift suggests that this may have been the “big bazooka” policy response that markets were hoping for.

However it remains to be seen how long the afterglow will last this time; previous periods of market “EUphoria” have turned invariably to disappointment as details of the latest ‘cure’ are picked over and flaws exposed.

In deed the longer-term risks of this latest plan cannot be ignored. In particular the potential inflationary impact of “unlimited” money printing; the potential loss of the ECB’s political independence as it strays into territory that looks dangerously like entangling itself in government fiscal policy; and the possible dampening effect the monetary back-stop will have on deficit-reduction efforts.

The EUphoria “half-life” in this case may be days, weeks, months or even years. What seems certain however is that even central bankers are not immune to the law of diminishing returns and eventually the marginal effectiveness of monetary policy will reach its natural conclusion.

When this happens we will realise that the floor we are walking on is thin ice.

Liquidity can trump economic fundamentals for only so long: eventually, something has to give.

Despite this, the adage “bad news is good news” continues to hold true for equity markets. Central banks are still pulling the strings for now and are largely succeeding in inflating asset prices in developed markets. The momentum behind the current bull run tells me it has legs yet and for the timebeing it pays not to stand in its way.

Sentiment can change rapidly however, and I recommend long positions in equities for short-term speculation and ultra-long-term investors only.

Trading update coming soon, where I plan to point out some big moves in Gold and the Dollar, as well as the latest on my S&P 500 trading.