Draghi takes the markets by storm

At the start of the trading day everyone was talking about how hard it would be for Draghi to begin his Presidency of the ECB in the middle of such a mess. However, the Italian took it in his stride. He went in there and cut rates, surprising the market (only 7 analysts interviewed by Bloomberg expected a cut) and his press conference was a very assured performance, he even managed to charm the pack of journalists and called some of them by name. Mr Draghi has arrived.

But while the performance was assured, the details of his comments are what matters for traders, so what did Draghi say? Essentially he didn’t hide the severity of the situation facing the Eurozone; however, he reassured markets that the ECB is here to help smooth the tough journey ahead. He said that downside risks to growth have been materialising and that it had increased the chance of downward revisions to 2012 growth (ECB staff revisions are released next month).

This opens the way to another 25bp rate cut next month. This is a repeat of 2008 - the ECB hikes rates then cuts a few months later. Luckily for the ECB the change of President means that the markets will probably not reflect on whether this has dented the ECB’s credibility. There is a chance that the decision to cut was made as the deterioration in Greece threatened to push Italy towards bailout territory, so Athens is not only dominating market sentiment, but may also be determining decisions at the ECB.

Although Draghi said that the rate cut was consistent with price stability (i.e., weak growth had increased the chances of deflation) he noted that the risks to medium-term price stability were “broadly balanced”. He also waded into the political debate and followed Sarkozy and Merkel by saying that all countries in the currency bloc need to implement the decisions agreed on 26th October. The ECB needs Greece to play ball. The political turmoil in Greece is causing shockwaves in the bond market, and every time yields surge to the upside the ECB is pressurised to step in and buy bonds and jeopardise the integrity of its balance sheet.

When it came to the press conference Draghi handled a huge pack of journalists and photographers with the ease of a showman. He answered questions quickly and clearly. He was asked whether the ECB will continue to buy sovereign debt and his answer was a coded yes, but within reason. He said that prior to the crisis bond spreads were too narrow and the credit markets didn’t reflect the various risk levels within the currency zone, now the markets are rapidly pricing this in and they are over-shooting on the downside. The ECB is there to restore some balance, but not too much. Draghi is a cool customer – he said this at the same time as Italian bond yields reached a fresh record high for the third day of 6.4%.

But beneath the dapper façade, Draghi made it perfectly clear – he is no radical. He will stick to the Treaty. He was asked repeatedly if the only way to save the Eurozone was for the ECB to become the lender of last resort for the currency bloc, “it’s not in the Treaty” was his answer. And indeed the Maastricht Treaty makes it perfectly clear that it is illegal for the central bank to issue Eurobonds. So when you scratch beneath the surface Draghi isn’t giving anything away, how very Trichet-esque of him.

Whilst Draghi was in Frankfurt the Athenian political drama continued, the G20 draft statement is dribbling out through the wires and the ISM non-manufacturing survey came in weaker than expected at 52.9, the lowest level since July. Added to this stocks in asset manager Jefferies were suspended from trading until the company came out and clarified its “net” exposure to European peripheral sovereign debt. It said that its exposure to Greece was a mere EUR3mn, and its hedges were cash not CDS so it doesn’t have CDS exposure to counterparty risk. The markets were worried that Jefferies could become another MF Global; however this statement has restored some calm to the markets.

The latest news from Greece is that the referendum is off the table, as the government and opposition have struck an agreement on the terms of the latest bailout for Greece agreed last week at the EU summit. Essentially this is the answer to Merkel’s question: Greece wants to be part of the Eurozone. However, it needs to toe the line otherwise it could see Merkel et al re-write the Treaty so they can expel errant members.

Risky assets seem to like the news from Athens and are moving together. Italian, Spanish and French bond yields have all moderated after rising earlier. Stocks are higher, boosted by the rate cut and Greek news, while the EURUSD has recovered from its low of 1.3650, where it found support after nose-diving post the ECB decision. It needs to get above 1.3795 before we can target 1.3850, the outlook is still too uncertain for 1.40 to come into view at this stage. We still think the euro will be range trading for some time as we don’t know if there will be a confidence vote in Greece tomorrow or not and if the referendum has been cancelled for good.

Either way, the Greeks have given the markets a very big shock. The southern European nation is a political hand grenade that could cause lasting damage to the EFSF’s mission to attract funds to its new investment vehicle; after all who would want to be involved with an economy and political system that looks more and more like a third-world basket-case. Thus, expect the unexpected, continue to remain glued to the news and headlines and prepare for more days of volatile trading conditions.

Source: Forex.com

03.11.2011