How To Train Your Draghi


If you’re wondering if the European situation is really fixed, you might want to ask yourself the following question – how many times over the decades has a central bank said it would do “whatever it takes” to head off some outcome? Then ask yourself, how many times has it succeeded?

The answer is, “zero,” and no, we’re not going to give credit for the defense of the Swiss franc. Yes, the Swiss National Bank (SNB) did set a floor of 1.20 francs to the euro, and yes, but for a few tiny cracks, it has succeeded. But there hasn’t been a euro event yet, either. If, for example, the vote on the Greek referendum had gone the other way in June, the SNB would have been overwhelmed and been forced to capitulate. It could still happen.

Forgive us for saying that we’ve seen this movie before, but we have. A currency or economy gets in trouble. The central bank assures that it isn’t a problem, and there’s a counter-rally. The problem doesn’t go away, though, because national finance isn’t as simple as printing money out of every problem. Eventually the bank must pull a surprise intervention, and another counter-rally pops up. It’s very much like cocking your arm at a bunch of hyenas – it frightens them away, but then they get bored with it. So you have to throw a rock or two, and that works, until they get bored again. Then they come and eat you.

So Mr. Draghi – head of the European Central Bank (ECB), you recall – said in July that the ECB would do “whatever it takes” to defend the euro. Except that it won’t, because to keep German Chancellor Angela Merkel and her finance minister, Wolfgang Schäuble, on board, Draghi had to promise that everything would occur within “conditionality.” In other words, countries have to apply for aid, negotiate terms, and possibly (probably, for some) bring in the IMF budget police. Since the terms will inevitably mean cuts in public budgets, countries already in the grips of deep recessions will not want to agree to it. It will come down to a stand-off, and someone will have to blink.

But when Draghi cocked his arm in the last days of July, he scared the shorts into covering and the fast money into buying. He cocked it again on Thursday and said the word, “unlimited,” and another flock of buyers took to the air (though as volume goes, it wasn’t a big flock). It’s important to remember who is doing the buying – professional traders, algorithms, and some scared fund managers.

If you think that the Germans will always give in, that is whistling past the graveyard. Draghi’s position attracted a storm of criticism in Germany, though he had some supporters too. But will the Italians, Spanish, and Greeks give in as well (not to mention Ireland, Portugal, Cyprus, etc)? The Italian economy is in a difficult recession, headed for worse. The Spanish economy is in near free-fall, headed for worse. Both of them will be asked for more austerity in exchange for bond support.

Perhaps the first round or so of terms between the ECB and supplicants can be fudged, leading to another burst of algo-buying for assets, but it won’t change the economics of the situation. The market seems to operate on the assumption that the time-bomb is 7% on sovereign yields, but those yields are just symptoms. The real time-bomb is the cratering economies of the south of Europe and the periphery, who cannot possibly get out of their misery in less than four or five years without a currency devaluation and debt restructuring – and that is one line too many for the north to cross. It may be financially feasible, but not politically.

However, like many a central banker before him, Mr. Draghi has learned that the markets can be induced into doing a central bank’s lifting for extended periods. He had only to cock his arm a couple of times (“irreversible,” “unlimited”) and yields went down while equities went up. Too bad the economy keeps going down – the ECB also revised its outlook for 2012 downward, to (-0.4%). Many believe that the EU will somehow muddle through, but to do so requires putting your head in the sand about the economy in 2013. If you think that more austerity in exchange for lower yields – until the budget targets are missed again, due to the austerity – is going to revive the Spanish and Italian economies in 2013, then I need your help freeing my cousin’s millions of dollars frozen in her Nigerian bank account.

A Bloomberg headline read that stocks surged on stimulus hopes after the weak jobs report; had the number been above expectations, then stocks would have surged on unexpected US strength, and had it been right on the money, then stocks would have surged on expectations that the Fed could continue with stimulus plans. The trading algorithms read the news flow and buy, the newswriters look at the buying and decide it must be good and so write more positive news words, leading the algorithms to read them in turn, and so buy more.

It works until it doesn’t, and that comes when the markets belatedly realize that the real economy has rudely intervened in marketland again. We wrote in Seeking Alpha last week that markets should rally into October before topping out, assuming that the Fed wheels out QE-3 next week and the German high court rules favorably on the European Stability Mechanism pact ahead of it (very likely, but do keep in mind that nothing is ever a sure thing). If the Fed doesn’t provide more easing next week, then markets could rally all the way into the end of the year, because the carrot of more easing will still be ahead of it.

As a final exercise, ask yourself what all of the above have to do with earnings and the real economy. Then recall that it usually takes at least two quarters for monetary policy to have an effect. Then recall the earnings warnings from Fedex (FDX) and Intel (INTC). Don’t fight this tape quite yet, because the momentum morons are leading the herd. It’s a time to rent stocks, not buy them.

The Economic Beat

The jobs report may have disappointed, but to us it was again a case of seasonals – there really didn’t seem to be much change from July’s trend. We heard a fellow from the Challenger job cuts report opine on public radio Thursday that firms were standing pat, neither hiring for firing. The report itself, however, warned of looming cuts in the fourth quarter, both due to observations of cuts overseas and the firm’s sense that “the ongoing crisis in Europe and weak economies around the globe will undoubtedly take a toll on the economy.”

But the August numbers themselves weren’t so bad, not the raw data. There were some troublesome indicators – temp jobs were negative, and the weekly payroll index was unchanged, not a good harbinger for August personal income. Average hourly earnings were actually down a cent. The household number fell by (-119K), though the actual number of jobs counted rose by 250K from August – before revisions, which were negative for both June and July. Goods-producing jobs declined (seasonally, though not absolutely) and more than half of the headline number was in the “eat, drink and get sick” category, or leisure, hospitality and health care.

But the year-on-year increase – again, before revision – was 1.38%, which for the moment is the same as the July increase. Like July, it was the best year-on-year percentage increase since 2006, though these numbers are only about half the rate of good years in the 80s and 90s. Through the first eight months of the year, the total increase in employment has been 0.1%, which may not seem like much but again, is the best such tally since 2006. It is weak when compared to prior expansions.

Considering the worries over what Europe might do, and the reality that it’s in recession, one would think the actual number (+250K) is a fairly sound number. However, there is no doubt that retail sales and employment benefited from benign weather in much of the country, particularly the densely populated Northeast (as for hurricane Isaac, it came after the cut-off date for the August jobs report). Employment is also something of a lagging indicator – in the last recession, real jobs didn’t start falling off until November 2007.

While the weekly claims data have been benign, improvements over last year have plateaued. The actual number of claims should begin to pick up next month along with the season, which won’t be a plus for GDP. The weakness in claims is usually offset by the beginning of an inventory rebuild in the fourth and first quarters, but the European hangover may dampen the effect this year. The pop in stock prices hasn’t done anything yet, and skepticism may soon set in again. Certainly the Economist isn’t buying the program as the new cure.

We would guess that warm weather played a role in the ISM services (non-manufacturing) number this month as well. While the headline number of 53.7 looked okay, it benefited from seasonal adjustments, as the number of respondents replying “higher” to categories eased. It was ten sectors growing versus five contracting, with most of the growth coming in weather-related sectors.

That was certainly a better score than the eight-eight in manufacturing, which posted a barely negative 49.6%. That’s about neutral, but the 8-8 score is weak and the responder comments talked about slowdowns nearly across the board. Most of the sub-components had negligible changes from the previous month, but inventories did build up, not a good sign. Construction spending fell (-0.9%) in July instead of rising as expected. That won’t help GDP, but the new home component rose nevertheless.

Motor vehicle sales were respectable in August and largely above estimates, while the latest weekly retail sales figures suggest that back-to-school shopping is okay. It doesn’t appear that much is changing within the U.S. itself, but the global slowdown is having an effect. Though Germany posted a surprisingly strong result for July industrial production, its August surveys indicate a slowdown. A big chunk of Chinese data comes out over the weekend, but not to worry if its slowdown continues – the market will just assume away an obligatory stimulus program that fixes everything.

Next week is something of an oddity in terms of the economic calendar. There are some smaller reports in the early part of the week, but no market-movers until the German court decision on Wednesday regarding the constitutionality of the ESM, followed by the FOMC decision on Thursday. We expect both to move the market higher, unless it’s already rallied too much in advance. The heavy data comes after the FOMC meeting, which is unusual: both retail sales and industrial production for August are out on Friday.

There is also a week of price data – import-export prices on Wednesday morning, the PPI (Producer Price Index) on Thursday morning and its consumer brother the CPI on Friday. They’ll be dwarfed by the events in Europe and the FOMC meeting.

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