Wednesday, February 29, 2012
will the ECB take away the punch bowl?
Today marked the second phase of the European Central Bank's cheap finance program designed to support the EU commercial banking system. The program is an open ended offer by the ECB of cheap, three year financing against bad collateral. According to reports EU commercial banks borrowed even more than expected today, probably because they are worried that the ECB will soon take away this punch bowl.
The effects of this program can easily be seen in the bottom two charts. The lower chart is a daily bar chart of the German stock stock market index, the DAX, while the middle chart is a daily chart of the S&P 500. The ECB announced its two phase financing program in early December of 2011. The initial market response was negative because it was feared that the program would not do enough to stave off a European banking crisis. But when the first round of financing was completed on December 20 the markets saw the effects of the program on the European bond markets - yields came down substantially on paper issued by governments with financial problems. The DAX and the S&P 500 then embarked on rally which has continued to this day.
But will the ECB take away the punch bowl? My guess is that they won't, especially if the stock markets start dropping from current levels. You can see on the charts what happened to the S&P and the DAX when the Fed ended its two quantitative easing programs. The first ended in April of 2010 and the second a year later. Both times the US and European stock markets dropped. My guess is that something similar will happen now but I don't think the drop will be nearly as bad as the ones in 2010 and 2011. Moreover, when the ECB and the Fed see what is happening I think both will step in with new financing programs which will ultimately boost the markets above today's highs.
The top chart is a chart of the euro priced in dollars. The most bullish thing that can happen to the euro from the perspective of US and European stock markets is a resumption of its drop to 1.200 and below. Such action would be a reflection of the ECB's willingness to do whatever is necessary to stave off a renewed financial crisis in Europe. Based on their behavior over the past three months I think they are willing to do this.
But first I think the markets will have to throw a scare into the Fed and the ECB. If so I expect the euro will rally some distance from current levels before resuming a longer term decline. I also think that the DAX and the S&P 500 are likely to break, perhaps back to their 200 day moving averages (red lines on the charts) before ultimately moving much higher.