A false sense of security?
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Jeremy Glaser is the markets editor for Morningstar US.
Stocks reclaimed plenty of multi-year highs last week. The Nasdaq touched levels not seen since 2000, and the Dow got back to its pre-crisis December 2007 high. The market seemed to be cheering progress in Europe and mostly shrugging off disappointing US jobs data.
The cheers were not totally unfounded. Europe did make a substantive step forward this week, and the jobs data - although disappointing - was hardly a disaster. But the world economy is far from out of the woods, and given how much stocks have run up, and how full valuations have become, investors must continue to exercise caution and should be prepared for a potential pullback.
Europe ends its vacation
Europe made a real effort to bring its debt crisis under control last week. After promising to act last month, we finally got the concrete details of the European Central Bank's (ECB) plans to keep short-term borrowing rates reasonable for some beleaguered eurozone members.
And the details mostly lived up to expectations. Unlike previous plans that seemed to be filled with hidden landmines, the new outright monetary transaction plan looks like it can achieve its goals. The rub is that the goals of this plan are modest compared with the size of the eurozone crisis.
The ECB is planning on buying bonds with maturities between one and three years from countries that have entered into some kind of bailout agreement with the European Financial Stability Facility or the forthcoming European Stability Mechanism. The bond buying should have the impact of reopening the short-term bond markets for some of the most indebted countries.
This potentially neutralises the troubling scenario where short-term rates rise so high for some peripheral countries that they would be unable to roll over their maturing debt and would be forced into a disorderly default.
The ECB likely made its program conditional on participation in a broader bailout in order to dampen political opposition. Although the bank is ostensibly an independent institution, it is still very much impacted by the political winds.
Germany in particular is worried about the euro being destabilised in an effort to bail out peripheral nations without imposing any structural reforms. Germany still isn't thrilled with this plan, but the conditionality helped it go down a bit easier.
The flip side is that this decision could make it somewhat harder for the ECB to back up its forceful statement that the euro is irreversible. Take Greece for example. It is almost certainly not on track to meet the requirements in its bailout agreement. If those requirements don't get tweaked, and the country is found to be out of compliance, will the ECB decline to purchase Greek bonds as it says it will?
If bailout funds are withdrawn, the only chance of the country staying in the euro would be a massive intervention from the ECB. This scenario would force the central bank to either change the rules of this program or back off from its talk on the euro. Neither of these options will be attractive. It is very much an open question which way it would go.