Storm clouds remain
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Komal S. Sri-Kumar is the chief global strategist with US investment firm TCW. This is an edited extract of an article originally published on the Morningstar US website.
Global markets closed the week in a euphoric mood, boosted by the jobs numbers in the United States, and by expectations that European leaders would find a way to bring down unsustainably high Spanish bond yields. On the US front, non-farm job creation of 163,000 for July was above consensus expectations of 100,000.
Coming after particularly poor employment figures in June, this set US markets up for a rally. In Europe, Spanish Prime Minister Mariano Rajoy hinted that he may request a bailout of the Spanish sovereign after all. Until now, he had claimed that 100 billion euros in aid from European official sources would be channelled directly to recapitalise the Spanish banking system.
And since European Central Bank President Mario Draghi had suggested that the European Central Bank (ECB) would buy debt in the secondary market only in the case of countries which had agreed to austerity conditions, Rajoy's move cheered investors in Spanish debt.
ECB - a reversal of position?
Spanish Prime Minister Rajoy's hope that the 100 billion euros in capital that the European Union agreed to infuse in the banking system would obviate the need for a sovereign bailout has not been met. Spanish debt yields have continued to rise and hit a high of over 7.50 per cent on 24 July.
Such a debt yield is unsustainable given Spain's continuing refunding needs, and the large deficit in the country's current account of the balance of payments. Fears the Spanish government may be forced to follow Greece, Ireland and Portugal in seeking an official bailout led to ECB President Draghi's reassuring comments on 26 July.
In a widely followed speech in London, Draghi said the ECB would do everything within its mandate to save the euro. The statement was taken to mean the central bank would join the bailout funds, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), in buying Spanish paper in the open market.
Debt yields fell sharply during the final days of July - which investors would want to fight the ECB with its unlimited money printing ability?
There was one major stumbling block to the market's optimism. And that is the view of the Bundesbank which, despite the formation of the ECB and the eurozone, still exerts a lot of influence, and treasures its independence. Draghi acknowledged in a press conference last Thursday that the Bundesbank was opposed to the ECB's purchases of the obligations.
Jens Weidmann, President of the Bundesbank and a former adviser to German Chancellor Angela Merkel, has remained opposed to bond purchases by the ECB, fearing they would lead indirectly to financing the European nations' fiscal deficits and, thereby, cause more inflation in coming years.
In a Bundesbank staff magazine published at the end of July, Weidmann emphasised the importance of structural adjustments that had ended Germany's status until the middle of the last decade as "the sick man of Europe".
His prescription to the crisis-ridden peripheral countries? Instead of further ECB easing, "if these countries go through adjustment processes which result in decreases in wages and prices, then this constitutes one-off shifts in the wage and price structure and not deflation".
Bundesbank opposition is probably why Draghi did not indicate at his press conference the specific steps he would undertake to resolve the crisis. He suggested that countries which may need ECB assistance in the future - probably referring to Spain and Italy - should first seek assistance from the EFSF and ESM funds which, in essence, means they need to submit to the EU austerity conditions.