Tom Essaye: One of the most anticipated ECB meetings in history occurred last week, and with it the European crisis entered a new phase. Generally speaking ECB Chief Mario Draghi and the ECB met most of the market’s lofty expectations, as evidenced by market action. Perhaps even more important, the ECB didn’t disappoint by “kicking the can” down the road as European officials have done so many times over the past three years.
The ECB pledged to act forcefully to defend the EU and euro by potentially buying bonds to reduce crisis-hit euro-zone countries’ borrowing costs, which is a good thing. The market didn’t price in the lofty summer rhetoric. But on balance, the announcement gives reason to be more bullish on the markets … still not a reason to run out and buy stocks with both hands.
I say that because …
Last Week’s Signal Was NOT an “All Clear”
There are multiple risks to monitor over the next several weeks in Europe. Here are three of them:
Risk 1 — Markets will test the ECB
|Spain will likely need rescuing first.|
First, you can expect markets to test the ECB’s will at some point over the next few weeks by pushing Spanish or Italian yields higher — just to see if the ECB was bluffing on its bond-buying promise. If I had to guess where, I’d bet we’ll see the first intervention in Spain before the end of October, as there remain multiple troubles brewing there.
Risk 2 — Spain and Italy have to ask for help before getting it
One of the disappointments of the ECB meeting last week was that more strict conditions were placed on countries who need the ECB to buy their bonds than had been expected. Economists on the Street are referring to this as “conditionality.”
In order for the ECB to buy bonds, Spain and Italy will have to formally request aid and submit to fiscal oversight by the ESM/EFSF and the IMF. That implies some loss of sovereignty (psychologically, anyway), which will make Spanish and Italian politicians less likely to request aid until it’s absolutely necessary.
As an outlier, there’s a chance that both countries won’t request aid. And then it becomes a game of chicken between those countries and the rest of Europe to see who blinks first. Don’t think it can’t happen either — Greece has basically done it twice, and Europe blinked both times.
Risk 3 — Will bailed-out nations comply?
What happens if Spain (NYSEARCA:EWP) or Italy (NYSEARCA:EWI) get the bailouts needed, but after a while stop adhering to the fiscal reforms mandated by the EFSF or ESM?
|The ECB seems willing to sacrifice the euro to save the EU.|
The ECB’s answer was very clear and another area of disappointment: If countries getting aid stop implementing necessary fiscal reforms, bond buying stops immediately — meaning all this could be an enormous waste of time.
The bottom line: If none of those risks mentioned above come to fruition, the ECB announcement last week was a game-changing event in Europe (NYSEARCA:VGK) and a reason to think the crisis is nearing an end. But, if any of those risks actually materialize, the consequences are potentially catastrophic. And even if they don’t fully materialize, if they appear to be gaining momentum, markets will fall and fall hard.
One thing we do know from last week’s announcement is that the euro will be sacrificed to keep the EU together. By the ECB choosing to print euros (NYSEARCA:FXE) to buy euro-country bonds, it means we’ll see a lower euro over the long term, even though in the short term we could see the euro continue to rally as investors bet the crisis is solved.
A big rally in the euro over the next several weeks could provide a great opportunity to position yourself for the next big move in the currency, which is bound to be lower.
The ProShares Ultra Short Euro (NYSEARCA:EUO) remains one of the best ways to play the ultimate decline in value of the single currency. This inverse ETF is meant to rise 2 percent for every 1 percent drop in the euro.
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