From: US GIO

From: US GIO To: Undisclosed recipients:; Subject: Macro Skinny: Draghi sets the floor for Europe Date: Wed, 22 Aug 2012 20:46:40 +0000 Inline-Images: image001.jpg; image002.png; image003.png; image004.png; image005.png Macro Skinny J.PMorgan Draghi sets the floor for Europe The European QE1 is officially here. Mario Draghi's latest speech should be seen as a genuine commitment to stave off EMU break-up risks. His argument: higher yields in the periphery prevent the ECB from easing monetary policy efficiently. As such, the ECB is likely to buy as many periphery bonds as needed to keep yields lows. This language is truly exceptional, and it is comparable to how the Fed and the Bank of England justified their first round of quantitative easing (QE1) back in 20092. It is essentially the European QE1, which is much stronger than SMP - the old bond buying program. The German resistance has collapsed. With the exception of Jens Weidmann—the president of the German central bank—the rest of the German political and monetary leadership has given a thumbs up to Draghi3. The Germans did, however, deny rumors that the ECB is willing to go as far as capping yields for the periphery4. But what Otto von Bismarck5 once said, applies today as well: "never believe anything in politics until it has been officially denied". After all, former ECB president Jean-Claude Trichet denied that the ECB was discussing bond purchases just four days before SMP was officially announced in 2010. Bottom line: Europe has learned that there is no other practical solution than ECB money printing. Managing periphery yields = proactive ECB policy. As a reminder, the mess in the periphery started when foreign investors (mostly Germans) asked for their investment money back. And since the periphery was broke (it spent this foreign capital long ago), it could only buy back these assets by borrowing excessively from the ECB6. As the left chart shows, up until early 2010, the ECB lent enough money to buy back the assets foreigners were liquidating. But since early 2010, the ECB became less proactive and lending fell short of foreign capital outflows, which is why periphery spreads widened (right chart). This is why a commitment to keep spreads tight by buying sovereign bonds in the secondary market is essentially a commitment to backstop the remaining outflow of foreign capital. This measure of `sovereign lending' should be complementary to existing `bank lending' activity (another LTRO with looser collateral policy is likely over the coming months). EFTA01180622 ECB lending to match periphery's capital outflows again Billions of Euros. cumulative 1,150 - 950 - 750 - 550 - 350 - 150 - -60 2007 2008 Source: M. Morgan Private Bank, Haver. Proactive ECB fending matches outflows Capital outflows Reactive ECB: lending lags behind outflows 2009 2010 2011 2012 2013 ECB lending • •• • • • proactive Policy again? ...as it moves to manage short-dated periphery yields Average 2-year periphery yield spread (to Germany) 7 8 5 4 3 2 1 0 2007 Source: Bloomberg... Morgan Private Bank. 'GDP-weighted average. 2008 2009 2010 2011 2012 2013 European assets should feel better, but not the Euro. It's encouraging to see that more than half of the foreign money has already left the periphery (left chart below), so `only' one trillion Euros of outflows are left to finance. The precise timing of when the ECB will actually launch its new interest rate targeting regime is unknown7 and it is quite possible that we could have a mini-bump in spreads before it happens. But one thing is clear - the discount embedded in European assets will likely be lower 12-month from now, even if it won't fall in a straight line. To be sure — the debt problem won't be solved anytime soon. But by shifting periphery debt away from the hostile hands of foreign investors to the friendlier hands of the ECB, the case for hiding behind 'cash mountains' is disappearing, even if Europe remains in recession territory for another year. As for the currency, Draghi just told us that "shorting the Euro" makes a lot more sense than "shorting Europe" (right chart). EFTA01180623 Over half of the hot foreign money has left the periphery Cumulative change,foreign private investment position. % of GDP 70 - 60 - 50 - 40 - 30 - 20 - 10- 0 2001 2003 2005 2007 2009 2011 Source: National central banks,. Morgan Private Bank 2012:Q2 is est. ECB balance sheet expansion implies gradual € weakness SI€ Spread of Fed and ECB balance sheetsizes, % of GDP 1.50 0 Fed-ECB relative balance sheet size 1.45 1.40 1.35 1.30 1.25 1.20 S1€fx rate 1.15 1.10 1.05 2009 2010 2011 F air vat, *Sao tie f a _ km . thing C r Sief ink heats .0.,.„,.3.freesheeteehrn. •• ex xPa • •• riSion • . . • . 2012 2013 2014 2015 Source: Federal Reserve Board, ECB, J.P. Morgan PB Economics. Michael Vaknin Chief Economist, J.P. Morgan Private Bank -10 -15 -20 25 [I] Draghi argued first that "exceptionally high risk premia in bond prices hinders the effective working of monetarpolicy". Then he went on to say that "the ECB may undertake operations of a size adequate to reach its objective." [2] As a reminder, back in 2009 the Fed and the Bank of England were faced with similar circumstances—elevated yields on US mortgage securities and UK government bonds, respectively. Both central banks argued that higher yields were obstructing the effective transmission of monetary policy and both followed up with successful asset purchase programs. [3] Importantly, Draghi was backed by Merkel, Finance Minister Schauble and Asmussen—the second German member in the ECB governing council. [4] Der Spiegel said the ECB is considering capping periphery yields, but the German Finance Ministry commented it is "not aware of any such plans", and the ECB said it is "misleading to report on decisions, which have not yet been taken". [5] Otto von Bismarck was the Prussian Prime Minister and the Founder and Chancellor of the German Empire, 1815.1898. [6] This situation is very different from past EM debt crises, where the IMF was reluctant to lend the necessary amount of dollars to allow the full outflow of foreign capital. These crises eventually resulted in massive currency devaluations. [7] Spain and Italy still need to officially sign a Memorandum of Understanding before ECB policy could be activated. It is very unlikely to happen before mid-September. Acronyms: ECB — European Central Bank EM — Emerging Market EMU — European Monetary Union Fed — Federal Reserve IMF — International Monetary Fund QE — Quantitative Easing SMP - Securities Markets Program EFTA01180624 IRS Circular 230 Disclosure: JPMorgan Chase & Ca and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Ca of any of the matters addressed herein or for the purpose of avoiding U.S. tax- related penalties. Note that J.P. Morgan is not a licensed insurance provider. The material contained herein is intended as a general market commentary. 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