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Fixed Income Update- Draghi Drops the Bomb

Quite clearly the ECB President Mario Draghi signaled that the ECB will not be buying Italian and Spanish bonds unless those countries enter into an agreement with the EFSF or in the future the ESM.

He clearly stated that even then the ECB may not intervene in the bond markets.

When asked about Italian Prime Minister Monti's trip round Europe asking for action to lower Italy's borrowing costs, he clearly responded by saying Italy would have to request a full bailout first.

He is also signaled that even then this time round the SMP would be different to the past uses of the SMP and the ECB will only look to buy short-dated bonds.

He also clearly stated, repeatedly that the ESM in its current legal framework will not be an eligible counterparty for the ECB, so no lending to the ESM from the ECB. ECB legal opinion says that the ESM is not a similar structure to the EIB. This importantly pulls the rug from those that have been suggesting that the ESM would be levered up to create a fund big enough for a full bailout of Spain and Italy.

So the market reaction to Draghi's speech from last week- has to be reversed. Draghi even clarified his speech when he stated that he had used the phrase "within our mandate" three or four times within the speech. So he was saying that the ECB will not do anything outside its legal structure.

And the fact that he has ruled out a banking license for the ESM means that peripheral bond yields will come under significant pressure as if both Italy and Spain was to require a bailout the financing would not be available.

Market reaction has been hectic and very volatile. As Draghi started to speak, the 10yr German Bund Futures fell 50c to trade at a low of 142.83. That equates to a yield level of 1.42%. Once the statements from Dragi made it clear that the ECB would not be restarting the SMP , German Bunds rallied to 144.73- all within 30 minutes. And in this time Italian  and Spanish 10yr yields were rising and now stand close to 6.20% and 6.95% respectively.

In the US the 10yr US Treasury has already traded in a 10bp yield range, 1.57%-1.47%. And S&P500 futures were initially up as much as 13pts but then fell as much as 14.2 pts.

So now some reflection needs to take place. Firstly the FOMC statement yesterday was very negative on the state of the US economy and only opens up the possibility of further monetary stimulus if the economy weakens further. And the ECB is leaving all the work to the politicians to sort the Euro zone debt crisis out.

Am therefore very happy to hold the current duration positioning for the portfolios - the coming days should see the US, UK and German Bund markets rally and sharply. 1.25% , 1.20% and 1% being the targets respectively.

[ba-button link="http://www.coininvest.com/wiki/wp-content/uploads/2012/08/Draghi-ECB-2nd-August-12.pdf" color="blue" target="self"]Draghi ECB 2nd August[/ba-button]

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