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ECB's Draghi Frames Debt Crisis Issues

Interest-Rates / Eurozone Debt Crisis Jan 13, 2012 - 12:56 PM GMT

By: Axel_Merk

Interest-Rates

ECB President Mario Draghi continued to impress with his very direct style during the European Central Bank's (ECB) first press conference of the year. While not lowering interest rates or announcing further easing measures, he made it clear that the ECB is "ready to act" should the environment deteriorate. Our takeaways:


Draghi increased pressure on policy makers: key facets in resolving the crisis are national governments, euro area governance, as well as financial stability. Draghi emphasized that the "fiscal compact" must be unambiguous and efficient. Notably, he urged a deadline to come to agree on the compact by the end of January, rather than March, as currently planned.

With regard to "private sector involvement" (PSI) in Greece (referring to the "voluntary" cuts for private creditors under negotiation), Draghi called them politically understandable, but took the opportunity to try to convince the markets that there will never be another PSI in the future, as promised by policy makers on December 9. He referenced the detrimental unintended consequences.

Referring to the effect of credit contraction on the Eurozone economy, Draghi outlined three factors influencing bank lending: lack of funding, lack of capital and risk aversion:

On funding: The unlimited 3-year liquidity facility (Long Term Refinancing Operation / LTRO) was put in place because €200 billion in bank bonds are coming due this quarter. Another LTRO will take place soon, easing collateral requirements to allow more banks to participate. The LTRO appears a success, as borrowing costs have come down across the yield curve, initially at the short-end, and most recently (on the backdrop of successful Italian and Spanish auctions), at the longer end of the curve. Further, some unsecured intra-bank lending has recommenced. Draghi also noted that a lot of the recent demand for sovereign securities has come from market participants other than those that have access to liquidity from the ECB. Our perspective: the LTRO boosts bank earnings. While the Fed's quantitative easing program allows the Fed to have record income (the more money the Fed prints, the more interest the Fed earns from the bonds purchased), the ECB's approach "splits the coupon", charging 1% for loans, allowing banks to reap the benefits of redeploying that money into higher yielding securities.

On capital: Draghi decried the stress test by the European Banking Authority (EBA) conducted last summer. Specifically, he argued, that stress tests are good, but there must be an avenue to fill the capital shortfalls discovered. He referenced the U.S., where money was available to shore up banks. In Europe, however, national governments did not have the resources, nor was the European Financial Stability Facility (EFSF) in place. We interpret that more stress tests are to come, but public money will be made available, should banks be unable to raise capital in the markets. As EFSF money may be deployed, this would mean German taxpayer money would be used to shore up Spanish banks, a very noteworthy development.

Our interpretation of the press conference was that Draghi clearly understands the issues. He does what all central bankers do: provide ultimate support to the banking system; he does so in an amazingly aggressive manner. For now, the euro is up as a result of the conference; short positions in the euro had reached extremes, a short covering rally could well take on a life on its own. As the year progresses, we expect both euphoria and panic to drive the euro. As the drama continues, expect central banks in the rest of the world to "take out insurance", i.e. be most accommodative because of the feared contagion. While the focus may be on the euro, should dynamics unfold as we see them, it could mean a weaker U.S. dollar and stronger commodity currencies, with the latter most benefiting from printing presses around the world fighting potential contagions coming out of Europe.

Please register for our Webinar on Thursday, January 19, or sign up for our newsletter to be informed as we discuss global dynamics and their impact on currencies. We manage the Merk Funds, transparent no-load currency mutual funds through which investors may add currency exposure to their portfolios while potentially mitigating stock market, credit and interest risks with the ease of investing in no-load mutual funds. To learn more about the Funds, please visit www.merkfunds.com.

By Axel Merk

Manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. Axel Merk wrote the book on Sustainable Wealth; order your copy today.

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

Axel Merk Archive

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Comments

Robert Browne
13 Jan 12, 21:19
downgrades

Mr Draghi has missed the boat once again on interest rates less than 24 hrs after he played it safe he has been made to look weak for not anticipating these downgrades which have been coming down the tracks for months now.


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