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Central Banker With a Vision

Landon Thomas Jr.
Wednesday, 29 Aug 2012 | 2:33 AM ET

Mario Draghi, the president of the European Central Bank, has helped the euro zone survive August. But can he save September?

This month, Mr. Draghi stared down bearish international traders who were convinced that Europe’s common currency project would collapse.

European Central Bank President Mario Draghi testifies before the European Parliament's economic affairs committee in his role as the head of the European Systemic Risk Board on May 31, 2012 in Brussels.
Thierry Charlier | AFP | Getty Images
European Central Bank President Mario Draghi testifies before the European Parliament's economic affairs committee in his role as the head of the European Systemic Risk Board on May 31, 2012 in Brussels.

“It is pointless to bet against the euro — it is pointless to go short on the euro,” Mr. Draghi said at a news conference on Aug. 2, a week after telling the world that the central bank would do “whatever it takes” to save the euro union.

Investors, or at least the ones venturing into the lightly traded markets this month, have taken heed.

Since Aug. 2, the euro is up 3.1 percent against the dollar. More notably, battered stocks and bonds in Spain and Italy have soared. The euro bears have rushed to close out their negative bets, and even some risk-averse traders have piled into assets they previously scorned.

But it will be September and not the lazy days of August that will truly test Mr. Draghi’s market-moving mettle. He will face severe pressure to provide specific details of his plan to shore up the euro zone’s weaker members by buying their bonds.

The first big test could come next week, on Sept. 6, when the bank’s governing council meets. Afterward, Mr. Draghi will again hold a news conference to try to explain whatever the central bank has or has not done. Bearish traders will be poised to pounce yet again on any signs of waffling.

Will the ECB Defend a Specific Yield Target?
Thanos Vamvakidis, head of European G10 FX strategy at BofA Merrill Lynch, told CNBC, the ECB will try to keep its options open; they will give a strong signal to the market but stop short of defending a specific yield target.

Worries are also swirling that Germany will refuse to grant Greece the time and resources it is seeking to reduce its debt, something that could push it out of the euro currency bloc. Looming as well is the possibility that a decision from Germany’s Constitutional Court, expected on Sept. 12, will rule out German involvement in the region’s new bailout fund, the European Stability Mechanism.

The schism within German policy circles has been revealed in recent days. In an interview with the magazine Der Spiegel on Sunday, the head of the German central bank, Jens Weidmann, who is also on the European Central Bank Governing Council, fiercely criticized any intervention by the European bank in bond markets.

But on Monday, Jörg Asmussen, a German on the ECB’s executive board who was a colleague of Mr. Weidmann in the government of Chancellor Angela Merkel, said during a speech in Hamburg that the bank had to buy bonds to stabilize European debt markets.

The stakes are sufficiently high for Mr. Draghi that on Tuesday, the central bank said that he had canceled plans to attend the annual meeting of global central bankers at the end of this week in the United States, citing his workload.

Despite the uncertainties, even the most savage euro bears seem willing for now to give Mr. Draghi the benefit of the doubt. And to the extent that Mr. Draghi can sustain this market mood, he will have resolved a problem that goes to the heart of the long-running euro crisis: how to compel traders to buy and hold euro-denominated stocks and bonds in the region’s higher-risk economies.

“You do not go back to the lira or the drachma or whatever,” Mr. Draghi declared at that same early August news conference. By alluding to the former currency of his home country, Italy, and seeming to put it in the same category of woebegone Greece, Mr. Draghi — who played a crucial policy role in the euro’s creation — signaled that he was taking the bears’ skepticism personally.

“It’s like Dirty Harry saying, ‘Make my day,’ ” said Stephen Jen, a former economist at the International Monetary Fund who manages a hedge fund based in London. “You can’t imagine Greenspan or Bernanke saying something like this,” he said, referring to the previous and current chairmen of the United States Federal Reserve, Alan Greenspan and Ben S. Bernanke. “It was very Italian and very powerful.”

Mr. Draghi’s weapon of choice is more subtle than the Smith & Wesson .44 Magnum favored by Clint Eastwood in the “Dirty Harry” movies. But from a financial markets perspective, there is no less firepower in his suggestion that his bank might buy the bonds of countries like Spain and Italy if they committed to tough measures to reduce deficits and revamp their economies.

Since Mr. Draghi took the central bank’s reins in Frankfurt last fall, investors have been calling his bluff in this regard. They have been betting that he could not persuade the euro zone’s biggest financier, the German central bank, to support any form of sustained bond buying because it would be seen as bailing out spendthrift governments.

But a view is now growing that Mr. Draghi may be on the way to persuading Germany that some form of central bank intervention — by committing to buy Spanish or Italian bonds when they rise above a certain interest rate, for example — can be justified. The challenge is to present it as simply one more step toward fiscal union as troubled euro zone members cede more control over their budgets to Brussels.

That is how Axel Merk sees it. Mr. Merk is president and chief investment officer of a mutual fund in Palo Alto, Calif., who manages about $600 million in currency-related investments. Long a euro bear, he began to buy the currency aggressively immediately after Mr. Draghi’s news conference, convinced that a policy Rubicon had been crossed.

“By imposing a vision, backed by rules and conditions, Draghi is achieving what politicians are not achieving,” Mr. Merk said. “He is basically saying to these countries that ‘if you give up control of your budgets, I will buy your bonds.’ He is laying out what he will do and holding people accountable. Some might call it genius, but it is really common sense.”

That said, many investors have not altered their core outlook that the currency must weaken over the longer term as economic conditions in the troubled countries deteriorate and richer countries like Germany resist putting up more bailout cash. Some even are pointing to Italy as more of a concern than Spain. Buying bonds may help in the short term, but it does little to address Italy’s inability to grow fast enough to pay down its debt, now more than 120 percent of its overall economy.

“The real problem is Italy,” said Gennaro Pucci, the chief investment officer at PVE Capital, a hedge fund in London with a focus on European bonds. “The banks are not lending and the debt-to-GDP is going up. The sooner the country asks for help from the IMF the better.”

Over the longer term, such a view may very well be valid. But when it comes to putting money to work in the euro zone, investment perspectives hew very much to the short term. And that, for Mr. Draghi, is the core problem, as frenetic buying and selling by foreign investors sustains a broad climate of fear and uncertainty in the market.

For example, from January through March of this year, investors were net sellers of close to 80 billion euros, ($100.6 billion at the current exchange rate), in euro zone stocks and bonds because of fear that Greece would leave the euro. In May and June, they bought 86 billion euros of euro zone securities as it became clear that a worst case would not materialize. Market mood swings of that sort are not conducive to the sort of long-term capital investment that can sustain economic growth.

For Mr. Draghi, then, the challenge is to persuade the newly optimistic euro zone traders to keep their positions and to persuade others that the waters are again safe for swimming. And to do that, he must persuade them that unlike his predecessor, Jean-Claude Trichet, he is not hostage to the doctrines that limit the bank’s powers of intervention.

“Draghi has put bond buying back on the table, even though there is no solution to the crisis — and that takes a lot of risk out of the equation,” said Jens Nordvig, a bond and currency strategist in New York for Nomura. Mr. Nordvig is advising clients to close out bearish euro trades before Mr. Draghi’s news conference next week.

“Draghi is perceived to be very pragmatic, and that is what the market respects,” Mr. Nordvig said. “The market does not respect dogma. If you are dogmatic in the markets, you will die.”