Very often during crisis we get weekend solutions. That is the time when markets are closde and there is enough time to figure out some kind of deal. The US$1T package came a few hours before the Asian markets opened and was initially treated with some skepticism before euphoria overran the markets on Monday. That was followed by doubts on Tuesday. More euphoria on Wednesday and more doubts on Thursday. In other words, there was some confusion over whether the package is big enough, how they will get the money and whether it will work and so on.
The trillion dollar package sets up a fund for the ECB to purchase govt debt in particular debt of PIIG countries. This money comes from contributions from IMF and EU govts. So how does it work? Whether it works or not depends on what problems you're looking at. The EU problems are divided into the short term and long term. Remember the long term debt problems have been there for years long before this crisis. The short term problems were triggered by accounting fraud in Greece discovered at the end of last year. Quickly it became very clear that Greece's debts are too big and the country is probably insolvent. Financial markets had been pretty calm and optimistic prior to that. All these factors made it very profitable for hedge funds and speculators to attempt to launch attacks on the Euro, govt debt, etc. The result was a 2-3 week panic culminating in tremendous intense fear and uncertainty of last week. The problem was these speculative attacks were driving up interest rates on govt debt of Portugal and Spain to something like 8% making it hard for these countries to raise cash to service their debt and because of fear that these govt will default the banking system in Europe was freezing up because banks were afraid of lending to each other and that could end the global economic recovery.
The package is already working for the short term problem by bringing down the interest on govt debt and the cost of protecting them. So while we still see some volatility, the panic has largely ended (I hope). There is a lot of confusing commentary that the package is not enough and so on....the package was never intended to solve the long term multi-trillion debt problem of Europe - those were around 5 years ago and will be around 5 years from now. There are not too many ways to solve it - monetise the debt and risk inflation, cut the budget deficits to slow the growth of debt. Both involve undermining the living standards in many parts Europe so the ordinary people will not be too happy. In the absence of financial panic, these problems can be amortised over longer periods..... entitlement cuts, welfare reduction, i.e. falling living standards.
I think the question on investor's minds is what will happen in the markets? While there is some silver lining from this - Federal Reserve will have to postpone rate hikes until next year and China too will probably lessen its tightening, the stock markets may a little harder to fathom in the coming days. Earlier I had forecasted a peak in May 2010 (best estimate 12 May) but the peak came several weeks earlier when the European problems erupted. I came out with the May date looking at the average time it takes for carry trades to build up and get disrupted/unwound. The carry trade is the use of a low interest currency to buy risky assets in another currency. The use of the carry trade is associated with benign currency movements i.e. stable or slowly weakening of US$ and the Yen...and is characterised by the overwhelming number of up-days (vs down days) on the stock markets. Because the carry trade feeds on itself - carry trade begets more carry trade, it tends to build euphoria in the markets. In the past, once every few months the carry trade get disrupted by speculators attacking the US$/Yen rate leading to sharp stock market corrections lasting 2-3 weeks....many investors panic and get shaken out of the markets by these sharp selloffs. Because they tend to occur when markets are in a semi-euphoric state, many small time stock investors get burnt. The events of the past 3 weeks cause the massive unwinding of carry trades - the very sharp one associated with the 1000pts drop in the DOW. 15 minutes before that huge drop, the Yen fell by 2%....such a huge drop probably triggered high speed trading 'robots' to sell equities ahead of carry trades unwind for profits.
How do we know that some kind of an intermediate bottom is formed in the markets? We will know when most of the most leverage carry trades are unwound and stock market movement decorrelated with currency movements or when currencies stabilise. As long as we have extremely low interest rates and thesis that the global economy is recovering is still believed, the carry trade will come back. Yesterday night the DOW fell by 100+ points in the last hour of trading and if you look at the US$ chart, the US$ moved up sharply by 0.5% against the Euro during that period so there is this clear correlation between currencies and stocks. The devaluation of the Euro perhaps another piece of the puzzle in getting Europe out of its rut - remember when Greece imploded, they said one of the problems is Greece does not have its own currency which it can devalue competitively when in trouble. The Euro has fallen by 15% in the past few months - the Italian marble you're thinking of using for your home is 15% cheaper, if not for the COE + crazy taxes in Singapore, Mercs and BMWs will be 15% cheaper. Many people are thinking of going to Europe for their next holiday. For Germany which is a major exporter, it benefits from the devalued Euro and sharp investors already know that - despite being part of the trouble EU and caught in this turmoil, the German stock index is only 1-2% from its 52 week high which is quite amazing given the turmoil we have seen.
The carry trade has always been involved in worsening market volatility when trouble occurs. Be it the subprime crisis or the Greek contagion, the carry trade become part of the transmission mechanism that disrupts markets. A number have come to warn that the carry trade will lead to next crisis (article : Currency carry trade could be next global crisis) whatever the underlying triggers (subprime debt, sovereign debt) are. The thing about the carry trade is it has to build up, bring euphoria and happiness to investors before it tumbles down like a house of cards. Speculators and hedge funds time their currency attacks to maximise the disruption in the markets with an element of surprise to create the shock and fear effects. Once you're passed the point of maximum fear as we saw last week, they will slowly back off to plot the next round of attacks. They were so ferocious and deceptive, the EU leaders called them 'wolfpacks'.
While the Greek contagion disrupted the carry trade a little earlier than I thought would happen. I also predicted that there will be a double top in a previous post. Why did I conclude that there will be another peak coming and why did I think that would be the final one? The next time the market goes up and come down, it may not be so easy to recover because we might be in an rising interest rate environment and inflation may so rear its ugly head forcing govts to tighten quickly...when that happens risky assets will decline no matter how sustainable the economy looks. For now, I still believe we will have another peak (I hope) and my advice is think seriously about getting out.