It’s all about Official Policy

It’s all about Official Policy 31 July 2012

Markets Bounce on Policy Hopes Although last week featured some lacklustre economic and earnings news, investors continued to focus their attention on the growing possibility of additional monetary policy action, particularly from Europe. For the week, the Dow Jones Industrial Average climbed 2.0% to 13,075, the S&P 500 Index advanced 1.7% to 1,385 and the Nasdaq Composite rose 1.1% to 2,958.

Last week saw a real transformation in financial markets. All of it thanks to a single speech from European Central Bank (ECB) President Mario Draghi, in which he made the crucial comment: “We will do anything to save the euro, and believe me, it will work.” Immediately, Spanish and Italian bond spreads turned around, reversing a downward spiral into a calm and much more interesting outlook. However, talk is cheap and action is much more important, and so markets will focus this week on Thursday’s meeting of the ECB, and what it actually announces to support Draghi’s comments and those by other European leaders over the weekend.

ECB needs to address monetary system The European monetary system no longer functions as it should; there cannot be a situation where a business in Italy is borrowing money at rates that are 4% higher than those for a similar business across the border in Austria. In addition, lending by northern European banks to their southern counterparts has contracted over the past six months, while the European interbank market has continued to fragment. Draghi made it clear that it was this part of the equation in which the ECB had to act to sustain financial stability. This is important, because there is a range of tools available to the ECB, including Securities Market Programme purchases of bonds, use of either the European Stability Mechanism or the European Financial Stability Facility, or even another Long-Term Refinancing Operation.

Much of the news coverage has focused on the width of the spread between 10-year Italian and German bonds, but this is looking at the wrong end of the yield curve; it is at the shortend, among two-year bonds, where there is an extra 3.5% risk premium. This is an uncomfortable level for what is supposed to be a single monetary system.

Subsequently, any action from the ECB on possible bond purchases should focus on the front-end and the belly of the curve, rather than the longer end. In doing so, it would be following the actions of the US Federal Reserve (Fed) and Bank of England, which have used bond purchase programmes to try to hold short-term rates down, after which long-term rates tend to look after themselves.

Last stimulus opportunities for the Fed The Fed’s Autumn meetings represent its last opportunities before November’s congressional and presidential elections to announce a third round of quantitative easing (QE3). The Fed will probably wait until September, after the Jackson Hole symposium on US economic policy before acting, in order to assess the latest available data. However, the fact that the S&P 500 has been rising steadily and US financial stability is relatively strong does not necessarily provide the best backdrop to provoke the Fed into taking action.

Germans are looking more inwardly Another issue is understanding why the Germans agreed to the ECB becoming the supervisor of the banking system in Europe when they now oppose the use of the ECB’s balance sheet to stabilise bond markets.

Several things are driving this, led by weakness in the domestic German economy. Last week, the flash reading of the Purchasing Managers Index (PMI) for Germany in July was 43.3, which is not the kind of number one would expect from an apparently strong economy. (A reading below 50 signals economic contraction).

Secondly, German policymakers have recognised that the German taxpayer is on the hook for southern European risk through the ‘Target 2’ initiative, where banks in Germany lend money to the ECB to lend on to southern European banks. It was therefore hardly surprising to see bond yields of 10-year German bunds rising last week, along with other ‘safe haven’ benchmark yields in the UK and US. Official policy will continue to drive markets It means that official policy will continue to be the most important driver for investment returns for the second half of this year across the world. August is always a quiet month, but the market will soon start focusing on the looming fiscal cliff in the US and the lack of budgetary reform as much as they will on the politicians touring the country seeking votes.

In China, anecdotal evidence suggests the deceleration of the economy in what looks to be the ‘softest hard landing’ in history is coming to an end. It is noticeable that prices of some of the more cyclical commodities have started to rise and precious metals values are picking up in anticipation of further central bank action. However, simply creating more money to support fragile credit dynamics does not in itself kick-start economies, particularly as the ‘money multiplier’ which defines the relationship between credit and base money supply has continued to collapse, except in the US.

Equity market returns are quite logical

Looking at equity market returns so far this year, they have been quite logical, with the US up 10%, Germany up 7-8%, and the stock markets of the really economically impacted nations down 15-25%. More puzzling is the weakness of emerging market equities until recently, especially after interest rate cuts in Korea, Brazil and South Africa. Other than that, it is a continued case of policy-watching, and determining on Thursday whether Draghi can act as well as speak.

Currencies On currency markets, the euro hit its weakest level in more than two years against the dollar at $1.2040, before rebounding on the back of Mario Draghi’s comments and speculation that the ECB could support the euro zone by purchasing government bonds. The €/$ rate ended the week at €1.23.

Oil Despite ongoing tension in the Middle East and increased risk appetite offering support to commodity prices, the oil price ended last week marginally lower at $90 a barrel, a decline of over 1%.

Bonds A broad improvement in risk appetite in the latter part of the week reduced demand for the safety of highly-rated German sovereign debt with investors moving back into equities and some peripheral bond markets. Despite the latest Italian two-year bond auction trading at an eight-month high of 4.86%, demand was strong and on a positive note, the yield on Italy’s ten-year bond fell in-line with that of Spain’s. The Merrill Lynch over 5 year government bond index ended the week down 0.9%.