After a few days where we saw world equity markets fall yesterday was a much better day. The Dow Jones Industrial Average closed up some 103 points at 10405 and European equity markets were strong too. However a note of slight caution is due because the Dow had been up around 160 points and ran out of steam and fell back at the end of the trading day. Part of the reason for the rally was the news that US industrial production for July which grew 1.0% which was better than expected after June’s 0.1% fall and capacity utilisation also rose to 74.8%. So after some weaker numbers for the US economy we got a stronger one although industrial production is a volatile series so again we need a longer trend. Those of a more suspicious nature may have noticed that yesterday was also a day when the US Federal Reserve was purchasing some US Treasury Bonds as part of its new QE lite programme and their minds might wonder as to where the US $2.55 billion might end up. I used to have a boss some 10/15 years ago who believed in the theory of the Greenspan put option which in many ways has turned out to be true, he also believed that in times of difficulty the Federal Reserve would buy equities which may or may not be true.
Commodity prices also continued their recent rise as measured by the Commodity Research Board spot index. This rose by 2.67 to 451.46 with rises across the board with metal prices being the strongest. This has become something of a theme as whilst the media now has “agflation” in its sights the rise in the price of the metals index has been less well reported and on a year on year basis it is up by some 27.1%.
The Greenspan Put Option
For those unfamiliar with the term this was related to the perceived monetary policy of former Federal Reserve Chairman Alan Greenspan. This view reflected the Fed’s pattern of providing ample liquidity and cutting interest rates whenever stock markets had problems which resulted in the perception that asset prices had the equivalent of a put option to protect them against sharp falls in prices. Investors increasingly believed that in a crisis or downturn, the Fed would step in and inject liquidity and cut interest rates until the problem improved and stock prices rose. In practice the Fed did seem to follow such a policy and even though we have changed Chairman in the meantime the policy does not look so different now does it? Hence the new phrase the Bernanke put. The moral hazard from this is that such a perception is likely to affect asset prices and perhaps encourage excessive risk taking so such perceptions may well have contributed to the credit crunch.
Ireland and her economic problems
In essence much of Ireland’s financial crisis comes from the side-effects of the property market boom which turned to bust. Her fiscal position was quite strong until this happened although one needs to add the caveat that some of this strength was due to taxes on the booming property markets and the consequential booming banking sector. When the bust came many of her banks hit trouble and one in particular Anglo-Irish Bank has proved to be a constant source of worry. Markets were reminded of this issue last week when Ireland received European Commission approval for an additional 10 billion Euro boost to the capital for Anglo-Irish Bank, on top of the 14.3 billion Euros the government has already injected into the bank. Just to add to the worries Bank of Ireland produced losses which were nearly twice as big as the previous year so minds were again focused on Ireland’s banking and property sectors which continue to have problems in spite of her efforts to contain them.
These issues may well be focusing minds on what will happen when the two Irish support schemes for her banking sector end later this year. The Credit Institutions Scheme ends in September and the Eligible Liabilities Guarantee was also supposed to end then too although it has now been extended to December for debts with more than three months in duration. However this leaves plenty of debt requiring funding as we move into the autumn of this year and we know that European interbank markets are currently function with weak liquidity. So we are left with two main alternatives. The first is that the Irish government extends the schemes and the second is for Ireland’s banks to fund themselves from the coffers of the European Central Bank in the way Greek, Spanish and Portuguese banks have. There are moral hazards in both alternatives as the ECB cannot go on forever doing this and extending schemes has the danger of them becoming de facto permanent.
In some ways this may give readers a clue as to what happens when the Special Liquidity Scheme expires in the UK in 2012 although one can still hope for a better financial environment to develop as we get nearer this date.
Ireland’s Bond Auction
Yesterday Ireland auctioned some government bonds with mixed results. She sold 500 million euros of 2014 notes at a yield of 3.63 % which compared with 3.11 % at the last auction in May. It also sold 1 billion euros of 5 percent 2020 bonds to yield an average 5.39% which compared with 5.54% at a previous auction in July. So we see shorter date borrowing getting more expensive and a small improvement in the ten-year although it remains at a level where Ireland might have considered going to the European Financial Stabilisation Fund or EFSF as it would have been cheaper to do so.
After this issue Ireland’s government bond prices fell back. If one stops and thinks then one is reminded that this is happening a lot with European bond auctions recently with yields rising into them and then falling after wards in what might be called a Grand Old Duke of York Strategy or more simply a spoof. Bond markets do seem to have something of an upper hand in this area at the moment although for this particular issue we will need to give it a few days to see if this plan has worked again.
Here there has been a similar theme to Ireland where there was a property boom and bust and now Spain also has a struggling property and banking sector particularly with her savings banks or cajas. Some reform has taken place but less than Ireland’s efforts. One feature of this is the amount of borrowing which Spain’s banking sector has been forced to take from the ECB as interbank markets have increasingly frozen many of them out due to the perceived risk of trading with them. This rose to a new high of 140 billion Euros in July which was up some 3.5 billion Euros on an already very high June figure.
Last week also saw a weakening of Prime Minister Zapotero’s commitment to austerity with him publically suggesting that it was no longer as important as before which many saw as a form of backsliding on his promises in this area. This is complicated by the fact that much spending in Spain is undertaken by the regions rather than the central government and some will wonder if Zapotero is sending a message to them. In addition to the regional preponderance Spain also has quite a few bodies similar to what in the UK are called Quango’s (Quasi Autonomous Non-Governmental Organisations) which also seem to be responsible for quite a lot of spending so this area needs to be watched carefully I think.
One area where some information has emerged is in Spanish public spending which is only partially picked up by Eurostat the European statistics body. This involves debts on the balance sheets of companies which are state, regionally or locally owned, as well as overdue payments for invoices (something which I have reported on for Greece) , and public-private-partnership-type leaseback-arrangements. The final section is similar to the Private Finance Initiative in the UK which in itself has by no means been fully quantified. None of these are usually classified as debt by Eurostat in spite of the fact they have all the characteristics of debt, but the repayments and interest payments are in fact classified. What this means is that Spain’s fiscal deficit is impacted by the interest payments but her debt to GDP ratio is not. Edward Hugh has done some calculations on this subject and believes that accounting for these policies correctly would raise Spain’s debt to GDP ratio from 58% to 75% which is by no means a small sum. Also the logical consequence of this is that it will not be so easy to bring Spain’s fiscal deficit under control particularly as her Prime Minister seems to be losing enthusiasm for the task.
I doubt whether Spain is the only user of such systems and Greece’s efforts in delaying payments and the UK’s Private Finance Initiative come again to my mind. However what they do is kick the can down the road and mean that getting out of current problems will be more difficult than the official figures suggest.
Spanish Bill Auction
Such fears did not seem to be particularly pronounced at Spain’s bill auctions yesterday. Spain borrowed 5.51 billion Euros in 12-month and 18-month bills at lower yields than at previous auctions. The main sale of 12 month bills took place at a yield of 1.84% which is quite a reduction on the 20th of July’s 2.22%. As the day progressed Spanish ten-year bond yields fell to 4.1% so the worries I wrote about above seem to be not impacting on markets at this time.
Possible causes for this are bond funds which may be looking for yield at a time when many other government bond markets have rallied strongly or perhaps the impact of the fact that the European Financial Stability Facility is now in operation as a type of back stop for sovereign risk in the euro zone. Neither seem convincing enough for me but markets can often be fickle.