Today is an opportunity to take stock of the tumultuous events of this week. There has been much more than a move by the US Federal Reserve, and if I may be permitted an aside thank you to those who have contacted me saying I predicted it pretty well. If we go back to before it we cam recall that central banks in India and Australia raised interest rates because they had inflation fears. As they preceded the US announcement we cannot say that they were caused by the US central bank saying.
measures of underlying inflation are somewhat low
However they were made in an atmosphere where we have rising commodity prices combined with the central bank of the world’s largest economy saying that it might move to raise prices or inflation or both. As we go forward this will be an influence in the “Currency Wars” which the extra stimulus by the Federal Reserve has turned up a notch and I wonder if we will see “Inflation Wars” develop.
The Bank of England,European Central Bank and Bank of Japan
All of these have had policy meetings over the past 24 hours and in terms of overt policy moves we got nothing at all. Their policies remain unchanged. Some expected action from Japan but I was more interested in the ECB as there is a lot going on in Europe as I will discuss later in this article and much of it,sadly, is rather self-inflicted. However there are several things to note.
1. Whilst the Bank of England took no new action it still has £200 billion of assets mostly UK government bonds on its balance sheet.
2. The Bank of Japan has planned new asset purchases of its own for a while and is widening its definition of what it will buy for example it will now purchase some real-estate investment trusts. I wonder if it will end up actively purchasing equities which has a lot of implications.
3. As he battles with various contrary strands and problems the President of the ECB Mr.Trichet took a swipe at the US Fed. ““The non-standard measures are by definition temporary in nature.” An interesting phrase when the US is making its own measures look ever more permanent! In essence the ECB is looking for the exit from its own measures and may well be heading north when the Fed. is heading south. Such views are prevalent in the world’s currency markets as the Euro has risen by around 18% against the US dollar since June.
So the theme going forwards is likely to be a clash between the Federal Reserve and the ECB.
Is there now a Bernanke inspired super put option for US equities?
This is an issue which as troubled me I would say for fifteen or twenty years. The debate started then as to whether the US Federal Reserve under Alan Greenspan would act to stop any sustained fall in US equity prices and rumours of such a strategy became known as the “Greenspan put” . An example of this would be cutting interest rates to support stock markets which of course has certainly happened. At the beginning Quantitative Easing was not explicitly thought of so you could say that the situation has expanded to that extent and why I call it a “super-put” now. However even then there were rumours at times of actual purchases of US equities by the Federal Reserve. My boss at that time (hello Rupert if you are reading this) certainly believed it for example.
If you look at recent moves by central banks around the world you can see evidence for this theory. The Federal Reserve has announced all sorts of extraordinary moves which it expanded on Wednesday and look at my point 2 above for plans for the Bank of Japan. Of course you could use Ben Bernanke’s own words as he has written an article for the Washington Post suggesting it is one of his objectives.
And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
In reality whilst there are some wealth effects on consumption they have proved weak and hard to measure. I do not believe that higher stock prices will help much and of course they are coming with higher commodity and oil prices which is inflationary. Returning to the theme let me explain what a put option does. It protects you against falls in a market and so the theory here is that equity investors are being protected against falls by the actions of the US Federal Reserve. Usually you have to pay a price or premium for a put option and I suspect that we will find it in the form of higher inflation.
If we return to the super-put theme and look at equity markets with the Dow Jones rallying 219 points yesterday and the Japanese Nikkei rising nearly 3% and the UK Ftse 100 up by 113 points they seemed to like something…
Commodity Prices , Oil Prices and Gold prices all rise
This is one area which is doing its best to give Ben Bernanke the inflation that he apparently wants. Of course price rises in this area leave US consumers with less money for other purchases so there is at best scrambled logic at play. But commodity prices have rallied in response to the actions of the Federal Reserve. The CRB spot index which I follow has risen to just below 500 after settling around 490 earlier this week and is up 26% compared with a year ago.
The oil price has surged this week and is up by 6.1% already in November and it has been on a rising trend for a while. The price of a barrel of West Texas Intermediate crude oil is now around US $86.4 which means that we are now up on the year around 7% after falls earlier this year. The rally has coincided with speculation about and the reality of QE2, although there are other factors too.
Gold bugs are happy too as we are back to new highs and at the current price of US $1387 per troy ounce we are some 33 dollars above the pre-FOMC benchmark I established. The rally is even stronger if you allow for the fact that the gold price fell in the run-up to the FOMC meeting.
Spencer Dale who is a member of the UK Monetary Policy Committee headlined a speech recently as “inflation,inflation, inflation” but I do not think he meant commodities,oil and gold all rising together.
The Euro zone problems: its currency and its politicians
Here there are two clear issues. The contrast between the ECB which is looking for an exit strategy from its measures just as the Federal Reserve is looking for an entrance has led to the Euro rally to around 1.42 versus the US dollar. This must be hurting the European economy and particularly those in difficulty. The effective or trade-weighted exchange rate has risen by around 7% from its low of early summer 2010. Put another way these are the impacts of the “currency wars” on the Euro zone.
There have been a litany of mistakes by Europe’s politicians in 2010 but there are two main ones which are becoming evident this week. The first has been the German inspired move to declare that in future in European rescues of countries private bond-holders will be made to take some of the pain. Many private bondholders have taken this as an invitation to stop investing in these markets leading to government bond yields in Portugal, Ireland Greece and to some extent Spain all rising. In Ireland this has become something of a rout even though the European Central Bank is rumoured to have stepped in as a buyer. My point is that this is a strategic success and a correct move but a tactical failure.
The next problem is the EFSF or European Financial Stability Facility. I wrote in an article on the 25th of June that it was not going to be of the size promised and have also written that it will be unwieldy and slow to operate. As it looks like more countries may need help others are starting to question it and wonder how it will work. I notice also that some are now questioning the interest rate at which it will be able to lend. Just to be clear it looked as though it would be around 5 to 5 1/4%. Now some think it might be 6% and Wolfgang Munchau has looked at it and as well as agreeing that there are size issues he feels that the interest rate charged may now turn out to be 8%! If you were writing fiction then I suspect such a manuscript would be turned down as being too far-fetched.
Will Ireland regret upsetting Roman Abramovich?
This may seem a curious question but Mr. Abramovich was one of the investors who are likely to be affected by Ireland’s “cunning plan” for bondholders in Allied Irish Bank. In the world in which we live where Mr. Abramovich is very wealthy and very well-connected I did wonder if this would turn out to be as cunning as many of the proponents suggested. I now notice that the Russian sovereign wealth fund will no longer invest in Ireland and as it happens Portugal and Spain. I did wonder about the wisdom of such a move and may be wrong as coincidences do happen but if Russia has been selling…….
Ireland presented her budget yesterday and it turned out in a strategic sense as I reported last week with 15 billion Euros of cuts and an element of front-loading. The real problem with Ireland suffering from a severe outbreak of cronyism will be summoning the will to actually do this particularly as many avenues are blocked by the Croke Park Agreement. However she has not lost her taste for cunning plans and indeed presented one with her budget.
Ireland’s government will not pay interest in 2011 or 2012 on promissory notes it is issuing to partly recapitalize three lenders. Essentially, in order to pay no interest for the next two years, the interest now is set to zero but the interest to be paid later on is increased by enough that the net result is the same. Oh and the interest assumed for later is at 4.7% which is around 3% below current market rates. As their credibility plunged the Irish government announced this wheeze had the approval of Eurostat so I guess what credibility it had can plunge with them too. This ruse “saved” about 1.5 billion Euro’s in these two years.
The net effect of all this is that Reuters report the ten-year Irish government bond yield is at 7.79% as I type this and this is some 5.42% higher than Germany’s.