The period of time since the announcement of a new expansion of Quantitative Easing by the US Federal Reserve has not seen the market moves that some might have expected. The rallies that have occurred in equity markets since then have been fairly self-explanatory in their response to a hoped for economic improvement. I established a pre-meeting benchmark of 11,188 for the Dow Jones Industrial Average and in spite of a small fall yesterday we are now at 11,406 for an improvement of just under 2%. However more intriguingly the Japanese Nikkei 225 index has improved its relative position. I have been following the spread between it and the Dow Jones and running up to the Fed. meeting it got as high as 2000 points briefly where as it is now 1712. So still high but improved.
A factor in this in my opinion is the way that the US dollar has performed. If we compare it to my pre-meeting benchmark it has now risen. Having set a dollar index benchmark of 76.68 it is now at 77.27. This may come as a surprise to some readers as I am afraid some sections of the media are locked in a “thought bubble” on this subject and do not appear to check. However from the point of view of Japan which has suffered from what felt like an ever-strengthening Yen this has come as a relief and her equity market has responded. This is not a get out of jail free card as the Yen/Dollar exchange rate remains weak in US dollar terms at 80.63.
Why might this be?
There are several factors at play here I feel. Firstly as the Fed. move was expected then financial markets had the opportunity to respond before it had even occurred. If you have any belief in markets being rational then this is very likely (particularly when the move is felt to be virtually certain). It marks a clear difference between my view and that of a Quantitative Easing supporter on the UK Monetary Policy Committee Adam Posen as he feels that you measure QE’s effects on a currency after the announcement whereas my view is that the expectation of it affects currency values beforehand too. My article on this subject was written on the 29th of September. Secondly we had come to a level where technical analysts expected some sort of recovery for a while. Added to this is that it had fallen from a high of 88.71 in early June and even the strongest market moves have ebbs and flows in them.
Currency Wars and the Gold Standard
Yesterday saw an intriguing message from the President of the World Bank Mr. Zoellick. He wrote the following in the Financial Times.
The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values……….Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.
As you can imagine this has led to a lot of speculation the more fevered of which has suggested he is looking for a return to a type of gold standard. The first impact of this was on the gold price which had already been performing well after the Fed. announcement. My pre-meeting benchmark for the gold price was US $1354 per ounce and it is now US $1413 per ounce or 4.3% higher. So there you have it perhaps the best-perfoming asset after Ben Bernanke acted is an asset usually invested in by his sternest critics! It may well be that gold bugs are too busy counting their profits to have much time to see the irony in this but I cannot help but have a wry smile at it. I somehow doubt that Ben’s plan to increase asset prices quite meant this.
Is a return to the gold standard likely or a good idea?
From our current position then a type of gold standard has attractions to it as faith in the value of fiat money has declined over the period of the credit crunch. However there are also weaknesses in a gold standard which is one of the reasons the world abandoned it. There is a danger here of whatever side of the fence you are on you look at the other and think that it is better. The fundamental problem with it for me is how do you cope with new discoveries? For fans of Science Fiction there is an example of this in Arthur C Clarke’s 2061 which was one of the follow-ups to 2001. I do not want to spoil the book by going further.
Either way our current generation of politician’s will not countenance such a move. These days their whole existence and the whole edifice from which they benefit depends on fiat money. An example of this is the wailing and gnashing of teeth going on in many areas about the austerity plans of the UK government which in spite of what you might read involve spending being higher at the end than at the beginning.So the edifice needs reform and the reform in itself would in my view have many of the benefits of a gold standard. Going forwards the problem would be human nature. If anybody has an answer to that I am all ears…
Problems in the Euro zone
The announcement that private-sector bondholders would be forced to share in any pain suffered by Euro zone countries in future which came on the 29th of October has had a shattering effect on government bond holders in many of the peripheral Euro zone nations and more milder effects on others. The country most hurt has been Ireland as such upwards pressure on yields has coincided with a worsening of her situation.
One factor which also does not look hopeful is the way that the narrower measures of the money supply are performing in the peripheral nations. The latest figures for this show that if you split the Euro zone into core and periphery then money supply growth is much more healthy in the core in spite of the European Central Bank’s efforts to help out in the periphery. So a monetarist view based on this would lead to a view that over the next few months we can expect a two-speed Euro zone, or put another way more of one of the fundamental causes of the current crisis. For once there is a little ray of sunlight for Ireland as her figures look like they may be turning for the better and perhaps so will her economy at the end of this year and early next.
The European Central Bank intervenes by using her Securities Markets Programme
I speculated last week and yesterday that the Securities Market Programme had been in action again and we now have figures to confirm this. The ECB has announced purchases of some 711 million Euro’s of debt which is likely to mostly have been Irish and Portuguese. Remember also that this is what the ECB has announced there are ways it could delay announcements if it wished as it only declares settled trades. There are a lot of problems with this strategy and let us consider them.
1. It is not doing much good as yields in the two main problem countries (if we put Greece to one side for now) continue to rise in spite of the purchases. As of last night’s close then ten-year government bond yields were 7.82% in Ireland and 6.88% in Portugal. Indeed as the ECB often buys at the shorter-end of the curve the rise in the yield at the short end of Ireland’s bonds is in some ways the most worrying as her bond which expires in November 2011 now yields some 4.18%. So a year of risk and a return of 4.18% versus an official ECB interest rate of 1%. As long as Ireland pays up this could be recorded as a profit for the ECB which if you think about its other actions it probably needs to offset its shocking credit risk. There is the danger of something of a Faustian Pact here.
2. By no means all of the ECB’s Governing Council support this policy and it looked as though it was trying to wean itself off such purchases. Yet it now faces the prospect of making more and more.
3. I would like to return you to one of the causes of the current situation, the declaration that private-bondholders should share in losses in any debt restructuring or default. Now if the ECB buys ever more of the periphery’s outstanding bonds we hit a logical conundrum as there will by definition be fewer and fewer private bondholders to share the pain with. This is particularly true of Ireland which is not currently issuing any debt. So something which should be a strength to Ireland is in danger of becoming a weakness. For as private bondholders see this they may fear a restructuring more and be willing to accept losses now by selling to avoid bigger losses in the future.This is potentially a vicious circle.
4. I have remarked before that the ECB is likely to have the lowest credit rating of the world’s main central banks because of the type of assets it has accepted in return for liquidity. The only change in this situation is that the US Federal Reserve is trying to compete to head this league table too! However returning to the theme the Securities Markets Programme holds some 64.2 billion Euro’s of peripheral debt if its announcements reflect the true picture. If we analyse it we can see that it definitionally has to be considered as a low credit rating as it is buying what in effect no-one else seems to want. But further to this if we look at the pattern of purchases it must be making considerable losses at current market prices.
5. Points 3 and 4 do in the end have a logical clash. After all the ECB could buy the Irish government bond market in its entirety as it is just under 90 billion Euro’s in size. However it will have then taken front-running to a new level and there would be no private-sector bondholders to share the pain of a restructuring.
Short-term fixes rarely sit well with long-term restructuring and reform. They are not stopping Ireland and Portugal getting ever nearer to the sort of situation that led Greece to call for international help.