Yesterday was a day of quite extraordinary equity market rallies and there was rumour after rumour to support it. If we start with the silliest there was a rumour that the United States was going to back/finance an International Monetary Fund bailout of Europe! Moving onto the ones with more meat to them there were all sorts of rumours about what the European Central Bank will do announce this afternoon. However this did go so far as a suggestion that the ECB will introduce its own Quantitative Easing policy and hoover up hundreds of billions of Euros of Euro zone debt. As I pointed out yesterday there would be a lot of dissent on the ECB against such a policy with even the President Mr.Trichet having spoken out against such a policy in the past, so for this to happen the ECB would probably have to be overruled by Europe’s politicians. This is not impossible as I believe they overruled the ECB back in May to set up the Securities Markets Programme as it started only 4 days after the Governing Council had denied it had even discussed the matter.
Rather oddly the Vampire Squid also made its contribution to the equity market rally by raising its growth forecasts for the US economy. This is rather odd because if we go back a couple of months it was forecasting that the US needed around US $2,000 billion of extra monetary easing or asset purchases which we certainly did not get. If you thought that such easing was required then your view on the outlook for the US economy at that point had to be very poor. But now we see.
On balance, we think that Fed officials will still buy more, pushing the total amount up to perhaps $1 trillion. But it is also possible that LSAPs will end at $600bn.
We have raised our sights for US growth in 2011 and expect further acceleration in real GDP in 2012. Specifically, our revised view calls for growth to remain at last quarter’s 2.5% annual rate through early 2011 and then increase over the next year to a 4% annual rate.
There does not appear to be a mention of what might have happened if the FOMC had followed their advice and started a stimulus programme of US $2,000 billion ! It would now plainly look too much and would have considerable inflationary dangers. Actually the Vampire Squid has been showing feet of clay of late but my point for now is that those who follow its views would have been more bullish yesterday.
The Financial Markets
The US Dow Jones equity index rallied some 249 points to 11,255 following on from European equity markets where the German Dax was the leader surging by 2.6%. This morning the Japanese Nikkei 225 has joined in by rallying 180 points to 10,168 and the Shanghai Composite equity index,which has been struggling of late, rallied 0.7% to 2844. So far this morning European equity markets have rallied again.
After discussing inflationary trends around the world yesterday I noticed that the crude oil price had quite a surge. On the West Texas Intermediate measure it rose by US $2.70 or 3.21% to US $86.81 per barrel. So a price rise for US consumers too and also around the world as whilst the US dollar drifted lower its fall was far less.
Government Bond Markets: No more safe havens and a rally for Spain,Italy and Portugal
THE turn of events meant a sudden ending for the “safe haven” status of UK and US government bonds. The UK ten-year gilt fell by more than one point as its yield rose to 3.36% and the US ten-year Treasury Bond saw its yield rise by 0.16% to 2.97%. In an interesting development the German ten-year bund saw its yield rise too by 0.12% to 2.80%. This was interesting because there was talk about a bond issue by the EFSF, now if you can get more than 0.5% of extra yield compared with German bunds and yet still be backed by the German taxpayer you might think that EFSF bonds are more attractive than bunds! Germany had a bund auction yesterday and for the second time in a fortnight it struggled somewhat. Should this trend continue and the German taxpayer becomes aware of this ( that there is an explicit cost to the bailouts right now), there could be further trouble for the Euro zone’s plans.
Rumours of action by the ECB in its policy meeting today led to rallies in several of the peripheral Euro zone government bond markets. The Irish ten-year government bond yield dipped below 9% to 8.92%. This was accompanied by falls in Spanish and Italian ten-year government bond yields to 5.4% and 4.54% respectively. In spite of a twelve month bill auction where the yield rose to 5.28% from the previous 4.81% Portuguese ten-year government bond yields fell to 6.84%
Portugal’s high borrowing costs
Seeing yesterdays auction reminded me of two things. Firstly whatever her government might say if she has to issue twelve month bills at over 5% on any sustained basis then she looks solidly insolvent in the longer term, even Ireland has a one year bond which only yields 4.8%! Also if you make international comparisons then at the longer two-year maturity the US can borrow at 0.53% and Germany at 0.89% and you have to go into 2013 before the UK pays more than 1%.
In a way this is the fundamental problem going forwards for the peripheral Euro zone nations that on top of their domestic problems financial markets are likely to make them pay a high price for any future borrowing. Euro zone ministers like to blame the markets but let me pose this as a question, what interest-rate would you lend to them at? There is an opportunity today for the ECB to announce new measures and for Portugal to seek aid at the same time which might prevent the debacle which surrounded the Irish aid package, we will see later if the various authorities spot this window of opportunity.
The European Central Bank today
Yesterday I ran through the two main policy options available to the ECB today. It can slow down or reverse its exit strategy from extraordinary monetary actions and/or it can increase its asset purchases under its Securities Markets Programme. After the moves yesterday and this morning the markets are waiting and expectant! However the ECB has disappointed on this front before.
If we look at the Securities Markets Programme there is a theoretical obstacle and that is that the ECB never established any target level of purchases. This of course makes it difficult in some ways to announce an increase as it would be an increase on what exactly? So they will need to think of a way of announcing this more carefully than usual. Also it is true that the ECB has already appeared to have expanded the use of the SMP yesterday with some market participants feeling that it bought bonds yesterday to drive the rallies in Portuguese and Irish government bonds. If this is true then it may have been “enforcing” a positive spin on and reaction to the speech of its President,which is not entirely healthy. Adding to the thoughts that the rally may have been driven by ECB purchases is market data which indicates that volumes were low. We are back to the theme of central banks intervening more and more in financial markets. For the actual published figures on the size of the purchases we need to wait until next week.
A Fundamental Problem with expanding the Securities Markets Programme
If the ECB announced today a substantial government bond purchase programme or an expansion of the SMP there is a big danger to my mind. Somewhat ironically is that it is that market participants will sell to them. You might think that this is the required result but I think that financial markets realise that such a policy would be abandoned by the ECB as soon as it could might think that this is the last chance for the exit so to speak. So we could find that the ECB has to buy more and more. Apart from the danger here of monetising government debt we could also see the ECB ending up owning most of the government debt of some of the peripheral Euro zone nations particularly Ireland who has a bond market which whilst about to increase is only some 90 billion Euro’s. My point is then you block any form of restructuring do you not as you are then restructuring the money of Europe’s taxpayers. Oh and by then you will have let the banks off, not quite scott-free but much more cheaply than otherwise.
So there you have it, an expansion of the SMP is another bank bailout in disguise. But if it blocks a restructuring of debt then rather than being a solution it will in fact become a problem over time.
Just to give an idea of scale here and how things would move on if Spain and Italy become involved then next year Italy plans to issue some 338 billion Euros of bonds and Spain some 157 billion Euros.
If we look at my theme of putting these matters to music if you are sitting on the ECB Governing Council and have heard of the Alan Parsons Project you may well be humming “Damned if I do, damned if I don’t”.
A Musical Response from the Bundesbank President Axel Weber
I do not know if Herr Weber is a music fan but if he was a dj and was listening to the suggestions above his playlist might be.
Stop (In the name of love) by The Supremes
No, No,No by Dawn Penn
The Drugs don’t work by The Verve
Don’t stop (thinking about tomorrow) by Fleetwood Mac
Any other suggestions will be gratefully received….
Emergency Policy Interventions of the US Federal Reserve
An extraordinary amount of information was released by the US Federal Reserve yesterday about its policy actions in 2007/08 as it struggled to cope with the beginnings of the credit crunch. Too much to fully review but I have 3 thoughts.
1. The scale and size of its response has come as a surprise even to those who were following it.
2. The Federal Reserve provided an enormous amount of funding to foreign banks providing some US $350 billion in total. As many of these banks had their own central banks such as the ECB or the Bank of England it makes me wonder does the Fed. consider itself as lender of last resort to the world? And if it does then do US taxpayers realise this? Personally I doubt this and wonder what US readers think.
3. The limits of central bank knowledge are brutally highlighted as some programmes were for banks which were supposed to be secure and solid. Unfortunately more than a few on the list have hit trouble and indeed I spotted Allied Irish Bank on the list. Ooops.
The UK economy
Recently we have become used to news on the UK economy being relatively good, inflation excepted. For example official figures for economic growth have been very strong in the past two quarters. The manufacturing purchasing managers index was very strong at 58 in Novemeber where above 50 signals growth. Some caution is needed because this is a survey rather than an actual measure of something but nonetheless in this winter chill it may help warm us up a little.
I have noticed something recently that I feel is rather odd. There have been suggestions that Mr. King should resign as Governor of the Bank of England on two counts recently. Firstly we had the accusation that he had been too political and secondly that according to Wikileaks he had insulted the incoming Prime Minister and Chancellor. The reason why I think that this is odd is that his actual job of controlling inflation has gone badly for quite some time and yet the same people do not appear to be calling for his resignation on that front. Is what you say more important that what you do? These days it often feels that way.
As the ECB meeting could easily be the event of the week I will update on it later assuming the UK has any news which is not swamped by our World Cup bid!