After reporting on the equity market surge of Wednesday I have to confess I did not expect the same result for Thursday. If you had pressed me when I knew what Mr.Trichet and the European Central Bank had announced at their meeting I still would not have expected it. The economic news from the United States was mixed too so there was no real cause there. I believe John Maynard Keynes once called this sort of thing “animal spirits”, as it appears the market was simply due a sharp rally. This makes me wonder what would have happened if Mr.Trichet had delivered what the market wanted? Sometime we are left with merely conjecture. The US Dow Jones equity index closed at 11,006 on Wednesday night but by last nights close had risen to 11,362 for a rally of 356 points or 3.2% in two days. The German Dax index rallied from 6688 to 6957 over the same time period for a rally of 4%. Most equity markets followed these moves although the inflation fears in China that I wrote about on the 11th of November mean that its equity market has rallied much less.
German equities versus German government bonds
Here an interesting development has taken place. I have written about how German government bonds have fallen recently and that German taxpayers may well become aware that there is a cost to them from this in terms of future issues of debt. However German holders of equities have just had a storming couple of days. An interesting divergence and if you had made a switch out of bonds and into equities only a few days ago you would have had a few days of outstanding success.
A Possible cause of the equity market rally, QE2
When you see such strong moves one has to ask if the Quantitative Easing programme or so-called QE2 is having an impact on equity prices. It is logical to assume that all the money being spent is having an impact but there is no way of accurately measuring this. Some might look at the total stock of purchases which for example over the credit crunch period have led to it being a holder of some US $926 billion of US Treasury Bonds or government debt. Others look at the flow of purchases as for example the US Federal Reserve bought some US $8.3 billion of US Treasury Bonds yesterday,some US $8.2 billion on Wednesday, US $6.8 billion on Tuesday and US $9.39 billion on Monday. The Wednesday purchases give some food for thought as they partly involved buying a bond which the US Treasury had only issued a week before! This leads to the thought, oh what a tangled web we weave.
But, however hard you try whilst there is probably a link between these purchases and equity markets there is no clear proof.In essence you end up with the problem of days when purchases are made but markets fall. However I guess Ben Bernanke will be happy at the turn of events. He will be less happy with the progress of one of his other targets which was reducing the yield on US government debt as the interest rate on the ten-year maturity reached 3% yesterday up around 0.5% on some of the levels after QE2 was announced. So switching out of bond markets and into equities would have worked nicely in the US as well this week. Put another way markets have become more optimistic if you look at the implications of their moves.
The European Central Bank’s policy
I wrote an initial response yesterday to the moves made by the European Central Bank yesterday. Let me just repeat my comment on it.
I feel that the ECB has done the minimum it feels it can get away with and I wonder if the announcement and the press conference was for our benefit at all. It had the feeling that Mr.Trichet was talking to Europe’s leaders and suggesting that the next move is theirs and that in effect central bankers and politicians are playing a game of chess or perhaps just a game. Unfortunately recently they have not been playing it very well.
I still feel that this is true in that we are seeing a debate being played out in public in some ways and in private in others between Europe’s politicians and her central bankers. One addition to this I can now add is that the Governing Council of the ECB had instructed the bond buyers of the Securities Markets Programme to charge into peripheral bond markets like the US cavalry in a western. So we had Mr.Trichet bobbing blocking and weaving like he is an opening batsman at cricket whilst he tried to get his officials to give the market a good push. There was a clear irony in this as these surprise tactics were a feature of the German Bundesbank but current members of the German Bundesbank voted against it as Mr.Trichet could only say that an “overwhelming majority” supported the SMP.
We saw a clear change in the tactics of the SMP as rather than buying in small packets it was see bidding for lines of 100 million Euros of bonds per clip. Perhaps some “shock and awe” from the SMP! Faced with such determination from the ECB then government bond yields fell sharply in both Ireland and Portugal with ten-year bond yields falling to 8.5% and 6.43% respectively. Yields also fell in other markets where the ECB did not buy as for example the ten-year Spanish bond yield retreated to 5.17%.
What is Mr.Trichet’s plan?
My contention is that the message Mr.Trichet was sending yesterday was that he could take care of tactics and the ECB can in the short-term can influence events. However he stopped short of outlining any strategy and I believe he is in effect telling Europe’s politicians that this is their job and that so far they have failed. I believe when he talks to French President Sarkozy today he will be asking for more from Europe’s politicians in terms of conditionality and discipline for the future.
The flaw in Mr.Trichet’s plan
This strangely is also the reason for its success yesterday. It worked because it has a short-term shock effect. Once that evaporates what does he do next? Any future buying will not be a shock. He could keep it up but then he is faced with the problem of how much of the Portuguese and Irish government bond markets he is willing to buy. If he stops buying then yields will head higher again. Also I do not believe he is punishing the speculators that the Euro zone’s politicians often rail against in their public pronouncements, I suspect that those investors who own these government bonds, and hence those politicians should be supporting with their policies, may well be using the ECB as a way of selling them and exiting the scene. You see people often discuss prices but rarely volume in markets. In the recent turmoil we have seen price falls but if you had a large position how much might you have been able to sell? Now however with prices higher you have a buyer in large size…..
If they exit and the ECB buys ever more of these markets we have two clear implications.
1. How will any debt restructuring work when you are restructuring assets on the balance sheet of Europe’s central bank?
2. The banks are being let off again. Yes they will have lost money but they are able to evade the worst consequences of their errors.
Just as a way of giving some perspective I first recommended that Ireland call for international aid on the 17th of September. On that date Irish ten-year bond yields were 6.15% and Portugal’s were 6.02%. Please look at the yields quoted above after all the “success” and think about all the money that is being committed…..
Confusion over the interest-rate on loans to Ireland
On Monday I made some suggestions as to what interest-rate will be on the various loans that Europe is making to Ireland and suggested that they could be as high as 7.5%. I notice that the Irish goverment has now published some of these but the development is somewhat troubling. The first point is that Ireland is not charging herself an interest-rate on her own money which changes the maths but not that substantially but let me make the other from the documentation.
IMF: 5.7 per cent per annum:……… This expresses the interest rate in terms which can be compared with the cost of borrowing from the EU sources.
And yet the IMF says
At the current SDR interest rate, the average lending interest rate at the peak level of access under the arrangement (2,320 percent of quota) would be 3.12 percent during the first three years, and just under 4 percent after three years.
There was no talk of such manoeuvering when money was promised to Greece back in the spring and both Ireland and Greece have the same currency. Of course now we see that Greece is being charged a higher interest-rate for her loans too. There may well be some sleight of hand here and I will continue to look into it.
We are back to central banks interfering in markets again and in the short-term this can give the appearance of success. But as time goes by I feel that more and more will ask the question what is the endgame? You can suppress symptoms creating what are false markets along the way by this route but you do nothing for the underlying problem. You also create an additional moral hazard because for those not in power creating a false market is illegal.
There is a historical perspective and it involves the Latin American debt crisis of the 1980s. The same strategy was employed there of private-sector debt becoming sovereign debt as governments assumed private-sector responsibilities. After a while they realised this was not a solution and defaulted. It took about four years or so for this to happen and the Brady Plan of 1987 restructured debts by 30%. We were supposed to have learnt the lesson from this debacle that it was better to restructure early but it would appear that we have not.
The US Economy and the jobs report
Today we will see the unemployment and also the employment report (under the label of non-farm payrolls) for the US economy and as ever it will be closely watched. Please remember that the U-6 measure for US unemployment is a better measure than the headline rate and also take care with the non-farm payroll numbers as they are often revised heavily.
If we look at where the US economy stands we have received some mixed information this week. Some numbers have been hopeful as pending homes sales figures improved and we have not had many improved figures from the US housing market in recent times. The initial claims figures for unemployment for this week also showed an improvement if you use the four-week average measure from 436,750 to 431,000. So better but still not enough to start to improve the unemployment figures. The Federal Reserve published its beige book report on the US economy which suggested that the US “economy continued to improve”. Yet we also saw that home prices continue to fall according to the Case-Schiller index.
So,in conclusion, the picture for the US economy appears to remain that it is growing slowly but not fast enough to improve the unemployment rate by much if at all. As I have written often it is hard to draw much more of a conclusion than that from the evidence and I wait for one thirty today UK time to hopefully find out some more.