Yesterday gave an interesting example of market behaviour. After a series of falls we saw equity markets surge in a pattern which usually defines a bear market rally. My metaphor for such an event is a summer shower of rain which may be heavy at the time but within a few hours there is often no evidence of its existence. No rule of thumb works every time but a 207 point rally in the US Dow Jones Industrial Average to 12,796 certainly fulfills part of the criteria. I found it particularly fascinating to watch the equity market in my subject of the day Italy surge by 3% as measured by the FTSE:MIB index on a day where she had produced poor industrial turnover and new orders numbers.
I have to say that I found the fact that we saw such surges followed later by a downgrade of France by Moodys (from Aaa to Aa1) particularly fascinating. After all the nation itself is informed of such ratings moves twenty-four hours before. I would imagine that I am not the only person wondering if the aggressive headling about France in the latest Economist magazine was influenced by some form of what is called “the early wire”?
What did Moodys say?
I covered the position of the French economy myself on the 9th of November and will discuss here only new thoughts. Mind you I do find the first point a combination of bizarre and maybe a perversion of the role of a ratings agency so let’s get straight to it!
A rise in debt service costs would further increase the pressure on the finances of the French government, which, unlike other non-euro area sovereigns that carry similarly high ratings, does not have access to a national central bank that could assist with the financing of its debt in the event of a market disruption.
The section that I have highlighted is a description of Quantitative Easing where a central bank buys the debt of its own country in return for providing the previous owners with what in effect is newly minted cash albeit of the electronic variety.
Are Moodys correct with this bit?
In my opinion Moodys are confusing credit risk with bond yields. In general the use of QE tends to reduce a country’s government bond yields but this is by no means the same as reducing the risk overall. There is a gain from it in terms of reducing debt financing costs as the recent shenanigans between the Bank of England and the UK Treasury have highlighted. However there are also costs in terms of inflation, feeding the too big to fail strategy and thereby stopping what is called “creative destruction” and the exchange rate. Ratings agencies should reflect risks rather than only prices and yields and Moodys have failed to do this here.
So we see risk as measured by a rating agency diverge substantially from credit worthiness in a repeat of the way they helped plunge us into the credit crunch by mispricing mortgage-backed securities. I suppose you could say that they are being consistent except that in this instance I do not mean it as a compliment, quite the reverse!
Emergency Liquidity Assistance
This is something available to the Bank of France although to do it then it theoretically requires the permission of the European Central Bank. I say theoretically because I have wondered if some of the users of ELA such as Greece and Ireland have in effect “bounced” the ECB into agreement. Whilst it is not QE it is something which in effect has quite a few similarities to it as a central bank takes assets (bonds) in return for freshly created cash. The assets are collateral -usually at the dodgy end of the spectrum- rather than being purchased but if you think about it there are quite a few scenarios where the central bank ends up with them. If we apply the sovereign-bank loop to this we see that whilst it is not the same it may well turn out to be to use one of the buzz-words of recent years fungible in its concept.
How much impact has the downgrade had?
One of the regular themes of this blog is that these downgrades have lost their impact on financial markets. We are seeing an illustration of this so far today as the French ten-year government bond yield has risen by only 0.03% to 2.1% and 2.1% is hardly a threatening yield is it? It is in fact not far from the lowest it has been in recent memory and the Euro era. The main French equity index the CAC 40 is down some 11 points at 3428 and when we consider that it too rallied nearly 3% yesterday we see the scale of the (non) response so far.
The oil price
Today’s topics are somewhat entwined as France is one of the countries most hurt by a rising oil price as she is not a producer of it on any but a minor scale and is 71st on a list of oil reserves by country. Yesterday’s equity market surge was accompanied by a surge in the oil price as what is called a “risk-on” day also had the political/war issues of what is currently happening in Israel/Palestine added to it.
The price of a barrel of Brent Crude Oil is above US $111 again but because on Friday the futures market switched from December to January it looked as though it lost three dollars when it did not! However even so it is now some 3% higher than it was at this point in 2011. So just when many economies least need it we are seeing a rising oil price which has both inflationary-via its role as a fuel and also input in many types of production- and deflationary -in a relatively cash-strapped era spending more on it means that other spending is likely to be cut-. Oil producing countries at least have the extra revenue but countries like France do not even have that as a counterbalance.
West Texas Intermediate
This has been rising too recently but it’s behaviour has over the past year illustrated one of the themes with which I started this blog. This was that in many ways it is getting ever harder to know what prices are as we face so many different tariffs which are designed to confuse. But with the oil price we have the issue that the price of West Texas Intermediate has fallen by 9% over the past year compared to the 3% rise for Brent Crude.
So as European and other readers frown American readers can permit themselves a smile! If we consider the theory the way that WTI has behaved should be the reality in a weakening world economy but we also know that these days theory and reality are like friends who meet infrequently.
Whilst there are challenges to it these days the oil price is still pretty much in US dollars so for most the exchange rate with it matters. For UK readers you can relax a little as a year ago we were here. Actually I exaggerate slightly as we have moved from 1.58 to 1.59 and a bit! However the Euro has dropped by 5% so oil costs in it will be driven up by that amount too. Even something which will be welcomed by many Euro nations has a drawback at times and in a way that is another theme of the credit crunch era.