Thursday, 27 September 2012

A historical revisionism, constitutional crisis and discord within the Fed

Nothing like a bit of historical revisionism on top of a constitutional crisis and not to mention discord among Fed governors to get the markets worked up.

On historical revisionism, German, Dutch and Finnish Finance Ministers seem to have re-interpreted part of what came out of June’s EU summit, which agreed that banks could receive assistance from the bailout funds (in Spain’s case it was agreed the assistance could be up to 100 billion euro). This group of finance ministers are saying that the European Stability Mechanism – which will take over from the European Financial Stability Facility – would not be allowed to take over the legacy assets recapitalised before the proposed banking union and ECB supervision were in place. The three ministers said “legacy assets should be under the responsibility of national authorities” after any ESM rescue, with the bailout fund taking “direct responsibility” for problems occurring under the new supervision. As reported by the Irish Times, this suggested that states would still be liable for losses materialising from existing loans, thus undermining the determination and efforts to break the link between the banks and the sovereigns.

However, it was also reported by a spokesman of the European Commission in Brussels that the communiqué issued by eurozone leaders after what had been agreed at June’s EU summit still stands. That has received less attention in the media.

As for a constitutional crisis, it looks like Catalonia, one of Spain’s many autonomous regions – and also the most indebted – wishes to go its own way. Catalonia is probably not alone in objecting to what it sees as the unfair burden sharing of the Spanish Prime Minister’s austerity measures required to meet budget deficit targets and also any financial assistance from the ECB’s bond buying operation, if the request is made. However, it is not clear what support there is for Catalonia’s President to test the water on independence within his own government. He was criticised by the Deputy PM for ‘adding a crisis to a crisis’.

On Fed discord, the lesson of financial crises is to err on the side of doing more – a lot more – rather than less, and this is what the Fed is doing. All but one of the FOMC voting members endorsed QE3. A few non-voting members including Bullard, Fisher and Plosser doubt the merits of the initiative and have been outspoken in their misgivings. However, there are several non-voting members who not only support the action taken by the FOMC but also think the Fed should go even further with the forward guidance it provides. Evans thinks the Fed should keep interest rates near zero until the unemployment rate falls to 7 percent or inflation rises to 3 percent and Kocherlakota thinks that interest rates should stay low until the unemployment rate falls below 5.5 percent, unless inflation hits 2.25 percent. So there!

Usually, when markets are technically stretched, a catalyst is often required for a correction. Given that the equity markets had reached overbought conditions, there is more than enough here to which they can react. As the chart above for the UK equity market still indicates, the overbought condition has yet to be fully unwound. So it is not unreasonable to expect to see more profit-taking and I suspect that this is all it will be. Neither the ECB nor the Fed is for turning back on what is now their way forward. The ECB is determined to eliminate the tail risk of euro disintegration and the Fed is determined, as long as Bernanke is Chairman, to reflate the American economy in the sense of creating more job growth and reducing the risk of deflation.

That said, some markets are also looking a little richly valued in view of the rebound over the past few months and there has been more downgrading in earnings expectations. The case for the FTSE 100 is shown in the following chart, so there is another reason to expect a period of consolidation. However, this should help provide a buying opportunity.

Finally, while trend for Wall Street has been up, that for the Shanghai Composite has been down as the following chart shows. There is an expectation that China, which has relied on fiscal policy more than on monetary policy to arrest the economic slowdown, will cuts rates again. This past week it has injected record amounts of liquidity into the money markets to meet shortages. However, the authorities are worried about relaxing monetary policy for fear that it could raise inflation or induce the kind of speculative activity it has worked hard to cool. The authorities have made clear their intention that current policy is aimed at stabilising growth rather than stimulating it. Less clear is the outcome, and hence the continuing weakness of the equity market.

Mike Lenhoff
Chief Strategist

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