Friday, 14 September 2012

Week in review: leaving the taps on…


Euro revival?
After the ECB’s pledge to buy potentially unlimited distressed bonds of European states, the Fed has followed with a potentially unlimited dive into the US mortgage backed securities (MBS) market (as Mike has discussed).

The term more commonly used to define the infinite scope of Fed Chairman Bernanke’s scope to buy bonds was “open ended” and it equates to leaving the taps on at a constant pace ($40bn) until the bath (economy) has seen its spare capacity (unemployment) has been filled (reduced).

After, laying out the options which the Fed has to employ monetary policy during his Jackson Hole speech, Mr Bernanke employed them all…and more. The further “asset purchases” (quantitative easing) stole the headlines, “changing balance sheet” composition also played a part as the Fed will be buying mortgage backed securities rather than treasuries for now. Thereafter there was an interesting amalgam of the three as the Fed made a brief reference to the fact that if the labour market doesn’t improve it will continue buying MBS but also start buying other assets (presumably treasuries but who knows?) “…and may employ other tools as appropriate.”

This is a massive gesture in so many ways. Being open ended should keep pressure firmly on the dollar. By referencing the unemployment rate specifically, the Fed has moved away from countering financial market turmoil, the weak housing market or deflationary expectations – all of which seem reasonably benign at the moment.

That makes the action perhaps a little more controversial in the way it crushes the expectations of those who thought the Fed would not ease before an election for fear of appearing political. The Republican Party will be fuming although perhaps they should blame themselves. After all, when, during the primaries, each candidate independently announced they would replace Mr Bernanke (Ron Paul even said he would abolish the Federal Reserve) they can hardly argue that anyone else made monetary policy political!

I imagine that by now each party’s strategists will have noted that it is far from impossible that the S&P500 and/or Dow Jones will make all-time highs which would provide a healthy unofficial slogan for the Obama campaign both in terms of refuting the President’s woeful economic record and showing that a more pro-business leader is not required.

Europe’s revival… 
Meanwhile, back in Europe, the German Constitutional Court gave a guarded thumbs-up to the European Stability Mechanism whilst retaining some reservations about the European Central Bank (ECB)’s bond buying plans which fortunately lie outside its remit.

Fortunately indeed, as following the currency market’s positive response to the previous ECB announcement, it now also cheered the Fed’s monetary activities (from a euro holder’s perspective). The euro rose 2% over the week and is now 4% higher since the start of September. This is not a currency that is being debased! Indeed Europe still has a monetarily conservative central bank (opposed to printing money) and a modest current account surplus (it sells more to the rest of the world than it buys from them) which will only be exaggerated as its recession worsens. It looks likely to strengthen further over the coming weeks.

That said, the ECB may not be finished yet! Ardo Hansson, ECB Governing Council member (and Governor of the Estonian central bank), said the bank may start debating negative deposit rates, and the central bank is "not fully satisfied with how (the monetary transmission mechanism) works".

The practise is designed to ensure private sector banks pass on the cuts in interest rates imposed by the central bank, but could have unforeseen implications for other elements of the market. Currently banks are ‘parking’ funds in reserves in order to reduce their risk and capital needs.

The euro it seems may be saved (for now) but its internal politics remain disparate. In Spain, the annual Catalonia Independence Parade received record attendance as the natives continue to decry their earning power being used to subsidise weaker regions – like the eurozone writ small. Adding insult to injury the region was placed on negative credit watch by the ratings agency Fitch due to the prospect of it running out of funding.

The week therefore finishes strongly for risk assets as peripheral European markets and emerging markets rallied while the more dependable regions made respectable gains too.

Guy Foster
Head of Portfolio Strategy

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