A quick re-cap on the Euro zone

The markets have continued a ‘risk on’ sentiment as participants still believe a successful Greek PSI deal is on the way, and will pro long any kind of disorderly default. As I said in previous posts, the risk is of course that the market has overlooked the event of the deal not saving everyone. The reason that this has been ignored by the markets is that it is believed that a disorderly default would be too much of a catastrophe for the euro zone to allow this to happen, and do whatever is necessary to prevent this from happening. However, as I said before the incompetence of the Greeks has been to put it politely ‘above average’, so we can’t assume everything will be hunky-dory. Currently we are supposed to be assuming that a deal is close to being secured. But, wasn't this repeated by minister after minister last week? And the week before?

Another thing we should all be aware of is the increasing yields in Portugal. The market is now reaching levels where the second Greek bailout became a predictable conclusion. If this scenario starts to unwind in front of us, then we will probably see some ‘risk on’ trades unwind. As a second bailout for Portugal will simply not work and the whole restructuring of debt fiasco will be repeated.... God I hope not!!

All eyes on NFP

On Friday we see the release of the famous non-farm payroll data. Last month saw an impressive 200k jobs created, although it was noted that about a quarter of this was down to seasonal delivery and courier jobs. Market participants will be watching closely to see if the up tick in employment will continue. At the moment the average prediction is looking for an increase of 150k, although this may change after the release of ADP on Wednesday.

Guru’s thoughts: I think that market participants will be running out of reasons to be long the stock market around now. We have seen huge rallies and it feels like it could be slightly overdone. If NFP comes out poor, then it could be the icing on the cake and encourage longs to covers at least some of their positions.

The risk on moves continues....

Wednesday’s action from the Fed has caused another round of selling in the USD as well as investors buying riskier assets. Although these actions acted as a catalyst for big market moves, they have simply been a continuation from recent ones. The Fed extended their exceptionally low levels until at least late 2014 from the previous mid-2013. The market reacted to this extreme dovishness by pilling into riskier assets as the Fed look geared up for another round of QE, despite the fact that most recent US data has reflected positively on the economy. Given that the current Fed is conquered by extreme doves, this can’t be ruled out. However, you could see it from the point of view that there is some scepticism out there, and maybe the US isn’t doing quite as well as it seems on the surface. Participants reaction to the news tells me that a lot of people are desperate to be in ‘risk on’ mode assets and not miss the risk rally.

Guru’s thoughts: I think this ‘risk rally’ will continue until something shocking happens or something fails to meet expectations, or at least until people realise that central banks actually don’t have a magic solution. In regards to the Fed, one problem I do have is: How does this actually help the man on the streets confidence?? I know in theory the money should trickle though and benefit the people, but surely he would just rather get betting returns on his savings.

IMF wants the ECB to take a haircut as well??

The FT has reported that the IMF has been putting pressure on the ECB to take a loss on its holdings of Greek debt it has built up under the SMP along with the private sector. The estimate amount is around E40bn at purchase value. The IMF now believes that the E130bn bailout put together in October last year will be inadequate to put Greece on a steady path. The IIF yesterday also commented stating that “all parties” should honor their commitments, a disguised call for the ECB to also take a loss on Greek paper. When commenting on this the ECB have always resisted this and have warned against an uncontrolled default. The FT also reports that the ECB have discussed fallback options such as forgoing the profits it expects on the bonds or for national central banks in the euro zone to take losses.

I would argue that the ECB still has strong arguments to resist pressures:

- It has effectively acted as buyer of last resort to the private sector

- I reckon the majority of Greek bonds is actually held with national central banks, so a write-down by the ECB would provide only limited solace

-If the ECB take a hit then it would put further pressures on stronger countries to contribute

- I would expect any impairment losses to be shared by the Euro system at large may put pressure on national central banks to re-capitalize

- A messy default raises the risk that investors turn their attention to the countries deemed next in line (contagion); ensuing capital

Guru’s thought: If I was at the ECB I would tell them all to piss off and shut up! From the start the ECB have said that no mater what happens they will get their money back in full. Fuck the banks and funds! If they were too short sighted to see that Greece is full of lazy knobs who dont like working or paying tax, then why would you lend them money??

A quick glance at today’s FOMC meeting

In spite of the recent surprisingly good economic data from the US that has improved a lot since the slouch of positivity that was seen last summer, there is still some optimism that the Fed will at least signal the readiness to ease policy further. In recent statements the FOMC board seem to be more dovish than they once were, this backs up the view that the Fed will sway towards a further easing of monetary policy. Today traders will be listening closely as the Fed are expected to release their funds rate forecast for the next 18 months, it is expected that they will show that rates will remain low for longer than investors first thought. Traders will also be listening out for signs that the Fed will accompany this with signs of more QE. The recent ‘risk on’ markets have been aided by speculation of this. So if the Fed fail to live up to what participants expect or have priced in then we could see riskier asset classes hand back some of their recent gains.

A few thoughts on Greece

The markets seem to believe all the dazed ministers etc that the Greek PSI talk will eventually be successful and palm off a disorderly default of Greek debt. The situation presents a tail risk, and markets have ignored a chance of this happening. The argument for ignoring it is the opinion that the impacts would be far too mad for the Euro zone not to do whatever it takes to avoid this. However, given the regular incompetence of the Greeks every step of the bloody way – you cannot simply assume that definitely won’t end in tears!

A glance at ze Bunds

Since the peak of 140.23 on Friday 13^th January, the Bunds have come off a smidge over 300 ticks flirting with the 2% yield level. Making a yield high of 2.008%. This 2% level proved to be very important last year. Participant will see this level as pivotal for the near future tend. A move through here and a breach of 136.69 may confirm that the recent rally has come to an end. In which case the market will propably test the 133.00 handle which has held the lows of the current range. If the market can sustain the recent levels then I favour we will rally back towards the recent highs and in particular the all time low yield level of 1.636%.

A quick look at Europe

One of the highlights that will dominate many market participants views will be Greece’s voluntary debt restructuring deal with its major creditors. Euro zone policy makers will be hoping that the deal does not inflame any further market uproar so that Greece will be able to receive further financial assistance tranche it was promised by the EU at the 26th October summit. Yesterday there were talks between Euro group ministers. These ongoing talk will be a main focus for markets ahead of the Brussels summit on 30th January. Other topics in focus at the meeting will include the ESM which will be the permanent Euro bailout fund that will take over from the EFSF in mid 2012. The ministers will also focus on the latest drafting of the EU’s fiscal compact and that member states are making cuts in debt, which was the main focal point of the summit on the 9th December. Acceptable progress will be key in whether the core euro zone will aid further financial assistance and maybe even from the ECB in the future. There have been recent setbacks in the drafting lately as Italy seeks to water down the compact’s limits on debt cuts. German Chancellor Angela Merkel and IMF Managing Director Christine Lagarde met on Sunday, with Greece no doubt high on the agenda at this particular meeting as well as proposals to boost the IMF’s firepower. No solid conclusions came of this meeting however. Today we saw a slight drop in the SMP purchases after many were expecting the number to trend higher. Buying of Spanish bonos and Italian BTPs was seen throughout last week, in response to news of the S&P downgrades but later shifted towards buying of Portuguese debt. According to a press report that was released yesterday stated that a haircut of more than 65% would cause the IIF to leave the negotiations as it would consider the haircut excessive and non-voluntary. Many economists believe that even if a deal is not negotiated then the EU would give a bridge loan to Greece for the gigantic 20th March bond redemption (14.4bn) that is to be re-paid. A joint press conference between the heads of the central banks and finance ministers of France and Germany should shed some light this week on any crisis developments.

Equity Gains

Last week saw very sturdy gains in equity markets. Most of the company earnings results met or beat expectations, par Google though the market brushed this off pretty quickly. German ZEW came in alot higher (-21.6 vs -53.8 previously) this was the biggest gain ever seen in one month.

Of all the indices the UK’s FTSE has lagged compeered it European and US equivalents. Though it hasn’t made as impressive gains it has firmly put a green candle in everyday. The Dax and Eurostoxx are now entering where they got destroyed on high volume in August. By the way its trading it seems as though many stops are being triggered.

BoE & QE

It seems as though people think it’s only a matter of time before the BoE vote in another round of asset purchase. February’s meeting lies just a week after the most recent round of 75bn which was voted in back in October finishes. Looking at recent UK data: unemployment was seen rising this month, weak GDP, continuing falling of house prices + sign that inflation is finally falling (yoy number was 4.2% in December down from 4.8%).

The BoE have often tended to go early with QE rather than wait. By the end of the month I’m sure that many will be calling for more QE.

Check up on the Fed

The biggest weapon that the Fed have is QE. With 1.8% GDP in Q3 2011 and strong economic data in Q4, the worry of a double dip has faded and a third round of QE had been put on the side lines for now. The risk of deflation seems far off with inflation (PCE deflator) at 2.5% in November, well above the 1.5% - 2% range of the FOMC’s projections published in November.

However, unemployment is still uncomfortably high despite a further decline to 8.5% in December, well above the FOMC’s longer term projections of 5% - 6%. Operation Twist is due to end in June and the US may start to feel the impact of an economic slowdown from abroad, these should both add to the downward momentum in inflation. The housing market remains depressed and house prices are still one third below their April 2006 peak. Fiscal policy options are limited due to the warfare on Capitol Hill and the urgency of bringing public finances into order.

I believe that during the course of 2012, QE3 may start to look like more of an attractive monetary policy option for the FOMC to embark on, especially if it is more purchasing of MBS instead of Treasuries alone, this would show that some effort is being put into boosting the housing market. In the Fed’s last meeting it stated that 3 Fed presidents voted against zero interest rate policy. This tells us that the days of easy money from the Fed are over. I think that it would take something bad to happen before the Fed decided on QE3, such as the US data to retreat it latest gains or a market crash i.e. S&P below 1,000.

Risk market strength

In spite of the euro zone downgrades seen at the end of last week, risk markets have successfully shrugged the news off. This has been put down to investor confidence as more and more traders believe that central banks will prop up the system and prevent another deterioration of the type we saw last summer. Weak Chinese economic figures have put more speculation and rumours into the market that the PBoC will embark on another round of rate cuts, this has aided a rally in commodities and Asian stock markets. The 3 year LTRO has helped improve sentiment in Europe as participants have chomped up the euro zone bond offerings this month to improve the repo collateral situation. US data is continuing to improve and despite this there is more and more talk of the Fed possibly going to embark on another round of QE. The overall belief in the market seems to be that the worst is behind us. However last year was a perfect example of just how fragile the market is, and how everything can change in an instance.

The ECB has pulled out all the stops

In December it decided to ease collateral requirements again and to provide 3-year loans to banks in two separate auctions. A reduction from 2% to 1% in the reserve requirement ratio for banks was aimed at improving access to the Eurosystem liquidity facilities, notably in the periphery. The council also cut its refi rate by 25bp to 1%. The first 3year LTRO on 21^st December had a whopping uptake of E489bn, this was deemed a success, although it is said that banks aren’t purchasing sovereign debt but using the money to re-finance their own bonds. The operation has added some E200bn to overall liquidity. However it is argued that liquidity measures do not solve the debt crisis, only soothe its consequences. It is expected that the hurdle to another rate cut to be significant, as the depo rate already stands at 0.25% and this is the most relevant rate in the view of the excess liquidity in the market. A further cut in the refi rate should not be ruled out should the euro zone slip into deep contraction or deflation. Although the threshold to large scale QE appears to be even higher, market developments in coming weeks may well underline the necessity to re-accelerate bond purchases by the Eurosystem, particularly if the euro zone leaders fail to come up with tangible solutions.

Should the UK be worried about a downgrade?

Christian Noyer (the governor of the Bank of France) recently ruffled some feathers when he stated that ratings agencies “should start by downgrading the UK” due to the country’s poorer fiscal fundamentals. There is definitely some truth to this statement. So why are ratings agencies not bothered? The main reason is that the BoE can always buy gilts to avoid a costly sovereign default, where as the ECB won’t be as forthcoming for any euro zone members. Also the UK government has a fixed plan for austerity measures put in place until 2016/17 where as France only has fixed measures for 2012. This is not to say that the UK’s AAA rating is set in stone as a major economic shock could tip the scales, such as an escalation to the euro crisis. 

UK CPI

Today we see the results of December’s CPI. Many economists are going for a lower number.

According to MPC member Spencer Dale, the main reason why growth in 2011 didn’t match up to the MPC’s original forecast, was due to weak household consumption. The sector in highly influenced by high job insecurity, austerity measures and turmoil in the Euro Zone. A fall in CPI should put a foundation under consumption as real incomes should hold more firmly.

However, the minutes of the December MPC meeting suggested that whilst there is a strong agreement that inflation will drop in early 2012 as the VAT hike falls out of the index, there is some doubt about the stickiness in inflation in late 2012.

The decline in the value of the GBP vs. the USD suggests that the high energy and commodity prices could be stubborn on UK inflation. This means that it could be a while before the 2% target is reached and real wages edge higher.

A lower CPI today will further the case for more QE. If it does drop, depending on how much will influence further QE projections. With the likely case of more economist joining the ‘February / March’ camp at 50 to 75bln.

So with some hope more QE will at least provide support to confidence and have a knock on effect to other assets.

It is said that further QE is being priced into the market. This should be negative for Sterling, but bear in mind that since the MPC announced more QE in October EUR/GBP has fallen nearly 5%. This is because the announcement was over overwhelmed by the 25bps cut from the ECB in November and December.