A glance at the equity markets

Yet again Greece dominated the markets focus with the coalition government prepared to vote on accepting fresh austerity measures laid out by the EU in return for dishing out further aid in the form of a second major bailout. Some ministers were shock and decided to resign in protest as they thought the austerity measures were too much, this led to equities selling off. This was the first time in ages where the markets have properly reacted to some negative news out of Greece. Luckily not all the Greeks are thick and the new terms were voted in and the markets have reacted accordingly, with risk markets opening higher: Dax +52, Eurostoxx +15 and eur/usd +92.

The central bank meetings we had last week turned out to be boring, with nothing unexpected said. The BoE increased QE by another 50bn as expected and the ECB staying in ‘wait and see’ mode. The meetings next month in my opinion should be much more eventful, as the second 3year LTRO will be out the way; I think this could sway the ECB’s policy decision a lot at the next meeting.

A few notes on the ECB conference

The recent drop in Euribor rates is due to a large extent to a fall in liquidity and credit risk premiums on the back of improved market sentiment. However, in recent weeks there has also been speculation on the market that the ECB may want to narrow the spread between the rate on its marginal lending facility (MLF) and the deposit rate. Assuming a parallel corridor would involve a cut in the refi rate, which could be either 25 or 50bps. The reason the ECB may do this is to give the greedy banks even cheaper funding, but also so that they can ensure a firm bid in the next 3year LTRO. However I see several problems to this theory: 1. The cost and benefits of such a move is way different to previous rate moves. With a large amount of excess liquidity being locked into the market, the impact on EONIA is likely to be minimal. The use of the MLF has dropped sharply since December and the ECB may be of the opinion that a sufficient boundary between the marginal rate and the refi rate (currently 75bp) serves as an incentive for financial institutions to handle their liquidity in a successful way. 2. The reduction in collateral requirements and the reduction in the reserve requirement ratio,  should ensure together with the 3year LTRO, that there are no volume restrictions for banks. Indeed, the ECB has always been of the opinion that the unconventional measures are aimed at improving the transmission mechanism. 3. With Euribor fix still in a down trend, there doesn’t seem to be an imminent reason for the ECB in trying to accelerate this trend. 4. I would argue that keeping a bit of spare doesn’t hurt anyone! If a more unfavourable economic situation occurs, or bank lending does not show signs of recovering in coming months, the ECB has a more fundamental reason to support the spending of its remaining ammunition. With regard to the economy, I expect Mr. Draghi to repeat his view that there are “tentative signs of stabilisation” (these signs have become a bit more pronounced with recent PMI surveys), whilst on the other hand the downside risks to the economy continue to be significant. Consumer spending data, for example, have been particularly weak lately. With regard to their inflation assessment, I expect the Governing Council to maintain a neutral view (a switch to downside risks would likely be a selling point if there is a rate cut). Whilst recent figures indicate that inflation is coming down now, the pace at which this is taking place is definitely slower than envisaged a few months ago, in part because of recent euro weakness and rising commodity prices. 5Y inflation swap contracts have risen by 40bp since November last year, an indication that the market is not buying into the deflation scenario, at least for now....

Guru’s thoughts: I strongly believe that the ECB will remain in ‘wait and see’ mode as there are too many variables that need to be played out. They still have bullets they can use and it’s all about timing. However I do think they will use at least one of these bullets in the coming months, I think the ECB will want to see the results of the 3year LTRO on the 29^th and then they can look to possibly cut rates further.

A few notes on BoE policy

It is expected that the Bank of England will announce an extra 50bn of QE today’s meeting. As at this point it is expected that the bank will have completed its previous 275bn of QE target.

Recently data from the UK has been acceptable, with the exception of weaker GDP. There were a few shockingly good figures such as the PMIs, this was decreased the expectation of a double dip in the UK. Despite this I am still weary of the UK. Inflation is still eroding wages which in turn is holding back demand.

Inflation has seen a slight trend change coming in at 4.2%, but still well above the BoE’s target of 2%. However last year’s VAT hike will drop out the index from January indicating a chance of a speedy fall in inflation at least in the early part of this year. Household spending in the UK amounts to around 60% of the total demand. So, if inflation were to fall below nominal wage rises this would improve consumption. The MPC still remains wary however as to how much inflation will drop this year. This fear was clearly pointed out in the December and repeated in the January minutes. In spite of this the chief economist Dale has been optimistic that a fall in inflation and therefore a rise in real wages will add fuel to growth in 2012. But always be aware that the Euro zone crisis is just next door and still has negative impacts our exports. The UK’s latest lending survey revealed that lending to firms and households fell in December. This is a strong argument for the BoE to provide more liquidity. I have changed my previous view of a 75bn increase in QE to a 50bn increase due to the MPC reiterating their ‘less dovish’ stance combined with the staggeringly good PMIs.

It is possible that any further QE this month could mark the end of the BoE’s easing cycle, though the outlook will be determined by the relative strength of forthcoming data releases and the unhelpful consequences of troubles over the channel. It has been suggested that a BoE rate rise is unlikely until 2013.

Guru’s thoughts: I believe that there will be an increase of 50bn, easing the storm from the euro zone combined with the good PMIs in the UK will mean that the BoE do not have to as urgent as I once thought. In my eyes there are three possible scenarios to trade that I will be looking at: 1. If there is a 50bn increase there will be some movement but not much, if fixed income rallies I will look to sell at some point and the same if it sells off I will look to buy some sort of dip. This is because there are people who are long looking for more than 50 and people who are short looking for less. 2. If there is less than 50 it feel it will be a colossal surprise to the market, this should see fixed income get slammed, I will then look to sell (at the time and for the near future), it will also be a good opportunity to put on short sterling steepeners. 3. If 75bn is announced then I will look to buy dips in fixed income and put on short sterling flatteners. Being as I am flat in UK products at the moment, from a trading perspective I hope for no increase as I think this will rattle and shock them market, and shock means opportunities. Good luck!

A look at the UK economy ahead of policy decisions

• I will start with the worst....GDP. It came in at -0.2% in Q4. The data showed a stand still service sector as well as manufacturing and construction sectors both stagnating. Technically speaking it would take another contraction in Q1 for the UK to be deemed in recession, though so far survey data has hinted to us that there will be an improvement. 
• The UK employment rate pressed to 8.4% although the lower than forecasted rise in jobless claims in December was encouraging. Retail sales remained strong in the lead up to Christmas. But survey data has hinted that this may not have lasted in January. 
• The latest borrowing data was better than expected and showed that in the financial year to December 2011 the government is holding close to its original borrowing target. This is despite the government’s autumn statement suggesting that in aftermath of lower growth forecasts the budget outlook has also taken a hit. The budget is no longer expected to be balanced during the current parliament.

US – I get down, but I get up again….

As Europe tries to correct itself, economic data has been good enough in the US to be called surprisingly strong, though much of that renewed strength appears to be from the constant adrenalin shots of stimulus. Most recently the Fed extended its low rate pledge for over a year into mid/late 2014, set an explicit two percent inflation target, and reiterated that QE3 is ready on a hair trigger. But stimulus is like a narcotic, the more you take the less effect it has.

With US data yielding many upside surprises in the last few months and bond yields pinned to extraordinarily low levels, equities have had a great start to 2012. Volatility has dropped significantly and stocks have gained steadily as the recovery finally seems to be taking hold. Yet the surprise improvement trends could create ever greater expectations for each successive data point, requiring ever better data to drive markets higher. Thus, any stumble in the economic data could be amplified as the winter months wear on.

The vital signs of the US economy have genuinely improved in recent weeks. Non-farm Payrolls have grown for sixteen straight months and the data has shown steady improvement over the last four months, capping it off with a resounding 243K reading last month, a twenty month high. The unemployment rate has also yielded pleasant surprises the last two months, coming in below expectations and falling to a nearly three year low of 8.3% in the latest reading. Measures of growth also improved in Q4, with an improving trend in US GDP and production indices. The second reading on US Q4 GDP will be out February 29 after the advance reading showed sequential improvement but disappointed expectations, while US production data has been uneven, though the most recent ISM data (both manufacturing and non-manufacturing) had its best showing in over half a year.

With moderate economic growth, however temporary, and employment indicators showing noticeable improvement, risk appetite has improved and the VIX "fear" index has hit a seven month low. But the nascent economic recovery may not be as healthy as some prognosticators believe. One key factor will be the continuing absence of a housing recovery. The construction sector has played a significant role in past economic recovery cycles, creating construction jobs and perceived wealth as home prices appreciate. But this time around, even though there have been some sporadic positive housing readings, the housing sector is unlikely to undergird the recovery in jobs and production.

Greek PSI deal

According to naftemporiki.gr the PSI deal is now
completed. The coupon would be 3% to 2020. The average coupon
would be around 3.6%. There would be a 50% nominal haircut. Bond
holders would receive 15% in cash and the rest in a greek
bond. By Wed next week they are going to publish the list of 80
Greek bonds that are going to participate in the PSI plus the
loans of the  greek banks.

European illness contained?

It now seems slightly less likely that a Greek credit event will cause a domino effect across Europe this year, but if the event occurs it will still have to be absorbed. Many believe that the bond payment that needs to be on 20^th March is the date that the start of an orderly default will commence. Talks with the private sector have avoided a disorderly default, and ‘apparently’ a deal is nearly achieved, although negotiations for the next troika package have been a struggle. Greek opposition parties and unions are arguing the idea of more cuts – although I think the morons don’t have much choice but to accept. The idea is that this will contain the infection that is Greece.

As much as the EU has tried to contain the infection, some symptoms of illness have been seen in Portugal and Hungary. The Hungarians have managed to make their European partners queasy by threatening the independence of their central bank. This in turn put the IMF loan package in jeopardy, which without Hungary would become a new source of contagion for central Europe. Portuguese interest rates have continued to rise even as other peripheries saw yields ease. Speculation is doing the rounds that the nation could need another 30bn bailout on top of the 78bn it received from the IMF,ECB, and troika last year. This has led to denials from officials that they won’t, but as history has proven that these denials tend to have an opposite effect, hinting that Portugal may soon need to enter bailout negotiations. The idea that Portugal may surrender to the same sickness that sent Greece to the A&E is worrying as Europe is almost expecting Greece to be on life support, no such preparations have been made for Portugal, which brings the next 999 call....French banks.

The doctors are currently trying to put an emergency medical kit together to contain such an infection. The new EU treaty is set to be signed by most of the union’s members, UK and Czech Republic decided against it and others such as Sweden may still get cold feet. This breakthrough treaty is a crucial moment for the Euro zone, as more central power gives Germany the political motivation to continue with the Euro experimentation. This could in turn lead to actual fiscal union and euro bonds. Officials have also confirmed that the ESM backstop fund will begin in July 2012, but discussions are still uncertain about boosting its capacity beyond 500bn.

Guru’s view: amputate!