After Ben Bernanke’s speech at Jackson Hole where he highlighted the weakness of the US labour market in the Fed’s failing of its dual mandate, Friday’s very weak employment report has given rise to more speculation as to whether the FOMC on Thursday will announce a new large scale monetary easing. As I have argued before, even if the US Employment picture is not improving, the justification for the FOMC to announce a wave of new asset purchases is just not there yet. And maybe it is this “yet” that Bernanke is worrying about. In three months time and in hindsight maybe I may not have realised that Bernanke is expecting a significant worsening of the US economy in Q4 and Q1 2013, such that additional stimulus would be a pre-emptive step. Maybe the threat of “the fiscal cliff” in the US, a Chinese hard landing, or a worsening European crisis could be used by Bernanke to argue for further stimulus but most FOMC members deal more in facts than expectations. One fact that is not in doubt is that the latest US employment report shows the lack of wealth generation in the US. US salaries are growing at near enough the same as the inflation rate. So the only way for middle-Americans to feel wealthier is in a stock market rally. Is that what Bernanke is trying to generate? For sure, as QE has little real effect on the US economy. But that is hard to come out and say as a justification for it. But as everyone now knows the plan, the pyramid scheme could fall.
This is all some in the markets appear to need to justify the relentless and growing expectation of a large scale asset purchase program being announced. JP Morgan are expecting a new $300bln in asset purchases spread across Mortgage Backed Securities and US Treasuries. Whereas I expect only an extension of the period that the FOMC believes that rates will remain low for, into 2015, I would also put a good possibility that the FOMC announce an extension of Operation Twist as a halfway measure between the doves and hawks on the FOMC.
And so here we are again, that as we see a worsening of the global economy, the prospects of further monetary stimulus is inflating asset prices of risk markets. From Precious Metals, Soft Commodities to Equities, prices have risen over the past month on the belief that QE is coming. The markets that have seen losses are those of the markets that would actually see the Fed do the purchases in. US Treasuries and Mortgage Backed Bonds. Whilst Friday we did see some buying of Mortgage Backed Bonds, long dated US Treasuries have weakened in the last 3 trading sessions. Friday was a mixed trading session, whilst it looked like the selling of 30yr US treasuries came from a belief that QE3 was less likely after the Unemployment Rate fell, it appears now more likely that the selling came from an expectation of a repeat of the performance of US Treasuries each time QE has been announced previously by the FOMC. QE2 saw yields back up 30bp in the month following its announcement. That coupled with the timing this week of a 30yr auction on the date of the FOMC statement is leading dealers to have an unwillingness to hold long positions ahead of the FOMC and if anything will see short positions being put on. Will this time be any different? With shorts being set in Treasuries and longs in risk assets, the market is already positioned.
And as we have seen recently, there is a break in the correlation between Risk Markets and US Interest Rate Markets. Interest Rate Swaps Implied Volatilities have continued to remain elevated at historically high levels and even in the falling levels of historical levels. There remains so much uncertainty in Fixed Income markets. Effectively the markets are suggesting that the yield curve will be significantly different in 3 months time.
Whether it is higher or lower still seems to be in the balance. Do other markets have a similar risk priced in, one way or the other, it seems not!
Europe is cured, apparently.
The reaction to the ECB’s Outright Monetary Transactions (OMT) has been centered mainly on Spanish and Italian bond markets and in particular that area o f the yield curve that the ECB would in the end be purchasing if it deemed necessary. The fall in front-end Spanish yields Has seen the 10yr vs 3yr CDS differential widening to the widest level seen since the financial crisis started. But as of yet it is not feeding through into the FX markets showing again that the rally in Spanish Bonds is not internationally driven.
However, whilst initially the buying that happened in the Spanish and Italian bond markets did come from external investors that buying appears now to have tapered off. It is now reliant in domestic buyers to continue. European bond funds were underweight both countries in their index based funds and especially Spanish bonds. The buying on Thursday and Friday last week may not have fully moved those funds back to have index weights but they will probably be closer now. But to what extent is this buying overdone. Whilst it is not in doubt that the ECB has a plan to break the risk that a financing crisis in Spain or Italy would automatically lead to a Euro break up, the conditionality of the use of the ECB’s plan means that it is never likely to be used. The political costs seem too high. In Spain it was initially rumoured that the Rajoy administration would seek a precautionary deal with the EU,IMF and ECB before the end of September. However because even this plan would require the Troika to visit Madrid and look over the books it now looks unlikely. Spain would probably face a credit downgrade to Junk by Moody’s as well. Rajoy faces a regional election in Galicia on October 21st. it will be the first test of the government’s austerity measures in the Prime Minister’s home region. So with the Spanish government having a late summer reprieve with yields having fallen already, there is little incentive for the Spanish administration to seek aid until after those elections. As always politicians will choose to save their own jobs ahead of those of their electorates.
It is why the OMT will have a similar time effect on the markets that the previous SMP and SMP II had. Namely 4 to 8 weeks. So come October Spanish and Italian yields will be back up at elevated levels.
We are in a period of over optimism again that the Central Banks of the world have done or will do enough to save the economy. That is leading to risk markets believing they have little to lose in being positive here, but with little in the way of wealth creation in the world, who will have the wealth to buy more risk.
So after a few days more of probable weakness in Fixed Income, we should see a move back to the realisation that the Global economy is not rebounding and in fact is weakening further.
So keep long duration positions here and avoid risk.