When I listen to Central Bankers these days I am hearing so much less than what the rest of the markets seem to hear. So when last Friday I heard Bernanke stating that the bar for further QE was very high, others heard him say that the Fed was just about to embark on another round of what they refer to as “money printing”.
Because as I have often stated the “Bar” for the use of QE in my opinion is that to fight deflation. And the arguments within the FOMC will point to the recent price surveys done by the Fed itself which show no signs of deflation. Because QE has been shown to have little effect on the other part of the Fed’s dual mandate, employment, it s difficult for an argument to be formed for the use of asset purchases to stimulate job growth.
There may be an argument for other extraordinary measures to target employment, but buying Mortgage Backed Securities or US Treasuries will do little to make US small businesses increase employment.
So my assertion here is that the market’s belief that another round of QE will be announced at the next FOMC meeting, scheduled for September 13th, will be found to be unfounded and hugely disappointing to those markets that have priced it in.
And in Europe the words of ECB President Draghi still seems clear to me. There is a justification for the ECB to buy short-dated bonds of countries where the ECB’s monetary policy is not feeding through to the real economy. However there is conditionality in this in that it has to be done only when that country has subjected itself to effective fiscal control by the ECB and EU so that the buying of the debt is not used as a means of financing that sovereign. The ECB should announce that they will make purchases of Portuguese debt, where 2yr Portuguese debt is still above 4%. That would signal that the ECB will reward those complying countries within the EFSF mechanism.
Neither Spain or Italy have requested aid from the EFSF as of yet and signs are that neither country is ready to sign up to a plan that would enforce similar austerity to that imposed on the three previous applicants, Greece, Ireland and Portugal. In fact the Spanish government seems to be on a collision course with the other members of the Eurozone as regards any terms of an official bailout. But the yield movement in the Spanish and Italian bond markets, where Spain’s 2yr bond yield has more than halved from the near 7% seen at the end of July, to hit 3% yesterday, looks to be pricing in a full scale buying programme to be launched by the ECB tomorrow. The buying must be coming from domestic institutions, external investors are still staying out of those markets. So when markets look at the level of yields on Spanish bonds to determine other asset prices, they will see a very illiquid and distorted price source.
In fact the FX market for once seems to be taking this into consideration where the Euro has not strengthened on the anticipation of a saving of the Euro zone.
Whilst the Spanish credit curve has moved back into positive territory 10yr less 3yr CDS curve now +40bp, neither the EURJPY or EURUSD has moved as you would have expected. Therefore I would use the more liquid FX market, for once, to show that the Spanish and Italian bond and credit curves are mispriced.
And the pricing of risk continues to also look mispriced. Interest Rate Implied Volatility levels are spiking again on the uncertainty of the next moves from the Central Banks.
US 5yr Swap short dated implied volatility is back to levels not seen since last summer’s crisis, September 2011, and yet the Credit markets remain strong with the 5yr CDX CDS Index still below 100bp when last September the index was in the 125bp to 150bp range. There still remains little justification for Corporate credit spreads to be at these levels.
Therefore I am maintaining a long duration position in the portfolios in core markets of the US, Germany, UK, Canada and Australia. I have little to no credit risk in the portfolios and will only look to add credit in specific issues and only opportunistically.