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Risk markets are betting all on Central Bank Liquidity Stimulus 0

Risk markets are betting all on Central Bank Liquidity Stimulus

The very weak US Employment data from Friday is being used as a reason to expect QE3 to be announced at the next FOMC meeting June 20th. Tonight's Fed Beige Book will give us a better idea of the economic data that the Fed will be seeing, but yesterday two Fed governors , Bullard and Fisher, for differing reasons signaled that they would not support QE3 just now. As I have pointed out before, the case for QE3 has grown as deflation fears are set to grow, but the case is not strong enough yet. And there still remains the question as to its effectiveness. So the S&P 500 reaction, a bounce of 1.5% from Monday's lows, seems optimistic.

The other reason behind the recovery in risk markets was the belief that the G7 Finance Ministers teleconference yesterday would yield some new policy initiatives. - nothing as yet has been announced apart from the usual words of support and co-ordination in the event it is needed. So nothing new.

And the Spain's Treasury Minister announced that Spain could not raise the funds in the market for the bailout of Bankia and the rest of the Spanish banking sector. But, Spain politically cannot request a formal Troika led Rescue plan. So it is arguing that the Spanish Bank Rescue fund, FROB, be lent funds directly from the EFSF/ESM. This is of course against the Euro-zone agreement on the EFSF/ESM as was pointed out by the Germans.

What it has done for the short-term is take the selling pressure off of the Spanish Government bond market. That is the only reason that Spanish 10yr yields have fallen to 6.25% and not risen to the 7%. But the cost of a full Spanish bank bailout is not fully known as of yet. Estimates vary- from the obviously overly optimistic "less than 40bln" from Spain's Montoro, to the €370bln to €450bln market estimates. So without a full blown review of the Spanish banks , now being undertaken, the EFSF/ESM would be foolish to commit to a rescue.  But it isn't stopping the markets from expecting that to happen.

The "safe haven" Government bond markets of Germany, the US and the UK, have sold off sharply. 10yr US Treasury yields have risen 16bp from the historic lows of Friday.

The rise in expectations for QE3 has led to a rise in US inflation expectations, but until today that hadn't fed through to rises in commodity prices. The US 5yr inflation breakeven has risen to  174bp and 10yrs to 213bp. Not a sharp rise- but it broke the trend to lower inflation expectations and changed sentiment in the bond market.

But the recent decline in commodities has not been reversed enough in the past few days to justify the rise in inflation expectations.

So it has made 10yr US Treasury and other safe haven bond markets look attractive again.

One of the major aims of QE has been to reduce Implied Volatility levels . And in a sign that the Equity markets belief that QE3 would be a saviour for the US economy is misplaced, the Interest Rate market has seen Historical Volatilities rise in the past few days and whilst the Implied Volatilities declined marginally yesterday, the decline is not sufficient to justify the rise in Equity markets.

The Bond Markets are not foreseeing as great an increase in QE3 chances as the Equity Markets. And the Bond markets have shown to be better foreseers than the equity market over the past decades.

And again suggests that the level of implied volatility priced into the Equity market is too low.

And Gold has been rallying along with the other risk assets in a price movement that was fuelled solely by the expectation of QE3.

So Gold should relinquish those gains once the hopes of QE3 subside. The Fed Chairman Bernanke testifies in front of Congress on Thursday and this may give some more clarity to the Fed's thinking.

Coupled with today's ECB meeting and press conference from ECB's Draghi then the market should get some more information. At the moment the rumour mill is in hyper drive  and investment decisions on rumours make little sense.

For the time being - the economic news is worsening, the risks of Spain needing an EU/IMF bailout have increased and politicians continue to show little consensus on what action to take.

So risks are rising of a severe recession in Europe with at least a slowdown in US growth as well.

Whilst I do not foresse Bond Yields of Germany and the US falling a long way  through the last week's historical lows. they should not rise from here and as such Government bonds are a safe haven as an investment still.

It is why I have been adding duration into the portfolios as the US Treasury market has sold off and whilst currently I have a short position in Euro Gold.

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