Drivers in the New Week

The US dollar is firm to start the new week, except against the Japanese yen,  amid a general risk-off tone.  Against most of the major currencies, with sterling being the chief exception, the dollar has recouped the lion's share its post-QE3+ losses.  

The fifth consecutive decline in the German IFO did not help matters.  Talk that the ESM can be leveraged through selling bonds to the private sector is not helping peripheral European bond markets.  Month-end and quarter-end flows and portfolio adjustments are also thought to be impacting. 

 

Actions by the Fed, ECB, BOJ and the BOE's ongoing gilt purchases have been taken on board.  It seems clear that the US is again more aggressive than the other central banks.  It is generally assumed now that when Operation Twist is complete at the end of the year, the Fed will replace the bond buying by extending QE+.  The Fed's balance sheet will expand by roughly $1 trillion. 

The ECB plans to sterilize the purchases it makes under the Outright Market Transaction program and unless there is another LTRO, the ECB's balance sheet is unlikely to expand very much.  The BOJ's recently announced extension of its asset purchase program will modestly increase the BOJ balance and  boost the monetary base.  

A further expansion is possible toward the end of the year.  The BOE's gilt purchase program has expanded base money by about 10% and although the three-quarter decline in GDP may have ended here in Q3, the economy remains fragile and the BOE is likely to announce new gilt purchases when the current operation is complete.    Yet there are other drivers of foreign exchange prices besides relative central bank balance sheet expansion and the quantities of money

European developments may overshadow central bank balance sheets in the days ahead.  There are several developments/events to monitor in Europe.  In Portugal, the recent public protests have the government looking for an alternative to the planned hike in the social security tax from 11% to 18%.  It has already been given another year to meet the fiscal target, but European officials still have not acknowledged what this means. It is unlikely that it will be able to return to the capital markets in nine months like it is expected to under the 78 bln euro aid package.  

Spain is the most complicated situation in the days ahead.  It will release broad strokes of next year's budget.  It will also announce a package of structural reforms that are meant to anticipate the conditionality that may be required if it asks for assistance.  Among the measures discussed are freezing pensions, accelerating the plan increase in the retirement age, and lowering the threshold of the wealth tax.

The results of the bottom-up analysis of Spanish banks is expected to be released at the end of the week. They will be compared with the early estimates of around 60 bln euros, which at the time was met with great skepticism on the part of investors.  Since then, the bad loan ratios have increased and deposits have fallen.

There is some talk that Spain could use the remainder of the 100 bln euro backstop for other purposes (like supporting its own bond market), beside bank recapitalization, but this seems highly unlikely.   Some observers expect Moody's to conclude its rating review by the end of the month, though there is not fixed date.  Moody's gives Spain the lowest of its investment grade ratings.

While skeptical of the "value" of the rating agencies sovereign ratings, which draw exclusively from public information, we suspect there would be strong market reaction if Spain were to lose its investment grade status. Finally, we note that the region of Catalonia is seeking formal guidance from Brussels on the legality of secession from Spain. There may be more developments on this front in the days ahead as well.  

Germany seems to be quite nonchalant about developments; displaying no sense of urgency.  It does not want the ECB rushed into the bank supervisory role.  Although some in the EU are pushing for a resolution on Greece at the heads of state summit in the middle of next month, Germany seems content to wait until November, which some reports link to the aftermath of the US presidential election.  

The IMF is also taking a very strong stance on Greece, perhaps in order to drive home its point that another debt restructuring is needed (official sector, including the IMF, has 2/3 of Greece's debt).  France and Italy reportedly were encouraging Spain to request aid soon, but Germany's Finance Minister was unequivocal. He had "unshakable conviction" that Spain does not need additional aid.  This perhaps foreshadows the difficulty it would be now to get German parliamentary support.  

France will also present it preliminary budget for 2013.  President Hollande's support has waned over the summer months and the going is about to get tougher.  After campaigning on a pro-growth platform, the cruel reality is that Hollande's government needs to demonstrate its commitment to the EU fiscal objectives by delivering a 3% deficit next year.

This requires an estimated 30-40 bln euro in savings.  Taxing wealthy household and large businesses will only get so far.  There has been some talk of a freeze of government spending in real terms.  However, ultimately investors want to see civil service reform.  Those countries on the periphery, including Greece, that have implemented serious cuts and reforms in the civil service, have seen unit labor costs fall (i.e., improved competitiveness).  Not so in France.  Moreover, after narrowly escaping a contraction in Q2, France does not look so lucky here in Q3.