Nervous Calm Prevails

There is a nervous calm in the foreign exchange market and in the global capital markets more general.   The only significant price action to note is the sharp decline in Spanish and Italian 2-year yields (around 30 and 20 bp respectively) to the lowest levels since the spring, ostensibly in anticipation of ECB purchases.  This has also helped their respective equity markets outperform.  Elsewhere as widely anticipated, the Reserve Bank of Australia left rates on hold (3.5%) for the third month.  The accompanying statement seemed largely neutral.  A cabinet reshuffle in the UK, leaving Chancellor Osborne in his post had little impact nor did the soft August PMI construction (49 vs 50.9 in July). 

This week's two big events, the ECB meeting and the US jobs data lie ahead.  The ECB meeting, and especially Draghi's press conference that follows it, is seen as providing new critical pieces to the policy response to the European debt crisis and in particular, the kind of support the central bank is willing to provide to countries who are prepared to sacrifice some elements of fiscal sovereignty, demonstrated by reaching a memorandum of understanding with the EU and EFSF.


It seems unreasonable, and therefore unlikely, that Draghi is prepared to announce a specific amount of short-term securities it is willing to purchase or what absolute or relative (to Germany) yields it will seek. Absent these details and in the absence of a formal request, we suspect some investors will be disappointed with the lack of resolution.  

Even after Bernanke's defense of the Fed's past asset purchase program at Jackson Hole, many participants continue to place great emphasis on the August jobs report due the day following the ECB meeting.  Ironically, the US monthly jobs report is among the most difficult for economists to forecast. Regardless of the report, there can be no doubt that for the Fed's leadership (Bernanke, Yellen and Dudley), the economic outlook on its current trajectory is not likely to allow it reach it mandate of full employment in any meaningful time frame and inflation conditions are seen as benign.  They appear to have forged a majority on the FOMC in favor of additional easing of policy.  

The key issues are how and when.  The "how" boils down to two paths, balance sheet or guidance.   Recognizing it is a close call, we are more inclined to see the latter as the economy appears to be expanding faster after slowing from roughly 2.7% pace in H2 11 to 1.85% pace in H1 12 and Operation Twist was already part of the response to the slowdown.  

The use of the guidance channel now also maximizes the Fed's options in terms of "when" should return to the balance sheet become necessary.  Waiting for example, until next month if particularly urgent, December, to announce a new expansion of its balance sheet probably makes little difference.  The Fed may not be yet prepared to target nominal GDP, over which there seems to be a growing discussion among policy wonks and economists.  However, depending on how the politicians deal with the pending fiscal cliff, this may become more compelling.  Announcing QE3, even if MBS purchases are included, now, only to revise the program in response to a fiscal shock, may diminish the Fed's credibility.  

As we await these two events, there are a few other developments that are shaping the investment climate,  

1.  The slowdown in China and what appears to be a less than smooth transition of power is becoming of greater concern.  The Shanghai Composite fell to fresh 3-year lows last week.  There is some concern that Chinese businesses with high fixed costs are incentivized to continue to produce even when demand and prices fall.

2.  France's Hollande is seeing his public support fall sharply as the economic crisis is forcing difficult decisions.  Hollande is seen reversing himself to provide new guarantees for France's second largest mortgage lender, pending the EC's approval.  Moody's had cut  Credit Immobilier de France rating three notches last week making it unlikely it would meet a 1.75 bln euro covered bond that comes due shortly.  

3.  Spain's Rajoy appears to be choosing not to use 30 bln of the 100 bln EU/EFSF bank backstop to aid Bankia.   The sticking point is that the memorandum of understanding required junior debt holders, like the preferred shares, sold to retail investors, would have to take material loss.   This goes against Rajoy's immediate political interests and thus he again flouts the rules.  He did this previously when he unilaterally announced new fiscal targets (which he is unlikely to achieve).  He did this again when he named a head of the central bank that under internal rules cannot complete his term and see through the structural reforms.  His "peacock" stance has cost valuable time and now the regional debt issue comes to the fore.

4.    Germany presently does not have a unified position and this contributes to the general uncertainty.  BBK President Weidmann continues to oppose to ECB bond purchases on principle grounds.  Asmussen is more willing to go along with the purchases, provided strict conditionality, including it seems, IMF participation in the memorandum of understanding.  Merkel has been cagey, supporting Weidmann but seemingly to support Draghi and his conditions publicly as well.