Thoughts on Recent Price Action and Drivers

The position adjustment and renewed risk appetite seen after a dismal September has been halted in its tracks by a combination of the more somber warnings from German officials that the sense of closure that many investors seek to the 2-year old European crisis will remain elusive despite the Berlin-Paris pledge for a comprehensive and durable solution, poor regional economic data and Moody’s reassessment of the outlook of France’s Aaa rating.

At the risk of being cynical, the lowering of expectations may reduce the chances of disappointment and actually may leave the market vulnerable to more favorable developments. Pressure on European officials to take decisive action cannot be exaggerated. The European summit this weekend may prove to simply be a preliminary exercise ahead of the G20 meeting in early November.

The firewall initially built around Greece proved insufficient. Ireland and Portugal succumbed and required international assistance, even if their debt crises were different in origin and composition from Greece. Although Spain was the next in line, Italy has jumped ahead of it and this is reflected in the yield differentials and prices for protection in the credit default swaps market.

Italy has such a large stock of outstanding debt that a few auctions in which yields are elevated will not increase its debt servicing costs very much. The 6% 10-year yield threshold that seemed so important for Greece, Ireland and Portugal, may not be the same for Italy. Italian banks have very little exposure to the other peripheral countries, but have extensive exposure to Italian government bonds. Italy itself runs a small primary budget surplus (excluding debt servicing costs).

Prime Minister Berlusconi has recently survived yet another vote of confidence. It is easy for some observers to blame Berlusconi for Italy’s plight, but he seems to be just as much, if not more, effect than cause. The opposition to Berlusconi offers a different (and despite everything often less compelling) personality, but not a different program.

Even Berlusconi’s critical finance minister Tremonti suggests that the reason Italian yields have risen above Spanish yields is that Spain has brought forward elections from next year to next month. The Popular Party is looking at the possibility of winning an outright majority of parliament and its program is similar to the current Socialists, accept for even more austerity.

Similarly the new governments that have come to power in Ireland and Portugal since the crisis began appear to have adopted the very programs that they were critical of when in opposition. The most significant failure in Europe is not the banks or sovereigns but the intellectual bankruptcy of the elites.

They see no alternative to the pursuit of a pro-cyclical fiscal policy—raising taxes and cutting spending—as the risk of a renewed economic contraction looms on the near-term horizon. The Spanish finance minister, speaking what many others were thinking or behaving as if they believed, that reaching the austerity targets was more important than meeting the growth objectives.

The US recorded surprisingly soft growth in the first half, while the euro zone did fairly well. The Schadenfreude (taking pleasure at someone else’s misery) was already being undermined as it was being articulated. The US economy appears to have grown faster in Q3 than in all of H1 and some of the momentum is likely to carry into at least early Q4. Europe on the other hand is looking tired. Although many German economic institutes say a recession can still be avoided, after a disappointing October report, ZEW warned that the German economy may contract this quarter and next.

With the US core CPI measure flirting with the 2% level, the highest since Lehman’s demise, and the economy stuck at growth rates too slow to bring down unemployment, some observers are tempted to call it stagflation. Yet if the US conditions are stagflationary, what are the conditions in the UK?

British inflation jumped 0.6% in September to 5.2% from 4.5% in August. This is the highest since September 2008. Despite renewing its gilt purchase plan earlier this month, BOE Governor King must write yet another letter to the Chancellor of the Exchequer to explain the overshoot. Seemingly with the approval of the government, the BOE appears to have, in practice, suspended its inflation target. The economy has all but ground to a halt in recent quarters. Beginning in Q4 10 through H1 11, the UK economy has not grown net-net in real terms.

I had not expected the major currencies to pullback as much as they have Monday and into Tuesday, but it fits the general pattern whereby Fridays are often trend days in the fx market and there is frequently some albeit limited follow through early Monday and that a corrective phase ensures. This pattern is still playing out and I am still reluctant (stubborn?) to give up on my idea that the euro and other major currencies have not yet peaked in this upside correction.

The euro staged a key reversal on Oct 4 recording a low near $1.3140. It than staged another potential reversal on Oct 17 hitting a high near $1.3914. The initial retracement objective (38.2%) comes in near $1.3620. It bounced smartly off the $1.3650 area to make new session highs late in NY on Tuesday. If the $1.3620 area breaks, a move toward $1.3530-50 is likely.

Sterling bottomed on Oct 6 near $1.5272. This is one example of when sterling did not lead the euro, but the other way around. On the other hand, sterling peaked on Oct 14 near $1.5853. Tuesday low represented, almost to the tick, a 38.2% retracement of that advance. A break warns of a move toward $1.5550-60.