Skepticism Due to Misdiagnosis

The US dollar is generally firmer in what appears to be a consolidative phase as the market digests last week’s developments and awaits fresh developments.  News of an unexpectedly large (10.6%) drop in Singapore’s August exports is seen as reflective of broader regional weakness.  The 2.1% decline of the Shanghai Composite, the most in ten weeks, was the largest mover, amid disappointment with the lack of monetary stimulus and declining home sales and corporate profits.   European bourses are also seeing some profit-taking after last week’s advance.    Peripheral bonds are also under modest pressure after recent gains.  

There is a sense among many investors and observers that the new steps by officials have reduced the risks of a new financial catastrophe. The main risk is thought lie with inflation, which currently does not appear problematic at around 2% in the US, China and Europe. Japan continues to experience slight deflation.

This is thought to help strengthen risk-appetites, which can be expressed across asset classes. If there was a meme over the weekend, it was “don’t fight officials.” That may prove to be only the first, dare one say, knee-jerk response. While acknowledging that European officials and the Federal Reserve have taken new and bolder steps, we are not convinced that they will enjoy any more success. The diagnosis of the problem has not changed. Can there will little wonder then that the prescription hasn't worked either? 

We continue to look for technical evidence that would suggest our fundamental view will move back into ascendancy. Our weekly review found such technical evidence still lacking. The main exception was the Canadian dollar, which looks vulnerable, and to a less extent, the Australian dollar.

Many seem to think Draghi’s OMT plan represents a victory for the debtors in Europe and a defeat for the creditors. It doesn't seem to do that as much as change the terrain of the debate. The fight now is over conditions attached.

A banking union may sound like another victory for the debtors, but the weekend EU finance ministers meeting shows no such thing. Recall that the banking union was set as a pre-condition to the ESM funds being used directly for the banks, rather than going through the sovereign as is now required.

Led by Germany, the creditors pushed back: 1) insisting on a deliberative process, which means it would not be ready at the start of next year; 2) the ECB should only have supervisory authority for the systemically important banks; 3) the before the ECB took over supervisory responsibilities, banks would have to undergo new stress tests; and 4) use of ESM funds would still require some sort of memorandum of understanding.

This is important because as the capital markets appeared to open up to European banks last week, it became clearer that the funding problem has not been resolved. Consider that several banks issued unsecured debt. Initially, this seemed like a positive indication that they could raise money. However, covered bond issuance offers cheaper capital. The issuance of unsecured debt appears to be due to the lack of sufficient eligible collateral. Moreover, if banks are having problems funding themselves, surely they cannot be expected to be a source of funding for others.

The problem is likely to intensify. Last week the Bank of Spain reported that house prices (residential mortgages are an essential part of the collateral of the covered bonds) are falling at an accelerated speed. In Q2 housing prices were 14.4% below year ago level. This compares with 12.6% in Q1 and 11.2% in Q4 11.

On top of this, Spanish banks were bleeding deposits in July (the most recent data). We have previously suggested that the transmission mechanism that was broken was not ECM monetary policy, but the mechanism that allowed the private creditors’ to recycle their surplus to debtors. Another transmission mechanism that is broken involves bank funding. If the ECB bought all of Spain’s debt with 3-year and less duration, it is unlikely to fix these broken mechanisms.

The Federal Reserve appeared to change playbooks with its promise to continue to buy long-term securities, beginning with $40 bln a month of MBS, until well after the economy is generating significant more jobs and a sustained basis. If the Fed does this until the end of the year and then increases its purchases to make up for the end of Operation Twist, its balance sheet expand by a little more than $1 trillion. This may have impact on some monetary aggregates. It may be bolster the equity market, though with the forward P/E near 14, some investors have expressed concern about sustaining earnings.

We agree with Bernanke when he says that monetary policy is no panacea. We think the economy is the middle of a structural transition away from those sectors like finance, insurance and real estate (FIRE) that were responsible for the lion’s share of net new jobs earlier. It is not clear which sectors will replace FIRE. We are concerned that Bernanke’s monetary policy experiment needs but will not receive support from fiscal policy.