The Reserve Bank of Australia must be feeling pressure to provide financial markets with explicit forward guidance on the long-term direction of its interest rate strategy. These days, with central banks all over the world providing markets with forward guidance on rates in an effort to shape market expectations, the RBA is one of the few remaining major central banks to maintain a sense of anticipation at each meeting – rates could just as easily go up as they could go down. Even the European Central Bank has finally backed away from its sacred no “pre-commitment” policy. Check out my previous post on forward guidance here.
Increasingly these days, what was once considered to be “abnormal,” markets are beginning to construe as “normal.” A central bank that doesn’t provide forward guidance is increasingly seen as hawkish (“do they have something to hide?”) and markets tend to react by driving up its bond yields and their respective currency – effectively tightening financial conditions.
Oh yeah, I’ll tell you something
I think you’ll understand
When I say that something
I want to hold your hand
- “I Want to Hold Your Hand,” The Beatles
Hand-holding is getting to be very popular with the world’s major central banks. Effectively constrained by zero or near-zero interest rates, central banks have been putting greater emphasis on the effectiveness of their communications. Central bank “speak” – if used wisely – holds the power to ease monetary conditions as much as, if not more than, policy rate changes. Read more
Last September, you may recall, the European Central Bank (ECB) announced their new bond-purchase plan, Outright Monetary Transactions, or OMT. What’s interesting is that the OMT hasn’t purchased a single bond, and yet Spanish and Italian bond yields have fallen a few hundred basis points since then, making the debt burdens in those countries a bit more sustainable. So besides the power of its name, how did the OMT turn things around? Read more
One big concern for long-term investors is systematic risk, or risks that are endemic to an economy as a whole. Systematic risks, as opposed to company-specific risks, were behind the majority of the pain suffered during the global financial crisis. And I tend to think that in the United States, the systematic risks that came to a peak in 2007 were purged from the system pretty effectively by the intensity of that same financial crisis.
Europe, though, I fear still has a lot of systematic risks that are being masked by the massive liquidity injections from the European Central Bank. Like a bandage that’s covering a particularly nasty wound, programs like the LTRO (Long Term Refinancing Operations) are perhaps stopping the hemorrhaging, but they’re also obscuring complications that lie beneath.
A program like the LTRO has led to “round trip” financing of the debt of troubled governments by the European Central Bank through to those countries’ own local banks. I can’t but feel that this will all end somewhat badly for the Eurozone sometime in the next two to four years. Let’s say Spain defaults on its sovereign debt in the coming year or two. As it stands now, that default would hit local Spanish banks (big holders of Spanish sovereigns), and the ECB (another big holder of Spanish debt), and…and not many other people hold their bonds.
If you extrapolate that out to other troubled economies in southern Europe, I suspect that systematic risks would include the potential undermining of the Italian, Spanish, and Portuguese banking systems. It’s likely this bandage of liquidity that’s preventing this systematic risk from showing up in conventional volatility spreads.
Earlier this week, I participated in an economics panel at the Principal Global Investors Summit Series held in Des Moines, Iowa. There was a question posed that bears repeating. A client asked what the impetus would be for the ECB to engage in quantitative easing, or QE, as has been seen from the Federal Reserve and other central banks.
The key to answering this question is Germany and its central bank, the Bundesbank. Given Germany’s scarring experience with hyperinflation in the 1920s, the Bundesbank’s sole target was to keep inflation under control. Nicknamed “The Bank that Ruled Europe” because of its size and relative importance, the Bundesbank was the model on which the ECB was built. It essentially dictated the newly formed ECB’s monetary policy set-up, which is why the ECB has such strict inflation targets and now stands out as one of, if not the, most hawkish of the world’s central banks. The ECB’s inflation target, it’s unfortunate to say, I think is probably one of the reasons that Europe is in the trouble it is.
Spain seems to have survived the most recent scrutiny by ratings agencies Moody’s and Standard & Poor’s. Last week, S&P hit Spain with a two-notch downgrade, but still kept them at investment grade…just barely though. Then this week, Moody’s confirmed Spain’s government bond rating at Baa3. This concluded a review for a possible downgrade that began back in June.
When moving Spain from BBB+ to BBB-, S&P focused on five factors: Spain’s delay in asking for ESM assistance, a deepening recession, Germany’s recent comments that any direct bank recapitalization by the ESM once the banking union is set up should exclude “legacy assets,” a deteriorating political climate, and likely fiscal slippage. Moody’s decision to confirm the Baa3 rating was based on three stated factors: a probable request for a precautionary credit line from the ESM (they viewed this as a positive), the government’s commitment to fiscal and structural reforms, and progress towards recapitalizing the banks.
Did you know that Shakespeare was a proponent of quantitative easing?
Sure! Go look at The Merry Wives of Windsor, act 2, scene 2. He says, “If money go before, all ways do lie open.”
And the Federal Reserve, the ECB, the Bank of England, and now the Bank of Japan all seem to agree that spending money can open up the path to increased economic activity…or at least that it’s worth trying. So all of these central banks are now back in balance sheet-expanding mode, buying assets to keep rates down. And equity markets loved it, but now that the initial intoxication of all that QE has hit the system, it’s time to look back at the data. That’s where we’re going to see the improvement…if it comes. Reviewing last week’s data, it’s still a mixed bag. Manufacturing activity, based on the Markit flash PMI readings, was up slightly in China, down in the Eurozone, and stagnant in the United States. Housing data – at least in the U.S. market – has continued on its strong path; though don’t expect it to hit its pre-recession peaks anytime soon. And in the United States, jobless claims were down, but the four-week average ticked up. So, all told, it continues to be a slow recovery.