In the end, some were disappointed that the Fed did not do more than merely extend Operation Twist by USD 267bn up until year-end. At the same time, in a clear statement of intent repeated ad nauseam at the press conference, Bernanke emphasised that the Fed would be prepared in the months ahead to undertake additional measures to support the recovery if necessary, including a further expansion of their balance sheet.
Jobs, or more specifically the lack of them recently, is the main driver of policy right now for the Fed, and making this explicit is a welcome development. As a result, even more attention will be focused on monthly payrolls, together with other partial indicators such as initial claims. The economy has definitely lost momentum over the current quarter – retail sales fell for a second consecutive month in May, and industrial production declined in May for the second time in three months.
Guest post by Forex Broker FxPro
Worth noting is that the Fed revised its forecasts for both growth and inflation down significantly at this meeting, which reinforces the perception that policy-makers have a bias towards easing. Also on the Fed’s radar is the very significant tightening of fiscal policy mooted for early next year, and Europe’s worsening banking and sovereign debt crisis. Market response to the Fed’s latest move has been underwhelming – indeed, risk assets were more concerned with the large downward growth revision by the Fed, and then the weak Chinese PMI figures released overnight. Still, Bernanke has clearly signalled that QE3 will return should jobs fail to pick up, so that ought to placate the market to some extent.
Commentary
UK QE around the corner. More quantitative easing from the Bank of England looks pretty much assured for next month in the wake of the latest MPC minutes, which showed the governor voting with the minority (four members in total) to extend the current asset-purchase facility at the June meeting. Although it’s not unprecedented for King to vote with the minority for a change in policy, this is the first time it has happened with respect to expanding QE (although in August 2009 he did vote for expanding by more than the majority view of GBP 50bln). The governor did provide a hint of his change in stance during his speech at the Mansion House last week, so while the change in his vote should not come as a total surprise, it is significant given the rarity of King dissenting in favour of a move and especially an easing one. Indeed, this appears to be only the second time it has happened, with no dissensions for lower rates from King since the MPC started. The lack of response by sterling to this latest news from the MPC backs up an observation we were making yesterday, namely that currencies are becoming less influenced by QE decisions, in large part because their economic impact is diminishing. This certainly remains the case in the UK, given the rising borrowing costs seen by both households and businesses over the past year.
Gilts outperforming Bunds. The outperformance of UK gilts vis-a-vis German bunds over the past month has been quite significant. For instance, the 10yr spread has narrowed by almost 30bp over this time frame; at one point yesterday, it was trading at just +13bp. At the height of the last euro-storm in late November last year, Gilt yields briefly traded through Bunds. This relative favouritism for gilts has more to do with concerns for bunds than anything to do with the UK. Investors and traders clearly fear that Germany’s quality as a AAA-rated sovereign is being compromised as Europe’s debt and banking crisis continues to worsen. If Germany relents to the pressure from elsewhere in Europe and takes on a further truckload of financial liabilities, then credit quality will be further diminished. Or, should Europe actually accept that structural reform and competitiveness is the road that prevents financial ruin, then bunds would presumably lose their safety premium. This reasoning all seems rather too simplistic, and dangerous. Even so, if the current concerns persist, then we could well see Gilts trade through bunds again at the long end fairly soon.
The holed eurozone lifeboat. Of no real surprise from the G20 was the feeling that world leaders still believe the eurozone needs to do more to help itself. For its part, the eurozone reportedly warmed to the idea of the EFSF (the temporary bailout fund) buying government bonds, even though this is not a new idea, despite the fact that it would not tackle the underlying causes and would probably not push yields lower on a sustained basis. Still, not to worry, for the eurozone lifeboat (the European Stability Mechanism) is due to come into force next month, provided that ratification by the German parliament goes without a hitch next week. The trouble is that the ESM was conceived (late in 2010) when European leaders believed that at the time of its launch (originally scheduled for 2014) the worst of the sovereign crisis would be behind them. There are two things that have conspired to thwart this. First and most simply, the chain of events in the eurozone (and elsewhere) that has seen the crisis worsen rather than improve. Second, the bringing-forward of the ESM launch to year earlier than originally planned. As such, the supposedly new and improved lifeboat is set to be launched in the midst of the storm that was expected to be over when it was first mooted. Unfortunately, there is a real danger that rather than serving to save the eurozone, it may hasten its demise. At present, there are four countries signed up for financial assistance from the troika (EU, ECB and IMF) in various forms, including Spain’s yet to be agreed bank loan program. Spain itself will struggle to survive at current market rates, especially given the rising debt burden from the bank deal. All these countries must still contribute to the capital of the ESM. The only provision allowing for leniency relates to those with per capita GDP 75% or less of the European Union average, but only applies to new ESM members (i.e. accession countries). But if Spain were to be formally ‘bailed out’, then there would be four countries whose capital contributions to the ESM (payable by instalment over the next five years) would still have to be paid. Without direct market access, these would be indirectly paid by the ESM, unless the IMF was to take a greater role. In other words, the contributions would feature in its funding requirements and (ESM) loan calculations for the coming years. The point is that beyond the debate about the size of the ESM (with regards to providing a backstop for the likes of Italy), there is a real need for a look at the structure which was designed for when the waters had calmed, not whilst the storm is still blowing. At present, it’s a house of cards and the more Germany digs its heels in on the austerity and ‘no bail-out’ mantra, it are merely making bigger waves that could sink the whole ship as the paid-in capital is funded by bigger claims on the ESM itself. It’s a potential vortex of lending to finance more borrowing, a route which can only lead to a credit crunch of epic proportions.
Italian banks also need urgent recapitalisation. Against a backdrop of collapsing property prices and a soaring volume of non-performing loans, it is perfectly understandable that the focus of attention of European policy-makers and asset markets has been Spain. Indeed, at the G20 meeting, German Chancellor Angela Merkel urged Spain to clarify its aid request as soon as the results of the bank audits were known. However, it is important to recognise that the deterioration on the assets side of the balance sheets of Italian banks is no less serious. According to figures released by the Bank of Italy, corporate and household bad debt jumped by 15% to EUR 109bn in the year ended April. Impaired loans – not including those already written-down – increased to EUR 58bn from EUR 50bn a year earlier. With the economy stuck in recession once more, and local property prices suffering, the direction of travel for non-performing loans can only be upwards. Morgan Stanley recently published an estimate claiming that Italian banks required a capital injection of up to EUR 42bn in response to the surge in bad loans. Recall that Moody’s downgraded 26 Italian banks last month because of concerns regarding poor earnings, bad loans and the faltering economy. These concerns are unlikely to go away anytime soon.
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