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Obviously more twisting just wasn’t enough. Risk assets cratered yesterday afternoon as some disappointing US economic data triggered renewed disappointment that Fed Chairman Bernanke did not request that the printing presses start up again. Appetite for risk was also hindered by nervousness ahead of Moody’s announcement that it was downgrading 15 global banks and securities firms.

Commodity prices and commodity shares were thumped – the S&P GSCI spot index of raw materials lost almost 3% yesterday, a decline of 22% since the high in late February. The oil price continues to plummet, with Brent crude now under USD 90 a barrel – back in early April, it was trading above USD 125. For global central banks, one huge upside to this latest bear market in commodities is that there is little need to worry about inflation in the near term.

Guest post by Forex Broker FxPro

As Bernanke made explicit on Wednesday night, policy-making for most central bankers is all about growth these days. In the currency world, the dollar was very well-bid throughout yesterday’s latest episode of risk repugnance, with decent gains against all major currencies. Interestingly, the gold price has dropped back markedly over the course of this week, principally because of disappointment over the lack of new QE from the Fed. It remains to be seen if the dollar can sustain these loftier levels – as we noted recently, bullishness towards the greenback is now very elevated.

Commentary

Back from the brink. Yesterday there was yet another example of that old investment adage that it is always darkest just before the dawn, as both Spanish and Italian yields continued to rally hard. The former have performed incredibly well over the past three days, down more than 20bp yesterday for a cumulative improvement since Monday’s record high of 80bp. Whether rightly or wrongly, it appears this idea that soon the EFSF/ESM will be buying peripheral bonds has been the major driver. Interestingly, German Finance Minister Schaeuble fed these hopes yesterday by suggesting that the EFSF could already buy bonds in the secondary market if a country made a request, as long as the country was prepared to undergo an adjustment program. It is this last part that remains the sticking point for potential applicants such as Spain (and, very soon, Italy) – Southern politicians want the money, but do not want to be held accountable for what happens to it after they get it. Germany, Europe’s financial backstop, would like to know where the money goes, and moreover would like to know when it might be returned. If Southern Europe could give Germany some reassurances on this front, then the latter might relent. Unfortunately, the former are incapable of delivering on those reassurances, even if they were prepared to give them.

Currencies and QE. It’s been a very instructive week in terms of the impact of central bank actions on currencies. On rates, the major central banks have pretty much completed the race to the bottom. Although none has their key rate at zero (Fed 0.25%, BoE 0.50%, ECB 1.00%), the ample liquidity on offer in various forms means that market rates are much closer together (0.33% range between overnight rates vs. 0.75% difference in policy rates). This in itself has drastically reduced the impact of QE on currency movements. Secondly, there is the impact on longer-term rates. Ten-year government bond yields between the UK, US and Germany are now within 20bp of each other, having seen as much as 100bp difference between them two years ago and 50bp just one year ago. All in all, interest rate differentials matter a lot less for currencies these days, especially amongst the majors. This has been evident in the reaction we saw this week to the lower inflation figure in the UK and the split vote at the June MPC meeting, both of which shifted the market towards expecting further QE at the July meeting. In response, Sterling has hardly budged, with the initial selling on both pieces of news soon reversed. The dollar was also largely unmoved by the Fed’s Operation Twist extension, although this decision was largely expected and does not expand the Fed’s balance sheet. What appears to be becoming more important is the perceived impact of the various QE programs on the economy. In the UK for example, mortgage rates are currently at a 1-year high, despite the GBP 125bln expansion of QE over this period. In the eurozone, the ECB expressed its desire to see the liquidity from the 3Y auctions, started in December 2011, seep into the real economy. In reality, banks bought around EUR 140bln of government bonds in the first four months of the year, whilst outstanding lending (M3 other lending to households) has fallen nearly EUR 7bln from December to April. With the end-of June deadline for banks to meet new EBA capital requirements fast approaching (one reason why banks were seen to be hoarding cash), central banks are rightly now placing a renewed focus on trying to make additional QE more effective. Fed Chairman Bernanke on Wednesday expressed interest in the UK’s ‘funding for lending’ scheme (announced last week), although highlighted the possible fiscal costs that it may entail, requiring more co-operation and integration between the government and central bank. In the near-zero rate world in which we live it’s likely that we could shift to a reversal of fortunes with respect to currencies and QE. If markets believe that further measures will make the (eventual) recovery come earlier, then at some point additional QE could actually become positive for a currency. It may seem counterintuitive, but it’s probably not that far off from becoming reality.

The inevitability of an Italian bailout. Very few policy-makers in Europe would want to swap places with Italian Prime Minister Mario Monti at the present time. Parachuted in by European leaders as the head of a technocratic government in the hope of putting Italy back on financial track, Monti has been thwarted by deeply entrenched and powerful domestic political interests. Despite months of negotiations with the major unions, Monti has been unable to get them to budge on much-needed labour reforms such as easing restrictions on firing workers and discouraging the use of temporary employment contacts. The legislation is still being extensively debated inside Italy’s Parliament. Monti is now being roundly castigated for implementing a significant austerity package, which imposed EUR 24 bn in new taxes this year alone. With the economy back in a very deep recession and unemployment soaring to almost 10%, his approval rating has plummeted from 71% when he took office back in November to just 33% currently (according to polling agency SWG). Interestingly, European policy officials are becoming increasingly frustrated with Monti as well. Some are apparently annoyed that he has not achieved more at home, believing that he has been too absorbed with attempting to rectify Europe’s financial issues rather than getting his hands dirty domestically. Moreover, Germany has become exasperated with some of his recent opinions and proposals – he threw significant weight behind Francois Hollande’s growth-push, and he supports the idea of Europe’s bailout funds being allowed to purchase the bonds of troubled sovereigns such as Spain and Italy. His loss of support locally has now reached the point where the main political parties are agitating for his removal and for fresh elections to be called. At this incredibly sensitive time for Italy, this prospect is no doubt contributing to the unease being felt by both traders and investors. Italy remains Europe’s largest sovereign borrower by some distance, with almost EUR 2 trln of debt outstanding. Over the second half of this year, more than EUR 200 bn of that needs to be rolled over, a massive challenge in the current environment, and very expensive at current yields. Just like Spain, it would be no surprise if Italy fell into the hands of international creditors before too long. Italy’s debt mountain dwarfs that of Spain in a ratio of 5:2, so an Italian rescue would really stretch international financial resources to the limit.

Merkel gets SPD to agree to fiscal compact. After much horse-trading, German Chancellor Merkel has obtained agreement with the Opposition SPD on ratifying both the fiscal compact and the ESM. For their part, the SPD have obtained Merkel’s support for a recapitalisation of the EIB and the issuance of project bonds. However, their attempts at gaining support for the joint redemption fund idea was knocked, as the CDU claim that it is against the EU’s rules.      

Tokyo vocals do the trick. USD/JPY is back above 80, a development that will no doubt be a welcome relief for the MOF. Just a week ago, it was down near 78.50 and looking rather ominous; suddenly, the MOF was probably weighing up industrial-scale intervention in an attempt to weaken the yen. However, risk appetite has improved a little since then (although it has been choppy), and interest rate differentials have moved against the currency. The failure of the Fed Chairman to press the button on QE3 just yet has helped the dollar, and also lifted longer term rates in the US. Also a factor has been a more aggressive tone by leading policy officials in Japan. For instance, the BOJ’s Ishida remarked on Thursday that the Japanese central bank needed to be bold when necessary, and that another easing next month cannot be ruled out. The MOF would be pleased if USD/JPY remained above 80 through the summer months.