Home A calm before the storm

After Tuesday’s horror show, Europe’s markets were eerily calm yesterday, but frankly it seemed nothing more than an uneasy quiet before the next thunder-cloud arrives. Talk of the ECB stepping up the pace of secondary market purchases helped steady frayed nerves, but even so it is a long way short of the buying power that is required to soak up the forced sellers.

More and more commentators are pushing the ECB to consider unlimited unsterilised bond purchases (aka QE), but both Germany and various members from the ECB reject this idea, arguing that it would massively compromise the ECB’s credibility.

The single currency continued to slide for a time yesterday, threatening 1.34 at one stage, before reversing and gradually drifting higher, now just above 1,35. With no real solution to the crisis in sight, it is noteworthy that the euro is not much lower. High-beta currencies also dipped the Aussie reaching 1.0060. For now, it is the dollar and the Japanese yen that are attracting the bulk of the safe-haven flows. Bonds in Europe were volatile as the panic sellers paused for breath – that said, it very much felt like the selling frenzy could recommence at any time. A critical test of sentiment will be today’s auction of French and Spanish government debt – yesterday, the FR/GER 10yr bond spread widened to a euro-record of 193bp, with the SP/GER 10yr spread also a record at 460bp.

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UK banking on more QE. The Bank of England tries to allow for all possibilities in its quarterly inflation reports, but even it admits that there is no way it can quantify the worst case scenario for the eurozone and its impact on the UK economy. In the latest report, once again the Bank has been forced to reduce its projections for GDP growth, but there’s another interesting factor in the mix. For years the BoE has always produced its own ‘backcast’ of GDP, on the basis that official data under-estimated growth and that figures were likely to be revised higher. As it happens, the latest revision shows the peak in growth to be higher but also the recession to be deeper. The bottom line is that growth was not revised up to the extent that the BoE believed would be the case and the Bank now believes that upward revision will be of a lesser degree than before. This may all sound a bit technical but it does mark a shift in approach from the Bank. The Bank appears to be taking a more downbeat view of the economy and this would certainly pave the way for it to further purchase assets from next year. Sterling markets were relatively unmoved by the inflation report, looking both at FX and also short-term interest rates. The Bank still sees inflation below target in two years time and on this basis markets remain hopeful of more QE to come. But as the bank admits, for the near-term growth outlook, the UK is very much at the mercy of the eurozone.

UK consumer confidence is cratering. Consumer confidence in the UK fell to a record low last month. The Nationwide measure of consumer confidence plummeted to just 36 last month, down from 45 in September. Apart from the deteriorating environment at home, exemplified by yesterday’s dreadful jobs figures, consumers are also clearly troubled by the eurozone crisis. According to the survey, only 13% of consumers are confident of their own financial situation.

Far from normal in eurozone bonds. After Tuesday’s bond market carnage, the ECB was reportedly fighting back on Wednesday, resuming secondary bond purchases in larger volume (some reports claiming it was in excess of EUR 1bn). If this talk was accurate, it would represent a modest stepping up from the pace seen last week. Worth highlighting at the same time are some of the other factors contributing to the bond market carnage. Firstly, banks right across the board are being forced to liquidate eurozone bonds and securities in order to satisfy capital adequacy rules. Even Finland could not escape the rout, with yields up around 10bp on the day during Tuesday, even though Finland has debt nearly half that of Germany (as % of GDP). Secondly, there is a severe reduction in liquidity going on as well, reflected in widening bond bid/ask spreads. This is not surprising as year-end approaches, but is also leading to a poorly functioning bond market. It is also worth noting recent developments at the short end. Switzerland’s t-bill sale on Tuesday saw yields of -0.3% on 3mth paper. This is not surprising given the surge in liquidity in the wake of the SNB’s decision to cap the Swiss franc back in September. It’s not inconceivable that the same could happen in Germany. Indeed, short-dated bills in Germany are being offered above par on some maturities, but this is more down to illiquidity. If the ECB does go big guns (a big if) and effectively start quantitative easing (i.e. acting as lender of last resort) then negative yields on German t-bills would be almost a given. It would be another reflection of the disjointed nature of the eurozone money market and another unintended consequence of the ECB going for broke.

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