Fed must re-evaluate their policy options
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Fed must re-evaluate their policy options

The continuing malaise in the US jobs market lifted hopes that the Fed may need to re-consult their policy tool-kit, with renewed speculation that QE3 would be back on the table. The difficulty for the Fed Chairman in terms of implementing further QE is numerous. The success of previous rounds of QE has been mixed – they certainly lifted both commodity and asset prices, and thereby possibly thwarted a dangerous lurch into deflation, but failed to materially impact on growth, weighed heavily on the dollar, and alarmed foreign creditors.

An additional challenge for the Fed Chairman is that some of his fellow policy officials are becoming increasingly uncomfortable with the extraordinary risks that the central bank are running, in terms of both credibility and long term inflation. Quite rightly, many Fed officials maintain that Washington should be doing more to reduce America’s fiscal obesity through a root-and-branch review of entitlements and a program of structural reforms designed to raise productivity and growth potential.

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However, as is the case almost everywhere across the major advanced economies right now, the political leadership to implement such a transformation is lacking, and as a result central banks are left to carry the weight of most of the policy adjustment. Should the Fed Chairman find additional QE too hard in the near term, then there is a growing school of thought that he may opt for a sizeable twist operation, whereby the Fed swaps short-dated maturities on their balance sheet in favour of longer-dated securities. It was this speculation that contributed to a significant flattening of the yield curve on Friday, with the US 2-30yr yield curve narrowing by some 15bp.

With risk aversion on full display once more on Friday against the backdrop of growing double dip concerns, it was again a fabulous day for bonds, gold and the Swiss franc and a dreadful one for stocks and risk assets. Both the US and German 10 yr yields are trading below 2.0%, the gold price jumped to $1,880, and German equities were down under 5,500 (a loss of 4%). In the fx market, high-beta currencies such as the Aussie and the Loonie fell back, the former now under 1.06.


US jobs picture still dreadful. The headline payrolls numbers showed that job growth stalled in the US during August, but as always there are a pile of caveats and different interpretations to the US employment report. The main one is the fact that the Verizon strike removed 45k from headline payrolls.   If we look at the household survey, employment grew by 331k, with the unemployment rate steady at 9.1%. The other stand-out was the tick higher in both the participation rate (those working or looking for work as proportion of working age population) given that this has been on a declining trend through the recession and also the subsequent recovery.   This is perhaps the only positive from what is a fairly weak set of data, but given the overwhelming downward trend here, it probably pays not to get too excited by it for the time being.   For those still in employment, average hours worked have been steady or falling since April, with average hourly earnings rising by 1.9%, which sits exactly on the average of the past year and slightly below the average of the past six months. In other words, the outlook for those in work is also deteriorating. But the pattern of the numbers should not be that surprising given the recent data we’ve see on real sector activity and also from leading indicators.   The overall pace of job creation remains woefully short of that seen during previous recessions and is at a pace that will take the US economy until 2017 just to reach the pre-recession level of overall employment, even before taking into account the labour force growth that will have taken place since.   If the US manages to escape a double-dip recession, the outlook remains for years of sub-par growth and constrained consumer spending, which fits with the payback times normally associated with balance sheet recessions.

Greece sinks deeper into the mire. Greece’s hapless Finance Minister Venizelos confirmed on Friday what was already widely expected, namely that the depth of the recession in his country this year will be much worse than expected (down an extraordinary 5%). As a result, Greece’s fiscal deficit will probably widen this year, to around 9% of GDP, well above the target of 7.6%. Upon learning that the Greek situation was much worse, Les Echos reported on Friday that a meeting between Greek officials and the ECB/IMF/EC had been postponed. Greece’s Finance Minister stated that progress on implementing structural reforms needed to take place more quickly. Unfortunately for Greece, this news comes at a terrible time, as a number of Eurozone countries are becoming increasingly uncomfortable with endorsing the second bailout package. In Finland, a poll undertaken by a major business magazine found that 49% rejected their country’s participation in the next Greek bailout, while only 34% were in support.


Swissie shining once more. Once again, it was the Swiss franc that caught the attention of forex markets in the second half of last week, with EURCHF seeing its third consecutive day of declines. The volatility over the past month in the Swiss franc has been pretty much unprecedented in recent history.  We’ve seen 1M vols on USD/CHF higher than for USD and GBP since the start of August (something not seen for three years now), with franc vols twice that for sterling.  If activity continues in the same vein as the past couple of days, then vol looks set to remain at these elevated levels. Why the renewed gains?  After the government’s announcements on measures to support the domestic economy, for the most part the authorities appear to be playing the role of fire-fighter.  They seem all too aware that the policy options available to them to directly impact the franc are of only limited impact in the face of global forces.  We’re in a situation where many emerging markets are better credits than many developed nations, but Switzerland stands out as the major exception to this rule. Investors appear able to tolerate the negative carry in holding positions in Swissie in return for the anticipated currency gain. Furthermore, the policy options available to the Swiss in terms of taxing foreign holdings in Swiss francs could be seen as stoking a round of interventionist currency wars, not something that would go down well on the wider global stage, however well-founded the motives may be. Also, the fact that the authorities have stepped back from the option of pegging to the euro (which was never a viable option in our view) has also seen the discount that the franc gained from such speculation being unwound. Tough times could well be ahead once again for Switzerland. .


Berlusconi’s fiscal reverse triggers further contagion. Outgoing President Trichet must be ruing the ECB’s decision last month to purchase Italian bonds as part of their SMP in exchange for various promises on fiscal consolidation from Italian President Berlusconi and Finance Minister Tremonti. Under pressure from his coalition partners, with only a wafer-thin majority in Parliament, and with his authority waning amidst fresh revelations on his colourful personal life, Berlusconi has relented on each of the major undertakings that were part of the original austerity package back in early August. Gone is the proposed tax surcharge on Italy’s wealthy, gone is the commitment to rein in regional spending, gone is the increase in the VAT and gone is the commitment to lower pension costs. Instead, Berlusconi has vowed to re-double efforts to clamp down on tax evasion and avoidance, an unconvincing and ultimately facile endeavour given the endemic culture of not paying tax in the country. Unsurprisingly, Italian bond yields have been climbing over recent days as the reality of Berlusconi’s fiscal reverse became apparent. The 10yr yield, which fell from near 6.5% early in August to below 5.0% two weeks ago after the ECB’s intervention, is now up to 5.3% and poised to go much higher if, as expected, the ECB balks at further Italian bond purchases. September is a huge month for Italy in terms of bond rollovers, with some EUR 46bn of maturities. Growth in Italy remains anaemic, government debt is elevated at nearly 120% of GDP, and the government shows no appetite for the austerity needed to balance the budget. As a result, the next few weeks could become very problematic for Italy, and by extension, the eurozone.

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