Getting the liquidity balance right

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On a day when the robustness of the US recovery stood in sharp contrast to the continuing difficulties being experienced in Europe, it was little wonder that the dollar consolidated the gains witnessed the previous day in response to the hawkish FOMC Minutes.

From the respectable ADP jobs figures to the decent auto sales numbers and signs of tightening rental market, the prognosis for the US economy does have a healthier glow. However, in Europe, ECB President Draghi spoke about downside risks to the economic outlook after a 0.3% decline in euro-area GDP in the final quarter of 2011. Video:

To make matters worse, the Spanish bond auction went poorly. As a result, risk appetite waned, the euro swooned and commodities headed south. The single currency threatened 1.31 at one stage – a couple of days ago 1.34 was in sight; EUR/JPY traded at 108 after nearly touching 110. Equities did not like the more hawkish stance on monetary policy from either the Fed or the ECB, with the German DAX down nearly 3%.

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Gold was a big loser – prior to the Fed Minutes it was up near USD 1,680 but by yesterday afternoon had fallen USD 60 to a three-month low of USD 1,620. Peripheral European bond yields rose sharply; the Spanish 10yr yield was up more than 20bp at 5.63%.

Investors and traders were collectively throwing their toys out of the cot at the prospect of the major central banks no longer supplying them with perpetual free liquidity. Just like an alcoholic denied their liquor, threatening to withdraw liquidity from heavily-addicted asset markets can have very nasty consequences.

Commentary

The ECB’s balancing act. The ECB meeting on Wednesday was not expected to bring anything solid on policy, but it was interesting to see the ECB President tread the fine line between balancing inflation risks whilst not scaring markets with talk of exit strategies.  He pledged to act on prices in a “firm and timely manner”. He’s been clear in his approach to communication, which has, so far, avoided the loaded language of his predecessor in an attempt to steer policy expectations. But the ECB’s policy dilemma is certainly increasing. It’s notable that manufacturing PMI data weakened in March, in contrast to the rising trend seen in the UK, US and China (even after taking into account seasonal distortions).  Even though it was the core countries (France and Germany) that were weaker, the ECB faces the longer-term issue of the structural reforms that are currently being implemented in many peripheral countries increasing some of the internal divergences with the eurozone. More than ever, the use of a single interest rate for the eurozone as a whole will be a blunt tool for steering eurozone inflation. Furthermore, to ensure the stability and sustainability of the eurozone, the ECB could find it difficult to respond to higher inflation in Germany and may be pressured not to do so as this would help solve the eurozone’s problems only by narrowing the competitiveness gap that divides Germany and most other nations (to varying degrees).

Anecdotal evidence supports US recovery thesis. More encouragement over recent days from various anecdotals for the thesis that the US recovery is becoming more robust. Private payrolls were up another 209K last month, according to ADP Employer Services, an outcome that augurs well for Friday’s critical payrolls report. Auto sales last month remained buoyant, although down from the strong sales pace recorded in February: domestic auto sales were above 11m units (at a seasonally-adjusted annual rate) in each month during Q1, for the first time in four years. That said, back in 2006 and 2007, domestic sales were regularly around 12.5-13.0m. In a sign that the housing market is tightening up, apartment vacancies (according to a New York-based property research company Reis Inc.) fell to just 4.9% in Q1, the lowest vacancy rate since 2001. The supply of rental accommodation has contracted – an increasing number of homeowners are being displaced because of foreclosures, a rising proportion of younger people are moving out of home, and lending criteria for home purchase have become tougher. As a result, rents are rising rapidly in some major cities. Finally, it appears that the haemorrhaging of local and state government finances which has been a huge drag on the economy over the past five years is steadying. According to census data, state and local government tax revenue rose 4.5% last year, and property taxes have been higher in the past two quarters. Municipalities are still under huge financial strain but at least their revenue streams appear to be stabilising.

How long can it last? A third consecutive day of good news on the UK economy? If this keeps up perhaps the British will be less miserable (a World Happiness report published Tuesday evening placed the UK in 18th place, behind the UAE and Israel). Halifax reported that house prices surged 2.2% last month, buoyed by the expiry of a stamp-duty exemption for lower-priced homes. However, it would be a mistake to ascribe this very encouraging result to any one particular simple tax measure. London house prices have definitely been on the rise in recent months, boosted by strong foreign demand and extremely limited supply. For many Europeans still looking to diversify their wealth exposure out of the single currency, and indeed for high net-worth individuals more generally, London property is still regarded as a safe-haven in these uncertain times. Although prices in the north of the country are still under pressure, the reverse is the case down south. Separately, the services sector of the economy is in decent fettle, with the CIPS Services PMI climbing to 55.3 in March, well above expectations. This follows encouraging outcomes for both the manufacturing and construction PMIs over recent days. As various policy-makers have already observed, the first quarter has been a better one for the British economy than expected. At the very least, it appears that GDP probably rose slightly in the quarter. For now at least, recession in the UK looks to have been avoided.

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