Long-suffering

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Volumes may be low but the mood of the markets is lower still. Thursday saw yet another burst of risk-repulsion with equities and commodities heading south, the dollar heading north and yields on government bonds drifting lower. Ongoing concerns regarding global growth and the situation in Europe continue to unsettle both investors and traders alike. Moody’s stuck the knife into Italy just a little deeper overnight when they announced a two-notch downgrade to its sovereign debt rating to Baa2.

Although cognisant of Italy’s primary budget surplus, Moody’s is concerned about the possible contagious consequences of a Greek exit and Spain’s ongoing debt woes. China’s growth figures out overnight failed to relieve the sense that the economy is still losing momentum: Q2 GDP rose by 7.6%, a 3yr low. Germany’s gradual back-sliding from the commitments made by Angela Merkel at the EU Summit two weeks ago is also hurting, with the single currency falling to 1.2170 at one stage yesterday, a new 2yr low.

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Interestingly, the high-beta currencies were the biggest casualties Thursday with the Aussie and Kiwi down by more than 1%, although there has been a minor recovery overnight in part because the Chinese growth figures were not worse than expected. Meanwhile, both the dollar and the Japanese yen continue to advance amidst this latest diversion into ‘safe’ assets/currencies. Over the past year, the dollar index has risen by 12%. Although the market seems quite long of dollars, it appears that, for now, the weight of capital flows still favours the greenback.

Commentary

Fed stuck between a rock and a hard place. How tough it is to be a central banker these days. Official interest rates are essentially zero, central bank balance sheets have exploded in size and exceedingly generous liquidity schemes have been wheeled out to ensure that the financial system continues to function with a modicum of normality. And yet, despite all of their endeavours, many major economies are either in recession or enduring sub-standard growth. As a result, there are now two major concerns for central bank policy-makers: first that the efficacy of monetary policy is invariably rendered impotent during intense phases of balance sheet-deleveraging, and secondly that they are fast running out of policy options. Indeed, one of the troubling aspects of the latest set of FOMC Minutes was that they gave voice to the second of these concerns. Although several Fed policy officials are ready and willing to sanction further policy action, there is a growing fear that expansion of the Fed’s asset purchase-program may be approaching a critical limit. Some members are clearly worried that the functioning of securities markets could be severely compromised should official holdings of government and mortgage securities become too large. This is an entirely justifiable cause of anxiety; for instance primary dealers have been increasingly hoarding treasuries over recent months (in anticipation of further QE and Fed balance sheet-twisting), with many large money managers doing the same in anticipation of Fed buying-interest. If the non-official sector starts to question the depth of the US treasury securities market then this would potentially jeopardise the dollar’s hegemony as the world’s major reserve currency. In some respects, the Fed is stuck between a rock and a hard place with respect to monetary policy. There is some understandable reluctance to resort to further QE at this point, as there are diminishing returns in terms of its usefulness and moreover it is verging on deleterious consequences. More twisting also has its limits, as the average maturity of the System Open Market Account is now almost nine years, and the Federal Reserve has expanded the scope of securities it is prepared to buy. Interest rates cannot go lower (assuming the Fed is not prepared to opt for negative rates), and it has already committed to exceedingly low rates for at least the next two years. Increasingly, Fed Chairman Bernanke will need to leaf through his play-book of unconventional policy measures. A decade ago Bernanke argued in favour of announcing an explicit target rate on government securities, although with the yield on treasuries still declining sharply, and amidst concerns over the size of the balance sheet, this idea is unlikely to gain traction any time soon. Another proposal involves the Fed providing low-interest loans to banks backed by a wide range of collateral. This idea has been a preferred option of the ECB, albeit without any real success in terms of aiding recovery. Indeed, it could very reasonably be argued that the large-scale LTROs conducted by the ECB have actually worsened the situation because equity and debt-holders have been bumped down the capital structure. The Fed also has the ability to buy foreign government bonds, although in the current environment it is unclear which they would buy and whether it would achieve very much. The US central bank could also intervene to affect the value of the currency; however, if it became genuinely concerned about deflation, for instance, would the Fed really be prepared to sell dollars (and buy euros)? Unfortunately, there are no easy answers for Fed policy-makers. At a time when the economic and financial environment has become just as challenging as it was four years ago, if not more so, policy officials need to be brave, imaginative and consider the unconventional. Thankfully, Bernanke is a disciple of monetary policy-creativity.

Aussie encounters significant resistance. As we suggested on Wednesday, the 1.0270 area was likely to represent a significant resistance level for the Aussie, although even we did not anticipate that it would fall back as rapidly as it did. The trigger for the sell-off was obviously the poor June employment figures out yesterday, with the selling continuing over the course of the London trading session down to a two-week low of 1.0100. The decline in jobs in June reawakened expectations regarding further RBA action over coming months, with bond yields down 10-15bp along the curve. Sellers of the currency yesterday were also encouraged by a litany of poor earnings data from Chinese companies. In addition, there was some squaring up of significant short EUR/AUD positions. How much further this sell-off runs is another question. It could well remain an arm wrestle in the near term, with sharp moves in either direction reversing quite quickly and without much net change.

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