Markets look to Fed for the magic touch

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Global stock markets, as measured by the MSCI world index, are now at levels not seen for a year, with markets down some 18% over the past few sessions.  Some are putting this down to the S&P downgrade of the US, but this is more the catalyst rather than the cause of what we are seeing.  The roots lie in the eurozone sovereign debt crisis, together with concerns regarding the US economy and the lack of confidence in the US budget situation. 

Any investors who are selling on the back of a ratings agency assessment have evidently learnt nothing from the credit crisis.  In FX, EUR/USD tells us little of what is going on.  AUD/USD is another matter, having slipped from above 1.10 to below parity in the space of just over a week.  There is a weight of expectation on the Fed today which meets to discuss policy.  In recent times, it has invaribly pulled a rabbit out of the hat at times like these, but right now there is only one bunny left, the QE one and it’s looking decidedly worse for wear.

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Commentary

China inflation higher but authorities boxed in.  The latest inflation data showed the headline rate rising to 6.5%.  Headline prices have been rising for nearly two years now, but there are signs that inflation on an underlying basis is slowing, so there are some reasons for suspecting that we may be near the peak. However, with inflation still substantially above the comfort zone, the ability of the authorities to respond to the slowdown we are seeing globally is hampered by the continued buoyancy of prices.

All eyes on the Fed meeting later.   As global stock markets tumble, there is keen anticipation of the Fed meeting later today. But with rates at zero, a commitment to keep rates low “for an extended period” and two rounds of QE completed, the options are naturally limited, as is their effectiveness.  Right now, more QE is the only real option available.  A commitment to keep long end rates low would have little impact (yields are plummeting of their own accord) and expectations of a Fed tightening aren’t behind the latest sell-off.

New and decisive highs for gold.  As well as peripheral debt, gold saw one of the bigger moves Monday, this coming after the directional uncertainty seen towards the end of last week. On Monday it was around 2.5% up and posting another record high and the first breach through the $1,700/ounce level. What’s really driving it this time is the fall in bond yields and in particular, global real interest rates. The inverse between this and the gold price reflects the fact that gold produces no yield (indeed, there is negative carry from storage costs), so lower after-inflation returns on other assets reduces the opportunity cost of holding gold.  Furthermore, rising sovereign debt, the threat of a renewed move into recession and the limited options available to policy-makers (rates are already near zero and central bank balance sheets already expanded) mean that investors fear the scenario of governments inflating their way out of their currency debt burdens even more. We’ve also seen the rising gold price run concurrently with inflows into physical gold ETFs. The increase over the month, in percentage terms, is the fastest pace of inflow since May of last year. Furthermore, this move goes far beyond the weaker dollar tone, with gold also making new lifetime highs vs. sterling and the single currency. It’s not over, but at present spot gold is set up for an 11th year of gains.

ECB’s statement buys some time. Bond markets understandably reacted positively to the ECB’s Sunday statement which was taken as a green light for substantial buying of peripheral debt, including Spain and Italy’s. Whilst bond markets were celebrating, with yield spreads over Germany down 100bp over the space of a couple of working days, the impact on FX markets is far less noticeable. The euro firmed vs. the dollar, but not dramatically so and softened into midday on Monday. Bond markets benefitted from what will be the assurance of a substantial bid, something that has been lacking in recent weeks. For the single currency, this is a positive, but more concerning are the ECB’s contradictions of the past few weeks. Whilst it has substantially increased liquidity provision in its repo operations, and now the bond-buying program (both designed to push market interest rates lower) it has also been on a policy tightening path for most of the year to date. Its credibility is looking in tatters at the same time that the single currency doesn’t yet have in place the plans (such as the expanded EFSF) that are designed to hold it together for the longer-term. From this perspective, the currency’s reluctance to appreciate is understandable.

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