Late last night, the US budget ‘super-committee’, set up in August to look for ways to tackle the deficit, failed to reach any agreement, switching the markets’ focus back to the US and its own debt problems. On one level, this should not be seen as a major surprise given the partisan politics of Washington, and there are spending cuts which will come into effect in 2013 which were contingent on the committee failing to reach an agreement.
So, this was one of the scenarios planned and legislated for. That said, just as eurozone’s peripheral nations were shielded from their fiscal profligacy by ultra-low rates between 2000 and 2007, so is the US at this present moment in time, via a strong reserve currency and demand for treasuries, pushing 10yr yield back below 2%. It’s a toxic combination, driven more by investor positioning and liquidity than pure fundamentals but if a country uses it to delay the required medicine, then the punishment will be severe.
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Unrelenting dollar demand. Ever so gradually, those question-marks over the dollar’s reserve currency status have almost disappeared. With the world’s second most liquid currency under sustained structural attack, and both the BoJ and the SNB pushing back extremely hard against local currency strength, for most investors there is little alternative to the greenback. The dollar index is up another 0.5% already this week; over the past three months it has gained more than 6%. The dollar’s allure as a safe haven, aided by hugely liquid capital markets and well-capitalised banks, has allowed financial market participants to set aside previous misgivings over the Fed’s preparedness to re-start the printing presses each time the economy looks set to lurch back towards recession. Concerns over the size of the budget deficit and the lack of political consensus in Washington to address it have also been, at least temporarily, ignored. Many European banks, struggling to access funding back home, have desperately been attempting to get funding in dollars. According to the Federal Reserve, deposits by foreign banks (to the Fed) have more than doubled this year, to USD 715bn. The insistence by regulators that financial institutions improve their liquidity positions has aided demand for short-dated treasury securities such as notes and bills – three-month treasury bills now yield exactly zero. Foreign buying of US assets has also been quite strong this year – witness the relative performance of US equities. Despite declines of 20% or more in most European bourses in 2011, the Dow Jones index is actually slightly positive for the year-to-date. In very simple terms, if the single currency continues to crater, then the dollar will remain a major beneficiary.
China’s refreshing honesty. No beating around the bush from China’s leaders recently. Most refreshing over the weekend were the comments from Chinese vice-premier and finance chief, Wang Qishan, who declared that “the global economic situation was extremely serious” and that “the only thing we can be certain of is that the world economic recession caused by the international crisis will last a long time.” A very pessimistic view, easily the most negative by a Chinese official, but nonetheless probably remarkably prescient. Recently, another senior advisor to the Chinese government stated that Europe needed to raise productivity, recognise that its social welfare model was no longer affordable and work harder. Again, simply said, but entirely accurate. As the world’s largest exporter, it is little wonder that China is increasingly alarmed by the significant slowing in global growth over recent months, especially in Europe. In addition, the candour of recent comments implies a shift in thinking amongst policy-makers in Beijing towards a more accommodating stance. China is well-placed to respond to any weakness in domestic activity through a combination of easier fiscal policy, lower interest rates and reduced reserve requirements. However, for those hoping for further yuan currency-appreciation, this is much less likely given the growth challenges China is now facing.
Spain’s race against time. The key difference between the change in governments in Spain (last weekend’s election) and Italy (Berlusconi’s resignation) is that in Italy it was a closer-run thing whether it was a crisis of politics or economics. In Spain there is hardly a debate to be had, with unemployment at 22% and youth unemployment at double that. The ambivalent market reaction was noteworthy owing to the fact that the incoming conservative government gained the biggest majority of any party for over 30 years. A year ago, such an outcome would have prompted rejoicing in the markets. By commanding an absolute majority in parliament, the ruling People’s Party will be able to push through legislation relatively easily, but much of what it is proposing is essentially tinkering around the edges. So far, it has yet to come up with the larger-scale proposals that would give it some breathing space in terms of market pressure and give it a chance of meeting its 4.4% target for the fiscal deficit next year. But the main question is whether the problem is now too big for Spain to deal with by itself. On this point, the jury is still out, but without some fairly drastic and early measures from the new prime minister, the verdict from markets will be pretty swift.Get the 5 most predictable currency pairs