Out with the Fed and back to Europe

Stocks in Europe have nose-dived today, with most of the major European indices down about 4%. There is a mixture of drivers for this: firstly fears for the US economy escalated last night when the Fed announced Operation Twist to try and boost activity and bring down the unemployment rate. Secondly, China’s PMI data was weak for another month in September, which suggests the Asian powerhouse is still coupled to the West. Also economic data released today from the Eurozone suggests that the currency bloc is on the cusp of recession. PMI survey data for September saw declines in both the manufacturing and services sectors of the Eurozone economy. The declines were led by weakness in France and Germany, the two largest economies in the currency bloc. This is concerning, since France is dealing with a major banking crisis at home and the German taxpayer is still on the chopping block for bailing out not only Europe’s weakest sovereign states, but increasingly the entire region’s banking sector.

Financial problems are still acute for banks in the US. Wells Fargo and Bank of America Merrill Lynch were downgraded yesterday by Moody’s, who justified the move by saying that if the banks needed more capital, support it may not be so forthcoming from the Federal Government. The cuts were expected after the banks were put on review in June. Negative court litigation on mortgages sold during the last boom combined with weakness in the economy has weighed on US banks, which were not helped by the Fed’s Operation Twist, which was like another knife in their sides. Since it is planning to help depress long-term interest rates, this will erode banks’ profitability since the sector’s traditional source of revenue is to borrow short and lend long – thus creaming off the spread in between. However, shorter term funds are increasingly drying up just as the rates of interest banks can charge to borrowers are falling. US banks have their own problems, along with their European counterparts.

Although we have got used to the Eurozone sovereign debt crisis flaring up every now and then, the latest flare up has notched up a gear in its severity since it seems to be encapsulating the banking sector. French banks in particular are exposed to more than $50bn of Greek public and private debt, and with the markets fearing a Greek default, possibly by year-end, and then these banks are getting punished. This is weighing heavily on the Cac 40 and the pan-European Eurostoxx index. Italian banks were also hit by downgrades from credit rating agency S&P yesterday. It downgraded seven banks in total, with one of the main reasons for the downgrade being their exposure to domestic debt, which is also being sold off as the Italian government fails to come up with a satisfactory budget consolidation plan. This is impacting banks such as Unicredit, which had more than EUR 60bn of Italian government bonds on its balance sheet as of the end of June.

If the European sovereign debt crisis leads to defaults then these banks would suffer huge holes in their balance sheets. The problem for the banks is this: for years the regulators actively encouraged them to hold sovereign debt, now that the sovereign debt is considered risky the banks find their capital buffers are not big enough. This leads investors to lose confidence in the banks’ ability to withstand any more stress in sovereign markets and so they ditch banking stocks now rather than wait for outright capitulation later. Once the banks start to get hit, this knocks economic confidence and dents growth – so we get a snowball effect that is toxic for risky assets.

This is also reflected in the bond market, which is showing signs of becoming a two-tier system in the West. German and US government bonds are being bought as aggressively as Greek, Italian and Spanish debt is being disposed of. Today Italian bond yields rose as high as 5.85%, too close to 6% for comfort. Yields fell mid-morning to 5.7%, which sparked rumours that the ECB may have intervened in the markets to reduce pressure on Europe’s third largest economy. Italy is the major concern these days. It has the third largest outstanding debt after the US and Japan and added to this it has more than EUR80bn of debt to auction by the end of the year, combined with more than EUR200bn in 2012. But is Italy the next Greece? There are reasons why it isn’t: its budget position is fairly favourable compared to most Western nations, so it has money on hand to pay its bills (unlike Greece/ Portugal/ Ireland et al). But its debt levels, combined with poor demographics, suggest that Italy needs to get its public finances in much better shape. The markets don’t have confidence that Italy’s officials will be able to do this, so the current stress in the market is a result of inept policy decisions by government. This shows that once investors need to rely on politicians the consequences for risky assets like stocks can be severe.

And Italy isn’t the only government to fail in this regard. Germany and other northern European states refuse to put an end to this crisis once and for all, increasing uncertainty and contagion fears even further. The current market action is a result of a lack of confidence and this is driving the global economy back to the edge of recession. Elections in the next few years could be interesting, with investors lining up to take revenge on what they consider the ineptitude of their politicians.

The dollar is the chief FX beneficiary from the feverish activity in the markets. It has punched through the 78.00 resistance level in the dollar index, which is the 61.8% retracement of the down-move from January to May. It is a significant level and suggests that the dollar rebound is in full swing post the Fed’s Operation Twist. The dollar is vying with the yen, which is also strong, especially against the euro. With the Swissie out of the way, EURJPY is becoming the ultimate risk trade. It is at a 10-year low, and is currently below 102.00. Surprisingly the BOJ hasn’t intervened even though the Eurozone is such an important trading partner for Japan. However, Japanese authorities have been burnt before from intervening and with such negative sentiment towards the single currency right now they might think the more prudent path is to stay away from intervention and instead help struggling Japanese exporters with subsidies etc. to try and ease the pain of a strong currency.

The strength of the dollar is also dominating commodity markets. Even gold is being sold off, as assets priced in dollars weaken as the greenback strengthens. Growth fears are likely to weigh on oil, which has been fairly resilient even as other growth-sensitive commodities like copper were sold off aggressively. Thus, oil may play catch up in the coming days.

Источник: Forex.com

22.09.2011