E Pluribus Nemo

September 19, 2011

By Mark Dow
The opinions expressed are his own.

While Felix is away, I will be posting off-and-on, as my day job permits. I hope to be able to put out at least a couple of posts more thoughtful than a market update, but let me at least start with an update for the time being.

The market had been hoping there would be some cohesion coming out of Europe in the wake of the Geithner meeting; but none materialized. The grands lignes of what could be a plan are there, but the political hurdles in Germany seem still too high.

One, as various surveys suggest, Germany, in the aggregate, supports the notion of an integrated Europe, but also strongly opposes dedicating more resources to it. Yes, this is an excellent example of cognitive dissonance, but it is where we are. Two, in a profound and visceral way, Germans want to defend the purity of the ECB’s single mission. For them, the ECB is the Bundesbank, in thinly-veiled drag. And Germans don’t seem to be in a compromising mood.

These views, unfortunately, are incompatible not only with a permanent fix, but also with basic crisis management. Market participants know this. Secretary Geithner knows this. The IMF knows this. And all parties (except, it seems, a good number of European policymakers) are very worried. This is much of what markets are responding to today.

Moreover, markets will likely remain under pressure until Germany finds a way to overcome the moralistic, rule-bound, penny-wise-pound-foolish policymaking that has characterized the approach so far. Concretely, they need to lead the EU into cutting losses. And, as immoral and unjust as it will no doubt seem when the moment comes, they will have to dedicate resources to the peripheral countries if they want to minimize the collateral damage to Germany and other core countries that will flow from Europe’s restructuring.

The other element driving the market this morning is the continued unwind of risk in emerging markets. There has been a significant outflow over the past two weeks from emerging markets local markets (local bonds and currency). This sector has probably received more inflows relative to the size of the asset class than any other over the past 2-3 years. If risk appetite doesn’t resume soon, the EM outflows will almost certainly intensify. Fundamentals won’t matter. Valuations won’t matter. Secular convergence (more on this in the coming weeks) won’t matter. Only flows and liquidity will.

There was some easing in the outflows late last week, as equity markets rallied and hope that the FOMC might try and shock the markets took hold. However, due in part to the article last night by the Wall Street Journal’s influential Jon Hilsenrath, today market participants are abandoning the hope of a deus-ex-machina Fed. In consequence, the unwinds are accelerating.

Here’s a graph of the DXY, 2006 through today, to give you a rough indication of how far things could go:

True, it could well be that the Fed is using Hilsenrath to dampen expectation so as to surprise the market come Wednesday. After all, Chairman Bernanke understands the centrality of psychology in all of this. But to me it seems the divisions within the FOMC are too great to bridge at this one meeting. My guess would be that the FOMC meeting tomorrow and Wednesday will be used to prepare the groundwork for more aggressive action at a later date. As for where we go on Wednesday, anything up to and including Operation Twist will most likely be taken as a disappointment by the market, result in another leg up in the dollar, and an accelerated unwind of emerging market local currency positions. Of course, in markets, unlike in economic punditry, it pays to never get too comfortable with your own views.


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