-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-
Back in the summer, things in the U.S. were so dire that the Fed had to step in to the breach and boost the economy with a $600 billion cash injection. This was only formally announced in November, yet within two months the outlook for the U.S. economy has brightened markedly. The dollar has had a flying start to the year and appreciated more than 2 per cent against the other major currencies.
– Kathleen Brooks is research director at forex.com. The opinions expressed are her own. –
Ever since the U.S. Central Bank formally announced its second round of quantitative easing back in November, bond yields have trended higher. Ten-year Treasury yields have jumped by 100 basis points and are back at levels last reached in May 2010. Higher yields underpinned the dollar, which has risen by more than 5 percent over the same time period. So what does this tell us about the market, and has the Fed’s grand plan actually backfired?
Ever since the financial crisis broke in 2008 some of the world’s major banks have their governments to thank for their survival. The fates of Royal Bank of Scotland or Citibank would have been much worse without large injections of capital from the UK and U.S. authorities. The UK government pumped more than £37 billion into its largest banks in the immediate aftermath of the Lehman Brothers crisis. Ireland took that a step further when it guaranteed all of its banks’ deposits and liabilities. This was affordable, the Irish government said at the time.
However, this policy failed spectacularly. Ireland’s bailout of its banking sector brought the country to the edge of bankruptcy and forced it to accept a 82 billion euro bailout loan from the IMF/ECB and the European Union. More than 30 billion euros of this loan is to re-capitalise the Irish banking sector and the rest is to shore up the state’s finances. The conditions of the loan mean that Ireland will have to implement harsh austerity measures for many years to come that will inevitably hurt growth.
The second bailout of a Euro zone nation in less than a year has spooked the markets and looks set to be the dominant theme as we move into year end. Ireland’s financial crisis, culminating in the state’s application for EU/IMF funding on November 21, has shattered market confidence and caused some sizable moves in the forex markets. Since the start of November the euro has fallen nearly 6 percent against the dollar, and the dollar index – which measures the dollar versus its largest trading partners – has risen by 5.5 percent over the same period as the greenback attracts safe haven investor flows.
Europe’s periphery has witnessed their bond yields rise to extreme levels, Irish 10-yr yields are currently above 9 percent. The markets remain unwilling to hold Irish debt because the outlook for growth remains uncertain, which continues to worry investors that Ireland may not be able to finance its beleaguered banking sector – the nexus of the emerald isle’s fiscal woes. Right now peripheral Europe, including Greece, Ireland, Portugal and Spain, are in a negative debt spiral. Investors sell their bonds because they believe their budget deficits are unsustainable, and then they sell them some more when austerity measures designed to reign in these deficits look like they will stunt economic growth. This is a dangerous position to be in, and right now there is no easy solution to the problems of the periphery. While the market remains willing to punish excessive budget deficits, investors need to ask who could be targeted next, and could this sovereign debt crisis go global?
Ireland’s banking crisis reached boiling point this week. The Irish authorities are still adamant the country doesn’t need a bailout and are trying to draw a distinction between a sovereign bailout (which Irish Prime Minister Brian Cowen, Finance Minister Brian Lenihan et al claim they don’t need) and banking sector support (which they most definitely do).
The assault on the Irish bond market by bond investors has continued with a vengeance this week with 10-year bond yields hovering close to nine percent at 8.91 percent. Since August yields have been trending higher, but they accelerated sharply in mid-October, when they were at six percent. At this rate, yields could be in double figures by next week.
The Federal Reserve’s second round of quantitative easing to the tune of $600bn put a firework under a trend that started back in August when Fed Governor Ben Bernanke first touted the idea of providing more monetary policy support to the US economy. Risky assets are in demand and the market is happy to sell dollars.
After digesting the Fed’s statement released after its meeting, investors aren’t willing to stand in the Fed’s way as it keeps its hand on the monetary policy trigger: “The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.”
The communiqué from last week’s IMF G20 finance minister’s meeting was the first step in trying to resolve the so-called global currency war. The ministers released a joint statement on October 23 which pledged that all countries would “move towards more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies.”
Even fears that the U.S. and China could have a bust-up over the U.S.’s charge that the renminibi is undervalued relative to the U.S. dollar were put to bed when it was reported that Treasury Secretary Geithner popped in to China on his way back from the G20 in South Korea to meet Chinese Vice Premier Wang Qishan.
The strength of the single currency since August has astounded some commentators in the markets. After reaching a low back in June, the euro has appreciated more than 17 percent against the U.S. dollar and eight percent on a trade-weighted basis.
Not even last month’s debt crisis in Ireland, when the Irish government announced that its total budget deficit would top 30 percent of GDP this year due to the bailout of Anglo Irish Bank, stood in the way of the single currency. The ease with which the euro can brush off concerns about the Eurozone peripherals since the summer has led people to ask if the euro is trading like a proxy for the German economy.