MacroScope

Market selloff – blip or new crisis?

A trader watches the screen in his terminal on the floor of the New York Stock Exchange in New York

A two-day summit of EU and Asian leaders, which was going to be most notable for a meeting between the heads of Russia and Ukraine, risks being overtaken by financial market tremors which have spread worldwide.

There’s a good case that markets, primed with a glut of new central bank money, had climbed to levels which the state of the economies that underpin them did not justify. With the Federal Reserve about to turn its money taps off, investors seem to have woken up to poor growth prospects in much of the world.

On the other hand, yesterday’s sell-off was sparked at least in part by some sub-par U.S. data and it’s hard to argue that prospects for the world’s largest economy have suddenly taken a turn for the worse.

For Europe – parts of it at least – this is dangerous. If the market rout continues it will hit already-fragile business and consumer confidence and curb spending and investment. The euro zone will be hoping its final September inflation figures, due this morning, are not revised down from a paltry 0.3 percent.

As tumbling stock markets took many of the headlines yesterday, Greece’s 10-year borrowing costs zoomed close to 8 percent – way above the level that would allow Athens to quit the bailout programme hated by its people and return to financing itself on the markets.

ECB rate cut expectations to be left deflated

Euro zone inflation has dropped to just 0.8 percent and the core measure is lower still – at 0.7 percent it has fallen pretty consistently over the last year.

Nonetheless, the European Central Bank is likely to sit tight at its policy meeting today. The Bank of England’s rate setters are also meeting but facing a very different set of problems.

It’s probably too early for any dramatic moves but the ECB may well be pushed into easing policy if inflation refuses to pick up and/or the banks clam up ahead of this year’s health tests. Today, Mario Draghi is likely to reaffirm its readiness to act.

Lew’s comes to Europe airing concerns

U.S. Treasury Secretary Jack Lew moves on to Berlin then Lisbon after spending yesterday in Paris. There, he urged Europe to do more to build up its bank backstops and capital, a fairly clear indication that Washington is underwhelmed by the German model of banking union which has prevailed.

Lew may also press for more German steps to boost domestic demand, after indirectly criticising Berlin for its policies during his last visit in April. If he does, he can expect a robust response from Schaeuble, at least in private.

Lew moves on to Portugal later in the day with Lisbon’s planned exit from its EU/IMF bailout presumably top of the agenda when he meets Prime Minister Pedro Passos Coelho.

EU lets genie out of the bottle in Cyprus bailout

Breaking with previous EU practice that depositors’ savings are sacrosanct, Cyprus and international lenders agreed at the weekend that savers would take a hit in return for the offer of 10 billion euros in aid.

Cypriot ministers are now scrambling to revise a plan to seize money from bank deposits before a parliamentary vote on Tuesday that will either secure the island’s financial rescue or threaten its default.

Whatever the final result, analysts say the genie is out of the bottle and the mere consideration of making savers pay for bailouts sets a dangerous precedent for the euro zone.

Spanish yield curve flattens, along with Europe’s fortunes

Ten-year Spanish government bond yields hit their highest levels since the euro was created – above 7 percent – on growing doubts that the euro zone’s fourth largest economy will be able to avoid a full-blown sovereign bailout.

News that Spain’s heavily indebted eastern region of Valencia would ask Madrid for financial help reinforced concerns the country may eventually run out of funds. The rubber-stamping of a rescue package for Spain’s troubled banking sector did little to allay concerns.

Short-dated bonds came under particular pressure, flattening the Spanish yield curve further in a sign of mounting credit worries. Five-year bond yields hit a euro-era high of 6.928 percent, flirting with the widely dreaded 7 percent mark.

Surprise plunge in bond yield forecasts may spell more trouble ahead

By Rahul Karunakar

The spread between 2- and 10-year U.S. Treasury yields will shrink to 180 basis points in a year according to the latest Reuters bonds poll – the narrowest margin since August 2008, the month before Lehman Brothers collapsed.

Historically, that spread has been a key indication of what investors and traders are thinking about the economy’s prospects: the narrower it gets, certainly with short-term rates already at rock bottom, the darker the outlook.

It wasn’t looking particularly good in August 2008, and of course we all know what happened the following month: the start of an epic financial and economic crisis the world is still struggling to shake off.

Battening down the hatches

There’s a high degree of battening down the hatches going on before the Greek election by policymakers and market in case a hurricane results.

G20 sources told us last night that the major central banks would be prepared to take coordinated action to stabilize markets if necessary –- which I guess is always the case –  the Bank of England said it would  flood Britain’s banks with more than 100 billion pounds to try and get them to lend into the real economy and we broke news that the euro zone finance ministers will hold a conference call on Sunday evening to discuss the election results – all this as the world’s leaders gather in Mexico for a G20 summit starting on Monday.
Bank of England Governor Mervyn King said the euro zone malaise was creating a broader crisis of confidence.

The central banks acted in concert after the collapse of Lehmans in 2008, pumping vast amounts of liquidity into the world economy and slashing interest rates. There is much less scope on the latter now. The biggest onus may fall on the European Central Bank which may have to act to prop up Greek banks and maybe banks in other “periphery” countries too although the structures to do so through the Greek central bank are in place and functioning daily. In extremis, we can expect Japan and Switzerland to act to keep a cap on their currencies too. As a euro zone official said last night, a bank run might not even be that visible and start on Sunday night over the internet rather than with queues of people outside their local bank on Monday morning.

Germany’s zero bound

The ultra-low rates offered by two-year German bonds reflect just how worried investors have become about the euro zone debt crisis and the continent’s sluggish economy.

Two-year German debt is currently yielding only 0.09 percent. That is less than the 0.11 percent offered by equivalent bonds in Japan – whose central bank has been grappling with deflation for some two decades. It is also below the 0.26 percent offered by similar U.S. Treasuries after the Federal Reserve more than tripled the size of its balance sheet compared to pre-crisis levels.

Elwin de Groot, senior market economist at Rabobank, expects the euro zone’s sluggish economy and intractable debt crisis to continue to favour a safety bid as long as policymakers do not take steps towards a closer fiscal union. He sees the two-year German bond yield hitting zero in three to six months and ten-year benchmark yields falling to 1.40 percent over the same period from 1.59 percent currently.

Euro zone hopes for funds from the Fund

Focus for the euro zone is firmly on Washington with G20 policymakers gathering ahead of the IMF spring meeting. The Fund is seeking an extra $400 billion-plus in crisis-fighting funds which, tallied with the $500 billion euro zone rescue fund about to be established, adds up to a meaningful firewall for the markets to ponder before they consider pushing Spain and Italy to the edge.

But as many sage minds are saying – U.S. Treasury Secretary Timothy Geithner among them – a firewall does not solve the root problems of the euro zone debt crisis. As our very own Alan Wheatley puts it, “It is not obvious why a stronger firewall should encourage anyone to enter a burning house”. Nonetheless, Reuters polling yesterday ascribed only a 25% and 13% chance respectively to Spain and Italy needing an international bailout.

If the IMF falls short, given the jittery mood in financial markets, that could be cue for a further sell-off. The IMF has pledges of $320 billion so far. The Chinese and British have yet to show their hands and the BRICS led by Brazil are demanding more power at the Fund before handing over extra cash. German Finance Minister Wolfgang Schaeuble told us earlier in the week that conflating those two issues was not acceptable so there is potential for a rift. The U.S. and Canada have already said they will provide no more funding. Finance ministers and central bankers from the Group of 20 advanced and emerging economies had dinner on Thursday night, ahead of a longer session on Friday.

Euro zone looks to Washington

So the debt crisis is back (did it ever really go away?) but it’s not yet anything like as acute as it was late last year.

Spain is coming under real market pressure, and dragging Italy with it to an extent, but there are good reasons to think it won’t fall over; banks well funded for now and the government’s savvy move to take advantage of benign early year conditions to shift almost half its 2012 debt issuance in three months.

Madrid faces another key test with a Thursday bond auction. Two weeks ago, it suffered its first wobbly debt sale for some months. The turning point is pretty clear – Prime Minister Mariano Rajoy’s decision to rip up Spain’s agreed deficit target for 2012 without consulting his partners. Since then, Spanish borrowing costs have soared though given the amount of debt Madrid has already shifted, that might not be as damaging as it was.