February 6, 2012
What a difference a month makes. We entered this year with a debtÂ crisis in Europe and a growth crisis in the US. Investors wereÂ terrified, governments were falling and there was a total lack ofÂ political leadership both in Europe and the US. Corporations were inÂ retrenchment mode and even the bulls were retreating, having taken aÂ battering in 2011, particularly in the second half of the year.
This weekend, the first one of February, we are looking at financialÂ markets all over the world booming. It is almost total reversal. BondÂ yields in Europe have fallen significantly, with the exception ofÂ Portugal.
For example, Italian bond yields are now down at 5.6 per cent, not aÂ million miles from where they were this time last year before theÂ European bond crisis blew up in Silvio’s reconstructed face.
Stock markets, too, are roaring ahead. In fact, the rally in stocksÂ since the dark days of late November has been spectacular. And theÂ feelgood factor isn’t just limited to Europe and the US. The IndianÂ rupee, the Brazilian real and the Mexican peso have risen by more thanÂ 7 per cent in four weeks. And investors have added about $7.7 billionÂ to emerging-market equity funds in the same period.
What is happening? Most fund managers have been caught out by theÂ rally, having opened the year in cautious mode. I have also been veryÂ surprised by the rally. But the job of columnists is to deal with whatÂ is happening. If they have been caught out, acknowledge it – and thenÂ seek a few explanations.
In answering the ‘why’ question, one aspect of the rally which isÂ important to note is that the most ‘risky’ assets have risen most – weÂ are talking about emerging market currencies and many European bondÂ markets. Why is it happening in the riskiest assets?Â For example, are Europe’s peripheral countries, including us, suddenlyÂ more creditworthy? No, we are not. The data in Ireland remainsÂ appalling. Meanwhile, EU-wide growth and unemployment figures areÂ still atrocious.
Taken together, in Ireland, Portugal, Italy, Spain and Greece, youthÂ unemployment is well over 30 per cent. Given the fiscal contractionÂ announced by last Monday’s fiscal compact, countries will have toÂ reduce national debt significantly each year for the next 20 years, toÂ get us moving down to the target debt-to-GDP-ratio of 60 per cent.
So how could we be more creditworthy? With the fiscal compact, thereÂ will be precious little money left here, so much will be going out inÂ debt reduction and interest payments.
The reason markets are rallying is that the central banks are creatingÂ money as never before. They are inflating the bubble again. TheÂ European Central Bank (ECB) for example, will lend â‚¬1 trillion toÂ European banks at the end of this month at 1 per cent. The banks ofÂ Ireland, Greece, Portugal, Italy and Spain give trashy collateral toÂ the ECB and the ECB will give them fresh crisp cash. Then the banksÂ lend this money to the bust governments. This is causing the yields onÂ the bonds to fall.
The banks borrow from the ECB at 1 per cent and lend to the hostÂ government at 6 per cent. They make a free 5 per cent. With all thisÂ profit margin, they can rebuild their balance sheets by what they seeÂ as a risk-free trade. It is called a ‘carry trade’ in finance.
Seeing this free trade, the hedge funds change tack and decide to rideÂ the wave of â‚¬1 trillion of free ECB cash. They buy ‘put options’ whichÂ are a trade that gives the hedge funds the right to buy an option toÂ purchase government bonds at today’s price for delivery in one month.
This means that, if the bond market keeps rallying, they will makeÂ good profits. But with the giant tsunami of â‚¬1 trillion of newÂ liquidity in the market, why wouldn’t they buy on that trade?
The only problem is that someone subsidises this trade. Who pays? YouÂ do, because the difference between the 6 per cent at which theÂ governments borrow and the 1 per cent at which the banks lend has toÂ be paid by someone. That someone is the taxpayer.
Outside Europe, the US Federal Reserve has stated that it will keepÂ the rate of interest below the rate of inflation for the foreseeableÂ future. This means you would be mad to save, so the market borrowsÂ dollars and lends these dollars to high-yielding risky assets. AnotherÂ state-sponsored ‘carry trade’.
The taps have been turned on. My favourite way to visualise thisÂ (apologies to regulars because I have used this image before) is theÂ champagne pyramid. When someone keeps pouring champagne at the topÂ (the central banks printing money) this liquidity gushes into all theÂ glasses – even the risky ones at the very bottom. So long as theÂ central banks keep the taps open, most asset classes should rally.
Significantly, had this financial market news not been accompanied byÂ huge gains in the US job markets, it would be easy to dismiss it as aÂ localised casino event in the global roulette table that is theÂ international financial markets. But the US is creating jobs again,Â lots of them – and just in time for Obama, too.
As we pointed out last week, the most important thing for a presidentÂ in re-election year is that the economy is moving in the rightÂ direction. The US economy is moving in the right direction for Obama.Â Combine this with a cynically timed pull-out of Afghanistan, and theÂ election may be his to lose.
Now before you go out screaming it is all over and the global cornerÂ has been turned, be careful because, below the surface, things are notÂ so rosy. Even with the new jobs numbers, house prices in the USÂ continue to fall, average wages are stagnant or falling and consumersÂ are continuing to pay back debt. This means consumer spending is stillÂ very weak and might remain so, dragging the economy back.
This is a liquidity-fuelled rally. But it is a rally nonetheless andÂ cleverer people than me are betting big money on it lasting.Â Time will tell if last week was a significant milestone or just aÂ flash in the central bank pan. Let’s keep watching the numbers.
For a novel look at the economy, look at my new initiative, PunkÂ Economics, using cartoons to explain tricky stuff on YouTube.