Investors Warned: Step Away From the Kool-Aid
European Central Bank (ECB) President Mario Draghi has said he will do “whatever it takes” to defend the euro and Ben Bernanke’s Federal Reserve has gone to infinity and beyondin an attempt to revive the U.S. economy, but a growing number of market watchers are beginning to doubt unconventional monetary policy will actually work.
“Investors don’t seem to have quite grasped the impotence of monetary policy in a world of supply-side problems. From labor market weakness to fiscal nightmares, our growing economic difficulties cannot be easily resolved simply by a wave of the monetary magic wand,” said Stephen King, chief economist at HSBC in a research note on Thursday.
King believes the U.S. economy is now locked in a low growth environment that cannot be dismissed as cyclical and is accompanied by surprisingly "sticky inflation" driven by high commodity prices, themselves a result of the Fed’s quantitative easingprogram.
“A massive increase in long-term unemployment has been accompanied by a persistent decline in the participation rate, suggesting that some workers have simply given up looking for employment. This seemingly structural deterioration has left employment depressed, activity weak and the economy seemingly unable to respond to the Fed’s financial temptations,” said King. He noted that the so-called fiscal cliff, or the confluence of tax hikes and spending cuts coming at the beginning of 2013, still hangs over the world’s biggest economy.
The Fed and ECB have managed to restore calm to financial markets and lower borrowing costs for governments across the G7 and European periphery. The boss of Bond giant Pimco told CNBC on Wednesday that he is hoovering up the very same debt the Fed and ECB plan to buy as part of their respective unconventional programs and expects to make a healthy return.
“We continue to anticipate what the Fed is buying,” said Bill Gross on CNBC’s Street Signs “They’ve told us they will buy $40 billion to $70 billion of agency mortgages every month until the cows come home. It pays to own these mortgages even though they’re overvalued.”
Pimco is also looking to get ahead of any ECB move to buy Spanish and Italian debt. “They told us they are going to buy Spanish and Italian 1- to 3-year debt should those countries apply for a rescue,” Gross said.
This trade has proven very profitable but pictures of rioting in Madrid and Athensthis week have seen a change in market sentiment, pushing Spanish 10-year borrowing costs back above six percent.
Before writing off the ECB’s potential support for euro zone debt markets we might want to wait for the ECB to actually buy something, as Carl Weinberg from High Frequency Economics has been saying for weeks.
“The ECB did not buy any bonds yesterday under its newly invented OMT program,” writes Weinberg day after day in his research report. “It will not buy any bonds today or tomorrow, or this week or next month.”
“OMT is not QE: The monetary counterpart to all bond purchases by the ECB under OMT will be sterilized. As of this moment, the ECB is not implementing quantitative easing in any way, shape or form. Neither is it committed to doing so,” said Weinberg who points out that the Swiss National Bank's attempts to keep the franc lower have probably done more to help euro zone bond markets than the ECB.
Analysts at Barclays believe the ECB and Fed are sending investors a "buy risk" signal and believe that even with stocks high, central bank action will be as well received as it was when the Fed and ECB intervened in December 2011.
“Weak but stabilizing global growth, excessive macro pessimism, light positioning, and elevated uncertainty about the policy outlook should give risky assets a boost, possibly beyond Q4,” said Guillermo Felices, the head of currency strategy at Barclays said on Thursday.