Waiting for next week's signs

Equity markets are consolidating. Both the SPX and DAX are sitting close to their 200-day MAs, awaiting direction from the Greek vote, European reaction and Fed meeting next week.

Meanwhile, the VIX is also close to its 200-day MA, also suggesting a 'finger on the button' kind of mode.

The Gold/Silver ratio is also at a key level.  This ratio appears to be more relevant/useful as a reflection of sentiment with regards to the market's perception of (expected) liquidity conditions at times of stress.

Definitely one to watch next week.

In the same vein, the Gold/WTI crude oil ratio, on the rise since the middle of March, has signaled a 'peaking' SPX. Will Gold/WTI move towards the levels seen in early October 2011, when risk sentiment bottomed out following a wild summer selloff? 

Market indicators seem to confirm a sense of heightened tension and anticipation at the moment. Let us see what next week brings.

Carrot and stick

When it comes to the process of European integration, one cannot help but note a 'carrot-and-stick' approach on the part of Germany. The carrot is a 'banking union', with elements like euro-wide deposit insurance, direct bank recapitalization, etc. The stick is a more comprehensive 'fiscal compact', with enhanced discipline and a reduction in national sovereignty by 'stealth'.

It is true that some degree of euro-wide 'order' on the fiscal front is necessary in order to address the moral hazard issues associated with greater European integration. And Germany is right to stress that fiscal/political union is a prerequisite for establishing a (more 'technical' in nature) banking union.

The key here is to focus on the dimension of time. Markets and market observers always urge for direct action, steps to be taken towards rectifying imbalances fast. They can afford to adopt a 'means to an end' approach, with demands for immediate implementation.

However, profound reforms such as the ones called for in Europe cannot be properly achieved in a matter of weeks or months. And when governments try to 'play with the market' and go for immediacy, the results leave a lot to be desired. A prime example of this is the insistence for harsh 'internal' devaluation in the 'bailed-out' countries as a means to regaining competitiveness; the more optimal/sustainable/growth-enhancing route of structural reforms simply takes 'too long' in political terms.

What is at stake involves the broader political issue of 'deciding to live together'; formation of a political union is the absolutely necessary bedrock of sustainable, genuine and enforceable economic/banking solutions.

Where the key lies here is twofold:
1) constructing a roadmap that is gradual (by necessity), credible (openly endorsed by political leaders without qualifications) and realistic (allowing for some degree of slippage along the way).
2) avoiding the existing approach of, just-in-time 'solutions', 'can-kicking' and persistent lack of 'one voice' (e.g. EU Commission vs. German officials) that has resulted in a series of 'half measures' so far. The most recent straw on the pile of half measures formed during the last two and a half years is the Spanish banking bailout. Its 'half' character is evident in the speed with which initial enthusiasm (merely short covering?) in financial markets fizzled.

Spanish 10yr sovereign bond yield

The second point is equally important with the first. In fact, it is even more important in the short term, in order to start gaining credibility with the markets.

The longer half measures remain the main ingredient of policy response in Europe (notwithstanding voices in the background calling for a braver and faster-moving agenda on the fiscal front), the more will the crisis continue moving along (Greece, Spain, Italy next?). And the more the crisis continues moving along, the greater the consequences when the breaking point arrives.
Procrastination is not only a prelude to economic stagnation (or stagflation down the road, esp. if and when the ECB feels the time is ripe for it to 'blink'), but also the catalyst for 'predictable escalation' of contagion in Europe.

Interestingly, this has particular implications for Greece. Heroic approaches driven by narrow-minded political aspirations are always a dangerous path to follow. This is even more important now, as Greece is in the delicate (largely self-inflicted) position of potentially becoming the catalyst for a sea change in European politics. A Greek government that refuses to be pragmatic and/or cooperative runs the real risk of 'exclusion' from the 'next day' of Europe's modus operandi.

Things usually get going when a visible example of the alternative becomes a real picture. A non-compliant Greece could easily play that role. It would be the hard way for everyone, but especially for the Greek people.

Michael Tory writes in the FT:
"The answer to the question of where to draw the line between worthy and unworthy countries is simple: eurozone institutions will help those countries that first help themselves. So we should not continue this never-ending, confidence-sapping series of half-measures to buy yet more time: at best they will postpone defeat while magnifying its eventual effects. It is now time to let Greece go in order to catalyse and legitimise the measures needed to save the rest."

This line of argument has been gaining strength recently, but Greek leaders keep offering plenty of ammunition to proponents of the 'Grexit' view.  Greek politicians should stop throwing extra straws on the back of a camel that is already near its breaking point. Because when it breaks, there is no turning back.

It would be fair to describe the Euro project as founded on Treaties of 'mutual distrust', not agreements aiming to bolster an existing trend that favours a voluntary (not PSI-style, of course..) arrangement to 'live together' (as opposed to being forced to live together). There is a real danger that the fiscal compact turns out to be just another of those Treaties, if the political capital behind it remains half-hearted. And the scale of the project, as well as its philosophy, do not leave much room for reluctance/wishful thinking.

Let us hope that a 'Greek accident' (á la Lehman) does not provide the kind of fear that can nurture compliance, discipline and feet-dragging to a new set of rules, as this would only act to magnify inherent 'imbalances' in the system. Because the real tragedy could then come from extreme/nationalistic politics taking centre stage in Europe, with unforeseeable implications for everyone.

Immediate checkpoints that will drive markets in the short term are the Greek election (17/6) and the Fed meeting (20/6).
The Fed seems to stand increasingly ready to act, but (as does the ECB) would like to see what comes out of Greece first.
Below, an interesting interview of Jim Bianco (Bianco Research), who argues that Fed accomodation is actually holding the US economy back.

Current thoughts

We seem to be getting nearer to an inflection point in financial markets.

This suggests expectations of a policy response are becoming increasingly relevant.  In fact, we already have a first concrete sign, with the People’s Bank of China (PBOC) cutting its benchmark rate for the first time since 2008.

Europe, US, China

Let us take what I call the three ‘pillars’ of the global economy, in turn.

1. Europe: concern remains elevated, both on ‘governance’ issues (Greece, Spain, euro breakup talk) as well as the economic growth front, with economic data implying stagnation, at best, with the exception of Germany (but for how much longer..?)

2. US: macro data has come out on the softer side recently, signaling that recovery may be losing momentum. The employment numbers, to which the Fed is particularly sensitive, appear to be on a deteriorating trend, missing expectations by a wide margin for May.

3. The Chinese economy has been exhibiting signs of persistent weakness. Soft data, such as the manufacturing PMI are indicating growth problems, also evident in ‘harder’ data such as industrial production growth. Further, indicators like electricity production and iron ore demand have not been encouraging.

The Chinese authorities’ concern about rising inflation has led to an aggressive clampdown on the property market with some success, as inflation has stabilized/turned lower. However, the Chinese economic growth model remains substantially dependent on investment/real estate development, and this cannot change overnight.

Today’s rate cut by the PBOC suggests the government’s line in the sand has been crossed.

Unlike previous occasions, when the PBOC started easing policy first through  a series of reserve requirement ratio reductions, this time a rate cut arrived ‘too fast’, potentially illustrating a sense of urgency.

The rate decision came before a raft of data to be announced this coming weekend, including industrial production and retail sales, suggesting numbers may be on the soft side. Furthermore, the Chinese may be getting increasingly pessimistic about the future course of the Eurozone.

The question here is whether to welcome this move at face value, OR see it as confirmation that ‘something is really not going well’ in China. Commodity price behaviour certainly seems to be suggesting the latter for a while now.

4.Other monetary authorities around the world have recently been ‘erring on the side of caution’ by opting to be more accommodative than otherwise, as a result of concern that another ‘Lehman’ event springs from the Eurozone.  For example, the Reserve Bank of Australia, the Banco Central do Brazil and the Reserve Bank of India have all reduced rates in recent weeks, explicitly citing the external uncertainty in their rationales.

Market stress and the coming response

Risk sentiment has been seriously hurt in the last month or so.

Equities have shed most of their year-to-date gains and 'safe haven' sovereign bond yields have reached extremely low levels.

Elements of a policy response are starting to fall into place.

The ECB stands ready to act, as president Draghi mentioned yesterday. Europeans usually take a bit longer before launching ‘solutions’, but a customized package for Spain and its banks appears to be on the cards.

Chairman Bernanke has also mentioned the Fed is ready to act if the US economy becomes ‘threatened’ by Europe. Rhetoric from other Fed officials has also in recent days highlighted alertness and left the door open for further stimulus, should the economic recovery show signs of exhaustion. Importantly, declining energy prices are giving more ‘room’ to the Fed, should it decide on acting.

Nevertheless, the ‘QE glass’ may still be half- empty and the Fed probably needs to see more before acting.

Such ‘readiness’ by monetary authorities may constitute a necessary, but cannot be a sufficient condition for addressing structural issues that require political will.

Three points worth making here:

First, it is once again to central banks that everyone looks to for ‘support’. The vacuum of fiscal presence is remarkable.

What is more, I am worried about China’swillingness or ability to deliver another ‘2008’. While China’s debt situation is probably much better than in most of the developed world, it is not exactly ‘healthy’, which makes it unlikely that the authorities have the appetite for another huge fiscal stimulus package. Furthermore, even if they did, it would in all probability act towards ‘undoing’ most of the progress made in tackling inflationary pressures (and expectations thereof). In addition, a fiscal package, almost certainly geared toward infrastructure investment, would not be entirely consistent with rebalancing towards a more sustainable, consumption-driven economic model. And let us not forget that there is a Party leader handover next year, hence one would expect the current authorities to not aim at major new policy initiatives in the meantime.

Second, notwithstanding the monetary authorities’ readiness to act, one should remember that such interventions merely ‘buy time’. 
More importantly, key developments/sources of uncertainty are still ahead of us.

In the case of Europe, there is ‘can-kicking’ until politicians get their act together. Chancellor Merkel is now talking about a ‘two-speed’ Europe…this can only add to market nervousness if not clarified / backed up by concrete proposals. Also, the Greek election is only ten days away.

In the case of the US, the ‘fiscal cliff’ approaching towards year end, the debt ceiling is bound to be reached again and there is an election coming, with all the associated uncertainty/political gridlock this could bring.

Third, central bankers may be standing ready, but not in an unqualified sense. Inflation remains a key concern and, as illustrated by the Bank of England’s decision today, monetary authorities still aim to keep a delicate balance.

The market has been ‘sniffing’ the policy response. Equities have bounced back from oversold levels, 'safe' sovereign bond yields have edged up a bit, gold and silver have moved higher since the US non-farm payrolls number, while the USD has shed some ground.

However, the rally that followed China’s rate cut did not last, or was not as strong as one would expect. Lack of hints for imminent QE from Bernanke today may have also dented the initial enthusiasm, something evident in gold's move lower.

Unless Europe miraculously and decisively resolves its issues in the next few weeks, the policy response will get more and more necessary and will likely not be denied by the monetary authorities. 
This is a sentiment/event-driven market, so reasonable valuations (esp. Europe) are getting trumped by the macro. We are likely heading to a very interesting summer for financial markets. 
Let us hope that uncertainty does not give rise to a 'Lehman' scenario materializing, as even central bank response has its limits.