FOMC Flip Flop May Not Derail Equities, Yet

QE3 is starting to show signs of going the same way as QE1 and QE2. Treasuries have reacted badly to the FOMC’s announcement last Thursday. Of course, equities have responded well and overall, the longer term call we made for US equities to rise significantly this year remains in place. Rather optimistically, it was suggested that “the S&P could surpass the October 2007 high (1,565.1) by the year end” (daily commentary, February 6th 2012). The euro crisis, a slowdown in US consumer demand and weaker exports in response to China’s cooling, have all put a break on US corporate earnings. But the recovery in house prices has been stronger than expected. Mortgage refinance has been well supported by low rates and HARP 2.0. The number of homeowners suffering from negative equity fell sharply in Q2, according to CoreLogic. This will increase the pool of borrowers able to refinance. The vicious cycle of falling house prices and rising negative equity that drove the downturn has been broken and is going into reverse.  However, for it to be sustained, borrowing costs have to remain low. QE1 and QE2 ultimately failed because the FOMC did not anchor long term rate expectations. QE3 could eventually fail for similar reasons.

Greece's Shrinking Deficit Could Strengthen Merkel Too

The German court decision will be seen as a victory for Chancellor Merkel.  However,  yesterday’s report from the Bank of Greece confirming a sharp improvement in the country’s public sector finances is potentialy more significant. The net balance of the central government showed a surplus of €815m during August, a big shift from the €3,582m deficit witnessed in the same month for 2011. Year-to-date, the central government net deficit was €6,371m, down from €18,605m in the corresponding period of 2011. Extending this drop of 65.7% y/y to the full year implies the deficit could tumble from €23,144m to €7,925m, or 3.9% of GDP. Either way, Greece is at an important juncture, with ramifications for the entire euro project. If the improvements in the deficit can be sustained for the remainder of 2012, it is difficult to see how or why Greece would be obliged to leave the single currency for the ‘foreseeable’ future - certainly this year and perhaps 2013 too. If Greece can cut its deficit ahead of expectations, it will reinforce the strong, domestic popularity of Ms Merkel and increase the Chancellor’s chances of a victory in next year’s (German) general election. Perhaps most of all, it would underpin her support for the ECB president, Mario Draghi.

Holding The Bernanke Put In Reserve

Part of the answer lies with Spain’s decision to ask for a €100bn bailout for its banks. Mr Bernanke may not be minded to give the markets their monetary fix when the problem is largely external, preferring to let the EU take the requisite action. That said, while the markets were unimpressed last Thursday by Mr Bernanke’s less overt support of additional monetary stimulus, his deputy was unequivocal. Speaking a day earlier in Boston, Ms Yellen left the door wide open for QE3 or an extension of Operation Twist. Ms Yellen also highlighted the benefits of “extended forward guidance” for the future path of the Federal funds rate and was clear that the shift to this policy since August 9th 2011 had worked, putting “additional downward pressure on long-term interest rates, improving broader financial conditions”. None of this, of course, guarantees that the FOMC is going to vote for additional stimulus on June 19th/20th. On the contrary, the FOMC is quite entitled to view the euro crisis with some equanimity given the resulting flight to Treasuries. The strength of the house price data (reflected in the latest CoreLogic report) underlines the power of the FOMC to reflate by driving rate expectations lower. Whether the FOMC chooses to use this leverage next week is less important than the knowledge that this and other powerful tools exist, in reserve.

Will Germny Look East?

The run on Greek banks is accelerating. The reports of €700m being withdrawn on Monday point to a dramatic escalation in the collapse of Greek M3. This one day alone represents a drop of 0.4% m/m in M3. Nonetheless, Angela Merkel still maintains that it would be better for Greece to remain within the euro. The necessary structural adjustments are possible within the confines of a single currency and are not going to be made any easier by currency devaluation, she claims. However, Germany is becoming more integrated and deepening its economic, political and cultural ties with Eastern Europe, not the peripherals. Germany has a strong export model that is working, and Eastern Europe provides a potential, alternative axis for the single currency. It is ironic: the trade data for Greece and Italy show that structural reform can succeed if given time. But for Greece, time has nearly run out. Germany may decide to stand firm and if necessary cut Greece loose, safe in the knowledge that it has the option of expanding its economic and political ties with Eastern Europe.