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It is amazing, given the high level of uncertainty in the world at the present time, that financial markets are as calm as they are. Whither the Japanese nuclear accident, the Libyan civil war and the Arab Awakening, the Ivory Coast, the euro zone bail-out system, or how will China’s encouragement of higher standards of living in the hinterland alter the terms of international trade and the cost of Chinese products ? |
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Our focus this week however falls upon the two unresolved riddles of the US economy, inflation and quantitative easing. |
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We have, in past weeks, expressed our surprise that inflation in the USA remains remarkably and inexplicably low (unless, of course, the statistics are deceptive). Non-dollar imports cost more as the dollar declines, while the prices of dollar-denominated imports - Chinese goods and commodities - have risen substantially. Some say that the absence of inflation is because wages are not rising, but that argument supposes that inflation has to be led by wage increases. We would suggest that raw material and import costs are equal, if not greater, contributory factors, and indeed this would seem to be borne out by the rise in inflation rates elsewhere around the globe. |
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Quantitative easing has also provided the US economy with a surfeit of monetary supply, and whilst much of this liquidity has undoubtedly been directed into financial assets rather than consumer products and services, household consumption has far from collapsed. So, much as we hate to admit it, the mystery remains. With the notable exception of Japan, history has taught us that quantitative easing usually leads to currency devaluation and inflation, however we would question whether Japan is a suitable model for the USA to follow. The riddle about US inflation must surely be when, rather than if, it takes off. |
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We have previously expressed our suspicions that a QE3 programme is on the cards, and this seems to be garnering wider acceptance as we move forward. Our argument is that further steepening of the yield curve will increase Treasury borrowing costs to unacceptable levels, and thus the Fed will be quietly asked to continue printing money, with the resultant inflation being accepted as a convenient way of lightening the government debt burden. |
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And then along comes St Louis Fed President Bullard with the suggestion that USD 100 billion could be knocked off the current QE2 programme! We believe his statement actually lends credence to our suspicion, for the immediate result was a higher yield on long-term government debt. We have given our answer to the riddle of QE3 and are almost embarrassed to find that it matches the Chinese view (see below)! |
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Last week we discussed whether demand for US Treasuries from foreign bank buyers was likely to decline, and in all probability, the answer appears to be yes. However, “Solvency II” (the equivalent of Basel III for insurers) encourages these institutions to purchase long-term government debt, at the expense of long-term bonds issued by banks. This could partially compensate for the decline of central bank purchases of government bonds, but Solvency II concerns mainly Europe. As we have seen with Basel III, the USA pays only limited attention to international supervision of finance industries, and this disregard is aptly demonstrated by the recent announcement by several US banks of increased dividends and share buy-back programmes, whilst the focus elsewhere remains on measures to preserve or increase equity capital. |
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The latest report from China’s Dagong rating agency is as critical of the USA as ever: “The United States, as the biggest country involved in the sovereign debt crisis around the world, will continue its quantitative easing policy when the country is in danger, and the world credit war will be escalated due to the overflow of US dollars”. |
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Market Focus |
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- USA: consumer confidence dropped more than forecast in March, although unemployment decreased in 27 states. Durable goods orders fell 0.90% in February. St. Louis Fed President Bullard stated that the Fed may be able to cut $100bln from its original plan to buy $600 bln in Treasury securities
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- EU: data from the Bank of International Settlements suggest that Spanish banks have the most at stake ($85bln of exposure) should Portugal collapse. S&P released an estimate that Europe’s banking system could require up to €250 bln of capital if faced with a fast increase in yields and severe economic contraction
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- Ireland: the Government wishes to impose losses on holders of senior bank debt in a bid to put pressure on the EU to cut the costs of its bailout package. Ireland failed in an earlier bid to have interest terms reduced as the country is unwilling to negotiate on its 12.5% corporation tax
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- Portugal & Greece: S&P downgraded both countries’ debt: Portugal’s ratings were cut twice over the week to BBB-; Greece was cut to BB-. Unnamed EU officials suggested a bailout for Portugal may total €70 bln whilst the prime minister continued to claim that the country is not in need of a help
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- Spain: thirty of Spain’s smaller banks had their senior debt and deposit ratings downgraded by Moody’s as the agency reviews the extent to which governments would support these institutions
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- UK: business confidence declined in March to the lowest level in two years and retail sales dropped. The Chancellor raised the bank levy rate for next year to offset a cut in corporation tax. The levy will be raised to 0.078 % percent from January and 2012 raise an additional GBP 100 million. The economy will grow more slowly than forecast in 2011 and the U.K. will need to borrow more than previously thought in the next five years
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- Switzerland: the Swiss consumption indicator fell for a second month in February to 1.46 from 1.66. The KOF institute estimates GDP growth of 2.80% in 2011. The IMF has suggested that the SNB should be in a position to start tightening in the near term
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- Bond Markets: European covered bonds for peripheral countries are having their longest rally since 2009 with spreads poised to tighten for a third straight month. The Basel Committee on Banking Supervision is considering a capital surcharge on the world’s biggest banks that may force them to hold proportionately greater reserves than other lenders
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- Credit markets: a paper released from the BoE discussed measures to reduce the influence of ratings agencies and suggested that improved access to issuers’ data would help investors conduct their own analysis. US corporate bond issuance soared on the week with around $50bln in offerings, a four-fold increase on the previous week. Chinese homebuilders are selling record amounts of bonds to fund construction, with $5.35 bln in new debt so far this year
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- Brazil: the tax on foreign purchases of short-tem domestic paper in Reals has been at 6% for a year in an attempt to dampen the currency’s rise. This did not affect Real-denominated Eurobonds. Now the government has increased from 5.38 % to 6 % and extended to 360 days the tax that domestic issuers have to pay on their international debt in any currency
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