Bottomed out for now? (ZT)

svca

Bottomed out for now?
By Jurrien Timmer

It has been quite a few months for stocks. The S&P 500® Index topped out on April 2 at an intra-day high of 1,422. Then on June 4, it fell to 1,267 on an intra-day basis. That’s a correction of 10.9% in the span of only two months.

In the grand scheme of things, 11% is not a huge decline. We have had many corrections of this magnitude throughout the decades, and most (but not all) of them turned out OK. But this one somehow feels worse. Perhaps it was the speed and persistence of the decline. As of last Friday (June 1) the Dow had fallen 17 of the past 23 days. Crude oil was even more dramatic, falling 20 of the past 23 days.

Or perhaps it is the fact that while the S&P 500 fell a “mere” 11%, many other markets have fared much worse: The MSCI All Country World Index (ACWI) has fallen 14% since March, as has the MSCI Europe Index, and the MSCI Emerging Markets Index has fallen 19%. Copper has declined 19% since March and crude oil has declined 26%, from a high of $111 in March to $82 today. The United States has definitely been the best house in a bad neighborhood.

We all know the reasons, of course, and they are plentiful—Greece, Spain, China, and now even the United States.

Unresolved issues in Greece and Spain
First of all, there is the ever spreading eurozone crisis. It wasn’t bad enough that Greek voters voiced their anti-austerity anger by electing a variety of so many fringe parties that it has necessitated a second election (to be held on June 17), but now the crisis has squarely spread to Spain. Unlike Greece, which has a solvency problem at the sovereign level, Spain has a banking crisis. Like the United States, Spain went through a property bubble, which is only now unraveling, leaving its banks exposed with too many bad loans and too little capital. The problem is that the Spanish government doesn’t have the money to recapitalize its banks, which means that it has to borrow. However, there is little appetite for Spanish debt these days, as evidenced by the fact that Spain’s 10-year yield has risen to 6.37% and its spread over German bonds (bunds) has widened to over 500 basis points.

There’s diminished appetite for Spain’s debt
The yield on Spain’s 10-year bonds has risen to 6.37% and its spread over German bunds has widened to over 500 basis points.


Source: Bloomberg as of 6/5/12.

Spain is stuck between a rock and a hard place. Prime Minister Mariano Rajoy wants the Troika (the EU, IMF, and ECB) to bail out Spain’s banks directly, as opposed to doing so indirectly via a bailout of the Spanish sovereign (with the funds then being disbursed to the banks). Why is this important? The thinking goes that if Spain accepts bailout money at the sovereign level, it would have to agree to the same kinds of austerity conditions that caused Greek politicians to get voted out of office. So, if the Rajoy administration can get the Troika to bail out the banks directly, it can presumably avoid a similar fate. The problem is that the Troika’s bailout fund (the European Financial Stability Fund, or EFSF) is not allowed to bail out banks directly, only governments (as it did with Greece). Plus, Germany wants to make sure that there is a stick to go along with the carrot.

It looks to me as though Spain is playing a game of chicken with Germany to see if it can let the markets get close enough to the abyss to force Angela Merkel to blink first and approve a direct bank recapitalization by the EFSF, or by the soon-to-be-established European Stability Mechanism (ESM). We’ll see how this all plays out, but for now the markets remain on edge, waiting for some sort of policy response from Germany or the European Central Bank.

What would a Merkel blink look like? Perhaps Germany will agree to have the upcoming ESM (expected to launch on July 9) lend directly to the banks, or for the ESM to borrow from the ECB so that it can “lever up” and gain more firepower. Or perhaps Germany could agree to provide funding for Spain but with fewer strings attached (e.g., austerity conditions). Or perhaps Germany is willing to back-stop a eurozone-wide bank deposit guarantee, which is what the United States has with the FDIC.

Any or all of these developments could certainly have a positive impact, which would be magnified if the ECB stepped back into the fray with bold action, such as cutting its policy rate (currently at 1%), conducting another long term refinancing operation (LTRO), or even buying sovereign debt outright, like the Fed’s quantitative easing (QE).

But so far, none of this is happening, and it is hard to see the Troika or even the ECB taking bold action before the June 17 Greek elections and French Parliamentary election, or the June 28-29 Euro Summit. It may want to keep its powder dry should the worst-case scenario of a Greek exit come to pass. The good news is that there is now a dialogue taking place between Germany and Spain on a potential bailout, and we are starting to hear more talk about a banking union (including deposit guarantees). So that is a step in the right direction.

Serious slowdown in China
The problems are not just in Europe, of course. We now have a serious slowdown going on in China, which has had a real impact on Asian stock markets and currencies, as well as on most commodities.

The question is: What can and will the Chinese government do about this? Many investors are assuming that the central government will simply pull some levers and stimulate the economy like it did in 2009, at which time China underwent a massive infrastructure spending boom that benefited the global economy. A repeat of such a boom is unlikely in my opinion, because the last one produced not only a lot of inflation but also a property bubble, as well as an increase in nonperforming loans in the banking sector.

That doesn’t mean that China will just sit idly by of course. There are still some levers that it can pull. One of them is to get more aggressive in cutting the reserve requirement ratio (RRR) for banks. This is the amount of funds that banks have to set aside when they make loans. The higher the ratio, the less there is available to lend, and vice versa. So far, the People’s Bank of China (PBoC) has lowered the RRR only a few times and the rate is still very high at 20%. So there is a lot more that can be done. In fact, China just lowered rates this week, by 25 basis points.

The question is what impact any of these measures will have over the long term. China underwent a massive lending boom for many years, but that appears to be coming to an end. Both loan growth and money supply growth are barely moving (see the chart). Furthermore, capital is leaving the country, as illustrated by a decline in the RMB. The result is that banks are having trouble growing their loan books because they can’t attract the necessary deposits.

Loan growth and money supply are barely moving in China
The massive lending boom appears to be coming to an end in China, so it won’t help ease a slowdown in the Chinese economy.


Source: Haver Analytics as of 6/5/12.

Perhaps China has reached the point where it is starting to push on a string in terms of monetary policy. Perhaps it has reached the law of large numbers, where its $7 trillion economy has gotten so large that incremental stimulus becomes less and less effective. I am skeptical that China has the kind of silver bullet in terms of a policy response that saved the day back in 2009. Nevertheless, it will likely do something, and lowering the RRR more aggressively appears to be the easiest option. If it does, the markets are likely to respond favorably.

Will the Fed act?
While the U.S. economy still appears to be in a sustained economic expansion, there is no doubt that the pace of economic growth has slowed markedly in recent weeks. We are now in a global slowdown coupled with a debt crisis in Europe and a potential hard landing in China. And I haven’t even mentioned the fiscal cliff, which according to the Congressional Budget Office (CBO) would cause a recession in the United States, if it came to pass. When it rains, it certainly pours.

This has the potential to bring the Fed, which meets on June 20, back into the fold with another policy response. Fed Chairman Bernanke can’t be too pleased to see the dollar rally as sharply as it has, to see the payroll numbers come in as soft as they have, and to see the stock market correct so sharply in the span of just a few weeks.

So, perhaps the Fed is ready to act. But what can it do? Certainly the markets would be thrilled if the Fed were to embark on another traditional large-scale asset program (LSAP), more commonly known as QE. Certainly the gold bugs would. Or perhaps it will announce an extension of Operation Twist (which would entail selling more short-dated securities in exchange for long-dated Treasury bonds and mortgages).

My guess is that the Fed is not there yet. I think the bar is pretty high for it to take such dramatic action, especially in an election year. Besides, what will either action accomplish over the long term? It is questionable whether the Fed's previous large-scale asset purchases provided much more than a temporary sugar high, and, after all, Treasury yields are already at historic lows, with the 10-year yield dropping to 1.43% on May 30.

Besides, there’s a reason rates are so low, and that is that collateral is becoming scarcer and investors are running out of so-called risk-free assets. This is why investors have been hoarding Treasuries, German bunds, and JGBs (Japanese government bonds) in recent months (and, as of last week, even gold).

The whole purpose of QE1 and QE2 was the so-called Portfolio Channel Theory, which holds that when the Fed steps in as an artificial buyer of risk-free assets (i.e., Treasuries), investors will then sell these safe assets to the Fed and be forced to go out the risk curve to buy risky assets like corporate bonds and equities. But in the current climate one really has to wonder if the Fed can reactivate this Portfolio Channel Theory. After all, if Treasuries are the ultimate safe haven, will investors easily part with them, even at inflated prices? Recent market behavior suggests they won’t.

What’s next?
So what will actually happen? I can only guess, of course. My sense is that things are getting bad enough to once again force the hand of policymakers in Europe, China, and even the United States. But what can central bankers and policymakers do quickly in order to satisfy impatient investors looking for instant gratification? Most of the measures in Europe, for instance, will take time to agree on, let alone implement.

There is still one piece of low-hanging fruit out there on the monetary policy front—a central bank liquidity swap, highlighted in a recent report by Aitken Advisors. This is a facility that the world’s largest central banks utilize to borrow and lend funds to each other. Currently, the rate at which other central banks can borrow dollars from the Fed is 50 basis points (bps)—half of one percent—for up to three months. You may remember that the Fed—in conjunction with five other central banks—lowered the dollar swap rate from 100 bps to 50 bps last fall in order to mitigate last summer’s liquidity squeeze (this liquidity injection was shortly thereafter reinforced by the ECB’s two LTROs).

With the dollar soaring and liquidity once again drying up, it is quite plausible that the Fed and its fellow central banks will resort to another coordinated move to lower the dollar swap rate (maybe to zero this time) and perhaps even extend the term (perhaps to 12 months). The advantage of a coordinated cut in the swap line (combined with a maturity extension) is that it can be done quickly and it would be relatively uncontroversial. In other words, for the Fed, this course of action might relieve the liquidity squeeze, please the markets, and do so without bringing with it the kind of political baggage that a QE3 would. As I said, it is low-hanging fruit and it could have an immediate impact on market sentiment, even if it does little to structurally improve the health of the world’s financial system.

Short-term market response

The global equity markets have been in a sharp decline since March, but things have now gotten bad enough that some sort of policy response seems likely. In fact, it is happening already, with several dovish speeches by Fed Governors, a rate cut in China, and more positive statements coming from Merkel about a unified Europe. Combined with oversold technicals, this seems to set the stage for a short-term counter trend rally in risk assets, including stocks, currencies, commodities, and credit, but our longer-term view hasn’t changed. The structural problems facing Europe and the global economy are likely to persist for some time to come (and perhaps even get worse). My sense is that the market has bottomed for now and that we are due for a temporary reprieve. I remain considerably cautious over the longer term.

svca

For those who do not want to read through, here is a minute

(1) No QE3 expected
(2) central banks and FED can lower the dollar swap rate to please the market
(3) short term counter trend rally is starting, but the finanicial structural issue cannot be resovled in the longer term.

jlht

svca 发表于 2012-6-13 16:32
For those who do not want to read through, here is a minute

(1) No QE3 expected

licai5688

lilitulip

plankton