Towards Troubled Times?
In times like these it is probably best to sit back, relax and 'enjoy' the show. However, as part of the financial punditry and as a macroeconomist it is simply impossible to not to weigh in on events. In the following I will account for where my focus is and (oh dear, oh dear) where and what I think will happen next.
First things first. What we are seeing now is of course by and large rumblings on the equity/FX/Futures markets which have the distinct theatrical effect that they occur in real time with very rapid moves up and down. Sometimes we then get so much real time action to the downside the hitherto slow movers in the form of central banks move in with emergency moves thus initially exacerbating the volatility as selling becomes buying and vice versa depending which market you are in. My poor poor monopoly money FX portfolio is a case in point. Thanks a lot Ben :). And all this was of course utterly unfair as it happened when I was completely incapacitated at a lecture in Capital Market Theory trying to learn how to derive tangency and minimum variance portfolios under various market conditions. So, this would then merely be to say that a lot of noise and fuzz are about and a real trend is difficult to discern. However, I do think it is possible to take stock on a couple of points and hypotheses which have been advanced in the past and to have a look at where it might be interesting look as we move forward.
Will Bernanke's Move Pay Off?
Well, look at your screens? You see red or green numbers? I think this will be the real and only testing ground for this. Markets will most likely continue to suffer but if the rout continues with the same force as we have seen it does not spell good news at all since then the Fed will have played all its cards and if people loose confidence in the Fed's ability to handle the situation then of course the whole edifice begins to crumble. In time of writing and as per reference to my fall from grace in FX monopoly money land it seems that the move might just have worked as intended; at least initially. The European bourses seem to be staging a comeback here at the end of today's trading. What is perhaps a more interesting question is not so much whether the Fed's response will avoid 1987 and 1929 market conditions but the effect it will have on the general macroeconomic environment. In my honest opinion the global economy now stands before its greatest test in a very long time and yesterday's and today's rush of volatility seem sure to be merely a faint sign of what is to come as we move forward. As for the US, the stock market indices seem to be trending firmly down which is not a good initial sign but now we just wait and see. One thing is sure, the Fed is playing a very high stake game on this one since it was never the Fed's job to protect equity traders and if this is conceived as such, the macroeconomic merits of the move may soon drown in the ensuing debate about the loss of the Fed's credibility.
Stocks in Central and Eastern Europe continue to fall sharply. Now this may seem a quite natural backdrop of what is happening at the moment but as I have argued extensively in the context of Eastern Europe this may very well be the venue of first real macroeconomic fallout from all this and from there on the line cuts straight across to Germany, Austria, Italy etc and thus into to the very heart of the Eurozone engine room. One of those proverbial shots was already fired across the bow yesterday as we learned that Swedbank AB who is the largest bank in the Baltic region had come under the weary spotlight of Moodys for a potential downgrade. The debacle here is that if the foreign banks decide to close shop in Eastern Europe they will basically be cutting off the lifeline which at the moment is preventing some of these economies from crashing. Moving on from the Baltics to the wider sphere of Eastern Europe the situation in Romania and Hungary is of course also something to watch very carefully and in a situation where carry trades are getting unwound the pressure on the Leu and the Forint will intensify and possibly to a degree which will bring about some quite unforseen and unwanted events.
Is Decoupling Dead?
I think it is. In fact I am dead sure it is. Over at the RGE Euromonitor Daniel Gros has a timely note in which he dishes up a rather traditional view of the Eurozone's performance vis-à-vis the American ditto. The conclusion is that whereas the Eurozone might avoid a technical recession the recovery from a very sharp slowdown might very well be longer than in the US. Now, at this point I don't to get into the technicalities of all this but merely point out that the Eurozone is not one single economy. As such, Italy is heading straight for a recession in my opinion and that with a political crisis to boot. So might Spain be if the mortgage debacle turns for the worse. I am still not convinced that the Eurozone will tumble into a recession but I do think that risks are severely tilted to the downside and quite frankly we might very well see an effect which is much worse than people expect.
Of course, all this has coincided with a subtle but highly noticable change in discourse of what exactly the rate policy should be at the ECB and when, if at all, those much predicted cuts should come. However, what is most interesting perhaps is the way in which the sentiment seems to have changed on the Euro and more specifically the EUR/USD which has been the epitomizing currency cross of the de-coupling debate. Edward sums it up nicely in a recent piece ...
So the fact that the ECB may be tardy in dropping rates is no longer being read as a euro positive. Market participants seem to be reaching out further into the future, and are thinking more about the future path of relative currency values. Since the ECB can't cut, economic growth will tank more than it would do otherwise, and then the ECB will cut vigourously, so at that point the euro will fall. This seems to be the reasoning, of course, by having the thought these participants simply bring forward the moment when the decline starts, and as a result it starts to fall now. I think this is a sea change.
Sea change or not; the recent driver of currency markets where inflation expectations have had the tendency to be equated with appreciation as a function of the expectation of wider yield differential may soon come to an end. In this respect the value of the already aggressive strategy by the Fed may simply be outweighing the future discouted value of what will happen next elsewhere. This is difficult to say, but it will be interesting to watch indeed and may determine a lot of things as we move forward. In general on the whole Eurozone discourse I do feel that things are now moving in line with what me and Edward have been arguing all along; as Edward succinctly sums up.
I think Claus Vistesen and I have been arguing quite consistently since the credit crunch began on 9th August 2007 that all of this was inexorably coming (see here, and here, and here, for example), and secondly it is ever so important to grasp that what is happening is much more extensive than the discourse Junkers advances seems to recognise. There has been a change in the credit conditions, and this change is now being felt, but what it is serving to do is reveal underlying weaknesses in some key eurozone economies. Weaknesses which would exist regardless of whether or not there had been a "sub-prime bust" in the United States. Each case is different, but Spain, Italy and Germany all now seem set to go into the grinding mill, strangely it would seem to be France - as I argue here, and Claus argues here, which may withstand all this the best.
Now of course, we will have to see just where all this ends but take note that this was never about de-coupling in the first place but about how a large external deficit in the US alluded people to think not only that the USD had to fall (which it did) but that the corresponding rise in the Euro and the Yen would simply be a symptom that de-coupling in the traditional sense was a reality. Moreover, the fundamentals were always against both the Eurozone and Japan as I have also argued on numerous occasions and essentially the whole subprime crisis only seems to have speeded things up. Consequently, I think that the correction in the Eurozone and in Japan will come swifter than many expect. One data point to watch out for is the Q4 GDP data which will confirm whether we have already moved into a recession or not and how close we are in the indvidual countries.
What Happens to FX?
Well, to be honest I am still a bit shell shocked from taking a sound beating on my monopoly money portfolio. I guess I am lucky though since I am still in positive from when I began and thus live to fight another day. It is unclear where markets are moving I think to say the least. From a technical perspective the past spurt of volatility which culminated yesterday and today have seen all kinds of breaks of support levels, wave corrections etc. An adept currency trader will, without a doubt be able, to infer many interesting technical points from the moves in the past week. What is unclear to me is the extent to which risk aversion will prevail. If we continue to see severe weaknesses in equity markets low yielders will continue to perform strongly (and this includes the USD by now as also noted by the recent issue of the MS GEF). However, as I mentioned above in connection to the EUR/USD it also seems as if the the market might just be discounting future interest moves a bit more vigorously than before which means that other factors may be at play. As for the Yen, it continues to shoot up a like a rocket even if today's slide on the back of profit taking and Bernanke's decision rippled through shows us that this is not a one way street (trust me, I know). At this point in time we need to understand that what happens in equity markets seem to be the main driver of currency markets too. The extent to which markets continue to slump will see a continuation of the carry trade unwinding, risk aversion, and move to safety as well as I think the Euro will suffer from this as this will be taken a de-facto sign that the ECB will have to cut sooner than later. If, on the other hand equities begin to look perkier we may just get back to the good old days where the EUR/USD sniffs at 1.50, especially since it seems given that the Fed will cut 0.5% come next week. At this point I also have to content that as goes for the Yen it seems completely disconnected from fundamentals in the Japanese economy. The question is when this will begin to have a real effect. The BOJ kept rates at 0.5% today but what happens if we see a cut, that is the big question for me.
Conclusively, as you can see I provide just as many questions as I do answers (if any on the latter front). However, this is how it looks from my table. I will continue to monitor events closely so stay tuned.