MARKETS | Government Debt
GEORGE TCHETVERTAKOV
HEAD OF MARKET RESEARCH, ALPARI
OVER the past three months, confidence in a global economic recovery has waned and volatility has risen spectacularly in May. And as we enter the second half of 2010, most asset classes are severely underperforming consensus estimates made at the beginning of the year. Libor (the London inter-bank offered rate) have spiked higher, equities have weakened across the world and US Treasuries have benefited from strong safe-haven demand. Yields on the two-year Treasury note have now fallen below their 2009 lows.
On the whole, fixed income markets have outperformed equities throughout the first half of the year while commodities have broadly weakened. But the stand-out performer so far this year has been gold, which reached a lifetime high of of $1,265 per troy ounce in mid-June indicating a strong element of risk-aversion still present in today’s post-crisis marketplace.
The European sovereign debt crisis has overshadowed global financial markets over the past quarter and a crucial side effect of European over-indebtedness has been to push the normally conservative European Central Bank (ECB) into embarking on a path of Anglo-Saxon market resuscitation.
Peripheral countries such as Portugal, Greece, Ireland and Spain have been able to find adequate funding since the emergence of the sovereign debt crisis but at the cost of being increasingly reliant on the ECB for capital. This is hurting investor confidence about the viability of non-core Euro members skewing investment decisions and preventing a broad recovery in the EU.
One of the major themes over the next two to three months will be European funding for sovereigns and financial institutions, which will face substantial difficulties this month despite the combination of the recent €750bn stabilisation fund, extensions in ECB lending facilities and even full-blown quantitative easing (QE). The latter is a policy tool that, by their own admission, gave ECB members nightmares when the US and the UK implemented similar policy responses in 2009.
The funding requirement for European sovereigns and financials is heavier in June and July 2010 than in any other two-month period for the next two years. This leaves the door open for distressed auctions, funding issues, deleveraging, duration mismatch and bouts of quasi-panic, pointing to strength in the buck, the yen and the franc.
Euro bears are adamant that a funding crisis is ongoing in the Eurozone and that the debt burden faced by many European countries is far too large for desperate budget cuts to alleviate. This may have an element of truth over the mid-to-long-term if the proposed fiscal austerity measures are not implemented efficiently. But in the short-term, if there was a true funding crisis then we would have seen European banks bid aggressively for US dollar funding given the greenback’s relative cheapness. What’s more, we should also have seen a strong rise in the repatriation of existing dollar-denominated assets and capital. Yet neither of these have occurred so far, in contrast to the 2008 financial crisis.
The huge liquidity and government support measures that have been put in place by most G20 countries over the past year have helped to raise confidence, business activity and trade. But the reality is that as the near-term outlook becomes clearer thanks to government and central bank support, the long-term becomes more blurry because of the inevitable problems that will arise when central bankers decide to unwind their immense liquidity provisions and governments cut into inflated budget deficits. We are already seeing a raft of fiscal adjustment in the US, the UK and mainland Europe – other territories are certain to follow if only to hide away from speculators looking for the next weak spot.
In the currency space over the next six months, we expect weakness in commodity-linked currencies to abate. The Swiss franc, the Japanese yen and the pound had been the top performers against the major currencies over the second quarter while the euro posted gains against both the Australian dollar and the Canadian dollar. Moves away from cyclical currencies such as the Aussie, the Canadian dollar and the Kiwi dollar into the greenback, the yen and the Swissie should diminish if fiscal austerity is implemented rather than simply announced and if the Chinese yuan is allowed to appreciate against the dollar by the Chinese central bank.
Emerging market currencies such as the Brazilian real and the Indian rupee are in a good position to benefit from foreign capital flows over the next 12 months because of increasing worries about inflation and excessive growth. Monetary policy in emerging markets is more concerned about inflation rather than fiscal imbalance or funding problems at domestic banks. This points to a widening yield differentials between rapidly expanding countries in the emerging markets and the developed world.