Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Sunday, 21 October 2012

Punchbowl Hopium Levels Running Low

Maybe the markets commemorated 25 years of Black Monday this Friday. But a saner and more rational explanation would be that the hopium is wearing off (again).

Forming conclusions based on one day’s price move is foolhardy especially given the conflicting data (see my earlier piece). However, the S&P500 has failed to make new highs since 14th September, the day after BernanQE injection. Moreover, at 1433 it is now lower than the 1436 close on 12th September. So much for the wealth effect. 

The market’s extreme pessimism in early summer was alleviated by three main factors. First was Draghi’s threat to monetise via OMT. Second was the reappearance of the illusion of European unity and resolve to combat the crisis. And third was BernanQE’s promise to push on a string with greater force. Unfortunately, with all the good news out of the way there are not many positive surprises left.

Draghi’s OMT, though untested, is still respected enough for peripheral yields to be supported. However, it is an unstable equilibrium not least because the exact details are still not known. The degree to which the ECB will intervene, the duration for which it will intervene and the conditionality involved are all unknown. Moreover, it is not certain whether it will hold its promise of accepting pari passu treatment on its bond holdings. This is because of its argument in the Greek case that any writeoffs will be tantamount to monetary financing (which is illegal). The assumption of ECB holdings being pari passu rests on the ECB being able to sell the holdings to ESM/other entities which then take a haircut, helpfully absolving it of blame. However, this requires elected governments to accept and then explain losses to their taxpayers. Not exactly a vote winning strategy (and the reason behind OSI not being seriously considered for Greece).

In addition, the coat of paint on the façade of European unity is peeling off revealing the ugly cracks in the foundation. Divisions between France and Germany have come to the fore in the latest summit. Germany along with Holland and Finland has backtracked on ESM funded bank bailouts for Ireland and Spain. And even the grand bargain over bank supervision has run into trouble. The post-summit communiqué was short on detail and long on the usual fudges. The gist is perfectly encapsulated in the introductory statement: “It [European Council] looked forward to a specific and time-bound roadmap to be presented at its December 2012 meeting, so that it can move ahead on all essential building blocks on which a genuine EMU should be based”. Translation: See you in December, meanwhile keep buying.

Finally, even though monetary policy has been impotent for a while, the anticipation of ‘BernanQE put’ has ensured uglies keep winning the beauty contest. But QE3's weekly buying quota has taken out the anticipation and future positive surprises. While the US economy is resilient and recovering, external shocks (from Europe and China) and falling off the fiscal cliff can yet make for a double-dip recession. And this time there may be little hopium to add to the punchbowl.

Therefore it may be wise to cash in some chips heading into the liquidity constrained final two months of the year. 

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