Market Direction To Become Clearer After Wednesday

The European debt crisis does not look like it is abating, despite austerity measures in the Southern European Union economies. Greece has missed their deficit reduction targets already, and it appears that further funding is necessary in order to keep the country solvent. Unfortunately, this looks to be just the tip of the iceberg, as these austerity cuts have done little but provoke social unrest. If more austerity cuts are made, social unrest could turn increasingly violent, further exacerbating the strife between the government and the people – be it in Greece, Italy or Spain.

Away from the social implications of the evolving sovereign debt crisis, the financial impact could be much deeper. Recently, concerns have spread beyond the periphery countries and into the core, mainly France. French banks have heavy exposure to Greek debt, and a Greek default would cause massive balance sheet losses. The reality of the situation is that many banks, if not all banks, don’t mark-to-market their assets. Essentially, present losses haven’t been realized yet, and further losses aren’t being considered. This is part of the reason why Christine Lagarde, Managing Direction of the IMF, recently suggested that European banks undergo widespread recapitalization, similar to how the U.S. Treasury injected liquidity into American banking institutions in September 2008.

There is thus a two-fold scenario that will unfold as a result of the European debt crisis. First and foremost, the decision needs to be made as to whether or not insolvent countries – Greece – or countries moving towards insolvency – Italy – will be allowed to stay in the Euro-zone. If the European Troika keeps disbursing funds to the embattled Southern European economies, and no core countries choose to exit the Euro-zone (France, Germany), the Euro is headed lower against the Dollar, Pound, and Yen. The downside pressure this would place on the Euro-Franc Peg would be enormous, perhaps to the point of the Swiss National Bank folding and allowing its currency to float-freely against the Euro once more. Such a move would create a massive capital flow into Switzerland, easily sending the EUR/CHF below parity. On the other hand, if the insolvent and increasingly insolvent Euro-zone countries are forced to exit the Euro-zone – in totality or for a short-period to shore up domestic fiscal policies – the Euro could actually become stronger.

As it stands, a 17-member Euro-zone can barely support itself, and its reliance on outside help has weakened future growth prospects on a growing debt burden (the European Central Bank just began three-month liquidity swaps with the Federal Reserve to help keep banks afloat). However, a smaller Euro-zone currency bloc, comprised of the core members, mainly Germany, France, Finland, Holland, et al, would dictate the necessity for a stronger Euro. While there would be some concerns for the economies in the near-term due to the ramifications of a Greek default, over the medium- and long-term, the Euro could easily move above the 1.50 exchange rate against the U.S. Dollar and the Swiss National Bank would no longer need to ‘peg’ the Franc to the Euro. This, however, is completely predicated on the notion of a smaller, fiscally-sound Euro-zone free of its most heavily indebted members.

The divide between the hawks (favoring higher interest rates) and the doves (favoring lower interest rates) is overblown. At the end of the day, Chairman Ben Bernanke has the final word, and his word has been that of further easing. This is evidenced by his support for the decision to keep low rates through mid-2013. Markets appear to be ticking higher on speculation that the Federal Reserve will announce the third round of quantitative easing at the conclusion of their meeting on Wednesday. Considering many have ridiculed the bond purchase program, the additional round of easing may come in a slightly different form. With concerns about liquidity in the foreground, the Federal Reserve may trim the interest rate it pays to banks for keeping their reserves at the Federal Reserve; with no return on the money parked at the Federal Reserve, there is an incentive for banks to lend out funds and collect interest payments.

There has also been talk that the Federal Reserve will change the composition of its balance sheet, with the procedure dubbed “Operation Twist.” While it’s hard to determine what the new composition of assets would be (in terms of size of purchases, what assets would be purchased, what maturities, etc), such a decision would be predicated on the idea that the yield curve could be artificially flattened. Studies suggest that a flatter yield curve could boost capital inflows into the United States and boost the value of the U.S. Dollar, though it is unlikely to cure labor market ailments. Of course, the Federal Reserve could simply announce that it will buy another $600 billion worth of assets, though such a move, I believe, is unlikely.

The length and magnitude of the slowdown will have a direct impact on risky assets, and the length and magnitude of the slowdown will be determined by how central bankers enact policies. I am of the opinion that no further easing should be announced, and although this could be the catalyst for a market crash, in the long-term, the financial system will be more secure (having to unwind all the additional credit in future years, in my opinion, would create a deeper crisis). If the Federal Reserve chooses to embark on further easing, however, risk-appetite will surge and the commodity currency block – the Australian Dollar, the Canadian Dollar and the New Zealand Dollar – will resume their appreciation against the U.S. Dollar over the next several months. Oil should find bids higher as well in the short-term, as the threat of a full-blown depression is staved off, for the moment. Gold would find support due to the fact that price pressures could rise due to the excess liquidity in the system. Conversely, if government intervention is limited, the global economy is poised to slide sharply, only exacerbated by a string of defaults out of Europe. While the commodity currencies and oil would drop acutely, Gold still could find support as an alternative safe-haven currency with the necessity to shelter investments from tumbling equity markets and bonds that offer little-to-no (and in some cases, negative) yield. Given my outlook on quantitative easing and the severity of the Euro-zone crisis, I think we’re on the cusp of seeing significant weakness in the commodity currencies and highly-correlated assets, such as oil, in the coming months.

Japanese authorities, from either the Bank of Japan or the Ministry of Finance, have had little success in intervening on behalf of their currency. While the Yen depreciates in the very near-term on interventions, the half-life of said interventions appears to be shortening. The most recent intervention, on August 4, lasted no more than 10-hours, with the USD/JPY topping in the 80.230 area. By August 8, the USD/JPY had fallen back to its pre-intervention levels. Barring a major move – another coordinated intervention by the G-7 – the Yen is headed higher relative to its peers, first because of demand for safety and secondly because Japanese monetary authorities simply lack the credibility to hold down their currency. In terms of Switzerland, the peg was a very shocking decision given rhetoric employed by policymakers and government officials in the days leading up to the currency floor announcement. The Swiss National Bank has announced that it will use its unlimited resources to hold the floor, a task that will entail Swiss policymakers simply printing more money and flooding the markets with Francs. In my opinion, while the move was necessary to help the Swiss economy in the short-term, the currency floor won’t hold for the medium-term. It really depends on whether or not Euro-zone sovereign debt fears calm and the Swiss National Bank feels that demand for Francs has decreased, but that’s doesn’t appear likely this year or next. In fact, as the crisis worsens, the Swiss National Bank could raise the exchange rate floor or even enact a hard peg in the coming weeks and months.

Officials at the Monetary Policy Committee have resisted calls to expand their bond purchase program thus far, with no change announced at the Bank of England’s monetary policy meeting on September 8. Inflation isn’t a concern for Bank of England policymakers, as they have announced their willingness to sacrifice price pressures in the near-term, which they expect to subside as global growth slows, for lower interest rates in hopes of stoking growth. It will take a negative growth print for the Monetary Policy Committee to shift their position on the matter. While the ramifications of a Greek default would have little direct impact on British financial institutions, the indirect effects of more tepid trading partners in Europe would certainly weigh on British exports and growth overall, boosting the need for further easing. With the global economic climate worsening over the past several months, the British Pound has depreciated in favor of the more traditional safe havens – the Japanese Yen and the U.S. Dollar – and further easing by the Bank of England would weigh on the Sterling further.