We were hoping for something interesting to come out of Jackson Hole, and have been rather disappointed. The QE3 we thought likely, without believing it to be a good idea, failed to materialise. The Fed's maintenance of low interest rates until at least 2013 is hardly breathtaking, and was flagged before the central bankers' meeting. Nevertheless, the period of relative calm that has settled on financial markets, even if it is only the passing of the eye of the storm, allows a degree of reflection on how conventional wisdom is changing:
the inability of central banks to improve the economy in face of inaction by political authorities is being recognised, not least by the central banks themselves
stagnation, or at best, slow growth, is all that can be reasonably expected for the Western economies for years to come
while austerity is an essential component of steps to bring government debt under control, it can be overdone (Lagarde)
the Asian economies are not quite the engine of growth they were thought to be
banks are losing confidence in each other, and prefer lending to governments than to businesses (see below)
A recent Bloomberg interview with Edmund Phelps of Columbia University provides an insight into how dire the outlook is for the US economy. The interviewer began by suggesting that euro zone debt was the most pressing problem facing the world economy, to which Phelps countered that the US debt situation was much worse, citing a figure of USD 66 trillion for the true indebtedness of the Federal Government, when entitlements were taken into account. He proposes a "war footing" to tackle the problem, although the only "war" we see in the USA is between the two political parties. As another commentator puts it, President Obama believes in a country that does not exist, where reasonable men can deal with each other to serve the common good.
Phelps echoes our views that central banks are at the limit of what they can do, and that policy decisions are needed to improve the economy. He recommended the creation of a "Bank for Innovation" and a change in corporate governance to move the focus from quarterly earnings to long-term growth (a very old critique).
For us, however, the most important observation in the interview, and this applies to both sides of the Atlantic, was that banks and governments have a "diabolical" arrangement. The banks have an incentive to buy government bonds as no reserves are needed against these positions, while governments are able to borrow at very low interest rates, thereby allowing themselves with get away with continued excess indebtedness, all the time diverting money from the corporate sector.
We had thought that the end of QE would put governments in competition for funds with corporate issuers, leading to yield curve steepening, and the freezing out of the private sector. This has not happened, mainly because the economy is so lacklustre. Yet the phenomenon of a private sector freeze-out has shown up in bank lending. The private sector in this case includes both the corporate sector and households. It has been belatedly recognised in the USA that banks, including the two big mortgage agencies, have been resisting requests from home-owners to refinance (at lower cost) their mortgages. Apparently the Administration has at last woken up to this issue.
Despite ongoing concerns over market liquidity, the prices of non-financial corporate bonds have reached a level at which buying opportunities are beginning to emerge.
Market Focus
USA: consumer confidence/sentiment fell to its weakest level since April 2009. Home prices fell 5.90% in Q2 from a year earlier. However, durable goods orders rose 4% in July, the most in four months, having fallen 1.30% in June, whilst consumer spending rose by 0.8 %, the biggest gain since February. At Jackson Hole, Bernanke sought to reassure investors and the public that U.S. growth is safe in the long run, and that the Fed still has tools to aid the recovery if needed. He stopped short of indicating that the central bank will move ahead with QE3
EU: an index of executive and consumer sentiment in the EU fell to 98.3 from a revised 103 in July. Industrial orders were also unexpectedly weak in June. Orders in the euro area slipped 0.7%, having risen 3.6% in May
Germany: Business confidence fell to the lowest level in more than a year, the Ifo business climate index dropping from 112.9 in July to 108.7 in August. Inflation slowed in August, from 2.6% in July to 2.4%
Spain: the economy grew by just 0.2% in Q2 as a result of contracting exports and shrinking public spending. Producer-price inflation accelerated to a four-month high of 7.45% per annum in July. The Spanish government won praise from Moody's ("the move is credit positive") for plans to put budget rules in the country's' constitution
Greece: Finland's demand for collateral on loans to Greece could trigger a default on ?18 bln of bonds. The securities, which represent less than 7% of Greece's ?286 bln of bonds, are governed by English, not Greek law, and include conditions that insist on equal treatment for all investors. Finland remains in negotiations over the final arrangement
ECB: the central bank is reviewing downwards in its assessment of inflation risks after growth slowed. The ECB stands ready to ease tensions in USD funding of European banks and has already lent $500 mln over seven days last week to one euro-area bank, its first such action in six months, as signs emerged that lenders faced renewed pressure to raise funds in USD
UK: poor data on most fronts: retail-sales for August fell to their lowest level since May 2010; economic growth slowed in Q2 to 0.2% as manufacturing contracted and services showed signs of falling momentum; an index of consumer sentiment declined 2 points to 49 from 51 in June, the lowest reading since April, while consumers' future expectations for the economy also weakened. Nevertheless, the BoE sees no need to expand the central bank's £200 bln bond-purchase plan
Switzerland: investor confidence fell to the lowest in more than two years in August along with the KOF Swiss economic indicator, which fell from 1.98 in July to 1.61. The UK and Swiss Governments are working on an agreement under which Swiss Banks will pay an estimated CHF 500 mln to the U.K. government to compensate for their clients' undeclared money
Japan: Moody's downgraded Japan’s sovereign rating one notch to Aa3, citing the revolving door political leadership and build up of debt since the 2009 recession. The move led to cuts in Japanese banks' ratings on concern that weaker public finances will reduce the government's ability to support lenders in times of crisis
Callable Lower Tier II: a research note issued by JP Morgan suggests that the majority of Lower Tier II instruments will be called at their first call date where the issuer is not subject to EC restrictions. JPM's study notes that during H1 2011, for callable bonds not subject to EC restrictions, 89% of issues were called. There was a 100% call outcome for issues with a minimum rating of A, indicating higher rated companies acknowledge the importance of adhering to market expectations. The study also looks at the relationship between issue size and the probability of calls based on year to date data and is available on request
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