"It’s Been A Fun Ride, But Prepare For A Global Slowdown"
While in principle central banks around the world can talk up the market to infinity or until the last short has covered without ever committing to any action (obviously at some point long before that reality will take over and the fact that revenues and earnings are collapsing as stock prices are soaring will finally be grasped by every marginal buyer, but that is irrelevant for this thought experiment) the reality is that absent more unsterilized reserves entering the cash starved banking system, whose earnings absent such accounting gimmicks as loan loss reserve release and DVA, are the worst they have been in years, the banks will wither and die. Recall that the $1.6 trillion or so in excess reserves are currently used by banks mostly as window dressing to cover up capital deficiencies masked in the form of asset purchases, subsequently repoed out. Which is why central banks would certainly prefer to just talk the talk (ref: Draghi et al), private banks demand that they actually walk the walk, and the sooner the better. One such bank, which has the largest legacy liabilities and non-performing loans courtesy of its idiotic purchase of that epic housing scam factory Countrywide, is Bank of America. Which is why it is not at all surprising that just that bank has come out with a report titled "Shipwrecked" in which it says that not only will (or maybe should is the right word) launch QE3 immediately, but the QE will be bigger than expected, but as warned elsewhere, will be "much less effective than QE1/QE2, both in terms of boosting risky assets and stimulating the economy."
From Bank of America
That sinking feeling
Sifting through our strategists’ top reports this week, we can’t help but notice one overarching theme – it’s been a fun ride, but prepare for a global slowdown. US stocks have been particularly volatile this week on earnings and we’ve also had the biggest weekly outflows in equities this year. Headlines continue to be macrodominated and it’s not easy to be a captain of a ship in such troubled global waters.
Shiver me timbers, Mr. Market
Rising Spanish and Italian bond yields were in the news this week, and the pace of the increase suggests the market believes more is needed to avoid a potential full scale sovereign bailout. According to economist Laurence Boone, the most market efficient but politically viable solution for Spain and Italy in the short term would be a combination of secondary market purchases by the European Central Bank and primary market purchases by the European Financial Stability Facility/European Stability Mechanism. The problem, though, is that this would likely produce only a temporary respite for the bond market and no sustainable relief from stress in the financial markets.
The case for further Fed action
As the economy sputters and downside risks grow, Fed officials once again find themselves contemplating further easing. In our view, the Fed will move when it is comfortable that the growth slowdown is likely to persist.
Likely next steps: forward guidance extension and QE3
We have revised our Fed call. We now believe the Fed will extend its forward guidance to “at least through late-2015” on August 1, rather than through “mid-2015”. We also expect the announcement of a $600bn QE program in Treasuries and MBS on September 13, up from $500bn in our old forecast. We expect lower 5-10y rates in the near term and recommend fading any significant knee-jerk back-up in rates on a QE3 announcement. We believe QE3 will be much less effective than QE1/QE2, both in terms of boosting risky assets and stimulating the economy.
The Fed has other tools
The Fed may cut IOER to 0 or 10bp, but we believe that the benefits are outweighed by the costs of disruption to the money markets. Further, the Fed can use the discount window to lend against collateral but bank capital constraints could limit the resulting increase in loan growth.
There are nuclear options if the need arises
With markets increasingly questioning the effectiveness or availability of the Fed’s tools, we analyze aggressive “nuclear options”, which will be much harder to implement, but would likely be much more effective. These include imposing a ceiling on yields; open ended asset purchases until certain mandate triggers are met (mandate targeting); FX intervention to weaken the dollar; money financed fiscal expansion; and raising the inflation target above 2%. In our view, the nuclear options become likely if the Fed believes the economy is sliding into recession or sees high risk of deflation.
Euro Area: No QE yet, but official intervention is possible
With Spanish and Italian bond yields at very high levels and after the 26 July comments from Draghi alluding to the ECB’s readiness to act to preserve the euro, we look at the possibility of official interventions (ECB, EFSF, coupling ECBEFSF). This could take several forms – from ECB pari passu purchases of all bonds (similar to Fed and BoE quantitative easing) to EFSF targeted purchases in the secondary market for countries under a program. The most market efficient but politically viable solution for Spain (and Italy) in the short term would be a combination of secondary market purchases by the ECB and primary market purchases by the EFSF/ESM. We argue, though, that this would produce only a temporary respite for the bond market but no sustainable relief from stress in the financial markets.
ECB purchases first, then EFSF/ESM once ESM is ratified
In our view, bond market intervention would first take the form of SMP, which could have an important impact on yields given the lack of liquidity in the bond markets. The temporary nature and limited efficacy of such intervention, should the bond market pressure not wane, could call for larger official intervention. But this would require countries under pressure to request such support, which could take several weeks or months to materialize in the current environment. For the time being, we think Spain has some room to maneuver: 1) it is under limited pressure probably until year end, even in current market conditions; and 2) the ESM will not be in place until October, thus limiting the size of EFSF/ESM interventions. Should a problem occur, it would likely be in the form of bank liquidity access, which the ECB tends to fix by lowering collateral requirements.
That said, we see four reasons for potential official intervention:
1. Fear of contagion if Italian yields rise to the same extent as Spanish yields, which could compel the ECB to intervene.
2. The EU may push Spain into requesting EFSF/ESM intervention once the ESM is operational. The loan to recapitalize Spanish banks could give the EU some leverage.
3. As we approach Q4, the market will focus on 2013 Spanish bond issuance needs. These are likely to be high given the funding needs of Spain’s regions, and impossible to complete without a reduction in yield levels (and therefore probably official intervention).
4. Rating agencies downgrade toward end Q3/Q4, and disappointing news on growth is a trigger point that could push bond yields in a new upwards spiral.
No Relief From Spain
No relief from the (S)pain. Judging by the pace of the recent increase in Spanish government yields, it appears that – despite bank recaps and various other reforms – the market believes more is needed to avoid a potential full scale sovereign bailout. Just as the final details of the Spanish bank bailout emerged, the market has grown increasingly concerned about Spain’s commitment to bail out its regions.
Clearly, as we have seen, US credit is not immune when potentially systemic risks play out for Spain and Italy. However, we have argued that – with increased prospects for policy intervention – the likelihood of big systemic European events impacting US credit in major ways has declined significantly. The market appears to agree, as for example, Friday, when the most recent Spanish concerns surfaced, we saw the third largest daily inflow to high yield funds on record ($740mm). Also, the iTraxx.main-CDX.IG relationship is again near the wides, even with US credit spreads tighter.
The Flow Show: Equity Exodus
Biggest weekly outflows in 2012 for equities (heavy selling of SPY, IWM, QQQ and GLD). Bond inflows still booming, potentially heading for bubble, especially high yield. Bearish positioning, profit and policy expectations = upside equity trading risk.
Continued stock volatility
In the past two US equity trading sessions 64 stocks have moved +/- 15% in price. This level of stock volatility creates concern, indicates performance issues, coincides with redemptions and may indicate investor rush to benchmark.
Wide trading range … central bankers protect floor
The big picture for equities is still that a wide trading range = a classic deleveraging pattern post credit boom-bubble-bust. When floors are threatened the central banks act. In July, Europe, China equities threatening floors, Italy/Spain bond/equity/macro collapse flipping into core Europe, threat of global recession. Significant event risk next week: August 1 Fed and ISM, August 2 ECB and BoE, August 3 Payrolls.
Deflationary ECB goes inflationary
German 2-year breakeven rates are now negative, ie German deflation discounted. ECB must turn inflationary. This week the ECB eased rhetorically, with Draghi promising action (similar to the Bernanke QE2 speech in Jackson Hole in August 2010. Assuming this materializes, the ECB could soon be QE buying short-dated peripheral bonds. Bottom-line: the probability of an unlimited, unsterilized sovereign bond purchase program by the ECB to reduce bond yields just increased.
What to watch, what to do
To track ECB success/failure, watch if 10-year German bund yield rises above 1.75%, for steeper yield curve 2-10s in core bond markets UST/UKT/DBR & temporary bounce in Euro. Lower peripheral EU bond yields would mean equity reversal trades: bounce in three most oversold global sectors are Eurozone banks, Eurozone utilities & telco; EM/Canada/Oz/UK resources to Labor Day.
EU/EM floors defended, fiscal consolidation needed to break US ceiling
Sustained rally in unpopular equities in H2 requires at minimum ECB/Fed QE success + signs of China growth reviving. No multiple re-rating is likely without sensible global fiscal policy consolidation. Bull market/bubbles to continue in growth, yield, quality, and weakening sales growth/potential policy failure argues risk aversion is set to make a comeback September/October.
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