Another week of central bank watching ahead, and markets will play their customary game of chicken with the U.S. Federal Reserve and the European Central Bank. Both central banks have policy meetings this week – the Fed’s concludes on Wednesday, the ECB’s on Thursday – and capital markets have been moving higher in recent days on the hope of coordinated action. For investors and traders, this sets up a classic “Buy the rumor, sell the news” pattern for the week ahead. But Nic Colas of ConvergEx asks the deeper question, and the one that will retard any lasting move to the upside, is how much central banks can do without help from fiscal policymakers.
Nic Colas, ConvergEx...
One of the overarching themes of these notes is that human history repeats because human nature does not change. We learn, yes… But the genetic coding that allowed the species to survive through the millennia is still hardwired into our decision-making processes. The best example for investors is that humans run away from danger and cluster together for safety. Great if you are facing a hungry animal, but problematic if you get scared out of a volatile market or think buying a hot new social networking company is the path to outperformance.
Boredom doesn’t get its fair share of the press as a dangerous human characteristic, and I know of no better example of this than Napoleon – Bonaparte, not Dynamite – to highlight this failing. Two hundred years ago to the day, the self-crowned French emperor was sitting in the little town of Vitebsk, in what is now Belarus. He had just pushed the Russian Army out of the town and decided to camp there for the winter and continue his invasion of Russia in the spring. But after just a few days in this sleepy hamlet, he grew bored. One of his aides, Philippe-Paul de Segur, later wrote that Napoleon’s fateful decision to immediately advance onto Moscow came from this logic:
“How can I bear the boredom of seven months of winter in this place? Am I to be reduced to defending myself – I who have always attacked? Such a role is unworthy of me… I am not used to playing it… It is not in keeping with my genius.”
The rest, as they say, is history. Advance he did, with his army of 600,000 men under arms, reaching Moscow on September 14, 1812. The Russians never gave him the decisive battle he desired, preferring to burn their capital to the ground and move further east. Winter, famine and disease did the rest, and the Grand Armee left Russian later that year with less than 120,000 soldiers. It was the greatest military defeat until the German Army replicated the effort in World War II, to similarly disastrous effect.
Such is the price of boredom, and exactly 200 years later the U.S. and European central banks are sitting in their own virtual Vitebsk. Both organizations have meetings this week, and both are clearly at the decisive moments of further action. They do not want to stop and rest for the winter, and capital markets are restless for further action. In a nutshell, here is the battlefield each sees:
- In the United States, the rush of better economic news during the first quarter of 2012 has slowed to a trickle. Employment gains have slowed to levels below demographic growth. The first look at Q2 Growth Domestic Product logged a measly 1.5% growth rate, down from 2.4% in the first. Long-term interest rates hover at or below century-low averages, signaling the threat of deflation - the greatest fear of any central banker.
- In Europe, it is a story of the haves and have-nots. German bond rates are even lower than those in the U.S., but the Spanish and Italian governments must pay 6-7% for their incremental borrowings. Unsustainable levels, those, for countries where tax receipts are insufficient to cover expenditures.
Capital markets in recent days have sniffed out the inevitable truth – that both the ECB and the Fed feel they have to act. The timing and scope of their announcements is a wild card, to be sure. Both central banks have already exhausted their arsenals of traditional weapons such as short-term interest rate policy, with only modest effect. Their next steps with unconventional measures such as further bond purchases (QE III in the U.S. and targeted purchases of periphery sovereign debt in Europe) have the feel of stopgap moves rather than time-proven steps.
Like Napoleon’s invasion of Russia, however, the enemy of economic downturn is not giving the Fed and ECB a decisive battle. By way of contrast, the Fed’s first round of Quantitative Easing in 2008 was successful in stabilizing the financial system and pumping liquidity into the stock market. This bought some time for corporate profits in the U.S. to rebound and opened capital markets so companies could refinance debt at ever-more attractive rates. Now, the battlefield is different. Some points here:
- In the U.S., we face the need to resolve the “Fiscal Cliff,” that combination of tax increases and reduced government spending that all come due between October 2012 and January of next year. The Presidential election process means little will be done to resolve this overhang until November, and even then a lame duck Congress will have little incentive to craft a lasting resolution.
- In Europe, the cost of holding together the euro currency continues to climb. The Greek and Spanish economies continue to struggle, limiting tax receipts needed to fund the countries’ ongoing spending needs. Italian bond yields, even after the end-of-week rally, still hover at an unsustainable 6%. At the other end of the quality spectrum, Moody’s downgraded the outlook for German debt last week. As we recently noted, consumer confidence across the Eurozone is now more varied than at any time since before the 1992 Maastricht Treaty that began the road to monetary unification. All this means that politicians may want the euro to succeed, but they face local electorates that have their own parochial concerns over the long-term costs of that goal.
In short, the Federal Reserve and European Central Bank know they face a difficult battle since their natural allies – democratically elected governments – are not yet on the field. Capital markets know this as well. But the temptation to do something – anything, really – is simply too strong for both central bankers and markets to resist. All this limits the effectiveness of any central bank action and similarly consigns any market rally to a short life.