Capital markets were bolstered by some good support for risk assets this week. Investors began the week in upbeat mood, boosted by the announcements from last week’s European Union (EU) summit, albeit exuberance was tempered by some less positive economic indicators from around the globe. Thursday brought a raft of announcements from central banks.
The European Central Bank (ECB) and the People’s Bank of China lowered interest rates (the latter something of a surprise), whilst the Bank of England opted to try to boost growth by increasing its quantitative easing (QE) programme by a further £50bn.
It looks like Europe has bought itself a bit of time. The EU summit actually offered a slightly better outcome than anticipated although, as we discussed in last week’s update, expectations for a positive outcome had been unusually low. The most important proposals put forward were to allow the ECB to allocate bailout funds directly to banks rather than via their respective governments, thereby offering up the opportunity to “break the vicious cycle between banks and sovereigns”.
This was an important, and no doubt welcome, development for Spain. Spanish sovereign debt has continued to struggle, in terms of both yield pressures and ratings downgrades, ever since the €100bn loan was accepted several weeks back to help resolve their banking problems. However, whether this approach has the ability to break the cycle remains up for debate.
If the banks use the funding to bolster their reserves through the purchase of (yes, you’ve guessed it) sovereign debt, then the cycle has merely been reversed. So the direct pressure is removed from the sovereign but the dependency remains. Notably, German yields continued to decline through the week which would signal that not all investors are happy to look on the bright side. The short-term pressure may have abated, but clearly more still needs to be done to resolve the underlying issues.
The central banks in the UK and Europe both moved out of their holding pattern on Thursday with the Bank of England announcing a further £50bn QE programme to buy more Gilts. This was not a big surprise as it was discussed at the last committee meeting and was narrowly voted down. This month Mervyn got what he wanted. UK market reaction to the news was fairly muted.
The ECB cut interest rates by 25 basis points (bps) down to 0.75%, a new low. But the biggest surprise came from China. Having made a rate cut in June (its first in three years) it was something of a shock that the People’s Bank cut its base rate by a further 30bps to 6%, ahead of no doubt disappointing economic results due next week.
The addictive nature of fiscal stimulus is evident in the way markets react to news flow: bad news is greeted positively on the hope of inviting further QE, whereas good news is often seen as disappointing because it delays further stimulus. It’s a quandary for the central banks; with each round of QE they implement it only reinforces the view that injecting liquidity into the system in dribs and drabs isn’t working. The Fed in particular has a challenge on its hands, given the impending ‘fiscal cliff’ on the horizon. A number of tax increases and spending cuts are due to kick in from 2013, and this week the International Monetary Fund warned that US policymakers need to deal with this impending crisis sooner rather than later.
Bob Diamond’s resignation, and the scorn heaped upon Barclays, has dominated headlines this week. The government, the Bank of England and the media duly have their metaphorical head on a spike, although this really feels like only the opening act of a darker piece of theatre. There are those who cast Barclays in the role of whistleblower and feel they have been punished for being first to the dock. Other banks could well be quaking in their boots, and less reluctant to cooperate.
There is more to come, we suspect. Whatever the outcome, it is unlikely to be good for the UK’s financial services industry – more regulation will likely be on the cards but other consequences will no doubt come to light.
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