What a difference a month makes. We entered this year with a debt crisis in Europe and a growth crisis in the US. Investors were terrified, governments were falling and there was a total lack of political leadership both in Europe and the US. Corporations were in retrenchment mode and even the bulls were retreating, having taken a battering in 2011, particularly in the second half of the year.
This weekend, the first one of February, we are looking at financial markets all over the world booming. It is almost total reversal. Bond yields in Europe have fallen significantly, with the exception of Portugal.
For example, Italian bond yields are now down at 5.6 per cent, not a million miles from where they were this time last year before the European bond crisis blew up in Silvio’s reconstructed face.
Stock markets, too, are roaring ahead. In fact, the rally in stocks since the dark days of late November has been spectacular. And the feelgood factor isn’t just limited to Europe and the US. The Indian rupee, the Brazilian real and the Mexican peso have risen by more than 7 per cent in four weeks. And investors have added about $7.7 billion to emerging-market equity funds in the same period.
What is happening? Most fund managers have been caught out by the rally, having opened the year in cautious mode. I have also been very surprised by the rally. But the job of columnists is to deal with what is happening. If they have been caught out, acknowledge it – and then seek a few explanations.
In answering the ‘why’ question, one aspect of the rally which is important to note is that the most ‘risky’ assets have risen most – we are talking about emerging market currencies and many European bond markets. Why is it happening in the riskiest assets? For example, are Europe’s peripheral countries, including us, suddenly more creditworthy? No, we are not. The data in Ireland remains appalling. Meanwhile, EU-wide growth and unemployment figures are still atrocious.
Taken together, in Ireland, Portugal, Italy, Spain and Greece, youth unemployment is well over 30 per cent. Given the fiscal contraction announced by last Monday’s fiscal compact, countries will have to reduce national debt significantly each year for the next 20 years, to get us moving down to the target debt-to-GDP-ratio of 60 per cent.
So how could we be more creditworthy? With the fiscal compact, there will be precious little money left here, so much will be going out in debt reduction and interest payments.
The reason markets are rallying is that the central banks are creating money as never before. They are inflating the bubble again. The European Central Bank (ECB) for example, will lend €1 trillion to European banks at the end of this month at 1 per cent. The banks of Ireland, Greece, Portugal, Italy and Spain give trashy collateral to the ECB and the ECB will give them fresh crisp cash. Then the banks lend this money to the bust governments. This is causing the yields on the bonds to fall.
The banks borrow from the ECB at 1 per cent and lend to the host government at 6 per cent. They make a free 5 per cent. With all this profit margin, they can rebuild their balance sheets by what they see as a risk-free trade. It is called a ‘carry trade’ in finance.
Seeing this free trade, the hedge funds change tack and decide to ride the wave of €1 trillion of free ECB cash. They buy ‘put options’ which are a trade that gives the hedge funds the right to buy an option to purchase government bonds at today’s price for delivery in one month.
This means that, if the bond market keeps rallying, they will make good profits. But with the giant tsunami of €1 trillion of new liquidity in the market, why wouldn’t they buy on that trade?
The only problem is that someone subsidises this trade. Who pays? You do, because the difference between the 6 per cent at which the governments borrow and the 1 per cent at which the banks lend has to be paid by someone. That someone is the taxpayer.
Outside Europe, the US Federal Reserve has stated that it will keep the rate of interest below the rate of inflation for the foreseeable future. This means you would be mad to save, so the market borrows dollars and lends these dollars to high-yielding risky assets. Another state-sponsored ‘carry trade’.
The taps have been turned on. My favourite way to visualise this (apologies to regulars because I have used this image before) is the champagne pyramid. When someone keeps pouring champagne at the top (the central banks printing money) this liquidity gushes into all the glasses – even the risky ones at the very bottom. So long as the central banks keep the taps open, most asset classes should rally.
Significantly, had this financial market news not been accompanied by huge gains in the US job markets, it would be easy to dismiss it as a localised casino event in the global roulette table that is the international financial markets. But the US is creating jobs again, lots of them – and just in time for Obama, too.
As we pointed out last week, the most important thing for a president in re-election year is that the economy is moving in the right direction. The US economy is moving in the right direction for Obama. Combine this with a cynically timed pull-out of Afghanistan, and the election may be his to lose.
Now before you go out screaming it is all over and the global corner has been turned, be careful because, below the surface, things are not so rosy. Even with the new jobs numbers, house prices in the US continue to fall, average wages are stagnant or falling and consumers are continuing to pay back debt. This means consumer spending is still very weak and might remain so, dragging the economy back.
This is a liquidity-fuelled rally. But it is a rally nonetheless and cleverer people than me are betting big money on it lasting. Time will tell if last week was a significant milestone or just a flash in the central bank pan. Let’s keep watching the numbers.