Trichet's Market Rebound May Allow Bernanke to Hold Off On Purchasing Debt
European Central Bank President Jean- Claude Trichet may allow Federal Reserve Chairman Ben S. Bernanke to avoid loosening monetary policy tomorrow by helping engineer a rebound in global financial markets.
Since June 7, when Europe’s equities were in a two-month slump, Trichet extended through September the ECB’s offer of unlimited cash to banks and pledged to keep buying government bonds. The Stoxx Europe 600 Index has risen 6.6 percent, and the euro has appreciated 11 percent against the dollar, wiping away the past three months’ losses. The Markit iTraxx Europe Index, which measures the cost of protecting investment-grade company bonds against default, fell to the lowest levels since May.
Markets have come back because of “easing concern about liquidity defaults in Europe and the removal of some uncertainty after the European bank stress tests,” said Lena Komileva, head of G-7 market economics at Tullett Prebon Plc, a broker for commercial and investment banks in London. “That reduces the pressure on the Fed to implement immediate action.”
The rally in stocks and bonds may give Bernanke and his colleagues room to acknowledge after their meeting tomorrow growing risks to the recovery without taking any steps such as buying bonds to spur the economy. Weaker than anticipated job growth in July encouraged speculation in the bond market that the central bank may provide more stimulus.
“They will be refining their prose, not their balance sheet,” said Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc.
A decision by the Fed to forego bond buying would come as a “very big surprise” to the currency market, where the dollar has fallen, in part, on expectations of such action, said David Gilmore, partner at Foreign Exchange Analytics in Essex, Connecticut.
The U.S. currency might rise to 87 yen in response, before falling back because of the slowing U.S. economy, he said. The dollar dropped to an eight-month low of 85.02 yen on Aug. 6 before settling at 85.51 yen, 0.4 percent lower than the day before.
Bond-market investors also may be disappointed if the Fed simply “nods” at the risks to the economy without saying that it will reinvest the proceeds of maturing mortgage-backed assets on its balance sheet, said George Goncalves, managing director of Nomura Holdings Inc. in New York.
In that case, the yield on the 10-year Treasury note might approach 3 percent, he said. The yield was 2.82 percent at 4:04 p.m. in New York on Aug. 6, according to BGCantor Market Data.
When asked at a July 21 Senate Banking Committee hearing what more the Fed could do to aid the economy, Bernanke pointed out that U.S. monetary policy “is already quite stimulative.” While he did lay out three strategies the central bank could pursue if needed, he added that each had “drawbacks.”
The Fed could reinforce its intention to keep short-term rates, which are near zero, “exceptionally low” for an “extended period.” It could lower the quarter percentage-point interest rate it pays commercial banks for reserves they hold at the Fed. It could also alter its balance sheet, either by reinvesting the proceeds of bonds it holds when they mature or by buying more.
Bernanke and his colleagues have begun to consider additional stimulus as the recovery loses momentum. The economy slowed to an annual pace of 2.4 percent in the second quarter, down from 3.7 percent in the first and 5 percent in the fourth quarter of 2009.
Consumer spending has sagged under the weight of persistently high unemployment. U.S. companies hired 71,000 workers in July, fewer than forecast, after a gain of 31,000 in June that was smaller than previously reported. The jobless rate, unchanged at 9.5 percent, remained above 9 percent for the 15th consecutive month.
The economic outlook is “unusually uncertain,” Bernanke said during the hearing, even as he forecast “continued moderate growth.”
Following the Federal Open Market Committee’s last meeting on June 22-23, the Fed said “financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad.”
That has changed as the markets have rebounded. The MSCI World Index of stocks in 24 developed nations has risen 5.2 percent since Fed officials met on June 23. Behind the gains is mounting optimism that Trichet and his fellow European policy makers have succeeded in defusing an incipient debt crisis in the region.
This helped boost the Bloomberg Financial Conditions Index last week to its highest level since May. A rise in the index means financing is easier to come by. The extra yield investors demand to own company debt instead of government bonds narrowed to 175 basis points on Aug. 6 from 194 basis points June 23, according to the Bank of America Merrill Lynch Global Broad Market Corporate Index.
The rally has come in the wake of a series of steps by European policy makers to quell concerns that a sovereign-debt crisis might drag down the region’s banks and its economy. In May, they unveiled an unprecedented loan package worth as much as 750 billion euros ($996 billion) to help backstop euro-area governments.
Trichet, in a move that split the ECB, threw his support behind the program by agreeing to buy bonds of Greece and other European nations. He also made it easier for banks to borrow unlimited cash and pressed European governments to follow up with steps to reduce government budget deficits, arguing this would boost confidence in the region.
News that the overwhelming majority of European banks had passed the stress tests, which gauged their ability to weather an economic slowdown, helped lift investor spirits. Seven of the 91 banks were found to have insufficient capital, European regulators announced July 23.
While Trichet told reporters on Aug. 5 that it’s too soon to “declare victory,” he said the euro-area economy is recovering faster than forecast and money markets are improving.
The rate banks say they charge each other for three-month loans in dollars has fallen steadily since the Fed’s last meeting as investors have grown more optimistic about the lenders’ prospects. The London interbank offered rate, or Libor, for such loans declined to 0.41125 percent on Aug. 6, the lowest since May 6, according to the British Bankers’ Association. It was 0.53825 percent on June 23.
The U.S. stock market has also bounced back, with the Standard & Poor’s 500 Index rising 9.7 percent from the 2010 low set on July 2. The rebound in shares since late July has boosted investor wealth by $1.1 trillion.
“I don’t know where the stock market is going, but I will say this, that if it continues hotter, this will do more to stimulate the economy than anything we’ve been talking about today or anything anybody else was talking about,” former Fed Chairman Alan Greenspan said on NBC’s Aug. 1 “Meet the Press” television program.
The snapback in stocks has been helped by a string of better-than-forecast U.S. corporate earnings. As of Aug. 6, 76.2 percent of the S&P 500 companies that reported earnings for the latest quarter announced profits that exceeded Wall Street analysts’ forecasts.
U.S. businesses also are taking advantage of the rally in the bond market to lock in financing for the future. Sales of corporate bonds totaled $90.1 billion last month, the most for July since at least 1999 according to Bloomberg data, and may reach $100 billion in August, the most on record for the month, Aladdin Capital LLC. said in an Aug. 6 note to clients.
Expedia Inc., the largest online travel agency, and International Business Machines Corp., the world’s biggest computer-services provider, sold bonds with coupons at historic lows last week. Bellevue, Washington-based Expedia sold 10-year notes at its lowest coupon for any maturity, and IBM, based in Armonk, New York, issued 1 percent three-year notes that carry the lowest interest rate of the more than 3,400 securities in the Barclays Capital U.S. Corporate Index of investment-grade company debt.
Jay Bryson, global economist for Wells Fargo Securities LLC in Charlotte, North Carolina, cautioned that it is too soon to sound the all-clear.
“Financial markets are still very fragile because the underlying major economies are fragile,” he said.
The U.S. faces a 25 percent chance of deflation and a double-dip recession, Mohamed El-Erian, chief executive officer at Pacific Investment Management Co., which runs the world’s biggest bond fund, told reporters on August 5.
Investors aren’t buying into the doom and gloom, at least for now, and that’s giving Bernanke and his colleagues some room to maneuver.
“The Fed is looking with gratitude at the easing of financial-market conditions,” said Lyle Gramley, a former central-bank governor who is now a senior economic adviser in Washington for the Potomac Research Group. “It is certainly not eager to jump into a big rescue operation for the economy.”