Where’s the bottom?

So, where is the bottom? To begin to fathom an answer, me must first understand why markets are falling. Last night’s action offers some clues.

Although there is plenty of press blaming the US downgrade, it is far more than that. For starters, the downgrade has seemingly done nothing to the attractiveness of Treasuries as a safe haven. Last night Treasuries were one of the hottest assets on the planet, with long dated yields ripping in. Short dated were largely flat.

Of course, there is a cascade of downgrades now flowing through the US government’s contingent liabilities, including the GSEs Fannie Mae and Freddie Mac. There may be a worry of higher mortgage costs for the US economy but that is surely down the track. Right now, yields on the 30 year bond, from which most US mortgages draw their interest rate, are dropping sharply.

Also on the positive side of the ledger, repo markets appear to be holding up well in face of the downgrade, meaning short term bank funding is not at risk.

The same cannot be said, however, in Europe, where EURIBOR, the measure of short term interbank funding rates is grinding upwards.

This is despite what seems to have been a roaring success in the announcement that the ECB will buy Spanish and Italian debt, albeit we don’t know how much, for how long, or what they’ll do with it. Nonetheless Spanish and Italian yields collapsed across the curve. Whilst nothing has been fixed the can has been well and truly punted.

So, the sovereign crisis appears to be giving way to nerves about and within European banks. The same is happening in the US, with banks stocks getting monstered and Bank of America surrounded by rumours of solvency issues.

This suggests to me that global equities are pricing for a European and the US recession. In this context, the relatively smooth US downgrade and (temporary) European liquidity crisis resolution are further blows to declining confidence, not reasons to buy.

If that’s true, we aren’t yet near the bottom.

What we’ll need to reverse course is decisive policy action on both sides of Atlantic. We’ve had about all we can hope for from Europe (and it appears it will stabilise the core sovereigns for now) so it’s over to the US Federal Reserve, which meets tomorrow.

What will they do?

Regular readers will know that that is a question that has dogged me for months. I have confidently declared that QE3 will come before a cycle ending event. Well, we are here, at the cycle ending event. And I’m not confident. Fed blogger, Tim Duy, writes today that the G7 has set up conditions for a new round of Fed printing:

I think this gives the Fed cover to move this morning; more later. I like this part:

These actions, together with continuing fiscal discipline efforts will enable long-term fiscal sustainability. No change in fundamentals warrants the recent financial tensions faced by Spain and Italy. We welcome the additional policy measures announced by Italy and Spain to strengthen fiscal discipline and underpin the recovery in economic activity and job creation.

The Federal Reserve. As I argued last week, the usual guides to monetary policy, a combination of Fedspeak and data flow, are not conducive to a near-term policy shift. An overriding factor, however, would be financial crisis, and the G7 statement seems to raise the current circumstances to crisis level. This should give the Fed a green light to act. I still think the best option is to come in before the market opens and announce they are buying $100 billion of Treasuries. Just get ahead of this. The problem is that so many Fed policymakers have come out seemingly dead set against any additional bond purchases that action just a day before the next FOMC meeting seems like a big leap. Still, a financial crisis is a good time for a big leap.

To my mind, a small printing exercise is the worst thing the Fed could do. It’ll have bugger all impact on market psychology and only blunt the effect of the next big round of purchases when its comes. Either the Fed goes all in or not at all.

So, is it able to go all in? A spectacular piece form Nomura via Alphaville gives me serious pause:

Here’s an interesting graphic from Nomura’s fixed income team for bubble addicts.

It shows the pain thresholds for QE3.

As you can see, inflation expectations are some way from being compatible with another round of bank note printing – although that hasn’t stopped a lot of market participants and parts of the media talking about QE as a potential market saviour.

Indeed, this time a year ago (just before Bernanke’s Jackson Hole speech) the 5yr-5yr rate (the Fed’s preferred measure of inflation) was falling towards 2.2 per cent. It’s just above 3 per cent at the moment after a sharp decline at the back end of last week.

True, the decline in shares prices as measured by the S&P 500 look similar to this time a year ago – 13 per cent, against 10 per cent now – and a drop in equity markets can prompt policy makers to act.

But for a third time? Surely the bar for further easing is much higher this time?

Nomura thinks so.

Although QE has been effective in lifting asset prices as a band-aid, its impact on expectations of balanced, durable growth remains an open question. Some have argued that the consequences of the form of QE used so far have been negative for global growth via higher commodity prices. Repeating the experiment in exactly the same way may not be as easy as the discussions we have had with clients would suggest – especially now that we have hard evidence that other global market participants are nervous about fast USD weakening.

However, all this ignores the other major difference from 2010 – increased sovereign risks. How those play into monetary policy decisions is not clear yet – more or less supportive of accommodation? It is this uncertainty that makes us nervous about ascribing a high probability of QE3 as a risk market saviour – or that if it is a relative game, that substantial further pain/systemic risk is required in risk assets if inflation expectations do not decline in tandem.

Gulp.

The US core inflation rate has been falling recently and oil has almost been hammered down into the seventies. But, it’s still not enough in my view. Take a look at the correction on the CRB:

Not much and certainly not enough to retard the advance of global inflation. Commodities need to go lower before the Fed can act. If this selloff really starts to get disorderly, the Fed can intervene with an inter-meeting announcement.

So, I conclude, no milky wilkies tomorrow.

Which means, unfortunately, global markets are going lower.