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.


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.

Houses and Holes


  1. While the location of the bottom remains uncertain.

    What is certain is that we are moving closer to Mr Swan and the RBA announcing special housing bubble maintenance measures.

    1. Low low interest rates

    2. First Home Owners Grants

    3. Special new tax benefits.

    4. Etc

    Rather than the sort of things he should be doing or encouraging the States to do.

    1. Cutting all the the red tape that makes it risky/hard for a developer to start building new housing

    2. Converting high upfront site development costs into a higher level of rates for the resulting blocks over 40 years. User pays but just not a big lump front. Texas Style!

    3. Reducing the nimby capacity to stop, slow and increase the cost of any project designed to increase density around transport hubs.

    4. If credit for developers is the problem, pay builders to build the houses and then auction them off to buyers.

    If he did this the building tradies would be run off their feet building affordable housing even if the price of housing is sagging.

    The only downside is that the housing speculators would be burnt.

    The punters living in their own homes and not planning on going anywhere may no longer feel like millionaires but they are only losing notional gains in value.

    But don’t hold your breathe waiting for Swan to try this.

    • Federal government cannot implement policies at the State level. State government can’t override their council either without being rebuffed in courts. Land restriction policy is a problem with the current Australian government structure. Too many actors have a vested interest in keeping real estate prices high.

    • For similar reasons that the US may need a higher level of pain for QE3 we will very likely need a higher level of pain for much lower interest rates and another stimulus. I am not even sure if the latter is even politically acceptable after all the Labor stuff ups and run up in debt by first home buyers of whom many are in big trouble now. We already have one massive stimulus which is NBN and quite frankly can’t afford another one and more government debt and in turn taxes down the track.

      • More FHBG wont be effective because the FHB demand brought forward in 2009 was so massive, that basically everyone that was going to get a home (and qualified) bought one… or chose not to buy one (many here). So it can’t work again. And they have already tried middle home owner stimulus in the form of the $600k stamp duty exemption for investors, etc. So low likelihood of success IMO

    • Witchsmeller Pursuivant

      What a genius. Sure thing, what Australia needs now is more supply into that market. I tell you what, I’ll swap my cow for your magic beans.

    • “But don’t hold your breathe waiting for Swan to try this.”

      I’m afraid the so-called Swan has proved to be still an ugly duckling.

  2. Weimar Republic

    TIPS spreads still show robust inflation expectations as well.

    Because it is an asset swap QE, in the form we’ve seen so far, doesn’t do anything for the economy. A key objective was to push down rates across the yield curve and we’re getting that anyway as people flock to those darn risky treasury bonds. Monetary policy is out of bullets and fiscal policy is at the mercy of lunatics.

  3. Why on earth would anyone be thinking of more stimulus in Aus right now? A long-term, gentle slide in housing prices is exactly what we need, and that’s what we are seeing.

    Aus itself is fundamentally pottering along OK. Its’ the loonies in the US & Europe that are giving us grief.

    The Bond market has responded to the “US downgrade” by reduced interest rates on long-term US debt – hardly agreement with the downgrade. Similarly, the ECB action has steadied key bonds there.

    This equity sell-off is not much more than nerves. Lets’ not talk ourselves into a crash.

    • Witchsmeller Pursuivant

      While some of us appreciate the inherent comedy in wishful thinking, can you answer me this: where is global growth coming from? Think of it in the broadest terms possible.

      This may not be THE crash, but it’s certainly more than “nerves”. I tell you what, if it’s just nerves, how about you buy in big today?

  4. My brother who is in equipment finance, just informed that rates on new loans have dropped by 2 from 10%)

  5. ‘The US core inflation rate has been falling recently and oil has almost been hammered down into the seventies.’

    WTI is only for the east coast of America, and is losing its significance for world oil prices.

    Brent crude is still at $104/barrel (the price payed by Europe)

    Tapis is still at $119/barrel (Australia/South East Asia)

    The marginal barrel of oil (tar sands/biofuels) is still $80/barrel.

    I’ll tell you what QE1 and QE2 didn’t do: it didn’t stall declining OECD oil production, nor did it stall declining production from existing oil fields. And QE3… QEn won’t change anything either.

  6. If the ALP was *really* smart they would make a great big fuss about making houses affordable, and proclaim themselves to be doing a good job while not doing much of anything.

      • Theres on aspect of 2008 that won’t be repeated, that being stimulus simply because the world seems to have embraced austerity as a solution, and I reckon anything that could be interpreted as profligacy would be political suicide. There will be no repeat of the 2008 “cheques in the mail” episode, nor a pump prime for property.

      • I think you’re right in the Australian context Delraiser, not too sure about the US/EURO, because they haven’t tried the Australian form of stimulus – “go households and go hard”.

        Imagine if QE3 ends up being a $10,000 cheque to each US household (Around $1.2 trillion) instead of a $200 billion cheque to each major US bank. (about the same)

        • “Go households, go hard” works better, but is a once off trick. Once you start to form a pattern, you are into hard devaluation of the currency.

          Especially if it comes from the Reserve rather than the government.

          The US thus has a hard time using that lever, given the likely need for QE4, …. etc afterwards.

          The advantage of the misdirection of funding the banks is that the psychological effect is softened.

        • It was said QE2 would have been more effective if Benny performed a heli-drop of cash rather than helping to repair bank balance sheets……………..

          Still, it doesn’t chnage the fact that any kind of cash stimulus is just more of the same can kicking. Fixed Asset repair/investment would be a boon to the USA as it would not only help to solve an employment dilemma, but also improve productivity by bringing so much of their crumbling infrastucture into the modern age.

        • Weimar Republic

          Your idea of QE3 is probably what QE1.5 should have been.

          The US did do cash for clunkers and their equivalent of an attempt to prop up housing with tax benefits but it was nowhere near the levels done here. Not sure about europe.

          Despite both parties parroting stuff about return to a surplus I would have thought a crash, with unemployment going to say 10% would have them spending hand over fist. If that happens lets hope it is not more pink batts and school halls.

        • Weimar I concur – if unemployment spikes here, the Treasury will dust off the Rudd/Henry “go households” card super quick.

          I doubt they will be able to reinflate the housing bubble, but they have shown a willingness to get stimulus into households.

          Personally, I think it would be a great opportunity to completely overhaul the tax/welfare system and initiate a negative income tax system across the board, whist cancelling the Age Pension for anyone under the age of say 45.

          Never let a crisis go to waste.