The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF lending money.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.

The key issue for the markets to contend with in 2010 is the risk that the economy slips back into recession (the so-called “double-dip”).  As the banks have now been largely fixed, should the economy double-dip then it is likely the retailers will be foremost amongst the suffers.   

The retail sector had a strong rally last year as the stockmarket discounted a recovery.  If we use MKS as a proxy for the sector, they rallied from just above 200p in Dec 2008 to finish at the 400p mark, with the annual dividend cut to 15 pence along the way.  The risk now is that the consumer gets squeezed after the May election and consumer spending suffers as a result.  Even if consumer spending does manage to hold up, the sector has already priced in a recovery and there is not enough upside left to reward investors sufficiently to risk owning the shares.  If the sector continues to trade lower then at some point it will make sense to buy back in for the next recovery trade.

A second sector to be very careful of in 2010 is the pub & restaurant sector.  Wet-led tenanted operators such as ETP and PUB are going to continue to struggle whilst their food-led competitors MAB and MARS may fare relatively better.

It is likely that a newly elected government will both cut spending and signal tax rises once the economy is strong enough to bear them. The Government has a massive hole to fill in, net borrowing will end up somewhere around £175 bln in 2009/10 and £180 bln is forecast for 2010/11.  The fact that this is 12.5% of GDP does not tell the whole story as it also represents 39% of pre-credit crunch tax receipts.  The government’s income has fallen by 12% over the past two years but spending has yet to be cut by a single penny.  The emperor has no clothes – Gordon Brown will not countenance spending cuts and doesn’t have any money to “invest in services”, whilst the best David Cameron will be able to do is maintain spending on the NHS and cut spending significantly everywhere else. 

Take a minute to think about the mountain that needs to be climbed in the UK.  Central government total tax income is forecast to be £397 bln in 2009/10.  Adding on £175 bln net borrowing implies total government spending of £572 bln.  In the best year ever, total taxes raised were £451 bln (2007/8).  Its going to be a long, hard slog to get back onto an even keel and it will take years to fill in this particular hole via a combination of spending cuts, tax rises and hopefully renewed economic growth causing the tax base to grow as well.  The Bank of England will wait a very, very long time before risking any rate rises against this backdrop – it is more likely that QE will be resumed (from its current £200 bln) to support the economy/gilts market before any QE exit strategies are implemented.

At the moment the retail sector carries all the risk of being first in the firing line should consumer spending weaken and lead the wider economy into a double-dip recession.  Avoid retailers until the sector offers patient long-term investors a much better risk/reward.

Do the last three weeks of US Dollar strength represent the start of a bigger upswing in the fortunes of the Dollar?

We have just seen the Dollar close higher for three consecutive weeks, as measured by the Dollar Index. This hasn’t happened since the Dollar topped out in March 2009 (as global stockmarkets simultaneously bottomed).  We last saw a strong Dollar rally during July – November 2008 as a mad scramble for dollars took place – see “Get me a Printing Press“.

There is also a confluence of fundamental factors coming together at the moment which together provide a more solid basis for a sustainable rally in the Dollar.  The Fed is scheduled to end its current bout of $1.75 trillion QE bond purchases by the end of Q1 2010.  In addition this week’s FOMC statement highlighted that most of the Fed’s special liquidity facilities will expire on 1 Feb 2010 and that the Fed will also be closing its Dollar swap arrangements with other central banks by 1 Feb 2010 too.  The net effect is that the Fed will be shutting down three different ways in which it has been supplying Dollars to the markets.

For its part, the Euro has been impacted by the recent turmoil seen in Greece’s government bond markets and the currency markets have once again taken note that the Euro is not the same thing as a Deutschmark and it can be undermined to a certain extent by the PIIGS membership.  If Greece really got into trouble, there is no way that the other, more stable, members of the Euro would allow Greece to be rescued by the IMF (and thereby show to the whole world that Euro-land couldn’t manage its own internal affairs).

The Japanese Central Bank is also offering 10 trillion Yen in 90-day money into its money market, although the Japanese have historically been quite timid with their Quantitative Easing and this measure runs true to form in being less aggressive than, say, purchasing long-term government bonds.

Finally the US employment report for November 2009 showed both the unemployment rate falling and weekly hours worked rising.  This implies stronger US GDP (70% of which is consumer spending) which has also served to boost the Dollar.

Neither is the Fed itself going to stand in the way of a Dollar rally.  Now that a tentative recovery has been established in the States and GDP is growing again, the Fed does not need to manage the Dollar lower from here but it would surely be happy to see a combination of the Dollar rallying and lower oil prices (which would serve to keep inflation under control and lower gasoline prices would put more money into consumers pockets).

A Dollar rally at this stage is not negative for US stockmarkets because consumers having more money to spend means that companies can grow their top-line sales and generate higher profits.  These higher profits will help to keep the stockmarket rallying into 2010 (the Dow has been in a 10,200-10,500 range for the last 5 weeks, consolidating now that it has recovered half of its Oct 2007 – March 2009 losses).

So two central banks have led the way and raised interest rates (Australia and Norway), starting their journey on the long way back to interest-rate normality.  But it does not necessarily follow that just because two commodity-linked countries have started to hike rates, the Fed, BoE and the ECB are about to follow suit anytime soon. Speculation that the Fed and BoE are contemplating rate hikes is way too premature – the order of events will surely be for Quantitative Easing spending to be halted first and only then will the central bankers turn to taking back some of the rate cuts they have implemented since the summer of 2007.

The US has recently reported GDP turning positive in the third quarter of this year but the US economy is still far too weak for the Fed to risk halting QE anytime soon, let alone even think about raising interest rates from their current floor of 0.25%. One positive quarter of GDP is just the start of a potential recovery  (which could easily fizzle out again next year) and the Fed made it clear in their Fomc statement earlier this week that rates are staying put “for an extended period” and the Fed won’t even finish spending its current $1.75 trillion QE money until the end of March 2010. As was announced today, US unemployment is still rising and has now reached 10.2%.

Similarly the Bank of England this week increased by £25 bln its QE target to £200 bln, to be fully spent by the end of January 2010.  The BoE will most likely decide to print even more money if GDP does not return to growth in Q4 (after the surprise of the UK posting another quarter of recession in Q3).  As the BoE will not raise rates ahead of next year’s General Election, theoretically the ECB is in line to be the first of the major Western central banks to implement a rate hike as they never embarked upon QE in the first place.  However the jury is out on whether the ECB will raise rates with Spanish unemployment of almost 20% and with Ireland looking set to go to the IMF to seek a loan.

Inflationary pressures will not be seen in the UK until a lot more of the £200 bln QE money finds its way off deposit at the BoE (where £151 bln currently sits) and out into the wider economy where it can begin to chase the price of goods & services higher.  Therefore the BoE will only come under pressure to raise rates in the near term if the Pound Sterling collapses.

So the sight of central banks raising rates looks to be spotted for the time being only in the economies of the world which export commodities.  China will probably be the first Asian central bank to increase rates because the Yuan is closely tied to the US Dollar and other Asian countries do not want to raise rates and cause their currencies to appreciate against the Dollar or the Yuan.

The Bank of England continues to do its best to debase Sterling by printing as much money as possible without scaring the gilts market.  The only reason Sterling hasn’t collapsed against other currencies is that the other major central banks are all involved in various forms of printing money (quantitative easing) themselves.  Sterling is however steadily weakening against the Euro as the ECB is the only major central bank not currently printing money freely (see Vee are Not Embarking on QE).

But the BoE has shown it means business by recently increasing the amount of money it is planning to print from £125 bln to £175 bln and the Governor letting it be known that there is more money where this came from as he would rather print £200 bln.  The Governor is doing his best to stay ahead of the likely £175bln-plus of gilts to be issued this year.  However so far the QE money spent by the BoE has ended up mostly in commercial bank reserve deposits back at the Bank of England (a telling indication of just how much cash the banks now have is that 3-month Sterling Libor at 47bps is now below the Bank Rate for the first time since the credit crisis broke in the summer of 2007).  The challenge is how to get this money injected into the real economy given that households and corporates don’t want to borrow and companies are preferring to launch rights issues to fund their acquisitions with equity rather than debt (and the REITs are busy selling new shares to pay down their debts too). 

The BoE have hinted that the next trick they will try in their attempt to move the money currently held by the banks at the BoE is to stop paying interest on this money.  Given that the Bank Rate is only 50bps then reducing it to zero may not be a big enough incentive and the banks may well just shift the money into the very short end of the gilt market.  However not paying interest on commercial bank reserves will come in very handy when the time eventually comes for the BoE to start raising interest rates again, so we can expect this policy move to happen at some stage.  The more drastic step of paying a negative interest rate on commercial bank reserves (by charging the banks interest to deposit money at the BoE) will achieve nothing as the logical response from the banks would be the same – shift the money into short-term gilts.

With everyone looking to raise equity and retire debt, getting the QE money into the real economy may take a quite a while longer to work (there is no history to refer back to here as the Japanese were too timid when they tried QE).  In the meantime the BoE has little option other than to carry on printing money until a sustainable economic recovery takes hold.  Expect Sterling to continue to depreciate against real assets and harder currencies such as the Euro.

The head of the ECB Jean-Claude Trichet was most insistent during his press conference after the latest ECB meeting that their proposed purchases of €60 bln of “covered bonds” (mostly mortgage-backed securities issued mainly by German banks) did not mean that the ECB was commencing quantitative easing.  His exact words during the Q&A session of the press conference were “we are not at all embarking on Quantitative Easing”. 

Instead the €60 bln covered bond purchase plan was presented as providing “enhanced credit support” to the covered bond market which will help to improve the spreads, depth & liquidity of this particular market, seen by the ECB to be in particular trouble at the moment.

The Bundesbank has clearly dug its heels in over the ECB going down the road of QE and has compromised by agreeing to throw €60 bln instead at the covered bond market.  Good to see the old City adage “If there is a problem then throw money at it until it goes away” has been taken on board by the burghers of Frankfurt.

Meanwhile the Bank of England has taken that particular City adage to heart by expanding its QE program from £75 bln to £125 bln.  And if that does not do the trick then expect the BoE to throw even more money at the problem…there is no shortage of money to spend when the BoE can just print it (even if they describe this printing as “electronically crediting the accounts of those instituitions” which sell securities to the Asset Purchase Facility).  The BoE is aiming to ease the flow of credit throughout the economy by purchasing gilts (mostly).  It hopes the selling institutions will re-invest the proceeds elsewhere, thereby boosting asset prices & tightening credit spreads.  It also hopes that some of this money will leak out into the wider economy and end up as spending on goods & services.  By restricting their buying to gilts, the BoE will be unlikely to lose money as they are financing their purchases at near-zero rates of interest and will likely hold the gilts to maturity.  By spending a big percentage of the Government’s borrowing requirement, the BoE is also hoping its purchases will help to avoid private borrowers being “crowded out” by the deluge of gilts being issued.  Expect the BoE to spend much, much more than £125 bln before its Quantitative Easing program comes to an end.  They truly are going to throw a great deal of money at this problem until it goes away.