Global monetary policy defines direction. Or maybe it's football?

Yesterday there seemed to be a modest sense of optimism from markets. Cynics, which unfortunately in this instance include me, would possibly say that it was a squeeze of ‘risk off’ positions combined with an, albeit brief, yield grab from investors looking for any port in a storm.

Green Day?

The previous two days had given rise to a significant rally in equities and risk assets including the beleaguered EUR, some of the rally could be put down to overextended market positioning and thus the reversal being propagated by position squaring on no ‘new’ news. However, as I see things the predominant driver was the expectation that further global policy stimulus was imminent.

Europe?

Mario Draghi and the ECB were first on the central bank roster and while some may have hoped for an interest rate cut or hints of further non conventional; support for markets, president Draghi chose to exalt the monetary policy response of the ECB, but highlighted the limits of monetary policy in curing the ills of the eurozone. In effect his commentary suggested that he (and the ECB) had fulfilled their mandate and delivered price stability; it is the job of eurozone governments and politicians to “act now” to restore confidence and stop financial and economic collapse.

Status Quo?

Yesterday it was the turn of the Bank of England’s Monetary Policy Committee (MPC). Whilst expectations for additions to the Asset Purchase Facility (or QE) where in the minority among economists, the market had priced in a significant probability. Therefore, after the better than expected service sector activity data, which showed a continued expansion of the UK’s dominant sector, through strength in new orders and employment (in fact the only real drag was a declining expectations balance – perhaps unsurprising given the current global macroeconomic backdrop), the unchanged policy announcement from the MPC, gave GBP a boost.

Fiscal Cliff (and the Shadows)?

In the US, the expectations of further policy accommodation (if not explicitly further direct QE) had risen over the course of the week, aided by Fed commentators and governors. However, Fed Chairman Bernanke’s testimony yesterday changed the expectations of policy easing and the dynamic of the market. In essence Bernanke mirrored the sentiment of the ECB in that, despite the disappointing level of growth and employment monetary policy has likely reached its lower bound. His suggestions that there “may be some diminishing returns” to further QE mean that with the possible exception of more ‘operation twist’ there is a very high hurdle for QE3 in theUS.

Perhaps more significantly (and increasingly so as we approach the November election) Bernanke again mirrored Draghi’s sentiment and urged congress to address the deficit and the global concerns of the impact of the fiscal cliff and the drag on growth from tax cut expirations and the deficit itself.

Example?

The shock event of the day was the Chinese rate cut, the first since 2008 and perhaps a hint that the authorities are becoming a touch more anxious about the current economic slowdown. A hard landing remains a long way off in China, as the ability of the central bank to provide monetary and fiscal stimulus remains supported by its relatively high interest rates and low government debt (~25% GDP) – The impact of the rate cut on broader markets however was soon forgotten as Eurozone concerns returned with a vengeance overnight.

The Darkness?

The announcement overnight that Fitch downgraded Spain 3 notches to BBB and kept their outlook negative in conjunction with reports of a funding gap of up to EUR112B for Spanish banks has put the EUR and risk assets back under pressure. Some rumours this morning that Spain is likely to request aid for its banks formally over the weekend may also play a part in the trading dynamic for the day as some may look to cover EUR shorts into the close.

However, after the rally of the last couple of days I see the current levels as an opportunity to re-engage a bearish EUR stance. If Spain does get some assistance for its banks over the weekend then I would prefer to be short EUR vs. GBP which continues to be my long term macro preferred trade.

On a lighter note; as the European football championships start today, it is worth noting that the last two winners of the trophy were Greece (2004) and Spain (2008). Lets just hope that this years winners do not suffer the same economic fate further down the line!