Irrational exuberance or rational despondence?
- Fed and ECB distract but Brexit is the elephant in the room
- Fed is clearly in no hurry to normalise policy
- Draghi seeks to clam markets on Brexit and economy
- ECB chief urges governments to begin structural reforms
- Click here for more Brexit analysis from Saxo's experts
In 1996, the then chairman of the Federal Reserve, Alan Greenspan unleashed the phrase “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions…” during a speech on the challenges of central banking. Against the current global macroeconomic backdrop where the challenges to central banking are as acute as ever, yesterday was the current Fed chair Janet Yellen’s "irrational exuberance" moment.
In her semi-annual testimony to congress, she delivered two very clear messages. Firstly, as Yellen painted a cautious and uncertain view of the economy, highlighting the momentum loss in the labour market and weak investment amid slow economic growth, she made it clear that the Fed is not in any hurry to enact further monetary normalisation.
Secondly (and from our perspective most significantly), the accompanying Federal Reserve Monetary Policy Report highlighted that “forward price-to-earnings ratios for equities have increased to a level above their median of the past three decades.” and while admitting that equity valuations may not appear rich to current treasury yields “equity prices are vulnerable to rises in term premiums to more normal levels”. We have argued for several months now that equity prices are overvalued as a function of forward discounting and fully expect that the sentiment offered by the Fed this week will be viewed historically as a the beginning of a (perhaps historically significant) correction in equities.
ECB faces many challenges
One of the European Union's five presidents, Mario Draghi, also spoke yesterday. His message was threefold. Firstly Draghi aimed to calm market concern, by making assurances that the European Central Bank stands “ready for all contingencies on Brexit”. Secondly, aiming to calm economic concern, Draghi stated that ECB action has put the recovery on a more “solid footing” and that “further stimulus is in [the] pipeline” – by this he is referring to the stimulative impact of the nascent corporate QE programme (CSPP), and the imminent TLTRO II auctions (where banks are effectively being paid to borrow money, under certain criteria), NOT preparing markets for further stimulus. Thirdly Mario Draghi reiterated his call for national governments to implement structural reform, stating that the “ECB alone cannot make [the current] cyclical recovery structural”.
He went on to suggest that the monetary union is “incomplete and fragile”. This is not a good platform to deal with the possibility of Brexit (whatever probability you place on such an outcome). Brexit would likely represent the next phase in the Eurozone’s rolling crisis, alongside the as yet unsolved economic, debt and migrant crises.
The ECB really is a central bank that faces challenges (to paraphrase Mr Greenspan): not only has it reached the point of diminishing (or even diminished) returns on its monetary policy toolkit, Mario Draghi’s cries for fiscal help are failing to convince 18 member nations - with varied and disparate national problems - of its merits.
Against the current backdrop, however, the notion that the Fed may consider equities overvalued or vulnerable, or the notion that the ECB is out of monetary ammunition while its members fight their own (fiscal) battles have had little or no direct impact on financial markets. The reason for this is the Union Jack painted (bemused faced) elephant in the room. Brexit.
Sun stands still
On Monday, the annual summer solstice (from the latin solstitium, or sun stands still) coincided with another celestial event, the strawberry moon - a once in a lifetime event. The UK Referendum, whatever your viewpoint, is also a once in a lifetime event. It is possible that the "Leave" campaign would describe the summer solstice as a day of "never ending sunshine possibilities" and the Remain campaign as "the nights are drawing in; we must prepare for the harsh winter". The electorate remains split
As we approach the referendum, financial market liquidity is likely to dry up. GBP is the likely epicentre, followed by broader FX markets and broader financial markets, and as such there will likely be moves that make little sense, but merely satisfy transactions in a low liquidity environment. It is difficult to gauge the timings of any announcement or statistical result of the Referendum vote, however, it is likely that we will have a pretty good idea (at least as to how close it is) by around 0300 GMT. After some positional adjustments today, for financial markets and the UK, tomorrow the sun will, in all likelihood, (if just for one day) stand still.
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– Edited by Clare MacCarthy
Neil Staines is head of trading at The ECU Group