Economy Oct 12, 2011
Angela Merkel and Nicholas Sarkozy are set to unveil a comprehensive European sovereign and bank rescue package; China is buying shares of its banks; Bank of England (BOE) is increasing the size of its bond purchase programme, the European Central Bank (ECB) is buying covered bonds and giving 12-month loans and the US Federal Reserve (Fed) has commented that it can do more to pump-prime the US economy.
What do all these factors add up to?
All these have contributed to a sharp rally from lows across equity, currency and commodity markets while bond yields in the US have gone up sharply on the back of some unwinding of flight-to-safety trades.
The positive news has taken up equities in the US and Europe by 6 percent and 10 percent respectively, while the euro has gained over 2.5 percent against the dollar. US 10-year bond yields have gone up by 50 bps (100 bps make one percent) while the Reuters CRB commodity index has gained 5 percent. All these gains have come over the last few days.
Indian equity indices have rallied by over 4 percent while the rupee gained by 1 percent against the dollar before falling back, on the back of global positive news.
The question is will this rally continue or not?
The answer depends on how the global events play out in the near future but, as the markets are heavily oversold, there will be a tendency to cover shorts at every dip in the market, and this will keep them from sliding down further.
The rally has happened from the lows for all markets - equities, currencies, commodities. Bond yields have risen from lows. The markets are basically covering short-sales in depressed markets and unwinding long positions in overvalued markets (US treasuries).
The eurozone rescue package is to be unveiled in the beginning of November 2011, and until then the markets will not short the euro. A stronger euro is beneficial for risk assets given the short-term positive correlation it has with equities, commodities and emerging currencies.
China buying shares of its banks is again positive for the markets as it improves sentiments across the globe. China's sovereign wealth fund, which is buying the shares, has assets of over $400 billion and the fund is capable of supporting markets through its purchases.
The increase in the Bank of England's bond purchase programme by 75 billion is positive for the UK economy, which will see higher liquidity in the system. The ECB's decision to give cheap funds to banks for 12 months will bolster confidence in European banks while its buying of covered bonds (bonds backed by assets) will infuse liquidity in the system.
The US Fed is replacing short-dated securities with long-dated ones for USD 400 billion to bring down mortgage yields. The Fed is willing to do more if necessary to support the economy.
The fact that there are many obstacles ahead will keep markets edgy. The Slovakia vote, the downgrade of Spanish banks and corporate results are all negatives that the market will have to surmount. The euro bailout plan depends on Slovakia voting for the plan and, given internal politics, Slovakia has voted against the increase in bailout funds. However, there is optimism that the vote will gate passed later this week.
S&P and Fitch downgraded top Spanish banks citing weak economic outlook and this downgrade adds to the slew of downgrades seen over the last few days, including Italy's sovereign rating and India's State Bank of India. Downgrades affect sentiment and pull down markets.
Corporate results are coming out and Alcoa, the largest aluminium producer in the US, has delivered results that were below analysts' expectations. The company cited weak economic conditions, particularly in Europe, as key risks going forward.
The markets are nervous and are reacting sharply to any kind of positive or negative news. However, given that they have come off from lows and are holding on despite negative news on Slovakia, Spanish banks, and Alcoa, there is a good possibility of the markets trending with a positive bias. Indian equities and the rupee should follow suit in trending higher if there are no major negative surprises in IIP and inflation data.
Wednesday's IIP data showed a lower-than-expected 4.1 percent growth in August. Now, it is up to the inflation numbers for September to keep the bull flag from flagging.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.
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