World leaders have depicted the shift in Chinese currency as an important step in addressing the immense financial imbalances that are at the heart of the current malaise infecting the global economy.
Yet more than a week after China’s decision to introduce more flexibility into its exchange rate mechanism, the sense of optimism that might be expected after a decision of such significance is conspicuous by its absence.
The FTSE (London) and Dow Jones indexes, for example, fell in the last week, hardly a rousing endorsement for a policy move of such importance. Moreover, during the same period, France’s CAC 40 and Germany’s XETRA Dax indexes slid 5.1 percent and 3.4 percent, respectively. We could ask ourselves if it is the euro zone itself to which we must attribute much of the blame for investors’ continued unease.
Tensions in the euro zone’s debt market remain high. Having recently dipped (in some cases), the spreads of euro-zone sovereign bond yields over German Bunds recently have risen inexorably, taking them firmly back to levels that prevailed prior to the unveiling of the EU’s “shock and awe” stability fund in early May.
Notably, this is true of both short- and long-dated bonds, and although still at relatively low levels, it is interesting to note that France’s two-year spread over German Bunds recently rose 37 basis points to its highest level since the height of the 2008 financial crisis. The recent ratings downgrade of the French bank BNP Paribas by Fitch won’t help the mood in the French debt market.
Also interestingly, a number of former IMF officials have recently stated that no fruit will be found without debt rescheduling and suitable currency devaluation, neither expected soon.
Perhaps unsurprisingly, therefore, portfolio outflows from the euro zone have been relentless: having flattened marginally earlier in the month, net fixed income outflows from Greece have now accelerated.
The Italian bond market, meanwhile, has scarcely enjoyed any respite, and net outflows have maintained a near perfect 45 degree downward trajectory for many months now. There are also fresh tentative net outflows from Ireland’s debt market – a country that until recently was busily implementing its deficit-reduction plan away from the market’s eyes.
The latest infusion of “positive news” from China appears to be dissipating quickly, which leaves investors contemplating the profound and unavoidable problems facing world policymakers.
The FOMC also has reconfirmed its commitment to keep U.S. interest rates low for an “extended period” – a reflection in part of anemic U.S. jobs growth. Along with some truly awful U.S. housing data, this has reminded investors that sustained recovery is by no means assured, and explains the Obama-Summers open letter to the G-20 imploring “a commitment to reducing long-term deficits, but not at the price of short-term growth.”
Some ears will be deaf to such calls, however, and the U.K. government for one appears unwilling to gamble on growth. After all, should recoveries fail (á la Japan), then the pump-priming process starts again with a whole lot more debt to boot. On this matter the ratings agencies also clearly agree.
The point is not to side with either one view, but to emphasize the risks irrespective of approach. We have yet to discern a clear path through the ongoing sovereign debt crisis in the euro zone. And there remains the inevitable and profound risks facing the Japanese economy, whether its government under Naoto Kan opts to implement its deficit reduction plan to the letter or not.
The atmosphere is set to seriously test the patience of certain central banks. It remains to be seen, for example, just what the Japanese government has in mind, having instructed the Bank of Japan to “do its utmost” to stave off inflation.
Meanwhile, although the Swiss National Bank appears to have used its "get out of jail free" card from a seemingly unsustainable intervention strategy by declaring the end to deflationary risks, it remains to be seen whether it can tolerate the ongoing plunge in the euro-Swiss franc – a plunge that could soon demand a re-think for even the most solid of economic recoveries. We may soon find out.
To me, all this appears to suggest that many investors will be simply awaiting the right moment to rebuild their euro short positions. With momentum in the euro-U.S. dollar remaining weak, that moment may not be too far away.
Heightened risk aversion could come back with a vengeance, once again.
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