Ben Warns More Helicopter Drops May Be Necessary

In a surprisingly (but also refreshingly) candid admission, Fed Chairman Bernanke declared last night that another round of quantitative easing may well be necessary to alleviate “high and persistent unemployment in an underperforming economy”. With inflation still low and Europe a potential drag on the economy, the Fed Chairman clearly feels that more asset purchases are a risk worth taking if it helps the recovery become more self-sustaining.

Also disconcerting was the fact that Fed officials lowered their growth expectations for this year, a shock for many who had become more confident in the outlook for the US economy. Despite recent pronouncements from various Fed officials suggesting that more QE may well be required, Bernanke’s statement caught dollar longs completely unawares, with the dollar index down more than 1%.

For the army of euro shorts, there was an even greater flurry of position-squaring, with the single currency soaring to 1.3125 after languishing under 1.2950 at the start of the New York session. Bernanke’s dovish tone helped both stocks and bonds, with the S&P up 2% from the low for the day and the yield on five-year Treasury notes falling to a record low of 0.76%. Big Ben did the gold bugs a huge favour as well – the price is above USD 1,710 this morning, up from USD 1,650 before his statement. QE is becoming the preferred tonic of choice for policy-makers – both the Fed and the MPC signalled their intentions to use it again yesterday.  

The inevitability of more QE in the UK. The Bank of England will face some tough choices in February when the next Inflation Report is published and the current round of quantitative easing (which started in October) comes to an end. It was not wholly surprising to see the latest GDP data showing a fall of 0.2% in the final quarter of 2011.

This is not the first negative reading since the emergence from recession towards the end of 2009, but the last one (Q4-‘10) was put down to a number of one-off factors which were subsequently largely reversed. This time around, though even smaller, the decline is harder to dismiss.

Meanwhile, there have been more indications that the BoE may be leaning towards further asset purchases. Tuesday night’s speech from BoE Governor King was a timely reminder that we are in for a long haul and also a period of balance-sheet adjustment.

Markets sometimes forget this, but the message was that “past experience shows that recoveries from recessions that are linked to banking crises are slow – but do eventually come”. He also reminded us that we remain in a world of imbalances, the correction of which “is not proving to be a smooth process. But it is necessary”.

These comments, when combined with the minutes of the January MPC meeting released yesterday, add further weight to the view that the UK is not done with QE just yet. Whilst there was unanimity surrounding the level of rates and asset purchase program, the minutes revealed that “for some members, the risk of undershooting the target meant that a further expansion of asset purchases was likely to be required”.

Even if GDP expands in the current quarter (and we escape a technical recession), for most it will feel like recessionary conditions, especially with credit conditions remaining tight. Furthermore, at least vs. QE1, the impact of the latest round of purchases has been more muted than the first round, even adjusting for the lower size (Insights blog 10/01/12 “The inefficiency of QE2 in the UK”). With the Chancellor not wavering from his fiscal Plan A (and with the numbers broadly on track), then further QE appears more likely next month.

Now Rajoy tackles the banks. New Prime Minister Rajoy is switching his focus from the parlous state of the government finances to those of Spain’s troubled banks. In particular, he is attempting to force Spain’s banks to properly provision for losses on bad and doubtful property loans.

According to some estimates, bad property-related loans held by banks are as much as EUR 200bln, whereas banks have only made provisions for perhaps one-third of that total. Total loans outstanding are EUR 1.79trln.

The Bank of Spain recently reported that loans in arrears (where no payment had been made for three months) rose to a 17-yr high of 7.5% in November. Economy Minister de Guindos is keen to see Spanish banks lift provisions significantly during the upcoming reporting season by setting earnings against it. A couple of weeks back he intimated that another EUR 50bln could be added to provisioning. The government is also keen on bank mergers in which some of the larger and stronger players take on the smaller, more vulnerable ones. In contrast to the approach adopted in some other European countries such as the UK, Rajoy wants to avoid committing any additional public funds to the banks. Instead, Spanish banks have been asked to foot the bill for some of the restructuring that has taken place already, and there is every prospect that they will be asked again. The problem with this approach is that investors may balk at investing in stronger banks while the risk that those earnings would be diluted remains. At the same time, the Spanish government simply has no other option - it cannot afford to inject money it does not have.

Watch the EUR/AUD cross very closely. Most forex market participants are probably perplexed by the ability of the euro to climb back through the 1.30 level over the past few days, despite the breakdown in Greek debt talks and the deep-rooted financial problems being experienced on the Iberian Peninsula. As observed by both ourselves and numerous other commentators, in cumulative terms traders currently have a record volume of short positions in the single currency. Interestingly, back in May last year, traders went very close to having record long positions in the euro, such was the pervasive negativity towards the dollar at that time. Over the past two years, trader positioning in the euro has swung wildly, from massive pessimism in the second quarter of 2010 to unbridled optimism a year later and now pervasive pessimism once again. In recent months, the majority of traders have adopted a negative euro stance through buying the Aussie dollar. As a result, the EUR/AUD cross has collapsed, from near 1.38 late in November to a recent low of 1.2220. Now at 1.2330, the signs in the last few trading days are that this cross might be due for a significant correction. With traders very short the euro and very long the Aussie, it is plausible that some short-covering in this popular currency-cross is already taking place, with more to come. If so, it would naturally benefit the single currency against the dollar as well. Right now, EUR/AUD offers critical insight into which direction the currency tide is turning.