What a difference a month makes. We entered this year with a debt  crisis in Europe and a growth crisis in the US. Investors were  terrified, governments were falling and there was a total lack of  political leadership both in Europe and the US. Corporations were in  retrenchment mode and even the bulls were retreating, having taken a  battering in 2011, particularly in the second half of the year.

This weekend, the first one of February, we are looking at financial  markets all over the world booming. It is almost total reversal. Bond  yields in Europe have fallen significantly, with the exception of  Portugal.

For example, Italian bond yields are now down at 5.6 per cent, not a  million miles from where they were this time last year before the  European bond crisis blew up in Silvio’s reconstructed face.

Stock markets, too, are roaring ahead. In fact, the rally in stocks  since the dark days of late November has been spectacular. And the  feelgood factor isn’t just limited to Europe and the US. The Indian  rupee, the Brazilian real and the Mexican peso have risen by more than  7 per cent in four weeks. And investors have added about $7.7 billion  to emerging-market equity funds in the same period.

What is happening? Most fund managers have been caught out by the  rally, having opened the year in cautious mode. I have also been very  surprised by the rally. But the job of columnists is to deal with what  is happening. If they have been caught out, acknowledge it – and then  seek a few explanations.

In answering the ‘why’ question, one aspect of the rally which is  important to note is that the most ‘risky’ assets have risen most – we  are talking about emerging market currencies and many European bond  markets. Why is it happening in the riskiest assets?  For example, are Europe’s peripheral countries, including us, suddenly  more creditworthy? No, we are not. The data in Ireland remains  appalling. Meanwhile, EU-wide growth and unemployment figures are  still atrocious.

Taken together, in Ireland, Portugal, Italy, Spain and Greece, youth  unemployment is well over 30 per cent. Given the fiscal contraction  announced by last Monday’s fiscal compact, countries will have to  reduce national debt significantly each year for the next 20 years, to  get us moving down to the target debt-to-GDP-ratio of 60 per cent.

So how could we be more creditworthy? With the fiscal compact, there  will be precious little money left here, so much will be going out in  debt reduction and interest payments.

The reason markets are rallying is that the central banks are creating  money as never before. They are inflating the bubble again. The  European Central Bank (ECB) for example, will lend €1 trillion to  European banks at the end of this month at 1 per cent. The banks of  Ireland, Greece, Portugal, Italy and Spain give trashy collateral to  the ECB and the ECB will give them fresh crisp cash. Then the banks  lend this money to the bust governments. This is causing the yields on  the bonds to fall.

The banks borrow from the ECB at 1 per cent and lend to the host  government at 6 per cent. They make a free 5 per cent. With all this  profit margin, they can rebuild their balance sheets by what they see  as a risk-free trade. It is called a ‘carry trade’ in finance.

Seeing this free trade, the hedge funds change tack and decide to ride  the wave of €1 trillion of free ECB cash. They buy ‘put options’ which  are a trade that gives the hedge funds the right to buy an option to  purchase government bonds at today’s price for delivery in one month.

This means that, if the bond market keeps rallying, they will make  good profits. But with the giant tsunami of €1 trillion of new  liquidity in the market, why wouldn’t they buy on that trade?

The only problem is that someone subsidises this trade. Who pays? You  do, because the difference between the 6 per cent at which the  governments borrow and the 1 per cent at which the banks lend has to  be paid by someone. That someone is the taxpayer.

Outside Europe, the US Federal Reserve has stated that it will keep  the rate of interest below the rate of inflation for the foreseeable  future. This means you would be mad to save, so the market borrows  dollars and lends these dollars to high-yielding risky assets. Another  state-sponsored ‘carry trade’.

The taps have been turned on. My favourite way to visualise this  (apologies to regulars because I have used this image before) is the  champagne pyramid. When someone keeps pouring champagne at the top  (the central banks printing money) this liquidity gushes into all the  glasses – even the risky ones at the very bottom. So long as the  central banks keep the taps open, most asset classes should rally.

Significantly, had this financial market news not been accompanied by  huge gains in the US job markets, it would be easy to dismiss it as a  localised casino event in the global roulette table that is the  international financial markets. But the US is creating jobs again,  lots of them – and just in time for Obama, too.

As we pointed out last week, the most important thing for a president  in re-election year is that the economy is moving in the right  direction. The US economy is moving in the right direction for Obama.  Combine this with a cynically timed pull-out of Afghanistan, and the  election may be his to lose.

Now before you go out screaming it is all over and the global corner  has been turned, be careful because, below the surface, things are not  so rosy. Even with the new jobs numbers, house prices in the US  continue to fall, average wages are stagnant or falling and consumers  are continuing to pay back debt. This means consumer spending is still  very weak and might remain so, dragging the economy back.

This is a liquidity-fuelled rally. But it is a rally nonetheless and  cleverer people than me are betting big money on it lasting.  Time will tell if last week was a significant milestone or just a  flash in the central bank pan. Let’s keep watching the numbers.

For a novel look at the economy, look at my new initiative, Punk  Economics, using cartoons to explain tricky stuff on YouTube.

0 0 votes
Article Rating
Would love your thoughts, please comment.x