By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman
Yes, it is the holiday season. Yes, you are unlikely to be taking action with your investments. Yes, the morphing of what is into what will be continues uninterrupted.
There were several developments over the weekend that will influence the direction of the markets in the days ahead, with the usual caution about the impact of the thinness of conditions.
First, the major focus remains the US fiscal cliff. One of the most important ways in which the US fiscal crisis differs from those seen in Iceland, Greece, Portugal, Ireland is that it has not been triggered by a capital strike. Investors have not fled the US. Interest rates have not trended higher. It is not a fiscal crisis. It is a political crisis.
And that political crisis has prevented the untying of the Gordian Knot that Obama and Congress created to paper over the political crisis earlier. With the holiday at hand, the politicians will not return until mid-week. A interim deal that would allow for some modest modification of the “cliff” while buying some time to reach a “grand bargain” does not appear to have sufficient support. Nor would it lift the pall of uncertainty that appears to be one of headwinds to the still fragile US economy.
Second, political uncertainty has not been lifted in Italy either. Technocrat Prime Minister Monti resigned following the approval of the 2013 budget and the approval of the fiscal compact. He remains the caretaker until the elections are held in late February (24-25). With much anticipation, Monti held a press conference, but rather than declare his intentions, he largely reiterated his willingness to serve if a coalition emerged that was committed to his reform agenda.
The coalition Monti has in mind appears to between the center, including the UDC, and the center-left-PD. Polls suggest such a coalition, with Monti’s support, could provide the basis for a stable government. However, besides the gravitas in Brussels and Berlin, it is not clear what Monti brings to the table. With the Italian recession deepening under his austerity and reform agenda, Monti is not particularly popular at home. Moreover, the PD’s Bersani, a former communist, has his own ambitions for the premiership and will have to form a coalition to govern.
Meanwhile, Monti’s coyness seems to work in Berlusconi’s favor. Many of Monti’s reforms lack full democratic legitimacy owing to the nature of his technocrat government and his penchant for
governing by decree. Berlusconi offers a populist rearguard attempt to dismantle Monti’s reforms. In lieu of a more compelling vision from the center-left, Berlusconi can fill the vacuum. Monti seems to think he is above politics, and therefore of the Italian people. Say what you will of Berlusconi he revels in politics and the people’s appetites.
Third, in November 2011, I suggested that Europe could learn something from the lowly NY Mets baseball team. In order to encourage more home runs, the Mets did not reform through acquiring new talent or devise a way to boost productivity. They simply brought the fences in. The European Commission is going to do the same thing. Reports suggest the EC will give Spain and France more time to reduce their budget deficits to 3% of GDP.
France would get another year which means 2014. It is not clear what Hollande did to “earn” this forbearance. The press reports are light on details. There seems to be some debate over how much more time to grant Spain. The reports suggest the IMF is seeking two years, while the ECB is pushing for one. The formal decision is unlikely ahead of the EC review of Spain in mid-February. However, it would seem to be both cause and effect of Spain not requesting assistance from the ECB’s Outright Market Transaction scheme.
Fourth, Japan’s Abe, who will be sworn in as prime minister for the second time, was clearly not satisfied with the BOJ’s move last week to expand its asset purchase scheme for the third time in four months. The BOJ bought some time, indicating that it will review its inflation target at its meeting on January 21-22. Abe threatens two things. He will appoint people to the top posts at the BOJ that share his sense of urgency and vision. He also threatens to change the BOJ’s mandate.
Many participants have high conviction that Abe will succeed not only arresting the yen’s strength but reversing it. Into the run-up to election on December 6, market participants were paying a record premium to acquire the right to sell yen (referring to the benchmark 3-month risk-reversals).
The key behind the yen’s strength never seemed that it was because the BOJ’s inflation target was too low or that it did not have open-ended QE (doesn’t expanding it 3 times in 4 months seem open-ended?). The heart of the problem seemed to lie Japan’s ability to recycle first its trade surplus, and now its current account and capital surplus. Will the weaker yen and stronger equity market discourage Japanese households and businesses from exporting their savings, in sufficient scale to offset the earnings stream from past foreign investments and from foreign investors buy Japanese assets, including the Nikkei, in which they tend to run under-weight positions? Therein lies the fate of the yen.