Three Thoughts for Friday

By Marc Chandler

The past two weeks have seen large disruptions in the global capital markets and various policy responses. Market participants are having a difficult time getting a handle on these developments. There are three things investors should consider before the weekend: 1) German-French meeting next week is suggestive of a new initiative, 2) FOMC decision to keep rates low for 2 years may be tantamount to a type of QE and 3) while a peg of the Swiss franc seems to be a non-starter, officials have succeeded in breaking the powerful one-way momentum.

France and French banks moved to the fore this week in the market’s angst. News that France, Italy, Spain and Belgium, though not Germany, had agreed to a ban on short selling of financial stocks for 15 days seemed to indicate that a new initiative from the Franco-German summit next week was unlikely. The editors of the Financial Times deemed that split to be headline material today. Now Germany has indicated it too is willing to consider the ban on financial shorts.

If Merkel and Sarkozy fail to propose fresh initiatives next Tuesday; if they merely recommit to the July 21 agreement, they risk adding to the market turmoil. Increasing the size of the EFSF, agreeing on a European bond are interesting possibilities, but something bolder would be better. The problem with bolder moves, however, is the weak political base and the treaty and constitutional barriers to fiscal union.

The Federal Reserve’s promise to keep rates low through at least mid-2013 has seen the US yields plummet. This provided a poor environment for the Treasuries refunding. Dealers took in a larger than normal share of the issuances, including the 30-year, for which the dealers took for the first time in years more than the indirect bidders. It is too early to say that this was a buyers strike–as even the 30-year was over-subscribed 2 to 1 (bid/cover), but the low yields may have deterred some buyers.

Even though the federal funds futures market was moving to push out the first Fed hike from 2012 into 2013 prior to the FOMC meeting, the Fed’s move may be seen as tantamount to a version of QE. Remember the Fed never called its $600 bln Treasury purchases QE. The purpose was to drive down the yield on the risk free asset to encourage the buying of riskier assets. The excessive reserves created under QEII are still sitting in member banks excess reserves position at the Federal Reserve. Treasury yields have fallen sharply this week–the week after the downgrade by S&P. The 2-year yield is off 11 bp and is now within the federal funds range and 3 bp above Japan’s 2-year yield. The benchmark 10-year yield is off 28 bp and is just above 2.25% now. The 30-year bond yield is off 11 bp this week to 3.73% currently.

The Swiss National Bank increased its sight deposits in two steps from CHF30 bln to CHF120 bln in the past two weeks. Its short term yields, reflected in the EuroSwiss futures strip and through its 2-year bond, offer negative yields. There are a number of other steps that Swiss officials can take, but speculation of a fixed exchange rates or a band vs the euro is simply impractical and a non-starter. It would be tantamount to joining the EMU without the benefits. Most observers recognize this, but Swiss franc is making new lows for the week today against the euro. Or to say the same thing, the euro has risen from CHF1.0075 on Tuesday to CHF1.1047 today, which barely puts it back into last week’s ranges. The violent squeeze on long CHF positions has had powerful ripple effects on other currencies as crosses are also forced to unwind, not just euro-Swiss or dollar-Swiss.

The best thing for Switzerland could be a global equity market recovery and for the Merkel-Sarkozy meeting to take fresh, market convincing initiative. The next technical retracement objective comes in near CHF1.12 for the euro.