Tape painting?

By Marshall Auerback and Edward Harrison

Marshall here. That was an impressive rally into the close in New York. Stocks ended up across the board. Yves Smith, who was off the grid today, asked “was there any news driving” the rally into the close or was it just tape painting. Here’s what I wrote:

No, I think it was pretty sold out. You could see that throughout the day. I think it could well go lower, but the faster this crisis intensifies, the better it actually is ultimately for the markets, because it will bring resolution and you probably want to start looking at some long ideas (which I haven’t wanted to do for a long time, I confess).

Consider this as a possibility: That Stark and Weber are now out means that the Austerians are losing ground in my view. They will have satisfied their moral hazard stance when they boot out Greece, and then they can go back to playing nice. Think Fed after they let Drexel go. You punish the guys who never should have been allowed to join the club in the first place, and then you recapitalise.

So in effect, you reverse 18 months of austerity. Now, Rob will tell you this does nothing to enhance aggregate demand, which is true, but it would alleviate a large chunk of the systemic risk.

Not saying this is THE most likely outcome, but I think we have to start opening our minds to the idea that we’re getting closer to resolution. Germany has fallen 40% from its peak. Hard to say that a lot of bad news is not being reflected in prices.

There were some weird intra-day divergences today that led me to suspect that we might get a bounce. And also, some of the higher quality high yielding stocks actually appear to have bottomed around the first week in August, and have since traded above those levels.

Straws in the wind? Perhaps. But I don’t think it’s all PPT or paint taping. I guess we’ll know in the next few days.

Edward here. I was pretty succinct in my reply to Yves, saying “there was nothing behind it all”. There were rumours about the Italians getting the Chinese to buy up their sovereign debt. But really the news flow has not been good in Euroland or in the US, where BofA is laying off 30,000 people.

On Europe, I have a similar take but different conclusions. Germany is preparing for Greek bankruptcy because the present extend and pretend policy has reached the end of the line. The contagion is just too much to handle. French banks, sovereigns in Italy and Spain are now all infected with the sovereign debt crisis bug and this has spooked policy makers into finally accepting the inevitable hard restructuring I have been saying would eventually happen.

The problem is that the contagion has spread too far and economic growth has decelerated so quickly that this is well beyond the movement policy makers and electorates in Europe are willing to make. I take a more Austerian view of the Stark resignation than Marshall. I see this in much the same way I see the Fed policy debates. Back in March when speculation about extending QE2 was rife, hawks were trying to lead the discussion the other way. I put it this way:

Hawks like Bullard, and now Hoenig, are saying the Fed should cut QE2 short in order to anchor the discussion. That’s significant. If Bullard is saying they should stop QE2, let alone not do QE3, that is going to get everyone talking about whether QE2 will meet an untimely demise. Personally, I think that’s the goal because it makes QE3 a non-starter right now. Basically, the QE2 trade is officially over and people are now thinking about its end. In a sense, that’s a good thing because it can help determine how markets behave without QE as a backstop. As you can tell from my comments above, I think low rates and QE are distortionary and will have negative consequences down the line (see my post on how quantitative easing really works).

But, Hoenig and Bullard are not in control. The centrists and doves are in control of the FOMC. Bullard is anchoring discussion but that won’t change Fed policy in my view. I do think rates will be low for an extended period. So I don’t see Hoenig’s comments or his retirement as a big deal in terms of policy.

–Hoenig says Federal Reserve is responsible for bubble

The hawks were successful in anchoring the discussion at the Fed. With Stark actually resigning at the ECB, the hawks will be even more successful in Europe. Unlimited bond purchases are out – and that means contagion will continue until we see even more austerity or defaults. This is a scenario which is negative for growth, and hence negative for stocks, high yield or other risk assets.