Markets are too addicted to repeated doses of cheap cash

THE MOOD OF the financial markets is becoming more downbeat. The enthusiasm driving strong share price increases since last autumn has given way to a wary attitude. Traders and investors are realising that the economic situation will remain precarious for the foreseeable future. Large injections of liquidity by the major central banks have played a key role in underpinning recent bouts of optimism. Earlier threats of banking crisis, disorderly eurozone breakdown or renewed recession have receded. But underlying solvency problems remain unresolved, and some of the dangers that have so far been averted may recur in the next 12-18 months.

The markets’ unease is being driven by renewed eurozone debt concerns, by disappointing US data, and by uncertainties over whether the Federal Reserve will launch a new instalment of quantitative easing (QE3). There are also worrying signs that the markets are becoming too addicted to doses of cheap money from the central banks. As a result, equity and gold prices have lost some of their gains, the euro has weakened, and the dollar is stronger. But Brent oil remains above $120/barrel, raising fears that falls in inflation may not be as large as the central banks are hoping The European Central Bank’s (ECB) long-term refinancing operations (LTROs), which involved the lending of almost €1,000bn (£825bn) to eurozone banks at very low interest rates, clearly helped to restore confidence. By strengthening banking sector balance sheets, LTROs raised demand for, and reduced yields on, periphery sovereign bonds such as Spain and Italy. This was a major factor in alleviating threats of an imminent euro breakdown. However, the LTRO benefits are now waning. Fears over a new euro crisis have resurfaced, as Spain’s ten-year government bond yield rose to its highest level since mid-December 2011, and a Spanish debt auction was given a disappointing reception. The Greek bailout has produced temporary relief, but the euro remains vulnerable.

The eurozone is facing recession. Unemployment rose for a tenth consecutive month in February, pushing the jobless rate to a new high of 10.8%. Huge divergences between core and periphery (Spain and Greece jobless rates are above 20%, while Germany and Holland are below 6%) highlight persistent tensions. Recent purchasing managers surveys indicate that there are declines in eurozone manufacturing activity in March, worsening risks of a downturn.

As expected, the ECB has kept official interest rates unchanged at its early-April meeting, at the record low level of 1%. Eurozone inflation, at 2.6%, remains higher than the ECB target of “below but close” to 2%. Nevertheless, in order to sustain demand and prevent the outbreak of a new periphery crisis, we expect the ECB to inject even more liquidity, and soon cut its official rate to 0.75%. Any increase in ECB official rates is most unlikely until mid-2013 at the earliest.

Lacklustre upturn

US economic performance remains healthier than in the eurozone. But, though the US does not face short-term threats of recession, the recovery is feeble. The housing market remains weak. Although house prices have shown signs of stabilising, they are still 3.8% lower than a year ago, and housing starts fell 1.1% in February.

Most worrying, the US labour market, which has been a major driver of the recovery, has slowed sharply. The US economy has created only 120,000 new jobs in March, well below expectations of more than 200,000. The pace of job creation in March was the weakest since October 2011, and compares with an average of 250,000 in the previous three months. The US jobless rate fell from 8.3% to 8.2% in March, but this was mainly because many discouraged workers stopped looking for a job and effectively left the workforce. Once growth strengthens, these people would start looking for work again, heightening the risk that the US may face a “jobless recovery”.

In the face of a lacklustre US economic upturn, and with modest core inflation at 2.2%, the Federal Reserve’s messages were unclear. After indicating that official interest rates are likely to remain exceptionally low until well into 2014, the Fed unsettled the markets by giving conflicting signals over the prospects for QE3. After initially dampening market expectations of an imminent increase in QE, Fed chairman Ben Bernanke reignited hopes by expressing concern over future job creation in the face of weak growth. The markets find the current situation confusing, but the addiction to cheap money is excessive and the Fed cannot realistically be more explicit. With our forecasts showing that US growth in 2012 is likely to be nearer to 2% than 3%, a further dose of QE is still a distinct possibility.

Positive signs in the UK

In the UK, after negative GDP growth of 0.3% in the last quarter of 2011, a stream of encouraging business surveys point to positive growth in the first quarter of 2012. However, there are concerns that exceptional distortions in the construction sector may produce negative first-quarter growth and push the economy into technical recession. Though this is unlikely, the possibility cannot be entirely ruled out.

It is important to stress that the positive business surveys give a better picture of true UK position in the first quarter. But, longer-term growth trends in the economy are still too weak. There is clearly a need for more effective growth-enhancing policies.