Concerted action by world leaders boosts recovery hopes

There is more than a hint of possible policy co-ordination in the air. Countries very rarely act in concert when it comes to major policy changes, but last Friday saw some good clues that global policymakers are coming together to help repair the global economy.

The Eurozone threw its doors wide open to new monetary policy initiatives, Japan called snap elections to get a fresh mandate for more policy stimulus and China cheered the markets with a surprise rate cut. The fact that it all happened on the same day suggests something more than serendipity is at play.

Fear can sometimes be a very powerful motivator and the dread of another global downturn has probably spurred world policymakers into action to boost recovery. Global economic summits generally tend to be long on promises and short on delivery, but the spectre of another world recession might have been enough to tip the balance at the recent Brisbane G20 world leaders’ summit. Their pledge to boost global output by an extra $2 trillion over the next four years, combined with last Friday’s events, suggests a new watershed in policy efforts to get the world economy working faster again. Global markets could have something really tangible to cheer about.

The Eurozone has given markets plenty to worry about in recent years as one of the weakest links in the global recovery chain. But that may be changing very soon. On Friday, European Central Bank President Mario Draghi ramped up the rhetoric that unless the Eurozone economy improves soon, the bank must do everything in its power to raise inflation and inflation expectations and quickly. In other words, Draghi is giving his blessing for full-blown quantitative easing (QE) – by buying bonds and printing money to fast-track the Eurozone economy into much better health, stronger growth and fuller employment. It marks a major sea-change for the ECB and boosted investor hopes for a potentially happy ending. The markets loved it with the benchmark German DAX share index ending Friday’s session up a massive 2.6%.

Japan is also picking up the baton for change after the economy slipped back into a shock recession in the third quarter. Japan’s Prime Minister Shinzo Abe dissolved parliament’s lower house last Friday for a snap election in December. The markets see this as good news as it should pave the way for extra stimulus measures to boost the chances of faster Japanese growth ahead. Critically, the second leg of an unpopular sales tax, which has clobbered consumer spending in the last two quarters, has been put on hold. The Bank of Japan will continue to bear the brunt of recovery efforts through hyper-easy monetary policy and the next government will need to conjure up more fiscal stimulus to pump up demand. As long as a return to faster growth remains the over-riding priority it should be good news for Japanese stocks.

China joined in Friday’s day of action too, surprising the markets with a cut in interest rates to boost the economy as it struggles to overcome its slowest expansion in a quarter of a century. The interest rate cut followed disappointing purchasing mangers’ data which showed manufacturing activity stalling and getting dangerously close to contraction. Slower growth, lacklustre domestic credit expansion and the cooling property market mean that this rate cut is unlikely to be an isolated incident. The case for further rate cuts extending into next year will continue to build. The pressure on the Chinese authorities to deliver more growth and jobs is not going to go away any time soon.

Meanwhile, in the background, the US and UK are doing their bit for global reflation efforts – by doing nothing on normalising super-easy monetary policy just yet. While the rapid pick-up in growth and employment prospects in both economies would normally dictate quicker policy reversals, the US Federal Reserve and the Bank of England both seem reasonably content to delay tightening for now to allow conditions for sustainable recovery to consolidate longer term. And while the Fed and the BOE continue to hold fire on higher rates, it is reassuring for global equity markets to know that the US and UK are keeping a mindful eye on the bigger picture and helping to propping up global GDP in the process.

The global recovery may seem on tenterhooks right now but there is no reason for markets to lose heart. If global policymakers are starting to pull together and stepping up efforts to boost world growth in a more co-ordinated way, the chances of securing a recovery capable of enduring a lot longer should improve dramatically.

It would be a watershed that could extend the five year old rally in global stocks for a few more years to come.

Reprinted by courtesy of South China Morning Post - 24 November 2014

Avoiding a hard landing for euro economy isn't rocket science

Europe can achieve great success when it tries. The European Space Agency has just managed to plant a robotic lander on a tiny comet after a four billion mile journey through space. It’s a scientific achievement that could help us unlock some of the deepest secrets of the universe.

European economic policymakers on the other hand cannot hit a barn door with a shotgun. That means the odds of a hard landing for the euro zone economy are rising, not falling some six years after the global financial crisis first erupted.

Policymakers appear paralyzed by the after-effects of 2008-2009 crisis and 2011-2013 twin recessions. Weak economic confidence, high unemployment, grueling fiscal austerity policies and growth-sapping debt deflation are big problems, but they are not insoluble.

If Europe’s politicians had the same kind of focus as their top scientists, it’s hard to believe that we’d have suffered the half-hearted and mis-directed reflation efforts that have kept the euro zone economy at a standstill and made a slide into deflation seem inevitable.

Euro zone GDP growth squeezed a meagre 0.2 per cent rise in the third quarter after a 0.1 per cent increase in the previous period. Without another major push, the economy could be bouncing along the bottom of recession for years.

The bloc’s largest economies, Germany and France, were spared an embarrassing plunge into triple-dip recession, but only by a small margin and they are not out of danger yet. Italy has not been so lucky. It is suffering its third recession in six years and deepening its economic plight in the process.

Some of the former euro zone crisis countries have fared better, especially Ireland, Spain and Greece, but this will be short-lived unless the Big Three core economies can achieve a growth orbit that is not at perpetual risk of decay.Stronger euro zone growth though is not going to happen unless policymakers do something much more substantive to fuel the recovery. The key building blocks for recovery – stronger consumption, increased investment, greater stock-building, more government spending and faster trade growth – have all been badly damaged and it is up to politicians to fix them.

Unfortunately, the political boffins seem stuck in denial, relying on a stubborn belief that recovery will spontaneously self-start at some stage soon. Considering the dismal economic backdrop at home and the wider international economy, the chances of that happening without official intervention are remote.

Without a plan for radical action soon, European Central Bank forecasts for 1.5 percent economic growth next year look highly improbable, and the chances of another recession look a much more likely possibility.

On the monetary side, the ECB needs to get its skates on for a speedy launch of quantitative easing (QE) – printing money to fund mass purchases of euro zone government bonds that will allow credit to be pumped into the economy to get the recovery’s vital life-signs working again.

The longer the ECB delays QE, the harder it will be contain recession and deflation once they break out again. In the long run, the cost of prevention will be much cheaper than the political cost of a possible future EMU break-up.

A return to expansive German fiscal policy could also boost demand for consumer and investment goods from abroad, lifting global growth prospects. Germany is, after all, the largest surplus economy in the world.

Putting the euro zone economy back on a clear growth trajectory will be an epic journey. Like every mission into the unknown, it needs brilliant organisation and enterprising ideas to help it on its way. Without it, the euro zone recovery could end up lost in space.

Reprinted courtesy of the South China Morning Post 17th November 2014

How EU withdrawal could turn Britain into an economic backwater

Britain's economic destiny hangs in the balance in the next few years. The country and the European Union remain on a collision course and, thanks to Prime Minister David Cameron's pledge for a public referendum on EU membership by 2017, a future British exit (Brexit) cannot be ruled out. A deepening gulf between Britain and Brussels and British voters' growing disenchantment towards Europe mean the chances of a messy divorce loom large.


The stakes are high. The fallout from an EU exit could wreak massive collateral damage on the British economy. Britain might not only end up marginalised outside Europe, but its growth prospects could be left badly scarred for decades to come.

The EU has done itself few favours in recent years. The spectacle of Europe's crisis-strewn economy and the image of the EU's bloated, over-regulating bureaucracy have alienated Britain's public opinion. With the British economy basking in 3 per cent-plus growth right now, it is no surprise that British eurosceptics argue the moment has arrived for the country to break free. They contend that greater national sovereignty is the best passport to faster growth.

They would be wrong to think that way. Britain's economic fortunes are completely intertwined with Europe's, no matter whether the country is in or out of the EU. Mutual economic dependency is so strong that if Britain plugs for an EU opt-out, the damage to both economies would be extensive and long-lasting.

Business with Europe is important to Britain. Export earnings to EU countries are worth up to £240 billion (HK$3 trillion) and support more than four million jobs in Britain. With business with the EU possibly worth up to 10 per cent of Britain's output, withdrawal from the EU would pose serious risks for the country.

Britain is a major beneficiary of foreign investment inflows. Since the early 1980s, multinational corporations have flocked to the country after former prime minister Margaret Thatcher opened Britain's doors to a European free enterprise zone. Companies from the United States and Asia see Britain as their gateway to Europe's single market. If Britain exits, there is a danger that these overseas firms would leave in droves, shifting their operations to Europe. The potential loss in production, investment and jobs would be catastrophic for Britain.

Britain's financial services sector would be under threat, too. London plays host to more than 250 international banks, accounting for a third of last year's £71 billion financial services trade surplus. Most US and Asian banks headquarter their European operations in London, giving them a passport to provide services across the EU. If Britain withdraws from Europe, many of these banks would abandon London and relocate to other EU financial centres to guarantee business continuity. The impact on London's financial industry and the fallout on construction and the property market in the southeast could be devastating for the economy.

In the long run, it would be a blow the British economy would struggle to recover from. It would be hard to imagine home-grown British companies rushing to fill the gap left by the exodus of businesses decamping to Europe. It would take years of government nurturing and massive national reinvestment to repair the damage. The dire state of Britain's public-sector finances would tend to rule that out. Britain could turn into an economic backwater.

Right now, Britain has the best of both worlds by being part of the EU, but not the euro and its associated economic risks. Dropping out from Europe's single market and relegation to membership of Europe's free trade association would see a key diminution of Britain's sphere of influence in European policymaking.


Britain's pro-independence politicians are gambling that the country can do better striking out on its own, a risky ploy in an uncertain world. Indeed, the EU needs vital reforms to put its economy back on the road to recovery.

In the long run, the better option for Britain may be to Fixit rather than Brexit.

Reprinted by courtesy of the South China Morning Post

Yellen's Fed adjusting to life in the fast lane

All good things inevitably come to an end. In the case of the US economy, it was about time that US Federal Reserve Chairman Janet Yellen brought the Fed’s five-year bond buying programme – quantitative easing – to a timely conclusion. The US economy has been hogging the fast lane of recovery for so long that last week’s decision to ease off the monetary throttle and set the stage for a new policy era seemed long overdue.

In the last six years the US has been through challenging times and it has taken radical action by the Fed to beat off recession, deflation and a punishing financial crisis. Janet Yellen’s predecessor, Ben Bernanke, needed to be a trailblazer, championing the use of zero interest rates and unprecedented amounts of bond-buying to snatch the US out of the jaws of disaster. But the US has become so hooked on cheap money that Yellen will have her work cut out, weaning the economy off its dependency, without compromising sustainable growth and full employment in the process. The last thing the US economy needs right now is a toxic withdrawal shock.

The Fed’s controversial era of quantitative easing is over, but the Fed is not about to go into a painful knee-jerk reverse just yet. Despite heading into a sixth year of recovery, the economy still needs careful nurturing. US third quarter GDP growth at 3.5% may look impressive, especially after a powerful 4.6% growth spurt in the second quarter, but weak spots remain in the economy. Consumer confidence is still wavering despite the US jobless rate falling to a six year low of 5.9%. A tell-tale sign of continuing vulnerability is the downward drift in US inflation below the Fed’s 2% CPI target. And on-going global uncertainties are another reason for the Fed to tread carefully.

Even so, Yellen’s new monetary regime is already underway. As promised, the Fed brought its monthly bond buying programme to a close, but still stands ready to keep its massive $4.4 trillion balance sheet intact for the time being. It is an important bellwether for investors as it underlines the Fed’s commitment to keep financial markets awash with more than ample liquidity to support risk-taking and investment in the economy.

The Fed’s language has assumed a more hawkish tilt too. In an important departure from past policy statements, US labour market slack is no longer described as being ‘significant’. The Fed has also downplayed global risks to US growth prospects, especially recent financial market volatility and the weakening economic picture in the Eurozone. The minutes say the Fed “continues to see sufficient underlying strength in the broader economy”. In other words, the US recovery has enough stamina to stand on its own feet.

The Fed is sticking to its belief that interest rates should stay near to zero for a ‘considerable’ time, but warns that rate rises will be brought forward if the Fed’s employment and inflation objectives are met too soon. The market still envisages the Fed will bump up borrowing costs by mid-2015, but this could be sooner now given the Fed’s conditional link to the improving economic picture.

There are good reasons why the Fed can take its time. US monetary conditions have already started to tighten thanks to the impact of a stronger US dollar. Since mid-year, the US dollar index against a basket of currencies has appreciated by 10%, equivalent in monetary terms to a 2.5% rise in short term interest rates. Over the next year this could shave as much as 0.25%-0.5% off US growth potential – no bad thing for the Fed if they are worried about possible overheating risks. Given the bullish mood surrounding the US dollar right now, the proxy tightening effect on the economy looks set to extend even more.

And as market expectations continue to discount higher US rates ahead, the impact of rising US bond yields will do the Fed’s work for it as US borrowing costs start to rise up in step.

Yellen has set the wheels in motion for tighter money without any reason to rush into it just yet. The economy is moving well under its own steam, job-creation is making good progress and inflation is not a worry. Yellen can afford to wait and see how the economy shapes up over the next few months. The Fed has done its bit for global recovery and now it is time other countries to step up to the plate.

The Bank of Japan could not have picked better a better moment with last week’s announcement to crank up growth prospects with extra stimulus measures. The European Central Bank just needs to grasp the nettle for full-blown QE and do its bit to help revitalise global growth in the next few years. 

Reprinted courtesy of the South China Morning Post - 3rd November 2014

How to repair the global recovery in 5 easy steps

Confidence in the global recovery is at a crossroads and the uncertainty about the road ahead has clearly fed through to financial markets in recent weeks.

Much of the blame for the recent downturn in sentiment lies at the euro zone’s door where renewed risks of recession, deflation and the deepening of a supposedly cured debt crisis loom large. 

But it will take a global effort to stop the rot. Five simple steps can easily mend the process of recovery. But it will take determination, flair and resolute action to put them into play.

1. The euro zone must adopt full-blown QE. Another shot of monetary stimulus is urgently needed. The European Central Bank’s recent decision to buy asset backed securities (ABS) in the hope of sparking a bank lending spree to jump-start faster recovery looks far too tame. ECB President Mario Draghi has hinted the ABS buying programme could be stretched to 1 trillion euros, but an asset purchase programme at least three to four times that size is needed to deliver a turnaround like that seen in the US and UK economies. Unfortunately, the German government and the Bundesbank still stand in the way. For them, full-blown QE remains a domestic political taboo, but Germany must embrace its responsibilities as a world economic leader – prioritising its commitment to a stronger, united Europe, instead of being side-tracked by myopic domestic issues. The survival of the single currency is at stake.

2. The euro zone should suspend the Fiscal Stability Pact. Vigorous Keynesian fiscal reflation is the second pre-requisite for recovery. Inadequate ECB monetary easing efforts so far have been badly blunted by intense political pressure on euro zone governments to balance their budgets and cut debt. Austerity cuts have deprived the recovery of vital stimulus and left unemployment at record highs around the region. A number of countries, including France and Italy, have ditched debt reduction and made stronger growth their top priority. This leaves Germany increasingly isolated on its prescription for an economic revival based on a balanced budget and no new debt issuance. The Fiscal Stability Pact should only resume when the euro zone is back to full employment and sustainable growth. That could be many years away.

3. A weaker euro is crucial for an export led recovery. The euro’s 10 per cent fall since May has given euro zone exporters a much needed competitive boost, but the windfall would have been much better if policymakers had actively encouraged the euro to weaken even more. The euro probably needs to drop a further 10-15 per cent before stronger export demand begins to have a more positive impact on euro zone growth prospects. A weaker euro would also raise import costs and act as a further foil against deflation.

4. The US and the UK must hold their fire on monetary tightening. There is no need to rush into raising interest rates or to unwind their QE asset stockpiles, particularly while the outlook for global recovery looks uncertain and low inflation continues to loom over the US and UK. The US Federal Reserve and the Bank of England would both be better advised to keep their policy powder dry should global economic conditions take a turn for the worse.

5. China must maintain a bias towards more easing. With China’s growth rate slowing to 7.3 per cent in the third quarter, the economy risks missing its official annual GDP target – 7.5 per cent for 2014 - for the first time in 15 years. China’s authorities could definitely lend a hand with easier monetary policy to boost domestic demand, increasing the economy’s appetite for imported goods and services at the same time. It would be a positive step in the government’s quest to reshape the economy towards more domestic consumption. But China would also win greater plaudits for making a stronger contribution to global recovery.

This is a moment of opportunity for global policy makers to turn things around. If they fail and the world economy and financial markets dive, they only have themselves to blame.

Reprinted courtesy of South China Morning Post  27 October 2014

RBA risks confusing markets with mixed economic signals

The Reserve Bank of Australia seems to have lost its policy bearings.

No wonder given the mixed signals it is getting from data and developments inside its own economy, let alone that of the rest of the world.

Unreliable jobs data at home, a persistent housing bubble, a slowdown in China, weakening commodity prices, a very patchy recovery in G7 economies and anaemic world trade growth is not a helpful backdrop to policy making.

Especially for a central bank that is all too keenly aware of the latest warnings from the International Monetary Fund that record low interest rates in the world's major central banks are fuelling excessive risk taking behaviour.

The RBA has been laying the groundwork for a hike from its record low cash rate of 2.5 per cent for quite some time, wanting to steer policy back to better equilibrium with economic growth that has been in a strong upward cycle for several years thanks to the boom in the resources and mining sectors.

The markets have definitely taken the hint - forecasters generally expect higher borrowing costs to kick in around Q1.

The problem for the RBA is that the commodity boom has begun to cool - far more quickly than had been expected - while the spillover effects to the domestic economy, particularly in property prices, are still building steadily.

Hopes for stronger global economic revival have caught a bad chill. 

The Australian dollar - typically a very good gauge of global economic sentiment and risk appetite – has lost its mojo. 

But it is not just worries about slower world trade, weaker commodity prices and falling stock markets that have dented the Australian dollar in recent weeks. Currency markets may be awaking to the possibility that higher Aussie interest rates is not the safe one-way bet that it is supposed to be.

The downturn in global economic prospects opens up a new thread in the interest rate debate. Australia’s record low official cash rate might not only end up stuck at 2.5 percent for a lot longer than previously thought. But, in a worst case scenario, another RBA rate cut could be in the offing if the global downturn suddenly takes a turn for the worse.

That's bad news for investors paying closer attention to recent IMF warnings about over-easy G7 monetary policies leading to excessive risk-taking and credit expansion – possibly sowing the seeds for another financial meltdown in the process.

But the prospect of slower growth in China has a direct bearing on Australia’s growth outlook and on the RBA’s interest rate considerations too – not least because over 35 per cent of Australia’s exports go to China. If China suffers anything close to a bumpy landing, Australia would feel fall-out in a major way, forcing the RBA’s hand into easier policy.

This makes it much harder for the RBA to find its true bearings and get rates headed in the right direction over the coming months. The RBA needs to find the right balance between rising external risks while meeting domestic needs at the same time. This is being made doubly difficult by some of the mixed messages coming out from the Australian economy right now.

Australia’s housing boom continues to be a thorn in the RBA’s side. House price inflation in metropolitan areas is running close to 10% and recently as high as 14.3% in Sydney. Ultra-low borrowing costs are clearly feeding the speculative frenzy, but the RBA has recently intimated that lending controls might be the better option than using the spike of higher rates to pop the bubble.

Employment conditions are sending oblique signals on rates as well. Where labour market data may be providing clearer policy signals for central banks like the US Fed and the Bank of England, in Australia, recent employment trends have been just plain confusing, thanks to hefty back revisions in the jobs numbers.

It is leaving the markets with a sense that the RBA is ‘flying blind’ on rates for the time being. October’s policy statement reaffirmed the RBA’s commitment to keeping ‘a period of stability in interest rates’.

But the RBA needs to be very careful about the message that it is relaying on stable rates, especially while dropping hints that the Australian dollar ‘remains high by high by historical standards’. Aussie dollar bears will soon start to scent blood.

If global economic conditions take a further dive and the RBA starts to wobble the Australian dollar will soon start to tumble.

Reprinted courtesy of South China Morning Post  13 October 2014

The euro is a broken currency and possibly beyond repair

The euro’s survival hangs in the balance as worries about weakening fundamentals that have dogged private sector investors since the onset of the global financial crisis are now spreading to reserve managers at official sovereign institutions.

The European Central Bank is hardly helping matters. Repeated policy failure has seen the bets stack up that the euro will fall to re-test parity with the US dollar in the near future.

The risk is that the combination of weak euro fundamentals and the dollar’s correction from its massively oversold position could take the rate a lot lower.

Dollar bulls are on a stampede and the euro/dollar exchange rate could easily get trampled down to 2000’s US$0.8228 low. Historical precedents do not end there.

Back in the 1980s, when the dollar was at the peak of its super-strong cycle, the ‘synthetic’ euro was low as US$0.5698. That implies a halving in value for the euro in a worst case scenario.

Right now, the fundamentals are clearly stacking up against the euro – relative growth, inflation, interest rate and bond yield differentials all undermine confidence in the currency.

The euro zone is being sucked into a downward spiral of recession, deflation and deeper debt. A third recession in less than five years seems on the cards. Headline inflation has sunk to 0.3 per cent - a whisker away from negative territory. Employment prospects remain grim. The euro zone jobless rate is stuck near to its 12 per cent record high.

By comparison, the US is notching up 4 per cent-plus growth, inflation is almost back to the Federal Reserve’s 2 per cent target and new hiring is surging. The juxtaposition of US unemployment sinking to a six year low of 5.9 per cent in the October employment report is not lost on the markets. The dollar surged 1-1/4 per cent against the euro in the wake of Friday’s US payrolls report.

Diverging interest rate and bond yield differences could pile a lot more misery on the euro in the coming months.

While the euro zone could be stuck with negative interest rates for years, the Fed is preparing the markets for rate hikes. The job of ‘normalising’ Fed monetary policy could easily take US official rates back to 3-4 per cent in the next two years.

With 10-year US Treasuries now yielding 150 basis points over euro zone government bonds, it lessens the euro’s appeal even further.

Euro zone policymakers are in disarray. They are hitting the panic button on fiscal and monetary stimulus in a last ditch attempt to bolster growth and jobs – and rescue monetary union in the process. But by doing so, they founding policy icons of currency union are being systematically pulled down. Markets are not impressed by what they see.

Fiscal consolidation has been put on the back burner. France has abandoned any attempt to reel in its budget deficit. Other countries look set to follow. Deficits and government debt across the euro zone look set to mushroom.

The weakest link is the ECB. Markets now see it as a lame-duck policymaker. The delay in launching full-blown QE was largely because of opposition from Germany’s Bundesbank.  The rift does not impress the markets. 

Data shows that speculative positions are starting to build against the euro. Investors are switching from US dollars to the euro as the best funding currency to finance carry trades in emerging markets – especially with ECB rates set at zero for quite some time.

But the bigger risk is that central banks are losing faith in the euro as a reserve asset. International Monetary Fund data shows that since the financial crisis the euro’s share of global central bank reserves has slipped to 24 per cent from a peak of 28 per cent. 

If reserve managers abandon the euro, the outflow could quickly turn into a tidal wave. In that scenario, the target of parity for the euro against the dollar would get very quickly submerged.

Reprinted courtesy of South China Morning Post

Markets priced for perfection imperiled by rising risks

Global asset markets are priced as if the world economy is in perfectly upward trajectory, but a rising raft of risks suggests the best bet for investors could be on a secular recovery for the safe haven US dollar.

The threat of protracted economic slowdown, gnawing geopolitical tensions and an imminent end to nonstop easy money are there for all to see. Markets can only shrug it off for so long.

Market fear gauges like the VIX market volatility index have begun to trend higher from historically low levels. 

Investors should be looking for higher returns to compensate for implied higher risk. Instead complacency seems to have set in.

The world's major stock benchmarks are locked in a five year-long rally and US Treasury bonds are charging along in a 33 year super bull market. 

That has encouraged investors to turn to more esoteric assets to boost returns - commodities, exotic derivatives, structured products and hedge funds.

It is no surprise that the likes of the International Monetary Fund are warning about excessive risk-taking in financial markets.

The world's major central banks are getting nervous too.

They have craved a return to healthy and exuberant markets since 2008 when they were forced down the path of unconvential monetary policy and quantitative easing (QE). That would signal a return to more normal economic conditions.

What they now face is a monster of their own creation - a market in which animal spirits run wild, fed by excessively cheap money that has papered over the cracks of the legacy problems that remain in the international banking system six years after the global financial system almost fell apart.

Make no mistake though, a change is in the air.

Investors will feel it most from the United States. Five years into its asset buying programme – QE – the Federal Reserve is about to turn off the monetary printing presses. 

The Fed is calling time on zero interest rates and paving the way for higher interest rates that will halt the hitherto endless flow of easy money to US consumers, businesses and markets.

Without a doubt it will be a shock to the system and is bound to have adverse effects on economic confidence. The 4.6 per cent GDP growth rate notched up by the US economy in the second quarter of this year could well mark the peak in the present recovery cycle.

As the Fed wrestles to contain its massively inflated balance sheet - quadrupled in size in the last five years - it is not only domestic growth potential that will be affected. 

Much of the Fed’s funding trove has found its way overseas into emerging markets and high yield assets. The end of US QE could mark a significant sea-change in global investor sentiment.

Near-zero interest rates elsewhere also have nowhere left to go other than up in the long run. Bank of England Governor Mark Carney has already started warning that rates could go up more quickly than previously anticipated. 

The spectre of higher rates is not good news for investor confidence, which will also take a hit when markets inevitably start to look at the global economy with a sharper eye. 

The euro zone is sliding back down into a spiral of recession and deflation. The European Central Bank is dragging its feet so much that whatever policy response it comes up with will probably deliver far too little, too late. Political risks are also becoming deeply embedded. The survival of European Monetary Union and euro cannot be guaranteed in the long run.

Asian fundamentals fare no better. Japan’s economic stimulus strategy – ‘Abenomics’ – appears to be losing its edge. Growth potential has lost momentum and inflation seems to be slipping back again, threatening the government’s long run economic agenda.

None of this is being lost on China’s economy. The downturn in global growth prospects is already casting a much chillier wind on China’s outlook. Growth has plateaued out to a level well below the meteoric expansion rates enjoyed in the early 2000s. 

As investors look for more assured performance in an uncertain world, the US dollar will inevitably be rediscovering its roots as a reserve currency. 

The prospect of higher US rates, stronger relative growth and better safe haven protection make a compelling case for dollar bulls. The dollar’s secular recovery looks set to extend.

Reprinted courtesy of South China Morning Post 29 September 2014

Scotland's separatist legacy continues to haunt Europe

The people of Scotland have spoken and said ‘no’ to independence from the United Kingdom. In the immediate aftermath last week, there was a palpable sense of relief in financial markets. Market fear gauges settled down and risk trades were put back on. But it had a hollow ring to it. Market optimism has proven short-lived.

After years of closer integration in Europe, political fissures are starting to re-open again. The Scottish independence debate has been a rallying point for European separatist movements - especially in Spain, but in Italy and Belgium too. There is growing anger about Europe’s dire economic outlook. Unless some quick economic fixes come along soon, the future of the Eurozone and the euro are at stake.

Scotland will remain in the union of Britain, but the key issue for UK investors is whether Britain stays in the European Union. Political domination by ‘Westminster’ parties was at the heart of Scotland’s independence debate. Many UK voters feel the same way about autocratic and unaccountable EU bureaucracy in Brussels. These sentiments will come to a head at next year’s UK general election. A referendum on a future UK exit from the EU will be a key theme.

It is a trend unfolding in Europe too. At the national level, mainstream pro-EU parties are losing support to the political fringes thanks to growing anger over economic austerity and deepening voter distrust. At a regional level, it is leading to a shift in support for the pro-independence parties in a number of countries.

In Spain, attention continues to focus on the Catalan separatists who are calling for an independence referendum of their own in November. The poll is not recognized by the Spanish government but it could mark an important litmus test for growing disillusion with central government policies. Spain has been bowed under the yoke of tough fiscal austerity after the country opted for an EU bail-out in 2012.

Catalonia accounts for around a fifth of Spain’s economic output and tax revenues from the region make up a major slice of government finances. Spain’s ability to service its large public debt mountain – accounting for over 110% of GDP – would come under serious threat in the event of separation. It is no wonder that the central government is so opposed to giving Catalan independence a voice.

Spanish stocks and bonds were among Europe’s top performers in the wake of Scotland’s ‘No’ vote. But Spanish markets are not off the hook yet, especially if the Catalan referendum goes ahead in early November. It could still present Spanish and European markets with a nasty surprise.

The ‘No’ vote in Scotland does not signal the end of separatism in Europe – but it may change the rules of the game. Independence parties will be encouraged by how Scotland managed to secure pledges of new powers and extra economic concessions from the UK government on the eve of the referendum. This will not be lost on separatists in Spain, Northern Italy and in Belgium. Playing the independence card to extract more regional funding will simply deepen Europe’s budget mess.

There is a more worrying dimension. With the Eurozone economy overshadowed by recession and deflation, handicapped by austerity and high unemployment and saddled with crippling debts, there are still high odds that countries could dump the euro and leave EMU. Any country leaving EMU would spell out the deathnell for the single currency. It would unleash a domino effect among other countries.

At a time when Europe needs closer political, economic, monetary and fiscal co-operation to deal with the economic crisis, political cracks are becoming more apparent. Eurozone policymakers need to make a stand. A plan for structured reflation needs to be carefully crafted. Eurozone policy needs to be more cohesive and mutually inclusive for all economies on an equal footing.

For a start, Germany needs to drop its opposition to quantitative easing and give a free-rein to the European Central Bank to begin buying bonds to release a major new wave of cash into the economy. The scale of any QE programme needs to be at least three times greater than the one trillion euros plan recently hinted at by the ECB.

The Eurozone needs to abandon the Stability and Growth pact and loosen fiscal policy. France has implicitly already done this by suspending its budget deficit targets for two years. A mix of tax cuts and public investment spending initiatives should be channeled into promoting growth across the Eurozone.

The ECB should actively target getting inflation back to 2% and aim to boost domestic credit expansion. Eurozone bank should be forced to meet new lending targets. ECB interest rates should be pushed further into negative territory to force banks to lend.

The euro should be encouraged to weaken in order to boost export competitiveness and stimulate demand.

Europe has a choice – to let the economy sink or swim. Greater policy cohesion can stop the slide towards economic rot and the political disintegration that would accompany it. Europe needs to pull together rather than pull apart.

US dollar renaissance

The US dollar is enjoying something of a renaissance. Dollar fundamentals are on the mend and the currency is winning back investors’ hearts and minds. US growth is surging, job creation is in full swing and monetary policy is about to tighten. Interest rates and bond yields are set to rise. This week’s Federal Reserve meeting will be pivotal.

Other major currencies – the euro, yen and sterling – are fast falling out of favour with investors. Safe haven flows are flooding back into the dollar thanks to growing geo-political uncertainties. This could be the US currency’s defining moment.

The markets certainly stand in thrall and the dollar is showing a spirited recovery. It has notched up a straight 9-week winning streak – its best performance in 17 years. There should be more to come. The dollar seems set for long term secular recovery.

This week’s US monetary policy meeting will see crucial changes to Fed thinking. The Fed’s forward guidance for interest rate expectations and the Fed’s asset buyback programme are bound to come under scrutiny. Monetary policy is stuck in excessive overdrive.  The Fed’s key priority must be to stop over revving the economy.

Against mighty odds, the Fed has beaten off recession, defeated deflation and stopped the slide into financial meltdown. Animal spirits of recovery have been rekindled. US growth has surged to 4.2%, inflation is bang on the Fed’s 2% CPI target and the equity bull market is running at full kilter.

There are few signs of economic overheating yet, but policy needs to be normalised as soon as possible. US interest rates at zero per cent are hardly consistent with a healthy economy in the long run.

The Fed will turn hawkish this week. As a result, expectations for the first Fed rate tightening will be brought forward – probably sooner than next March. The Fed’s asset buying programme, which has quadrupled the Fed’s balance sheet in the last five years, will be closed within the next month.

This will have a seismic shift on interest rate expectations along the US curve. Short term interest rate futures should anticipate a faster tightening profile. As the Fed’s asset-buying fest dries up, the effects will be felt along the US Treasury curve in higher long term yields. This will be manna from heaven for US dollar currency bulls.

US dollar debasement has reached the end of the road. The Fed’s dogged commitment to zero interest rates and a seemingly inexhaustible appetite for Treasury debt has been the bane of the dollar in recent years. Artificially depressed US bond yields are now free to rise. The US Treasury market’s 33-year bull rally has come to an end.

Higher bond yields will be a powerful spur for US dollar longs. Ten year US government bonds already offer much better yield appeal relative to the Eurozone and Japan – and it looks set to get better as US yields continue to rise. Ten year US Treasury yields have hit a two-month high of 2.60%, 200-basis points over the Eurozone and 150-basis points over Japan.

On a relative basis the dollar looks a much better bet than many of its major currency rivals. The dollar stands head and shoulders above the euro, yen and pound.

The euro remains deeply affected by major uncertainties surrounding EMU – and whether the currency can even survive in the long run. The threat of recession, deflation and the impact of deep austerity cuts are forcing the European Central Bank into more super-stimulative monetary policy. Eurozone interest rates have dipped into negative territory and the ECB stands ready to bring out the Big Bazooka – quantitative easing. This is bad news for the euro. A slide back down towards parity against the US dollar is a very real possibility.

In Japan, the yen remains bowed by ‘Abenomics’, the government’s action plan to restore the economy to better health. As part of this, a weaker yen is aimed to boost exports and help meet the Bank of Japan’s 2% inflation target. The yen has already fallen 40% against the dollar in the last two years. A further 10%-15% yen slide could still be in the pipeline.

Investor perceptions towards sterling are being pummelled by the threat of Scottish independence and a possible future UK exit from the European Union. In the worst case scenario, an economically divided Britain, marginalised outside the EU, could lead to a very serious run on the pound.

Set against this backdrop, it is no surprise currency investors are turning to the dollar as a better safe haven hedge in uncertain times. With global political tensions heating up over the Middle East, Russian sanctions and the crisis in Ukraine, investors will increasingly turn to the dollar for sanctuary.

Emerging from six years of financial turmoil, US economic fortunes are in a much stronger position. This will not be lost on the Fed this week. And it will not be lost on the markets. The stronger dollar’s time has arrived.

Sterling risks becoming a doomed currency

Financial markets have a deep aversion to uncertainty. In the coming months, the UK economy and sterling will both be sucked into a vortex of the unknown. It is not just a possible shock from Scotland’s independence vote on September 18^th that is weighing on the pound. Further out there is a much bigger risk in store for UK markets.

UK politics are shaping up for a huge seismic shift in attitudes towards Europe. Next year’s UK general election could mark a High Noon for Britain’s future in the European Union. The stakes are extremely high and the threat to the UK’s future economic prosperity is considerable. Sterling stands at a crossroads. And it is no surprise global currency markets are starting to give the pound a wider berth.

Thanks to growing market worries, the pound has already sunk to a seven month low, losing 7% of its face value two months after hitting the peak of a six year cyclical rally in early July. The currency is likely to feel more pain in the short term – and over the long term too.

Next week’s Scottish independence vote will be cathartic for UK currency perceptions. There is so much at stake – not just for the pound, but for the UK economy and for Britain’s long term political future.

At this stage Scotland’s referendum vote is too close to call. Last minute polls suggest only a 2% swing to the Yes-camp would be enough to win independence for Scotland.

An outright win for independence opens up a Pandora’s Box of deep economic, social and political risks ahead. The only positive outcome for the pound would be for Scotland to reject independence. A short term relief rally would probably follow, but the damage has already been done.

Whatever next week’s outcome, Scottish independence is already a done deal at some stage. The momentum for change and self-determination in Scotland has been so great in recent weeks that the bandwagon effect is bound to carry over.

The economic consequences of Scottish secession are huge. UK GDP would shrink by 8% at a stroke. The UK economy will be deprived of key oil revenues - worth up to £6.5bn in taxes paid to the UK government last year. The crisis in UK public sector finances, already in serious trouble as a result of the post-2008 financial crisis, would deepen even further.

There are no contingency plans for separation. Deep uncertainties remain over Scotland’s currency intentions. Central bank supervisory authority is in serious doubt. There are major question marks over Scotland assuming any share of UK national debt. There are serious risks of a max exodus of Scotland’s financial services sector – major banks and fund managers – seeking cross-border refuge in the UK in the event of a split.

Political and economic divorce would be a very messy, long drawn out affair. Increased uncertainty will have serious consequences for investment, employment and growth prospects for years to come.

The structural shock to UK public sector finances would have grave implications for UK credit-worthiness. UK sovereign debt ratings would be badly affected. The risk of a run on sterling and a sharp sell-off in UK government bonds could lead to a very damaging rise in interest rates and higher long term yields.

Question marks over the pound would play into the Bank of England’s hands short term. The UK economy is well down the road to recovery and looks set to expand by 3.5% this year. The BOE are keen to ‘normalise’ interest rates as soon as possible. Raising UK interest rates from zero back towards a 3%-4% target in the next two years would help stabilise sterling in the event of a market run on the currency. More importantly, the BOE needs to keep a steady hand on the tiller in uncertain times.

There is a much more deep-rooted danger for the UK further ahead – the risk of the UK voting to leave the European Union at some stage over the future. This will come to a head at next year’s general election – due to be held by 7^th May 2015.

Recent polls show the majority of UK public opinion supporting an EU exit. It could be a self-fulfilling prospect. British Prime Minister David Cameron, under pressure from rebels in his own Conservative Party, has already pledged to hold a referendum on the EU by 2017 – if re-elected next year.

If the UK leaves the EU, the consequences for the economy would be cataclysmic. The UK economy could be ruined beyond repair. UK trade would be jeopardised, since the EU is Britain’s biggest trading partner. Major foreign companies would desert the UK’s shores for Europe. Output and employment would collapse – UK depression could be on the cards.

Britain without Scotland and marginalised outside Europe would become an economic backwater. There would be a very serious run on the pound. The odds of sterling testing parity against the US dollar would be very high. Sterling would be a doomed currency.

Sound bites: ECB delivers half the goods; more to come - QE will get its moment

The ECB has not learnt from its lessons. The ECB should only be rewarded 5 marks out of 10 for effort. The ECB has only delivered half the goods on easing. They have cut rates by a marginal degree and increased market liquidity, but there is a lot more they could and should have done to boost recovery prospects and to beat deflation. They should have deployed the big gun of real quantitative easing for a start. And they should have done a lot more to ease capital adequacy requirements weighing down on Eurozone banks to help boost borrowing. Domestic credit contraction has been one of the main factors obstructing recovery and lending needs to be freed up. The ECB simply needs to look at what the US Federal Reserve and UK Bank of England have achieved through effective QE programmes – much faster growth and much stronger job creation. With Eurozone rates at rock bottom and deflation risks rattling the front-gate, the ECB has no other alternative now. It is all about end-game. The ECB must embrace full-blown quantitative easing - printing money and buying assets - to put the Eurozone recovery back on track. Without it, the Eurozone recovery is at risk of crashing back down to earth and deflation risks will continue to fester. Japan had been stuck in the deflation doldrums for over a decade until it was prepared to bite the bullet with much more effective monetary pump-priming measures. Abenomics has finally turned the tide in Japan – faster growth and higher inflation have re-engaged. It is up to the ECB to learn instructive lessons from its G7 partners. The ECB should be bold with full-blown QE to take the Eurozone into a new era of recovery. The ECB must avoid being meek with fitful monetary measures or else the Eurozone will founder on the rocks of recession and deflation risks for another decade. Give it another three months and the ECB will be forced to adopt QE. Euro currency bulls are at serious risk now. EURUSD is set for a major break lower and should be down below USD1.30 within a month. Longer term, the euro looks set to trade down towards a much lower trading range of USD1.20-1.25.

High Noon for the ECB

Europe’s voters have spoken. Opposition to Brussels’ austerity has reached fever pitch. The clarion call to the European Union (EU) is for more growth and jobs. It is time for action.

This week is High Noon for the European Central Bank (ECB). Thursday’s monetary policy meeting should see new easing measures pulled from the hat. Expectations are running high. The odds are they will fall short of the mark.

The European elections marked a major watershed for change. Europe’s long-suffering electorate expressed its anger at the EU’s ruling elite in Brussels. The tide of protest is rising. Europe’s anti-austerity and euro sceptic parties are tapping in and gaining strong support.

Europe’s mainstream political parties have been shaken to the root. Gathering at a post-election summit, shell-shocked EU leaders were unanimous in pin-pointing faster growth and better employment conditions as vital policy imperatives ahead.

But Europe needs to go much further than this. It needs to dump austerity and kick-start Keynesian-styled reflation policies to fuel faster recovery and boost jobs.

Europe’s cash-strapped governments remain deeply hamstrung though. In the name of austerity, governments’ spending power has been radically constrained by the EU’s tough budget cutting mandate. This has reduced policy-stimulus options to a one-trick pony. Only the ECB is left to fill the gap and lift the Eurozone from the doldrums.

Major hopes are being pinned on the ECB this week. Front-running favourites for new policy initiatives are expected cuts to all the ECB’s key interest rates combined with a package of new measures to boost market liquidity.

Without a doubt, the ECB will be tip-toeing into unchartered waters this week. The ECB should cut its deposit rate into negative territory – possibly to the tune of -25 basis points. This would mark a first for a major central bank. The move is intended to boost lending by penalising banks for hoarding funds at the central bank, encouraging them to open up their doors to new borrowing instead. It is unlikely to be enough.

It is still tinkering at the margins of incisive monetary stimulus. The ECB needs to be much bolder. It needs to take the plunge into quantitative easing (QE) to boost growth and help steer the Eurozone off the rocks of deflation. The ECB does not need to look too far to see how effective QE can be when the chips are down.

The US Federal Reserve and the Bank of England both embarked on major QE programmes during the financial crisis. By printing money to buy assets – and releasing vital swathes of liquidity into their cash-starved economies – it helped secure the turnaround that put the US and UK on the express train to recovery. The ECB needs to do the same.

Unless the ECB intends springing a huge surprise on the markets, the QE option appears sidelined for now. That is despite past promises by ECB President Draghi to do ‘whatever it takes’ to save the euro. It may be the ECB prefers to hold its QE option ‘in reserve’ just in case economic conditions deteriorate once again. The ECB’s monetary arsenal is already dangerously thin with interest rates already at zero.

Delaying QE is taking a big gamble with the Eurozone economy. The recovery still needs to reach critical escape velocity to break free from the clutch of recession. Economic headwinds remain strong. Consumer and business confidence in the Eurozone is rising but is still generally diffident about the outlook ahead. Uncertainty about global economic prospects, worries about the crisis in the Ukraine and the long wait for additional ECB easing have all been clouding the recent picture.

Deflation remains a risk. Inflation has been stuck in the bank’s ‘danger-zone’ below 1% for seven months. The headline rate is currently at 0.7% with a bias still tilted lower considering the tepid demand-pull and cost-push tendencies.

Weak monetary dynamics back up the case for radical ECB action too. Eurozone domestic credit contraction running at -1.8% remains a major block on growth. Weak borrowing demand, restricted credit supply and a low level of economic confidence all compound the weak recovery picture.

The ECB can make a difference by pushing official interest rates into negative territory and forcing the reluctant banks to lend again. But it can do a lot more.

If the ECB can open the door to real quantitative easing, flooding the economy with extra liquidity and weakening the euro at the same time, the impact on the economy would be cathartic. Growth expectations for the Eurozone over the next year could easily double from 1% to over 2%.

Although German exporters may not need it, hard-pressed Eurozone exporters elsewhere would relish the added impetus to competitiveness and growth from a weaker euro.

The euro is already poised on the brink of a major break lower. With the US and UK on the cusp of higher interest rates,  the advent of Eurozone QE could be the nudge that pushes the euro back over the cliff. Euro currency bulls had better beware.

Re-printed by kind permission of South China China Morning Post