One Year Later, the Euro’s still hear and the Zone Lives as One

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“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

‒ Mario Draghi

Those were the now famous words of European Central Bank (ECB) President Mario Draghi this time last year as he pledged to do whatever it takes to save the Euro currency. And the markets believed him, thus far at least. It is only his words that have had to stand behind the recovery of the Eurozone as their central bank is yet to participate in the Outright Monetary Transactions (OMT) where they would act as a buyer in the debt markets to support struggling European nations. But as Europe proceeds’ forward, some analysts seem to forecast the worst is soon behind them in terms of growth as they attempt to escape a triple dip recession. The caveat, however, is the employment scene despite improving marginally is still dire.

The most pertinent part of a recovery in Europe is that it is sustained, and in order to attempt to bring their public finances back into balance it becomes necessary. Their states and governments require revenue, and that is achieved from a broader tax base of an economy that has reached full employment. Jobs have been the long term problem to any of the economic recovery’s around the globe. The United States is witnessing devastating effects to the long term unemployed members of their labour force, but particular to Europe are the stories of little prospects for the youth either graduating high school or university.

There is still a massive divide between the North and South Eurozone. It is no secret the German’s have benefitted from a strong export sector that has learnt to rely on a weak Euro. And for that reason, the German economy has a strong labour force. Michael Steen in the Financial Times writes, “if you are out of work in Germany and apply for a job, there is, statistically, just one other person vying for that position, but in Portugal there are 89, in Spain 71 and in Ireland 31.” That tells us that labour is immobile across the Eurozone, and either before or after Chancellor Merkel attempts to get re-elected this fall, Germany has decide what real part they will play in supporting the peripheral nations.

Under no circumstances will the Eurozone be able to move forward without greater integration between member nations, both fiscally and economically. And this is not a call for bigger government; moreover, there is a need, like elsewhere in the world, to systematically restructure their system of government. To make headway though and move forward, this recovery needs legs, and the recovery is dependent on jobs.

Continual improvement in the labour force will be the only way for Europe to move forward. It’s very similar to the US where indeed their employment situation is not perfect, but modest gains have continually been made to give their recovery traction. Everything in Europe is good news at the moment. Business surveys have turned positive for the first time in over a year and a half, and employment data in countries like Spain have shown improvement in the right direction. For things to continue to get better though, ‘sustained recovery’ is the key word.

A Farewell to Congress

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“The economic recovery has continued at a moderate pace in recent quarters despite the strong headwinds created by federal fiscal policy,” was Ben Bernanke’s opening line when delivering what is expected to be his final testimony before the often unpredictable US congress on Wednesday. Only if congress was smart enough to realize he was taking a shot at them. But as his testimony continued, he seemed to create a bit of a wobble in the markets, only to see them in turn trade higher as he reaffirmed the point that the fed intends to slow asset purchases this year should the US economy continue to grow stronger.

The main point of Bernanke’s testimony, and it is a central one that many continue to miss, is that US monetary policy is not on a predetermined course. While many are expecting the US Fed to begin to “taper” come September, they will only do so should the economy continue to show signs of improvement. It is strictly the data that drives the decision making for the Fed, and not what many believe to be the intuition of a bunch of policy wonks at the central banker.

That being said, this is particularly why Bernanke still sees easy monetary policy going forward as unemployment is still high and only making its way down gradually. And as gradual and moderate have probably been the most frequently used adjectives out there to describe this recovery, they speak to the point that improvements in the US labor market have been anything but robust.

The other roadblock continues to be that the measured level of inflation is under their targeted level, so in this regard there is no pressure to tighten monetary policy. Not only would tightening be premature, but also it almost becomes too restricting or unproductive. Albeit, as asset purchases may indeed slow from the US Fed, they continue to provide the forward guidance to let creditors and borrowers know that interest rates will stay low until at least 2015.

The explanation of the Fed’s policy approach highlights the three distinct policy tools in which they may interact in the economy: asset purchases (QE), setting interest rates (the Fed Funds Rate), and forward guidance (offering insight into policy direction). And despite the media not often being able to differentiate between the three, the Fed continues to present their objectives, which carry implications for the financial markets. It is the notion of forward guidance, however, that despite not being a substantive tool in the sense that it does allow the Fed direct interaction into the financial markets—it seems to have the most impact.

Forward guidance offered by the US Federal Reserve affects the market in what might be thought of as fed induced volatility. To the gold market, we know it as “buy the rumour, sell the news” because it was the announcement of a new policy of increased treasury purchases that created the catalyst for a rally, instead of the actual event.

For many investors who bet on the failings of a US recovery, we seemed to have hit a roadblock. To reference back to the opening sentence borrowed from Chairman Bernanke’s testimony, fiscal policy has been the biggest drag on the economy. However, that being said, the economy is improving. The US Fed utilized imperfect tools to try and assist in what seemed to be a hopeless task. The problem is financial markets don’t seem to worry about patching a hole in the roof when the sun is shining. We can talk all we want about how doomed the US social safety net programs are and how dysfunctional their system of governance is, but ultimately we’ll have to wait for the repercussions until it starts to rain again in the markets.

The Bernanke Put Lives On

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Investors who have been salivating for reassurance regarding the outlook for more monetary stimulus from Federal Reserve Chairman Ben Bernanke got their wish this last week. It truly is phenomenal that we can flip flop so many times on a consensus for the US Fed in terms of their direction for policy, but as Bernanke seized the opportunity to differentiate between asset purchases versus record low interest rates – the market rallied higher. And that was the key difference that the US central bank governor touched on this week. Winding down asset purchases is entirely different from the prospects of the Fed’s funds rate, their key interest rate, and since it has been record low interest rates that initiated this run of mispriced and cheap credit the story will play on.

In hind sight though, it’s almost as if the volatility and the uncertainty introduced by the Fed at the end of June was all for nothing. The first time around, the thought of tapering or easing back of monthly asset purchases pulled the carpet out from underneath the markets. It started a firestorm in the bond market and sent everything else except the US dollar tanking. As the apparent revelation came to be that asset purchases carried no implications for interest rates, risk assets came into play again. Assets ranging from equities to commodities to currencies all moved higher. And that is why it is important to differentiate between the two policies the Fed currently has in place. One is the extraordinary stimulus known as quantitative easing, and the second is control over the fed funds rate, which has been held at record low levels.

The Fed Funds Rate is akin to the overnight interest rate maintained by the Bank of Canada, and it very much gives the respective monetary authority power over the shorter end of the yield curve. QE was such a phenomenon when first introduced because it stepped beyond conventional monetary policy. It allowed the central bank to alter the prices of long term debt instruments, which carries extreme implications for the amount of control over financial markets. Never has the term free market been so distant since we have seen these policies in place, and now that central bankers have realized this ability to influence the markets in this manner, these policies have become almost common place.

With the world renowned Mark Carney now at the bank of England, awaiting their economy to achieve “escape velocity,” the developed world looks open for more and more easy money. Between the Bank of England, the European Central Bank, the Bank of Japan, and the instigating US Federal Reserve, a new norm has been rewritten in terms of coping with economic crises and let alone any slowdown in the economy. The belief still is that the Fed is likely to start tapering their asset purchases by September of this year. However, just to sit back and watch the markets react to random dialogue from the US fed (when nothing has changed fundamentally) indicates that the amount of uncertainty around how asset prices will fare when this day comes is still unknown.

My bet has always been that when the time comes, moving forward from QE and emergency level interest rates will not be as seamless as anticipated. Particularly because the underlying US economy is not as strong as many perceive it to be, and the outlook over the long term is weak due to the structural changes that have failed to be made.