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US Federal Reserve Underwhelms as Euro Deal Reassures Markets

The Bundestag, where final approval for the EFSF rescue package was agreed on 29th September 2011 © Deutscher Bundestag / Werner Schüring

Stock markets of the world are in a manic depressive state as the US Federal Reserve’s  “Operation Twist” underwhelms.

The current financial crisis has manifested itself globally in different guises. In the form of US deficits, sovereign debt or trouble with the euro, these issues have created significant knock-on problems for economies and sectors globally.

The Australian dollar and the price of gold have fallen while Arabian Gulf bonds strengthen. While The Australian and Gulf Economies are outside of the Eurozone and US, the ripple effect is evident as investors look for safe havens during a time of volatility.

A lot is said about the euro and sovereign debt crises as well as the US double deficits – and rightly so, they are intertwined. The underlying drivers of this big picture are the chronic trade imbalances between Europe, the US and the developing world.

Over a trillion dollars of developed world capital ends up in the developing world every year as the result of trade imbalances favouring poorer nations. A flow of capital has turned into an avalanche. The developed world is being drained so fast it is bordering on collapse.

The governments of the West became accustomed to inventing and using new credit devices to expand money supply. They long-harvested the investment of the developed world, accessing capital to lever state sectors to unsustainable levels.

This cycle ended with the credit crunch.  As the tide of credit receded, the budgets of Europe and the US were left stranded on the economic high tide line. Economies of the developed world are now left hoping for another tide to re-float them. Unfortunately, there is none in sight.

This is why “austerity measures” has become the new catch phrase. Unless countries cut back on outgoings they will go bust, as is currently happening in Greece.
The level of debt and unsustainable spending is so huge that markets simply can’t price it in. All over the world, markets are shaking, as the outcome of the credit crunch begins to play out at an international level.

While the most severely affected countries during ‘Credit Crunch Part One’ could be bailed out by governments, there is no senior tier in place to rescue huge economies. Italy and Spain are not Iceland or Argentina; they’re so big no one knows what the knock-on effects of a debt failure would be. As the IMF said last week, such a failure cannot be planned for or modelled. The world economy is in uncharted territory.

The margins of the markets are in trouble. Commodities have collapsed. Even high stake ‘gamblers’ of the market are leaving the game to try and hide. The Russian stock market is quivering as Russians automatically think of themselves as being on the margin of developed world markets and therefore likely to suffer in any final market move down.

The world looked to the US Federal Reserve for another round of inflation to try and save the US economy, and hence everyone else. Instead ‘Operation Twist’, while looking like a $400 billion dollar stimulus, turned out to be akin to a shuffling of the deck chairs on the Titanic.

This lack of an inflationary boost was all it took to send markets diving off the ledge. The prospect of inflation is the best the market can hope for in the current situation. It’s the only deal in town. With the Fed turning away from it – at least for now – austerity is now looking real for the US, too.

This is why commodities collapsed. Commodities are the ‘anti-dollar’, a store of wealth against an inflating, devaluing currency. Stocks and commodities thrive in times of inflation – at least in terms of the price on the ticker, if not in terms of ‘real value’.  It would seem that cycle has turned.

Trade deficits are too high, so currencies must fall. This would inflate away huge debits and increase income. In turn, trade deficits would rebalance by increasing exports and lowering the attractiveness of imports. This, too, raises prices that increase income whilst lowering currency; so the inflationary cycle turns and the debts and trade balances of the developed world are expired.

The markets see this as the only trade. As Germany and the Fed seem to be reluctant to face the inevitable, so the market swoons. Yet if inflation is inevitable, and it is already becoming entrenched, so the markets will fly up.

Europe’s EFSF (European Financial Stability Facility) is set to pull out a 440 billion euro cheque to underwrite the euro and its ailing members – potentially all economies bar Germany. 440 billion euros would be a big monetary stimulus. It would certainly give inflation a push. It’s no surprise then that the markets are manic today, as I write, ahead over 2.5% in the UK.

With no real near-term solution to the core problems of bloated governance and huge trade imbalances, what’s certain is that volatility of a giant nature will continue. What’s more, it won’t take many miscalculations to send the market into a new, giant tailspin.

About Clem Chambers

Clem Chambers
Clem Chambers is the CEO of financial website ADVFN.com and author of “101 Ways To Pick Stock Market Winners".

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