Risk Appetite Set To Freeze

by: Tim Clayton

Severe arctic winds have reminded much of Europe that winter still has some bite and, in a similar vein, risk appetite is likely to peak as a more sobering reality returns. A key issue is that governments will look to take advantage of any improvement in conditions to row back on reforms and austerity as they face an increasingly hostile electorate. Key banking-sector reforms are also likely to be delayed with underlying issues left unresolved and business confidence is liable to dip again as seasonal components become much less favourable. The dollar should be able to resist heavy selling even if a Greek solution can be found.

Yet again, the Greek situation will have an important impact as the latest deadline for a deal approaches. Following daily promises that a private-sector restructuring deal would be concluded shortly, the mood turned notably more pessimistic late in the week, especially after Eurogroup head Juncker stated that the situation was extremely difficult. The PSI talks have been rapidly overshadowed by the real talks between Greece and the troika made up of the European Commission, ECB and IMF.

In essence, what is probably the longest recorded game of poker in history has still not been resolved. The Greek government is betting that the troika will not let Greece carry out a destabilising debt default. There has, therefore, been further delays in budget cuts and reforms as the coalition political parties look ahead to April elections. Once a PSI deal is concluded, leverage on Greece will decline and the troika wants a far stronger commitment to reform before then as frustration continues to mount. The troika has warned that no PSI deal will be accepted until reform guarantees are made and a deal must be concluded within the next 24 hours.

As negotiators face a series of catch 22 situations and the March 20th bond payment deadline, Greek officials may again calculate that the troika is bluffing. The austerity plans in Italy will also be watched closely as there have been some signs that an easing of severe market pressures on Italy, coupled with a series of satisfactory bond auctions, is also having the effect of lessening the urgency for internal reforms within Italy. There were reports on Friday that the government is looking for less intrusive international monitoring.

Central bank interest rate decisions will be an extremely important focus during the week, especially as there is a high degree of uncertainty over the outcomes. Banks will be feeling more optimistic as a combination of improved economic data and rising equity markets has lessened the doom-mongering and this is likely to be reflected in a subtle change of mood at meetings this week.

The aggressive liquidity operations have certainly eased the threat of a destabilising credit crunch as dollar Libor rates have fallen consistently. Evidence of solid growth has improved conditions, lessening the need for further central bank action. Given the underlying pressure for de-leveraging and a re-pricing of sovereign risk, the relief could prove to be short lived.

As far as the Bank of England is concerned, there will be calls for further quantitative easing, especially with money supply data extremely weak. The latest PMI surveys, however, have been better than expected with a notable improvement in the vital services sector. There has certainly been an easing of pessimism surrounding the economy and it will certainly be much more difficult to achieve unanimous approval for any additional stimulus. There is now a much greater chance that further quantitative easing will be scaled back or delayed.

To some extent, the ECB is facing a similar situation. The Eurozone as a whole has pulled out of the nose dive seen late in 2011 and there has been a marked improvement in liquidity conditions. The peripheral economies remain in severe difficulty and there will be further fears over deflationary pressures. The ECB in theory needs to consider monetary conditions throughout the Eurozone as a whole which will lessen the pressure for immediate action.

Political considerations will also be extremely important as the central bank will want to maintain the pressure for fiscal and wider economic reform. There will be concerns that an early move to cut interest rates again will increase the risk of delay and back-sliding on reforms. In this context, the bank will be tempted to make the promise of further support, but hold back from action at this stage, especially with the Greek situation still in a major state of flux and the ECB under intense pressure to take losses on its Greek bond holdings.

The Australian central bank will take note of fresh gains in the Australian dollar which would increase pressure for a further cut in interest rates. In contrast, the main central bank theme late last was fear surrounding the global economy and these fears will have eased since the turn of the year. The bank may, therefore, decide to hold further rate cuts in reserve for now.

After the traditional adrenaline rush of the monthly payroll data, the US economic data is unlikely to have a major impact during the week. Most attention is likely to focus on the University of Michigan consumer confidence data on Friday. The Conference Board reading for January was surprisingly weak and the Michigan data will be watched closely to assess whether there has been an underlying deterioration. Given the employment data it would appear more likely that confidence should be showing a gradual improvement.

Comments from Fed Chairman Bernanke will be watched closely with another round of congressional testimony on Thursday. Markets will want to assess whether the payroll report has had any impact on Fed thinking and whether the prospects of further quantitative easing have faded.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.