Weekly Pulse: Fed could twist the curve

By David Andrews | September 19, 2011 | Last updated on September 19, 2011
3 min read

As expected, equity and fixed income markets took their cues from the ebb and flow of news out of Europe this week. The appetite for risk was initially quite weak following Moody’s credit downgrade of two French banks and news that another rogue trader (this time, one at UBS) had lost as much as U$2 billion due to unauthorized trading.

Makes you wonder what would have happened had he earned rather than lost the $2 billion? Investor sentiment shifted in decided fashion on reports that China was now in talks with Italy and looking to invest in Italian bonds and other strategic assets.

Markets experienced another positive lift following a Sarcozy/Merkel/Papandreou conference call to discuss the next tranche of the Greek bailout. Germany and France said they are confident Greece will meet its 2012 fiscal targets and remain a part of the European Union.

A further shot of adrenaline was a European Central Bank statement indicating they would join forces with the Fed, the Bank of Japan, and the Bank of England, to provide a US dollar lending facility to Euro zone banks.

These comments all but assured Greece it will get its next €8 Billion lifeline and gave reason for equity investors to rejoice with markets up for five consecutive days, the longest rally since July. All eyes will be on the Federal Open Market Committee (FOMC) next week. The meeting, originally scheduled to be a one-day affair, was expanded to two days to discuss ways to provide additional monetary stimulus.

This is important since we find it hard to imagine the Fed scheduling a two-day meeting and not having some policy response come of it. Business and consumer confidence in the U.S. has been weakened by a leadership vacuum in the face of historically high unemployment and deep deficit spending. Bernanke and the majority of FOMC members will likely feel pressured to act soon. They are unlikely to sit idle as economic momentum wanes.

Canada’s dollar started the week below parity with its U.S. counterpart for the first time in a month but rose in step with global stocks finishing at a two-week high. Embattled Research in Motion reported yet another black and blue quarter as it struggles to compete with Apple Inc’s iPhone and Google’s Android software. Shares of RIM dropped 20% this week.

The Trading Week Ahead

The two-day FOMC meeting is clearly the highlight of this week. Given the weak economic data, the Fed is now almost certain to do something. The question is what will they do and will it be effective? The most likely proposal is to lengthen the average duration of the Fed’s assets. Dubbed Operation Twist, this appears to be the front runner as the rebound in the rate of inflation since late last year is likely to have made Fed officials leery of implementing further quantitative easing for now. Housing data will at best be mixed with housing starts falling last month even as existing home sales re-bounded a touch.

In Canada, August Consumer Price Index is released on Wednesday. The index will likely be unchanged on a month-overmonth basis, but slightly higher versus last year. Canadian markets, including the loonie will take their lead from global markets with little in the way of economic or corporate news to go on.

Aside from the ongoing debt crisis, the main focus in Europe will be on the September euro-zone composite PMI (Thursday) and German ZEW Index of investor sentiment (Tuesday). Both are expected to show the Euro zone continues to teeter on the brink of recession.

In China, the closely-watched flash estimate of the manufacturing Purchasing Managers Index for September is released Thursday. PMI rose in August, after successive monthly declines and remains below 50. China’s economy is expanding at a relatively slow pace. Any dramatic increase in the PMI would have positive carryover to the S&P/TSX.

David Andrews is the Director, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @David_RGMP

David Andrews