By Cees Bruggemans, Chief Economist FNB Cees@fnb.co.za

30 November 2010


For a moment earlier this year it looked as if the strapless bra was about to go out of fashion, making for another avalanche of Dollar weakness in the closing months of the year, deepening global currency unrest.

But each time risk appetite revived as the Fed gunned its monetary engines, a situation guaranteed to make for Dollar weakness (fully intended, according to the Chinese and ex-Fed chairman Greenspan) SOMETHING happens and pop goes the weasel.

The weasel is a very sensitive animal, scurrying for safety when danger lurks, for which reason weaseling out of something is a well known activity.

One can observe it nowadays daily in financial markets. Lively bond buying by the Fed should be a no-brainer for any self-respecting speculator and set juices going, dumping US assets and buying foreign.

But the world on an average day nowadays is muggy, not clear. The Fed bond buying itself is suspect, for what is it supposedly to achieve? Where is it supposedly to lead (if not higher inflation?).

And if it isn't the Fed that's being closely questioned about its honourable intentions, it is sovereign debt generally which seems to be gradually losing its long-term attractiveness due to pure fear.

This sounds ridiculous in big strong countries which big tax bases ready and willing to underwrite anything, even very high government bond borrowing.

But when the smaller Europeans start to belly, first Greece and now Ireland, with Portugal next and the biggie being Spain (with aspersion thrown on Italy, France, UK, even the US, in fact ANYBODY) one starts to wonder, especially considering the weakness of many banks holding such paper.

Thus we may have real reason to wonder. About future haircuts, not ONLY on new future debt issuance as the Germans now generously try to suggest, but also on existing debts held by many (weak) banks (as streetwise shrewdness would suggest being more and more possible, considering the rising political stresses in many of these countries).

Supposedly one doesn't loose innocence in stages, but that is the impression bond markets are giving.

They haven't even seen a whiff of inflation yet, except in old stamp collections of the Weimar period, but all this 'strange' central bank behaviour of buying so many bonds and injecting so much liquidity may be 'normal' to them, but it comes across as weird to the rest of us.

That text books prescribe buying trillions at moments like these in some countries doesn't make it sound any more believable to ordinary folk, including those populating investment houses and financial institutions.

So there's deep suspicion, indeed a fine paranoia evident. Ever so gradually, Western politicians with their delays and shock tactics are scaring bond markets through stages of lost innocence.

Instead of seeing long Anglo-Saxon yields approach the zero bound and their currencies depreciating robustly, as was the intention, in order to get equity markets and economies to bounce, we are seeing in fact the very opposite. Long bond yields have risen, not fallen.

To this confusing, threatening picture we must still add questions about a Eurozone breakup (with what kind of consequences?) and the Chinese domestic scene (with inflation strains and the willingness to tighten policy, backwashing into commodity markets and other risky assets, scaling down expectations left and right).

Instead of getting Euro, Yen and Yuan strength, also pushing other emerging and commodity currencies higher so that Dollar and Sterling can head further south, accelerating the needed global adjustment, we are back to the strapless bra condition.

Elevated risk is (again) creating a Dollar 'safe haven', keeping the Dollar magically suspended, high and dry, even while Fed actions should actually make it slide (as very much intended).

For many policymakers in emerging and commodity countries this must come as a welcome relief, a breather from 'the wars', as the upside pressure on their currencies is being lessened for now.

But such a breather is being bought at the expense of higher risk aversion, meaning higher long bond yields and lower asset prices, with in the back of the mind (as we know) always the fear of sudden outflows of capital and the destabilizing complications these can create.

So the respite isn't coming free of charge. The strapless bra condition imposes its own price, also not always wanted, depending how threatening it becomes.

So how will this end?

The sovereign-debt-cum-banking-problems in Europe look like playing for many years yet as enormous burdens are levied on many populations, while many investors would like to reduce their exposure to such assets.

There is enough strain here to keep us hopping for many a day, at times inducing risk aversion that also can hold back our markets, meaning bonds, equities and the Rand. That creates inflation upside potential and limits interest rate downside potential.

Meanwhile, the US economy is far from being at full throttle, with likely many years to go before again achieving more acceptable resource utilization. This suggests policy pro-activity of the exceptional kind still for a long time, potentially years. So watch the Fed, possibly getting impatient by not quite getting what it is actively looking for, potentially doubling up on its policy action, if that is what it takes in 2011-2012.

This can have the wished for effects of boosting US prospects through various channels, like a weaker Dollar. Or the backwash from such actions neutralizes much of its intended effects through elevated risk aversion in large parts of the world that otherwise would have been readymade recipients of global excess liquidity.

Thus the strapless bra fashion upholding the Dollar remains with us, returning for the fall (and winter) seasons (thinking up north), but potentially still many seasons to run, considering the state and complexity of the world, whether America, Europe, China or indeed the many small fry dancing to their tune.

For us it may mean the Rand has only limited firming and some weakening potential, however artificially crafted by global risk aversion. And this also could limit the downside for inflation and interest rates, creating scope for their upside.

Our asset prices could face more headwinds, while the balance of winners/losers in the economy would shift back to a more neutral Rand stance. Not an unwelcome condition, but not so much achieved by our own policy doings as accompanying the Dollar's strapless bra (global risk aversion stresses).

Meanwhile, among all that bond market restlessness, Euro pain and Chinese preoccupations, don't lose track of the Fed. It has its own timetable and looks like remaining pretty determined to deliver to the American People (a favourite expression over there).

Cees Bruggemans
Chief Economist FNB
Cees@fnb.co.za