Tuesday, November 1, 2011

When will bad news be good news?

The ink is barely dry on the eurozone Grand Rescue Plan and now we have a chorus of "it won't work". I was part of that chorus (see my previous posts here and here). Over the weekend, the bad news kept on coming:
  • Greek prime minister George Papandreou has proposed a referendum early next year on the wildly unpopular rescue package. I wrote here that the success of the Grand Rescue Plan depends on the cooperation of the Greek Street and thought that they would acquiesce as long as no further austerity cuts were asked of them. Now that assumption seems to be unraveling.
  • Portugal is unraveling and asking for a bailout. Analysis from John Hussman indicates that the implied default probability from Portuguese bonds is somewhere between 68% and almost 100% within two years.
  • Chinese premier Wen Jiabao has pledged to maintain curbs on the Chinese property market.
  • China has signaled that it will not be the savior of Europe.
  • The 10-year Italy-Bund spread is blowing out. Though Macro Man postulates that the selloff in Italian bonds is a natural reaction because investors don't trust the sovereign CDS market because the rules can be changed so defaults become "voluntary". As a result, they are shorting Italian paper as a hedge.
While the news appears to be bearish, I also wrote in my last post to beware the policy response. We have the FOMC meeting this week and the subsequent press conference on Wednesday and the ECB rate decision and press conference on Thursday.

Will the Bernanke Fed stay with the message of "we can't do anymore, it's up to fiscal policy" message in order to put more pressure on the deadlocked Super Committee? Or will the doves win the day and signal it is willing to undertake QE3, which will likely be in the form of MBS purchases, were the economy to weaken further?

What about the Draghi ECB? Will it lower interest rates? Or will Draghi show the Germans that he is more German than the Germans in the price stability message. Ed Yardeni may already have an answer to that question. The (Trichet) ECB has already been quietly expanding its balance sheet, perhaps as a sign of pragmatism or a precursor to QE.

While I hate conspiracy theories, these actions by the ECB suggest that a backroom deal had been done. First, on the day that the Grand Rescue Plan was announced, Mario Draghi "independently" asserted that he supports continuing the ECB program of sovereign (read: periphery country) bond purchases, which was supposed to be temporary and end when the EFSF came into being. Now we find out that the ECB under Trichet has been expanding its balance sheet, albeit in a minor way.

Putting it all together, these signs point to an imminent ECB easing and friendlier environment for quantitative easing in Frankfurt.

Watching for a shift in market psychology
For me, the most important "tell" of market psychology is how it reacts to good news and bad news. Supposing that the Fed and ECB were to signal tilts towards easier monetary policy this week. Bruce Krasting wrote that the September NFP figures may have been unusually strong because it had five Fridays, which meant that people getting paid every two weeks may have received three paychecks and that Five-Friday effect would have distorted the economic releases for September. By contrast, October 2010 had five Fridays but October 2011 only had four Fridays, which could lead to disappointment on a yoy basis.

Supposing that Krasting is correct and the NFP release next Monday is disappointing. If the Fed were to signal a more accommodative monetary policy based on further economic weakness, will bad news become good news for the equity markets?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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