Markets Insight
November 13, 2012 12:09 pm
Washington, not markets, calls the shots
US politicians face formidable challenges putting the country’s public finances in order. One they have escaped is the sort of bond market pressure that has plagued eurozone governments over the past three years.
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Thanks to the US Federal Reserve’s “quantitative easing”, now in its third round, Treasuries have extended a long-running rally. US equities dropped sharply last week as attention refocused on the fiscal cliff of automatic tax increases and spending cuts that, if not pre-empted, take effect from the start of next year. But bond yields, which move inversely to prices, have eased further.
Contrast that with the soaring yields felt by governments in Ireland and across southern Europe since the eurozone crisis erupted late in 2009, which have forced sweeping fiscal, banking and structural reforms.
Rather than providing incentives for a sensible fiscal consolidation, Treasuries would benefit if the US fell off its fiscal cliff – the country’s borrowing needs would fall, reducing supply. The only snag would be a serious US recession that jolted the world economy.
James Carville, an adviser to President Bill Clinton, famously quipped in the 1990s that if he was reincarnated: “I would like to come back as the bond market. You can intimidate everybody.” But the Fed has eased policy hugely without any measurable pick-up in inflation expectations – sending the bond vigilantes into retreat.
“People did play the [inflation] trade but when, after a year, it doesn’t work, you can’t do it any more,” a US hawk tells me. “The Fed is monetising the debt. It’s as plain as your nose and somebody ought to say it.”
The political dangers of the Fed being the “only game in town” were highlighted recently by Lorenzo Bini Smaghi, a member of the European Central Bank’s executive board until the end of last year. Speaking at the University of Chicago, Mr Bini Smaghi warned that the Fed has “taken away the incentive from the fiscal authorities to start implementing the kind of fiscal adjustment which would be consistent with a sustainable debt profile in the US and would justify QE3.”
He went on: “If the real obstacle to sustainable economic recovery turns out not to be the high level of real interest rates – or I should say the insufficiently negative level of the real interest rate – but rather uncertainty about taxation on households and firms, which is bound to prevail as long as there is no credible medium-term fiscal adjustment plan, and if QE3 delays the adoption of such a plan, one could conclude that QE3 is in fact adding to uncertainty.”
Mr Bini Smaghi spoke from bitter experience. The ECB had made mistakes in its own dealings with governments during the eurozone crisis, he admitted. In May 2010, Jean-Claude Trichet, then president, launched a government bond buying programme, only for politicians to delay the launch of a planned European bailout fund.
Bank stress testing and recapitalisation steps were also delayed. “All this led to a reversal of market sentiment and a frustration of the ECB’s actions,” Mr Bini Smaghi complained.
Similarly, in summer 2011, the ECB rescued Italy and Spain by intervening in their bond markets – only for reform pledges to be watered down, especially by Silvio Berlusconi, then Italy’s premier.
Learning the lessons, Mario Draghi, ECB president since November 2011, has insisted on strict “conditionality”. Under his recently launched “outright monetary transactions” programme, the ECB will only buy Spanish bonds if Madrid agrees an economic reform programme with European Union authorities and the International Monetary Fund. If the programme goes awry, then at least in theory the ECB will stop buying bonds – although, Mr Draghi’s resolve has yet to be tested.
In US financial circles, there is not a little awe at Mr Draghi’s apparent grip over eurozone politicians. The Fed operates in a different political environment.
It was created by Congress, rather than an international treaty as in the ECB’s case. It also has a dual mandate to tackle unemployment as well as inflation. The political backlash Ben Bernanke, Fed chairman, would face if he postponed action to help the jobless in order to pressure politicians is easy to imagine.
Financial markets have not let the US politicians off the hook, of course. Share prices have shown fragility in the face of uncertainty and the threat to growth from gridlock in Washington. Corporate bonds could prove vulnerable. Another US credit rating downgrade could knock share prices further, even if the politicians shrugged off the rating change itself. Share prices have a large impact on Americans’ wealth and economic confidence. But equities – unlike bonds – do not directly affect government borrowing costs. In the world’s most market-orientated economy, it may not be markets that call the shots in the weeks ahead.
The writer is the FT’s capital markets editor
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Copyright The Financial Times Limited 2012.
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