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Analysis
Waiting for the bubble to end

Waiting for the bubble to end

Dislocation warnings loom ever larger

Hollande lays plans for ‘economic government’

by David Marsh

Mon 20 May 2013

For months, European central bankers have been warning of dislocation between financial markets and the real economy. No one has paid much notice, with equities proceeding to new highs on hopes of ever more central banking easing, coinciding with a continuing run of poor data confirming the miserable state of the euro area economy.

The signs are that the cautionary messages are starting to get through. As we head towards the sensitive period before the German elections in September, the next four months on the equity markets should be a great deal less relaxed than the last four. We are in a kind of bubble – central bankers prefer to speak of ‘misallocation of investment’ – and sooner or later it will come to an end.

August/September look set to be a particularly nervous time. Central banks are in the position of simultaneously chiding financial markets for getting ahead of themselves, yet also of being responsible for the credit-enhancing mechanisms that are giving market operators ever more reasons to put aside any feelings of bearishness.

Over the past 30 years, German elections have been the period for currency realignments within Europe’s old exchange rate systems. Now that exchange rates have been abolished within the euro bloc, that can no longer happen. But tensions can ensue in other areas, notably through an enlargement of credit spreads and a hold-up to the European Central Bank’s praiseworthy efforts to lower financial fragmentation.

One small sign of renewed nervousness was a Cyprus-related rise in April of the Bundesbank’s credit line to the ECB under the euro bloc’s Target-2 internal payments mechanism, ending a five-month run of declines in these balances.
 
Amid news that the 17-nation monetary bloc is still mired in recession, a combination of continued leverage (especially in Europe) and growing economic risks is increasingly reminiscent of the market’s pre-correction stage of 2007.
 
Anxieties about whether the levitation phase of world stock markets may be about to end have been heightened by the feeling that the principal influence behind buoyancy, quantitative easing (QE) in the US and Japan, may either be tapering off or losing effect – or both.

Stronger US economic figures this summer may intensify the debate over when the Fed should start curtailing quantitative easing. On the other hand, latest US inflation data, showing that revealed price pressures had fallen to their lowest level in two years, have continued to boost bond prices and lower yields.

An underlying drag on Treasury debt has been a sharp rise in Japanese government bond yields, as the world’s third-largest economy has engineered massive quantitative easing in a way that seems to be paying off in spurring higher Japanese growth – but is also sparking fears of ‘currency wars’ through forceful yen depreciation.

While the US Federal Reserve will be eager to withdraw QE firepower when appropriate, policy-makers are fearful of reducing support too early and impeding self-sustaining recovery.

Meanwhile underlying problems for the euro area have been underlined by French president François Hollande’s launching of an ‘offensive’ to bring ‘more growth and less austerity’ to Europe. Billed as an attempt to bury the hatchet with German chancellor Angela Merkel over well-publicised policy differences, Hollande last week laid down plans for further measures which are certain to draw scepticism from Germany.

They include a call for an ‘economic government’ for the euro, as well as the possibility of common borrowing – anathema to many in Germany opposed to euro bloc debt mutualisation.

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