The coming week will be a kind of make-or-break for the global financial markets. Not only do we have a Congressional election in the US, we’ve also got the FOMC‘s decision on further quantitative easing coming up. In addition, the European sovereign debt problem has taken a turn for the worst, with the difference in CDS spreads hitting a record high on Friday.
“The next few days will have a crucial importance on both politics and economics.”
The revival of political risks in Greece, Portugal and Ireland, and the growing potential of an Anglo Irish Bank debt exchange, caused the sovereign CDS spreads to widen further. The basis between the Markit iTraxx SovX Western Europe Index and Markit iTraxx Europe Index reached 53bp on Friday – the widest on record.
However, according to Markit.com, the SovX is trading with a considerable skew; “i.e. the theoretical level of the index is trading tighter than the index itself,” credit analyst Gavan Nolan writes in Markit’s weekly credit wrap.
And when comparing the theoretical levels of the two indices the difference is 36bp.
“A high level but nothing exceptional and well below the 47bp reached on May 6,” Gavan Nolan points out.
Formerly Known As “Political Risk”
Politicians have been derided many times for their often shaky knowledge of economics.
Ronald Reagan’s supply-side policies were dismissed as “voodoo economics” by none other than George Bush in the 1980 presidential race.
Probably one of the best indications of how deep the knowledge of economic and financial issues are (in general) amongst our political leaders, sadly.
More recently, the newly appointed UK shadow Chancellor of the Exchequer Alan Johnson has faced opprobrium for his supposed ignorance, even half-joking that his first action would be to “pick up a primer of economics for beginners”.
But whatever their levels of competence – and many of them are more than competent – the actions and utterances of
politicians have a direct influence on the economy and asset valuations.
“Events in the euro zone’s periphery over the past few days have made this evident. Political instability in two of the most troubled countries in the currency club has caused a mini-revival of the volatility seen earlier this year,” Gavan Nolan writes in this weeks market wrap.
Greece’s spreads widened sharply this week, reversing some of the strong rally seen over the last two months.
The Prime Minister George Papandreou warned that “we have not yet escaped the danger. I am sounding the alarm”.
As if this wasn’t enough to deter investors, Papandreou threatened to call a general election if his party fail to win decisively in the upcoming local elections.
Then the finance minister George Papaconstantinou weighed in, revealing that the country has “serious tax compliance issues”.
“Those familiar with Greece will regard this as a truism, but if the sovereign is to get its fiscal house in order then it needs to fix this issue quickly,” Nolan points out.
The country’s budget deficit is expected to be upgraded by Eurostat to over 15%, and the sovereign’s spreads are still indicating that a debt restructuring might be the most likely – and least painful – way forward.
“On the other side of the periphery, Portugal – hardly a paragon of fiscal prudence – has its own political problems.” Nolan comments.
Budget talks between the minority Socialist government and the main opposition party, the Social Democrats (PSD), broke down on Wednesday. The latter party is insisting that spending cuts should make a larger contribution to the austerity package.
It is likely that a compromise will be reached before the final vote on the budget next month.
“Nonetheless, the uncertainty created by the deadlock caused spreads to widen and they are set to remain volatile until an agreement is reached,” Nolan notes.
“Political friction in the euro zone will no doubt be relevant to risky asset valuations next week,” the analyst writes.
Theof the Week
But any fresh developments are likely to be overshadowed by events across the Atlantic, as Tuesday brings the US mid-term elections.
The polls are predicting that the Democrats will lose control of the House and maybe the Senate.
“As investors digest the implications of possible political gridlock they will be hit by the FOMC decision the following day,” Gavan Nolan adds.
The markets have been pricing in additional QE for some time now, and are expecting a confirmation on Wednesday.
The big question is how big – and how gradual – the liquidity injection will be.
“Prior to both events are the ISM and Markit Manufacturing PMIs on Monday (services on Wednesday) and then the week ends with non-farm payrolls on Friday,” markit.com informs.
“The next few days will have a crucial importance on both politics and economics,” Gavan Nolan concludes.
Related by The Swapper:
- QE2 May Not Be So Big, Stocks Pull Back (blogs.wsj.com)
- Greek prime minister makes pre-election pledge on pay and investment (guardian.co.uk)
- Political upheaval rocks eurozone debt markets (telegraph.co.uk)
- Ireland, Greece Debt Woes Reverse Sovereign Default Swaps Rally (businessweek.com)
- Beware Our Blind Seers (online.wsj.com)