Sort of good news is very good news (of a sort) in markets for the moment

While the sizzling summer heatwave continues without abate around the globe, financial temperatures have decreased in the last few days. The US stock market indices, hitting official bear market territory last week, have managed to pull back as the VIX index, the so-called Wall Street’s fear gauge (a measure of the volatility of US stock prices), has retreated as well. Perhaps the most eye-catching development has been the rapid fall in the price of oil, to around $130 from last week’s peak of $147. Yet just one week ago, with bank stocks collapsing, oil prices reaching new peaks, the dollar falling to record levels against the euro and US government-backed mortgage institutions on the way to collapse, the world seemed to be once more going towards financial meltdown. This sudden turnaround, in turns, begs for answering the following questions: 1. What is behind the latest positive mood? 2. Are we finally seeing the beginning of the end of the liquidity cum credit cum financial crisis, as Deutsche Bank CEO Joseph Ackerman stated over the weekend or is the latest relief a temporary phenomenon like a summer rain and even hotter days are ahead for the financial landscape?

The answer to the first question is likely to be helpful in tackling the second, so let’s try to justify the recent positive mood in financial markets. A casual look at the last couple of weeks reveals that there was no major data release or market-mover event after the always-watched US payrolls data at the beginning of the week. We did learn that European economies are slowing down and US house prices are continuing to fall, but not anything to justify the positive moods in markets. On the contrary, as Wall street started to report earnings in the second half of week, markets had embraced the worse. However, the banks’ performance, while way from being stellar (or even mediocre), turned out to be better than expected, with the Bank of America being the latest bearer of “good bad news”. Moreover, unlike Japan in the 1990s, where banking problems ebbed on for a good 15 years, Wall Street is showing its resolve to clean its house. Not only banks are taking solid steps in getting rid of their dead assets, they are also working hard to cut costs, such as limiting their executives use of private jets’ (those Merrill executives have my deepest sympathy). The bottom line is that the market perception, supported by facts, is that banks are moving in the right direction.

In fact, there are other signs that the storm may finally be passing. While everyone has their own indicator of financial strain, the Princeton economist (New York Times columnist, prolific author and die-hard Democrat) Paul Krugman prefers the TED spread, the difference between yields on Eurodollar interbank loans (LIBORs) and US Treasuries. After falling from April to mid-June, as credit tensions eased, the spread shot up after the collapse of Bear Sterns, reaching 145bp early last week before starting to ease again since then. Moreover a chartist approach (the so-called technical analysis, the mere mention of which is likely to lead to crucifixion by the economics profession, which tends to dismiss such analysis as witchcraft) reveals that the spread has peaked five time since the summer of 2007, with each peak lower than the previous. So, maybe we are on the road to salvation.

However, it is way too early to declare that we are out of the woods. First, house prices are continuing with their downward spiral in the US. Unless house prices stabilize, we are likely to see more banking woes and credit strains. While the slack in US wages is a boon to inflation, it is one of a long line of indicators hinting that US Main Street is likely to feel the effects of the crisis once the effect of the recent tax rebates wears off. And perhaps most importantly, even if it is maybe on the way to recovery, the US financial system is still fragile; maybe a couple of “bad good news” is all the market will need to be painfully reminded once again of that unfortunate fact.

The Week Ahead

This week will be a litmus test of the age-old saying “when the US sneezes, Europe catches a cold”. This issue, set amidst the broader context of global decoupling, is currently on the market’s agenda. However, we can not ascertain how hard the US is sneezing to begin with: While underlying weakness in the US is being masked by tax rebates (the consensus forecast for second quarter GDP growth is around 3%), domestic demand growth is likely to ease further through the second half of the year as the effect of the rebates wears off. In addition, manufacturing production has fallen in the last three quarters and private sector payrolls have contracted every month this year. All in all, while there is still some doubt, we are likely to see more and more evidence that the US is in recession in the coming weeks.

On the other hand, it is much harder to ascertain just how weak Euro Area growth is. GDP grew at an annualized pace of 3.2% in the first quarter of this year. While this figure compares favorably with US’s 0.9%, Euro Area growth is likely to get a correction when the second quarter figures are announced on August 14^th. However, GDP numbers are notoriously volatile, so business surveys are probably a better indicator of the common currency economies, and this week, we get important indicators on that front, most notably the German ifo survey and Euro Area manufacturing PMIs, both on Thursday. The market is expecting the latter to remain below 50, signaling continuing contraction in the manufacturing sector. Similarly, the consensus view is for another substantial fall in the ifo survey (to 100.0). While these outturns, if realized, would suggest that the downturn in the Euro Area is well underway, the economy is likely to avoid a technical recession (defined as two consecutive contractions of GDP), given that consumption continues to hold well and exports are still being buoyed by the relative strength of emerging markets in the export-oriented big three economies. However, credit and macro analysts from leading banks and research houses are pointing to decoupling of a different kind in Europe, that the varying growth prospects in Europe are being reflected in the spreads of sovereign credit default swaps, which insure against the country’s debt of defaulting. In particular, as it has been noted, it has become increasingly expensive in the last couple of weeks to get insurance against the debt of Greece and Italy, while German and French CDSs have barely bulged. While the claims certainly make sense, there might be a liquidity effect going on as well, since the bond markets of the latter are much more liquid, an issue which I tend to return to later in the week. The upcoming European business survey will also shed light on this issue.

Meanwhile, on the other side of the Atlantic, we get house prices, the Fed's Beige Book, existing & new home sales, durable goods orders and the final Michigan reading for June. As is the norm, there will be a couple of Fed speakers, which the market will be tuned in order the have a better sense of the Fed’s perception on the risks to inflation on one hand and growth, on the other (note that with the financial strains easing, the markets have raised their expectations of rate hikes for the year from 25bp to 50bp). In Europe, we also get German consumer prices, Euro Area money supply & credit, and in the UK more mortgage lending figures and the latest Bank of England minutes. Among this second-tier data, I would devote my attention span to the money figures, as the European Central Bank (ECB) follows those figures carefully for early signs of inflationary pressures- in fact, the ECB recently published a couple of research papers reestablishing the link between money & credit and inflation. Finally, it's another relatively quiet in the emerging world this week, with no change in interest rates expected in Hungary.