Twist & shout

So the Fed has now come up with its latest wheeze to try and kick start the flagging US economy: the so-called "Operation Twist", which seeks to help bring down the yields on longer dated bonds by purchasing these as the Fed's current holdings of short dated Treasuries mature.

Whilst the Fed can't be blamed for trying, the base fact is that it is left with few powerful weapons in its locker, and is reduced to tinkering on the sidelines of the main event. As the Fed Chairman, Ben Bernanke, highlighted in his speech last month at Jackson Hole, the Fed's use of monetary policy is reaching the limits of its effectiveness and it is now up to the two year olds in Congress to come up with fiscal policies to address the current problems.

It's not an issue of the cost of borrowing: the Fed has reduced interest rates to almost zero and loan demand has remained anaemic. The core problem is a weakness of demand and therefore a weakness of sales: without either of these two things, few companies will be encouraged to make use of their substantial cash balances to invest in new capacity or the creation of new jobs.

Such a lack of confidence reflects the poor quality of political leadership in the US and Europe.

The two main parties in the US appear to have given up trying to reach any form of compromise, preferring to posture in front of their narrow bases, and ahead of an election that is still 14 months away (if you thought the election season of 2008 seemed looong, you ain't seen nothin' yet). In the meantime, of course, the economy will continue to flag, increasing the likelihood of a new recession, for which politicians of all stripes will share an equal element of blame.

In Europe the situation is as bad or worse.

It has been clear to virtually everyone for a long time that a Greek default is inevitable. The repeated attempts to force swingeing spending cuts on the Greeks do little, particularly when the consequence is simply to deepen an aleady severe recession in Greece. Such policies further postpone its ability to pay the interest on the new debts it is taking on (and don't even talk about repayment of the principal).

This week's edition of "The Economist" has an excellent analysis of the problems facing the Eurozone this week, and a possible solution. Not surprisingly, this focuses on the need for the Germans to get over their (understandable) annoyance about bailing out the profligate Greek beach goers and recognising that a managed default is ultimately preferable to the alternative: a disorderly default and the collapse of the Euro. The Germans, more than anyone else, have too much invested in the project to let it die (as an aside, don't forget that it was Germany and France that first bust through the deficit limits underpinning the Euro in the mid 2000's).

The disquieting thing is that politics is driving the timetable.

One gets the sense that the politicians are waiting for a greater sense of crisis before they have the courage to present the truth to their voters. In the US this means spending cuts and tax increases (otherwise the "Math" just doesn't work). In Europe this means fiscal union with a collectively guaranteed Eurobond to underpin the borrowing costs of all Eurozone members, but with far tougher enforcement and compliance from a German-led European finance ministry.

Will this happen? Probably, but the crisis could get worse in the meantime.

The only saving grace for investors in markets is that interest rates are not going anywhere any time soon. Any hint of adult leadership will result in this money sloshing in from the sidelines with nosebleed inducing speed.

Keep the tissues handy.

Steve
e-mail: steve.davies@javelinwealth.com
contact: +65 65577186

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