Long wait for a new market dawn

How long before we can pronounce the effectiveness of US and European stimulus? Market calm indicates a begrudging acceptance policymakers are getting it right – but in the end, recovery will be up to the private sector.

Global financial markets have been remarkably calm in the last month. Daily share market moves are generally up and down not much more than a quarter or half a per cent. Bond yields in the G7 markets are little changed from levels a month or two ago. In currency markets, the US dollar is weaker as the market correctly judges that the Fed’s latest QE is a structural break for its currency, but in the event, the depreciation has been orderly.

Policy makers and investors should be delighting at this lack of volatility which reflects tentative news of an economic recovery and a growing acceptance that policy makers are finally on the right track.

Financial market participants have just witnessed some of the most far-reaching and radical policy changes ever seen. Those policy changes are of course focused on the open-ended bond buying from the US Federal Reserve and the European Central Bank, which are part of the "do whatever it takes” campaign to generate a sustained and meaningful economic recovery. Adding to the easing tone is the Bank of Japan which extended its QE with close to $US800 billion of asset purchases.

The relative market calm, which follows periods where it was not uncommon for daily stock market moves of one or two per cent or more, may also reflect a holding pattern for investors as the huge stimulus in the global economy weaves its magic on borrowing, lending, confidence and spending in the months ahead.

The market calm begs a question: How long should markets wait before forming judgment of the success or otherwise of the Fed and ECB actions?

Obviously it will later rather than sooner before we see economic and jobs growth return to normal levels in the US and much of Europe and with that, the repair of bank balance sheets and profitability. Indeed, it could well be a good year or two before there can be full confidence that the worst has definitively past.

Given its slightly more favourable position, the US recovery is likely to be earlier and more meaty than in the eurozone.

In a chicken and egg type situation for markets, if the economy in either the US or Europe improves earlier and faster than currently expected due to prior stimulus or some other factor, the Fed and ECB will be delighted. This is clearly the best case scenario and in the event, share prices would be well advanced from current levels if this happens. We would also be seeing higher government bond yields and discussion of exit strategies from the bloated balance sheets of the central banks.

More likely, unfortunately, is a period where the economic news is mixed for the next half year or so. Bits of good news, such in the housing sector in the US, will likely be tempered by ongoing sluggishness in the jobs market. Signs of improving consumer spending could well be offset by still fragile confidence. In Europe, sound news in the German economy is likely to be offset by a torrent of bad news in Greece, Spain and Italy.

In all this time, governments in the US and in Europe will be implementing fiscal austerity – either mild, medium or strong – as they all work to repair the fiscal damage inflicted from the crisis. Cuts in government spending, reduced public service numbers and higher taxes all point to a sharp contraction from activity from public demand. This is a given.

This means that when looking for a sustained recovery, it will be up to the private sector to engineer and lock in a return to prosperity.

Which loops back to the bond buying of the Fed and ECB. Patience is required for the efforts of central banks to keep borrowing costs lower for the corporate sector generally and, in the US, the mortgage market.

Academic literature is littered with research that shows there is a long and variable lag between and interest rate change and the impact on the real economy.

This time is no different.

In the near term, the data are likely to confirm ongoing sluggish economic conditions, which means markets will be focusing on events like bond auctions and judging whether governments are funding themselves at reasonable rates.

Updates on the fiscal progress will also be vital for market sentiment and the extent to which the sovereign debt problems are receding will have the potential to move markets.

For now, the current market calm is good news. There is a begrudging acknowledgement that the policy makers are getting closer to getting it right.

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