I was asked recently to provide some color around the state of global fixed income markets as we close out the first quarter of 2013. Of course, one of the more watched situations in the global markets has been Cyprus’s banking crisis. I won’t go into too much depth on the subject here, as my colleague, Cosimo Marasciulo, has recently provided a comprehensive analysis.
The bottom line is that European monetary authorities have decided to take Cyprus depositors to the woodshed. In the recent history of bank restructurings, all depositors have been sacrosanct while equity holders and some subordinated holders have received “haircuts.” This time around, European monetary authorities have decided to give almost every stakeholder in Cyprus’s financial system a taste of the harsh medicine.
This sent shudders throughout European risk asset markets and spilled over into other geographies, with the U.S. maintaining the most stability, as investors pondered whether we had entered a new paradigm of harsher treatment for financial stakeholders in Europe. For U.S. investors, the latest chapter in the European saga has had minimal impact as the Fed’s “monetary accommodation spigot” remains full-on.
Greater Liquidity in the U.S. Market
The ‘insurance’ that was taken out by the Fed late last year, in the form of QE3, is pumping about $85 billion of liquidity into the market on a monthly basis. So far, this obscures any monetary consequence from Cyprus. The U.S. Treasury has been enjoying a strong bid as a result of this and, given the uncertainty generated by Cyprus, may ironically be considered by global investors as a “safe haven,” despite the generally more upbeat economic data in the U.S. and greater resiliency of our domestic stock markets.
Meanwhile, the European Central Bank (ECB) has been passively draining liquidity from their marketplace as European financial institutions have been paying back funds from the Long-term Refinancing Operation, or LTRO (taken out last year). This, in combination with poorer than expected economic data (in part, we believe, a consequence of the less accomodative monetary environment), has led to increased European financial market volatility, a worsening of some financial indicators (such as Euro swap spreads and peripheral spreads) and a general “risk-off” tone to European markets.
The question on everyone’s mind now is: Can the U.S. equity and other risk market assets – and even the underlying economy – continue to do well as economic activity in Europe is anemic at best and may be on a path of continued deterioration?
My answer is: It depends. It depends on how much worse Europe gets and how long it takes the ECB to draw a line in the sand. It is clear to us that there is a potential for yet another “spring-summer” swoon if investors get spooked by the combination of European economic malaise, stalled policy response (what ever happened to the so-called banking union?), and some re-appearance of some “known unknowns” (North Korea anyone?). However, we don’t think it will happen this year.
We believe that, given where we are in the process of finally casting off the things that have weighed us down since the Great Financial Crisis of 2008 — the deleveraging consumer, hobbled banking system and dysfunctional political system (well, two out of three ain’t bad…) — the building momentum of the housing recovery and the re-surging investment in manufacturing and energy will allow the U.S. to finally reach the point of “economic escape velocity” from the quicksand that has been Europe over the past few years.
So, as we sit here today, recognizing that the path won’t always be straight upwards for risk markets in the U.S., we remain comfortable with our call that domestic risk assets and the dollar will perform well this year and may be one of the “safer havens” in 2013.