David Morris
Last Friday, equity markets were rallying on rumours that central banks were preparing for coordinated action, should the majority of Greek voters make the “wrong” decision and back the anti-bailout party, Syriza. Yesterday, the major indices gave up early gains following the news that Syriza came a close second to New Democracy. After all, although Syriza lost and the immediate threat of a Grexit disappeared, there was no need for collective central bank intervention. In addition, the Greek economy is still in the same dire straits that it was in on Friday. New Democracy gained the largest share of the popular vote, but it now has to build a workable coalition to form a government. This should be possible given that the pro-bailout parties of both the right and left consider that the stakes are so high. However, such alliances across the political spectrum are hard to maintain, and it is worth remembering the strong popular support for Syriza. This is likely to make life very difficult for a government that attempts to raise – or even collect – taxes. And impose the unpopular and controversial austerity measures demanded by the troika. The likelihood is that Greece will need another bailout anyway.

So, turning to the Fed, investors now have to assess the probability of additional intervention being announced on Wednesday. Certainly, US economic data over the last few months has deteriorated markedly, and many investors now feel that this gives the Fed an incentive to loosen monetary policy further. China’s growth is slowing, and the People’s Bank of China responded with a surprise rate cut a week ago – its first since 2008. Australia, the best proxy for assessing China’s economic health, has slashed its cash rate by 75 basis points so far this year. The Eurozone is a basket case although policymakers are doing just enough to keep the ball in the air for a little longer. In the UK, following Mervyn King’s Mansion House speech last Thursday, analysts have started to cut the odds on the Bank of England adding to its asset purchase programme as early as next month.

Put all this together, and the Fed could decide to join in and intervene further. As I wrote last week, this could be the last opportunity to act before the US presidential election campaign gets into full swing. After all, if the Fed takes aggressive measures to loosen monetary policy close to the vote in November, it could be accused of trying to boost the economy at a time which could help the incumbent administration.

If the Federal Open Market Committee decides to intervene further, what form could this take? An extension to Operation Twist – whereby the Fed sells short-maturity debt to buy longer-term Treasuries – would be the least controversial measure. After all, the current programme is set to end this month, and it doesn’t add to the central bank’s balance sheet. Although it arguably makes it less stable. But some analysts worry that the Fed is running out of Treasuries in the 3-month to 3-year maturity band to sell. Consequently, to extend Operation Twist, the Fed would need to include Treasuries with maturities over three years, which would distort the yield curve even more than it is already. In addition, extending Operation Twist may have little impact on a market which is pricing in more aggressive measures. Ironically, the robustness of the markets makes it difficult for Ben Bernanke to justify an outright asset purchase programme like QE2. After all, quantitative easing (QE) is highly controversial, not just in the US, but in developing countries, such as China, India and Brazil, where its inflationary effects are felt most. Fortunately, oil is down around 24 per cent since its high point earlier this year and inflation in the developed world is moderating as deleveraging proceeds. But the higher this market goes, and the more QE gets priced in, the bigger the scope for disappointment.