David Morris
MOST global stock indices rallied strongly in the first two months of this year. Investors bought equities in response to the European Central Bank’s (ECB) two Long-Term Refinancing Operations (LTRO), which provided around €1 trillion in liquidity to Europe’s banking system. But the indices have struggled since March, with the sell-off accelerating from early May. This was when the US Federal Reserve and the EC) held back from loosening monetary policy further, meaning that investors would have a month of uncertainty before the next ECB meeting, and six weeks until the Federal Reserve’s open market committee (FOMC) sat down again for a two-day meeting on 19-20 June. Consequently, investors scaled back their exposure to risk assets and headed back to the relative safety of the US dollar and Treasuries, German bunds, UK gilts and Japanese government bonds.

Investors were also unnerved by the lack of a clear result from the Greek general election. Since then, a number of polls have suggested growing support for Alexis Tsipras’s anti–bailout, yet pro-euro, Syriza party ahead of the re-run of the general election on 17 June. If Tsipras becomes part of any ruling coalition, then the danger is that he will tear up – or at the very least attempt to renegotiate – the terms of the Greek bailout. This has raised fears that Greece will lose its emergency funding and could exit the Eurozone. Arguably, the Spanish bank bailout agreed over the weekend could strengthen Syriza’s position. After all, Greek voters will note that Spain has been given aid without quarterly inspections from the troika.

Last week, the ECB and the Bank of England (BoE) again refrained from further monetary intervention. The People’s Bank of China announced a surprise 25 basis point rate cut, but the positive effects were soon negated as investors fretted about the weekend’s batch of data releases. Now the ball is back in the Federal Reserve’s court. Ben Bernanke testified before the Joint Economic Committee last Thursday. The Fed Chairman said nothing new, sticking to the line that the Fed was ready to act if needed, while inferring that action was not needed yet. Fed vice chair Janet Yellen was considerably more dovish when she spoke on Wednesday and many investors were hoping that Ben Bernanke would build on this.

I still think there is a good chance that the FOMC comes up with something at its meeting later this month. Politically, the opportunity for further intervention is ebbing away. The presidential election takes place in November, and the campaigning will heat up now as Mitt Romney has been confirmed as the Republican candidate. Quantitative easing is not without its critics (principally from Republicans) and Ben Bernanke will not want to be accused of being politically motivated – a charge that he could face if he launches a fresh round of stimulus close to the election. After all, this could be spun as supporting the incumbent administration. Even if the Fed acts because the situation in Europe deteriorates, this will play badly with many American voters. Additionally, Scott Walker’s victory in last week’s recall vote in Wisconsin was a blow to the Democrats and President Obama. The state governor has cut taxes and spending and this hit the right note with voters.

On top of this, “Operation Twist” (where the Fed sells short-term debt and buys longer-term bonds) is set to end this month. With global growth slowing and the European crisis accelerating, investors worry that without further Fed action, Ben Bernanke’s “virtuous circle” (looser monetary policy boosts stock prices, so increases wealth, which raises confidence, and lifts spending, which leads to higher incomes and profits, further supporting economic expansion) will cease to function.

With so much deleveraging still to take place after years of debt-fuelled spending, investors fear a world without additional monetary stimulus. So if the Fed fails to act, financial markets face a torrid time, as investors question their reasons for holding onto vulnerable assets.