RALLIES TURN TO DECLINES AHEAD OF FED

 
David Morris
GLOBAL equity markets rallied sharply last week. The initial catalyst came from rumours that China stood ready to purchase Italian debt. Then stocks shrugged off worries about the credit-worthiness of the largest French banks, after German Chancellor Merkel and French President Sarkozy insisted that Greece will remain a member of the Eurozone. Greek Prime Minister Papandreou also promised further austerity measures.

The buying gathered momentum as short-sellers rushed to cover their positions. This was despite Chinese Premier Wen Jiabao warning that there were limits to China’s generosity, while urging Europe to “get its house in order.”

Bullish sentiment got an additional boost after the ECB announced a coordinated central bank move to provide a series of 3-month US dollar liquidity operations. This will take the pressure off European banks that have had trouble borrowing US dollars. However, the move is also an admission of the problems at the heart of the European banking system.

There was a souring of sentiment over the weekend as the meeting of European finance ministers proved to be a damp squib. In addition, US Treasury secretary Geithner was effectively told to go home and put his own house in order before lecturing Europe. Merkel’s party lost another regional election and there is a nagging feeling that the Eurozone is preparing for a Greek default. The FTSE 100 reversed sharply from resistance at 5,390/5,400, the 38.2 per cent Fibonacci retracement of the March 2003 to October 2007 rally. Both the German Dax and the US S&P 500 have failed to build on breaks above significant resistance at 5,600 and 1,208 respectively.

The two-day FOMC meeting ends on 21 September. While worries of a Greek default are currently keeping a lid on stock prices, it looks as if investors have priced in additional stimulus measures from the Federal Reserve. At the very least, the expectation is that the Fed will cut the rate paid on bank reserves to stimulate bank lending and/or sell shorter duration debt and use the proceeds to buy longer-dated bonds. This should lower long-term rates further, and so reduce borrowing costs for companies and individuals. But there is also a possibility that the FOMC will announce further asset purchases. The problem is trying to assess if additional quantitative easing is priced in to equities or not.