Market Roller-Coaster Reprieve In Sight?

December 06, 2011

Investor hopes are rising for a respite from the last several months of market volatility.

 

As we head into the end of the year, hopes are rising among investors for a reprieve from the roller coaster ride in the markets, which has featured twelve 7% swings in the S&P 500 in the past five months.

 

 

The ongoing crisis in Europe has been the principal cause of recent volatility. The latest downdraft culminated the week of Thanksgiving, when Europe seemed on the verge of financial collapse. The subsequent “risk-on” euphoria of the past week has been based on hopes for the latest installment of the European rescue plan, as well as coordinated actions by the major global central banks to provide liquidity and stimulus.

Italy is a case study of how quickly a country with a suspect debt structure can go from perceived solvency to perceived insolvency. Italy also illustrates the degree to which overly indebted governments (which represents most of the developed world) are dependent upon the maintenance of low interest rates. Hence, the calls for the European Central Bank (ECB) to intervene to cap bond yields as the Federal Reserve has done in the U.S.

Italian short-term government bond yields have fluctuated wildly in recent weeks, and have become a key barometer in assessing the current state of the European crisis. The two-year Italian government bond yield reached a high of 7.9% on November 25, up from 4.6% just a month earlier. At present, the bonds are trading at a not-so- alarming yield of 5.6%, as European bond markets have stabilized in anticipation of bold policy action this week. The bar is set at a high level for European policy makers to unveil a credible plan at the end of this week at what has been described as a “make or break” EU summit meeting. Rallying markets reflect expectations that policy makers will do enough to quell this particular phase of the crisis and, at a minimum, postpone problems for awhile.

Hopes now revolve around a deal in which expanded support from the ECB is conditioned upon centralized fiscal control. Germany wants profligate countries to submit to stricter fiscal rules and enforcement mechanisms in exchange for aid. Last Friday, German Chancellor Angela Merkel called for rapid EU treaty changes to allow greater EU control of national budgets.

Germany and the ECB are loath to follow the U.S. policy of fighting debt with more debt. They have dismissed quick fixes such as massive Fed-style money printing by the European Central Bank. They correctly point out that an ECB bailout would remove the pressure on profligate governments to enact the necessary reforms.

 

 

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