The next few months will be crucial for markets and economic direction. Equity markets have remained high but have no serious underpinning, and bonds are ready to move quickly.
For now, the long players are ascendant, but they are on thin ice.
In navigating the markets, keep an eye on the following issues in the weeks and months ahead:
EUROZONE UNCERTAINTY
Greek officials recently made a bond payment but then announced they are using cash set aside to recapitalize banks to meet general obligations. That's not good. The country's fiscal plans are in tatters, and consumer and business confidence is at depression levels. Further bailouts will come.
But for now, the best hope is to keep discussions going and hope that Germany continues to back the Greek government.
In an effort to improve the situation in the eurozone, the European Central Bank unveiled a plan to buy bonds of the troubled eurozone countries. As part of the move, which is aimed at keeping yields manageable for its member states, the ECB is considering rate targets on its purchases of Spanish bonds and German bunds.
This seems crazy.
Spreads are now 506 basis points, compared with a two-year mean of 316 basis points. Any spread target requires management of the price of each bond and the gap between them. The issue is Spain's absolute cost of borrowing, not its cost relative to bunds, and a spread target may have unintentional consequences, including a rapid sell-off in bunds.
We're also still faced with unanswered questions about how any bond-purchase program would work: which country, with what conditions, when, how much, sterilized or no, seniority issues and so on.
Meanwhile, the ECB's president, Mario Draghi, will likely wait until Germany's Constitutional Court rules Sept. 12 on the legality of that country's ratification of the treaty establishing the European Stability Mechanism before unveiling the details of his plan to buy government bonds. Following lawsuits by German academics and political groups, the court is deciding whether to nullify the Bundestag's approval of the ESM, a proposed international organization which, if approved by all 17 euro area nations, would serve as a permanent bailout fund to provide financial assistance to members of the eurozone.
So mark your calendars. If team euro pulls this off, we should have an operational ESM — with German backing, operated by the ECB, responding to requests by Spain (and maybe Italy) for intervention — active in the markets by mid-September.
If not, then kerplunk.
U.S. SITUATION
Here in the U.S., the situation is just as dicey.
The federal government will run a budget deficit of $1.1 trillion in fiscal 2012, or 7.3% of gross domestic product, the Congressional Budget Office estimated in a report released Aug. 22. The report highlighted the dangers of letting the federal government go over the fiscal cliff. On Jan. 1, if lawmakers don't act, a combination of tax rate increases and cutbacks on deductions will go into effect, along with a 27% drop in Medicare physician payments, automatic and enforced discretionary budget cuts and reduced unemployment benefits.
All this would increase revenue by 20% and leave outlays pretty much unchanged. Think of it as instant fiscal discipline — or idiocy — depending on your view. The immediate effect would be to improve the deficit/GDP ratio to 4% and lead to a decline in GDP of 0.5%. That, in turn, would increase unemployment to 9.1%.
This would crush the economy and, because the stakes are so high, Washington likely will engage in protracted brinkmanship. Forty percent of companies are delaying investments. If there's any probability of a recession, no company wants to be caught expanding, especially if they have government contracts. The federal government terminated 13,579 contracts this year, more than double the level of five years ago. This is going to be the biggest scare that the markets will face for the remainder of the year.
Christian W. Thwaites is president and chief executive of Sentinel Asset Management Inc.
