Summer Volatility Brings Fall Worries

Since July 1st, we've had dramatic movements in the financial markets that have been astounding.  The S&P fell from 1340 to 1102 as a low and then rebounded to 1,230. This is a 17% fall with a 12% rebound, all within two months.  The US dollar against the Canadian dollar rose from 0.94 to 1.00 and then back to 0.9730. The US Treasury 30 year bond had a 100 bp drop in yields and the two year note had a 30 bp drop in yield. This type of volatility reminds many market participants of the 2008 global financial crisis. The challenging question remains:  what changed in July that made us go through these huge disruptions and dislocations within the market?
First and foremost, growth is not accelerating in the United States as we entered into the second half of the year. This is particularly striking given that many

Andy Busch,
Global Currency
and Public Policy Strategist
BMO Capital Markets

economists and strategists had predicted strong US economic growth due to the extension of the Bush tax cuts and the cut in the payroll tax. On July 8th, we had weaker than expected non-farm payroll and unemployment data. Then on July 29th, we had an extremely weak US Q1 GDP revision from +1.9% to +0.4% and Q2 GDP data was 1.3% versus expectations of 1.8%. (And, historical data were revised lower to show that the recession was deeper than initially reported.) On August 2nd, personal spending fell for the first time in 2 years and underscored the distressed nature of the US consumer.
Therefore, we’ve had a sharp shift in expectations over future growth with macro-strategists reducing their growth expectations for the end of 2011 and for 2012 between 0.5-1.0 percent. In turn, this shift led to selling of equities due to the reduced growth prospects.
Next, European political problems and the debt problems deepened since July 1st. This lead to European votes on expansion of the European Financial Stability Facility or EFSF, votes on a new Greek bailout package and a vote in Greece over new austerity measures. The process created a miasma of uncertainty for the financial markets and further reduced expectations of future growth.
Also, the United States political environment was unstable and this created negative conditions surrounding the debt ceiling hike in early August. Afterwards, the decision by Standard and Poor’s rating agency to downgrade the United States from AAA was a major negative surprise. This led to a cascading effect with additional downgrades from agency debts to municipal debt to even Warren Buffet’s Berkshire Hathaway. In turn, the markets began to reassess the remaining AAA rated countries for a potential downgrade. This led to France and then led to questions raised over French banks. This negative feedback loop is analogous to what occurred during the 2008 financial crisis as the markets froze up due to counter-party risk.
This is what drove the financial market upheaval and ructions into early August.  Fortunately, the world doesn't stay the same for very long and policymakers stepped in to stabilize the markets. First, Europeans did change the European Financial Stability Facility. They've increased the size and critically allowed for member countries to borrow from the fund to lend to their banks for capital injections. This will eventually reduce the counterparty risk issue, but only after it’s ratified. Next, the European Central Bank agreed to expand what they call their SMP or their sovereign bond buying program, to include Italy and Spain.  This has had the salubrious effect as bond yields in those countries dropped quickly after the announcement. Subsequently, both Italy and France have worked on new austerity measures to reduce their budget deficits which further have reduced fears over funding issues.
On August 4th, the Bank of Japan intervened unilaterally in the currency markets to buy US dollars against Japanese yen to lessen the Risk-Off trading in the markets. The Japanese Ministry of Finance announced a new program on August 24th to spur Japanese spending on foreign corporate acquisitions and resources. The government will send foreign currency reserves to an agency which in turn will make loans to commercial banks. Remember, the stronger yen hurts Japanese exporters as it makes their goods less competitive and reduces the value of their overseas earnings.  
Switzerland has been one of the countries that have been severely impacted by the market volatility. Market participants bought the Swiss franc as a flight to safety and this created enormous volatility against the Euro currency with fluctuations of over 10%. On August 17th, the Swiss National Bank (SNB) responded by expanding the supply of funds to their money markets by 200 billion francs and said it would take additional steps if needed. Finally, the SNB has discussed pegging the Swiss franc to the euro and a leading Swiss business group supported the move.
In the United States, Congress and the White House agreed to a compromise deal to increase the US debt ceiling by $2.1 trillion to avoid default. Also, the deal cuts discretionary spending by $917 billion over ten years and establishes a process to cut an additional $1.2-1.5 trillion over the next ten years which, if not done, would set off an automatically triggered round of cuts. While this structure didn’t stop S&P from their downgrade, Fitch and Moody’s didn’t follow S&P and therefore the markets didn’t react by selling US Treasury securities.  
Another major stabilizer for the markets was the action by the Federal Open Market Committee (FOMC) to change the language of their monetary policy statement. On August 9th, the FOMC stated:
To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.   
These highlighted changes reassured the markets that the central bank would continue to engage in easy monetary policy to assist the US economy.
In summary, the financial markets in July and August of 2011 have had thrilling moves to both the downside and upside. Market expectations over future global growth have shifted as US GDP and consumer spending data disappointed to the downside. Also, political events and critical votes created conditions for heightened uncertainty. Finally, policy makers across the globe reacted to the temblors by easy monetary policy or by enacting austerity measures to reassure queasy financial markets. Further policy actions will be warranted to maintain the recent snap back in global stock prices, but it is comforting to know that world did not come to an end at the beginning of August.
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