Markets Await Fed Announcement

With fundamental data pointing to waning global aggregate demand, markets are betting that central banks will provide the impetus to keep the recent rally in growth assets alive.  This line of thinking has proven sound over the past few months, as investors have cheered the decision taken by the European Central Bank to extend its bond-buying programmes, and fully expect the Fed to follow suit with additional stimulus this Thursday.  

Contributing to the positive mood today are reports that Wednesday’s ruling on the ESM by Germany’s Constitutional Court will not be delayed by recent lawsuits filed by regional German politicians.  The ruling is expected to be in favour of approving the ESM. However, the risk remains that approval will come with strict conditions aimed at ensuring that Germany’s balance sheet isn’t torn to shreds as it acts as guarantor for the weaker euro zone countries.  Such conditions threaten the current optimistic view of the European debt crisis. 

Elsewhere, Thursday’s Fed announcement is proving increasingly difficult to predict.  On the one hand, the Fed is not meeting its dual mandate of achieving full employment and containing inflation, which suggests that further stimulus may be warranted.  On the other hand, we can easily make the case that the lacklustre recovery in employment is not a cyclical problem that can be fixed by low interest rates; rather, it is a structural problem resulting from a disparity between skills and demand in the labour force.  Record low interest rates alone may not be enough to fix such a problem, and therefore the addition of further simulative measures may prove futile and actually hinder a sound resolution by sparking inflationary pressures in the future. 

But the market remains convinced otherwise at the moment, and is looking for more cheap money to keep the rally going, having fully priced-in such an outcome.  That said, Bernanke has proven that he is the most unconventional chairman in the Fed’s history yet, so even in the face of a looming presidential election and the diminishing returns of further stimulus, the market is expecting him to announce--at the very least--an extension of current policies.