More stimulus posturing...

The Fed signaled yesterday that it would probably maintain rates close to zero until sometime in 2014, a revision from a previous statement targeting 2013! All this is good because stimulus is still very much needed but it doesn't really help when you find yourself in a "liquidity trap". The economy is far from being out of the woods, the debt burden as a percentage of GDP continues to rise, fuelled by a budget deficit that shows no sign of shrinking whilst growth sputters, putting pressure on the government to adopt a more drastic austerity plan. This sort of pattern is endemic across a large number of the developed economies and most particularly in the Euro-zone that is facing its biggest challenge to date.

In Europe, heavy handed austerity measures have been force fed to the more "sickly" members of the Euro-zone. It is hoped that by doing so, the deficit will shrink and eventually turn into a surplus which should help reduce the mountainous pile of debt and, in turn, cut the overburden of borrowing costs. Austerity does have a major drawback in that it stifles growth, so the question becomes: will the shrinkage of the deficit through austerity have a greater impact on debt than the economic slowdown resulting from the same austerity?

Patience is a virtue but if we take history as a guide, these highly unpopular measures have never survived long enough. They are more likely to be traded in for some form of financial repression down the road.

In denial...

Standard and Poors, one of the big three rating agencies, fired a shot straight at the Euro-zone debacle over the weekend by downgrading the debt ratings of several countries, most notable of which was France and Austria losing their respective triple A ratings. Market reaction was somewhat mooted, probably because it is already reflected in the price, but the main message of the announcement was that things are really starting to go from bad to worse. Markets have become accustomed to the fact that the European "powers" (the "usual suspects" that call the shots) are very adept at organizing hollow summits but keep on falling short of what is needed to stop the situation from getting out of control.

Greek bonds are trading as if they have defaulted already (which they technically have) and there is still no agreement on what the so called "haircut" should be, but, maybe more worryingly, countries in the "too big to fail" camp such as Italy have been flirting with a whopping 7% yield on 10 years making it very costly to refinance at a time of austerity.

What the "authorities" don't seem to be paying much attention to is that even if what needs to be done to put an end to this mess is clear and will be deployed as a last resort, the delay itself will make it far more costly to intervene and there is a growing chance that it doesn't work at all.

It is clear that the treaty and the whole setup is not designed to function in this type of environment, it is a major flaw that the original architects didn't think through but, if they play their cards right, the Euro-zone that possibly emerges from this crisis situation will be far more robust in construction.