2010: A Year in Finance - Welcome To Our Site
Introduction: And We Thought 2008 Was Interesting
The year 2010 saw two primary events that served as bookends: The European debt crisis centered on Greece in late April/early May, and the announcement of the second round of quantitative easing in November. A third event that also took place was the ending of the first round of quantitative easing in March. "QE1" saw the purchase of $1.25 trillion in mortgage-backed securities and $175 billion in agency debt purchases (primarily Fannie Mae and Freddie Mac). With QE1 brought to a close, the Federal Reserve was on standby until August 27, when Chairman Bernanke gave a definite positive hint towards QE2.
Stocks' Wild Ride
The two major events of the European debt crisis and the announcement of QE2 sent the stock markets on a roller coaster ride. After recovering from the bottom in March 2009, the stock market rallied strongly throughout that year. At the beginning of 2010, the market went through a mild correction, then continued to rally until the European debt crisis hit, sending stocks crashing downwards until early July. The earlier correction saw the Dow Jones Industrial Average (DJIA) hit a low of 10,012 on February 5. The crash that began in late April saw the DJIA go below the 10,000 level on June 4 and again on July 2.
The market recovered once more into early August, then started to crash again until August 27 rolled around. The hint of more quantitative easing was enough to send the market racing toward new highs. August 27 saw the DJIA at 10,150. By the end of December, the DJIA had risen to 11,577. The rise was not smooth by any means. Another correction had nearly begun in November when the Federal Reserve announced QE2, sending the DJIA upwards once more. Stock investors put themselves at the mercy of the Federal Reserve for the entirety of 2010.
Internationally, global stock markets gained a total of 26 percent in 2010, continuing the initial recovery seen in 2009. (2) With regard to specific markets, the Greek stock market fared the worst, posting a huge 41.96 percent loss for the year. The Spanish, Italian and Portuguese stock markets all did poorly as well, posting losses of 20 percent, 13.7 percent and 11.5 percent, respectively. On the positive side, the stocks markets of Malaysia, Chile, Peru, Thailand and the Philippines were the clear winners. The Philippines took the top prize with a staggering gain of 58 percent. Thailand, with 55.7 percent, and Peru, with 54.6 percent, nailed a close second and third. Malaysia came in fifth with a total positive gain of 38.3 percent. (3)
Thailand, Malaysia and the Philippines benefited from their geographic locations close to the economic powerhouse of China. Rising commodities prices such as gold, silver and copper put extra cash into Peru and Chile. 2010 was not a bad year for these five countries. The rest of the world closely followed the European debt crisis and events in the United States.
Foreign Currencies Realize The Game Is Up
Foreign currencies continued their multiyear declining trends after the carnage of 2008 saw a large spike in the dollar relative to most of the U.S.'s major trading partners. The noted exception to this was the euro. The U.S. dollar continued its decade-long decline against the Australian dollar. January 1, 2010 saw the USD/AUD currency pair at $1.11. By December 31, that pair had fallen to $0.98, indicating a loss of purchasing power for the U.S. dollar relative to the Australian dollar.
The euro, on the other hand, saw a huge upward spike in terms of the dollar in the first part of 2010. The dollar began 2010 at the level of €.69. By June 8, it had reached a peak of €.80, which indicated that the dollar gained purchasing power relative to the euro. The gain quickly evaporated as the summer wore on. December 31 saw the dollar at €.75, a total gain for the year of €.6.
Unfortunately, the euro was probably the only major currency against which the dollar performed favorably. Overall, the truth of the U.S. economy was seen in the performance of the U.S. dollar relative to other major currencies. The dollar fell against most but eked out a small gain against the euro.
European Debt Crisis: PIIGS, Bailouts and Terror
This crisis actually began in 2009, but it did not become a serious issue until the spring of 2010. In April and early May, the yields on Greek government bonds suddenly skyrocketed. The 10-year yield had hovered around five percent through 2009. Towards April 2010, it slowly moved upwards to about 6.5 percent. Without warning, it suddenly shot upwards to reach a peak of over 12 percent before falling back down to around 8 percent. The reprieve was short. By July, the yield broke through the 10 percent level again. At the end of 2010, the yield had almost reached the 12 percent level once more.
The reason for the sudden extreme movement can be summed up in two words: bond vigilantes. A bond vigilante is a bond investor who protests monetary or fiscal policies they see as inflationary by selling their bonds. Bond prices move inversely with yields, so a sudden increase in the quantity of bonds forces prices down through supply and demand, sending yields surging. This puts the pressure on the government that owns the bonds to get its house in order because the higher yields result in more money going to debt servicing. No government wants to be at the mercy of these investors. The Greek government got a taste of what they had in store for it in the spring of 2010. The Greeks felt the investors' wrath all the rest of the year.
The European Union (EU) and the International Monetary Fund (IMF) quickly hammered out a bailout package for the besieged country. In return for steep budget cuts and other austerity measures, the Greek government would receive €80 billion in the form of loans from Eurozone members and €30 billion from the IMF directly. The total package of €110 billion ($147 billion in 2010 dollars) was projected to save the Greek government over €30 billion through 2013, if the Greeks fully implemented the austerity measures. (4) Unfortunately, that part of the plan ran into vehement opposition from the Greek citizenry.
The plan did not work as advertised. The Greek government received a second bailout in 2011, and a Greek default is widely rumored to occur before 2011 comes to a close. Greece is a basket case that is dragging the Eurozone towards a painful death. A major fear among international players is the end of the euro as a currency.
The House That Bernanke Tried To Build
It is hard not to have a least a modicum of sympathy for Ben Bernanke, the Federal Reserve Chairman. He had a nearly impossible task set before him after the crisis of 2008. Under his leadership, the central bank wound down and ended QE1, while continuing the zero interest rate policy (ZIRP) that began in December 2008. Renewed economic weakness combined with the negative effects of the European debt crisis resulted in a hint of QE2 in August and a formal announcement of the $600 billion program three months later in November. The Federal Reserve was frantic to stop any hint of deflation dead in its tracks. The central bank was willing to go all out and try radical new experiments at the so-called "zero bound" rather than risk a new Great Depression.
Chairman Bernanke evidently paid close attention to the Consumer Price Index (CPI) in 2010. The first half of the year saw low inflation levels ranging from 2.6 percent to two percent. Then, in July, the CPI rate suddenly collapsed from two percent to barely above one percent. The CPI never rose above 1.2 percent for the rest of 2010. The fall in the inflation rate no doubt frightened Bernanke, realizing the recovery was not as strong as he had hoped. Changing inflation expectations called for a second round of quantitative easing.
Quantitative easing itself is simply a euphemism for printing money. 'QE' essentially means indirect deficit spending. The Federal Reserve works closely with a network of banks called the Primary Dealers. They help the central bank carry out open market operations, where the Federal Reserve buys and sells government bonds. During both iterations of QE, the Primary Dealers bought bonds from the U.S. Treasury and sold them to the Federal Reserve. The Federal Reserve thus indirectly financed the U.S. government for the duration of both programs.
Through QE, the Federal Reserve hoped to basically bully the economy into a recovery. Raising inflation would make holding cash expensive, while raising the attractiveness of risky assets like stocks through price increases. Chairman Bernanke hoped to artificially create a virtuous cycle where higher inflation would move consumers and investors out of cash, re-starting the investment process. More investment would hopefully lead to more income and more spending, lifting the economy out of the doldrums. This happy outcome did not happen.
Bonds: There's Something Funny Going On
The stock market eagerly awaited new signs of stimulus from the Federal Reserve, which it received in abundance. A $600 billion bond-buying program is enough to make any stock market happy, but it inspired a large rally in stocks that took the major indexes up over 20 percent by the end of the year. The bond market behaved less schizophrenically, but it did have some surprising movements, especially towards the end of the year.
Economists consider the bond market to have predictive powers when it comes to inflation. At the very heart of interest rates is an innate inflation premium. Theoretically, if the inflation rate for next month was known to an absolute certainty to be higher than this month's rate, bond yields would automatically rise to compensate investors for the higher rate. Since prices move inversely to yields, this means that investors would sell bonds, which historically do poorly in times of high inflation.
Something curious happened in the bond market in the late fall of 2010. A major part of the rationale for QE2 was to keep interest rates low. The entire reason the Federal Reserve was purchasing bonds at all was to increase their prices and lower their yields. Government bond yields play a large role in determining interest rates throughout the economy. For instance, the yield on the 10-year Treasury note strongly influences the interest rates on 30-year fixed-rate mortgage loans. The average term length of a 30-year loan is actually only seven years because homeowners refinance or move.
By keeping yields low, Chairman Bernanke hoped to keep borrowing costs low throughout the economy, which would, in theory, stimulate economic activity. After the announcement of QE2 in November 2010, exactly the opposite effect happened: government bond yields started to rise! The 10-year Treasury yield stood at 2.5 percent on November 3, 2010. On December 31, the yield had reached 3.2 percent, a gain of .70 percent or 70 basis points. For a program that promised to keep yields and interest rates low, this was not a promising start.
The gain in the 10-year yield continued through the first two months of 2011, reaching a peak of 3.7 percent on February 2. Since then, QE2's promise seems to finally have taken effect, sending the yield racing downward to below three percent by the end of June 2011. Currently, it stands below two percent, a level it has never reached before in U.S. history.
There are multiple ways to interpret this strange movement. The most alarming possibility is that the Federal Reserve has started to lose, or may have already lost, control of the yield curve. This would mean that economic conditions have gotten so bad the central bank has essentially lost the ability to influence the economy. A more practical interpretation would simply observe that bond investors obviously sold their bonds to get into the stock market and enjoy the ride.
Conclusion: What A Year
The year 2010 was a year to remember for the financial world. Strong gains in global stock markets, losses in the dollar's purchasing power against other major currencies, the near-bankruptcy of Greece and more central bank stimulus combined with odd happenings in the bond market wrapped up a very interesting year. As consumers hunkered down and paid down their debts, the rest of the world tried to figure out what to do next. China raced ahead, the inspiration for the East Asia region, with several economies piggybacking their way to growth.
2010 was merely a prelude to 2011, a year that has made it extremely unwise to think that it cannot get any more interesting. When 2011 draws to a close, investors might look back and long for the bubble years, disastrous as they were for the U.S. economy. Going forward, the economy has some serious hurdles to overcome, with the prospect of even darker days ahead weighing on the minds of many a pessimist. Ultimately, it will be up to the economy itself as it reallocates and heals from a decade of losses.
(1) http://www.bankrate.com/finance/federal-reserve/qe1-financial-crisis-timeline.aspx (2) http://seekingalpha.com/article/246810-global-stock-markets-increase-by-26-in-2010 (3) http://www.dailyfinance.com/2010/12/29/best-and-worst-global-stock-markets-of-2010/ (4) http://online.wsj.com/article/SB10001424052748704608104575219430378257618.html?mod=WSJ_hps_LEFTWhatsNews#printMode