Shock and awe needed for risk rally

LONDON: After a poor start to the fourth quarter, investors' mood may be just starting to stabilize after moves by European policymakers to help fragile banks and avert a financial meltdown. But it may take a lot grander plan to truly kick start a risk rally.

The coming week -- packed again with heavy political and economic events -- may provide a key insight into what kind of initiatives policymakers are planning to implement to stave off recession and contain the effect of a possible Greek default.

The start of the third-quarter U.S. earnings season -- with Alcoa <(AA.N), JP Morgan (JPM.N) and Google GOOOG.O due to report -- also offers a health check-up on the corporate sector in an economy under threat of another recession.

World stocks, measured by MSCI, rebounded 8 percent after hitting a 15-month low earlier in the week and are on track to post their second weekly gain.

This, to an extent, bodes well as the fourth quarter has been the best period for equities since 1971, with stocks rising on average 3.7 percent in the period.

What has bolstered the market was some policy moves. The Bank of England surprised investors on Thursday by launching a second round of quantitative easing, pledging to buy a bigger-than-expected 75 billion pounds of assets with new money.

The European Central Bank followed up with aggressive liquidity measures, throwing a lifeline to cash-strained lenders. The European Union also said it would present a plan for a coordinated recapitalization of banks by member states.

For many investors, who have already moved to a defensive strategy of underweight equities and overweight bonds, it would require a "shock and awe" development to turn their mood around.

"You will probably need 2-3 trillion euros to frighten the market. We are positioned as if the euro will break up -- underweight periphery, banks and euro. We don't think it will happen but the market pain could be as hard," said Carl Astorri, global head of economics and asset strategy at Coutts.

"Sixty percent of the world GDP is deleveraging, which slows down growth. That's a long process, just as credit bubbles took time to build. We may be in the process for another 3-4 years."

Over the weekend, French President Nicholas Sarkozy is meeting head of IMF Christine Lagarde, before moving to Berlin to meet German Chancellor Angela Merkel where they are likely to discuss bank recapitalization.

The focus is also on Franco-Belgian bank Dexia (DEXI.BR), which has become the first victim of the fresh crisis after its shares fell to a record low before suspension. The board will vote on a break-up plan on Saturday.

Friday brings the Group of 20 finance ministers meeting, where investors could assess the appetite of surplus-rich BRIC emerging nations -- Brazil, Russia, India and China -- to help the euro zone.

A source told Reuters the European Commission is expected to present a proposal on bank recapitalization before the EU leaders summit on Oct 17.

Credit Suisse said it would revise its underweight position of continental European stocks if it saw an additional package worth at least 1-1.5 trillion euros, equivalent to 40 percent of outstanding debt in the peripheral euro zone countries.

Within this, Credit Suisse reckons European governments should spend 300-400 million euros to recapitalize banks.

It also said a weaker euro needs to be part of the solution of the euro zone problems, given each 10 percent decline in the euro adds 0.7 percent to European GDP growth.

EASING STRAINS

Following European steps, there is a tentative sign that strains on money markets and banks are starting to ease.

The three-month EURIBOR-OIS spread is down nearly 10 basis points this week to 74 bps, its lowest in a month.

In the FX swaps market, the premium for swapping euro LIBOR into dollar LIBOR over three months -- known as the cross currency swap -- eased to around 102 bps, off a September high around 123 bps.

Earlier in the year, European banks needing funds were forced to turn to FX forwards and swaps, causing a sharp widening of the dollar premium in FX swaps, especially in euro and yen markets.

A credit default swap index based on 25 European financials fell to 252.56 bps, down nearly 19 percent from a September peak.

JP Morgan said an issuance of unsecured bonds by Deutsche Bank and ABN Amro late in September worth 2 billion euros following a three-month freeze presented an important step for European debt markets.

"Coupled with (upcoming ECB funding operations), it is likely that bank bond issuance will improve further over the coming weeks, boosting confidence in credit markets," it said.

And confidence in the credit market is essential for a broader risk asset market.

"The key thing to watch is the corporate credit and government bond market, which is much better at judging what's going to happen than equity markets," Astorri said. - Reuters