What now after the Italian downgrade?

From Forbes:

Standard & Poor’s pulled another late move on Monday, downgrading Italy’s sovereign credit rating by one notch to A/A-1.  The credit rating agency cited weakening economic growth prospects as public and private borrowing costs rise, and a fragile political coalition failing to adequately respond to a challenging economic environment.

While the downgrade doesn’t come as a shock, as S&P had Italy under a negative outlook since May, it will rattle markets.  Europe’s sovereign debt woes have grappled nervous markets the last couple of weeks, with every word coming from Greece, Germany, or the ECB sparking massive moves on both sides of the Atlantic.

This has sent certain (risk-addled) European banks spiralling downward, leading the European Systemic Risk Board to warn policy-makers that the time may soon come to make a massive liquidity injection into European markets (i.e., throwing money at saving bad banks)

BNP Paribas:

SocGen:

In America, traders today were in a more bullish mood.

From Zero Hedge:

Shrugging off Italy’s rating downgrade (somewhat expected but continued negative outlook), funding stress in Europe (Libor levitating and Swiss/French banks divergent), cuts in global growth expectations (IMF and World Bank), concerns over systemic risk contagion (ESRB and World Bank), and escalating rhetoric in Sino-US trade wars, US equities have managed to reach up to Friday’s highs as rumors of AAPL being added to the Dow seemed enough for hapless traders.

More significant than excitement over Apple — and the main reason that markets today are levitating, in spite of all the turmoil — is the hope that Bernanke will throw more policy tools at the American economy.

Will he?

Although I have been specific about the idea that QE3 is definitely coming I don’t foresee QE3 being initiated this week. Why?

Firstly, because I think Joe Biden promised Wen Jiabao that America would hold off QE3 in the short-term to preserve the value of Chinese holdings.

Bernanke will probably initiate a program to roll the Fed’s holdings onto the long-end of the spectrum of bonds: as 2-year bonds in the Fed’s portfolio reach maturity, the Fed will replace those with 10-year bonds, to reduce net interest rates.

More significantly, I expect Bernanke to announce that the Federal Reserve will announce that it will no longer pay interest on excess reserves. Banks have accumulated massive excess reserves since the 2008 crisis, when the Fed determined to pay interest on reserves not lent — ostensibly to increase flexibility in the banking system in case of further collapse:

In theory, unleashing these excess reserves into the economy would get capital to productive ventures without infuriating bondholders and retirees any further with more quantitative easing. But in practice a surge in lending might do the precise opposite — unleashing a tidal wave of inflation, further diminishing the purchasing power of dollars.

The potential loans possible on these reserves could be up to $16 trillion. GDP is currently $14.99 trillion. Unless the GDP keeps pace with the money supply, these new loans would create the potential for substantial amounts of inflation.

Could this be the spark that triggers a runaway inflationary spiral? It could be. It’s not in the interest of either debtors, nor creditors — but that doesn’t remove the risk.