LTRO, QE pullback could lead to further correction: Citi

After nearly a quarter of strong gains, global markets have over the past few days started a downward trend. US indices kicked off the week on a negative note, with all three major indices falling over 1 percent. The S&P 500 broke below 1,500 and the Dow declined more than 200 points, retreating from its fresh multi-year high.

Meanwhile, John Woods of Citi Private Bank tells CNBC-TV18 that this correction is likely to continue due to the return of risks that were seen in 2012. “The Eurozone crisis and the hung parliament in Italy have potentially important implications for risk and the risk-on trend that we have seen for the past six weeks or so,” he said.

He further added that the market is spooked by the possibility of liquidity being sucked out of the market with the pullback of the US Federal Reserve’s quantitative easing (QE) program and the European Central Bank’s Long Tern Refinance Operation (LTRO).

Below is an edited transcript of his interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying video.

Q: What have you made of the events of the last couple of days? Do you feel that they are pointing to a much deeper correction for global equities?

A: Yes, I think that is probably the case. The three main risks that shaped the year 2012 appeared to have returned. Obviously the Eurozone crisis and the hung parliament in Italy have potentially important implications for risk and the risk-on trend that we have seen for the past six weeks or so.

There also is uncertainty over the longevity of China’s recovery with the slump in the Purchasing Managers' Index (PMI) reading that we saw yesterday. Along with the USD 85 billion spending cut likely to be enacted on March 1, 2013 in the United States, we now have returned to the policy risk that shaped the later part of 2012.

So three important drivers are now are shaping risk, and they have the potential to encourage and sustain this correction that we have seen over the past few days.

Q: One of the talking points yesterday was the way the VIX shot up 34 percent. Do you expect markets to just turn volatile over the next few weeks or is there a possibility of an 8-10 percent drop in prices across the global indices?

A: Whenever we have seen the VIX around the 12 area over the last five or six years, we have usually seen that as a sign that markets are getting somewhat complacent in terms of their pricing of risk and it has been quite usual that we have seen a bounce. So this should not come as too much of a surprise.

We have seen some liquidity being sucked out of the market, particularly by the External Commercial Borrowings (ECB) and the Long Term Refinancing Operation (LTRO) money. Typically there is a pretty strong correlation between central bank liquidity and market action and indeed the implication that the Fed might be ready to take liquidity away from the market in terms of its Quantitative Easing (QE) program spooked the market last week. So the market will be very much focused on Bernanke’s comments at his testimony before Congress today and tomorrow.

All these risks and uncertainties in addition to those I just mentioned really do have the capacity to cause markets to continue to correct. I think the metric that you mentioned is entirely likely, not least because we have had such a fantastic run over the past quarter or so.