Too many eyes – and too many concerns – focus right now on the Fed’s next move and the trajectory of US bond yields, worries that, in the opinion of some key commentators, are gaining a momentum of their own and could even derail equity markets in coming weeks.
An excellent and admirably compact weekend summary from Simon Johnson on Baseline Scenario (Where are we now? A five-point summary) deals with some of these preoccupations:The consensus from conventional macroeconomics is that there can’t be significant inflation with unemployment so high, and the Fed will not tighten before late 2010. The financial markets beg to differ — presumably worrying, in part, about easy credit leading to dollar depreciation, higher import prices, and potential commodity price inflation worldwide. In all recent showdowns with standard macro models recently, the markets’ view of reality has prevailed. My advice: pay close attention to oil prices.
Emerging markets, meanwhile, are increasingly viewed as having “decoupled” from the US/European malaise, adds Johnson:
This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new bubble — based on a “carry trade” that now runs out of the US. The “appetite for risk” among investors is up sharply. The G7/G8/G20 is back to being irrelevant or merely cheerleaders for the financial sector.
The FT’s Fed watcher Krishna Guha effectively sums up the Fed’s dilemma in an article on Monday that notes the recent sharp increase in both US bond yields and mortgage rates presents the Fed with two key decisions next week: whether to increase its purchases of Treasuries and whether to push back against expectations of early interest rate rises.
As the Fed is unlikely to authorise large increases in Treasury purchases, he says, “the debate is between stopping at the declared $300bn, or increasing this total modestly to enable a gradual phase-out”.
In the behind-the-scenes debate going on, some Fed officials are arguing in favour of redirecting some money slated for purchases of mortgage-related securities towards Treasury purchases – to provide more latitude without increasing overall purchases. Whether they prevail will be seen in coming days.
And on interest rates, the Fed is likely to reiterate that it expects to keep rates near zero for an “extended period”, challenging market expectations of early tightening, notes Guha. But, he adds, it will also repeat – and might sharpen – the message that it is not tied to any course of action.
Regardless of what the Fed is likely to do or not do, particularly at its next FOMC meeting, market concerns are generating a momentum of their own, as various commentators note.
CLSA strategist Christopher Wood goes as far as to warn that premature fears of monetary tightening could cause an equity sell-off later this summer. But, as he says in his latest client newsletter, any monetary tightening scare in coming weeks will be a “fake out”. The view, at least at CLSA, is that the Fed will not tighten in 2009 and the US Treasury bond now represents good value in the context of the continuing deflationary environment.
After all, any further back up in government bond yields will further constrain the economy by putting upward pressure on mortgage rates. The rate for agency “approved” 30-year conforming mortgages is now 5.7% and for “jumbo” mortgages 6.7%, he notes – all of which is why the Fed is going to be under increased pressure to announce increased purchases of US Treasury bonds at the next FOMC meeting.
Remember, says Wood, that the Bernanke Fed has so far bought more agency mortgage bonds than Treasury bonds as part of its “credit easing” policy – $533bn worth of agency mortgage-backed securities since the purchase programme began in January, and $156bn worth of Treasury bonds since March.
As for the ‘decoupling debate’: Wood reiterates a long-held view that Asia and emerging markets are in long-term secular bull markets that began at the depth of the Asian crisis in 1998; and that the US and various other western “consumption-driven appendages” are in secular bear markets. To Wood, this view implies that sooner or later decoupling has to happen in the capital markets.
For oil and commodities, though, the key tactical issue is whether the market will take its signal from resilient emerging market growth or disappointing US growth, he says. But already, as oil moves higher towards Woods’ ‘guesstimated peak’ of $80 to $85 in this counter-trend move, the more vulnerable it becomes to disappointing news from the US and the West.
The eloquent Gerard Minack of Morgan Stanley in Australia, meanwhile, sums up the critical question thus: Is it positioning, liquidity or fundamentals that are driving markets?If liquidity, as captured by soaring money supply measures, is the key then don’t expect a big stumble in risk assets – at least, not until policy makers turn off the taps. If fundamentals and positioning have been the most important factors – my view – then a significant setback is possible because I think several markets have overshot their fundamental fair value.
If one indicator reliably led risk assets, we’d all be watching it, all the time – and we’d do little else, he notes. But that investor holy grail doesn’t seem to exist (or those who know aren’t telling). Over the long run, fundamentals drive returns. However, experience shows that markets deviate from fundamentals, sometimes by a long way (a point only efficient-market aficionados in academia or central banking could miss).
Fundamentals and positioning, in Minack’s view, explain most of what we’ve seen over the past few months:
The economic free-fall following the Lehman’s collapse justified a discount on assets for the risk of a near-depression outcome. That tail risk has faded, so the discount could be removed. As importantly, positioning became extreme, at least in developed markets, in the six months after Lehman’s. The interaction of less-bad fundamentals with extreme positioning has largely driven the rally…
Already, fundamental improvement is more than fully priced, in Minack’s opinion. Indeed, he says, many markets are now pricing a robust recovery that seems unlikely to eventuate. Positions appear to have returned to normal ranges, having come from extremely defensive positioning in the March quarter; hence, the view that the rally has only a limited life.
If liquidity is the key, however, that prognosis would be wrong. Notes Minack:
Most liquidity measures remain at, or near, extremes. One example is the so-called ‘cash mountain’ (the ratio of household liquid assets to equity capitalization in the US). It suggests more flows to come. I think this indicator is bunk. Most of the big swings reflect changes in equity values, not changes in the cash levels. Growth in cash assets has been slowing since last April; the ratio kept rising because equity values cratered.
The cash mountain is one liquidity indicator. But ‘liquidity’ is a slippery concept and the most common indicator investors now refer to is money supply. Because of quantitative easing, money supply is now ripping higher in most developed economies. “If this really is the key to markets, then markets seem set to move higher for longer than I expect”, he adds.
Now, however, with financial systems under stress, there is a large gap opening up between money and credit, and this is likely to persist, in Minack’s view:
I continue to think the creation of fresh credit for financial investment will remain limited. But the bigger picture point is this: it’s credit expansion (or contraction) that drives markets, not money supply liquidity measures… If I’m right, then ‘liquidity’ is not the flood that’s lifting all the risk asset boats. Moreover, if positions have normalized, then the market should start to become more sensitive to fundamental news – and potentially vulnerable if, as I think, the fundamentals start to disappoint through the second half.
Related links:
Fed faces key decisions on Treasuries and interest rates - FT