Bull markets need two ingredients – these are a plausible narrative and an abundance of cheap money.
The ‘narrative’ or story is that the banking crisis has given cause to doubt the growth prospects of the OECD countries. These same countries have pushed a huge supply of low cost monies into the global financial system. The combination has driven the Gold, Bond and Emerging Equity markets well above their equilibrium price. The narrative part of the equation is compelling because the difference in the state of government finances and the trend in foreign exchange reserves are huge between emerging and developed countries. However, there are a number of good reasons to believe that central banks in the Western Hemisphere are about to exit their easy monetary stances.
1) Business conditions may be sluggishly in some quarters, but they have generally improved in a sustainable fashion since the end of last winter. Confidence in the economy is steadily improving. The Federal Reserve Board forecast is calling a change of 3.0%, 4.0% and 4.2% in real GDP for 2010, 2011 and 2012 respectively with an inflation pace of 1.0% to 2.0%. In this connection, the Fed will be forced to normalize the target rate to appropriately reflect rising inflation and growth rates.
2) Banking conditions have swiftly recovered from the gravest financial crisis since the Great Depression. By paying back government rescue funds with private capital, confidence in the financial system is rising nicely. Citigroup and Wells Fargo stand alone as the only two giant banks with TARP money. The Bank of America is about to shed the government stigma by year end. In this connection, the Fed will be less compelled to keep the government yield curve steep in an effort to restore banking profitability for liquidity and capital ratios are now good enough to keep them out of trouble.
3) In the diplomatic corridors of G-2, there may be a deal in the making. It is not in the mutual interest of either US or China to allow protectionism, capital controls and competitive devaluation to spread. It could very well be that rate hikes in the US would be matched with corresponding revaluations of the Yuan.
4) The markets are, in effect, daring the Fed to raise interest rates. Stability is still regarded as "an anchor for policy makers". Otherwise increased risk awareness of investors will mount and impose discipline on the Government. That is one thing that the Fed does not want to loose control over. Rate increases typically come after the unemployment rate peaks. This might be based on Friday’s job report. The futures markets are putting a 68% chance that the federal funds rate will be raised to 0.50% by June and more than a 90% probability that it will hit 1.00% by next December.
5) There is a lot of political and investor pressure on the Fed to change direction and be more forward-looking in its actions to protect credibility, keep inflation expectations low, oversee directly the soundness of the banking system and stop the "carry-trade" from transferring precious domestic capital to emerging equity and commodity markets. The Fed may deem it necessary to act in manner to show independence from and resolve to Congress.
6) As we move closer to increased regulations in order to protect the financial system from the excess vagrancy of monetary policies and banking practices, it will become less important to hold interest rates low to mop-up bursting bubbles permitting small and frequent rate increases to tame the markets.
Acknowledging that monetary policy works with a lag on the economy but how quickly markets can respond to it, the Fed has already started to use reverse re-purchase agreements to drain some of the $1 trillion in excess reserves of the banking system and may soon start to normalize the level of short term interest rates. Since inflation is relatively low, even baby steps toward normalcy could cause a surge in demand for US dollars causing changes in capital flows. As a matter of fact, the sooner the Fed backs-off its near-zero rate policy, the more capital will be allocated on the basis of relative value and less with complete disregard to valuation constraints. It seems to us, that both the narrative and the abundance of cheap money are in a process of change.
Even though the repurchase market, where securities are used as collateral for loans by investment banks, shows that the North American equity markets are not in a bubble state, it would be unrealistic to assume that the Fed can exit without some effect on asset prices. We took a few chips off the table in Gold, Emerging and Home markets for good profits and entered into a small short position in the TSX for downside ‘insurance’ protection.
Hubert Marleau ,Chief Investment Officer, Palos Management Inc.