| The Economy and the Credit Market | |
| Are the US and global economies developing a speculative bubble? Just a year ago, investors and policy makers were still reeling from the fallout of the worst financial crisis in modern history. Today, though growth projections are reserved and yield expectations are far below the levels seen through the boom years, the Dow is 60 percent above its 2009 lows. This is a side effect of the world’s governments laying down a safety net for speculators in the form of policy and encouraging risk taking through unprecedented injections of stimulus. Interest rates near recent-record lows have opened the doors to financing and leverage; and market participants are happy to recover some of the wealth lost through the preceding crisis. However, a factor that has been ignored for too long through the bullish rally is that this market cultivation is temporary. Eventually, the government has to withdrawal its support and the market will have to stand on its own weight. Considering the sharp rally in the dollar and drop in risk-sensitive markets today, this eventuality can no longer be ignored. And, while this particular spike in volatility doesn’t necessarily mark the turning point for speculation; it nonetheless speaks to the doubts that lie just beneath the surface. Should a move to fairly value capital markets develop, the dollar will be a primary benefactor as a primary source of funding behind the carry trade build up. Furthermore, when the US and Japanese 3-month Libor rate finally flip in the dollar’s favor, the greenback won’t have to depend on risk alone. |  |
| A Closer Look at Financial and Consumer Conditions | |
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| All the normal signals out in the market are pointing to stability: junk bond premiums are contracting; mortgage debt leverage has returned to 10-to-1; the banks have paid off most of their TARP loans; and the Dow is just off of 13-month highs. However, all these factors are a reflection of risk appetite and invariably supported by the government’s liberal support. Most savvy market participants know that both of these conditions are temporary. The US government is already withdrawing stimulus; and this week’s earnings data shows what the costs can be. It will be a delicate balance to roll back support slow enough to not disrupt speculative sentiment. There are more than a few cracks in the system as it is; but the real threat is investor fear itself. | There is a disconnect between the current market levels and the outlook for economic activity. The record-breaking appreciation in the equities and other fungible markets over the past year doesn’t match the reserved outlook for growth that officials and economists have laid out for the immediate future. Yet, speculative interests aside; the world’s largest economy is still on pace for a gradual but steady recovery. In its recent update of growth forecasts, the World Bank projected the US would expand 2.7 percent this year. On the other side of the monetary policy coin, recent data revealed a sharp increase in the inflation rate to a 2.7 percent clip. While this has been deemed temporary, the shifting balance towards hikes is unmistakable. |
| The Financial and Capital Markets | |
| Investor confidence was shaken this past Wednesday when all the major asset classes fell into a slump. However, this sharp decline in equities, commodities, bond yields and other liquid securities has not confirmed a lasting and broad reversal in underlying sentiment. Rather, this rapid adjustment has reminded traders that the market is notionally and fundamentally expensive. What instigated this quick correction? The fourth quarter earnings season in the United States and warnings from the Chinese banking regulator that they would limit lending (and therefore investment) were notable catalysts. Yet, doubt and fundamental weakness has been building up in the background for some time now. Moving forward, both of these factors can further weigh the market down. The strong earnings from American firms over the past year were the product of cost cutting and accounting. Eventually, the limited outlook for growth and credit availability will filter through to revenues. As for China, the explicit efforts to prevent a speculative bubble from building and bursting speak to sentiment in the global financial markets. The world’s governments are trying to withdrawal support of the market and do so without undermining investors. Taking some of the air out of the ‘hot money’ is a means; but it don’t guarantee the end. |  |
| A Closer Look at Market Conditions | |
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| Looking at the benchmarks of the various capital markets, it was clear that risk appetite was shaken this week. The CRB Commodities Index slipped first as fundamentals never materialized in the form of supply-and-demand or speculative build up to support the aggressive rally behind crude oil. For equities, volatility has certainly increased; but the same qualifications for ‘reversal’ have yet to be met. The benchmark Dow marked a sharp drop through Wednesday; but the index’s two-month long, 300-piont wide ascending trend channel is still intact. If the markets are indeed set to establish a new trend; they will have to make their move to follow up on it soon. | We are seeing contrasting views of risk. A view of the bigger picture reveals that the traditional and non-traditional gauges for fear and loss are progressing to levels not seen since before the Lehman Brothers collapse. However, focusing on more recent activity, we see that these excessively cheap rates for market insurance have been prone to volatility. It is true that with the financial crisis having passed and the economy entering a gradual recovery, market swings will smooth out. Yet, that does not mean we will not see marked corrections. Current levels for volatility indicators and insurance-related derivatives suggest the market is undervaluing even a modest retracement in risk appetite. |
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Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at jkicklighter@dailyfx.com.
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