Wednesday, 17 December 2008

Fed pulls out all the stops and stock markets get it right

Federal Reserve's statement yesterday was no less than historic. For the first time, Fed commits to use "all available tools" to fight the downturn. It looks like a Japanese-style Zero rate policy, but it is a good deal more. In fact, Fed allows itself to inflate its balance sheets through unlimited asset swap transactions and no questions will be asked about the quality of the collateral for an extended period of time. By making funds available to the banks at an interest rate of zero, the banks can make money on lending even at a couple of per cent. Nonetheless, this move is largely symbolical compared the continued expansion of the asset swap program.

Given that the banks have so far reduced credits instead of granting new ones, the asset swap program partially bypasses the banking sector by offering the possibility for Fed to grant collateralised loans directly to non-financial institutions or at least to non-bank organisations. All well and good, and there is now no doubt that Fed is applying plan C in targeted and consistent way. I has already had the desired effect on the longer term yields with 10-year treasury yields heading towards 2 per cent and mortgage rates falling in parallel.

What may not be so positive is the background for this move. The US economy is still deteriorating. Not one single economic indicator is pointing even to a stabilisation. One element of a recession, namely an increase in the corporate default rate is only at the beginning. Even if the savings rate has jumped sharply – sober estimates say to 2.5% of disposable income – in a matter of months, it is still anybody's guess when the US households will finally feel that they have reduced their debts enough in order to resume normal spending. Car sales are still dead in the water and credit card companies are reining in debt instead of expanding it. The only shimmer of light comes from the weekly refinancing activity, where an increase is an indication that US home owners are in fact restructuring their debt by taking longer term loans at the currently attractive rates. All of these factors are unknowns that make it very difficult to time when the US economy may hit rock bottom and begin to rebound.

We have seen some powerful rallies in the stock markets recently. They are built on the assumption that with all the good work by Fed and Obama signalling ever-growing economic stimulus once he has moved into the oval office. It makes sense that with so much power and determination being poured into the project of getting the economy going, it will eventually happen. The only question is when this will happen.

I earlier subscribed to a point of view that 3rd quarter of 2009 would be the time when the US economy could have seen the bulk of the contraction and it would be possible to imagine a rebound. I am not so sure it will happen that fast. The mainline scenarios for growth now appears to have settled on a contraction of about 2 per cent for the US economy in 2009 after an almost flat/slightly negative growth in 2008.

At the same time estimates for the "necessary contraction" required in order to re-establish the savings rate to healthy levels have ranged between four and seven per cent accumulated over the duration of the downturn. Even if we stay at the comfortable end of this range, the current mainline growth estimations for 2008 and 2009 only sums up to half of that. So either the negative growth will continue into 2010 or the downturn in the economy will be a good deal more severe than the current consensus estimates.

Which brings us back to the stock markets. While the stock market perennially prides itself of being able to predict events that will happen 6-9 months time, this ability appears somewhat impaired recently. And the stock market needs an economic rebound to see an earnings rebound. What if the rebound only comes well into 2010 because the debt overhang is still too heavy? Obviously it would lead to another downturn in the market. I simply refuse to believe that the average of the stock market operate without being able to take into account this possibility. Yet we have seen a healthy recovery in the stock markets recently.

If looking for an alternative explanation, it might be useful simply to think as follows: the market suffers from a total "lack of visibility". This is analyst-speech for "we don't know what will happen" – which appears a rather sensible thing to admit. So we all act on the basis of perceived probabilities instead. With each of the initiatives coming from the US and even from Europe over the past weeks, the perceived probability of a rebound in 3rd quarter of 2009 has clearly increased. That makes the case for maintaining short positions less attractive. So it could indeed be that the main driver of the recent rallies have been short covering, punctuated by selling from those who still have to liquidate positions (read: hedge funds being hit by redemptions). Judging by the relatively low volume of turnover in the stock markets, this could indeed be the case. While this is not exactly a strong basis for a sustained rally, it at least gives some legs to a continued rebound, which will last as long as the market perceives that the probability of a rebound within 6-9 months is increasing.

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