The Cost Of The 60% Market Move; The Benefits Of Free Liquidity
There is now no question that the sole, undisputed factor driving credit and equity markets is the dollar destructive collusion between the Fed and the major global central banks. As long as the Fed is dead set on inflation, and is willing to throw trillions of free liquidity at any problematic flare up, and is happy to keep interest rates at 0%, liquidity-addicted equities will likely push higher until such time that the incremental hopium "hit" does nothing, and markets overdose, ending up not just in the critical condition reminiscent of fall 2008, but outright death. Until then, expect to see your daily dose of market buoyancy from whatever algo is currently the dominant momentum platform gunning the market ever higher, even past all disconnect with traditional correlations such as FX, credit and commodities. If the Fed wills it, so it shall be. Alas, while the Bank of England was apparently an easy target, when it comes to massive financial fraud and malfeasance, the Fed is untouchable.
The major benefit to asset managers is that they can fire their entire analyst teams: the only relevant metric to determine where stocks will trade is reading between the lines of Fed statements and following the daily dollar action tick for tick. This way even hedge funds can start reporting phenomenal EPS on collapsing revenues (shockingly, redemptions are still occurring quite aggressively throughout the entire buyside community). For a more objective quantification of the near-term benefits and long-term catastrophe of the Fed's liquidity avalanche, Bank Of America has put together several observations on the matter.
That government intervention policy has successfully mitigated the credit crisis without a clear cost [$9 trillion apparently is not clear enough for Merrill Lynch. oh well] remains the key to the recovery in risk assets and our near term bullishness. However, that strategy front loads the benefits and back loads the risks. The benefits are manifest in the rebound in capital markets, the reopening of credit markets and the substantial reduction in credit costs bolstering risky asset pricing. These benefits follow direct and indirect government intervention in financial markets. Direct intervention through the effective nationalization in case of residential mortgages, TALF and PPIP support for consumer ABS and CMBS and ZIRP (zero interest rate policy) for corporate credit all resulted in the collapse in credit costs and the expansion of credit availability as Figure 1, Figure 2, and Figure 3 nearby highlight. This repair in credit markets further supported the rebound of equity markets.
Ah the American way: 150x P/E yesterday, benefits now, credit card statement later, payments never.
The cost for such a strategy remains the long term inflationary consequence of such policies. As Figure 1 highlights, near term, the inflationary “consequence” can be seen only in asset prices rather than in goods and services inflation. With substantial resource slack, coincident measures of inflation (core and headline) have continued to decline. And those declines have underpinned stable inflation expectations (which rose from their deflationary concerns of last
The price of adjustment for those policies would be either interest rates or the dollar or both. Dollar declines highlight the concerns over these long run consequences though only bring the dollar back to its pre-crisis levels. Gold by contrast stands well above its pre-crisis levels indicating a higher level of inflationary concern.
However, the largest impact to the real economy would be through interest rates. Benign long term interest rates even in the face of rapidly expanding government deficits are critical to near term financial market performance, in our view. Longer term, our Interest Rate Committee expects a gradual rise in 10-year rates (4.25 YE 2010 and 4.45 YE 2011). Such a gradual increase would likely still be supportive of overall asset price inflation in risky assets (credit and equities). But faster increases in rates would clearly undermine near term support for risky assets. Our outlook remains that next week will not yield a new environment for the rates outlook from the FOMC meeting, the refunding announcement or the employment situation. Clearly though the risk is skewed to the surprise and the downside for risk assets and the upside for rates.
Did someone just say Goldilocks economy? We all remember how that worked out last time. A direct consequence of everyone terrified of standing up to the Fed, especially with equity markets barely gathering enough volume to challenge dark pools, a better place to look at is credit.
Credit markets are outperforming equities across the board, both in higher and lower quality tiers of the universe. This relative outperformance has been driven to a large extent by the direction of fund flows, as we discussed above, where most of $430 billion in outflows this year from money market funds went into various bond funds – from municipal securities to corporate credit and emerging markets – with no meaningful flows into equities, see Figure 8 above.
Perhaps the best way to visualize the degree of impact from such a positive liquidity backdrop on credit markets is Figure 10 below, where we show the relationship between the stocks (S&P 500) and high grade corporate spreads. Normally we would expect an inverse relation where increasing stock prices are associated with tightening credit spreads3 and, while that relation generally holds, the recovery since March 2009 is following a different path than the financial crisis from July 2007 to March 2009. Clearly credit is recovering more rapidly than stocks – that is a result of the liquidity effect as investment flows have been directed toward corporate credit.
Another way to look at this issue in high yield is to show that excess liquidity is capable of moving spreads against their fundaments, ie, defaults. Figure 11 above shows that high yield spreads and defaults, which are naturally highly correlated with each other, have moved in dramatic opposite directions over the past year. While spreads have tightened from 2,000 bps late in 2008 to roughly 750 bps today, the default rate has increased from 3% to 12% over the same time interval. And while spreads normally anticipate future defaults, this time the turn was to an even grater degree as the benefits of liquidity postponed default risk. That liquidity conditions will mitigate future defaults is best summarized by our favorite quip: a rolling loan gathers no loss.
While not presenting anything new or original on the matter of defaults except for some witticisms that have long since stopped being witty, what BofAMLCFCTARP forgets to focus on is that any extension in death expectations comes at the cost of ultimate recoveries. Cumulative losses are being delayed indefinitely as trigger events are being virtually prohibited courtesy of the administration's loose actions. Yet the underlying asset values still get exhausted. The Fed can prolong the pain only so much before 20% real unemployment (the U-6 should get there within 3-6 months), vacant office buildings, and collapsing world trade extract their toll on cash flow generation capabilities. But if papering over a hollow economy has worked so far, why not let it work a little longer. As has been made all too clear, the 2-3 computers holding all the marginal stocks at the end of the rally will be wiped out, all the insiders will have sold their shares, and those in the middle class who think they can compete with Wall Street will be selling hot potatoes to themselves all they way down to whatever the new low becomes. If this low is accompanied, or preceded by the Fed's launch of a tightening strategy (very, very unlikely: the Fed will likely keep interest rates at zero as Australia's hit 20% at some point in 2012), we will see lows much worse than what was experienced in March 2009.