All Eyes on The US Federal Reserve

Before we get into today’s Markets and Money, just a quick reminder to keep an eye out for a new ‘Revolutionary Technology Report’ coming out later today. It should be with you around 3pm. It’s the culmination of the three part tech-trilogy video series from Kris Sayce and new technology analyst Sam Volkering.

Right then, what’s in store for this week? Well, for a change, all eyes are firmly focused on the US Federal Reserve. This cabal of central bankers meet on Tuesday and Wednesday in the US to privately wonder what in God’s name is going on…to contemplate the damage they have wrought across the world…and to nervously guess what move they should make next.

Of course, the minutes to the meeting will emerge a month later showing conviction and confidence in any decision made and discussion had. If you don’t really know what you’re doing, you at least should sound like you do.

After all, this is one big confidence game the Federal Reserve is playing. And lately, maintaining confidence has been a bit of a problem for the institution that sets the global price of credit. With all their unconventional monetary actions over the years, they have now got themselves into a spot of bother.

They’re creating plenty of asset price inflation, but not much in the way of sustainable economic growth. They have come to the belated realisation that increasing asset market speculation is bad for the economy. It actually makes things worse!

So in order to keep this speculation in check, Fed Chairman Ben Bernanke has introduced the word ‘taper’ into financial markets. As in he will soon (but not too soon) ‘taper’ the pace of asset purchases to wean markets off their heavy dependence on the Federal Reserve.

Like most things espoused by the Federal Reserve’s largely academic board, it sounds good in theory. But markets couldn’t give a hoot about theory. So they’ll be listening intently to Bernanke’s press conference following the board meeting this week. It he utters the wrong words, or gets the phrasing wrong, we could be in for a wild ride.

The market is already very nervous. Yields on US Treasury bonds are rising. Over the last 12 months, yields have jumped from 1.6% to around 2.2%. This is representative of monetary tightening across the board.

The chart below shows a sharp jump in the 30-year fixed rate mortgage.

US Mortgage Rates Spiking Higher

US Federal Reserve
This next chart shows a spike in the borrowing costs for below investment grade corporates. With or without Ben Bernanke and the Federal Reserve, financial conditions are getting tighter.

Below Investment Grade Corporate Rates Spiking Higher

US Federal Reserve
And emerging markets have felt the effect of monetary tightening emanating from the world’s largest economy and manager of the global reserve currency.

Since peaking in January this year, the Brazilian market is down a whopping 22% and Mexico’s bourse is off 14%. Asia is not far behind. Chinese stocks are down 13.5% from the peak in February, while Thailand (-10.8%), the Philippines (-15.6%), Indonesia (-8.7%) and India (-6.1%) are all down from their highs in May.

Now this might just be a correction and nothing to worry about. After all, interest rates are still incredibly low from a historical point of view. You could just be seeing a pullback following a central bank induced liquidity melt-up earlier in the year.

But given the inherent instability in the system…and the fact that nothing has changed to correct the problems that brought about the first big credit crisis in 2007, we would be inclined to take the recent market action as a warning sign of trouble to come.

To understand why, you need to understand how the financial system ‘works’. The US economy is the source of global liquidity. Due to massive US budget and trade deficits, US dollars (in the form of Treasury and mortgage securities) flow out into the world. Countries that stand to benefit the most from the deficit spending soak up the flow of dollars with, in many cases, newly created domestic money and credit.

This has the effect of both financing over-consumption in the US and building up the foreign exchange reserves of the country in question…reserves which the domestic banking system can then use as a base to expand its own credit creation activities. It’s a liquidity-creating positive feedback loop.

While the US economy, buoyed by cheap money, continues to spew ever increasing amounts of greenbacks into the financial system, and emerging market export-dependent countries continue to mop up those greenbacks and increase their ‘foreign-exchange’ reserves, credit and equity markets will tend to inflate.

But this global dynamic relies on confidence in the ‘system’ to go on creating enough dollars and credit to keep the asset inflation going. And we think that confidence is beginning to wane.

So even though interest rates may still be historically low, it’s the change in rates you should be looking at. And compared to a few months ago, financial conditions are now tighter. And tighter conditions in the US mean tighter conditions around the world. Monetary tightening doesn’t usually inspire confidence amongst financial speculators.

Don’t forget, the US fiscal consolidation plays a large part in this too. For the past five years, the US government has churned out $1 trillion plus budget deficits. But government spending is set to contract sharply following the repeal of the Bush-era tax cuts and some changes to spending.

The Congressional Budget Office (CBO) now projects that the federal budget deficit will total $642 billion in 2013 and $560 billion in 2014. Last year, the CBO estimated that the deficit would remain over $1 trillion in 2013 and reach $924 billion in 2014.

That’s quite a tightening. The supply of new Treasuries is still high, but it’s the change that’s important and if the government can hit the CBO forecasts (unlikely) it will represent a significant fiscal contraction over this year and the next.

So you’ve got monetary and fiscal tightening going on behind the scenes, combined with hugely inflated, derivative driven asset market casinos where the players want to keep on rolling the dice.

But maybe not all the players. Perhaps what we’ve seen over the past month or so is the ‘smart money’ taking their chips off the table and exiting the building. When this occurred in past tightening phases, it was a prelude to a crash…more on this tomorrow.

Greg Canavan
for Markets and Money

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From the Archives…

Truth or Dare Time for the Investment Industry
14-06-13 – Vern Gowdie

The Launch of Revolutionary Tech Investor
13-06-13 – Kris Sayce

The Architecture of Oppression
12-06-13 ­– Dan Denning

The Upside of a Dive to 85 for the Australian Dollar
11-06-13 – Dan Denning

Courting Controversy Over Australian Property
10-06-13 – Dan Denning

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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