When you really think about it (as we do quite often) this market makes no sense. Bulls give the less than convincing argument that you must invest because the Fed is printing that much money you’d be mad not to.
But when we look at the actual data, we’re not convinced of this argument. 2011 ended with the Fed’s balance sheet at US$2.92 billion. Now, it stands at US$2.87 billion.
Of course there are compositional changes in the balance sheet related to the Fed’s most recent monetary operations – ‘operation twist’. This is where the Fed buys longer-term treasury bonds and sells short-term notes. The size of its balance sheet doesn’t really change, but it encourages speculation by forcing (coercing) the market to take on more risk to achieve returns.
This is part of the good old risk/reward trade-off. Many think this equation simply means more risk = more reward. But that only works when the perceived risk is highest (and actual risk quite low due to the attractiveness of asset prices).
There is not a huge amount of perceived risk at the moment. The perception is that the greatest risk is to be out of the market. When it reaches that point, you know that taking on risk will not provide the expected reward. Actual risk is very high.
But the perception the central banks will prop up the markets at all costs is a strong one and that provides confidence. Confidence produces liquidity, which produces share prices gains, which fuels even more confidence…and the cycle continues.
It reminds us of former Citigroup CEO Chuck Prince’s comments in July 2007:
‘When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.’
The cycle continues until reality intrudes. When that point is, nobody knows. But we think this belief in central banking – the source of the market’s liquidity and confidence – is seriously flawed. While the Fed’s recent actions are relatively circumspect, the European Central Bank (ECB) has put in a herculean effort to save a flawed monetary system.
And where has that got us? Europe’s peripheral countries are in recession/depression. Their competitiveness vis-à-vis northern Europe is as bad as ever. Their debt dynamics continue to deteriorate.
Yet the market continues to believe.
for Markets and Money
From the Archives…
What the News on Bond Yields Say About the “Resolved” Eurozone Crisis
2012-04-13 – Eric Fry
The Art of Selling Stocks
2012-04-12 – Chris Mayer
Misguided Faith in an Economic Recovery
2012-04-11 – Joel Bowman
Beware the Big Government Debt Switcheroo
2012-04-10 – Dan Denning
The Discount Rate: Borrowers, Lenders and Bonds
2012-04-09 – Nick Hubble