Friday, August 14, 2009

How the Fed is feeding the frenzy

I had friends when growing up who would labour on those 10,000 piece jigsaw puzzles for weeks at a time. They would work from the edges in - gradually unveiling the picture that was hidden in the mass of fragments. Feels like this week I have made a little headway on the puzzle that is the market that we are living through (still at the edges though).

The key is the Fed and its printing press.

A mate was in the US recently. Initially, trapsing around the west, he was convinced of the absolute mess the US is in. Negative equity, unemployment, crumbling state finances are all symptoms of the problem. He left that part of the land a confirmed bear.

But landing in New York changed everything. Wall Street is awash with cash. The banks have a seemingly endless supply of cheap money at their beck and call, all they need to do is find an asset to invest it in. It's the simplest of carry trades. With one side of the ledger underwritten by the Fed, they are bidding up any and all of the credit spreads that had moved to stupendously wide margins. No wonder then that the likes of Goldman have been making such extraordinary returns. He left New York convinced that the worst is behind us, and that the risk trade has legs.

To me this speaks of a schizophrenic market. The fundamentals remain poor. But the voices in your head are saying buy. The Fed has manufactured this artificial bid. And it will remain so, until they rein in the liquidity they are providing. At the limit, the Fed can continue until the financiers of its money printing call in the men in the white coats. The indicators to watch here are the USD, credit spreads and the yield curve. There can be no escaping the fact that the lenders will ultimately demand higher returns from the US government for all it debt profligacy.

In Australia, we too are recipients of the Fed's largesse. Credit spreads here that were completely disfunctional six months ago have been cranking in with the trading desks of our very own banks making hay in historical proportions while the sun shines.

As credit spreads have contracted and, as the press reports it, risk appetite has returned, the equity markets have built up a head of steam.

So how long will this continue? The simple answer is until the Fed starts withdrawing the liquidity. If they are committed to printing money until October per the FOMC minutes, this would seem to at least put a floor beneath demand until then. Talking to an equity fund manager, he reported that consensus amongst his fraternity was for a correction in October/November. Seems to fit.

Now does that mean the markets can continue to run? I'm not so sure, but it's certainly possible. When I hear that Macquarie brokers are spruiking 5000 for the All Ordinaries by Christmas - but that its a trading market, buy now with the plan to sell before the top is in - I'm thinking that we are in for a pretty quick correction when it comes. It may run higher, but the higher it goes, the harder it will fall. A market where consensus has punters trading long but ready to run for the exits (and expecting to be the first to the doors) is a fragile one.

Conclusion - this is not a market to buy into. The turn when it comes will be quick. The market can however continue to motor on as long as the Fed continues to prime the presses (and the suspension of disbelief that this requires).


  1. This is a very good explanation for what seems an implausible ramp up in share prices. It is a kind of asset bubble happening in shares.

  2. It's all a question of timing I guess...