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Andy Xie: Tight Spot for Fed, Blind Spot for Investors
Market chatter over green shoots and rising prices has fueled a bear market rally that won't last, despite policymaker 'noise.'
By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
(Caijing Magazine) A combination of growth optimism and inflation fear has catapulted asset markets in the past few weeks. These two concerns should drive markets in different directions: Inflation fear, for example, should limit room for stimulus and prompt stock markets to retreat. But the investment camps expressing these opposite concerns go separate ways, each pumping up what seems believable. As a result, stock and commodity markets are mirroring the behavior seen during the giddy days of 2007.
Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for more than a year, they just couldn't sit around any longer. So they decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. Now that the rising trend has been around for three months globally and seven months in China, even the most timid have been unable to resist. They're jumping in, in droves.
When the least informed and most credulous get into the market, the market is usually peaking. A rising economy and growing income produces more funds to fuel the market. But the global economy is now stuck with years of slow growth. Strong economic growth won't follow the current stock market surge. This is a bear market rally. People who jump in now will lose big.
Over the past three weeks, the dollar dove while oil and treasury yields surged. These price movements exhibited typical symptoms of inflation fear, which is complicating policymaking around the world. The United States, in particular, could be bottled in. The federal government's fiscal stimulus and liquidity pumping by the Federal Reserve are twin instruments for propping up the bursting U.S. economy. The fiscal deficit could top US$ 2 trillion (15 percent of GDP) in 2009. That would increase by one-third the total stock of federal government debt outstanding. Such a massive amount of federal debt paper needs a buoyant Treasury to absorb. If the Treasury market is a bear market, absorption becomes a huge problem.
U.S. Treasury Secretary Timothy Geithner recently visited China to, among other things, persuade China to buy more Treasuries. According to a Brookings Institution estimate, China holds US$ 1.7 trillion in U.S. Treasuries and GSE paper (about 15 percent of the total stock). If China stops buying, it could plunge the Treasury market into deep bear territory. If China does not buy, the Treasury market will get worse. But China can't prop up the market by buying.
In the past few years, purchases by central banks around the world have dominated demand for Treasuries. Central banks have been buying because their currencies are linked to the dollar. Hence, such demand is not price sensitive. The demand level is proportionate to the U.S. current account deficit, which determines the amount of dollars held by foreign central banks. The bigger the U.S. current account deficit, the greater the demand for Treasuries. This is why the Treasury yield was trending down during the bulging U.S. current account deficit period 2001-'08.
This dynamic in the Treasury market was changed by the bursting of the U.S. credit-cum-property bubble. It is decreasing U.S. consumption and the U.S. current account deficit. The 2009 deficit is probably under US$ 400 billion, halved from the peak. That means non-U.S. central banks have much less money to buy, while the supply is surging. It means central banks no longer determine Treasury pricing. American institutions and families are now marginal buyers. This switch in who determines price is shifting Treasury yields significantly higher.
The 10-year Treasury yield historically averages about 6 percent, with about 3.5 percent inflation and a real yield of 2.5 percent. This reflects the preferences of marginal buyers in the United States. Foreign central banks have pushed down the yield requirement substantially over the past seven years. If marginal buyers become American again, as I believe, Treasury yields will surge even higher from current levels. Future inflation will average more than 3.5 percent, I believe. Some policy thinkers in the United States believe the Fed should target inflation between 5 and 6 percent. The Treasury yield could rise to between 7.5 and 8.5 percent from the current 3.5 percent.
A massive supply of Treasuries would only worsen the market. The Federal Reserve has been trying to prop the Treasury market by buying more than US$ 300 billion – a purchase that's backfired. Treasury investors are terrified by the inflation implication of the Fed action. It is equivalent to monetizing national debt. As the federal deficit will remain sky-high for years to come, the monetization could become much larger, which might lead to hyperinflation. This is why the Treasury yield has surged in the past three weeks.
One possible response is to finance the U.S. budget deficit with short-term financing. As the Fed controls short-term interest rates, such a strategy could avoid the pain of high interest rates. But this strategy could crash the dollar.
The dollar index-DXY has fallen 10 percent from the March level, even though the U.S. trade deficit has declined substantially. It reflects the market's expectations that the Fed's monetary policy will lead to inflation and a dollar crash. The cause of dollar weakness is the outflow of U.S. money, in my view. It is the primary cause of a surge in emerging markets and commodities. Most U.S. analysts think the dollar's weakness is due to foreigners buying less of it. This is probably incorrect.
The dollar's weakness can limit Fed policy options. It heightens inflation risks; a weak dollar imports inflation and, more importantly, increases inflation expectations, which can be self-fulfilling in today's environment. The Fed has released and committed US$ 12 trillion (83 percent of GDP) for bailing out the financial system. This massive overhang in money supply could cause hyperinflation if not withdrawn in time. So far, the market is still giving the Fed the benefit of the doubt, believing it will indeed withdraw the money. Dollar weakness reflects the market's wavering confidence in the Fed. If the wavering continues, it could lead to a dollar collapse and make inflation self-fulfilling.
The Fed may have to change its stance, even using token gestures, to assure the market it won't release too much money. For example, signaling rate hikes would soothe the market. But the economy is still in terrible shape; unemployment may surpass 10 percent this year. Any suggestion of hiking interest rates would dampen growth expectations. The Fed is caught between a rock and a hard place.
Oil prices have doubled since a March low, even though global demand continues to decline. The driving forces again are expectations of inflation and a weaker dollar. As U.S.-based funds flee, some of the money has flowed into oil ETFs. This initially impacted futures prices, creating a huge gap between cash and futures prices. The gap increased inventory demand as investors tried to profit from the gap. Rising inventory demand caused spot prices to reach parity with futures prices. Rising oil prices, though, lead to inflation and depress growth. It is a stagflation factor. If the Fed doesn't rein in weak dollar expectations, stagflation will arrive sooner than I previously expected.
Stagflation in the 1970s spawned the development of rational expectation theory in economics. Monetary stimulus works by fooling people into believing in money's value while the central bank cheapens it. This perception gap stimulates the economy by fooling people into demanding more money than they should. Rational expectation theory clarified the underpinning for Keynesian liquidity theory. However, as they say, people can't be fooled three times. Central banks that tried to use stimuli to solve structural problems in the '70s saw their stimuli didn't work. People saw through what they tried again and again, and began behaving accordingly, which translated monetary stimulus straight into inflation without stimulating economic growth.
Rational expectation theory discredited Keynesian theory and laid the foundation for Paul Volker's tough love policy, which jagged up interest rates and triggered a recession. The recession convinced people that the central bank was serious about cooling inflation, so they adjusted their behavior accordingly. Inflation expectations fell sharply afterward. The credibility that Volker brought to the Fed was exploited by Alan Greenspan, who kept pumping money to solve economic problems. As I have argued before, special factors made Greenspan's approach effective at the same. Its byproduct was asset bubbles. As the environment has changed, rational expectation theory will again exert force on the impact of monetary policy.
Movements in Treasury yields, oil and the dollar underscore the return of rational expectation. Policymakers have to take actions to dent the speed of its returning. Otherwise, the stimulus will lose traction everywhere, and the global economy will slump. I expect at least gestures from U.S. policymakers to assuage market concerns about rampant fiscal and monetary expansion. The noise would be to emphasize the "temporary" nature of the stimulus. The market will probably be fooled again. It will fully wake up only in 2010. The United States has no way out but to print money. As a rational country, it will do what it has to, regardless of its rhetoric. This is why I expect a second dip for the global economy in 2010.
While inflation expectations are causing some in the investor community to act, the rest are betting on strong economic recovery. Massive amounts of money have flowed into emerging markets, making it look like a runaway train. Many bystanders can't take it any longer and are jumping in. Markets, after trending up for three months, are gapping up. Unfortunately for the last-minute bulls, current market movements suggest peaking. If you buy now, you have a 90 percent chance of losing money when you try to get out.
Contrary to all the market noise, there are no signs of a significant economic recovery. So-called green shoots in the global economy are mostly due to inventory cycles. Stimuli might juice up growth a bit in the second half 2009. Nothing, however, suggests a lasting recovery. Markets are trading on imagination.
The return of funds flowing into property is even more ridiculous. A property burst usually lasts for more than three years. The current burst is larger than usual. The property market is likely to remain in bear territory for much longer. The bulls are talking about inflation as the bullish factor for property. Unfortunately, property prices have risen already and need to come down even as CPI rises. Then the two can reach parity.
While rational expectation is returning to part of the investment community, most investors are still trapped by institutional weakness, which makes them behave irrationally. The Greenspan era has nurtured a vast financial sector. All the people in this business need something to do. Since they invest other people's money, they are biased toward bullish sentiment. Otherwise, if they say it's all bad, their investors will take back the money, and they will lose their jobs. Governments know that, and create noise to give them excuses to be bullish.
This institutional weakness has been a catastrophe for people who trust investment professionals. In the past two decades, equity investors have done worse than those who held U.S. market bonds, and who lost big in Japan and emerging markets in general. It is astonishing that a value-destroying industry has lasted so long. The greater irony is that salaries in this industry have been two to three times above what's paid in other sector. The key to its survival is volatility. As markets collapse and surge, possibilities for getting rich quickly are created. Unfortunately, most people don't get out when markets are high, as they are now. They only take a ride.
Indeed, most people who invest in the stock market get poorer. Look at Japan, Korea and Taiwan: Even though their per capita incomes have risen enormously over the past three decades, investors in these stock markets lost money. Economic growth is a necessary but not sufficient condition for investors to make money in the stock market. Most countries, unfortunately, don't possess the conditions for stock markets to reflect economic growth. The key is good corporate governance. It requires rule of law and good morality. Neither is apparent in most markets.
It's a widely accepted notion that long term stock investors make money. Actually, this is not true. Most companies don't last for more than 20 years. How can long term investment make money for you? The bankruptcy of General Motors should remind people that this notion is ridiculous. General Motors was a symbol of the U.S. economy, a century-old company that succumbed to bankruptcy. In the long run, all companies go bankrupt.
Property on the surface is better than the stock market. It is something physical that investors can touch. However, it doesn't hold much value in the long run either. Look at Japan: Its property prices are lower than they were three decades ago. U.S. property prices will likely bottom below levels of 20 years ago, after adjusting for inflation.
China's property market holds even less value in the long run. Chinese properties are sitting on land leased for 70 years for residential properties and 50 years for commercial properties. Their residual values are zero at the end. The hope for perpetual appreciation is a joke. If you accept zero value at the end of 70 years, the property value should only be the use value during those 70 years. The use value is fully reflected in rental yield. The current rental yield is half the mortgage interest rate. How could properties not be overvalued? The bulls want buyers to ignore rental yield and focus on appreciation. But appreciation in the long run isn't possible. Depreciation is, as the end value is zero.The world is setting up for a big crash, again. Since the last bubble burst, governments around the world have not been focusing on reforms. They are trying to pump a new bubble to solve existing problems. Before inflation appears, this strategy works. As inflation expectation rises, its effectiveness is threatened. When inflation appears in 2010, another crash will come.
If you are a speculator and confident you can get out before it crashes, this is your market. If you think this market is for real, you are making a mistake and should get out as soon as possible. If you lost money during your last three market entries, stay away from this one – as far as you can.
Good speculating to you all and please don't ever, ever forget that "an investor is a speculator who made a mistake and will not admit it".
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