Has Complaceny Set In? China Rolls Over
A: One of the trickiest thing about equity trading is figuring out when stocks have fully priced in all available information - this is one reason why stocks are both not rational and not always right. The concept of when a stock has fully priced in or priced out information is one that will always baffle even the best traders and research teams. With that said, what type of recovery has this market already priced in? And has the market priced in future exit strategy announcements from our fed? Anyone watching the global markets probably has noticed the rolling over of China's Shanghai Index lately in response to the governments threat of pulling the punch bowl away from the banking sector. I find this very interesting because the Shanghai market seems to have been leading other markets in regards to the reaction to major stimulus and now the reaction to possible 'more restrictive' policy. Could this be a glimpse of how equities will react when our fed has to take the same path? Since policy actions taken to stem this crisis has been gargantuan to say the least, the debate will rage between whether the fed slowly and methodically conducts their exit strategy or if we are in for a swift pull of the punch bowl too.
China's Shanghai index is now down 23% in the past month or so; shown on the chart to the right. This is worth watching because it looks like China will be the first test case of sterilizing uber lending that took place in the first half of 2009. Imagine if our Dow falls to 7,400 or so in a months time - do you think people would notice!
According to this Bloomberg article 10 days ago, "China plans to tighten capital requirements for banks, threatening to curb the record lending that’s fueled a 60 percent rally in the nation’s stock market, three people familiar with the matter said."
The gov'ts plan was to require the banks to 'deduct all existing holdings of subordinated and hybrid debt sold by other lenders from supplementary capital', forcing the banks to raise more capital and possibly sell shares. The immediate reaction was that this was the government's way of taking away the Kool-Aid that powered the equity markets up over 103% since the lows. China is taking a different route to toughen capital requirements to curb aggressive lending that was previously encouraged to re-stimulate the economy, and its equity markets are reacting to this new information. It's quite nice to see proactive actions taken to prevent another speculative bubble from forming.
2010 and 2011 will no doubt be the years that sees our unprecedented stimulus eased back in. So what will our fed do? Here are my thoughts in order.
1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov't would could happen - seeing that result all but solidified the 'too big to fail' mantra.
2. Second, they will be forced to raise rates - that's right folks, 0% - 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.
3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road - perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed's paid interest on excess reserves - the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.
4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.
These are the things we will start to see in 2010 and into 2011. I do not think stocks have begun the pricing in of possible fed exit strategies. This cycle will prove much different than past ones and the fed may have to act aggressively to start the exit strategy, and then move to a slow and methodical approach to maintain the policy. Time will tell if the initial shock causes a disruption to this equity surge.
Whether we reach #4 (tightening of capital/reserve requirements) is a big question mark and when #3 (reversal of POMO operations to drain liquidity from excess reserves) happens is a question of later rather than sooner. For now, the stimulus remains in place and the fed is finishing off its outright coupon purchases through permanent open market operations at the NY Fed. Lets see whether our fed and banking regulators have the political will to do what they need to when the time comes to get this economy off life support as the equity markets price in future recovery.
I am in the double dip recession camp and I think the 2nd dip is a way off! First we have to get through the good economic data that comes from the side effects of a surging equity market, 'less worse' trends, restocking of inventories, gov't stimulus programs, and a dramatic improvement in credit. As a result, I expect the second dip to come in early 2011 or perhaps 2012 and the banks to deal with a second wave of pressures from losses associated with commercial, prime, jumbo, whole loans, private equity financed leveraged buyouts, etc.. - in addition to less accommodating decisions from the FASB regarding off balance sheet accounting rules. It started with the banks, it seems the banks are leading the way out now, and I think the banks will once again lead us into the second dip in a few years. I expect the next wave to be significantly less fierce than what we just experienced, but perhaps be more drawn out. For now, the banks raised a ton of money and the fed has engineered an environment for banks to earn their way to a healthier balance sheet. Will this go too far and has complacency set in? Now that we saw what happened to China's indexes, are we prepared for a similar fate?
Watch for good news to hit the headlines, but stocks to selloff - the opposite of what happened in early March when stocks rallied on bad headlines. That is when you know the market probably fully priced in the near term expectation and is now adjusting to the possibility that the expectation may not be sustainable for the longer term. After all, they don't say 'buy the rumor & sell the news' for nothing!
Comments (1)
Thanks for the information
Posted by Rick Arvielo | August 31, 2009 12:45 PM