Morgan Stanley: 'The Tightening Has Begun'

Posted by urbandigs

Mon Jan 25th, 2010 09:49 AM

A: Interesting comments out from Morgan Stanley's European equity analyst Teun Draisma this morning regarding the future reality of tightening policy. The main point of the comments is that tighter policy will 'intensify' as 2010 rolls on, shaping up more like '1994 and 2004'.

From Business Insider, "Morgan Stanley: Sell Into Strength, The Tightening Has Begun":

Morgan Stanley analyst Teun Draisma:

Sell into strength, as authorities have switched from "all out stimulus" to "let's start some stimulus withdrawal". Tightening measures are coming in thick and fast around the world. We always thought that the start of tightening was not the first Fed rate hike, but could be many other things including higher taxes, less spending, more regulation, Chinese/Asian tightening, or Fed language change. Recent initiatives include Obama's banking initiatives, and several Asian tightening measures. In the next few months this theme is set to intensify, and we expect positive payrolls, a Fed language change, and the start of QE withdrawal. This willingness of authorities to move away from crisis mode is an important change and means that the tightening phase in the broad sense of the word has now started. Thus, indeed, 2010 is shaping up to be like 1994 and 2004, as we expected.

The start of tightening is hardly ever the end of the growth cycle, and normally the accompanying dip needs to be bought, but it typically is a serious double-digit dip lasting 2 quarters or more. The sector rotation has of course already started in October-2009 and is set to continue. As a result we move 2% from equities to bonds in our asset allocation, going to +5% cash, -2% UW equities, -3% UW bonds. We think short-term strength is quite possible, and we have not quite gotten an outright sell signal on our MTIs either, but the 6 month risk-reward of being long is worsening, and we recommend to sell into strength. Our 12 month MSCI Europe target of 1030 implies 6% downside.
As tighter policy comes in, especially in the early stages, the talk will probably go something like this...'well, the fed is confident enough in the recovery that we can start to withdraw stimulative policy'. So the economic strength negates the tighter policy, and perhaps equities rally further. But it will be the pace and effectiveness of the exit strategy that I will keep my eyes on. How does Bernanke, if he is re-nominated, pull off a perfect withdrawal of all stimulative policy measures without disrupting the markets? And the real kicker, does Bernanke's Fed have control over how the markets react to this policy reversal? In other words, will the markets force their hand or overreact like they usually do - perhaps sending rates higher at a much faster pace than the fed would like to see?

Meanwhile. Goldman Sachs says, "It'll Be a Disaster If Bernanke Raises Rates", and calls for a 'gradual exit' from the current accommodative policy:
"On the surface, the backdrop for the Federal Open Market Committee meeting next week looks quite encouraging for members pressing the case for a gradual “exit” from the current accommodative stance.

We also are not sure that Fed officials will need to raise the discount rate in order to facilitate draining excess reserves. It is unclear whether—and if so when—they will actually decide to undertake such a drainage operation. Our own view is that the volume of excess reserves does not have important effects on the broad financial system and the economy, at least now that the payment of interest on reserves enables the FOMC to raise short-term interest rates without having to match the demand and supply of reserves. Moreover, even if Fed officials do introduce a term deposit facility that is priced attractively enough to mop up a significant share of the current $1 trillion excess, the rate on this facility would likely be well below 0.5% given the current slope of the yield curve. This would make arbitrage unattractive even without a higher discount rate.

The argument that a higher discount rate would be a signal that liquidity conditions have normalized is therefore similar to the phasing out of the other emergency facilities. But against this, it is important to consider the potential tightening in financial conditions if markets view such a step as a precursor to a hike in the funds rate. Especially at a time when the economy clearly needs all the monetary stimulus it can get, this risk should not be overlooked."
Interesting talk on the draining of over $1trln in excess reserves that banks are currently hoarding and receiving interest payments on. The real inflationists concern is that this money gets lent out, and multiplied by our fractional reserve banking system - something that is not happening at the moment! Keep an eye on how the fed handles that one.

2010 will likely not disappoint in terms of volatility and surprises. It's always something from left field that nobody expects that comes out and changes the world as we knew it - its just timing it and predicting exactly what that will be that is a constant challenge! It is very possible that any double dip in our future is a direct result of the fed purposely tightening policy to control unintended inflationary consequences from the massive stimulus applied to stem the severe deflationary episode we just experienced. That, however, could be years away.

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