Markets seem to have declared victory over the forces of financial darkness; little Hansel and Gretel, holding hands, have burst out of the dark and sinister woods of sub-prime crisis into the sunshine of Bernanke-land, where the deer are gambolling and the butterflies dance upon the breeze.
Wall Street has rallied 12% and the US financials 25%; the S&P/ASX200 is up 11.3% from its March low; two-year US Treasury yields are up 110 basis points; investment-grade credit default swap spreads have halved; the VIX volatility index is down 50% from its peak.
Happy days are here again.
Well, actually they’re not. If anything, things are still fundamentally getting worse, in three ways:
- Food and energy prices are both at record highs and showing no sign yet of returning to “normal”, whatever that is from here on in. Oil is hovering near record highs above $US123 a barrel; other than rice, agricultural prices are up 60%; rice has more than doubled. Global CPI inflation is at a nine-year high of 4% and must only go higher from here as recent food and energy price increases flow through to the official data. Not only will the high prices constrain household spending, but central banks now have one arm tied behind their backs (last night the European Central Bank left rates on hold because of the risks to inflation).
- The Western world housing crash is worsening, not getting better. In the US the speed of the decline in house prices is, if anything, accelerating as inventories grow as a result of rising defaults and foreclosures because of resets on adjustable rate sub-prime mortgages. This is now being exacerbated by climbing unemployment. Britain, Spain and Ireland are now joining in with very significant real estate adjustments of their own and an Australian price crash seems to be just around the corner as auction clearance rates collapse.
- Credit conditions in the US are continuing to tighten, not loosen. In the latest Federal Reserve senior loan officer survey published last month, 55% of domestic banks – up from 30% in January – reported tightening lending standards to large and middle-market firms over the past three months, and 70% of banks reported that loan spreads were rising. There is no evidence of easing credit standards anywhere else in the world. Royal Bank of Canada economists suggested in a recent note that we are witnessing a “structural change” in attitudes to risk.
Clearly financial markets are getting a bit of premature euphoria. In fact futures markets are now pricing rate increases rather than more cuts.
Rates have so far not been reduced as much as in previous cycles, partly because of the boom in food and energy prices.
The smallest cut in the Fed funds rate over the past five cycles has been 5.5%; this time, so far, it has been cut by 3.25%.
The sharemarket, and most other financial markets, are now priced for a solid economic recovery.
But the risks to this are all on the downside; any disappointments in the economic data and Hansel and Gretel’s bread crumb trail will be eaten by crows and they’ll be back in the woods.