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Fed-speak: Ease Air Out of Bonds – Support Equities

Posted by Larry Doyle on May 20, 2013 9:38 AM |

“Don’t fight the Fed.”

While the fundamentals of our underlying economy bump along with continued structural headwinds and fiscal support from Uncle Sam remaining anemic, the Federal Reserve’s QE-infinity remains the underlying cornerstone supporting our markets.

With equities making new highs and high yield bonds trading at stratospheric levels, recent pronouncements from Fed officials strike me as looking to accomplish two goals:

1. ease the air out of the bond bubble, especially the most speculative sectors of the market, i.e. high yield corporate bonds, while simultaneously,

2. maintaining a base of support to the equity market.

While selected Fed governors have long called for an end to the QE “maddening manipulation of markets”, I strongly believe Fed chair Bernanke will be slow to ease his foot off that pedal and if he were to do so I think he would indicate he is not looking to apply the brakes but perhaps merely slow the rate of acceleration.

But let’s posture if the Fed were to actually not only decelerate but actually apply the brakes to its QE. What would be the normalized rate on the 10 year Treasury in an environment in which the “quoted” rate of inflation is running between 1- 1.5%? Even if the 10 year were perceived to be “fully valued”, I believe the 10 year would be trading at best at a rate of 3% rather than the current rate of 1.93%.

A 100+ basis point selloff in bonds would be painful to those who own these instruments but given that markets tend to overshoot, the market decline would not likely be orderly. For that reason, I do not believe the Fed is likely to make any sort of of pronouncement of an actual end to QE. I think Bernanke and his likely dovish successor Janet Yellen will try to “talk” the market through this so as to try to ease the air out of what they know is a bond bubble.

On the flip side of the coin, that being the equity market, I see similar signals by the Fed to “talk” the market up and legitimize the current levels. How so? Bernanke just the other day delivered a commencement address promoting the benefits of innovation at Bard College. Specifically he stated,

. . . that IT and biotechnology have tremendous scope to improve healthcare – which absorbs a considerable amount of U.S. household income and where costs are projected to rise – as well as the potential for the development of cleaner energy.

One might wonder if a White House official helped him with his remarks?

All this said, what is going on in the real global economy? A continued sluggishness reflected by a decline in the price of most commodities. Even in the face of global liquidity printing provided by the Fed, ECB, and now the Bank of Japan, a basket of commodities reflected by the UBS Commodity Index is down over 20% in the last two years. What does that tell us? The underlying global economy continues to struggle with deflationary pressures. What else does it tell us and what do many in the markets share with me? Many market segments remain heavily manipulated by central banks and those doing their bidding for them.

What do readers think?

Navigate accordingly.

Larry Doyle

Isn’t  it time or overtime to subscribe to all my work via e-mail, an RSS feed, on Twitter or Facebook.

I have no business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

  • LD

    PIMCO’s Bill Gross brought a smile face mug on Bloomberg TV’s “Market Makers” today to illustrate to Erik Schatzker and Sara Eisen how happy he is. Gross said the end of the 30 year US bond rally is unlikely to be like 1994 and he sees 12-months of treasury, corporate and high yields that don’t move much.

    Gross also said: “We see bubbles everywhere, and that is not to be dramatic and not to suggest they will pop immediately.”

    Gross on how to explain the 15% on the S&P 500:
    “We are not always right, but we are always certain. And how do we explain it? Simply from a lot of check writing and the market doing exactly what FED wants investors to do, expand the circle. I do not think there has been a lot of switching from bonds to stock per se but there has been a lot of risk taking under the assumption that the FED will support stocks over the long-term and under the assumption that the U.S. Economy is doing better than most economies. For all those reasons, there is a lot of money chasing a lot of risk and in some cases it may be justified.”

    We See Bubbles Everywhere

    • Randee

      Please consider quoting someone with a better track record for prognostication than Bill Gross. May I suggest, Fred, the Psychic Eel? Bill Gross promoted a “new normal” in 2011, which included below average returns for the stock market. The only person with less credibility than Bill Gross is Bill Gross’ plastic surgeon.

      • LD

        The new normal refers to the economy not the market.

  • LD

    In regard to many market segments being manipulated, what about the oil market?

    Platts collects voluntarily submitted information on bids, offers and transactions in the otherwise opaque physical-oil market in an effort to provide an assessment of the market price around the close of trading. The process is complex, and while traders can’t predict it perfectly, they recognize that transactions late in the day are most important, said Rosa Abrantes-Metz, a principal at Global Economics Group who has studied Platts.

    “If you put in a price that is a bit off, you can affect the benchmark in a meaningful way, particularly because there just aren’t that many transactions at the end of the day,” she said. “You may try and move Platts in a particular way and lose in that transaction, but then gain, by moving the index, in a larger transaction on the opposite side or on your derivatives position.”

    There are also concerns about the fact that reporting to Platts is done by traders voluntarily. In a report issued in October, the International Organization of Securities Commissions — an association of regulators — said the ability “to selectively report data on a voluntary basis creates an opportunity for manipulating the commodity market data” submitted to Platts and its competitors.

    Oil price manipulation: the next Libor?

  • Randee

    The Fed can manipulate the market all it wants. I’m up 150% since investing in 2009. What I didn’t buy @ the bottom, I bought close to the bottom, and I’m up 100% to 120% with that stuff.

    I’d like to personally thank CNBC, especially a show called Fast Money, as well as Ali Velshi @ CNN, financial reporters at Bloomberg, the Wall Street Journal and websites like Larry Doyle’s for talking down the market to absurdly low levels while many of those named compared the ’08-09 turmoil to the Great Depression. It was bad in 2008-09, but not even close to the Great Depression. THank you, thank you, those named, you have made me a wealthy man.Also, a special shout out to Sean Hannity, who openly bragged about how he sold all his sticks when Obama as elected, and has missed out on a near 100% run up in the market.

    • LD

      Congratulations. Good for you. Hope you are doing s well in all your pursuits.

  • Jay

    Raising margin requirements on select asset classes is how the FED would do it

  • LD

    An excellent read on gold and the markets in general from today’s FT and written by Pimco’s Mohamed El_Erian.

    There is no better topic than gold to polarise an investment discussion. So the recent sharp drop in the metal’s price has pushed to fever pitch the debate between two camps with deeply held convictions: those who view gold as overvalued and lacking both income and capital appreciation attributes; and those who feel it is only a matter of time before others appreciate again gold’s unique role as an antidote for virtually any economic ill that could hit a diversified investment portfolio.

    As interesting as this debate is, it understates the potential significance of what has taken place. The recent volatility speaks to a dynamic that has played out elsewhere and, more importantly, underpins the gradually widening phenomenon of western market-based systems that have been operating with artificial pricing for an unusually prolonged period.

    The consensus gold narrative is a familiar one. In an increasingly fluid ecosystem, and a world in which a growing number of central banks have ballooned their balance sheets aggressively, investors rushed into gold as a means to hedge against identifiable risks (inflation), as well as to counter nervousness about big uncertainties (including previously unthinkable disruptions to economic systems).
    Rising prices generated even higher prices, significantly disconnecting valuation from underlying fundamentals of physical demand and supply – that is until an otherwise insignificant bit of news pulled the rug from under the operating paradigm.

    While lower inflationary expectations and surging equities played a role, the real catalyst for the dramatic price drop was a rumour that Cyprus could be forced to sell its holdings by its European partners. This involved a tiny amount of gold (valued at less than $1bn at the time), but it made investors suddenly pay attention to the possibility of significant supply hitting the markets from other European economies (particularly Italy with holdings of some $130bn).

    This simple change was enough to bring the gold price down 15 per cent in less than a week. Since then, the metal has struggled to re-establish a firm footing, (it is currently trading at about $1,385 a troy ounce).

    In corporate terms, think of the underlying dynamic as one of a powerful brand where valuation has become completely divorced from the intrinsic attributes of the product – thus rendering it vulnerable to any change in conventional wisdom (or what economists would characterise as a stable disequilibrium).

    Over the past year, a similar dynamic has played out in Apple and Facebook shares.

    Gold prices have suffered their sharpest fall since the 1980s, heightening fears that the metal’s decade-long bull run has ended.

    After a steady increase to just over $700, Apple’s share price hit a dramatic air pocket. Its price collapsed to less than $400. Today, it trades at around $440. Why? Basically because, as powerful as it is, the brand’s “enchantment” (to use a term coined by author and former Apple employee Guy Kawasaki) ended up inducing investors (inadvertently) to disconnect valuation from the reality of the furious catch-up on the part of Apple’s competitors.

    In the case of Facebook, it was widespread familiarity with the name, and the associated hype, that persuaded investors to oversubscribe to an IPO that valued the company at $38. The stock traded up briefly before dropping below $20 as a large number of professionals resisted the massive and blatant disconnect between valuation and fundamentals. Today it is trading around $26.

    Of course, these are name specific examples; and, to the extent that insights can be generalised, they point to the fact that financial markets overshoot on both sides. Yet, today, I believe there is an additional insight from gold in a world where central banks, pursuing higher growth and greater job creation, have inserted a sizeable wedge between financial markets and economic fundamentals.

    Firm and repeated central-bank commitment to asset purchases has done more than push a growing number of investors to add portfolio risk at evermore elevated prices. It has also repressed market volatility, lowered correlations and given the illusion of stability – all in the context of a complicated ecosystem characterised by unusual sovereign dynamics, changing regulations, considerable tail risks, widespread need for new growth and job models, and innovation that accentuates rather than contains worrying inequalities.

    Essentially, today’s global economy is in the midst of its own stable disequilibrium; and markets have outpaced fundamentals on the expectation that western central banks, together with a more functional political system, will deliver higher growth. If this fails to materialise, investors will worry about a lot more than the intrinsic value of gold.

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