As we near the end of March, the new year has brought stock returns of close to -20%. We’ve seen the Dow touch 6,469.95. This was almost inconceivable, and one of the few people who were calling this level while the Dow was hitting 14,000 was Bill Cara.
We’re in a very different political, social and economic climate than we were a year ago. Central banks around the world have abandonded their coy monthly meetings, opting for bold statements and massive monetary actions that would have not been thought possible two years ago. Major news outlets used to report if Ben was carrying his briefcase in his left or right hand!
Calculated Risk, excellent as usual, has the state of the present economy presented in graphs (link will open new window). This is prerequisite viewing for the rest of this article.
Every valuation starts with the denominator on the other side of the trade. Cash historically has had very simple relationships. The USD moved with yields, and inversely to risk and inflation sensitive assets. Since the beginning of the year, USD cash has outperformed euros, stocks, oil and yields while underperforming silver and gold. Far more money is in each of assets than the total size of the gold market, so it’s clear that deflation is still the most significant risk.
Inflation and deflation are a big see-saw which largely reflects the net increase in borrowing. Looking at the Fed Funds graph, it is clear that the prime broker/dealer appetite for borrowing money (and consequently taking risk to commit risk arbitrage) has certainly become far more stable than it has since the fireworks began.
The question is: where is this borrowed money being relent? Examining the asset classes in the USA yields a clear answer. We can assume that the dominant buying force on the market is this money since everything else in hard deflation.
In the past, I wrote about the curious relationship between different government borrowing and lending instruments. I found a curious divergence in the 5 week t-note and all other treasury borrowing. Instead, it seemed to follow the path of Federal Reserve lending through the discount window, but most especially through repurchase agreements. The obvious reason is that money created and lent by the FRB was being used for risk-free arbitrage on higher yielding government securities.
I think it’s safe to say the same is happening here, except on a much larger scale. The bubble in government securities is probably being directly funded by the government! The Fed lends cheaper money to big banks who will buy up higher yielding treasuries.
The conclusion I come to is that central banks now, more than ever, are the greatest influence on asset prices. The balance sheet has become a giant juggling game of replacing maturing lending operations with new ones. If they slip for even a minute, violent deflation will return, and probably more quickly than we’ve seen yet. The New York Fed Open Market Operations should be monitored very closely for this. In the absence of violent deflation from a flaming torch juggling error, I think we will see momentum carry over from the recent movement: precious metals and bonds will increase in value while stocks decline. General economic pressure — mostly stemming from declining home values — are putting far too much pressure on deflation for a different outcome to take effect.