ALBERT HERTER

‘SPRING FLING THEN SUMMER BUMMER?,’ by Fidelity Director of Research. Upside in the spring, perhaps followed by sell-off over the summer.

In Uncategorized on March 2, 2010 at 13:57

The market for risk assets—stocks, credit, commodities, and currencies—has undergone a meaningful correction since mid-January as investors began to worry about two things. First, that Greece was going to be the “other shoe” to drop, with contagion and systemic risk spreading to all markets much like it did in the fall of 2008. And second, that China’s tightening marked the end of the market’s “sugar high,” the unprecedented period of liquidity growth and quantitative easing that has reigned since the fall of 2008.

My take has been that Greece was not the next shoe to drop and that China’s tightening was much ado about nothing. As a result, I have viewed the sell-off as just that: a correction in a bull market. But that scenario could reverse later this year if market interest rates rise and credit spreads widen. In that case, the market’s current spring fling could lead to a summer bummer. Of course, another bout of Fed easing and fiscal stimulus could help keep the bull market running, but that could hurt the economy and the stock market longer-term.

Signs of stability

So far, things are looking good for my correction thesis. Stocks have continued to recover after dipping below technical support levels two weeks ago. Investor sentiment has gotten more cautious after getting too bullish in mid-January. Credit spreads have settled down. And copper, a common proxy for the global economy, has rebounded sharply.

From a technical perspective, I would sum up the market’s condition as neutral, following an oversold extreme two weeks ago. The S&P 500  is once again above its 50-day moving average, after breaking below it in January, and market breadth isn’t that far from its January peak. And in terms of investor sentiment, things have normalized a bit after hitting oversold levels two weeks ago. I would describe current sentiment as neutral as well.

The S&P 500 Index1 remains above its rising 200-day moving average, and the chart still shows a series of higher highs and higher lows. That is the most basic definition of an up-trend. Correction or not, the bull market so far remains intact.

Another positive sign: High-yield credit spreads, which had widened from the low 600-basis-point range to the low 700s, have narrowed a bit to the high 600s. As you can see in the graph below, falling credit spreads have tended to correlate with rising stock prices, and vice versa.

It has been my sense from the beginning of this correction that Greece’s contagion would play out via the dollar carry trade, and not to the U.S. credit markets in general. That is, as the Euro plunged, the dollar rose, and as the dollar rose, the margin calls went out to the levered dollar carry traders. The fact that credit spreads have widened only a little (following the huge rally in 2009) and that a wide range of short-term credit conditions remain undisturbed tells me this has been the right call so far.

That’s not to say that the fiscal disorder in Greece today is not a sign of things to come for the U.S. down the road, but that is a different story and one that I don’t think is ready to play out yet.

In the meantime, commodities have rebounded nicely as well. “Dr. Copper” has staged a reversal from its low, and there are many buyers for both gold and oil despite all the dollar strength of recent weeks. In fact, gold has fallen much less vis-à-vis the large rally in the dollar. Does this mean that eventually gold is decoupling from the dollar? We’ll see.

Bullish signs after the Fed’s discount rate hike

What was notable—and bullish—for risk markets was their behavior following the Fed’s hike in the discount rate after the bell on Thursday, February 18. Friday before the bell, S&P futures were down 1%, the dollar was up 1%, gold was down $10 and oil was down $2, all in response to the Fed’s action. By the close on Friday, stocks were up, gold and oil were up, and the dollar was flat. That was very positive.

Of course, the Fed said that this recent hike in the discount rate was not really a tightening at all, and technically they are right. After all, normally the discount rate is set 100 basis points (or 1%) above the Fed funds rate, and it has been much less than that since the credit crisis hit us in 2008. That’s because the Fed wanted to make it easy for banks to borrow directly from the Fed at the discount window. So, this really is just a step toward normalization and not the beginning of a tightening cycle

Nevertheless, as so often happens, investors had sold the rumor and bought the news. Since mid-January, risk markets had sold off and the dollar went on a tear. I believe that was in part because of Greece, but in part also out of fear that a new tightening cycle was coming (led by China). One month later, the first signs of tightening appeared through the increase in the discount rate, and after a brief reaction it appears that the market has taken it in stride.

I have seen this movie before. Most people think that tightening is bad for stocks, and eventually it is. But more often than not, the market has sold off in anticipation of the first tightening and then rallied when that rumor became news. It has then typically continued to rally until the weight of a number of successive tightening moves has been enough to finally break the bull. This is why technicians have the “three steps and a stumble” rule.

This makes perfect sense of course. Tightening has often meant things are getting better, and tightening off a low base (as occurred in the early 2000s) has often mean that there is a lot of run room before growth is choked off. Think about it: the Fed considers a neutral Fed funds rate to be 2% real (after inflation). Currently the real funds rate is at minus 2%. Therefore, it appears to have a long way to go before even reaching neutral, let alone restrictive.

Why a Fed tightening seems unlikely anytime soon

Eventually a Fed tightening cycle typically leads to higher funding costs and an inverted yield curve, and that has historically been negative for the economy and the stock market. But I believe we are a long way off from that happening, especially this time around, because in addition to dropping short rates to zero, the Fed has engaged in an unprecedented degree of quantitative easing (also known as printing money) through the injection of $1 trillion of reserves into the banking system. It is important to remember that the Fed has never been in this kind of position before.

It seems to me that even if the Fed does decide to start tightening, it will be difficult to get ahead of the curve on this. In my opinion, that means the economic recovery has the potential to continue longer than the consensus expects.

Why? Let’s just assume for a moment that the banks start lending out these reserves to the private sector (which is not even happening yet). When they do, they will likely be able to charge upwards of 5% or 6%, if not more. Right now the interest on excess reserves is 0.25%. For the Fed to able to compete with private sector lending and entice the banks to keep their reserves at the Fed, it would seem to be me that it would have to raise rates significantly.

With unemployment high and likely remaining high for some time, I just can’t see the Fed raising rates very much in the near term. That suggests that the economy (and therefore the markets) could keep going for a while, even if we do start a tightening cycle. Of course, the fly in the ointment is inflationary expectations, which are already creeping up.

But Mr. Market could do the tightening

Having said all that, what I am most worried about is not Greece’s fiscal disorder or China’s tightening or the Fed’s discount rate hike. What I am most worried about is a de facto tightening, not by the Fed, but by Mr. Market.

Next month, the Fed’s extraordinary program of quantitative easing—i.e., long-term asset purchases (mortgages, agencies, Treasuries)—will come to an end. By then, it will have benefited the bond market to the tune of $1.75 trillion.

What happens when the program comes to a conclusion, as it will soon? One possibility is higher interest rates and wider interest rate spreads over Treasuries for mortgage-backed securities and agency bonds.

Currently, the yield on the ten-year Treasury is hovering just below 4%. From a technical perspective, a break above that would violate the neckline of a potential head-and-shoulders bottom (see chart), which technicians believe would project a move up to 5.5% for the 10-year Treasury over the coming year or so.

What could a rise to 5.5% amid widening credit spreads for mortgage-backed securities and agencies mean for consumers, investors, and the housing market? Would that be a de facto tightening? We already know that the money supply (M2 and M3) is barely growing at all, despite the massive infusion of reserves into the banking system. It looks to me like a big reason for that low growth rate in the money supply is a large decline in money market fund assets, caused by investors moving into bond funds. (M1 and M2 are measures of money in circulation that do not include bond fund assets.)

I don’t know the answers to these questions. After all, rising rates coming off a low base are not necessarily bad for the economy and the stock market, at least not initially, because they are usually a symptom of an improving economy. In fact, since the late 1990s, rising rates have been correlated to rising stock prices and lower rates have been correlated to falling stock prices. The former spells recovery and the latter spells deflation (the bad kind). So, perhaps this is a worry about nothing.

But, this is an economy that that has benefited from the Fed’s decision to keep interest rates low, not only allowing the household sector to continue to de-lever and refinance, but also helping the Treasury keep the deficit spiral under control.

What will be the end game?

For now, stocks and other risk markets have rebounded nicely from their lows set a few weeks ago. The economy is getting stronger and earnings growth is robust. Bullish investors are still nowhere to be found, which from a contrarian point of view is positive.

I am guessing we are in the seventh inning of this bull market and that the final innings could get sloppy. The bull market likely won’t be a one-way street like 2009, because with every new surge will come worries about the Fed’s tightening and rising rates. This is a tactical environment.

What will be the end game? The key point here is that while I don’t expect the Fed to tighten anytime soon, it may not have to tighten in order for liquidity conditions to deteriorate. It could happen just because the Fed is no longer easing.

What would happen next? If rising rates and wider spreads are seen by the Fed as a threat to the economy, the Fed may have to “blink” and start up a whole new phase of asset purchases (either directly or via the banks). The threat of an economic relapse could also prompt Congress to try to deficit-spend its way out of trouble even more than it already has. That could stabilize markets in the short-term but destabilize them over longer periods.

What could it mean for the markets to have an ongoing cycle of deficit spending and debt monetization? Higher inflation, higher interest rates, a weaker dollar, and surging gold could all be possibilities. Whether stocks did well or not would be a matter of whether investors considered them an inflation hedge in that scenario.

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