``Cycles in markets do exist, but it's impossible to pinpoint how long they will last with any precision. Much depends on the actions of government officials and the intelligence of the public. Each time is different. I recall commentators calling for a six-year gold cycle, or a 10-year real estate cycle. They are all ephemeral, because, as Shakespeare says, our actions are "not in the stars, but in ourselves."”-Mark Skousen Invest U
Figure 1: Economagic: Fed Fund and the US S & P 500 benchmark
Much like the inflation bogey, the Federal Reserve raised by a “measured pace” on its interbank lending rate by 16 times from 1% to 5% since June 2004. Yet rising interest rates have not deterred the benchmark S & P 500 from climbing to multi-year highs until May 10th, as shown in Figure 1. In short, market expectations on the Fed and its policies, aside from its actualization; have not essentially spoiled the fun...until recently. So what has changed?
There are those who pin the blame on the neophyte FED Chief Ben Bernanke for smudging the Fed’s ascendancy over his recent media fumbling (remember the L'affaire Bartiromo at CNBC). In an effort to redeem the Fed’s ‘tarnished’ credibility, officials have undertaken a concerted makeover to regain a semblance of ‘control’ over its “inflation fighting capabilities” hence the continued rhetorical “hawkish” stance.
There are also those who argue that the marginalization of leverage or arbitrage plays have been prompted by Japan’s declared intent to normalize its money policies. Having thought to have funded the prevailing ‘carry’ trades, which could be exemplified by borrowing in Yen and investing in assets with greater yield spreads relative to the Yen, such as emerging market assets and/or commodities, etc., these arbitrage trades is said to have fostered an inordinate degree of leveraged speculative positions at the global financial markets.
With Japan’s economic recovery gaining some important headway, the previous undertakings to combat deflation through accommodative monetary policies (QE, ZIRP, and currency manipulation) have been promulgated to be reversed thereby allegedly serving as the proverbial “pin” to have pricked the lathered assets bloated by the Yen funded liquidity arbitrage. (See May 22 to 26 edition Jim Jubak/Gavekal: Yen Carry Tumult)
I am less convinced of this argument since the market’s reaction appears to say otherwise.
Figure 2: ADB’s Asiabondsonline: JGB’s 2 and 10 Year yields climbing higher
Repatriation of residents and government funds stashed overseas should in effect be seen with a rising Japan’s Yen and/or expanding stockmarket bellwethers (Nikkei and Topix) and/or Japan Government Bonds as shown in Figure 2. Unfortunately, none of them appears to be responding positively to such stimulus, in fact all of them have been victims of the recent onslaught.
Maybe Morgan Stanley’s Stephen Jen could be right arguing that relative to cumulative financial markets, the Yen arbitrage while having some effects could not be the catalyst for the collective decline (emphasis mine), ``I am not arguing that the BoJ policy has no effect on global asset prices. Rather, I am refuting the view that there is something extra special about JPY carry trades. When interest rates rise in Japan, capital outflows from Japan would clearly be adversely affected, ceteris paribus, and some risky assets could be hurt. I do not challenge this point. But it is unreasonable, in my view, to think that BoJ tightening would trigger a collapse in global equities, most commodity prices, etc. Even massive money printing by the BoJ failed to support the Nikkei for years and so I don’t see how money from Japan could have such a big impact on the world. Monetary tightening by the BoJ will have no more and probably less of an effect on asset prices than if the Fed or the ECB tightens.” Hmmm.
There is also the case of heavily levered Hedge Funds absorbing significant or outsized losses which has led to a contagion (some of which are said to be 200-300 times levered more than invested capital, according to a Hedge Manager interviewed at Bloomberg), aside from suspicions about the state of “innovative products” in the form of derivatives, where 85% of the outstanding derivatives in the US have been interest rate based bets, and where 96% of US derivatives bets have been concentrated on ONLY 5 banks(!!!), according to the BIS in October 2005.
Forbes’ mainstay guru Gary Shilling argues that the credit induced mortgage boom in the housing sector is in the process of an implosion from its own weight (emphasis mine), ``The speculative housing craze is crashing from its own excesses, not Federal Reserve action.”
In addition, another possible angle is that the recent rate hikes which appears as “coordinated” across the globe could be construed as IN RESPONSE TO (note: not the cause!) the initial bout of outflows, where interest rates have been driven up to curb the massive outflows, which has, over a very short term period, destabilized and wreaked havoc on domestic currency values relative to the US Dollar.
As the only proponent of liquidity based market movements among my domestic contemporaries, the present developments have not been unexpected, considering that as early as November of last year, we discussed the incipient signs of risks arising from liquidity compression (see November 21 to 25, 2005 edition, Declining Global Liquidity: Believe It...or Not?).
I have argued that inflation, in the monetary definition, has long been imbedded into the global monetary system (see November 14 to 18, 2005, Inflation Cycle A Pivotal Element to Global Capital Flows), and responsible for the majority of the movements of the Philippine financial markets. Such that rising gold prices relative to most if not all currencies in the past have likewise reflected on this phenomenon (see March 27 to 31, Listen To Your Barber On Higher Rates and Commodity Prices!), and that the present concerns of higher inflation (as reflected in consumer prices) and attendant interest rates increases are natural consequences to the past policies adopted by government authorities worldwide. As in the past, central command, conventionally thought to be as messiahs to the world’s multi-dimensional problems, always miscalculates, if not abuses. Yet we never learn.
Now the draining of US dollar based liquidity has its belated effects percolating into the US economy today, compounded by the persistent high levels of energy prices, which appears to rein on the trailblazing surge in economic growth brought about by rampaging asset prices particularly in the real estate industry.
Consumer spending has basically driven the economy which has been essentially funded by surging home prices. Yet, underpinning both consumer spending and soaring property prices have been massive growth in credit. ``The problem is that after allowing a late 1990s stock market bubble and a 2003-2006 housing bubble, the Fed has basically lost control. It feels the necessity to fight inflation until further signs of economic softening show up, and by that time it is too late to avoid a likely recession” comments the comstockfunds.com.
In my June 5 to 9 edition, (see US Recession Watch: A Fed CUT in June or August?), I have laid my contrarian analysis anew where I contended that the activities global financial markets could be portentous of this deceleration or softening. Since the US has been the key growth engine on the consumption side with China as the major production platform for the world, an economic slowdown would translate to respective growth reductions on its trade partners mostly dependent on the US markets for revenues. And such is the reason why, I think, commodities, with the exclusion of gold) and emerging markets have adjusted downwards. So the lagged effect of diminished liquidity aggravated by high energy prices has, in tandem reduced growth prospects in the US, which again may spillover to the world and manifested in financial markets.
On the other hand, noted economist Henry Kaufman interviewed by Kathleen Hays says that (emphasis mine) ``These are not extraordinarily repressive interest rates. Today, anyone who really wants to borrow can borrow. Today, anyone who wants to borrow creates Credit. And the Federal Reserve is not yet at that point where there is some pain in the system.” Mr. Kaufman believes that rates would have to go further than 6% in the coming 12 months with possible 50 points increases in the near future due to the Fed’s prevailing policies, Mr Kaufman adds, ``The Federal Reserve is going to have to decide when to abandon this measured response of 25 basis points. That’s a very difficult chore for them, considering how long they have pursued this policy here in the past. Secondly, I think as financial market participants we will continue to create a lot of Credit until there is much more uncertainty in the interest-rate structure. I think there is going to be significant volatility in the financial markets over time. ”
Mr Kaufman believes that the US economy can still endure more of rate increases before any pain can be evinced. The markets are signaling inchoate dislocations, which could be interpreted as doing so otherwise. Except for the 10 year treasury bonds yields, the equity benchmarks have not broken down YET and may even surprise to the upside to uphold Mr Kaufman’s view.
However, given the developments in the bond markets, yield inversions plus rising yields on the intermediate end have not behaved favorable to equity benchmarks in the past. This downcast outlook is likely to foreshadow the economy’s diminishing tolerance level for tightening.
Moreover, given that it is political season again in the US, question is, can the incumbent party afford to inflict pain on its citizenry, which could represent a sure recipe for electoral defeat?
Furthermore, given the ideological leanings of the Fed Chief (Friedman “monetarist” adherent) would he risk overshooting and face his dreaded nightmare of DEFLATION? Bubble bustin’ ain’t Bernanke’s game, I think.
The inflationary backdrop may go into a reprieve in the interim as the softening of economic growth takes hold. But unless Bernanke does a Paul Volker, i.e. boldly raise rates until its chokes economy and inflation despite the uproar (unpopular), I think the seeds of a long term inflationary environment have been deeply rooted and would accelerate over the fullness of time. 
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