The global financial markets reacted impassionedly to the Fed’s recent statements following its 17th interbank rate increase to 5.25%. The US dollar index cratered, the bond markets (sovereigns and corporate) rallied furiously as shown in Figure 2, global equity markets and commodity prices vigorously rebounded.
Figure 2 Stockcharts.com: US Dollar (left chart) and benchmark US Treasury Yields (right chart-candlestick) breaks down, while JP Morgan Emerging Debt (line chart) Rallies
Despite being noncommittal on its next moves, as reflected by their latest FOMC statement (emphasis mine) ``The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information'', the markets appeared to have discerned on the culmination or the near-peaking of the US ‘interest rate cycle’ following the perceived “dovish overtures” from the Fed.
``Everyone jumped on the statement's focus on moderating growth (emphasis mine). What about the shift in emphasis from the recent one-note chatter on inflation, inflation and inflation? Instead of accusing Bernanke of flip-flopping as they had in the past, analysts lapped it up, praised Bernanke for becoming his own man and congratulated him on gaining the necessary credibility to let the data take center stage” decried Bloomberg analyst Caroline Baum on the market’s U-turn.
Robert Folsom of Elliott Wave International adds his dissenting voice to the market’s seeming irrational exuberance saying that present movements signify ``defiant mockery of everything the media has said about stocks for nearly three months – namely that the Fed has been raising rates because of "inflation fears," and in turn "inflation fears" have made the stock market decline.”
True. Fundamentally speaking, as to how a “moderating” or softening economy would translate to growing/expanding earnings is something beyond me. In addition, current price valuations reflected on the financial markets have been that of “rose colored” glasses or of a “goldilocks” (not so hot or not so cold) environment, or to say at least have been priced at the high or optimistic side, a natural response to a slowdown should be a downwards re-pricing. Yet the critical question is, how rational has the markets been?
One thing I understand is that Global GDP estimates are at $54 trillion in 2005 according to theGlobalist.com, which quotes World Bank figures. Whereas the world’s aggregate capital markets have been at over $118 trillion, using Mckinsey Quarterly estimates in 2003. This suggests that the global financial markets have virtually LED the global economy (by a ratio of over 2:1) more than serving its traditional function which is to basically provide support.
Moreover, according to Bank of International Settlements (BIS) on its June quarterly review issued last June 12th (emphasis mine), ``Combined turnover measured in notional amounts of interest rate, equity index and currency contracts increased by one quarter to $429 trillion between January and March 2006.” This implies that derivatives (or instruments used as a hedge, such as options and futures contracts, which derives their value from an underlying security, group of securities or index) bets are about 4 times the “derivative value” or the worth of the world’s capital markets and about 8 times the size of the global GDP. That is how leveraged the world is!
As to how these phenomena extrapolates on the rationality of the markets...since the world’s GDP is highly interdependent on the advances of financial markets (including the housing industry), it would need accelerated injections of money and credit to retain its present growth clip, something patterned like a grand-scale PONZI or pyramiding scheme to keep the present system afloat.
It also means that the global financial markets have to always keep growing too, regardless of what “micro fundamentals” says. The “chase for yields” and the “Current account imbalances” have been symptomatic of these burgeoning asymmetries fostered by the current monetary system, the US dollar system, matched by an equally compelling interrelation borne out of the Fractional Reserve banking system (fraction of deposits kept in reserves). Today’s liquidity flows have been multidimensional (bank and non-bank) and too complex to measure.
Once the liquidity injections reverse or the least “stalls”, the world financial markets and economies shrivels, falls or collapses like a house of cards. To quote Gavekal Research, ``Bull markets are like drug addicts whose next fix/liquidity injection provides diminishing returns. To get the same effects, the fix/liquidity injections need to always get bigger…Or serious withdrawal follows.”
I do not like to sound so macabre, or adopt the slogans of the inveterate goldbugs...yet empirical evidences point towards the escalation of these systemic risks.
For instance, recently, Emil W. Henry, Jr., Assistant Secretary for Financial Institutions of the U.S. Department of the Treasury, acknowledged about the risks posed by the mushrooming outsized Government Sponsored Enterprises (GSEs) combined mortgage investment portfolio amounting to US $1.5 trillion, where he cautions, ``While the U.S. financial markets are highly efficient and resilient, they are not infallible”.
Like all incumbent officials deliberately downplaying on its potential occurrence as “unlikely”, he admonishes that in the event that it does (emphasis mine), ``An obvious transmission mechanism is through direct losses to the commercial banking system, derivative counterparties, or other creditors. If these key financial intermediaries suffered losses related to their GSE exposures, this could lead to a broader contraction of credit availability – for example fewer loans being made or more restrictive loan terms - that could have adverse implications for overall credit availability and U.S. economic performance.”
In other words, while the endemic systemic risks have been mounting worldwide for quite sometime now, global financial markets have been inured if not hardwired into believing of the constancy of advancement, irrespective of the enormous leverage latched into the system. That’s how rational the markets are. Add leverage in order to advance the financial markets, which should translate to economic growth.
So, aside from the analogy of addicts alluded to by Gavekal Research, global investors behave like the ‘Pavlov’s drooling dogs’, (where Nobel prize awardee Russian priest turned scientist Ivan Petrovich Pavlov, 1849-1936, discovered that stimulated reflexes honed by the ringing of bells to associate for food caused dogs to drool), equally stimulated with the Bernanke-speak Fed induced monetary accommodation.
I have to confess, I am one of these investors and portfolio manager ‘addicted’ to the realm of easy money. And like Pavlov’s dogs, salivate at the stimulation provided for by loose liquidity spawned by policies authored or engineered by Bernanke & Co.
Investing on conviction has hardly been a profitable venture as experience taught me, similar to fate of goldbug zealots. While I maybe possibly a goldbug at heart, premised on the constant abuses adopted by collective governments, I have to be a pragmatic investor or trader, and by principle, a sovereign liberal individual. However, unlike the archetype ‘addicts’, adopting contingent plans over the possibility of a sigma-4 standard deviation, black swan or low probability, high impact event is a must. 
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