Watching the Tape: We’re Keynesians for the Moment

``The exit strategy is painfully simple: Ultimately, it is up to Ben Bernanke – and whether he has both the wisdom and the courage to break the daisy chain of the “Greenspan put.” If he doesn’t, I am convinced that this liquidity-driven era of excesses and imbalances will ultimately go down in history as the outgrowth of a huge failure for modern-day central banking. In the meantime, prepare for the downside – spillover risks are bound to intensify as yet another post-bubble shakeout unfolds.”-Stephen Roach, The Great Unravelling

Lord John Maynard Keynes once said, Markets can remain illogical far longer than you and I can remain solvent. The statement seems indisputably accurate, and when applied in a different context, it simply means we shouldn’t “fight the tape”.

Yep, markets today have rebounded strongly from its recent shakeout lows last late February, and if one were to use the China’s Shanghai Index as barometer to future directional flows, then figure 1 tell us that what was said to have been the epicenter of the latest bout of volatility had been merely a blip.

Figure 1: Chartoftheday.com: Shanghai Composite Index: What Volatility?

The losses during last end-February had been completely erased and with this week’s 5% gain as the Shanghai Index trades at new record HIGHS!

And it is not just a picture of China; we see various markets in all parts of the world, appearing to have been injected with renewed adrenalin.

Figure 2: stockcharts.com: Carry Trade Still At Work?

In figure 2, courtesy of stockcharts.com, we note that the US benchmark, the Dow Jones Industrial Averages (candlestick) bouncing ferociously off its lows coincidental to the decline in the Japanese Yen.

The inflection points (red arrow) of the Japanese Yen seems to ran inversely parallel to the turning points of the Dow Jones (blue arrows) and the JP Morgan Emerging Debt Fund (lower panel-blue arrows).

What this probably implies is that the carry trade is “back in business” and that the declining yen could have provided for the necessary fodder or ammunitions to restore the risk taking activities as reflected by the bounce in emerging market stocks and bonds, as well as in the other asset markets.

While it is to my opinion that the present behavior of markets have been simply cyclical, undergoing a natural corrective phase, then signs are that the US markets following the break from its 50-day, may further advance. However, one noteworthy development is that the breakout came amidst tepid volume (shown above) which leads us to question on the strength or sustainability of the breakout.

The Phisix also has been at the trails of its counterparts rallying 3.52% over the week, with the Peso nearing its record milestone high to close at Php 48.16 per USD over the week. Since we noted that the Phisix and the Peso has shown some relative strength, I will have to change my neutral view on the Phisix, once the Peso breaks its recent high at Php 48.03 to a US Dollar, to a buy.

Of course, IF the Yen have been a crucial factor in determining liquidity conditions allowing for today’s worldwide rally, one must be reminded that the downtrodden Japanese currency in spite of its recent flagging conditions has been drifting near its all time lows relative to the US dollar and the Euro as discussed last March 5 to 9 edition (see US Markets: Risks of Ponzi and Speculative Finance). Hitting support levels usually generate violent reactions which may once again lead to heightened volatility.

The question is IF the Yen has indeed BEEN a pivotal factor in determining liquidity flows.

Figure 3: Stockcharts.com/The Rhodes Report: Yen Volatility has led to Financial Market upheavals

In Figure 3, Richard Rhodes of the Rhodes Report depicts of past financial market upheavals as a result of the Japanese Yen’s volatility. Again, a critically oversold Yen may lead to severe market swings which may affect global asset prices.

Of course, others may argue that the recent rebound by the global markets have been due to statement changes by the US Federal Reserve, indicative of a potential shift in FED policy.

Figure 4: Federal Bank of Saint Louis: Market prices in a RATE CUT?

The indicated changes in the recent FED outlook implies of a slightly weakening economy [from “somewhat firmer” to “mixed”], but still concerned over inflation represented by the price indices [“Recent readings on core inflation have been somewhat elevated” and “the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected”]. However, the most striking development in the word parsing game over the FED’s statement was the explicit EXCLUSION OF THE “ADDITIONAL FIRMING” clause.

The market seemed quick to interpret this as carte blanche omission of further rate hikes and instead tilted the outlook toward a RATE cut, as shown in Figure 4. ``Interest-rate futures show a 28 percent chance the Fed will lower its target overnight lending rate between banks a quarter- percentage point to 5 percent on June 28” from a Bloomberg report.

In my view, the shift in the statement represents as INSURANCE, where if the US markets would feel the pinch from the ripple effects of the unwinding subprime mortgage implosion towards a greater segment of economy, the FED has made available its “BERNANKE PUT” option or readiness to deploy its contingent “liquidity of last resorts” measures. So those contending that US FED will not intervene have now been given a preview of what comes next. On the other hand, it also marks the concern of the FED over the degree of landing.

In the event that the US economy decelerates more-than-what is-expected the Bernanke Put would likely be set in motion. Whether such actions will successfully reduce the impact of the deterioration has yet to be known although, I am in the camp of PIMCO’s Paul McCulley and Merrill Lynch’s David Rosenberg (March 5 to March 9 edition, see US Markets: Risks of Ponzi and Speculative Finance), who suggests that any forthcoming slowdown in the FED will be LESS determined by the price of credit, again to quote Paul McCulley ``It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policy makers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand.”

Yet, the bizarre part is how prices can persist to rise in view of an economic deceleration and declining trends in corporate profits. These shows of how distorted market pricing has been and how addicted the global financial economy have been to “low interest rates” and to the “massive creation and intermediation of credit, derivatives and digital money”.

Another timely reminder comes from, William Hester of the Hussman Funds, who warns that present expectations have been derived from conditions different from the past, ``In any case, investors should keep in mind that the stock market's reaction to Fed cuts has historically been dependent on other conditions such as valuations, economic expectations and the slope of the yield curve. The belief that rate cuts strongly benefit the stock market is based on conditions that don't match the present very well. It's possible that a Fed cut might help the stock market later this year. But given current conditions, history doesn't support much risk-taking based on that hope.”

Well, it’s hard to be overly optimistic knowing the possible risks of Damocles’ Sword hanging over the US and global markets via the Carry Trade or the degree of the impact by an imploding US real estate industry. However, Lord Keynes is right in terms of market’s irrationality, which means we shouldn’t fight the tape. Yet we can ACT on using the tape for our benefit.