The multi-trillion dollar infusion of credit and guarantees by the Treasury and the Federal Reserve in 2009 haven’t anything to produce an economic recovery. However, they have taken the risk out of speculations. Private debt has been transferred from financial institutions to the Fed, although for many decades the Fed was allowed to buy only AAA securities. Now they are being everything but the proverbial “kitchen sink.”
The efforts of the Fed have been geared to preventing a recurrence of the financial crisis. It’s been a very expensive effort. However, it has flooded the banking system with huge liquidity. That has produced one of the steepest yield curves in history, i.e. short term interest rates are far below long term rates. The Fed and government thought all this liquidity would be used for lending. But banks find it much safer and easier to borrow money at 0.25% and then buy US Treasuries yielding 3.5% or more. No loan exposure, no need to look at financial statements or take the risk of being accused of “discriminatory lending.”
As a result, the financial system is flush with cash which is not being used for economic activity. Therefore, the capital is used for speculation, similar to what produced the financial crisis in the first place. The carry-trade is a favorite speculation once again: cheap US dollars are borrowed at 0.25% and reinvested in governmental bonds of higher-yielding countries at perhaps 5-8% with great leverage, perhaps as much as 100:1. This is a great way to make money, until the currency trends change. If the dollar rate increases by just 1%, with that leverage all the equity would be wiped out. If the bank has those losses, the taxpayers will probably get the losses, while the banks’ trading operations got the prior profits.
With the declining US dollar in 2009, it was more attractive to buy shares in companies which at least have a chance to grow profits, even if sales don’t grow, then just buy money market funds. In effect, stocks became a hedge against the depreciating value of the currency. In 2010, investors may turn out to be wrong when profits follow sales downward and the dollar rises in value. A rising dollar would turn the tide for many currently most popular investments, such as commodities, emerging markets, etc.
Although a steep yield curve traditionally has meant a good economic recovery was ahead, this time there are many obstacles to a recovery. Higher taxes, and promises of even more taxes in the years ahead, make business creation a game of “hope over experience.” A flight away from the questionable policies of a U.S. Congress, which threaten to destroy the U.S. economic system, is already occurring. U.S. companies are moving abroad because the writing is on the wall. Success will be punished in the U.S.
The “trader tax” proposal, thought to be dead earlier this year, is gaining traction again as Washington desperately looks for new sources of revenues. It would impose a tax on every stock market transaction. It would destroy the U.S. financial markets. Trading would move off-shore. But politicians are usually oblivious to the reality of the market place.
BOTTOM LINE: The excess liquidity spilling over into the investment markets has produced the illusion of a new bull market. But it’s just plain speculation. Once the Fed starts reducing the stimulus, reality will return.
The markets in 2010 will bounce between disillusionment about economic reality and liquidity injections by the Fed. Another crisis will be averted, but significant parts of the economy will be totally under the control of Washington. This suggests that there will be no economic recovery, just long-term stagnation, shrinkage of business enterprises, insufficient job creation, and continued loan contractions.
The Dubai and Greek financial crises are the “canaries in the mine” confirming that all the rescue efforts of major central banks around the world have been insufficient to stop the crumbling of the global debt pyramid. It will be important not to confuse new mini-bubbles created by the central banks with genuine, sustainable economic growth.
