Tuesday, June 01, 2004
It is like a rehash of 2003. Right now the US dollar is going down, and everything else is going up: stocks, bonds, commodities, precious metals. It looks very much like a replay of 2003 once again with the same "reflation trade" induced by ultra-low interest rates. Will this go on forever? Of course not. It is simply not possible to have every financial asset save the US dollar being positively correlated with each other for an indefinate period of time. Somewhere down the line, at some unknowable point of time in the future, this situation of everything moving either up or down together will have to be violated.
For example, gold cannot be positively correlated to bonds forever. If there is inflation, bonds will sell off, and gold should do well --- eventually that is; no one knows what will happen in the short or even medium term. If the US dollar strengthens, then conceivably paper assets like bonds will attract greater demand, thus making bond prices go up and bond yields go down --- this scenerio is bad for gold because gold will go down whenever the US dollar goes up.
You can carry out the same kind of analysis of gold versus stocks. It is left as a homework exercise for you. Suffice it to say that each financial asset moves according to different sets of catalysts, so it would be highly illogical for ALL of them to be pairwise positively correlated on a long term basis.
Now, the reason why everything went up in 2003 was because investors and speculators, enticed by super low interest rates, leveraged up their accounts and starting punting on all assets regardless of underlying value. It is the greatest "reflation trade" incited by Greenspan and Co. Stocks went up in anticipation of an economic recovery. Bonds did not do too well --- there were a couple of mini crashes in 2003 --- but in general they held up okay given that all the deflation scare turned out to be a giant load of bull. Gold did well. Silver did well. Commodities roared to fresh multi-year highs. In short, you could have bought all the assets that were traditionally negatively correlated and still made good money on all of them. It was the lazy investors' dream come true, the sort of market that makes your next door grandma rich.
Now markets are currently pricing in a series of interest rate hikes --- the bond market is anticipating a 100 basis point rate hike by the time the elections are over, and a Fed Funds rate of a full 3% by December 2005. Greenspan says he wants to raise rates at a pace that is likely to be measured. The bond market is calling his bluff and is saying he will eventually panic. I disagree. He has already been re-elected for another term, and he is one heck of a cool guy ... sitting on top of the greatest financial asset bubble in history and talking as if he steered the economy out of the woods and can afford to be "patient" and "measured" because inflation is nothing major. Heh heh heh.
Okay, on a more serious note, this cool Greenspan guy really does know what's going on in the economy and he knows he can act cool and patient and measured for a considerble period. Why is this so? Well, although commodity prices have risen sharply, wages and income has been muted. In fact, incomes are still falling on a year-to-year basis. Pundits have been yelling that soaring commodity prices will cause high inflation down the road, but in reality, wage growth has a much larger impact on inflation that commodity prices. I think Greenspan knows this. And that's why he can choose to ignore inflation, because he's betting that with wage growth remaining non-existent, soaring commodity prices will not filter down to give rise to any significant increase in inflation. I know what that guy is thinking.
The problem is, by keeing interest rates so low in an economy growing at 4%, he risks (and has already) induced multiple asset bubbles across the markets --- in stocks, commodities and property. The entire economy is leveraged on 1% Fed Fund rates. Furthermore, there are many intense headwinds that the US will face in the not-too-distant future, for example, a cooling Chinese economy, the possibility of runaway oil prices adding a further indirect tax on the consumer, and continued geopolitical tensions in Iraq. The business cycle CANNOT be repealed, as much as the media and financial cheerleaders would have you believe. If the Fed does not reload its policy cannon now, it will have to face the next downturn with no ammunition to combat it, and when that happens it will have to use unconventional and untested methods such a monetizing the long end of the yield curve. The safest thing the Fed can do now is to raise rates while it still can.
Short term, global equity and bond markets are on a rebound, but this rebound will not last. I think this will continue to be a period in which all assets (stocks, bonds, commodities, precious metals) will do well, but after the middle of June, I expect this trend to change to one in which everything does poorly again. At some point, this positive correlation among all asset classes will have to give way. Assets cannot be pairwise positively correlated indefinately. At some point in the future, I expect precious metals to go up while stocks go down --- a scenerio that has not happened in the past one and a half years or so. I also expect bonds to go down (that means yield go up) as the bond market gets more jittery about Fed rate hikes. I am also placing an outperformance on Asian markets, but being cautious on India and China. I am more comfortable with Asian and European investment-grade debt, and Asian equities. Gold and silver should be bought on dips, and even then, only very cautiously using small amounts. Their time is not here yet. I will tell you when it is.
For example, gold cannot be positively correlated to bonds forever. If there is inflation, bonds will sell off, and gold should do well --- eventually that is; no one knows what will happen in the short or even medium term. If the US dollar strengthens, then conceivably paper assets like bonds will attract greater demand, thus making bond prices go up and bond yields go down --- this scenerio is bad for gold because gold will go down whenever the US dollar goes up.
You can carry out the same kind of analysis of gold versus stocks. It is left as a homework exercise for you. Suffice it to say that each financial asset moves according to different sets of catalysts, so it would be highly illogical for ALL of them to be pairwise positively correlated on a long term basis.
Now, the reason why everything went up in 2003 was because investors and speculators, enticed by super low interest rates, leveraged up their accounts and starting punting on all assets regardless of underlying value. It is the greatest "reflation trade" incited by Greenspan and Co. Stocks went up in anticipation of an economic recovery. Bonds did not do too well --- there were a couple of mini crashes in 2003 --- but in general they held up okay given that all the deflation scare turned out to be a giant load of bull. Gold did well. Silver did well. Commodities roared to fresh multi-year highs. In short, you could have bought all the assets that were traditionally negatively correlated and still made good money on all of them. It was the lazy investors' dream come true, the sort of market that makes your next door grandma rich.
Now markets are currently pricing in a series of interest rate hikes --- the bond market is anticipating a 100 basis point rate hike by the time the elections are over, and a Fed Funds rate of a full 3% by December 2005. Greenspan says he wants to raise rates at a pace that is likely to be measured. The bond market is calling his bluff and is saying he will eventually panic. I disagree. He has already been re-elected for another term, and he is one heck of a cool guy ... sitting on top of the greatest financial asset bubble in history and talking as if he steered the economy out of the woods and can afford to be "patient" and "measured" because inflation is nothing major. Heh heh heh.
Okay, on a more serious note, this cool Greenspan guy really does know what's going on in the economy and he knows he can act cool and patient and measured for a considerble period. Why is this so? Well, although commodity prices have risen sharply, wages and income has been muted. In fact, incomes are still falling on a year-to-year basis. Pundits have been yelling that soaring commodity prices will cause high inflation down the road, but in reality, wage growth has a much larger impact on inflation that commodity prices. I think Greenspan knows this. And that's why he can choose to ignore inflation, because he's betting that with wage growth remaining non-existent, soaring commodity prices will not filter down to give rise to any significant increase in inflation. I know what that guy is thinking.
The problem is, by keeing interest rates so low in an economy growing at 4%, he risks (and has already) induced multiple asset bubbles across the markets --- in stocks, commodities and property. The entire economy is leveraged on 1% Fed Fund rates. Furthermore, there are many intense headwinds that the US will face in the not-too-distant future, for example, a cooling Chinese economy, the possibility of runaway oil prices adding a further indirect tax on the consumer, and continued geopolitical tensions in Iraq. The business cycle CANNOT be repealed, as much as the media and financial cheerleaders would have you believe. If the Fed does not reload its policy cannon now, it will have to face the next downturn with no ammunition to combat it, and when that happens it will have to use unconventional and untested methods such a monetizing the long end of the yield curve. The safest thing the Fed can do now is to raise rates while it still can.
Short term, global equity and bond markets are on a rebound, but this rebound will not last. I think this will continue to be a period in which all assets (stocks, bonds, commodities, precious metals) will do well, but after the middle of June, I expect this trend to change to one in which everything does poorly again. At some point, this positive correlation among all asset classes will have to give way. Assets cannot be pairwise positively correlated indefinately. At some point in the future, I expect precious metals to go up while stocks go down --- a scenerio that has not happened in the past one and a half years or so. I also expect bonds to go down (that means yield go up) as the bond market gets more jittery about Fed rate hikes. I am also placing an outperformance on Asian markets, but being cautious on India and China. I am more comfortable with Asian and European investment-grade debt, and Asian equities. Gold and silver should be bought on dips, and even then, only very cautiously using small amounts. Their time is not here yet. I will tell you when it is.