Tuesday, June 23, 2009

Profit Flaunting no More?

Three months ago, I logged a post titled "Profit Flaunting" in which I observed the Western banks peculiar behaviour of flaunting their profit for first quarter than had not yet ended. Perculiar because such disclosures were not required by securities guidelines and regulations. Nevertheless, the market reacted positively and their share prices promptly jumped. Indeed the momentum generated followed through and led the equity markets worldwide into successive months of upward movement.

We are now near the end of the second quarter but we have yet to hear any preliminary announcement from any major banks- flaunting type or otherwise. Are we to infer from the non-announcement or should we just sit tight and await the normal flow of announcement?

090626 Update: Standard Chartered PLC has announced that it has made good profit for the first five months of the year.

Monday, June 15, 2009

The Conundum of High Treasury Yields Amidst a Strong Equity Market

10-year treasury yield has reach multi-month high in recent weeks while equity markets too were reaching year's highest levels. This seem to go against the conventional thinking that interest rates and share prices are inversely related.

I think this is not the normal business cycle that retain normal correlation. The 'Black Swan' we are witnessing is caused by the actions of the Fed. Specifically, the act of printing money, or 'quantitative easy' as a better name, has upset the system.

In a normal cycle, as economy overheats, monetary policy is expected to be tighten and treasury yields go up due to slowing money supply. Equity prices hence go down due to higher cost of funds. As economy slows, perhaps even becomes recessionary, the Fed engages in a expansionary monetary policy and money supply is growing again. All the while, the Fed is only setting a benchmark rate and letting the market decides the actual interest rates.

Presently, with the Fed directly purchasing treasury bonds, the money supply is immediately increased due to expanding monetary base. Hot money created is chasing stocks higher while bond traders are factoring in the possibility of climbing inflation by bidding for treasuries at higher yields.

Meanwhile, aggregate demand and economy's production capacity remain relatively unchanged.

Therefore, I think the debate over whether we are in an inflationary or a deflationary cycle is irrelevant- we are in both. i.e. asset prices are going up (note the price movement of crude oil) while wages and other production costs are stagnant (due to overcapacity).

It seems the Fed has not learned any lesson from the era of stagflation in the 1970s, which is to control the money supply and putting price stability at the highest priority. By control I don't mean keeping it fixed but any easing of monetary policy should be done in moderation and all the while letting the market know that price stability is top priority. Quantitative easing runs in contrary to objective of maintaining long term stability of both price level and economic activities. In addition, the direct purchase of treasury bonds and other commercial papers set a precedent and may impair the Fed's Independence. In future, Fed may be pressured politically into taking such inflationary action.

To prove my point, last week's 10-year treasury yield reached a 2009 high of 4% but subsequently retreated due to intervention from the Fed. It has purchased in total close to US$150 billion of the US$300 billion target, barely two and a half months since the start of the programme. There are already opinion by economic columnist hinting that it should raise the US$300 billion cap.

Once the expectation of inflation is out of the bottle, it is very difficult to contain.

Would the over-extended treasury market collapse and bring about a plunging US Dollar?

That would be a disaster that US government will do its best to avoid. I think that scenario will not happen as USD is still the reserve currency and all the major holders of treasury bonds, namely the central banks around the world, will be serving their own vested interest in supporting the US treasury bond market.

However, with ever-increasing supply, treasuries prices will continue on its downward trend. As yields move in opposite direction as bond prices, long term interest rate will stay high and move higher. Along the way, USD will be under pressure as US budget deficit continue to grow due to higher refinancing costs.

US equity market will be stagnant- on one hand negatively affected by high interest rate while on the other positively impacted by 1. the government spending; 2. hot money arising from expanded money supply; and 3. assured profit due to government guarantees (from TARF to bank deposits to motor vehicle warranties to commercial papers purchased by the Fed, you name it).

Not much restructuring will occurs as companies are largely above water, albeit barely, so there is no incentive to rock the boat.

I am afraid my prognosis shall be that US will be entering its own lost decade a la that of Japan.

It will take another Paul Volcker to bring major changes that will involve some level of pain to shake the economy out of the malaise.

To quote Nassim Taleb: "The Obama administration's attempts to fight the financial crisis with more cash is like treating a bad tooth with Novocain instead of a root canal."