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Wednesday 30th October 2013

Fed Bubble Agonistes Persists as Zero Rates Prompt Debate - Here is the opening to this topical item from Bloomberg:

Financial-market bubbles are proving a more pressing threat than inflation to Federal Reserve officials who've bought trillions of dollars in bonds and kept the target for short-term interest rates near zero since 2008.

"There is a threshold out there somewhere" where markets will become too frothy or thebalance sheet becomes too large and the central bank will have to react, said Michael Gapen, a former member of the Fed board's Division of Monetary Affairs and now a senior U.S. economist at Barclays Plc in New York. "The problem since the beginning of quantitative easing three is there isn't significant enough clarity for what is the stopping rule."

Policy makers and regulators see worrisome signs. The Fed and Office of the Comptroller of the Currency are recommending lenders strengthen underwriting standards for leveraged corporate loans, as the amount of this high-risk debt approaches levels not seen since before the financial crisis and their quality deteriorates.

Kansas City Fed President Esther George, who has dissented against every Federal Open Market Committee decision this year, has highlighted an increase in farmland prices as a concern, and Richard Fisher, president of the Dallas Fed, has pointed to rising home prices in Dallas and Houston as a sign of a U.S. housing bubble. Fed Governors Jeremy Stein and Jerome Powell also have warned this year that some bond yields might be too low for the risk investors are taking.

Fed Vice Chairman Janet Yellen named financial stability as the central bank's third mandate -- along with stable prices and full employment -- when she accepted her Oct. 9 nomination as chairman. This means well-functioning markets for raising money through sales of bonds or stocks and a sound banking system that can transmit the Fed's interest-rate policy to all borrowers in the economy.

"One scenario to be worried about may simply be a sharp increase in market-wide rates and spreads at an inopportune time, such that it becomes harder for us to achieve our dual-mandate objectives," Stein said Sept. 26 in Frankfurt. That "may be among the most relevant" risks to financial stability "when thinking about the costs and benefits of our current highly accommodative policies."

David Fuller's view There are plenty of nervous and concerned comments in this article. The reason is that no one knows exactly how the tapering and eventual ending of quantitative easing (QE) will play out in the markets and the economy, because we have not previously been in this situation. However, few of us will be surprised if the onset of that transformation results in market turbulence.

Meanwhile, stock markets have been celebrating the postponement of QE in high style, evidenced by Wall Street's runaway performance which I have been commenting on recently, not least yesterday in discussing this month's surge by the S&P 500 (weekly & daily). This is partly due to exuberance in the naïve belief that nothing can now go wrong until March 2014, at the earliest. Really? How about vertigo, especially in the Nasdaq 100 (weekly & daily)? The October surge also includes trend chasing, not least by investment managers who had been underweight and are hoping to catch up before yearend.

Contrast this with sentiment almost a year ago in mid-November 2012. The crowd was decidedly bearish, with many pundits forecasting another crash, despite the ongoing bull market since 2009. In other words, investors were underweight and most stock markets were about to resume their climb up the 'wall of worry'.

The bearish sentiment of a year ago proved to be a very good contrary indicator, one of many since stock markets began to bottom around yearend 2008. Today, with investors chasing uptrends we have another contrary indicator although not of the same magnitude. Wall Street and many other performing stock markets are due for at least a reaction towards the trend mean, approximated by their 200-day moving averages.

The difference between the two contrary indicators is monetary policy which remains extremely accommodative. This will cushion downside risk as we have seen repeatedly since 2009. However, it would not prevent a sharp correction if 'irrational exuberance' led to a further near-term surge. Meanwhile, valuations have certainly increased during the slow rate of economic recovery.