On August 13 I said that if economic data along with the Fed can be used as a guide, there was no reason to see global stock markets retreat to any appreciable degree going forward and to expect that the market rally will continue over the third and fourth quarters. However, thereâ€™s another important reason which has me even more convinced the rally will continue.
My argument for improving markets really comes down to an exercise in logic, so follow my thinking. As Iâ€™m sure youâ€™re aware of, weâ€™re in the middle of the largest fiscal and monetary expansion in history, one that is globally coordinated. These policies are designed to do one thing-reflate asset values in order to counter the dangerous effects of deflation.
Now, one of the big concerns among some economists is that policymakers will be too slow to withdraw all this liquidity once the global economy shows signs it can make significant improvements, as itâ€™s starting to do at this time. The reason for this is because monetary policy thatâ€™s overly expansionary has the potential to create asset bubbles. Indeed, itâ€™s generally accepted by most major economists, including Nouriel Roubini, that an important factor in the development of the housing bubble was the Fed keeping rates too low for too long after the 2001 recession and then raising them only gradually (in 25 basis point increments) once they did begin to tighten policy in 2004. At this time, because those policies have been implemented in conjunction with fiscal stimuli that risk is likely to be even more pronounced.
But what we also saw at the Federal Reserveâ€™s annual retreat in Jackson Hole over the weekend is that policymakers are of the belief that the global economy is far too fragile at this time to even begin thinking about tightening policy, with the Financial Times reporting that â€œin private and in public, most officials indicated they believed that rates could be maintained at ultra-low levels for a considerable time without generating excess inflation, in spite of better economic data and a return of â€œanimal spiritsâ€ in financial markets. â€œ
ECB President Trichet, who warned against â€œa return to complacency,â€ went so far as to say that talk of economic conditions returning to normal made him â€œa little bit uneasy.â€
â€œBecause we have some green shoots here and there, we are already saying: â€˜Well, after all, we are close to back to normal,â€™ he said. â€œWe know that we have an enormous amount of work to do and we should be as active as possible,â€ a strong implication that ECB monetary policy will remain accommodative for an extended period.
Harvard economics professor Martin Feldstein, the first prominent voice to call for rate cuts at the 2007 meeting, thought it would be possible to have â€œtwo years or more of very low interest ratesâ€ without risk of excess inflation, given the spare capacity in the economy.
The most recent FOMC statement reiterated that policymakers continue â€œto anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.â€œ
So, hereâ€™s where the exercise in logic comes in; if expansionary monetary policy is known to have the potential to create asset bubbles, and if we have a historic amount of liquidity being provided on a global scale, and if, as every indication shows, policymakers intend on keeping policy expansionary for an extended period of time, doesnâ€™t it then follow that markets pretty much have to go up absent a catastrophe?
Weâ€™ve all recently learned just how dangerous bubbles can be, but what we as traders should also have learned is that these bubbles take a long time to grow and that they can persist for many months and sometimes even years. And shouldnâ€™t the goal as traders be to ride that bubble (if one is even occurring now) as best we can with trades in currencies, futures, options etc that are liquid and therefore easy to close out of?
So, thatâ€™s why I continue to believe that equity markets and commodities will continue to rise over the rest of this year and probably well into 2010. And with that occurring the dollar will depreciate against the better-yielding currencies (Aussie especially) as those continue their months-long appreciation against the yen.