I have been doing a lot of thinking and questioning with regard to the surge in equities and other risk assets, namely high yield corporate bonds. The answers that I have been getting from people that I respect for their insights as well as their position to see capital flows have all centered around a similar theme. The government and the Fed, through it's traditional monetary policies, quantitative easing programs, debt guarantees and and super cheap lending facilities has essentially worked to drive cash out of the low end of the risk spectrum to the high. While it may very well be true that back in the early Spring, a package of high yield loans or bonds with spreads greater than 13% was very attractive, they are a lot less attractive at +6.5% to +7.5%. However, the money keeps coming. Here is a piece from Mr. Odey's article (I strongly suggest that you read the whole piece.)
With money set to stay artificially cheap, with many governments facing commitments they cannot meet, and with taxes rising, it is rational that investors want assets whose value is as far as possible independent of governments.
Equities buy a slice of a company's future earnings and current assets. Commodities buy something tangible and possibly scarce. Gold is portable wealth. It is rational to seek returns not correlated with governments' ability to pay. This is a rational bull market in real assets, with room to run.
However, we are not in a sustainable recovery. Too much debt brought about the crash, not just bankers and their pay packets. And debt levels have not fallen. Much of the debt has merely been transferred to or has been underwritten by governments. We are no more secure than before. A world economy in which rational consumers take to paying down their debts, as they are doing, will not allow a return to the inflated demand we knew. There is more money around, but it is not being spent.
The rational investor drives up real assets; the rational consumer pays down debt. And governments? They do not bestride the world; they are, like Atlas, holding it up. They are angered by the spectacle of the croupier-bankers raking a cut from the rising asset prices. But Atlas knows that if he shrugs, the world drops to the floor. That is why ChinaU-turned on plans that would have prevented smaller banks from increasing loans without raising equity. It is why President Obama is in trouble over healthcare because US voters will not accept what they see cannot be paid for. It is why central bankers in euroland and the UK talk of ending stimulus measures but know that if they do, the recovery ends.
How far are governments able to meet their social promises, and how and when will they settle or partially default on their IOUs?
The investor, whether he is fully conscious of it or not, is trying to run as far away from the government time bomb as fast as possible. Unfortunately, I do not think that he can get far enough away in enough time. "Rational" behavior is driving flows into sectors on a massive scale, pushing them way beyond their fundamental values (in my opinion) and setting more and more precious investor capital up for another gigantic wipe out.
Meanwhile, in related news we have the Fed looking at tapping the $3.5 trillion money market to help the Fed drain at least $500 billion of excess liquidity as part of their eventual plan to unwind it's unprecedented creation of excess reserves and liquidity. One of my favorite shows, and hence my title, is Larry David's "Curb Your Enthusiasm". The story line for every show centers around the neurotic Larry, spinning some sort of ridiculous lie or scheme that he thinks he can get away with. However, by the end of the show, in hilarious fashion, Larry's lie always comes back to nail him in ways he never thought possible! This is how I feel about the Fed's plan, introduced here in the Financial Times Fed Eyes Money Market Fund Link For Exit Strategy.
The Federal Reserve is looking to team up with the money-market mutual fund industry as part of its strategy to ensure that its unconventional policies to stimulate the economy do not produce a bout of post-crisis inflation.
The central bank envisages eventually draining liquidity from the financial system by engaging in trades called “reverse repos” with the deep-pocketed money-market funds. In these, the Fed would pledge mortgage-backed securities and Treasuries acquired during the crisis as collateral for short-term loans from the funds.
First of all, I have to applaud the Fed for trying. However, what I see happening here is the Fed becoming a victim of it's own strategy, as noted earlier. They will have spent more than two years feverishly working to drive money OUT of the money market and now they realize that they must lure it back to exit their extraordinary liquidity programs. The Fed wants to hit up the money markets for at least $500 billion in borrowings through treasury repo transactions. I am sure they will also be using something similar for their near $trillion mortgage backed securities portfolio (dollar-rolls, a funding transaction to be discussed at a later date for those non-MBS geeks!). Either two things can happen.
At least when Larry David's nonsense comes back to bite him in the ass it's funny! Here's the theme song and as a special bonus, one of my favorite scenes.