Why the Fed is reflating, and what this means for asset prices.

[MichaelW]

Hi guys,

Read a very interesting snippit from my Colin Twiggs Trading Diary email the other day that I thought was worth sharing.

Recoveries And Inflation

Investors may wonder how the market can possibly rally when the economy resembles a punch-drunk boxer hanging on the ropes. The answer is fairly simple: the big money is not betting on the economy it is betting on inflation.

The Fed is printing money as fast as it can — in order to save the banking system from annihilation. Nobody gets up off the canvas without assistance after taking a 1 trillion dollar sock on the jaw. While the Fed can provide liquidity, there is only one way to protect banks from falling asset prices which threaten to wipe out their reserves. That is to create inflation — to reverse the fall in asset prices.

Investors and financial markets response to low interest rates from the Fed is to borrow all that they can and invest in real assets in anticipation of rising prices. This becomes a self-fulfilling prophecy as demand for real assets exceeds supply, driving up prices.....and the next asset bubble is born.

The Fed does not mind, as investors mop up surplus money in the system and prevent it from flowing through to consumption — where it would affect consumer prices. Economists thought that they had found the holy grail. They could stimulate the economy without any significant impact on consumer prices. Only to discover that it is a poison chalice. There is no quarantine fence around asset bubbles and eventually higher asset prices flow through to consumers. When average workers can no longer afford to buy their own home, upward pressure on wages starts to rise. And when asset bubbles burst, as they are prone to, causing severe shocks to the economy, the Fed's only available response is to..... you guessed it ....... print more money and start the next asset bubble. The ever-increasing shocks are eroding the ability of the economy to recover and grow in a stable, predictable environment.

So where is the next asset bubble likely to occur? With wounds from collapse of the housing bubble still fresh, there are only two viable alternatives: stocks and commodities.

Inflation targeting by central banks is a major cause of bubbles. Inflation targeting is based on CPI which is a poor measure of the loss of purchasing power of the dollar. Why have house prices doubled in the last 5 years if inflation is averaging between 2 and 3 percent? Not to mention gold, oil and most other commodities. By using CPI as a measure, the Fed responds to crises long after the real damage is caused. Ever tried to steer your car while looking through the rear window to see where you are going? No wonder the Fed crashes into the sidewalk every time they encounter a bend in the road.

If you believe this is all too complicated and best left to a bunch of academic economists and self-interested bankers to sort out, allow me to remind you that the definition of stupidity is to repeat the same action and expect a different result.

I've posted a couple of times lately how I believe the Fed is clearly reflating now and that I think they'll pull it off. Its a brave man that bets against the Fed. So, the obvious question for us as investors is: What does this mean for asset prices in Australia? My personal conclusion is that the Fed's actions will restore global liquidity in time and the cost of capital will come back to more comfortable levels. Inflation in Australia is probably going to stay hot for some time yet and there is the high likelihood of a wages breakout. I see all asset classes representing improving value now and would expect Property and Equities to both perform very well over the next decade.

I know there's some perma-bears out there that won't buy it, but I think the current environment is a prelude to a significant asset price boom in the coming years. Its not the end of the world as we know it with prices set to crash globally in all asset classes. It almost was with Bear Stearns being the turning point. The Fed put a floor under the market and declared their hand: too big to fail and we're reflating.

Bring it on! As an investor, the ensuing asset reflation will be a boon. Hard assets are a great hedge against inflation!!

Cheers,
Michael

 

[Kennethkohsg]

Hi guys,


I've posted a couple of times lately how I believe the Fed is clearly reflating now and that I think they'll pull it off. Its a brave man that bets against the Fed.

So, the obvious question for us as investors is: What does this mean for asset prices in Australia?

My personal conclusion is that the Fed's actions will restore global liquidity in time and the cost of capital will come back to more comfortable levels.

Inflation in Australia is probably going to stay hot for some time yet and there is the high likelihood of a wages breakout.

I see all asset classes representing improving value now and would expect Property and Equities to both perform very well over the next decade.

I know there's some perma-bears out there that won't buy it, but I think the current environment is a prelude to a significant asset price boom in the coming years.

Its not the end of the world as we know it with prices set to crash globally in all asset classes.

It almost was with Bear Stearns being the turning point. The Fed put a floor under the market and declared their hand: too big to fail and we're reflating.

Bring it on! As an investor, the ensuing asset reflation will be a boon. Hard assets are a great hedge against inflation!!

Cheers,
Michael

*********************
Dear Michael,

1. Thank you for your interesting post.

2. I think that your above projections are quite "plausible" and "likely" developments in the near future;- though another significant " wild" card to this equation which we may need to also consider is the "China" factor after the post -2008 period once the Beijing Olympic Games Celebrations is officially over in August 2008.

3. As Access Economics has said in its latest Business Outlook Report,
"2008 looks fine for China - and hence for Australia too."
--" The theory is that as long as China continues to buy our coal and iron ore (at increasingly higher prices), we will sail through the rest of 2008."

http://www.hotspotting.com.au/index....&productId=226

4. for your further comments and discussion, please.

5. Thank you.

Cheers,
Kenneth KOH

 

[stumunro]

Macquarie Bank have a new fund called the Global Equities 100 fund or something. I might go to the seminar night next week about it.

P.s The only major problem is that they inflated the economy around 2000 when they really SHOULD have had a recession. Instead of letting the economy correct, they pushed it harder, increasing the money supply, inflating the bubble.. and it doesnt look like they won't do it again. Unfortunately by continually doing this they run the great risk of debasing their dollar and could cause a major major monetary crisis, in which debtors to the U.S will finally pull their money out and the only option will be to print enough money to pay everyone back. Which as you probably know, a likely outcome could perhaps be hyper inflation. Perhaps the end of a great run of a major fiat economy, could the currency be reset to a gold backed dollar?

 

[Francesco]

...
I've posted a couple of times lately how I believe the Fed is clearly reflating now and that I think they'll pull it off. Its a brave man that bets against the Fed. So, the obvious question for us as investors is: What does this mean for asset prices in Australia? My personal conclusion is that the Fed's actions will restore global liquidity in time and the cost of capital will come back to more comfortable levels. Inflation in Australia is probably going to stay hot for some time yet and there is the high likelihood of a wages breakout. I see all asset classes representing improving value now and would expect Property and Equities to both perform very well over the next decade.

I know there's some perma-bears out there that won't buy it, but I think the current environment is a prelude to a significant asset price boom in the coming years. Its not the end of the world as we know it with prices set to crash globally in all asset classes. It almost was with Bear Stearns being the turning point. The Fed put a floor under the market and declared their hand: too big to fail and we're reflating.

Bring it on! As an investor, the ensuing asset reflation will be a boon. Hard assets are a great hedge against inflation!!

Cheers,
Michael

Thanks MW, a good read and better reasoned than a 50 year depression due scenario.

 

[Aaron Sice]

I know there's some perma-bears out there that won't buy it, but I think the current environment is a prelude to a significant asset price boom in the coming years. Its not the end of the world as we know it with prices set to crash globally in all asset classes. It almost was with Bear Stearns being the turning point. The Fed put a floor under the market and declared their hand: too big to fail and we're reflating.

my seniments exactly. i don't believe the Fed are THAT naive as to sit back and let it happen and wait for opportunity to stimulate. i believe they ARE hard at work trying to put a floor into the bottom of the market wherever it'll fit.

P.s The only major problem is that they inflated the economy around 2000 when they really SHOULD have had a recession. Instead of letting the economy correct, they pushed it harder, increasing the money supply, inflating the bubble.. and it doesnt look like they won't do it again. Unfortunately by continually doing this they run the great risk of debasing their dollar and could cause a major major monetary crisis, in which debtors to the U.S will finally pull their money out and the only option will be to print enough money to pay everyone back. Which as you probably know, a likely outcome could perhaps be hyper inflation. Perhaps the end of a great run of a major fiat economy, could the currency be reset to a gold backed dollar?

thats some scary s__t to think about. while it would be a great starter for a non-fiat based economic system, i believe that situation would trigger a call for a global currency, one government, one fed. Think OCEANIA from George Orwells 1984. And you know what? i think they ( the underlying govt ) may use this next stimulus as a chance to do exactly that - just like the European Union.

Inflation in Australia is probably going to stay hot for some time yet and there is the high likelihood of a wages breakout. I see all asset classes representing improving value now and would expect Property and Equities to both perform very well over the next decade.

i honestly believe that wages will HAVE to take a serious spike or we will lose all our skilled (and unskilled!) peoples to places like Dubai, Shanghai, Singapore, Dublin, London and Scandinavia. I am also incredibly bullish about the next decade of EU and AU property and i have NO qualms about admitting it publicly.

 

[trendsta]

Hi MW,

I dont agree .. I think Fed wants a slowdown without credit problems.. slowdown to bring inflation back in ... There is a massive danger in what you say .. reflating and continuing to grow will fuel more inflation and spike inflation.

Here are the Treasury yields as of late last week:

2 year - 2.25
5 year - 2.98
10 year - 3.79
30 year - 4.54

based on your scenario do you see some problems here?