A Dangerous Central Bank Party - The World is Awash with Easy MoneyEconomics / Analysis & Strategy Feb 24, 2007 - 12:20 AM GMT
Mardi Gras 2007 just wrapped up. The revelers have gone home. The garbage is being swept up. The Big Easy won't be hosting another one of its famous parties until next year …
But the world's central bankers? They aren't putting away the party beads or the booze. Instead, they're still doling out the easy money and saying, “Laissez les bon temps rouler!” (“Let the good times roll!”)
Now, there's nothing inherently wrong with a party. But there's also a time and place for a celebration. And in a moment, I'll tell you how the parade could careen out of control.
First, I want to tell you a little bit more about central bank actions around the globe. Let's start with the U.S. …
“Gentle Ben” Bernanke Lives Up to His Name
Last week, in testimony before Congress, the Fed Chairman sounded like he didn't have a care in the world. His comments practically overflowed with optimism …
Rising prices? No problem! Here's what Bernanke said,
“Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen, in large part as a result of declines in the price of crude oil. Readings on core inflation — that is, inflation excluding the prices of food and energy — have improved modestly in recent months.”
The future outlook? It's all good! Quoth Bernanke,
“The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next.”
Gentle Ben went on to say that housing is already bouncing back, and that the unfolding disaster in subprime mortgages is contained and won't affect bigger banks.
Bernanke's testimony was also noteworthy for what he didn't say. The Fed head didn't say much about the near-record low in credit spreads … the explosion in leveraged buyouts … the ridiculous prices being paid for commercial property … or any one of several other signs that monetary policy is anything but tight.
Heck, he made no mention of the fact that U.S. money supply rose 5.3% year over year in December, the biggest gain in almost two years.
In short, Bernanke's message was, “Let the good times roll!”
It's the Same Story
In Japan and the U.K.
Japan is arguably the world's biggest supplier of excess liquidity and easy money. So traders held their collective breath as this week's Bank of Japan meeting approached.
The big question: Would the bank make up for its last meeting, when policymakers basically bowed to political pressure and kept rates stable?
On Wednesday, we got the answer. The Bank of Japan did hike short-term rates to 0.5% from 0.25%. But at the same time, policymakers assured the markets that this wasn't the start of some Godzilla-like rate-rising rampage. According to Governor Toshihiko Fukui, “There's no change in our stance that adjustments will be made slowly.”
Translation: “Let the good times roll!”
What about the U.K.? Well, British policymakers surprised the market with a rate hike in January. But it was a close call, with a vote of 5-4 in favor of hiking. Moreover, minutes from the meeting show that banking officials were concerned that “a closely spaced series of interest-rate increases might lead to excessive tightening.”
Let me tell you, monetary policy in the U.K. looks as easy as ever. The broadest measure of money supply (M4) jumped 13% year over year in January, just shy of a 16-year high!
I could go on and on. For example, in countries like India and Thailand, political pressure is mounting on central banks to stop hiking rates. Even the European Central Bank is getting flack for its recent series of rate hikes.
Result: The “let the good times roll” mantra is being translated into other languages all over the world.
Here's the Problem with The Easy Money Atmosphere
Too much easy money almost always leads to heartache down the road. Just look at the high-risk mortgage market …
The Fed's reckless monetary policy and hands-off regulatory approach helped inflate the biggest housing and lending bubble in U.S. history. Encouraged by the monetary largesse, lenders gave money to practically every borrower with a pulse.
Now, borrowers are saddled with loans they can't pay back. Mortgage delinquencies and foreclosures are surging. And we're seeing the most widespread declines in home prices in U.S. history.
The Nasdaq boom and bust is another example …
Alan Greenspan mused about “irrational exuberance” in the mid-1990s. But then he let the matter drop. As a result, stock traders went wild, driving tech and Internet stocks to the moon. Later, stocks crashed and many investors lost their life savings.
So, where are the danger areas right now? In my opinion, here are two markets that are currently being over-inflated by easy money:
1. Commercial property — Values are surging through the roof, and property “yields” are dropping to record lows. We're also seeing the biggest Real Estate Investment Trust (REITs) buyouts in history.
2. Derivatives — The liquidity flood is encouraging hedge funds and big financial institutions to go hog-wild with derivatives, which are financial instruments based on other assets (options, futures, swaps, etc.). As of June 2006, total over-the-counter derivatives volume had surged to a whopping $370 trillion , 32% higher than the previous year and 68% higher than the same period two years earlier.
And don't forget that there's another side effect of easy money — inflation. Too much money chasing goods and services drives up prices.
Just look at what happened in January — the core Consumer Price Index, which excludes food and energy, jumped 0.3%, topping forecasts. The year-over-year core inflation rate is now 2.7%, well above the Fed's 1% to 2% comfort zone.
Here's what I suggest: Ride this wave of monetary largesse while it lasts. But focus on investments like:
- High-yielding foreign shares: There are lots of attractive foreign companies out there, and U.S. investors can potentially win in three ways — capital gains, dividends, and favorable currency exchange rates.
- Gold: Gold blasted off on Wednesday, jumping $23 an ounce to a nine-month high. The yellow metal tends to do well when inflation fears are rampant.
- Other natural resources stocks: Crude oil recaptured the $60-a-barrel level this past week, and other natural resource-related shares look poised for more gains, too.
- Select stocks in winning sectors here in the U.S.: In my book, there are still some attractive areas in domestic markets, including defense companies and consumer staples shares.
However, please understand that the good times won't last forever. Use risk-control measures like stop losses, and keep a hefty chunk of money in cash or cash-like investments.
After all, the party shut down on Bourbon Street this past Wednesday. And it'll shut down on Wall Street at some point, too.
Until next time,
By Mike Larson
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