So the stock markets have been able to take the subprime mortgage crisis in their stride. The Sensex is close to its all-time highs and markets across the world have rallied. As a matter of fact, it now looks like the “crisis” was little more than a healthy bull market correction, allowing investors to take some profits off the table and get in again at lower levels.
True, last month’s jitters had seemed different from the usual run-of-the-mill pullbacks, with reports coming in of several large banks in trouble in the US, in Europe, in Australia and even in China. The credit system had seized up, with short-term rates shooting up and banks unwilling to lend to each other. All this was very different from earlier market corrections in the last four years.
Why should stocks be rallying now? Simply because of the assurances of Messrs Bernanke and Bush; because of the decisions of the Bank of England, the Bank of Japan and the European Central Bank to put their plans for raising interest rates on hold; and because the US Federal Reserve has been making very reassuring noises.
As a consequence, the markets are expecting the US Fed to cut its policy rate by at least 25 basis points at its next meeting on 18 September—some even expect a 50 basis-point rate cut. If that happens, US mortgage rates will drop, enabling the borrowers of subprime loans to pay their instalments and perhaps even refinance their mortgages. Interest rate futures show that the market is pricing in a 25 basis-point rate cut by the Fed as a certainty.
Why hasn’t liquidity declined? How can it, with the US and European central banks continuing to add billions of dollars in short-term money? On 6 September, the US Fed pumped in $31.25 billion (Rs1.28 trillion). The European central bank is also adding funds to the system, ensuring that there’s no drying up of liquidity—it injected $57.7 billion on 6 September, on the day it announced that it will not raise rates despite agreeing that inflation risks remain in place and monetary policy continues to be accommodative.
Strangely enough, that hasn’t yet restored confidence in the credit markets. Credit spreads remain at levels well above those before the start of the crisis. Three-month dollar London Inter-Bank Offer rates (LIBOR), a measure of the cost of borrowing for three months in dollars, recently rose to their highest level since January 2001. Three-month Sterling Libor and Euribor rates have continued to rise. Credit problems have spread to the asset-backed commercial paper market and to structured investment products. Moody’s, the rating agency, has said that it could take up to six months for the credit markets to return to normal. The flight to safety continues unabated, as seen from the yield on the US 10-year Treasury note falling to its lowest in five months. Volatility in the US Treasury market is at a three-year high.
In other words, the stock markets have decoupled from the credit markets. Decoupling in recent years has meant the ability of the rest of the world to grow without the support of the US economy, but the divergence between the stock and credit markets is a new type of decoupling, one that raises several questions.
Why, for instance, haven’t reassurances by the central bankers helped the credit markets, while they have rallied stocks? Since the problem is with the credit markets, do they know something the stock market doesn’t know?
How is it that the liquidity injections have not led to a return of confidence in the credit markets, which is what they were intended to do, while they have boosted equities? These are the issues that suggest we have not seen the last of the credit crisis yet and investors would do well to keep a sharp eye on the credit markets. Also, the global stock market rally is treating a Fed rate cut on 18 September as a done deal. That is by no means so. Because, if the Fed does indeed cut rates, it will clearly signal that it is willing to put a floor under equities. That raises all kinds of questions about moral hazard. In short, it’s possible the stock markets may have become a bit too confident too soon.
But that’s not the only explanation of this decoupling between the credit and the equity markets. Charles Gave, a partner in global research and money management firm Gavekal Research, in a piece titled “Hermès Ties, Longines Watches and Sub-Prime Bonds”, written on 22 July, just when the credit crisis was breaking, compared credit derivatives to the fake Hermès ties and Longines watches sold on the pavements of Asia.
He said that it was a giant Ponzi scheme, which had allowed Wall Street to get what it wanted: junk bonds with AAA ratings. But while he points out that credit markets will suffer because “at some point, reality always sets in and Ponzi goes to jail”, he thinks that’s actually good for the equity markets. Why? Because “after all, our Ponzi scheme, which in the last few years has been the only competition in town to stocks and commodities, is now disappearing. Should we be surprised that, as the Ponzi-scheme competition disappears, equities around the world, along with commodities, are making new highs?” Simply put, Gave believes all that money that used to go to the fancy high-yield bond and credit derivative schemes will now find their way back into old-fashioned equities. At the moment, Gave’s explanation fits the facts very snugly indeed.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular.
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