Finally a central banker has admitted he is as clueless as everyone else. “It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value,” said the US Federal Reserve chairman in a speech on 16 November. Ben Bernanke then contradicted himself, however, by adding: “It’s not obvious to me in any case that there’s any large misalignments currently in the US financial system.” If the first statement is true, the second cannot be.
Bernanke has no idea what a bubble looks like, but China and Germany reckon they do, suggesting that the US policy of low interest rates and a weak dollar are causing a speculative rise in asset prices.
In quantum mechanics, a so-called superposition is when something exists in two or more states at the same time. These days, the same seems true across economies and financial markets. The following markets are rising in perfect synchronization after they have fallen after prolonged rallies: equities, equity volatility (measured by the Chicago Board Options Exchange Volatility Index, or VIX), commodities and the dollar.
Oil prices and stock prices have moved in a perfect correlation of late. High oil prices indicate high demand and high economic activity. It is equally possible to make the opposite argument—high oil prices increase the costs of doing business and depress economic activity.
Heading into the coldest part of the year, oil inventories remain well above their historical average. Yet, long-dated oil prices have risen to within a whisker of $100 a barrel, in an environment of fragile and uncertain demand.
Lithuania has been downgraded by Fitch Ratings three times in the past year, and its gross domestic product (GDP) is expected to fall 18% this year. Yet, demand for its $1.5 billion issue of five-year bonds in early October was so great that this Baltic country could have sold nearly four times as much.
In India, between September and October, the value of PNs (overseas participatory note investments) has increased by nearly 13% from Rs1.10 trillion to Rs1.24 trillion, assisted by the dollar carry trade, while the total value of assets under management of foreign institutional investors has increased by just 6%. The market-cap to GDP ratio of the Bombay Stock Exchange stocks is at 99% compared with an all-time high of 109% reached during 2007-08.
Oddities abound. Gold and treasurys are climbing along with shares, which usually move in the opposite direction. Prices for New York apartments are falling, while those in Hong Kong and Mumbai, which are just as tied to the financial industry, are nearing previous highs.
Buoyant traders, who want risk, love Australian dollars and Brazilian reals. But safe-haven currencies such as the yen are rallying as well. Likewise, gold investors are schizophrenic; encouraging signs and negative news both seem reasons to buy.
The recent debt standstill request by Dubai World, the city kingdom’s largest state-owned conglomerate, has caused a repricing of risk both in and beyond the Gulf. The Dubai five-year credit default swaps are being quoted as high as 500-550 basis points, higher than even Iceland.
If the creditors of Dubai World do not agree to the debt standstill and a sovereign default does occur, the dollar carry trade could begin to reverse as investors return to safe-haven currencies.
Because the links between oil, forex and stocks have been driven so much further than their fundamentals permit, a correction in one could engineer a steep decline in the others. This is what the inner mind of the markets seems to be suggesting!
Sunil Kewalramani is CEO, Global Money Investor. Comment at firstname.lastname@example.org