Contradictions in markets

Real activity has got off to a slow start. However, one has to record the sharp turnaround in durable goods orders with a big revision in February data. Investment spending has thus carried momentum into the second quarter.

The Federal Reserve Board tried to shine more light on its policymaking by putting its chairman in front of the press after its policy meeting. Ben Bernanke’s first press conference stuck to predictable lines on monetary policy, on inflation and on the US dollar. He claimed inflation was transitory. He said a strong dollar was in the interest of the US and that monetary policy could be tightened as warranted later. But when it came to the policy signal, the Federal Reserve promised to maintain exceptionally low rates for an extended period. That gave the game away. Unsurprisingly, financial markets voted with their feet the next day, sending the dollar lower and all other assets priced in dollars higher.

Also Read V Anantha Nageswaran’s earlier columns

There is zero credibility for American protestations on inflation and on the US dollar as long as policy does not back up verbal assurances. That does not augur well for financial market stability down the road—something equities are content to ignore for now. But then, they always wake up once it is too late.

In the Asia-Pacific, Japanese economic data afforded the first glimpse into post-tsunami, post-quake economic activity. It wasn’t pretty. Industrial production slumped. While jobs data did not show much deterioration, housing starts did. The Bank of Japan should do a lot more than it has on monetary easing. Liquidity spigots should be opened more widely than they are now. Japan does not have to fear inflation. The rest of the world would of course be discomfited by another major power adding to global liquidity. That would (or should) make the US face the global costs of its unilateral policy decisions. The privilege of issuing the global reserve currency must be accompanied by accountability for global costs of unilateral policy-making. If not, global tensions and conflicts are in store.

Unsurprisingly, the Reserve Bank of New Zealand left its policy rate unchanged at 2.5%. What is surprising is the strength of the New Zealand dollar in the face of soft economic activity. Of course, that is not the only anomaly in financial markets these days.

Australian consumer price inflation in the first quarter accelerated from the previous period. Estimates exceeded consensus expectations. Australia is unlikely to tighten the policy rate now, especially since the Australian dollar is levitating at unbelievable levels against most currencies. Purchasing power parity estimates put out by the Organisation for Economic Cooperation and Development (OECD) suggest substantial overvaluation of commodity currencies, including that of the Norwegian krone. Only the Canadian dollar, as per the OECD measure, is not as overvalued as the Australian, New Zealand and Norwegian units are.

Meanwhile, in Europe, the 10-year government bond yields of the problem countries are approaching new highs, leaving levels reached last April-May looking insignificant in comparison. Irish sovereign yield on 10-year paper has joined Greece in the double-digit camp. Portugal is not far behind at 9.51%. At some point, the bonds of these countries must be deemed attractive, but the catch is the euro’s overvaluation. Investors willing to take the risk of restructuring (assuming it has been priced in) must hedge the currency exposure sooner than later.

In sum, the more we know, the less sure we are. The “disconnect" between reality and financial markets, precipitated and nurtured by abnormally low policy rates and plentiful liquidity, continues. That has been the defining feature of the last decade and more. Until that changes, mispricing of risk and consequent economic dislocations are inevitable. In fact, they would be more frequent than before.

For policymakers, the short-term benefits of such a policy posture exceed the long-term costs, which are borne by someone else. Until the public wakes up to this reality, or until incentives and accountability resolve this anomaly, rational investors would have an unenviable choice. Either they join the crowd and burn with it when economic reality brings financial market frenzy to an end, or they stay on the sidelines and risk being blamed for being wrong.

This has been the problem for rational investors since time immemorial, except that it has become more regular now from being occasional in the past. They should find a better way of saving for the future than relying on financial markets to do so.

V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at baretalk@livemint.com

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