14th September 2012
In the short-term, risk assets have rallied. The equity markets have seen substantial gains across the board. Within that, higher beta markets such as France, and the markets of vulnerable countries, such as Spain and Italy, have seen the strongest gains. Within sectors, it is the more cyclical commodities and banking sectors that have performed well, while more defensive areas such as pharmaceuticals have struggled.
Commodities have also gained: Brent Crude oil spiked above $117 per barrel, while metals prices have -in some cases – seen double-digit gains. Prices had been relatively depressed to this point on the weak growth outlook from China. Copper is up over 10%, wheat is up over 25%.
Currency movements have also been significant. The dollar has sold off, which has pushed up the price of gold. If this endures, it could be bad news for the Eurozone and UK economy, which have benefited from the relative weakness of their currencies.
So far, this has all the hallmarks of a risk-driven rally. For a long time, markets have valued safety to the extent that a number of experts have been concerned that they are over-paying for defensive, high quality stocks. This has left many cyclical stocks languishing, so there was some scope for a bounce. But can this exuberance last?
This depends on a number of factors: Perhaps most importantly, it depends on whether the Federal Reserve's plan succeeds in boosting economic growth and also whether it ‘succeeds' in creating inflation. Many believe that this is the ultimate goal of Operation Twist. If this is the case, a rally in risk assets can endure.
Keith Wade, chief economist at Schroders, points out that long bond yields have risen since the announcement, adding: "The suspicion that the Federal Reserve is trying to inflate its way out of the debt crisis remains." He believes that the Fed action will push people higher up the risk spectrum: "The search for yield will become even more acute and investors will be driven into riskier assets in the search for income."
This piece on Zerohedge makes a convincing argument that the Federal Reserve's move will ultimately debase the US dollar, leading to higher prices for gold, and push up the oil price: "this flood of liquidity will raise the nominal price of every asset (from whimsical pieces of stockholder paper to barbarous relics and black gold). Some of these assets, like stock prices and high-yield credit spreads do have point-in-time 'value limits' to their price – though at times it seems a dream that fundamentals would ever matter again; but some have less of a binding constraint – such as gold.
"Should the Fed proceed, as seems likely, and do its worst/best to blow its balance sheet wad then we estimate Gold will be priced at least $2250 per ounce by the end of 2013 (of course higher if the Fed sees no evidence of recovery). Meanwhile, deeper underground, the world's mainstay source of energy, WTI Crude oil, could jump to record highs over $150 per barrel."
Of course, there is a flip-side. If cyclical and higher risk assets are becoming more attractive, those safe assets that have been havens for risk-weary investors are likely to suffer. The yield on the 10 year gilt is already 0.24% higher than a month ago (at 1.86%). This may be the start of the long-awaited sell-off in government bond markets.
The move certainly ensures that cash remains unattractive. In fact, Bernanke admits that he is aware of the problem, but has no plans to make life easier for savers:
"My colleagues and I are very much aware that holders of interest- bearing assets, such as certificates of deposit, are receiving very low returns. But low interest rates also support the value of many other assets that Americans own, such as homes and businesses large and small. Indeed, in general, healthy investment returns cannot be sustained in a weak economy, and of course it is difficult to save for retirement or other goals without the income from a job. Thus, while low interest rates do impose some costs, Americans will ultimately benefit most from the healthy and growing economy that low interest rates help promote."
A boost for risk assets and commensurate sell-off in safety looks like the most likely longer-term outcome of the Fed's move, particularly given the current high value on ‘safety' and low value on economically sensitive assets. However, there is also a danger that the Fed's actions are completely ineffective – economic activity and therefore inflation remain low. In this scenario, it is likely that life would just go on as ‘normal'.
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