JP Morgan was out with an excellent piece of research explaining (and defending) their opinions on many of the market myths that are currently swirling regarding the government’s response to the crisis and the reaction by various asset classes. Is the Fed blowing bubbles? Aren’t we repeating the problems of our past? JP Morgan explains:
- What is asset reflation? It is the broad rally in all major asset classes—bonds, equities, and alternatives.
- What drives it? A record low return on cash and falling uncertainty and volatility are inducing investors to flee into any asset that promises positive returns. We do not need economic data to surprise on the upside. It is enough and even better if data merely come out as expected.
- What assets gain most? The higher the yield and risk on the asset, the higher the return from asset reflation.
- What will upset it? Uncertainty from either renewed downside risks on the economy, or sudden rises in inflation risks that require premature rate hikes. Several central banks have started hiking rates and will be joined by others in coming months. Will that not upset the asset reflation trade? No offense, but it is only the monetary policy rates of the biggest central banks that matter here.
- And what about major central banks starting the normalization process by removing excess liquidity and reserves or the unwinding of money market support measures? By our thinking, it is the price of money, rather than its quantity, that matters most. Hence, mopping up excess reserves without pushing up money rates should not impede asset reflation.
- Aren’t central banks again committing the sins of the past by keeping borrowing costs low? It may seem like this, but excessive private sector borrowing is clearly not the problem now. Au contraire! The sins of the past only become a danger if rates are kept too low in the face of rising inflation risks.
- Won’t asset inflation by itself force central banks to hike? Not directly, in our mind. It is the economy and goods and services inflation that are the mandate of central banks. Admittedly, the asset cycles of the past two decades have taught policymakers to pay more attention to asset prices as a driver of the business cycle. They are thus more likely now to use asset prices as an early warning device, but will not likely hike to contain asset reflation for its own sake.
- Isn’t the weak dollar the real cause of a new asset price bubble, creating negative borrowing costs, as it has been claimed? We do not think so, at least not directly. It is not because the dollar has slipped 7% against the euro this year that somebody funding the purchase of bonds in dollars would have considered this a 7% funding subsidy. Shorting the dollar and buying bonds are two very separate trades. What is correct, though, is that a weak dollar, combined with a reluctance by a number of EM central banks to allow their currencies to appreciate, has forced them to buy dollars that are then at least partly invested in bonds. Pegging your currency to the dollar means you import US monetary policy and stimulus.
- Isn’t asset reflation just the next asset bubble? Not yet, and with good timing and fortune, we can avoid the eventual normalization that punctures this balloon. A rally becomes a bubble when excessive leverage is applied and carry becomes negative. We are quite far from there.
Good stuff and well explained, however, the fatal flaw in this thinking is the assumption that the Central Bank can predict and contain the reflation trade using their crystal ball-like forecasting skills. Unfortunately, one of the flaws of the Central Bank has been their total lack of risk management and incredibly poor forecasting skills. Why JP Morgan thinks their crystal ball has cleared up is beyond me. As I’ve previously mentioned Bernanke has been behind the eight ball at every twist and turn of this crisis. I don’t expect his reactive approach to change now:
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.