Sunday, August 12, 2007

About The Market Turmoil

It is difficult to know where to start when commenting on the extreme market turmoil of the last few days. A good place would perhaps be to read George Reisman's excellent summary of the background of the crisis. We should never forget to emphasize how this is all Alan Greenspan's fault.

After you've finished reading Dr. Reisman's piece, a few additional points should be noted.

1) Markets are more erratic than ever. I have followed financial markets on a virtually daily basis for more than 10 years and so I have experienced large up and downs in all markets. Yet I cannot remember the markets ever being quite as erratic as this week. This means not only that the short-term mood swings, the sudden swings between extremely bullish and bearish sentiment, are larger than ever. But most importantly that the swings are more detatched from news and rationality than ever.

Two movements were especially noteworthy in this context. On Tuesday, after the FOMC decided to keep a relatively hawkish stance, the stock market first fell on the news as expected. But then after just half an hour or so, it suddenly reversed cause and rallied sharply, a rally which continued on Wednesday. What gives? Well, supposedly Bernanke indicated that he wasn't worried about the subprime crisis and that was supposedly a reason to buy. As if Bernanke's comments had any relevance with regards to the underlying fundamentals.

Similarly, on Wednesday, oil prices first rose after a report showing declining crude oil and gasoline inventories. But then they turned down and finished lower than they started.

Not to mention of course, the swings between the sharp sell-offs late last week, the sharp rally Monday to Wednesday and the sharp sell-off on particularly Thursday.

With the markets behaving so irrationally it is dangerous to engage in short-term speculative movements. The erratic nature of the markets ultimately of course reflects nervousness about the housing bust and its repercussions.

2)The black helicopters did arrive. And not just the Federal Reserve helicopters but helicopters from the ECB and half a dozen or so other central banks and they all flooded the markets with newly created money to force down the interest rate on overnight loans to their target rates.

Note however that this does not represent a loosening in monetary conditions per se, only that the central banks prevented the markets from tightening them on their own.

The markets are now pricing in a Fed rate cut at the next meeting at latest, and perhaps even at an emergency extra meeting next week. I think the latter is unlikely unless we see a further dramatic deterioration in financial conditions, but the former now appears likely.

I have previously not believed in rate cuts anytime soon, but now it appears a lot more likely. I don't think they should cut as inflationary pressures are too strong, and I have a feeling that most FOMC board members too are more skeptical than the markets about the benefits of rate cuts. However, can they really withstand the pressure from the markets and pundits to lower rates? I increasingly doubt it. Not that rate cuts are going to save the day. A recession will likely appear anyway and by not rooting out inflationary pressures now, we are simply likely to see a prolonged recession and a weaker recovery later.

3) As previously noted, the markets are so erratic right now that short-term speculation is dangerous. However, since the underlying fundamentals are so weak we are first of all likely to see these erratic swings continue and any trend movements are more likely to be sloped downward rather than upwards.


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