FYI | Jun 27 2008
By Greg Peel
The following chart shows what the analysts at GaveKal call their Velocity Indicator. The indicator is calculated by looking at banking multipliers, spreads between government and corporate bonds, bond yield curves, relative performance of bank shares and mortgage refinancing across the US, Japan, Europe and the UK. As GaveKal suggests: “By combining official data on what commercial banks are doing, how much debt the consumer is willing to accept, and market data on how much risk the system is willing to take, we believe that we get an accurate measure of the ‘animal spirit’ prevalent in financial markets. Thus velocity helps us gauge the amount of liquidity created by the private sector.”
In other words, the indicator is a measure of “the willingness to increase risk”.
It would come as no surprise that the indicator has turned down once more, after a brief flirtation with positive territory since March. GaveKal published its report last night, so it is unclear exactly what point last night’s market demise had reached as the analysts’ views were being expressed.
Looking at the wider picture, one can see that there was an uncertain period at the beginning of the century when tech stocks bubbled then burst, followed by 9/11 and finally the 2002-03 recession. But after 2003, we experienced a long period of strong risk appetite in which, one can now say with perfect hindsight, too much liquidity was pumped into the system by the private sector. Thus followed the credit crunch of 2007-08, and the brief post Bear Stearns return to risk.
As the system was flooded with liquidity during the 2003-07 period, there was always a risk of rising inflationary pressures, notes GaveKal. And the reality now is that most of the new money created by the private sector found its way into commodity markets.
But from mid-2007 on, the market has been generally reducing leverage and withdrawing liquidity. The immediate effect is represented by the precipitous fall in equity prices. But what it should also mean is that a lagged effect will follow – that of falling inflation. “After all,” says GaveKal, “inflation is always and everywhere a monetary phenomenon and with less money around, can we really expect prices to continue to rise?”
This is exactly how the Fed appears to be playing the finely balanced situation as well. Last night’s big sell-off in the US dollar might have been sparked by comments from OPEC, but the fall included a vote of no confidence in the Fed. But are the markets getting ahead of themselves, asks GaveKal, in expecting the Fed to raise the cash rate? The Fed has indicated that inflation risk is real, but the committee is still backing a fall in inflation in coming quarters.
GaveKal does not expect the Fed to raise. Indeed, from a political aspect the timing of the upcoming Fed meetings is not conducive. While the next two meetings are on August 5 and September 16, most in the market are now looking for a rate hike later in the year. The following meetings are October 28 – just before the presidential election, and December 16 – right before Christmas. Neither are good times for raising borrowing costs, notes GaveKal.
That would only leave August and September, but GaveKal does not believe the US economy is yet strong enough to support a rate hike so soon.
