After a long, long time, we seem to be back to a real market. By this I mean a reasonably divergent set of views on most economic and market variables, starting with the US recovery. Is it real or are we simply being set up for a second dip? Is the global equity rally (despite the recent modest pullback as on September 25) the start of a bull market, or are we ready for a second 1930s’ type plunge? When will inflation return? How will global central banks deal with this? Why is the VIX so low?
Most importantly, of course, where do we go from here?
Clearly, the huge amount of liquidity pumped in by monetary authorities around the globe is likely, at some point, to generate a burst of inflation. Of course, increased money supply by itself doesn’t drive prices — rather it is the product of money supply and the velocity of money, which, at a high level, can be substituted by growth. The trick, of course, is to find that correct point to tighten the money supply, or, in the current circumstance, reduce the “quantitative easing.” This is notoriously difficult at the best of times; with a global economy that is just — and perhaps not even — out of the ICU, it requires more than the usual amount of luck.
The situation is compounded by the fact that, over the past few decades, central banks the world over — with the notable exception of RBI — had apparently forgotten that their job was to take away the punchbowl just as the party gets hopping. The resulting crisis — analysed to death and back by the nattering nabobs of negativism (thank you, Spiro Agnew) — has reminded them of this failure in spades. This, of course, further complicates decision-making: Are we jumping the gun (on tightening) to correct for our built-in aggressiveness in the past?
Of course, markets are still betting that the Fed (and, by extension, other central banks) will remain biased towards growth — the five-year swap rate remains close to 10-year lows and falling. And, certainly, the political establishment, for both fiscal and public opinion reasons, needs growth. In other words, the convergence of needs that became a crescendo when the world went into crisis still appears to be in place.
Except, as I mentioned earlier, that we are beginning to see an increasing divergence of opinions in financial markets. For instance, the difference in the average and the mean of USD/INR forecasts for September (in our currency forecast contest) was over 0.5 per cent, which suggests a reasonable divergence of views. Another interesting divergence that I see is the growing number of articles warning that dollar weakness is not a continued certainty. Part of the reasoning is that the increase in US private savings is already beginning to off-set the dramatic increase in government spending, as a result of which the amount of foreign capital the US needs to finance itself has been falling sharply — from around $240 billion a quarter a couple of years ago to less than $100 billion a quarter today.
Again, and importantly, President Obama, despite the conservative backlash, is definitively focused on making the US great again. This will require considerable investment in education and infrastructure, amongst other things. This means that the US budget will remain in substantial deficit for years to come, the difference being that a significant part of the borrowings will be for investment rather than just spending. Clearly, if you need to continue to borrow money from the world, you can’t continue to pay them back in a depreciated currency.
The US’ main creditor — China — is already whining and flailing about for an alternative to the dollar. Its second biggest creditor — Japan — has recently undergone a structural political change, which means it is no longer “anything America says”. And, finally, the US’ geopolitical strength is also weakened by the impact of the crisis on its key ally, Britain.
On the other side, the strength of America’s key adversaries — Russia and Iran (separately) — would be sustained by a weaker dollar, since it translates into higher commodity prices, which fund the global adventurism of both of these “global black sheep”.
Thus, I believe that the US Treasury Secretary’s refrain in the 1970s — the dollar is our currency, but your problem — no longer holds, and, as we transition from the storm, we will see a stronger dollar and lower commodity prices over the medium term (say, 18 months) and higher market volatility (buy the VIX).
