Market Commentary

Stocks rose as economic and earnings reports boosted optimism
February 19, 2010

Stocks rose as economic and earnings reports boosted optimism that the recovery will be sustained.  This view was further validated by the yield curve or the spread between the two year and ten year treasury.  Yesterday it steepened to a record 2.93% as per Bloomberg.

In my view the yield curve is one of the most fundamental economic predictors.  For example an inverted yield curve has a 100% correlation to a slowing economy.  Conversely an expanding economy and growing inflationary pressures are closely correlated to a steep yield curve.

The Central Bank has stated its intent to keep interest rates low “for an extended period of time,” a position the treasury market is now suggesting that the Central Bank is falling behind the proverbial inflationary curve.  Is the Fed attempting to err on the inflationary side of the equation as inflation is easier to combat than deflation?

A fundamental assumption of our asset based economy is to permit the existence of nominal inflationary pressures; buy something today and pay for it with tomorrow’s dollars.  As widely discussed asset values (i.e. real estate) have declined anywhere between 20% and 45% since 2006.  Some contend the banking system is practically insolvent given the massive amount of loans perceived to be underwater.

I must write this is not the first time the above was a common perception.  The last time was around 1990 and before that was the early 1980’s during the Central and South American debt crisis.

Is the Federal Reserve attempting to generate inflationary pressures to increase asset prices? 

As widely accepted the Federal Reserve is slow to react and overshoots its intended target.  Is this the case today?

However against this backdrop, late yesterday afternoon the Central Bank increased the discount rate—or the rate that member banks can borrow from the Federal Reserve—by 0.25% to “encourage financial institutions to rely more on money markets rather than central bank for short term liquidity needs.”

As widely noted this crisis began in earnest in August 2007 with a surprise 0.50% reduction in this symbolic rate which some at that time viewed as a “genius move.”  This rare intermeeting move was 10 days following the last FOMC meeting where the Committee viewed inflation as the predominate threat.

Has the Federal Reserve just issued the proverbial “All Clear” sign?

What will happen today?

Last night the foreign markets were down.  London was down 0.08%, Paris down 0.37% and Frankfurt down 0.16%.  Japan was down 2.05% and Hang Sang down 2.59%.

The Dow should open moderately lower following the first of many expected steps to drain the financial markets of excess liquidity.  As mentioned several times, during the tightening cycles of 1991 and 2003 the S & P advanced handsomely following an initial sell off.  Will history again repeat itself?   The 10-year is up 1/32 to yield 3.80%.