Equity markets are surging overnight as traders are optimistic that the release of today's bank stress results will yield no major surprises. Rumors have been flooding the market for the last 10 days speculating on how many banks are safe and how many will need capital. The stock market, however, never retreated on any of the negative stories. When the results are released after the close, traders are going to have to decide whether the Fed is telling the truth about the condition of the banks. So what started out as a potential disaster for the banking system because it opened up the possibility of wild speculation has actually turned out to be almost a non-event.
The Treasuries are the markets to watch because interest rates are the true indicator of the condition of the economy. Both the Treasury Bonds and Treasury Notes have been telling investors since March 18 that the Fed has matters in control. This has been reflected in the steady decline since that date. When the Fed unleashed its plan to use $1.2 trillion to buy-back assets, it told investors that it was serious about turning the economy around now not later.
Interest rates have slowly increased since that date but the Fed's action has slowed down the rate of appreciation. The Fed's job now is to make sure that mortgage rates stay low so that the housing market has a chance to begin its recovery. If mortgage rates begin to creep higher then it may cause potential buyers to back out of their plans to buy a home. Although certain sectors of the economy are showing signs of a recovery, the housing market has to be a major part of that recovery.
The decline in June Bonds and June Notes this morning is indicating that investors are gaining confidence in the economy and no longer feel the need to hold on to treasuries for safety. The selling pressure we are seeing this morning is also a sign that interest rates will rise as the economy recovers. Besides keeping mortgage rates down, the Fed is going to have to figure out an exit strategy so that all the money it has pumped into the economy does not turn inflationary.
June Gold traders are beginning to bet that there is going to be inflation. The way it is trading, however, is indicating that the Fed is going to allow some inflation but not runaway inflation. Bernanke is on record as saying the Fed does not believe that inflation will be an issue for a while but gold traders have a contrary opinion. Some of the gold buying taking place is also a hedge against a potential banking crisis although this scenario seems remote at this time. Nonetheless, some gold traders feel the need to protect themselves just in case the stress test results reveal some serious holes in the system.
The strength in the commodity markets is reflecting both speculation of increased demand and the possibility of inflation. This is particularly true in the crude oil market. Although records still show a world awash in oil, speculators are betting that the combination of the OPEC production cuts along with an economic recovery will eat up the excess oil. Venezuela said yesterday that OPEC members want to see crude at $70. This is a possibility if demand begins to increase and OPEC cuts once again. OPEC backed off a production cut at its last meeting fearing it would shunt the global economic recovery. Now that the global economy seems to be improving, it may implement another cut just to make sure it gets the price it desires.
The Bank of England decided to keep interest rates unchanged but crushed the British Pound when it announced that it would increase the size of quantitative easing. This is in effect flooding the market with cash. This could turn out to be inflationary because it debases the currency and could lead to inflation later. Traders are responding to this news by selling British Pounds and buying gold.
The European Central Banks cut its benchmark interest rate to a historically low 1.0% this morning. Traders are now waiting for the ECB's plan to buyback assets. Remember that they may announce a plan but do not have to implement it immediately. This morning's news that German manufacturing surged may cause the ECB to refrain from implementing its quantitative easing plan right away and instead may choose to take a wait and see attitude toward the economy.
Moving forward traders are going to have to pay more attention to interest rates. Rising rates will indicate that the economy is getting stronger. This also increases the possibility of inflation. Equity markets will continue to rise as the economy recovers, but if rates rise too fast, investors will begin to take money out of equity to lock up the higher guaranteed rates in treasuries. This is the only scenario I see that could put in a top in the stock market.
