JP Morgan was out with an excellent piece of research explaining (and defending) their opinions on many of the market myths that are currently swirling regarding the government’s response to the crisis and the reaction by various asset classes.  Is the Fed blowing bubbles?   Aren’t we repeating the problems of our past?   JP Morgan explains:

  • What is asset reflation? It is the broad rally in all major asset classes—bonds, equities, and alternatives.
  • What assets gain most? The higher the yield and risk on the asset, the higher the return from asset reflation.
  • What will upset it? Uncertainty from either renewed downside risks on the economy, or sudden rises in inflation risks that require premature rate hikes. Several central banks have started hiking rates and will be joined by others in coming months. Will that not upset the asset reflation trade? No offense, but it is only the monetary policy rates of the biggest central banks that matter here.
  • And what about major central banks starting the normalization process by removing excess liquidity and reserves or the unwinding of money market support measures? By our thinking, it is the price of money, rather than its quantity, that matters most. Hence, mopping up excess reserves without pushing up money rates should not impede asset reflation.
  • Aren’t central banks again committing the sins of the past by keeping borrowing costs low? It may seem like this, but excessive private sector borrowing is clearly not the problem now. Au contraire! The sins of the past only become a danger if rates are kept too low in the face of rising inflation risks.
  • Won’t asset inflation by itself force central banks to hike? Not directly, in our mind. It is the economy and goods and services inflation that are the mandate of central banks. Admittedly, the asset cycles of the past two decades have taught policymakers to pay more attention to asset prices as a driver of the business cycle. They are thus more likely now to use asset prices as an early warning device, but will not likely hike to contain asset reflation for its own sake.
  • Isn’t the weak dollar the real cause of a new asset price bubble, creating negative borrowing costs, as it has been claimed? We do not think so, at least not directly. It is not because the dollar has slipped 7% against the euro this year that somebody funding the purchase of bonds in dollars would have considered this a 7% funding subsidy. Shorting the dollar and buying bonds are two very separate trades. What is correct, though, is that a weak dollar, combined with a reluctance by a number of EM central banks to allow their currencies to appreciate, has forced them to buy dollars that are then at least partly invested in bonds. Pegging your currency to the dollar means you import US monetary policy and stimulus.
  • Isn’t asset reflation just the next asset bubble? Not yet, and with good timing and fortune, we can avoid the eventual normalization that punctures this balloon. A rally becomes a bubble when excessive leverage is applied and carry becomes negative. We are quite far from there.

Good stuff and well explained, however, the fatal flaw in this thinking is the assumption that the Central Bank can predict and contain the reflation trade using their crystal ball-like forecasting skills.   Unfortunately, one of the flaws of the Central Bank has been their total lack of risk management and incredibly poor forecasting skills.  Why JP Morgan thinks their crystal ball has cleared up is beyond me.  As I’ve previously mentioned Bernanke has been behind the eight ball at every twist and turn of this crisis.  I don’t expect his reactive approach to change now:


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Strangely a bank carrying 85 trillion usd derivatives value in contingent liabilities, has omitted derivatives as a good friend of assets reflation.

  2. They sound too smug for thier own good. It seems like first they picked they answers they wanted and then built an argument to support it.

    Their point about intrest rates only having an effect, but not the amount of money seems to be the weakest of all. The stocks started rising right when the FED started QE, not when the reates where slashed to 0%.

  3. I don’t think they realize how big a risk this is to their trade: “What will upset it? Uncertainty from…renewed downside risks on the economy.” The U.S. alone will continue to have all kinds of problems from commercial real estate, a new wave of ARM resets, and no further increase on the margin from the stimulus spending. But all kinds of other things could go wrong globally. Japan looks like it’ll blow pretty soon, Europe has swept all its problems under the rug for now, and farther out, China looks like an enormous potential black swan, though if we’re all talking about it, perhaps a grey swan. As Taleb would say, this trade is like picking up pennies in front of a steamroller.

  4. I can either put 10K in my mattress or put 10K on red – just seems like there are so many potential risks.

  5. This is a scary chart of the DJIA, head and shoulders over decades:^DJI&t=my&l=off&z=l&q=l&c= . If this chart is right we should see a 20% increase in markets over the next few years and then a crash that makes march look tame.

  6. Other thing to note, I was looking at a volume indicator (VFI – Volume Flow Indicator by Markos Katsanos). For SPY and DIA, this money flow indicator was following the price uptrend from March till about mid-sept. From Oct to now, the money flow has been declining while the prices have continued up – new highs in price have not been confirmed with new highs in money flow.

    Just another thing to think about.

  7. By implication JPM seems to be suggesting that it is not fundamentals (supply/demand) that is fueling the risk trade – since the primary force behind it is that borrowing is cheap, thus spurring on speculation, due to very low major country CB interest rates.

    The question not dealt here is what might be the catalyst for a reversal of the risk/inflation trade.

    Seems to me that while the arguments made here are perfectly sound, they are also entirely of the rear view mirror kind: since credit/finance risk has been arrested, then lets get on with the reflation/risk trade, regardless of what is taking place in the real world of global economies of work/consumption.

    Is it possible that the feedback loop of real economy stagnation/decline back to credit/debt/finance takes hold, pressuring speculators to call in their chips.

    In other words, is it not the case that the real issue open to debate is whether the global economy is truly on the mend and trending towards rebounding -an analysis based on past business cycle dynamics – or might it be that this time it really is different, and the anticipated rebound isn’t/doesn’t take place?

  8. Oh yes. They raise their SPX year end target to 1160 from 1100. Hmmm. Why today? And why does the year end time matter at all. To funds maybe .. but for the individual investor? Looks like they are long and they need mkts to hold here.

  9. “Our central economic scenario assumes a slow recovery for the global economy, but with government debt at all-time highs, in this report we spend some time taking a hard look at the downside risks. Using debt as the key variable we also draw up two alternative economic scenarios (bull and bear) and consider the implications for strategic asset recommendations. In particular we focus on strategies for those who believe we may be set for a Japanese-style (non) recovery.”

    Societe Generale reviews 3 scenarios: Bear, Central, Bull