MARKET OBSERVER – N° 123

The continuation during the past weeks of the positive dynamics on most of the main world stock exchanges deserves clarifications aimed at better understanding what could be the market scenario this summer. In fact, the S&P 500 index in New York has just registered a new all-time high close to 3000 points, stimulating the positive short-term trend of many other world indices. So it is legitimate to wonder where the extreme pessimism went that characterized the stock exchanges at the end of 2018, caused by the fear that there would be a global economic recession.

With the benefit of hindsight, the answer is simple, the concerns gradually faded starting in January, especially when the FED and partly the ECB had suddenly reversed the course of their monetary policy. Since the third week of May, the Chinese central bank, PBOC, has begun to massively inject liquidity, supplanting the FED, which for now has acted more in words than in deeds, awaiting a concrete decision that could occur on July 19th. Considering that the monthly data of the various PMI indices remain compatible with a modest recession and that we are witnessing a disinflationary recrudescence, within a short period of time the central banks could officially start QE4. Quantifying the previous interventions, QE1 for 2.5 trillion dollars in the period 2008/2010, QE2 for 2.6 trillion at the end of 2010 for the whole of 2011, QE3 for 2.5 trillion in 2012/2014 and the G20 intervention of Shanghai for 3.6 trillion in 2016/2017, an intervention of 2.5 trillion could be hypothesised that would increase the total balance sheet of the world’s central banks, estimated today at 20 trillion, of around 12%, exactly the opposite of what was feared in mid-2018. Going towards a QE4 would also be confirmed by the dynamics of long-term rates, which despite the common belief, determine the level of the cost of money and not vice versa.

In fact, long-term rates have two components, the expected future rate in the reference period and a premium component that fluctuates in relation to the investor’s perception of risk. These risks are mainly linked to inflation and expected volatility, which in turn depends on the liquidity available in the system. So, during QE the volatility drops and there is less interest in buying refuge assets and therefore their return goes up, while during the tightening of a QT program, the lower available liquidity forces down the return on treasury securities, as has happened since October 2018 to date. In practice, the bond market is indicating to the Fed that it expects less inflation and more economic weakness and therefore it is necessary to reduce the cost of money. Statistically, an increase in liquidity precedes by 6 to 9 months a positive inclination of the yield curve, therefore the imminent QE4 could lower the yield of the ten-year treasury to 1.5% initially, accompanying the base rate down to 1%. If these hypotheses were to find the consensus of the markets, the lateral action of the stock indices hovering close to recent historical highs, could continue during the summer months even in the presence of negative economic data, which would be considered transitory. The plausibility of this thesis will find a first confirmation in the decisions that the FED will make in about ten days, bearing in mind that the best context for the stock exchanges is constituted by a hesitant economy that the central bank tries to revitalize, which is the current scenario.

Nicola Bravetti Data Source: Bloomberg

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