Don’t fight the Fed. It’s an important piece of Wall Street wisdom built on the often-repeated power of changes in the Federal Reserve’s policies on interest rates and the money supply to overwhelm all other financial market trends. When interest rates are headed down and the money supply is headed up,  most of the time, stocks will head up too.

Not always, of course, since the Fed itself can get overwhelmed by a global financial crisis here or a euro debt crisis there that can lead to a situation where the real economy doesn’t respond to the Fed’s monetary prodding.

But the saying is true frequently enough so that aligning your investment strategy with Federal Reserve policy makes sense most of the time.

So what about when it isn’t just the Federal Reserve that’s lowering interest rates and pumping money into U.S. economy, but the European Central Bank pursuing the same course in Europe, and the Banco Central do Brasil in Brazil, and, just beginning but accelerating, the People’s Bank of China in China?

Is this flood of cash enough, by itself, to push stocks higher in 2012—no matter what the real global economy is doing? Traders and investors have started 2012 by answering that question with an emphatic Yes. January’s rally in U.S., European, and emerging market stocks is based on a belief that the huge wave of cash that the world’s central banks have unleashed—or are about to unleash—on global economies will send stock markets higher and set economies to growing faster.

Let me give you two reasons why the global version of Don’t fight the Fed won’t work out quite as well as the current optimism suggests this time around. Read more

On August 5 Standard & Poor’s downgraded the credit rating of the United States to AA+ from AAA.

What’s happened to the debt of the United States since then?

Treasuries have rallied and sent yields to historic lows. Last week the yield on a two-year Treasury fell to 0.19%. The yield on a 10-year Treasury closed the week at 2.06. That was slightly above the low set on Thursday of 1.97%. That was the lowest yield on the 10-year Treasury since 1950.

There’s no way to escape a certain amount of Schadenfreude. There is pleasure, admit it, in seeing the market thumb its nose at Standard & Poor’s, the credit rating company that got the mortgage-asset market so terribly wrong and helped create the global financial crisis by giving AAA ratings to so much paper that quickly demonstrated that it didn’t deserve an AAA rating by collapsing in price as the underlying mortgages went sour.

But I wouldn’t let the grim pleasure at Standard & Poor’s discomfiture become your primary emotional reaction to the rally in U.S. debt markets. That main emotion should be worry. This rally isn’t a sign of health in the financial markets. Read more

I understand why the Greek debt crisis is a big issue in Europe. The European Central Bank holds about $200 billion in Greek debt. At least three French banks and some regional banks in Germany have enough of the stuff stashed in their portfolios that some technically bankrupt banks could be forced to declare actual bankruptcy. The wage cuts and tax increases that have sent tens of thousands of Greeks into the street to confront helmeted riot police deploying tear gas hang over workers in Portugal, Ireland, Belgium…

But why should the rest of the world care? Greece is the 39^th largest economy in the world, according to the CIA World Factbook, once you correct its GDP for differences in purchasing power. That puts it below Nigeria, Venezuela, and the Philippines and just above the Ukraine. If any of those countries were teetering on the edge of default, would world financial markets blink twice?

Why should we care? Derivatives. The same toxic stuff that brought down Lehman Brothers and that was just a bailout away from taking down American International Group and, perhaps, the global financial system is at it again.

Here’s what Mario Draghi, who will replace Jean-Claude Trichet as head of the European Central Bank, said at his confirmation hearing on June 14. Who knows what the effect of a Greek default would be, he told the European Parliament. Sure, everybody who owns Greek bonds is insured in the derivatives market using credit-default swaps against the risk of default. But “who are the owners of credit-default swaps? Who has insured others against a default of the country? We could have a chain of contagion.”

In other words, according to this delightfully blunt-spoken Italian banker, three years after derivatives almost destroyed the global financial system, they again pose an unknown risk to global finances.

This to me is the most troubling aspect of the Greek debt crisis. We’ve wasted a crisis that took the financial system to the brink of disaster. We don’t have any better idea today of where the risk is because derivatives still represent a dark place on the map. Regulators in countries such as the United States that are trying to get a handle on the derivatives market are still months away from finishing their first draft—and I don’t know if they’ll be allowed to finish. On our map of the financial markets we might as well label derivatives  “Here there be dragons.”

Remember what happened last time? Read more

Double double toil and trouble.

The world’s financial market are only facing two witches stirring the pot, but between them they’re quite capable of adding a third bubble and bust in 2011 to the run that began in 2000 and continued with 2007.

I’d be a lot less worried about a potential financial bubble if it were just the Federal Reserve stirring the pot by setting 600 billion greenbacks lose on the global financial markets by the end of June 2011.

But the Chinese government with its $2.65 trillion in foreign exchange reserves is as much of a force—possibly more so—in inflating any bubble. It’s China’s effort to give that cash a home—and earn a decent return on it—that’s pushing up the price of iron mines and oil fields, gold, and the value of bonds denominated in Aussies and Loonies and Reais.

Which makes figuring out what to do about a potential 2011 bubble and bust—following in the footsteps of the bear market of 2000 and the financial crisis and bear market of 2007—so difficult. But in my November 9 post on the potential for a bubble I said I’d try so here’s how I’d approach the possibility of another bubble and bust.

In that November 9 post I laid out the reasons to think that the Federal Reserve might be creating another bubble (http://jubakpicks.com/2010/11/09/whoops-is-the-fed-about-to-do-it-again-create-another-asset-bubble-i-mean/ ) so I’m not going to cover that ground again. But let me take a paragraph or so to explain China’s role in any potential bubble.

China currently plays two roles in inflating asset prices around the world.

First, China’s extraordinary 10% growth rate becomes an excuse for investor to bid the price of global assets higher. Oil should sell for higher prices, for example, because China will need so much more of it in the coming decades. On November 10 the International Energy Agency forecast that China’s demand for energy will jump by 75% between 2008 and 2035. China alone will count for 36% of the growth in global energy use during that period.

The same story is used by traders and investors and Wall Street analysts to justify ever-higher prices for copper, corn, iron ore, nickel—you name it.

China’s economic growth is indeed stunning, but investing logic says that some part of that future growth is already embedded in today’s asset prices. Economic history says that higher prices change consumer behavior—we can already see that in China’s drive to follow the path of Japan, Germany, and even the United States and reduce the energy intensity of its economy. And those two elements set up the likelihood that t some point China’s demand for these commodities will disappoint investors even if China continues to grow at today’s stunning rates.

Second, think about what happens to all those surpluses that China accumulates after it accumulates them. They don’t just sit in a vault somewhere—they get managed. That means China buys things with them: U.S. Treasuries, Canadian debt, gold, iron ore mines, Greek government debt. And whatever China buys trades at a higher price than it would have without that buying.

In one critical way the $600 billion let lose by the Fed’s program to buy Treasuries and China’s $2.65 trillion in foreign exchange reserves have the same effect. All this money—from other sources—is looking for profitable homes. And as it flows to whatever asset and market promises that home, the total $3.25 trillion (or $5 trillion if you add in the $1.75 trillion in the Federal Reserve’s first program of quantitative easing) bids up the prices of the assets in those markets.

And the biggest effect is on asset prices—whether for stocks, or real estate, or iron ore mines or and oil fields—in developing economies. Yields are higher, growth rates are higher, recent and potential returns are higher. Why wouldn’t money searching for a home head in that direction?

But as I noted in my November 9 post, developing economies don’t present the largest and most liquid markets. India, for example, is struggling to absorb the $25 billion—the highest amount on record–that has flowed into Indian stocks from overseas equity funds in 2010.

$25 billion is a problem when the Federal Reserve and China are talking about $3 or $5 trillion? You see the mismatch that might lead to an asset bubble in the world’s developing economies?

How close are these markets to bubble territory? Read more

2000. 2007. 2011.

Is the Federal Reserve about to do it again? Is the Fed about to preside over the creation of another financial bubble?

Asset prices in the world’s emerging economies are climbing on the crest of a flood of dollars from the Federal Reserve. Central bankers in the world’s emerging economies certainly have started to worry about what happens if all the hot money flowing into their economies and markets suddenly starts flowing out. “As long as the world exercises no restraint in issuing global currencies such as the dollar,” Xia Bin, an advisor to the People’s Bank of China said, “then the occurrence of another crisis is inevitable.” (For more about reaction to the Fed’s policy see my post http://jubakpicks.com/2010/11/04/everybody-loves-bens-600-billion-at-least-in-the-short-term/ )

I think some degree of worry—less than full panic but more than polite concern—is appropriate at this stage. And that worry should play a role in shaping your investment strategy as the decade advances. In today’s post I’m going to lay out the Whoops, the Fed’s done it again scenario. In a Friday post I’ll tell you what I think you can do about that danger.

In 2000 I’d say the sin was one of omission. The Fed sat on the sidelines aware that a stock market bubble was building but it did nothing to head it off. Remember then Federal Reserve chairman Alan Greenspan talked about “irrational exuberance?” Well, it was all just talk. The Fed, which had the power to try to moderate the bubble by tightening credit on Wall Street, believed that trying to manage bubbles was futile. All a central bank could do was watch from the sidelines and then help clean up the wreckage.

And quite a bit of wreckage there was. The NASDAQ Composite Index peaked at 5048.62 on March 10, 2000 and it bottomed at 1114.11 on October 9, 2002. That was a loss, top to bottom, of 77%.

Eight years after the October 2002 bottom, the NASDAQ Composite is up handsomely—131% from October 9, 2002 to November 5, 2010.

But ten years after the bear market began in March 2000 the NADAQ has barely recovered half its losses. From a high of 5048.62 the market has clawed back to 2578.98 at the close on November 5. That means the NASDAQ Composite Index is still down 49%.

I’d put the Federal Reserve’s role in the financial and economic crisis set off by the U.S. mortgage crisis in a different class. The sin here was one of commission. The Fed played an active role in creating this global meltdown and in making it as bad as it was. (Or maybe that should be “is”?)

To clean up the wreckage from 2000, the Federal Reserve lowered short-term interest rates. Read more