Dropping Home Sales Derail Growth Optimism

Shares fell around the world yesterday after U.S. new home sales dropped by 3.6% in September, according to the Commerce Department. A broad move back into safe haven assets was driven by fears that the economic recovery in the United States may be weaker and less robust than anticipated. Gold, copper, and silver futures fell, and December crude oil contracts fell 2.5% during the trading session. Treasury debt rallied, and gold prices rose slightly. The Japanese yen and the U.S. dollar were the primary beneficiaries of the flight to safety, both posting strong gains against most other currencies.

The euro has fallen well off its highs, below 1.4700 as sentiment appears to have shifted on the currency after it recently topped the psychologically important 1.5000 barrier. Economic weakness in the European Union and tilting interest rate differentials may keep the euro under pressure for some time. The Aussie dropped over 2% after domestic inflation numbers came in higher than expected, but at manageable levels. The Kiwi tumbled as well, after the Reserve Bank of New Zealand held benchmark rates steady, and said that policy would not be tightened in the near future.

CAD Continues to Dance to Carney's Tune

The U.S. dollar index has now rallied for four consecutive trading cycles, and the CAD has extended recent losses, moving into the high 1.0750 to 1.0800 range. While a broad based USD rally is occurring, the downward move in the CAD has been supported by Bank of Canada Governor Mark Carney’s recent currency intervention comments. Carney’s threats have been widely credited with driving the Canadian dollar down, but markets are also simply heeding Carney’s words of caution. It must be quite interesting to be in Mr. Carney’s shoes right now: as a Goldman Sachs alumnus, he spent plenty of time dancing to the market’s tune and now finds himself holding the fiddle. That he is playing a dirge is rather illuminating.

The next trading cycle should be very interesting, with U.S. GDP numbers due today, and unemployment figures out tomorrow. An unexpectedly negative unemployment number carries the potential to cause a more thorough unwinding of the risk trade, and a further rally in the U.S. dollar. On the other hand, positive news would stop the dollar rally in its tracks. Either way, high volatility is a strong likelihood – keep a close eye on the markets during the next few days for any opportunities that present themselves.

Ask Karl: Of Bubbles and Baths

This week, we return to a theme which has occupied our minds over the last few months, as markets have scaled ever greater heights in spite of a less-than-favourable global growth economic outlook. Equities have rallied over 50% in less than six months, crude oil is trading at double its long-term average, and real short bond rates are close to zero. In Canada, home sales are up 18% over last year, and prices are up 12% nationally, in spite of a declining trade balance, rising private sector unemployment, and negative GDP growth. Even the most optimistic forecasters do not see a return to strong growth for a number of years. There is little question that assets are being mispriced. The question is whether these bubbles will go with a bang, or whether authorities will manage to slow their growth enough for economic fundamentals to catch up.

Most economists agree that rising asset values are being driven by the flood of cheap money into the worldwide financial system. During the crisis, central banks were given clear mandates to increase liquidity by dropping interest rates and printing money. This has worked wonderfully, freeing up capital in an impressive fashion and contributing to economic optimism worldwide. However, much of this excess liquidity has made its way into asset prices rather than into the general economy, because banks that are reluctant to make real loans have devoted the funds to trading activities instead.

Rather incredibly, a financial crisis which was largely caused by an oversupply of liquidity was fought using an oversupply of liquidity. The popping of one asset bubble has simply begotten another for at least three economic cycles so far, and concerned authorities are beginning to consider ways to avoid a similar situation in the future. Central banks are looking to expand their mandates beyond traditional inflation fighting roles to include the pricking of asset bubbles before they grow damagingly large.

Historically, central banks relied upon money supply and short interest rates as tools for exercising influence over financial markets and economic growth. However, monetary policy is a terribly blunt instrument: it has economy-wide effects, and can cause mispricing in a number of ways, if used too aggressively. Raising benchmark interest rates makes borrowing to buy a home less attractive, but also causes foreign capital to flow into a country, expanding the amount of money available to be borrowed – one can cancel out the other.

In several countries, central banks are doing their best to contain overheating asset markets by raising benchmark interest rates. Australia has already done so, with the RBA’s Governor Stevens highlighting “appreciable increases” in residential real estate markets, and Norges Bank pointing to rapidly rising house prices prior to raising rates this morning. Both currencies have strengthened as a result, marking the amount of foreign capital which has flooded in.

Banks clearly need to coordinate their actions worldwide, or they need to target their policies more specifically. Achieving true worldwide political consensus is unlikely, so as the crisis has evolved, the banks have evolved too. They are using an ever greater number of tools in a wide variety of ways to specifically target areas of the financial system needing assistance. Targetting precise aspects of credit growth, enacting financial regulations that dampen investor enthusiasm, and exercising “moral suasion” on the financial industry are a few of the ways that monetary authorities can slow asset bubbles more accurately.

Governments worldwide are attempting to deflate asset bubbles in equity and fixed income markets by enforcing regulations such as greater margin requirements, stricter trading rules, and higher reserve levels, while keeping benchmark rates low. It is a matter for speculation, but it is possible that the Bank of Canada was behind the move a few weeks ago by the major banks to raise fixed five year mortgage rates. The Bank is holding short interest rates at historical lows in an effort to stimulate economic growth, while at the same time expressing concern that the housing market is overheating - rising real estate prices are a good thing for the economy as a whole, but a collapse would derail any hopes of a recovery. This increase may have been a direct reflection of the rise in long dated bond interest rates which occurred the week previous, or it may have been a case of moral suasion exercised by officials at the Bank of Canada. Either way, it meets the Bank’s objectives quite nicely.

Commodity price bubbles are much more difficult to deflate because the markets are truly worldwide. Rising inventories, particularly uncounted ones in China, and a slackening in demand should cause price levels to slowly drop over time, particularly as liquidity is withdrawn. The longer that prices and fundamentals remain on divergent paths, the greater the risks will grow – and authorities will try to devise new ways to address the situation.

Asset price bubbles have inflicted substantial damage on the world economy over the last two decades. Governments and central banks have woken up to this fact, and will use many of the tools at their disposal to pop new ones in the coming years. This is a very good thing, because it will help to nurture more sustainable growth in the future, but investors and traders that underestimate their resolve could land in very hot water indeed.

By Karl Schamotta, Market Analyst
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