It is the psychology that matters...

Futures markets are pricing another 25 basis point cut for the FOMC meeting scheduled for next week. There is a strong feeling that the Fed will likely take a pause after cutting rates for the 7th time in 8 months.
Although there has been a clear bias shift from worrying about inflation to worrying about the economy soon after the subprime induced troubles erupted last year, the surge and persistence of high commodities prices have created a sort of malaise as the slowing economy does not seem to be having its desired effect of acting as counter force. It should be noted at this point that the surge reflect structural changes in demand and supply which include the impact of the growing wealth of emerging economies, reallocation of food crops for energy purposes, ongoing climatic changes and other unanticipated supply disruptions.
All this is to say that although the downturn will add a cap to wage induced inflation as the labor market slackens, the risk of provoking higher inflation expectations considering the rise in commodity prices and the aggressive easing in monetary policy in recent months is substantial. The problem remains that once this perception takes hold in the minds of households and businesses, stopping it becomes difficult. For this very reason the Fed is likely to take a breather for a while after next week's anticipated cut to eliminate the perception that it is feeding inflation and to assess the impact of its recent actions.

The households headache

Things are looking pretty bad for households, the bedrock of U.S. growth. It all started with the housing recession back in '06, leading to a steady erosion in the value of homes. This in turn led to a surge in debt as the corresponding collateral shrunk in value. With the sharp rise in delinquencies and the widespread direct and indirect exposure to the subprime market, confidence was shaken to the core, triggering a material and chronic pullback in lending. In this environment, households have been finding it increasingly difficult to borrow to counter the rise in naked debt (savings is unfortunately nonexistent in the U.S.). Further harming an already precarious condition has been the constant rise in food and gas prices which have acted as a sort of disposable income tax, not to mention inflation in other goods and services that are eating away into salaries which are already growing at a slower pace (leading to a lower real disposable income). A jittery stock market and signs that unemployment is rising isn't much help either.
No wonder consumer sentiment is at an all time low. So why isn't there more gloom and doom in the numbers given that the great unwind is in full swing and households are being battered from all directions?
Well for one, the rest of the world has so far shown a surprising degree of resilience to the crisis (although there is strong contention as to how long this will continue). Combined with a dramatically weaker dollar, exports have been booming (not to mention the sovereign fund bargain hunting spree). To this we add a federal reserve, that, although in the beginning was dragging its feet (with its inflation concern), is now much more focused in its bid to save the economy. Bernanke's creative touch combined with a willingness to sacrifice moral hazard risk to avert the growing risk of a protracted recession (as seen with Bear's rescue) should help diminish the impact of the crisis. This will take time though considering contagion and the abundance of toxic debt still to be written off. It will take a painful cleansing process of the economy before we start to see an end to the obsessive/compulsive nature of the markets.

The commodities conundrum...

Theory backed by empirical evidence tells us that during an economic downturn, commodity prices follow suit, acting as a sort of barometer on the level of economic activity (i.e. in times of global expansion, there would be greater demand for scarce resources and vice versa).

There is heated debate in the current environment as to whether this relationship still holds, given that almost all commodities are at or close to record levels. The answer is important because it could determine the extent and duration of the turmoil at hand (higher commodity prices that remain sticky would deteriorate further an already fragile economy through its adverse effect on spending, not to mention ravages of inflation).

Why are prices so stubborn in the current downturn you may ask? Well, apart from the speculative money that has been driving prices higher we have secular trends that are starting to play an increasingly deterministic role on pricing. The emergence of China and India as global centers for production and services have led to the creation of a distinct middle class with greater spending power and resulting shift in lifestyles. One of those changes concerns food (or the move towards a more protein rich diet). Another is the growing population (more mouths to feed) or manmade environmental changes (freak weather conditions such as extended droughts) or even flawed government policies (food crops reallocated to the production of fuel). All these factors are likely to have profound and, in some cases, long lasting impacts on scarce resources across the board.
It should come as no surprise therefore that commodities will be amongst the most serious issues that will need to be tackled this century. Again, no surprise as it is, after all, a case of forcing mankind's infinite needs and wants in a world of finite resources.

Bull or Bear?

I concede it is a no brainer question considering the direction of markets, not to mention economic releases and Bernanke's latest testimony. We have been and continue to remain in a Bear market environment ever since the subprime turmoil of August last.
What is also certain is that this crisis is unprecedented in its nature. It does not compare to the dot com collapse or the '87 crash as multiples are not the catalyst, it doesn't compare to LTCM which was a very focused event, it doesn't compare to the Asian currency crisis nor the Russian defaults. Only if we go back to the Great Depression can we draw some parallels, but even then the comparisons are very limited.
Like today, a great unwind followed the market crash of 1929 as households and businesses had piled and were sitting on mountains of debt. But unlike today, Central Bankers were not as sophisticated and did not have much history to rely on, the flow of information was far from light speed, there was no computing power to speak of and you didn't have the type of coordinated and collegial support amongst the various institutions that we observe today.
These differences together with the fact that this crisis originated in the U.S. also means that there is a greater probability for it to be resolved in a shorter time frame. The U.S. is more likely to take losses on the excesses of the past or turn the page, so to speak, than a country like Japan which ended up paying a monumental price for their stubborness in keeping bad debts in their books for so long.
So the bear will eventually turn into a sustainable bull but it is anyone's guess as to when that will occur. The only effective way to exploit this uncertainty is by remaining diversified and ensuring that the portfolios are rebalanced whenever such action is necessary. The rest is just hot air...

A modern day equivalent of a run on the bank?

Granted, the Fed's intervention to avoid the total collapse of Bear Stearns is not exactly analogous to saving an institution from the threat of a bank run if we consider the precise definition of a run on the bank, i.e. a situation in which panicked customers simultaneously withdraw their savings as a result of fear that by not doing so they may lose what they have. As the bank only keeps a fraction of deposits in cash, without some type of external help, it will implode.
Bear Stearns is not a commercial bank and therefore technically does not have any deposits to raid. In Bear's case the crisis began when their ability to borrow was suddenly cut off. It ensued the collapse of Carlyle Group's flagship Carlyle Capital fund when rumors began to circulate that Bear had a large stake in the fund. So why, you may ask, would this be considered the modern day equivalent of a run on the bank, warranting Fed intervention? The answer has to do with the bigger picture. The Fed figured that the risk of triggering systemic risk by allowing Bear to go bankrupt was higher than the risk and repercussions of moral hazard. It would have led to further casualties in the financial sector as lenders became more reluctant. In addition to coming to the rescue of Bear Stearns, the Federal Reserve announced that it would extend its lending facilities to a wider segment of the financial sector. This should help substantially to mitigate the risk of another blowup.
As for market conditions, the rough ride is likely to persist as the root housing crisis will drag on for a while to come irrespective of what the Fed and/or government do.

A record breaking month...

March has turned out to be a month in which several records were broken. In the commodities front both gold and oil were notable for surging past their all time highs whilst in currencies, the ever so weak U.S. dollar reached new lows most notably against the Euro and the Swiss Franc. It also turned out to be a month in which wealth got wiped out in record breaking speed with the dramatic implosions of Carlyle Capital (a highly leveraged flagship fund of the Carlyle Group) and Bear Stearns (formerly the 5th largest U.S. bank) which saw it's 85 year history evaporate into thin air in just a couple of days.
The Fed has attempted to counter the hemorrhage from several angles by boosting the term auction facility to 200 billion dollars and raising the lending period to 28 days, cutting the discount window by 25 basis points and cutting the target rate by 75 basis points. It is clear from these actions that the Fed perceives a growing threat on the orderly functioning of the financial system. These moves have also brought the morale hazard debate back into center stage as a growing chorus of pundits are arguing that bailing out the likes of Bear Stearns is sending the wrong message.
In an environment in which fear has overtaken greed and where emotions are running high, irrational behavior seems to be the order of the day. The sharp drop in commodities following the 75 basis point cut in the target rate is a prime example of this. It seems that the sell off occurred because the market was anticipating a 1% cut and was therefore disappointed with a cut that was a quarter point less. If we take this train of thought a step further, what the market seems to be suggesting is that a difference of 25 basis points will be enough to determine whether we will experience an economic expansion or a recession or whether there will be inflation or price stability. If this is not insane, I don't know what is!

Want a tip?

Treasury Inflation Protected Securities, better known as TIPS are all the rage these days and should be, given their stellar returns (more than 6% since the start of the year versus roughly 4% on plain treasuries). In effect, these instruments are the equivalent to plain vanilla treasuries but carry even lower risk given that they protect the holder from the corrosive effect of a surge in inflation which is accomplished by adjusting the nominal value at maturity by changes in the broad measure of the CPI index. The inflation hedge explains why yields are below those of standard treasuries.
TIPS which were introduced in 1997 are also an important measuring tool for inflation expectations. One looks at the spread and the change in spread between the treasury yield curve and that of TIPS to get a feel of inflation expectations. Like with an ordinary bond, if the yield (or real yield in parlance terms) remains the same, the bond price doesn't budge. But if there is a shift in inflation perception, price movements occur (like we have seen over this year and last).
With a steepening yield curve and the performance in TIPS and commodities in general, the market is telling us that the risk of inflation on the horizon is rising. It is no wonder given the aggressive cut in rates over the past weeks and months. But then we have a lag factor of between 6 and 8 months from the moment a change in rates takes place and it's effects begin to appear in economic releases. This means that the Fed is playing a very delicate balancing act whereby as soon as it feels confident enough that the conundrum has subsided for good, they will have to aggressively tighten to avert inflation from getting out of hand. In the mean time, having some form of hedge against inflation in one's portfolio should be considered as a sound proposition.

In the age of turbulence...

It is challenging enough to keep a cool head in an environment of negativism when a growing chorus of industry pundits are suggesting the end of the world is near. Now I am not suggesting that a major correction is not in the cards, what I am trying to point out here is how difficult it becomes for a portfolio manager to stay the course when turbulence hits with full force. An environment of elevated psychosis in which emotions are running high frequently leads to a situation in which managers lose focus of long term objectives (a key feature of modern portfolio theory), and instead concentrate on playing cat and mouse so to speak. In the current environment where uncertainty reins, one may be tempted to switch into cash and just stack it under a mattress. But what happens when things return back to normal? More specifically, without hindsight, how can we be sure that normalcy has returned?
To illustrate these important points let's take the October '87 crash. On a single day the S&P 500 lost around 20% of its value. Emotions where running very high at the time and a lot of investors decided to take the plunge either by liquidating their positions and switching to cash or bonds. But who would have guessed that just a bit over 3 months later, 90% of that loss had been recouped. Those that had ceded to panic had not only lost 31% of the value of their investments (if we take the drop from it's peak), but failed to capture any of the upturn (bonds had already peaked before the stock market crash).
Again, I am not suggesting that staying the course in turbulent times is an easy task. On the contrary, it can be extremely challenging. If there are any lessons to be learnt, however, it is that ceding to emotions can prove to be an extremely costly endeavor in the long run as we have seen with the example and there are plenty of studies out there that support this view.