William McChesney Martin Jr., the revered former head of the U.S. Federal Reserve, is remembered for many things – including an unprecedented term as chairman that lasted from March 1951 to January 1970.
But Martin is perhaps best remembered for the central-banking aphorism that says that the Fed's most important job is "to take away the punch bowl just as the party gets going." (See accompanying graphic below.)
We'll have to wait until June 30 to see if current Fed Chairman Ben S. Bernanke brings down the curtain on "QE2" – the quantitative-easing bash that he spiked with $600 billion worth of economically inebriating liquidity.
Before that happens, however, we may discover that recent interest-rate increases by central bankers elsewhere in the world will act as sobering cold-water bracers that end up crashing the global-growth party a lot sooner than Bernanke & Co. desire.
Foreign Central Banks Muscle In
If you own stocks, bonds, or commodities, it's time to be vigilant – and even worried. With power-players China, Australia, Brazil, and the European Union (EU) already raising interest rates to dampen inflationary pressures, U.S. and global investors need an answer to a very specific question: Will rising currencies and escalating interest rates yank the "punch bowl" away – blunting global gross-domestic-product (GDP) growth and killing market speculation?
In order to answer that question, investors need to understand just how we got to this point.
The short story is that, in the aftermath of the global credit crisis of 2008, central banks around the world had to flood their respective financial systems with massive amounts of cash to keep the entire global economy from sliding over the cliff.
If there really is a financial-market "punch bowl," as Martin described, central governments and central bankers "spiked" it with trillions of dollars worth of stimulus money.
That's how the global economy became awash in "liquidity."
Another Wall Street aphorism holds that "Money never sleeps." It doesn't earn anything buried under mattresses. It has to be physically put to work in order to generate an investment return. Eventually, the ocean of cash that was keeping barely buoyant economies afloat found its way onto – and then flowed along – some productive paths.
One reason that process took so long was that some of the older channels had collapsed. These were channels that investors could employ to pursue long-term profits. With their collapse, investors were transformed into speculators. Those speculators sought "liquid" markets where they could dock that cash, and be sure that it was accessible even in a future financial panic.
The best places to dock cash happens to be in U.S. Treasury bonds and exchange-traded markets, which offer day-to-day – and even moment-to-moment – liquidity.
An Emerging Market Rebound
After a near-vertical descent, stocks achieved a bear-market bottom in March 2009. Almost as soon as the bottom was reached, stock prices reversed course and started to rise.
Emerging markets weren't as waterlogged by the speculative excesses and demise of the residential-real-estate-securitization schemes that very nearly drowned the U.S. and other developed-world markets.
In these emerging economies, the cash that came out of government-sponsored stimulus packages was actually put to productive use. And since these economies had been rising quickly on a tide of exports, with their currencies only recently beaten back, they were able to rev up their export engines pretty quickly.
The world didn't end. In fact, it started to recover. But the recovery unfolded at different rates in different markets. Developed countries rebounded more slowly, struggling with the overhang of real estate, weak banks, and unfavorable demographics. But emerging economies, not so encumbered, began growing as their export machinery began firing on all cylinders.
Commodities were a big beneficiary. As emerging-market economies revved up their export engines, they bid up the prices of the raw materials they needed to manufacture goods for both domestic consumption and for export abroad.
Speculators immediately hitched a ride with the upward sloping prices of materials, minerals, metals and agricultural commodities. After all, there's plenty of liquidity in the exchange-traded markets where commodities, metals and other raw materials can be bought and sold, especially with the phenomenal growth of exchange-traded funds (ETFs).
As emerging markets surged, they were flooded with capital investments. In order to invest in other countries, you have to use their currencies. So investors mostly sold U.S. dollars to finance their purchases of these other countries' currencies.
When you have a flood of capital investment in any economy, the result is a steeply rising currency.
That's how we got to where we are today. To see where we go next, watch the foreign central banks.
Inflationary Pressures Abound
As capital investment has flooded into these expanding overseas economies , their now-swollen currencies have made their exports more expensive on world markets. Rising commodity and raw materials prices are creating inflationary pressures. And robustly growing economies – fueled by the stimulus infusions – are actually now experiencing rising wage pressures from workers who are struggling to keep pace with soaring food, energy and services prices.
China's growth remains robust, to say the least. But inflation fears are mounting. February's consumer price index (CPI) came in at an annualized 4.9% rate. That's well above the central bank's 4% target. The People's Bank of China has already raised rates four times since last year and increased the amount of reserves banks have to hold, to slow lending.
Part of what's worrying Chinese Premier Wen Jiabao is social unrest. In his most recent State of the Union address, Premier Wen outlined plans to increase the country's minimum wage by at least 13% a year for the next five years. That comes on the heels of China's decade-long average annual wage increase of 14%. According to Credit Suisse Group AG (NYSE ADR: CS), all 31 provinces in China will experience higher wages in 2011.
If China's exports fall and domestic consumption can't replace international demand, rising inflation on the heels of suddenly suppressed wages could trigger civil unrest.
China is Australia's largest export market. But exports may slow down if the rise of the Australian dollar makes Aussie raw materials and goods less competitive. Because Australia has been experiencing rapid economic growth due to its robust export markets, strong capital-investment flows there have lifted the country's currency and juiced speculation and inflationary fears.
The Australian central bank was the first developed-world reserve bank to raise domestic rates and increase reserve requirements aggressively. But the Aussie economy continues to grow – as does real-estate speculation. According to a Morgan Stanley (NYSE: MS) global-developed-markets strategist, Australia's real estate is 40% overvalued. Even 63% of Australians, surveyed by QBE Insurance Group Ltd. (PINK ADR: QBIEY), consider their real estate market overpriced.
Then there's Brazil. To stem the extraordinary rise in its currency, known as the real, Brazilians now endure possibly the highest interest rates in the world. Last month, Brazil's benchmark interest rate was bumped up half a percentage point, a move that took that rate up to 11.75%. Brazilians are worried about inflation – and they should be. Brazil's CPI rose last month to an annualized rate of 6.1%, far above the government's 4.5% target. Politicians, as well as central bankers, are worried about Brazil's loss of competitiveness as the prices of that country's exported goods keep rising.
The same scenarios are being played out elsewhere around the globe. In the United Kingdom, consumer-price inflation has reached 4.4%. In Russia, it's a staggering 7.75%. Even the European Union is afraid that inflation might take root there. The European Central Bank, on the heels of a recent headline 2.6% annualized CPI number, raised its benchmark interest rate a quarter point to 1.25%.
Pulling the Punch Bowl
The ongoing global recovery, which hasn't touched all corners of the globe equally or evenly, is still a tenuous one, at best. Part of the capital-investment-flow phenomenon that's so disturbing is that, as governments raise interest rates to slow investment inflows and growth, more capital is actually attracted to those countries because they offer higher rates of return.
We would do well to remind ourselves that the short-term flow of capital into countries with high growth rates can reverse just as quickly. That happened in 1998, lest we forget what history calls the great Asian Contagion.
And it can happen again.
If there's a stop to the short-term-investment capital flows, we could see an end to the speculation in commodities and stocks around the globe. And that's just what could happen if high-enough interest rates threaten that sensitive cycle.
The question should be: What do we watch for to determine if the bottom is cracking?
Oil would be the best place to start. If oil starts to drop, meaning if crude breaks below $100, and then breaks $90, look out below. Commodities – in particular, copper – are another asset class to watch. Because copper is a bellwether of industrial production, if its price breaks support and falls below $4.00 a pound, look out below.
As an asset class, commodities have been bid up – and not just from actual demand, and not just as a result of weather, or expectations that rapidly growing middle classes around the globe will goose demand. Commodities have been bid up exponentially by speculators waving short-term capital flags.
If rising rates slow global growth and currency speculators and commodities speculators dump positions, it won't be but a New York minute before stock prices finally experience the correction that investors have been worrying about.
Indeed, if that happens, it will have been the foreign central banks that have taken a page from the late Fed Chairman Martin: Their rate increases will have yanked away an overflowing punch bowl to end a party that's been rolling along since stocks bounced off the bear-market bottom back in March 2009.
As a retired hedge fund manager who's willing to share the secrets of what goes on behind Wall Street's "velvet rope," Gilani is able to spot the stock market's hottest profit opportunities.
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Gilani recently helped develop a strategy for individual investors to bring in the big money Wall Street tries to keep for itself.
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News and Related Story Links:
- Money Morning Quarterly Report (Q2 2011):
Oil Prices Look to Top $150 by Midsummer On Resilient Demand and MENA Turmoil.
- Money Morning Quarterly Report (Q2 2011):
Second Quarter Forecast: Three Predictions, Three Ways to Profit.
- Investment Research:
Brazil's Shifting Fortunes: This BRIC Economy is Ready to Fall Out of Fashion.
- The Quote Investigator:
"I take the punchbowl away."
- All Movie Guide:
Wall Street: Money Never Sleeps.
William McChesney Martin Jr.
- Money Morning News Archive:
News Stories About Quantitative Easing.
- People's Bank of China:
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of 10X Trader, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade.
Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps.
Shah is a frequent guest on CNBC, Forbes, and Marketwatch, and you can catch him every week on Fox Business's "Varney & Co."
He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.