Eyes on the Credit Markets

March 24, 2009 | By: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (March 23rd):

...[S]ome positive things occurred last week. As our economist, Scott Brown notes:

Following its two-day policy meeting, the Fed surprised the financial markets by expanding its credit easing program. To support mortgage lending and the housing market, the Fed more than doubled the amount it will purchase this year in mortgage-backed securities – to $1.25 trillion (vs. $500 billion) – and double the amount of agency debt it will buy – to $200 billion (vs. $100 billion). The Fed indicated that it would also purchase up to $300 billion in long-term Treasury securities over the next six months ‘to help improve conditions in private credit markets.’ The Fed’s surprise move quickly generated fears that it is sowing the seed of future inflation. The dollar took a hit and commodity prices firmed. However, there is a huge amount of slack in the U.S. and global economies. Inflation will not be a threat anytime soon and Fed Chairman Bernanke is confident that the Fed can remove policy accommodation without generating inflation as the economy recovers.

While I certainly agree with Scott in that deflation, not inflation, is the worry in the short term, the various inflation hedges seemed to agree that the seeds for long-term re-inflation have been planted.

Verily, on last week’s Fed’s announcement, the Dollar Index collapsed while the precious metals and energy complexes surged. To be sure, such a move is good for our investment positions in gold, platinum and energy; the dollar dive, however, is troubling (see chart).

Nevertheless, the Fed’s announcement did cause interest rate spreads to tighten, which, as the astute GaveKal organization opines, is important. To wit, “The bigger question is whether the credit markets will start to participate in the rally. If they do, then the current [stock market] rally should have legs and will likely turn out to be explosive. If they do not, then this could be a flash in the pan. As such, we will spend the coming days with our eyes fixed on our credit market indicators.”

Consequently, we begin this week with our eyes focused on the credit markets. And for those who think interest rate spreads can’t narrow much more because the Fed is “all in,” and consequently “out of bullets,” we offer you these thoughts from Marc Chandler:

1) TALF can be extended further with more liberal collateral rules that could help remove the toxic assets from banks' balance sheets; 2) The Federal Reserve could buy corporate bonds in addition to agency bonds, MBS securities and Treasuries. The Fed could also buy commercial real estate backed securities; 3) The Federal Reserve could seek authority to issue its own bonds. Some other central banks, like the SNB issues its own paper; 4) An aggregator bank to warehouse and sell distressed assets has still not been established.

The call for this week: In recent weeks, copper, steel, and energy prices have crept higher. Additionally, building permits and housing starts have come in better than expected. Meanwhile, tax refunds are up 13.3% when compared to this time last year, which is probably why retail sales have stabilized despite rising unemployment. Only time will tell, but it feels like the economic deterioration is no longer accelerating? Could it be that the huge increase in money supply, negative real interest rates (inflation adjusted rates) and the reintermediation we have been speaking about are beginning to have a positive impact on the economy?

The stock market might just be sensing that, having leaped off of a generational oversold condition into a 20%, ten-session, upside stampede that produced four 90% Upside Days (March 10th, 12th, 17th, and 18th) within a two week period. Such enthusiastic buying has tended to be associated with the start of new bull markets.

Yet as the Lowry’s service notes, “Our 2002 study of 90% Days showed that the start of new bull markets are typically identified by a single 90% Upside Day, representing a rush of enthusiastic buyers which typically calms down after the first dramatic day. On rare occasions, two 90% Upside Days have been recorded in the first 30 days of a new bull market. However, until the Uptick Rule was eliminated, the past 60 years have not witnessed any cases of four 90% Upside Days within a period of just seven trading sessions.” To which we reply, “While we are cautious, we remain hopeful and continue to favor the upside until proven wrong, which is why we are still ‘long’ various indexes and have selectively been accumulating stocks.”

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