The week of October 25th: Conspiracy Theory

The G20 meeting of finance ministers and central bankers concluded last weekend on a somewhat predictable yet positive note. The markets had been looking for confirmation of a commitment to reduce the chances of global imbalances being a constant impediment to growth in the developed world. With the VIX volatility index seen to be at the lowest levels since April in the past weeks, investors got a confidence boost at the proposal of a 4% cap on current account surpluses and consequently US equity markets traded higher on Monday morning. 


Although some commentators complained that there was no overt effort to address the currency issue like in the Plaza Accord that the US signed with Japan in the eighties, I see no rational justifications for laying down such regulations. Japan can indeed blame some of its stagflation miseries on the sharp Yen appreciation following the Accord which managed to reduce the dollars value against the Yen by over 50% between 1985 and 1987. This Accord served to reduce the trade deficit problems the US was facing with the other signatories; West Germany, France and Britain, but not with Japan (due to inherent structural imbalance problems).


A sharp correction was due in the S&P 500 this week, but that correction never came. There was a minor sell-off on Thursday but one which was nowhere near levels that were expected, chiefly because of the unsure nature of the upcoming Fed announcements about further stimulus on Wednesday. 


I have a conspiracy theory about what happened before the G20 meeting between the US and China. I have a strong feeling that in the weeks leading up to the meetings in Seoul, an under the table deal was made between the two key economic players.


In the week before the summit, China raised its interest rate by 25 BPS, which caused a flight to safety in equity markets. It changed rates for the first time since it cut rates in December 2008. It was a small change which had a substantial sell off effect in the DOW and S&P. Further, it was a discretionary move, one which was completely unforeseen by the markets at large, much unlike the way the Fed goes about doing things.( The debate between the utility outcomes of having a transparent system like the Fed does and a discretionary system such as the PBOC, has been going on for some time now in monetary economics. What was amply clear with this rate change by the PBOC though was that for short term reactions in the market, discretionary moves have a  much bigger impact, while on the other hand, potential rate changes by the Fed are priced into the market based on announcements and FOMC minutes way before the actual change is made.)


In my opinion, this slight rate hike by China was part of a deal made with the US, which entails more such rate hikes over the medium term in exchange for a mellower stimulus policy which will push down the value of the dollar in small increments. After listening to the various Fed members speak over the last few weeks, it has become pretty clear that the stimulus is going to be of around $500 billion initially and then more further asset purchases will occur on a monthly basis upon reassessment of the prevailing economic conditions. 


This week on Friday, the advanced reading for the last quarter's GDP in the US came out in line at 2%. This was a result that disappointed traders as they were hoping for a number which was not in the predicted range. In the end it turned out to be quite the snooze fest on day which had been built up for the past week as a great opportunity to trade. The number further consolidated the chances of stimulus (as if there was ever any doubt), since it was not much better than predicted. Goldman Sachs had the most bearish consensus at 1.5%, but overall, it was at an average of 2%. Rumours that the Fed was also making inquiries about investor demand in the big institutional players also help consolidate expectations for QE2. 


There is little uncertainty that the Fed is going to announce a stimulus on Wednesday. The uncertainty is about the amount of initial stimulus and the projected goals. Last Sunday, Economists at Goldman Sachs came out with the projection that an injection of $4 trillion was needed to prop up the US economy; a number only GS is capable of projecting! I am sure that the Fed will keep in mind that China is playing along in this game of mutual reassurance and acceptance, and will choose to announce a smallish initial stimulus so that the dollar does not weaken too much too fast. In either case this coming week will prove to be an exciting time for the markets, and only time will tell if this conspiracy theory unfolds the way I think it will.