David Rosenberg is chief strategist for Gluskin Sheff + Associates Inc. and a guest columnist for Report on Business
Federal Reserve chairman Ben Bernanke will likely sound dovish about interest rate expectations when he delivers his semi-annual Monetary Policy Report to Congress tomorrow and he might even soft-peddle the change in the discount rate as a technical manoeuvre. This could weigh on the U.S. dollar and provide a lift to the gold price, at least over the near term.
Last week's hike in the U.S. discount rate was only a surprise because of the early timing. The Fed had been warning for some time that this was going to be part of the process of taking the emergency stimulus out of the financial system. The immediate reaction to the discount rate move was predictable but this was because the market has always held it in high esteem - likely more than it deserves. Keep in mind that back on Aug. 17, 2007, the Fed cut the discount rate before the market opened and the Dow rallied 233 points that day - hardly the right call.
However, changes in the discount rate do pack a psychological punch in the near term. Investors will now be reminded that the exit strategy, while gradual, is about to start. So don't look for a lot of talk about a liquidity-driven market. This could have a dampening effect, as has been the case in China, where two moves this year to raise reserve requirements have knocked the Shanghai index down by roughly 8 per cent.
Pundits who claim that what the Fed is doing is great news for the stock market because it is somehow ratification of the view that we are into a sustainable growth phase should heed what happened in China. The reason the S&P 500 could muster a 70-per-cent rally off the March lows in advance of anything beyond "green shoots" in the economy was in large part because of all this Fed-induced liquidity.
The move in the discount rate does signify a shift in central bank strategy. It is all part of a strategy to withdraw the Fed's unprecedented support for the economy, which occurred through the rapid expansion of its balance sheet rather than traditional interest rate cuts. After all, even after cutting rates to microscopic Japanese-like levels in December, 2008, it still could not manage to put a floor under the economy, let alone the markets. Only when the Fed began to treat this as a credit cycle as opposed to a liquidity cycle by rapidly expanding its balance sheet through quantitative easing measures did the turnaround in most economic indicators and investor confidence happen.
The real test for the markets is going to come when the Fed begins to shrink its balance sheet.
It is not just the size of the Fed's balance sheet, which expanded to $2.2-trillion (U.S.) from a stable $850-billion, but its composition that matters most. The Fed now holds more housing loans ($1-trillion) than Treasury bills, notes and bonds. It is this change in the Fed's balance sheet that carries the greatest market uncertainty because the Fed has as much experience in dismantling a super-sized and complicated balance sheet as it did in creating it - none.
For all we know, Mr. Bernanke is about to pull a 1937-38 premature exit strategy that ultimately leads to a market and economic relapse. Or maybe he is going to get it just right. Readjust the discount rate under the impression that the banking sector has been nursed back to health, and start the process of support withdrawal from the mortgage market with the hope that the housing market has stabilized. It is a legitimate question as to who in the private sector will be lining up to buy these assets - especially mortgages - and at what price.
In the current environment, the odds of a policy misstep are still greater than zero. It does look as though the U.S. economy has moved into expansion, but like the markets, it is volatility around the downward trend.
Back in the first quarter of 2009, real GDP growth sank 6.4 per cent, but by the fourth quarter, it surged to post a 5.7-per-cent gain. What a swing! It does remind me of Japan, which experienced no fewer than 12 quarters of 5-per-cent-plus GDP growth since its bubble burst in 1990, and one-third of these occurred in the initial years after the crisis began.
Volatility is the only certainty in the economy following a credit collapse - and this goes for the markets, too. Japan's Nikkei index has closed higher 2,500 times since 1990, but it is still down 70 per cent from its peak.
It was no different for the United States following the prior credit collapse in the 1930s, a decade that saw 20 quarters of 5-per-cent-plus sequential GDP growth. That's a depression? Of course it was, because there were 13 quarters of contractions mingled with those intermittent positive spasms.
And how long did it take the equity market to get its next secular bull run under way? That didn't begin until 1954 - 25 years after the prior peak.
The message here is to focus on the forest, not the trees. While Mr. Bernanke will likely look to soothe the market with those dovish words on rates, treat any wiggles in the economy, or the markets, as movement around what is still a fundamental downtrend.
