Tuesday, November 4, 2008

Election Day Equity Rally

.....well almost everything rally I guess (USD moved much lower):

S & P 500 + 4.08%

Oil up over $6.00

Gold up $40.00

10 year Treasury up over a point

I have often said that it is extremely difficult to read anything material into one day's worth of trading. Today was a low volume day, not to mention an Election Day in which the bias was to rally on finally having a political outcome. However, when all asset classes rise in a single session, I am compelled to investigate.

The U.S. dollar was smacked around, pointing to an end of the carry trade unwind. Risk assets, equities included, may have found a bottom as liquidity driven sales abated. Oil and gold moved higher on the back of the dollar, in addition to the Saudi production cuts. That leaves us with Treasuries. Why did they rally?

- Dollar was down, bearish for Treasuries

- Commodity prices higher, bearish for Treasuries

- Risk trade unwind slows (short covering of Treasuries slows), bearish for Treasuries

- Details of Quarterly Refunding tomorrow, could be either bullish or bearish (hardly a reason to buy today though)

Hmmmm. My best guess is the following: the Treasury market is not fooled by the last few weeks' rally. If deflation is on the horizon, real interest rates are poised to move higher. Remember, nominal rates are bound by zero. The ability of the Fed to control policy is hampered by losing this important tool. If monetary policy and fiscal policy prove ineffective, the growth rate of the economy will slow dramatically. So much perhaps that it would offset the increase in the amount of Treasury securities and the result would be lower nominal Treasury rates.

In review:

- deflation leads to higher real interest rates: if the Fed wants to keep the economy running, nominal rates need to be lowered or quantitative easing need to be increased

- nominal rates are bounded to the downside by zero

- if financial institutions are conservative, the easing will not have the desired multiplier effect

- companies have no incentive to produce if this occurs. Why pay interest on borrowed money if the sale price keeps dropping?

So, which market is right ????????

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