By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Limited

Stock markets have rebounded sharply in the past month.  Credit spreads have narrowed.  The dollar has stabilized.  The US reported 0.6 percent GDP growth for 1Q2008, better than expected.  The heads of Wall Street banks spoke in unison that the worst was behind us.  Even the Bank of England suggested in the latest report that the worst of the banking crisis may be over.

If you listen carefully, all the optimists speak with hedged language, because they sounded the same optimism last fall and were proven wrong.  'The worst is behind us' is the most common language for the optimists.  'Closer to the end than the beginning' is another popular choice.  Some on Wall Street use baseball lingo and describe the current situation as the 7th or 9th inning.  For those who are not familiar with baseball, a normal game has 9 innings.  But, a game tied at the end of 9th inning goes into overtime.  The overtime could last a long time.  No matter what the future is like, today's optimists have dug quite a few escape holes in the words they choose to express their optimism.

After the Fed bailed out Bear Stearns, I wrote in this page that the crisis was on pause and could return in June.  I think the scenario is still quite likely.  I could be off by a month or two in terms of timing.  The current calm may last longer than I expected.  The calm comes from the Fed's direct lending to investment banks, which allows investment not to sell assets to raise cash.  It decreases forced asset selling and allows the investment banks to book fewer losses from asset depreciation or even book some gains from their asset holdings. 

Goldman Sachs booked ＄2.07 billion of net unrealized gains from the appreciation of level 3 assets for the first quarter of 2008, equivalent to 96 percent of the company's ＄2.14 billion of pretax income.  Morgan Stanley booked ＄4.24 billion such gains, almost twice as much as its reported profits.  Lehman booked ＄695 million of non-cash gains last quarter on corporate equities classified as Level 3, slightly more than the company's ＄663 million of pretax income.   Without booking capital gains from the hard-to-understand level 3 assets, financial institutions would not be profitable.  Of course, such profits don't bring in cash.  To stay in business, they have to borrow money, preferably from the Fed at a 2.5 percent interest rate.

Under the rules known as Financial Accounting Standard No. 157, Level 1 means assets that can be reliably marked-to-market constantly.  For example, S&P index contracts or big-cap stocks like GE and Microsoft.  These assets can be liquidated at prices quite close to the observable price quotes.  Level 2 assets can be marked to market on their similarities to some Level 1 assets.  For example, if 10 year treasuries are well traded and liquid, the illiquid treasuries that have maturity of 9.5 years can be priced on its value relation to the 10 year treasury.  Level 3 means the value of a given item includes at least one significant “unobservable” input, reflecting a company's “own assumptions about the assumptions market participants would use in pricing the asset or liability.” Essentially, as long as one can come up with a plausible argument, you can give Level 3 assets your own price.

I am not suggesting that the Wall Street banks are making up numbers out of thin air.  They need something to justify Level 3 asset appreciation.  All the banks booked such gains in the first quarter, suggesting that they saw something similar.  The market rebound after the Bear Stearns bailout gave some clues to their valuation models.  This shows how dependent these banks are on market direction.  It also explains why some important people, usually highly paid, are talking up the market.  If the asset prices go back to the previous peaks, all their troubles are gone.  Even central banks like the Fed consider asset prices in their policy decisions, i.e., they are targeting asset prices, mainly stocks and credits.

But, are asset prices too low or too high?  The asset reflation strategy that policymakers are adopting will fail or succeed on the answer to this question.  The companies in the S&P 500 are trading at about 15 times estimated earnings and 2.5 times book value.  These are not low numbers for a normal market in a normal economy.  As the economic momentum is still downwards, the market appears expensive. Further, earnings estimates may be exaggerated.  Financials account for one quarter of the market and trade at around ten times earnings.  We know why they appear cheap, because the market is unsure about their future.  Take them out, rest of the market trades 17 times earnings.  In addition, 45 percent of the earnings of S&P 500 companies are international.  Dollar has depreciated by 30 percent.  The translation effect has boosted their earnings by about 13 percent.  The market is not in a shape to stage a sustained rally.  The 10 percent bounce from the March low is probably a dead cat bounce rather than the beginning of a new bull market.

The US inflation-linked bonds are priced at zero real interest rate currently, down from 1.2 percent last November.  This is the first time that the inflation protection bonds pay only for inflation.  The investors who buy such bonds essentially believe that other assets, on risk adjusted basis, will have returns lower than inflation.  This negative view about other assets can be interpreted positively by other investors.  The stock market is valued on the net present value of future dividends.  The discount factor is the sum of interest rate plus risk premium.  The reduction in real interest to zero should, ceteris paribus, give the stock market higher valuation.  Of course, one should ask why the bond market accepts zero real interest rate.  It implies negative factors that also negatively impact stock market.

What is occurring, I think, is that central banks around the world have managed to sustain liquidity level despite capital losses in the financial sector, through unconventional liquidity pumping measures.  The bailout of Bear Sterns allowed the market to believe that no significant financial institution would be allowed to go bankrupt.  Hence, credit investors bought their debts and brought down their borrowing costs.  Direct lending to investment banks has given them the channel to stay cash positive without selling assets or earning revenues.  The Fed is now force-feeding banks like Peking ducks with liquidity through its cash loan auctions.  It is actually a form of quantitative easing.  It recently raised the target of this biweekly auction by 50 percent to ＄75 billion.  Normal central banking works through setting interest rate and waiting for banks to borrow voluntarily.  Such auctions set up quantity targets and let price fall to where demand matches the targets.

The liquidity pumping has temporarily stabilized financial markets.  It works through lessening the pressure on financial institutions to deleverage.  Most big financial institutions have become dependent on warehousing assets for appreciation profits.  As these assets depreciate, they have to book losses.  The depreciating capital base requires them to shrink their balance sheets, i.e., selling more assets, which causes asset prices to drop further.  Central banks consider this dynamic a vicious cycle and require policy interventions to stop.  Such thinking may appear reasonable on the surface.  It doesn't consider the scenario that the massive leverage at financial institutions has exaggerated asset prices and, hence, the so-called 'vicious cycle' is a necessary process of price normalization.  What the central banks have done is to slow down the air leaking out of the bubble.

Asset prices depend on liquidity.  If liquidity doesn't contract, asset prices are not likely to go down.  If this is the case, could central banks target asset prices to stop the financial crisis through cutting interest rate and/or quantitative easing.  The problem with liquidity is that too much of it will cause inflation.  Evidences are piling up on the linkage between the Fed’s policy and commodity prices.  The liquidity pumping has inflated one commodity after another.  Rising commodity prices, in turn, have increased the cost of living for workers, which will trigger demands for wage increase.

While inflation is surging everywhere, even Japan, the land of deflation, reported 1.2 percent CPI increase from one year ago, bond markets are yet to price in high inflation.  The US 10 year treasury now yields 3.85 percent, lower than 4.1 percent inflation in the US in 2007 and certainly lower than the likely inflation in 2008.  Bond markets are yet to wake up to the inflation reality.  This is because the market still believes in central banks.  Until two years ago, inflation was declining for two decades.  The unusually long period of disinflation brought an aura to all the central banks, especially the Fed in containing inflation.  This faith in central banks is the reason that markets are giving central banks the benefit of doubts on inflation fighting, despite all the evidences to the contrary.

The central banks are essentially taking advantage of the market's faith in them by releasing liquidity to lessen the financial crisis.  In theory, the faith slows down the transmission process of money supply into inflation.  However, financial institutions that are losing businesses have found a profitable one by borrowing cheap money from central banks and speculating in commodity markets.  This has established a direct link between money supply and inflation.  When the masses are caught up with this phenomenon, they will demand wage increase, which completes the cycle between money and inflation.

The Fed has become concerned that markets may stop believing its inflation fighting resolve.  If it happens, the consequences can be catastrophic.  Ten year treasury yield may surge above 6 percent, which would cause the property market to completely melt down.  Hence, it has expressed concerns about inflation and signaled that it would stop cutting interest rate.  However, the current official policy rate at 2 percent is probably three percentage points below 2008 inflation.  The big gap automatically stimulates money demand and pushes up inflation.  Hence, the monetary policy will loosen on its own, as negative real interest rate increases, without cutting the official policy rate.  The Fed's jawboning may be to buy some time from the bond market.  As long as bond yield stays low and inflation is between 5-6 percent, it cushions the property downturn.

So far, financial markets are taking the Fed's talk seriously.  The dollar has staged a small rally from the bottom.  Commodity markets have sold off from their recent highs.  Gold, for example, retraced 15 percent from their recent peak.  The commodity sell-off is a correction, not the end of a bull market.  The dollar's strength comes from deteriorating economic news in Europe and Japan, not from improving economic news in the US.  As I wrote at the beginning of 2008, Euro-dollar may peak at 1.6 on deteriorating US economic news in the first half of 2008 but will retrace its gains on deteriorating economic news in Europe in the second half.

Market has been linking commodity rally to a weak dollar.  As the dollar bounces a bit, many have gone short gold and other commodities.  I think that the market in future will link commodity rally to global inflation rather than weak dollar.  Globalization has produced an unusual inflation phenomenon.  Every country believes that it cannot deal with inflation because of the influences behind its control.  This belief is causing them reluctant to tighten.  However, the world is a closed economy and global inflation must reflect supply-demand imbalance at the global level.   If every country thinks that way and acts accordingly, inflation is not being checked and will rise further.  In such a scenario, even thought the dollar may stabilize, all the currencies in the world are depreciating, being inflated away.  That will support the commodity market.  The commodity bull market or bubble will reverse when all major central banks shift their priority from maintain financial stability and economic growth to fighting inflation.  That is one year or longer away.

Central banks around the world are using their credibility on inflation to maintain a loose monetary policy despite inflation high and rising.  The resulting negative real interest rate has brought calm to financial markets.  I believe the calm is temporary.  The current policy stance cannot stop property price from falling in most major economies like the US, UK, Spain, Japan, Australia, etc.  Falling property prices will cause demand to weaken, which in turn causes unemployment to rise.  The process will expose excess consumer indebtedness in Anglo-Saxon countries.  The crisis so far is about subprime mortgage debt.  Next in line are home equity loans-the debt backed by home value above mortgage debt for consumption and total over ＄1 trillion, similar to the size of subprime debt, in the US.  The home equity loans rank below mortgage debt in seniority and get exposed first when property prices fall.  When unemployment rate rises, credit debt gets into trouble.  In the US, the credit debt has rise from ＄500 to ＄8,000 per capital.  Low income households have been using credit debts to sustain their consumption habits.  Hence, if unemployment rate rises, the credit debt would also go bad.  Like subprime debt, home equity loans and credit debts are mostly securitized and sit in the inventories of banks and investment funds around the world.  When these two classes of debts go bad, some financial turmoil may be inevitable.

A far more serious crisis is central banks losing their credibility.  It sounds far fetched now but may come as soon as in the second half of 2009.  Central banks didn't really earn their credibility.  It was mostly a gift of the time.  Two decades ago, planning economies around the world gave up planning and switched to open market economy.  The transition brought severe economic downturns in this block.  Their demand, hence, declined.  It caused commodity prices to stay low.  Also, they adopted an export-led strategy to build up their economies, which depressed prices in the west.  The big central banks didn't have to try to keep inflation low.  The market mixed good fortune with ability and gave central banks enormous credibility for keeping inflation down.  The illusion may not last long.  The market is fickle and may change its mind in a flash.  When it happens, bond yields will spark up around the world.

After two decades of growth, the ex-planning economies have exhausted their surpluses in resources and labor.  Hence, they all have gone into an inflationary phase.  Rising labor and land costs in China, India and Russia are the leading indicators for inflation in the west.  But, the major central banks will laugh at this notion now.  Time will make fools out of them.  I will tell the story in the next article on the big inflation cycle.