Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Insightful Perspective From Merrill Lynch

This commentary from Merrill is about a week old but, nonetheless, offers timely insights into current market valuations versus economic fundamentals.

 

The prevailing view among the institutional investors we met this week in the US and Canada is that the markets are too bullish about growth prospects. The continuing weakness highlighted by the Fed’s Beige Book and the decline in Euro area industrial production in April were cited as evidence that the downturn has not ended. Even as we remain optimistic about recovery prospects, we concede that the financial markets have in recent weeks experienced a significant repricing that now demands some validation from the hard data. But, given the severity of the recession, it will probably take a few more months before the data turn unequivocally ‘bullish’.

Against this backdrop, the rise in interest rates at the short end may look excessive. Indeed, money market futures are now suggesting that the Fed and other leading central banks could be hiking rates already in the final months of this year. This is especially the case of US rates, as at some stage this week the market was pricing a total of 75bp of Fed hikes over the next nine months. After that, the Fed hinted to the financial press that it could slow down purchases of government bonds and that led a small retracement of the rise in expected rates.

We believe that the sell-off at the front end of the curve has a lot to do with Fed policy. The stated quantitative and credit easing plan, if fully implemented, would take the total securities portfolio of the Fed to almost US$2tn, raising serious concerns about how the Fed would subsequently drain all the resulting liquidity. Furthermore, if the economy did recover somewhat in the second half of the year and credit extension picked up, the Fed would be ‘printing money’ while macro conditions indicated a reduced need to step up the policy stimulus. The Fed would thus have to drain some of the liquidity created via outright bond purchases. This may well entail a rise in Treasury bill rates and interbank rates.