The Fed made it clear to the market with this week’s FOMC statement that speculation of a rise in the Fed Funds rate anytime soon is completely misplaced.  The Fed pointed out that with US GDP still contracting the economy has not yet even begun to work through the vast amount of slack in the system (capacity utilisation down near 65% and unemployment at 9.4%). It is this same spare capacity that means they are also not worried about the recent rise in energy & commodity prices feeding through into a sustained rise in inflation.

Even when US GDP starts to grow again (possibly later this year given that excess inventories now seem to have been worked off by manufacturers) it will take many quarters to chew through all the slack in the system (and the US economy has yet to contend with Obama raising taxes/allowing the Bush tax cuts to expire).  Therefore the FOMC “continues to anticipate that [the Fed Funds rate will stay at 0.25%] for an extended period”.

Those who think that the economy will bounce back strongly and that the Fed will soon be taking back some of its rate cuts should watch what the Fed does when it completes its $300 bln purchase of Treasuries in the autumn.  If the Fed announces it is going to spend additional money buying Treasuries then rate hikes will stay off the agenda.  Stock markets have bounced and bond yields have backed up as financial markets have regained their poise this year after the carnage inspired by Lehman’s bankruptcy last autumn.  Markets have gone from pricing in a depression to pricing in a prolonged recession and equities are currently consolidating after their sharp rally off the March 2009 lows and digesting the supply of fresh equity from corporates who are either getting their balance sheets back into shape or raising funds to take advantage of opportunities they see in the current environment (banks are not lending and credit spreads remain wide so equity is currently the default source of funding).  This is why the “green-shoot spotters” are out in force at the moment as the next move in the markets will be driven by perceptions of economic recovery or a slip back into a W-shaped recession.

For the foreseeable future the Fed continues to stimulate the economy by keeping rates close to zero and buying up Treasuries & mortgage-backed securities.  It will keep the pedal pressed firmly to the metal until the economy has grown sufficiently to have taken some of the slack out of the system.  Anyone expecting the Fed to hike rates the instant GDP starts to grow again is going to be disappointed (it is not going to repeat the 1997 Japanese mistake of raising taxes and snuffing out economic recovery the instant it has started)- a better guide to the timing of a rise in the Fed Funds rate will be given when the unemployment rate is at least two percentage points off its high and capacity utilisation is above 75% and the Fed has seen what impact any Obama tax increases have on the economy.

Insurers got themselves confused between the subtle difference of writing a diversified portfolio of credit default swaps (essentially a bet that credit spreads were too wide and the future level of defaults would more than compensate the risk taken) and investing in a diversified portfolio of corporate bonds  (also a bet that credit spreads were too wide and the future level of defaults would more than compensate the risk taken).

The reason the comments in brackets are exactly the same is that it is in fact the same bet.  But insurance companies are supposed to take their premium income (customers paying the insurers to shoulder risks) and invest them in financial markets.  Writing credit default swaps, however diversified a spread of risk that is written, is not the business of insurance companies trying to acquire or write premium income.  They should not double-up on their risk but should simply invest their “float” of premium income in such financial assets they deem most attractive at any point in time.

This was essentially the mess AIG got itself into and other insurance companies should steer well away from writing credit default swaps (other insurers have dabbled in the CDS market but none to the extent AIG did).  The end result will be wider credit spreads than otherwise prevailed when AIG was in its CDS writing prime, but these will compensate real-money investors for the risks they take in lending money to companies.

If credit spreads get too wide then eventually investment money will be attracted to the asset class and spreads will tighten, which is how the world is supposed to work.

In the meantime avoid any insurer which writes Credit Default Swaps.

Over the past 6 weeks the FTSE has repeatedly pushed above 4500, only to fall back on each occasion.  The best recent closing high was 4506 on 1st June and the other intra-day highs of the past 6 weeks were 7 May 4520, 19 May 4512, 20 May 4504 and 10 June 4505.

There have been two lows at 4295, creating a double bottom, in between these repeated attempts at 4500 and therefore we now have a very clear recent trading range of just over 200 points established on the FTSE.  The key question is in which direction are we going to break out of this trading range?

There are a couple of key moving averages also currently muddying the picture.  The FTSE has been trading around its 200-dma (currently 4309) during the past 6 weeks but has now closed above it for the whole of June thus far.  The FTSE has also run into its 50-week moving average (currently 4484) in the last two weeks and this 50-wma is providing some resistance at the moment.

However in June so far the FTSE has traded in the upper half of its recent trading range and it looks like the odds now favour a break higher away from this 4295-4506 consolidation area.  Watch the price action for two daily closes above 4506 and let the market show us where it wants to go next.

Notwithstanding the Bank of England doing its best to inject £125 bln into the Gilts market, Gilt yields are backing up along with US Treasury yields and those of German Bunds.

There are basically two schools of thought as to why gilt yields are rising.  The more popular at the moment is that government bond investors are running scared of the deluge of supply of new government debt which is coming the market’s way over the next few years and the yield backup is a way of making room for all this new supply.  The other (less popular) explanation is that markets are anticipating economic recovery and the backup in bond yields simply represents the usual move away from risk-free assets to other more risky securities such as equities and corporate debt.

The second explanation is consistent with the rally in equity markets (with cyclicals such as retailers & mining stocks outperforming defensives such as pharmaceuticals, food processors & utilities) since early March and is also given credence by the synchronised backup in US, UK and German government bond yields.  The Dow has also broken above its 8587 May 8/20 double-top this week and is continuing the rally which started in March and which paused for breath during May (we have had two daily closes above 8587 which have negated the double-top reversal pattern).  The rally in the oil price is also consistent with an expectation of economic recovery and the only market not rallying is credit spreads.  Ordinarily these would be expected to tighten in anticipation of an economic recovery but this time it may simply be the case that banks are still not in a position to lend freely and the SIVs (which would normally be borrowing close to Libor and buying corporate bonds at wide credit spreads) are not in business any more.

Markets are clearly rallying in anticipation of economic recovery which means the rally will only be derailed by clear evidence that the economy is not recovering as per market expectations (i.e. we are still bumping along the bottom or we are going to double-dip back into a W-shaped recession); the catch is this evidence may not show up for quite a while…in the meantime it looks very much like the bears are going to be squeezed hard all summer long.