Beware of Great News

Today the market headlines were nothing more than sensational. Corporate earnings from Intel Corp. (NASDAQ:INTC), J.P. Morgan Chase & Co. (NYSE:JPM), and CSX Corp. (NYSE:CSX) were all better than analysts expected. Everything is great in the stock world again. Day after day the stock market climbs higher shaking off European concerns, housing troubles, and 16 year high office vacancies, to name a few negative problems.

One must ask, if everything is so wonderful why is the Federal Reserve Bank’s fed funds rate still at zero percent? The Federal Reserve Bank stated in the minutes from the last FOMC meeting that they would leave rates at low levels for an extended period of time as long as there was not inflation. Many investors and traders know when a country has ten percent unemployment there is not going to be any inflation. Deflation is the problem.

Bank stocks have lead the rally since February 5th, 2010. Today J.P. Morgan Chase & Co. reported very good earnings. However, a huge amount of there money came from trading. This gives us insight on who is propping the markets up. The volume has been unusually light since the March 2009 bottom signaling that the retail investor is not participating in this bull rally. Currently the big banks can borrow from the Fed at zero and buy stocks and U.S. Treasuries to make money. This is one of the major reasons for this Bull Run over the last 13 months.

Is this type of action sustainable for the long term? The answer is simple; of course it is not. Former Federal Reserve Bank Chairman Alan Greenspan used the same technique in 2002 and 2003. Back then Greenspan lowered the fed funds rate to 1 percent and that created the greatest housing and credit bubble in 100 years. Now Fed Chairman Bernanke has lowered rates to zero percent. Rates have been down at this level for well over a year now. How much longer will the fed funds rate remain down here? Everyone knows that low rates lead to an asset bubble and inflation. We understand they would love inflation; however, can the markets survive the next bubble?

Nicholas Santiago
Chief Market Strategist

Great post! If this is the case can we expect to see a drop in profits reported by the major banks when the Fed does increase the interest rate? If so how severe do you think this drop could be?