Around the Street

Experts Talk Bernanke and Geithner, Inflation, Small-Caps


Bloomberg BusinessWeek compiles comments from Wall Street economists and strategists on the key economic and market topics of Apr. 20.

Kim Rupert and Michael Wallace, Action Economics

The Bernanke-Geithner show [in Apr. 20 testimony before the House Financial Services Committee] was mostly an opportunity for Congress to scold the dynamic duo for any role in the Lehman debacle—and for them to deflect any blame. [Federal Reserve Chairman Ben] Bernanke suggested it would be wise to limit risk-taking and give regulators the authority to break down too-big-to-fail firms. [Treasury Secretary Timothy] Geithner argued for capital adequacy for institutions that pose systemic risk and regular stress tests.

Securities & Exchange Commission [Chairman Mary] Schapiro more interestingly interjected that the SEC has asked the largest firms to disclose how they are using repos and that she is mulling whether new rules are needed to "prevent masking of debt at quarter-end." This suggests the SEC is continuing to press Wall Street on various issues, perhaps due to political pressure and also to reclaim some of its lost credibility.

Vassili Serebriakov, Wells Fargo Bank

Currency markets have switched gears, with global risk appetites and equity markets on the rebound today. Against this backdrop, the U.S. dollar and Japanese yen are broadly weaker vs. the other major as well as emerging currencies. It is particularly noteworthy that the best performers in the currency market today are supported by central bank activity. The Canadian dollar is the most notable case as the Bank of Canada left rates steady at today's meeting but hinted at a June rate hike. Meanwhile, the Reserve Bank of India raised its policy rates in line with expectations, Sweden's central bank continued to hint at rate hikes in the "summer or early autumn," and the minutes from the Reserve Bank of Australia suggested further policy tightening.

We suspect that continued exit from accommodative policies will increasingly become a key theme for currency markets in the coming months. In that context, we see currencies of countries that are leading the global tightening cycle, such as the commodity and emerging Asian economies, outperforming in the months ahead.

Sven Sten, Goldman Sachs

While we expect core inflation to fall further throughout this year and next, the Federal Open Market Committee (FOMC) appears to disagree. The midpoint of the central tendency of its inflation forecasts—which the committee defines by dropping the three highest and lowest projections from its 17 participants—implies expectations for core inflation of 1.4% and 1.45% in 2010 and 2011, respectively. However, this pattern is due to asymmetry in the committee's views on inflation. For example, excluding the top and bottom four inflation projections, which is just as arbitrary as dropping the top and bottom three, leads to inflation expectations of 1.25% and 1.3% in 2010 and 2011, respectively.

Given the current environment of spare capacity and falling core inflation, these "trimmed" forecasts appear more appropriate than those implied by the central tendency as conventionally defined, albeit still well above our own. Using the "trimmed central tendency" inflation expectations measure in our preferred version of the Taylor rule reinforces our belief that the Fed is unlikely to hike until early 2012.

Steven DeSanctis, Bank of America Merrill Lynch

Even with the drop off in performance on Friday, Apr. 16, the Russell 2000 is off to one of its best starts ever. What is even more impressive are the gains since the market bottom back on March 9, 2009, and small caps are easily beating the large caps over both time periods. Up until Friday's showing, it certainly seemed to us as if the small-cap market was getting a bit frothy and thus we questioned the legs behind the outperformance. Performance has been led, both year-to-date and since the bottom, by low-quality stocks and we have found that this tends not to be sustainable.

The strength of the rally since the March 2009 low is one of the strongest ever but this tends to bode poorly for subsequent performance. The gains in the small caps have also pushed up both absolute and relative valuations to where the size segment is now more expensive than its historical averages. We have also seen earnings estimates start to edge lower and this could create a turning point in performance. If fund flows do slow down once again, we do not think that investors have enough firepower to keep this rally rolling, as cash levels now stand well below 4%.


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