In a fell swoop by increasing its discount rate and with ramifications still to unfold, the Federal Reserve has re-asserted its leadership not only as regulator with respect to private finance but also internationally. Its timing provides maximum flexibility ahead of March 16, a date both of the next FOMC and the finance deadline for Greece from the European Union. The Fed and other central banks still need to provide cover for the politically difficult task of addressing deficits despite stubborn unemployment and the drive for growth. The upcoming Fed Semi-annual Monetary Policy report should be noteworthy. In markets re-adjusting from massive quantitative ease, we expect yields to rise across upward sloping curves globally until neutrality is established with as benchmark, the 10 year U.S. T Notes approaching 5% in yield. Capital markets are likely to monitor developments like fixed income yield curve pivots more closely than is generally recognized. Our theme extends into focus on credit quality within fixed income, with our favor still for the short to mid maturity portion. In equities, it extends into little potential for valuation expansion and more favor for situations able to deliver both dividends (financial strength) and growth (operational strength), available in portions of information technology, healthcare and integrated energy. On risk, we do see as positive the recovery of the U.S. dollar, now to 1.35/Euro and likely to continue with little consternation from the Federal Reserve or other central banks. Separately, we see gold as a hedge against general, not just dollar, uncertainty in an era of large deficits.

We regard the politics of leadership and yield curve pivots versus central bank policy as likely much more important than is generally recognized. The issue of Greece and the size of its deficit are likely but global signposts in markets re-emerging into an environment of standards after a period in which massive quantitative ease and cohesion favor predominated in the face of credit crunch that had been wrought by a lack of appreciation of risk. In another dimension now to watch, other global sign posts include food inflation having reached over 20% in countries as diverse as in Argentina with its vast resources and in India, despite a visceral fear of such inflation that is driven by the politics of poverty, strong growth. Now, as already seen in late 2009 from smaller countries, a period of enlightened self interest may be emerging from central banks that could be distinct from striving for cohesion when large quantitative ease was being implemented. As such, the movements of yield curves and their pivots are likely to be in general capital market focus. With our perspective on risk and return as global recovery unfolds, it was surprising that smaller central banks with more flexibility like the Reserve Bank of Australia and the Norges Bank after signaling policy change via modest rate increases then stopped ostensibly on currency concerns. In our view, policy transparency and efficiency needs to dominate now as differentiation becomes more important during recovery. March 16 was always likely to be an important upcoming date for the financial markets as it marks both the next FOMC as well as the deadline from the European Union (EU) for a credible and detailed financing package from Greece. However, by increasing its discount rate now, in a fell swoop, the Federal Reserve (Fed) has re-asserted its leadership domestically not only as regulator with respect to private finance but also internationally. Domestically by increasing its emphasis on distinguishing between fed funds and the discount rate, the Fed appears underscoring its support for finance for the real economy but subtly putting private finance on regulatory notice after prolonged commentary from some in private finance, notwithstanding the credit breakdown of 2008, of a lack of benefit from such support.

Not just the smaller central banks of Australia and Norway recently paused. Also, among those with strong growth and espousing wider policy flexibility, namely India and China, the recent focus has been on changing reserve requirements but with rate increases still to come, food and or asset inflation notwithstanding. At the other end of the spectrum in the large zones, deflation fears have forced the Bank of Japan to remain with flaccid policy and strident rhetoric notwithstanding, deficit stress could be forcing the European Central Bank to be hamstrung. This milieu makes the Fed discount rate change all the more noteworthy. In the interest of optimizing future stable growth, the Fed and other central banks do also need to provide cover for the politically difficult task of addressing deficits, despite current stubborn unemployment and the drive for growth. We do believe that the signposts of food inflation and relatively stable energy prices do detract from excessive focus on core inflation that has been used as cover by both the Federal Reserve (Minutes of the Federal Open Market Committee, January 26-27, 2010) and the Bank of England (Letter from the Governor to the Chancellor (pdf file). Core inflation was coined in the late 1960s/early 1970s into general use to cover reluctance to face up to energy price increases that were not temporary, to inflation psychology that was building but not recognized as such and also deficits—all issues that had later to anyway be confronted. Fed action now has increased its future flexibility and that of other central banks. The February 24, 2010 Fed Semiannual Monetary Policy report should be noteworthy. We see as unlikely the imminent potential for inverted yield curves that have been espoused as some. Such inversion on a pivot occurs usually towards the end of a cycle as central banks endeavor to control inflation while the long end factors in risk aversion from economic slowdown to come. Due to large deficits and the need for risk differentiation, we also see as unlikely as being imminent, rising short rates but stable long yields at low levels that could be considered normal for slow growth. Instead, we see potential for yields to globally rise across upward sloping curves, until neutrality is established with as benchmark, the 10 year U.S. T Notes approaching 5% in yield. Contrary to recent commentary and market behavior that appeared to favor a weaker U.S. dollar, we see as a risk reduction positive, the dollar recovery now to 1.35/Euro, after being as low as 1.51/Euro. In our view, a continually weakening dollar beyond the 1.50/Euro level would have been a negative in increasing risk of a market break of the 1987 variety. We see benign neglect between 1.20/Euro ( or close to the level of the introduction of the euro) and 1.50/Euro, as favorable not just for capital markets and the United States but also for Asian and European exporters, hard pressed by Chinese fixed exchange rates. Historically, currency recovery enhances focus on efficiency within many corporations while potentially moderating inflation, both key for enhancing growth.

As the reporting of actual earnings for 2009 diminishes, we clearly discern that cost cutting has contributed mightily to bottoming earnings but bifurcation within sectors remains strong, even for historically well managed companies with global exposure in defensive businesses, such as consumer staples. We believe some focus within equity markets is going to be on revenue growth delivery, which may not be as seamless as the markets have appeared to incorporate since Q1/2009. For equities however, an incipient focus is likely also to be on developments in fixed income, including gyrations of the yield curve. Our rationale is straightforward. Central banks need for longer term reasons to engineer out of the massive quantitative ease already injected or risk destructive distortions in capital allocation. Large government deficit financing carries with it the risk of more constraint of liquidity available for the lesser credits, by country as well as by company. An upward move in the yield curve across maturities can be expected to constrain earnings multiple expansion which expands as earnings decline cyclically but normally becomes problematic as earnings recover from the bottom into recurring levels but which also contracts as and when markets sense a developing peak in earnings. Valuation risk both from the perspective of bond yield pressures as well as poor quality of delivery did develop in the 1970s. It also did reverse with assistance from both quality and lower rates in the 1990s. It however did so to an extreme into the bubble of 1999/2000 when the markets attempted to place peak multiples on peak earnings. The present environment appears to us to be in none of these categories. Still, and unlike 2009 with its favor for lesser quality in relief over ease, the return to a focus on standards in capital markets is likely to favor quality of delivery. We ascertain that the most favorable stance lies with delivery of both dividends (on indications of financial strength) and growth (as indicative of operational strength), examples of which lie in information technology, healthcare and integrated energy.