A "melt-up" not "melt-down" is the new key theme in the financial markets. There does not seem to be any fear of a market decline in the current environment. Call it the Bernanke floor. Rather the fear is that we are headed to multiple speculative bubbles around the world. Look at the strong showing in the US stock market and credit markets. Given current growth rate, are the current equity levels sustainable? Are credit spreads at levels that will offset default risk? Are housing prices consistent with economic growth? What about Canada housing and other markets where rates are exceptionally low?
It is well-known that equity markets are not closely tried to economic growth in the short-run. Valuation changes can have a significant impact on prices. Similarly, there is not always a close link between earnings and growth. This, of course, changes in the longer run. This is one of the reason why the melt-up occurs. Investors are not willing to trust the economic number. They do trust the momentum.
The policy of central banks has been to inflate where they can. In this case, financial markets have been the easiest. The idea is simple. The inflating of financial assets will increase wealth which will translate into higher consumer spending or greater investment which will boost growth. This story assumes that the link between wealth and spending is tight. It is not. Additionally, if investors do not believe that the increases in wealth are permanent, there will not be a increase in spending. If businesses do not feel that growth is strong, there will not be a corresponding increase in investment regardless of the level of interest rates.
We continue to melt-up under the hope that optimism takes over and allows for more spending. It does not feel as though this policy is working.
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