A money flood for the markets

(breakingviews.com) -- Markets reflect investors' best estimate of long-term value. Markets also reflect the strength of investors' own short-term cash-flow. Right now, the second may be more relevant than the first.

Equity, credit and commodities markets had fallen so far that the latest uptick is really a "feel less bad" rather than a "feel good" rally. But it is still dramatic. The S&P 500 index (SPX) is up 27% since March 6 and the iTraxx European index of investment grade credit spreads has narrowed by 24 basis points to 258bps. The oil price is up 47%.

There has been some good news. Chinese exports rose 7.5% in March. Sales of existing houses in the U.S. were up 4.4% month-on-month in February. And big bank executives have been exuding optimism about profits, validated partly by a strong first quarter at U.S. investment bank Goldman Sachs (GS, Fortune 500).

But this is not much to justify a sustainable market rally. The bull case goes like this: the economy is stabilizing, banks are lending again and higher prices breed confidence. Markets are looking ahead.

That argument relies on a few thin green shoots of recovery. But the alternative explanation, that the market rallies are driven by investor cash-flow, rests on much bigger numbers. The U.S. Federal Reserve's balance sheet has expanded from 7% to 29% of gross domestic product. That equates to huge transfer of cash into the banking system. It's supposed to support lending, but trading may be the first beneficiary.

The U.S. government deficit - the excess of cash put into the economy over cash taken out - was $957 billion for the last six months, up from $313 billion in the previous year. Add in the effective near-zero policy interest rate in most of the world and there is more than enough new cheap and free money to push up asset prices.

Investors seem to be forgetting that mass produced money can lead to inflation. They also seem to be paying insufficient attention to unemployment and other signs of weak business conditions. The predominant trend in the real economy remains downward. In the real world, there are complicated imbalances that cash cannot necessarily heal.