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2006-06-19 :: China Raises Reserve Requirements

All four of the big central banks are now in tightening mode.   Normally this would be bad news for the equity markets, and Friday when it became public, we saw some retracing of the gains earlier in the week.  However, an even bigger announcement from the Bank of Japan indicating that they had stopped draining liquidity from their banking system is the key item for this summer.

Last week we had a big announcement from the Bank of China that they were raising their reserve requirements to combat inflation.  The increase will be at the 1/2% level, not huge, but enough to take some of the froth out of the system.  This put China in the same  position as the Fed, European Central Bank, and the Bank of Japan.  It also put the world in unknown territory as I do not recall anytime since China became such an economic force that all four banks were in tightening mode at once.  Uncertainty is ususally a really bad thing for equity markets, and being in a new situaiton involving simultaneous liquidity drain from the four central banks, leads to uncertainty (hence Friday’s small decline).

The good news, though, is that Japan announced (as I wrote last week) that they had ceased their increased reserve requirement policy.  The new bit of news is that they had drained over $175 billion in excess liquidity from the Japanese banking system.  This is a big number, and looking  back at the carnage in the markets from May 10 through mid last week, it only makes sense that this huge liquidity drain was the proximate cause.

As liquidity dried up and banks began to reduce their lending to the hedge funds, the hedge funds had to cover their positions (ie, sell the stock they bought with borrowed funds) and that put a huge downward draft on the market as they had to get out at any price or face being short funds to payoff the debt.

With Japan’s announcement, this means that we now have just some incremental interest rate increases ahead of us.  The Fed will likely increase to 5.5% over the summer; Japan will likely increase to 1%; and the European Central Bank will likely increase another 0.5% as well.  These incremental increases will likely stem whatever inflationary pressures are out there from the demand side, leading to a soft landing and sustained economic growth.

This is VERY BULLISH for the stock market, particularly the commodity stocks that rely upon sustained economic growth. 

The summer will likely be rough, with lots of ups and downs, but we will be using these as opportunities to realign portfolios to increase exposure to the energy, metals, and infrastructure stocks I’ve written about here over the last couple of weeks.  Once the general public gets comfortable that the end of the interest rate increases is near, we should see money begin to flow back into the markets, pushing them back to the pre-selloff highs and beyond.

If you are managing your own portfolio, consider starting to buy on any down days for your targeted stocks.  On any up days, use those as days to sell positions that you can use for liquidity to make your buys.  Look at P/E’s, relative P/E’s, and PEG ratios as an indicator for your sale candidates.  Look to buy the ultra low PEG energy service company stocks as they will make you a lot of money when the next leg up in the energy bull market really takes off.

More later!