A View from the Trenches, January 20th, 2010: "Two dimensions (Part I)"
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In my view, we have two forces today, shaping the market scene.
These are “dimensional” forces. The first force or dimension is
associated with capital flows. I will call this force the non
neutrality of money. The non neutrality of money, as we wrote many
times already, is evidenced by the fact that, when central banks inject
liquidity, relative prices are distorted. This distortion depends on
the markets that receive the liquidity first.
During 2009, the first market to receive this liquidity was the
Agencies debt market (Fannie Mae, Freddie Mac). Consequently, the
spread between Agency debt and Treasuries tightened violently,
appreciating this debt vs. other assets. Another way of looking at this
is by comparing it with the mainstream view, that money is neutral
(implicit in Krugman’s and David Rosenberg’s works). The neutrality of
money is expressed in the famous equation, called the exchange equation:
Money in circulation * Velocity of circulation = Price level * Output level
This is why economists like David Rosenberg or Krugman tell you that
you should not worry about inflation (Price level), because even if
Money in circulation grows, the velocity of circulation is low. They
told you precisely that while markets rally, spreads compress or gold
goes from $854/oz to $1,138/oz in the past twelve months. These same
economists will now increasingly ask you to worry, because the rally is
not justified by the output level vs. its potential level (whatever
that is). And of course, they have been wrong since the whole
inflationary process began, on an afternoon of Dec 5th, 2008, with the
first purchase of Agency debt by the Fed.
Having said this, and back to my main theme, I see the non-neutrality of money shaping 2010, as follows:
Assumptions: a) The Fed will maintain a steady supply of liquidity
(not touching policy rates) and b) the US fiscal deficit will not fall
With these assumptions and given the unwinding of quantitative
easing by the Fed (i.e. will stop buy Agency debt by this spring), I
expect Treasury yields to rise with a steeper curve. The steepness in
the curve will be driven both by a compression in the front end, as
well as a sell off in the long end (For those interested in the
reasons, pls. write back. I’ll be happy to further elaborate and have
your feedback). The rise in Treasury yields should compress corporate
credit spreads. The impact of this compression can bring three
consequences: a) Further debt refinancings; b) share buybacks with
leverage, and c) capital expenditures. These three channels should
provide further fuel to the equity rally, commodity prices, and
finally, activity.
If you believe in this story, a beta strategy, where you invest in
liquid instruments as indices, should do well. I began the year firmly
believing in this story, but as with any good story, there’s always a
risk, a “bad guy”. In this case, the bad guys are sovereign risk and
political risk in every relevant currency zone. I thought these would
become relevant later in 2010, but here we are, facing them in January.
These sovereign/political risks constitute the second force shaping
the market scene that I referred to above. Tomorrow, I will elaborate
on this second dimension: Time. Why time? Because these risks affect
every monetary zone today, but with different degrees of “imminence” or
urgency. The degrees of imminence affect the foreign exchange crosses,
which define the second dimension.
Martin Sibileau
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