A View from the Trenches, July 8th, 2009: "On the pricing system"
The retrenchment in risk assets continues. Yesterday, stocks sold
off again (S&P 500 closed at 881.03 or -1.97%) while Treasuries
gained (30-yr yield ended at 4.304%). The chart below says it all. The
Libor-OIS spread we discussed yesterday continued to compress, with
3-mo Libor now at 53.75bps. It is a trend, certainly, but without the
violence we got so accustomed to see in 2008. It looks like the markets
are under anesthesia, provided by central banks, while everybody waits
for a surgeon to show up and do the dirty job…
I have the feeling that I could safely say that nobody can affirm
with certainty today where markets are headed to (Except of course the
usual bearish voices, the same ones that missed the huge rally of
2009). We cannot blame analysts for their lack of certainty. However,
perhaps, there is value in acknowledging ignorance. What do I mean? I
could argue that today there may be more merit in acknowledging
ignorance than betting on a path. But, if forced, one can always go
back to the comfort of those self evident truths. Whenever I need to
understand something new, I just go back to reading classics. For
instance, let’s rescue Mr. Keynes’ thoughts back from oblivion. If we
want to be consistent, we need to recognize that the goal of every
government’s interventionist policy since 2007 is to increase output
back to a “full employment” level. What should the world look like, if
their efforts are successful? At the end of the 3rd section, Chapter 13
of “The General Theory of Employment, Interest and Money”, Maynard very succinctly told us that: “…when
output has increased and prices have risen, the effect of this on
liquidity-preference will be to increase the quantity of money
necessary to maintain a given rate of interest...” Keynes
could not have been clearer on this. The only possible way out of a
financial crisis is to inflate the way out of it (By the way, that’s
why we have central banks). Anything else is pure hypocrisy and a
painful and unnecessary delay.
In the meantime, the painful and unnecessary delay is caused by
inconsistent intervention that dislocates and segments markets. We
discussed the issue yesterday, in relation to the compression of the
Libor-OIS spread and risk assets dynamics. The intervention is very
harmful, because it affects price relationships. The pricing
system is nothing else than a communications system. In fact, it is not
the only one we have to signal gaps between supply and demand in every
market, but it is also the best one we have within all our
imperfections. Thus, every regulation, every exogenous purchase or sale
of assets done by any government distorts this signaling system and we
end up getting the wrong signals. We then have to hear
mainstream economists say that “equities got a bit ahead of
themselves”. This is nonsense. This school of thought is the same one
that sustains that markets are not rational. See, if you sense a
monster in your room and you run away, you are not irrational, for
escaping monsters is precisely the rational thing to do! What is the
problem then? The problem is that there are no monsters in your room.
You simply had the wrong information. And so do markets today! Who provides it? Governments! The sooner their intervention ends, the sooner we will recover.
Chart 1: 30-yr Treasury (white) vs. S&P 500 Index (orange), intraday (Source: Bloomberg)
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