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Analysts are striving to understand the action in equities in the
last two days and in credit and Treasuries since yesterday. As I wrote
before, I am not a big fan of statistics, indexes and all the
ammunition mainstream economists use. My dislike for them is based on
the assumptions; the methodologies used to measure, and last but not
least, their respective goals. But this goes beyond the scope of this
letter. Enough is to say that regardless of what was excluded or
included in the calculation of the Producer Price Index released
yesterday, the same was higher than expected and, most importantly,
showed that there is no deflation.
In Canada, another relevant flag is that on July 13th and yesterday,
the Bank of Canada had offered to purchase up to $3BN and C$1BN
respectively, under the Purchase and Resale Agreements (PRAs). These
short term transactions are meant to provide liquidity to the market.
The news is that for the $3BN 84-day offer, only C$2.25BN was sold (for
an average yield of 0.254%), while for the C$1BN 28-day offer, only
C$700MM was sold (for an average yield of 0.50%). This in itself
shouldn’t have caught my attention. What was so special then? Between
July 13th and today, the Canadian dollar appreciated approximately 2.5
US cents. To me, this is bullish of Canadian “stuff”, for not only have
commodities followed the reversal in stocks (S&P500 closed at
905.84pts) this week, but there is also an important amount of Canadian
savings on the sidelines. However, let me be clear here: It is never
wise to take a rally for granted because there is money on the
sidelines!
Finally, let’s recap here what I think is unfolding. I acknowledge I
have been a contrarian since June, but the markets appear to be with me
here. On June 3rd, I said that: “…I expect equities to simply stagnate, orbit within a certain range. The harsh side of this coin will be a high unemployment…” (www.sibileau.com/martin/2009/06/03
). I also maintain that in order for us to see a fire sale in risk
assets, we need some exogenous, political event to trigger it. Therefore,
I might as well be on the wrong side of the bet, because the last two
sessions have ended up based on positive (or better than expected)
data. (I may be right for the wrong reasons) although it is too early
for a final conclusion.
Thus, given the general confusion, let me repeat why I am inclined
to expect agony in the markets, together with high unemployment:
Because of the ongoing inflationary process. To most people, this is
extremely counter intuitive, as they have been educated into the
mainstream theory of inflation, which sees this phenomenon as a one-act
play: A high CPI announcement. For us, educated under the Austrian
school, inflation is the distortion in relative prices. This distortion
can last many, many years, before it translates into a high CPI
reading. This distortion also generates enormous imbalances, obstacles
to firms and uncertainty. The uncertainty is what keeps unemployment
high. What then could get us on a steady growth path? A
reliable fiscal budget in the developed world! Why? It would bring a
reliable benchmark issuance schedule, and demand would consequently
adapt to it.
July 14th 2009, Intraday: S&P500 Index (orange) vs. 30-yr Treasury (white) (Source: Bloomberg)
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Today is the 220th anniversary of the storming of the Bastille prison, in France. On a 14th of July in 1789, an angry crowd liberated what were mainly political prisoners in this fortress-prison, outside of Paris. The anger had brewed during previous years, as Louis XVI ran into massive deficits, which he sought to cover with rising taxes. People back then thought they had seen the worst crowding-out effect ever, by a careless government. But perhaps they were wrong. Perhaps, with yesterday’s announcement of the US 9-month fiscal deficit of $1.1 trillion, those courageous French seeking to end nonsense have been dwarfed by the American taxpayer. In any major crisis, new ideas are born. In the case of the French crisis of the eighteenth century, the new idea was that quantitative analysis could be useful. Yes, quantitative analysis (what follows is my view only; I invite anyone to check if I am right here) was born with the Tableau Economique, of the so-called physiocrats. This analysis sought to make the point that agriculture in France was important and that the government had to develop its potential (as you can see, the United Auto Workers are not original).
Equities rallied today. Maybe because Meredith Whitney was positive on Goldman, maybe because the market sold Treasuries, or Bank of America may not have to pay $4BN in fees to the US government, or perhaps the macroeconomic data is not as bad as it seems. As we have said in recent letters, endogenous factors alone do not guarantee new lows. This does not mean there cannot be new lows. All I have been saying is that, by itself, the macroeconomic fundamental situation should not push a panic sale, because governments have ensured there is liquidity going to the financial system (We will have more to say about this, in the case of Canada). If this flow of liquidity stopped, or if the market believes that it can stop, or if it is challenged by an exogenous effect, then the spiraling asset deflation could indeed be triggered.
How do I know I am right here? I don’t. I can only hope my own Tableau Economique is right. When stocks fell approx. 25% with the Lehman bankruptcy, between Sept. 15th and Oct 10th 2008, the Libor-OIS spread (= 3-mo Libor minus Overnight rate; www.sibileau.com/martin/2009/07/07 ) shot beyond 364bps. Today, the same spread keeps narrowing in the face of all the negative data. It is still above the 2bps pre-crisis, at approx. 31bps. With the chart below in mind (source: Bloomberg), I fail to see why investors should engage in an asset liquidation wave, realizing losses, seeking to preserve that which is currently not lacking. Unless again, exogenous, political, factors show up and break the status quo.
