A View from the Trenches

Martin Sibileau's market letter

A View from theTrenches, August 31st, 2009: What keeps the rally going?

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Back from a brief vacation, a week later, I sit here trying to summarize what happened last week, and what may continue to happen…On August 4th (www.sibileau.com/martin/2009/08/04 ), I had updated my forecast and said that equities could reach higher levels, from the stagnant range they were in July. I reaffirmed this view on August 18th (www.sibileau.com/martin/2009/08/18 ) and do so once more today. Of course, in credit land, the tightening may continue, following the rally in equities. (I’m sorry; I should not call it a rally, but asset inflation).  What drives this trend?
1.-Liquidity
For a hundredth time, I show below (source: Bloomberg) the chart with the 3-month Libor –Overnight Index swap spread. It is still making lower lows, with a close of 16.75bps last Friday. How much lower can it go? Before this mess unfolded, it was stable at 10bps, suggesting that it still has some room to tighten.

aug-31-2009

We are not watching this spread alone. Last week, Michael Cloherty (Bank of America) pointed out that Libor may not be a reliable metric lately, given the wide range in offered rates (3-mo Libor was 34.75bps on Friday and Mr. Cloherty estimated the range at 18bps, which is significant vis-à-vis 34.75bps). Why do I bring this up? Because I was exactly expecting this sort of cautionary comment. The answer to this is that the absolute level does not count. What matters is the relative level, the trend. We should not care about the exactitude of a spread at 16bps. That’s not the story. The story is that this spread was above 100bps in March and is now at 16.75bps. Liquidity is out there chasing risk, and as long as we see this indicator, we may see the bid for risk continuing.
2. - Global Coordination in monetary policies
By now, it should be pretty clear that global coordination has been the stability factor in this crisis. As we said countless times, global coordination is what makes this crisis different from any other one in the past and it is the factor that has made this rally stable. In summary, liquidity fueled the rally and global coordination provided the stability for the rally not to be killed by the bears. It was on July 27th, a month ago; when we explicitly suggested this thesis (Implicitly, we suggested it on April 21st, when we said that all currencies are being debased in calculated order, denying gold the chance of playing a lucrative asset). A month ago, we said central banks can thwart any rebellion. This is what we saw two weeks ago happen in China and last week in Canada. In China, the Renmimbi is being “driven” to appreciate, with the central bank restricting liquidity growth and changing the composition of its assets both by asset class and maturity, while in Canada, the Federal Government plans to sell USD bonds, to boost foreign-exchange reserves and support lending by the International Monetary Fund. That is at least the official excuse. The most idiotic ground to justify this bail out on the USD was that Canada needed to diversify its sources of funding! What nonsense is that? We have capital flowing in spite of all the latest horrible fiscal policy and we even have the luxury of issuing bonds in our own currency, yet our government decides to ask investors to buy USD if they want to go long Canada risk? This is a perfect example of my point that we are going to see global coordination to a degree never seen before, and any rebellion will be dealt with swiftly.
When will the rally stop? The rally will stop if and when, having a fiscal problem erupted within one (important) country, the rest of the coordinating countries (also important) refuse or are unable to lend a hand. If that happens, the price of gold would jump, destroying any currency’s chance to be a reserve asset.

Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

Posted: Sun, Aug 30 2009 10:04 PM by Martin Sibileau | with 4 comment(s)

Comments

Jonathan M. F. Catalán said:

I've been following your blog posts for quite a while.  I have a friend who received a fairly large inheritance from his deceased father.  He put an undisclosed (I don't know the amount; although, I know that it's relatively large) amount of money in the stockmarket, and of course he has made a large sum of it back.  He is not an Austrian, so he does not share my opinions on inflation and the business cycle, but he does listen to me (he is also a graduate in economics and mathematics).

I'm afraid that he may lose a lot of the money he has invested.  What would you suggest me to tell him?  I'm aware that this might come off as a stupid question. :P

# August 31, 2009 12:22 AM

Martin Sibileau said:

Markets are absolutely driven by political economy, through incremental government intervention. This creates volatility that is not related to the general productivity of economies, but to the vicisitudes of politicians. Along the same line, liquidity is totally dependent on central banks' intervention. Therefore, investments should be placed on highly liquid instruments, to be able to exit as soon as things (political) go bad. As you might have read from my blogs, I am constructive of the markets, at least in the short term, as the non-neutral effect of money expansion (an Austrian concept), has not fully unfolded. Therefore, long index investing, both in credit and equities, should make sense. I don't like commodities, particularly gold, and do not feel there is a good rationale for sovereign risk (i.e. Treasuries).

# August 31, 2009 12:13 PM

Bogart said:

As long as the government/central bank continues to give money away and mess with pricing system of future purchases, then there will be booms and busts in the financial markets as investors, capital seekers and speculators get incorrect signals about the value of future production.  

What is really bad about this is that the clowns running the central bank really believe that by giving capital seekers an incentive to engage in longer term project that this is good for the economy.

# August 31, 2009 8:29 PM

Martin Sibileau said:

Bogart, I agree with you. However, something entirely new is happening these days, something that not even Ludwig Von Mises in his "Human Action" ever imagined: Central banks are coordinating their money supply rates. I am shortly going to fully elaborate on this. For the time being, think of the Walrasian method. If you're familiar with it, you will know that it is an undetermined system, with relative prices only and without a medium of exchange. Although as Mises well pointed it out, this method is flawed, it fits very well the foreign exchange markets (cross rates), where exchange rates are only determined in relative terms. If central banks get away with leaving the system UNDETERMINED, they will avoid a financial collapse. To leave the system undertermined, they need to exterminate any chance of a common denominator (for instance, the price of gold) out of the equation, which implies that they need to succeed in subsidizing their respective fiscal deficits. This is what Canada and China are doing for the US, for instance. And this is what France did not for England, in the 1930's.

# August 31, 2009 8:56 PM