A View from the Trenches, August 12th, 2010: "The rules of the game have changed"
Please, click here to read this article in pdf format: august-12-2010
In our last comments, (ref: www.sibileau.com/martin/2010/08/10), we suggested that the relationship between the cost of liquidity in the Euro and USD currency zones and the Euro was breaking and signaling a reversal, together with the widening of Euro sovereign spreads. The mystery was disclosed on Tuesday by the Fed and with it, the whole macro backdrop has changed, rather violently.
The thesis we suggested last Thursday (www.sibileau.com/martin/2010/08/05 ) is totally outdated. The rules of the game have changed dramatically and, in our opinion, for the worse. The Fed’s announcement, explicitly saying that they will target the size of their balance sheet, surprised us, deceived us. Simply, the Fed decided that instead of allowing its balance sheet to shrink, as the mortgage backed securities and agency debt it holds are repaid, it will reinvest those amounts (which are not minor, estimated at $200BNover the next 12 months) back into the Treasuries market. We understand it will target purchases in the 2-7yrs range, which caused the 10-30yr to steepen sharply in the last two sessions. The spread between costs of liquidity in the Euro and USD currency zones, discussed a week ago, continued to widen also for this same reason, but the sensitivity of risk assets to it reversed. Another thing to keep in mind: If the Fed purchases Treasuries directly from the Treasury, it will not only be keeping the size of liquidity available in the system steady but also, it will be monetizing fiscal deficits. The street is watching…
One of the first rules any student of Economics learns is that if a monopoly controls quantities, it cannot control prices and vice versa, if it controls prices, it cannot control quantities. Until Tuesday, the Fed was targeting the price of its liabilities. It was concerned with the so called general price level. Since Tuesday, it is concerned with their quantity. Yes, we are aware that this is consistent with Keynes’ idea, which we have so often quoted here, 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…” (Chapter 13th, “General Theory”)
Output and asset prices have indeed increased since 2009 and the Fed’s effort is exactly directed towards maintaining a given rate of interest. The problem of this perspective is that it is not dynamic. Once the market has incorporated that monetary growth in its expectations, it will demand that growth to remain in place. It’s plain addiction.
On the other hand, we disagree with the popular view that there will be no growth in the supply of money. We think there is in the sense that instead of having a Fed’s balance sheet that shrinks, we have a constant one. To illustrate our point, let:
Mt = Money supply at time t, measured in months
b= Average mortgage-backed securities and agency debt paydowns, per month
Therefore, before Tuesday, we had: (1) Mt = Mt-1 – b* t,
which meant that the money supply on month t equaled that of the previous month, less proceeds from average paydowns that the Fed withdrew from circulation.
Since Tuesday, we have : (2) Mt = Mt-1 , which means that the money supply on month t will equal that of the previous month. Money supply remains constant.
If we take the difference between (2) and (1), that is to say, if we see what has occurred since Tuesday on the margin, we will see that: (2) – (1) = Mt-1 – [Mt-1 – b* t] = (b * t), where (b * t) >0.
Therefore, we think that there is growth now vs. before, which brings us to the next question: why did the market sell off today?
We see the sell off as the market’s way of forcing the hand of the Fed. As we wrote before, the street knows that until asset prices fall more, the Fed will not engage in active quantitative easing. The rational thing to do therefore is to sell before everyone else does so. If you notice smoke in a room and hear the firemen approaching…why wait? Why not rush to the exits before they get clogged?
From now on, we will need to get to that critical level. Is it a S&P500 at 850pts? Who knows…But once we reach that level, we will have lower activity or a lower amount of goods being produced, but being chased by a market with a higher amount of fiat currency. In other words, we will have stagflation.
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