A View from the Trenches

Voila! Yesterday equity markets in North America rallied about 3% on average, in the face of high unemployment, a Fed that acknowledges weakness and a market that speculates on upsized purchases (by the Fed), the possible bailout of CIT (at closing, trading on this company had been halted and seems to be heading to bankruptcy) and weak economic data. The rally pushed credit spreads tighter (CDX IG reached 131bps) and of course, triggered the sell-off in Treasuries. Mortgage convexity hedging needs did the usual amplification of the move.

In the land of foreign exchange, the Canadian dollar caught again the winds that seem to push it to parity with the USD. I didn’t feel however, that things are going back to normal, where the Fed pumps liquidity to decrease rates, investors reallocate funds from Treasuries to equities and commodities, and money flows out of the US to safer and more promising bays. The first thing I noticed this morning was that the usual bond issuers of the last two weeks (sovereigns, financials and utilities) were replaced by issuers of other sectors (i.e. gaming), perhaps a coincidence or a conscious decision to take advantage of whichever window of opportunity the market leaves open. Back again to our commentary of June 3rd, where we laid out the investment thesis for these recent weeks (www.sibileau.com/martin/2009/06/03 ) : “…I think that the issuances that we see today, the capital raising initiatives, the maturity swapping we are witnessing are exactly about that: Inventory growth. Why? Because we don’t know what prices will look like tomorrow. Could some firms be buying inventory (liquidity) at a high cost? Absolutely…” Companies are building “stocks of liquidity”. We will see “more cash and less cash flow”, as an analyst recently described the situation.

En fin, one has the feeling that change is breeding since Tuesday. It is not a clean change. It’s full of confusion, anxiety, fear. But it is very healthy. We are discussing how to defuse the next big bomb out there: The municipal and state deficits in the USA. Even another more surprising change is the tone of the debate in monetary policy. For instance, Morgan Stanley’s Global Economics Team put out a note yesterday, suggesting that central banks should switch the policy goal from inflation targeting to price level targeting. As useless as it seems to me, the relevant lesson here is that things maybe changing and changing fast. And that, I believe is healthy.
The municipal and state deficits, to me, are adding pressure to Treasuries and constitute a fundamental underground force behind the late weakness in the USD. The prospect that the Federal government may step in and increase the overwhelming supply of coupons so far this year, creates great concern. Perhaps one bit of good news today was to read that China is continuing to build its USD denominated reserves, which now amount to $2 trillion. This build up in reserves is hugely inflationary and simultaneously supportive of commodities. Year to date, apparently (one can never be too sure about these figures) M2 in China is up 28%!

Meanwhile, what is our beloved Canada doing to take advantage of this excellent opportunity? Nothing, if one excludes the new visa requirement on citizens of one of the countries we have the most important free trade agreements with. We may not need to do anything. After all, the Canada Mortgage and Housing Corp. yesterday offered to buy up to C$4Bn in mortgages to facilitate balance sheet rotation for the country’s big banks, and these barely took more than C$2Bn.

Implementing policies to increase our productivity is critical for a good outcome in this crisis. And the moment is now! As Keynes put it: “…if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…” (The General Theory of Employment, Interest and Money, Ch. 13). If we want to avoid stagnation with inflation when the liquidity being injected today finds its way through the system tomorrow, we need to undertake enormous reforms to make our nation more competitive, more efficient. This letter is not the place to discuss this issue, but I can safely say that hostility with trading partners is certainly not the smart way to go!