A View from the Trenches, October 4th, 2010: "Back to the obvious"
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It’s Friday, October 1st. We’ve had a very busy week dealing with loan refinancings and as we go for a late afternoon walk in downtown Toronto, we wonder what we will write on our next letter. Everything we can write about is obvious and we have written about it in the past. We ask our friend André for his opinion. His answer is quick and short: “Then write the obvious!”
Today, therefore, we will write the obvious. In fact, we have already written about it too. In our first (public) letter, on April 14th, we presented this graph:
This graph corresponded to the beginnings of what is now called Quantitative Easing 1, which assumes we are about to embark on Quantitative Easing 2. As you can see, the Fed was filling the bucket of treasuries, mortgages and commercial paper. Now, it will only be filling that of treasuries, as mortgages are being paid down. (We will have to write more about this in our next letter)
Back then, we wrote (see: “Remembering Haberler”, April 14th, 2009, at www.sibileau.com/martin/2009/04/19 ):
“…We will keep reading the bearish comments from those who see a bear market rally in stocks, as they single out all the horrifying figures of the real estate, labour, retail, etc. markets. There is nothing wrong with those figures, but this is not a bear market rally. It’s just the “relative” inflation Gottfried Haberler wrote about 77 years ago. Now, some people recognize inflation only by stage 5 above, when liquidity reaches consumption goods (They are the same who then tell you we consume too much and don’t save enough!). In conclusion, as long as the Fed and all the other central banks keep flooding buckets with liquidity and feed us with daily announcements, we can see prices NOT falling. Looking at the picture above, do you think that by stage 5, an exit strategy by the Fed will be effective? Why…?”
Today, 18 months later, this seems obvious. It wasn’t then. In fact, we were writing in answer to the bearish comments Mr. David Rosenberg was making, which we thought were wrong. But we refrained ourselves from mentioning the explicit allusion (refer: Bank of America’s Economic Commentary, April 3rd, 2009: “Recession ebbing? Someone forgot to tell the labor market”, by David Rosenberg”).
Eighteen months later, looking at stage 5, in the above graph, and knowing the current levels of interest rates and the stagnation we are in, which was caused by the distortion in relative prices triggered by central banks, it is clear that there will not be an exit strategy. Therefore, we need to return to comments made on March 18th, of this year (see: “The winter of our dynamic inflation” March 18th, 2010, at: www.sibileau.com/martin/2010/03/18 )
“…let us add that although most agree that credit is already too tight and can still become tighter, default expectations have not necessarily decreased, particularly in High Yield. Finally, fundamentals are signaling a stronger than expected recovery in the US, Canada and Europe.
Is this all the lagged consequence of the earlier quantitative easing policies? Certainly, but why should we care?
In our view, the latest action in the markets proves that they are dependent on a given rate of money supply. This is a difficult concept to grasp in the developed world, for it is the base upon which the dynamic theory of inflation was developed. A rate of money supply is a dynamic concept, and we are used to think in “comparative static” terms. The dynamic approach to inflation evolved during the ‘60s, mostly under the so-called “heterodox” line of economists. …(…)
Basically, this line of analysis sustains that agents in the market “get used” to a rate of money supply, which they incorporate in their expectations. For instance, if you have the Fed buying, say, $10BN of mortgages/week, the respective market incorporates this liquidity metric and invests accordingly. It is a “sticky” expectation and the problem with it is that policy makers begin to interpret that the problem is with the markets, in that they expect “irrationally”. More so, when an exit strategy like that of the Fed is being widely publicized. But this interpretation is incorrect, because it ignores the non-neutrality of the rate of money supply.
Regardless of expectations, the intervention of central banks in the rates markets has a real impact that distorts relative prices. In our present case, the intervention has been steady and consistent, and we have become too comfortable with it.
Think about it for a moment. Think about the message the markets are sending: “Don’t worry about the upcoming supply of public debt, because there will be demand for it”…But, what is supporting that demand? Low-yield investment alternatives and a sea of liquidity. Where does that liquidity come from? From the Fed’s purchases of public debt…”
There you are! We’ve reiterated the obvious, which might have not been so obvious to everyone so many months ago. The market has indeed got used to a certain rate in the supply of money. In fact, it bases all its investment decisions on that rate, with analysts updating on a weekly basis net debt supply of Treasuries vs. demand by central banks, vs. net debt supply of corporate issuances, to calculate movements in spreads. This is not new, of course, but it had never been so critical or even worse: So easy to calculate and understand.
Without an rise in productivity, prices are left to the operations of central banks. And there cannot be a rise in productivity because there are no investments. But there are no investments because the future is uncertain, even institutionally: We don’t know what our fiat currencies are going to be worth say, in five years, !!! Even the operations of central banks are not coordinated. A protectionist currency war is in full display before us, as the Bank of Japan and the Fed went on their own.
The thesis for gold has never been so clear to us. We intuit there might be a temporary pullback if the Republicans decisively win in the upcoming election, as the market wrongly interprets that win as a sign of future fiscal austerity. It would be wrong to conclude that, because the Tea Party “sect” within Republicans is still weak, in our view, and President Obama would still remain in power.
Martin Sibileau
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