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Some Great Reading

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book_1(Sept. 10, 2009 - Thaler's Corner) Given the dearth of new statistics published today, I would like to suggest two texts, which I am sure readers will find highly instructive in the current situation.

The first, which makes for quick reading, is the speech by Charles L. Evans, President of the Chicago Fed, entitled, The Great Inflation 2.0 Debate, delivered yesterday before the Council on Foreign Relations in New York.

He neatly sums up the acrimonious debate in recent months between the proponents of (hyper) inflation, (Allan Meltzer, Carnegie Mellon University, podcast) who are terrified by the doubling in the size of the Fed’s balance sheet, and those who instead fear a “deflationist trap”, due to the record growth in the output gap (Paul Krugman, ‘The Power of D’, NY Times, 7 September 2009).

 

The second text, “No One Saw This Coming: Understanding Financial Crisis Through Accounting Models » (MPRA, 16 June 2009), is a bit longer, but it is really worth taking an hour this weekend to read it, since it will give you a better perspective on the turbulent “philosophical” battles being carried out between the various macroeconomic schools of thinking.

Above all, the text will help you understand why the theoretical and mathematical tools used by central banks and the major international institutions completely missed the nature of the 2008 crisis.

That is perhaps the only valid excuse the ECB has for making its historic error of July 2008.

In his text, Dutch academic, Dirk J. Bezemer, explained the major differences between the neoclassic school, which assumes that economic agents behave rationally, and the post-Keynesian school, which instead concentrates on credit flows and their implications on the balance sheets of these same agents, inspired, in my opinion, by the incisive writings of Hyman Minsky.

Before we go further, I would still like to comment on the figures published yesterday evening in Japan, which are consistent with the recent difficulties in the land of the rising sun.

Machine tools orders contracted 9.3% for July, following the 9.7% rebound (“green shoot”) in June, vs expectations of -3.5%, bringing the y-o-y contraction to 34.8%.

The prices of goods exchanged between businesses fell 8.5% y-o-y, a record low. Although this indicator should pick up, we have just gone by the peak base effect from commodity prices, which confirms the severity of the Japanese deflationist trap.

You will also see in this article in the FT, Cost-conscious consumers in Japan break with tradition, how the household consumption sector is affected by this phenomenon and its lessons for the probable evolution of Western consumption patterns in the coming years.

As for Europe, check out three little sentences by Buba chief Weber :

  • “All in all, inflation fears, understandable as they may be, are unfounded.”
  • “It’s too early” to withdraw the monetary stimulus
  • “The ECB will probably reduce the number of its long-term refinancing operations; it’s unlikely to reduce them to pre- crisis levels.”

This adds ample balm to our bias in favour of fixed interest rate instruments, because it implies that the ECB may extend the LTRO (long Refis) next year, which is absolutely not included in the prices of the directly related financial instruments.

Since our favourite part of the yield curve did particularly well in recent months (1-4 year), the main question now is we should consider moving to the longer part of the slope.

Our feeling is that above the 220 bp spread with 2-years, the 10-year bund begins to be sufficiently attractive in relative value.

We still have the same opinion for stock markets. We have considered it prudent to avoid participating in the recent rally, since the risk/profitability ratio does not look all that sexy.
We saw yesterday, for the first time in several weeks, new flows of calls’ selling on the Eurostoxx index by investors long on indices.

 

Erwan Mahé

Asset allocation and option strategy

22, rue des Capucines
75002 Paris

TEL : + 33 1 53 05 57 20

FAX : +33 1 53 29 35 28

 



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