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No let up in debt deflation!

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economy2(Oct. 2, 2009 - Erwan Mahe) I know very well that some are tired of hearing about this issue, but I feel a need to return to it at a time when officials persist in circulating apocalyptic forecasts of a resurge in hyperinflation, based on the explosive growth in government debt and in central bank balance sheets, along with the super easy monetary policies.

As such, I would like to cite Cleveland Fed President Sandra Pianalto, whose background in economic enables her to gauge the changes in the economic situation with a certain distance.

Like many of her colleagues on the Fed board, she figures that the return of growth in the US may be much weaker than certain fans of a V-shaped recovery would like to believe, particularly in terms of inflation.

As she said last night:

“Despite all of the varying opinions about the relative significance of slack in the economy and its effects on inflation, I do see tangible evidence suggesting that inflation will remain subdued. Wage pressures are being held down in this environment. In recent productivity reports, unit labor costs have slipped into negative territory, and the employment cost index has steadily declined since the recession began.

Also, economists at the Federal Reserve Bank of Cleveland have provided me with two particular pieces of research that have helped to guide my inflation perspective.

One of my economists, along with his colleague at the Federal Reserve Bank of Atlanta, has been examining the detailed price data by splitting the consumer market basket in the CPI according to whether the prices for goods and services are sticky or flexible. Sticky prices, such as the cost of food in restaurants or haircuts don’t change very often. But flexible prices, such as the cost of food at grocery stores or the price of used cars tend to jump around a lot. Sticky-price goods and services appear to be a particularly informative measure of underlying inflation trends because they predict future inflation rates more reliably than flexible-price goods and services.

This analysis shows that the inflation rate of sticky-price goods and services has shifted sharply lower this year. This trend points to suppressed inflation rates for the next few quarters.

The second piece of research is a model of inflation expectations that does not rely on Treasury Inflation-Protected Securities, or TIPS, to estimate inflation expectations. Instead, this model estimates expected inflation using a combination of inflation data, nominal bond rates, survey measures of inflation expectations, and inflation swaps.

This model shows inflation expectations holding steady over the two- to ten-year range.

This analysis enables us to understand why certain central bank officials are regularly sent to the front that they are independent institutions, that they will never monetize the debt and that they are already preparing exit plans!

They are making these plans, not because they are worried about a resurgence in inflation but because they want to influence inflationary anticipation, which play a role, as many studies have demonstrated, in the development of inflation.

Above all, let's not forget one fundamental, so often forgotten by "classic" observers:
We are experiencing the post-securitisation recession in the history of mankind.

This means that the impact that impact that the "death of securitisation" had on money circulation is incomparable to what we have experienced in previous recessions!
This phenomenon, which goes to the core of the debt deflation we have been monitoring so closely, has just provided us two striking new examples.

In Japan, the new Ministers of Financial Services, Mr Shizuka Kamei, has told his inspection agency to authorise banks to provision "lightly the loans they have granted to small and medium sized businesses so as to avoid pushing them into bankruptcy:

Japan may consider easing its classification of bad loans in a bid to aid struggling smaller companies

“The Financial Services Agency's financial inspections should aim at turning around struggling corporate borrowers instead of leading them to go bankrupt,"

The other example is the case of CIT, the US lender to SMBs, about which I have kept you informed in recent days via IB Bloom.

After receiving a $2.3bn injection in government funds a year ago and then being saved from bankruptcy by a private loan of $3bn, this firm faced an 1 October restructuring deadline.

Considered as non-systemic risk by the government, it must reach an agreement with its creditors ($30bn) to negotiate a solution to its debt ($30bn) and proceed to a debt-to-equity swap, which would wipe out existing shareholders.

The resolution of this problem is crucial, since if the firm declares Chapter 11, it would be the fifth biggest bankruptcy in the history of the United States, behind Lehman, Wau, Worldcom and GM.

However, the CDS issue has raised its ugly head once again in this case.

With respect CIT’s $30bn in debt, there exists over $50bn in CDSs, of which more than $3.3bn in net exposure.

This means that more than 10% of CIT’s bondholders have every reason to push it to file Chapter 11, since such a scenario would mean that they would be 100% paid on their debt!

This phenomenon, which we have often examined in other cases of failed restructuring efforts since last year, renders the debt deflation process even more virulent than it need be …

In such a context, we prefer to maintain our asset allocation biases:

- Favourable to fixed interest rate instruments, with a now more favourable bias to the 5-10 year range.

- On stock markets, we have returned to a negative bias after hitting our target range of 2850-2900 on the Eurostoxx, with, for example, the October put ladders. We did not advise an overly aggressive hedge strategy because the fact that indices rebound after each plunge highlights the persistent desire to invest of laggards frustrated by 0% interest rates.

A good weekend to all!

Erwan Mahe



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