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Major differences in economic viewpoints…

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economy4(Oct. 20, 2009 - Erwan Mahe) Aside from the major differences in the macroeconomic climate between China and its satellites and that of G5 nations, discussed often in these lines, the sharp differences in viewpoint on the dollar’s future and US interest rates has really come to the fore in recent months.

Such highly respected individuals as David Einhorn and Julian Robertson (Tiger) take such a pessimistic view on interest rate markets and have made investment bests that make us wonder if they consider that the world is truly coming to an end.

Mr Einhorn has thus bought gold, options on gold, gold stock, and even went to so far as to replace his ETFs indexed to gold with physical gold lingots in order to avoid excessive friction costs and neutralise counterparty risk.

He also set up a huge bet on rising interest rates on US government debt via long-term out-of-the money options.

Mr Robertson has invested in CMSs (Constant Maturity Swaps), essentially long-term puts on bonds. He believes that rates could rise by 15% to 20%!

This type of positioning is mainly driven by fear that the Fed will excessively monetise US government debt, which would diminish its credibility and undermine the US currency and bond prices.

Given this sort of fretting, Barron’s issued an article this weekend (C’mon, Ben !) urging the FED to hike its benchmark rates as soon as possible to 2% and to reduce its QE in order to protect savers who no longer earn anything on the yield-bearing deposit accounts and lower stock market indices (precisely where these savers are now invested!) which have developed a bubble. I will leave it to readers to judge the logic of their argument...

In the meantime, signs of deflation continue to mount in the United States (and other G5 nations).


  • Credit continues to contract, with banks preferring, for reasons of risk control and regulation (Bale 2), to invest in government debt with strong carry than to lend to the economy:
  • American SMBs, which are unable to access directly markets via the issuance of corporate bonds, are experiencing a rapid meltdown in their cash positions.

These companies have historically been the main job generators in the US and, for the time being, they are also the ones who have least used the tool of job layoffs to protect profits. In this context of declining prices and volumes, and inaccessible financing, they will also have to cut their payrolls, which will have a recessive/deflationist impact on aggregates.

Check out, below, the changes in commercial and industrial loans since 2004. The graph speaks for itself.

Note the peak at year-end 2008, resulting from the emergency draws on existing credit lines with banks.




  • Problems in the debt renegotiation plan of CIT, the leading lender to SMBs in the US, are hardly helping matters.
  • We a similar trend in loans to households. Personal credit cards have thus declined from 425m in 2008 to 344m this year.

Mortgage interest rates are still at around 5% only because the Fed dried up the market with its MBS purchase programme. So what will happen if it does not prolong its QE at the end of Q1 2010?

  • Banks thus prefer carry positions, which is logical in today’s context of a steep yield curve (Fed Funds at 0.15%, 10-year Tnotes at 3.50%), since it allows them to reconstitute their capital by accumulating reserves over time.

This situation is valid both for the US and Europe which faces the same regulatory constraints and the same recapitalisation process.

This implies that, since these banks’ balance sheets are hardly in good shape, the concerned central banks have their hands tied for a few more years in terms of short-term interest rates. If they were to hike them, they could send the carry-heavy banks reeling.

  • This is especially true now, as a wave of CMBS defaults (Commercial Mortgage Backed Securities) begins to take form. Check out the behaviour of the concerned prices in the graph, below.



  • The savings ratio of US households, which has declined in recent months as a result of the stimulus programmes in the auto and real estate sectors, will climb anew, as the Obama administration has quietly taken new measures taken to encourage savings, as indicated in the New York Times article: US Savings Bind.

President Obama announced two key measures in this regard:

  • Employees will be able to receive their tax refund in the form of US savings bonds instead of cash, which will slow consumption but will slowly shift the burden of federal debt to US households from foreign investors.
  • Another plan will promote automatic enrolment in retirement funds for workers at medium and small firms so that employees will have to opt out of saving, rather than opt in, as is the current practice.

While this drive to hike savings is needed to bring more balance to the current accounts balance, the domestic impact will naturally be deflationist.

  • In Europe, the same credit contraction process is continuing:
  • Mr Smash declared this morning that the growth rate of bank lending to the economy should not pick up before 2010, and that banks must focus on recapitalisation, because the special support measures taken by central banks will not last forever.
  • The president of the German business executives association said this morning that if “banks do not relax their lending terms, a fatal credit crunch will develop, leading to unnecessary bankruptcies and a hike in unemployment”.
  • Same causes, same effects in Japan, where the “lost decade” is entering its third decade:
  • BoJ boss Hirakata warns that the purpose of the central bank remains to monitor risks of economic contraction and price declines”.
  • This caution is understandable, once we examine this morning’s statistics on the large department store sales in Tokyo!

This new decline in September comes to 10.5% on an annual basis. The graph, below, illustrates perfectly the results of the combined decline in unit prices and volumes sold (deflationist spiral).

Given an average decline (red line) of 2.85% per annum, these sales have contracted 42.50% since 1991 !


· Only China continues to show of buoyancy, but with the continued dangerous allocation of resources:

- Residential real estate sales surged 74% on an annual basis in September, which shows the growing credit market bubble in the Middle Kingdom since the beginning of the year.

-     But today, the National Development and Reform Commission (NDRC) published a declaration, signed by 10 ministers, the Pock and the CBRC, prohibiting banks from lending funds to sectors considered to be in overcapacity (steel, cement, flat glass, coal chemicals, polysilicon and wind power equipment,).

This missive forbids businesses in the above-mentioned sectors from obtaining financing on the bond market or by issuing shares.

Asset inflation caused by a surplus in credit, production price deflation caused by overcapacities -- > the classic schema continues …

PS: With respect to the so-called turnaround in world trade, which so many of our Asian contact have spoken to me about, the situation on the West Coast gives a different picture: Imports dive at ports of Los Angeles and Long Beach.

Investment focus:

· positive bias toward government debt instruments, especially, on the eurozone 5-10 year segment, which benefits from the ECB's credibility;

· on stock markets, we prefer limiting hedging operations to small deltas, to theta and to minimum credit.

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