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The problems are above all political!

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politics August, 2011 (Erwan Mahe)

The Fed's decision

To start off, I would just like to make a point about the Fed's announcement yesterday evening that it would keep short-term interest rates at 0% to 0.25% until, at least, June 2013.

While it is very risky to give a prognosis of events in the current situation, but, with the Liquidity Trap and O% Lower Bound constituting a constant thread in their Thaler's Corner texts since mid-2007, I can resist the temptation of reprinting an extract from last Wednesday's Thaler's on this subject:

“Thaler's Corner 03-08/11: Patience and time length--> A Very Very ‘extended period of time?

"The Fed will have a very hard time trying to justify a new quantitative easing, given the harsh reaction to QE2, both from trading partners in the process of manipulating their own currency (which really takes the cake!) and aficionados a certain shiny yellow metal who dream of the Fed's demise…"

"In contrast, it could make use of the power of language, as it did so successfully during the outbreak of the crisis, to keep short-term interest rates at 0 for longer than those who have been warning against a Liquidity Trap (ourselves) could have imagined.

If the Fed were to make such a move to keep short-term interest rates at rock bottom for several years, the market would initially react via a tremendous surge in long-term interest rate market volatility. Afterwards, these rates, whose behaviour in reality stems from expectations of short-term rates adjusted for carry costs on the period, would pluck us firmly into a Japanese-style scenario."

It is now time to move to the next stage, the probable asset reaction to this decision.

I reiterate my view of the likelihood of a Japanese style scenario for long-term interest rates. Unlike the continued assertions of so many neo-classical "experts", long-term interest rate levels do not depend on growth and inflation expectations, + 1 investment risk premium. And even less on the rating of this debt by credit rating agencies, at least in the case of a country with its own currency in which its debt is denominated.

In reality, rate levels depend solely on the expected behaviour of short-term rates on the asset's carry period!

The behaviour of the yield curve on Japanese debt for the past 20 years however should have led "money supply" supporters to go back to their theoretical drawing board, particularly in the case of ZIRP and a massive output gap.

In contrast, one thing is for sure, and that is that the influence of these mainstream "thinkers" (mainstream, as in the WSJ and other journals) remains sufficiently strong that many people are worried about the risk of an immoderate inflationary hike. As such, they are betting on a hike in long-term interest rates. We may therefore see periodic steepening surges, given the persistent volatility.

The political problems

In the United States, S&P's downgrade of US federal government debt did not stem from default risk in the classic sense of the term, i.e. a government lacking the financial resources to meet its debt payments sometime in the future. The absurdity of this notion was exemplified by the simultaneous downgrade of the Federal Reserve System, which issues the very own currency in which its liabilities are denominated! Here's how Allan Greenspan reacted to their "logic":

"The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default".

It is amusing to observe one of the strongest defenders of pure monetarism rediscover the joys of Modern Money Theory when confronted with the even harder reality of economic events.

It would really put the cherry on our cake if Niall Ferguson were to recognise that his predictions of a surge in long-term interest rates in the wake of the Fed's QEs were, to be put kindly, off the mark. It is too bad, because I really liked his book, The Pity of War. In his defense, when you are historian specialising in periods of hyperinflation, like Snow White, you tend to see dwarves everywhere.

On a more serious note, the downgrade in US debt did not stem from the  S&Pitiful sight presented by congressional leaders in recent weeks. The Republicans' refusal to approve a hike in the debt ceiling and to hold the entire world hostage to the threat of debt payment default is one of the sorriest spectacles to ever come out of Washington! But this horrendous action appears to be only the symptom of the root problem, which is the GOP's infiltration by the Tea Party's Mellonesque and economical illiterate views. Remember, it is Congress itself that had approved this budget in the first place!

In Europe, although divided and unhappy, the ECB finally decided to take over the relay from governments by purchasing Spanish and Italian government debt on secondary markets.

Increasingly "original" scenarios of the eurozone's implosion continue to circulate, thus adding to the prevailing stress and sending financial shares to the mat, with losses of between 6% and 10% on the market today!

Whenever a German political leader opens his mouth it is to announce bad news, like this morning's statement that they were opposed to any increase in the EFSF's resources, although such a move is essential for the medium-term stabilisation of financial markets!

And despite the unsustainable level of youth unemployment in so many European countries (riots in England), governments are continuing their austerity drive, instead of investing massively in education and training!

In terms of the planet, how much longer will it take for developed countries to require that our trading partners, mainly China, comply with WTO rules?

After all, it does not seem to be realistic to impose specific tariffs, despite the rampant de-industrialisation caused by their their unfair and anti-competitive practices. That said, it is precisely the weapon used by the Fed more and more effectively.

It is the quintessential advantage of a nation boasting its own (fiat) currency and with debt denominated in that same currency to impose negative real interest rates on the recycling of their trade surplus money.

It is just too bad that Europe refuses to use the same weapons at its disposal, as it leaves the euro overvalued by 10% to 15% against the dollar and even more against Asian currencies.

As long as political leaders, as opposed to economic authorities (at least central bankers are trying, with more or less success, to do their job), are unable to present a clear and realistic view of the choices confronting us, we fear a new series of crises, punctuated with governmental commissions and half-baked comments, which augurs nothing good for risky assets, such as equities.

Unfortunately, I fear that we not far from the beginning of a painful Japanese-style liquidity trap for equity markets.

Have a good day!

Asset allocation biases and advised option positions

Notice: Due to the high market volatility, we change these positions frequently, as it is important to be abel to react quickly to any game changer.

Feel free to contact me at any time!

Negative on Eurostoxx

Everything changes every day, with fluctuations of 7% in a day, but the negative biases remain valid.

Neutral to bullish on the Bund

Everything changes every day, with fluctuations of 7% in a day, but the neutral to positive biases remain valid.

Have a good day

Erwan Mahé - Asset allocation and option strategy

22, rue des Capucines - 75002 Paris

TEL: + 33 1 53 05 57 20  



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