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Wednesday September 30, 2009 - 21:55:23 GMT
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Forex Blog - Central Bankers are from Mars, Traders are from Venus

I am not so sure what follows really plays on the title above, but I liked it and thought it would be a cheap way to get more people to open the email and read what I think is going on in markets and at central banks.


I will save for another day an attempt to describe central bankers as self-perceived fully informed, rational, and scientific weighing machines whose only problem is traders who are emotional, drama machines, like immediate gratification and are predisposed against the scientific model.


But picking up on the Mars theme, the central bankers pontificating about an exit strategy from credit and quantitative easing as well as conventional easing is not unlike a discussion about what to do after landing on Mars as if getting there has been thoroughly nailed down and is a given.  Dare I say this is a little presumptuous?  It seems to me that central bankers would do themselves and the rest of us a service if they could pin down how the voyage to Mars will go and what to do when it (we) get there is the easy part.  And the record for central bankers in pinning down flight paths? 


There is currently a line of thinking that some very smart people are promoting (hybrid Mars-Venus types – former central bankers who now trade) that have declared policy and economic evolution as too uncertain to allow for any reasoned or obvious answers on what to do today, tomorrow and the day after tomorrow (though this group is quit good at explaining yesterday).  Mohammed el Arian in the FT this week took at stab at the complexity hypothesis – though he still managed to shoe-horn in a long long bond position (hmmm from a major bond fund manager). 


If anything, whenever a group of really smart people get together in something like the financial markets and we include monetary authorities in this instance, there is usually a tendency to turn the simple into the incomprehensible. 


How can we have equities up 40-60% from the March lows and bond yields the lowest since last July when they were near 40-year lows in May? 


It’s simple stupid.  Liquidity can lift all asset classes from one end of the risk spectrum to the other, especially when it approaches relative infinity and a near zero cost (negative cost in Sweden).  The credit creation machine that normally funnels high powered money to households and firms where it is spent and invested is not really functioning…it is at the margin but not to the extent that it supports private-economic expansion that can sustain full employment and price stability (as in no deflation).  Where liquidity is going is into the banking and shadow banking system (in case you did not get the memo the latter is alive and well) which is accumulating financial assets of all types (include commodities and currencies). 


All assets are likely to hold current values or rise more (funding currencies for carry trades are an exception) so long as central banks offer near free money to the banking system, encourage risk taking in this sector and regulators demand higher levels of capital – banks pledge iffy collateral with c banks and in return get cash to buy far less iffy assets.  This is a near license to print profits…it is not a license to print money as moronic gold bugs argue (if a central bank expands its balance sheet by a trillion dollars and the decline in asset prices saw 7 trillion dollars in wealth destroyed, the chances of one trillion in monetization unleashing inflation, never mind the output gap, is laughable). 


Central banks are comfortable pumping money into the banking system and indirectly asset prices so long as the feedback loop yields a positive wealth effect – as portfolios recover, people’s confidence recovers, and they act accordingly…spend more and invest more.  However Mars-like c bankers are, few seem confident that higher asset prices will translate into more private sector activity – the lifeblood of a sustainable recovery and the opening for exiting ultra accommodation.  In other words the path to Mars is highly uncertain, problematic and demands lots of attention from policy makers – I think another round of massive fiscal stimulus is a given. 


So what should we make of asset prices now?  They are highly distorted and reflect more low cost funding than prudent valuation calculations.  Applying normal trading assumptions to highly distorted asset markets is a ticket to disaster.  And you don’t need to be from Mars to know that the next big trade is when the buy-anything-not-nailed-down-trade ends.  The minute the central banks start to pull back the liquidity dole, it will be lights out for a wide range of assets…well they will find new levels based more on traditional valuation models rather than on a banking system smoking crack provided by your neighborhood central bank. 


Unfortunately for the risk reward contrarian type, the crack house is likely to stay open for a very long time.  Fed’s Warsh did not expose a rift over the timing of an exit from ultra accommodation, just one over the speed and scale (Lockhart and Kohn, former explicitly and latter implicitly, confirmed this today).    How does Warsh know ex ante what the speed and scale of rate hikes and reserve withdrawal will look like?  This assumes he knows what the real economy and price level will do once a “sustainable” recovery is in place and that he will know what a sustainable recovery looks like when he sees it.  Downright Martian.  And I doubt early rate hikes from the likes of Norway and Australia will provide micro sample of what is to come – they never really got anywhere close to ZIRP, quantitative or credit easing.   


If there is one issue that I am less sure about (my Venus talking), it is whether central bankers are aware of the Frankenstein market their desperation has delivered and are now inclined to lean into overshooting asset prices with verbal intervention.  So far the evidence is modest at best.  But it deserves watching.  The safety net for the high wire act (asset price overshoots) is arguably the real economy…and from my perch in the universe it looks more like Swiss cheese than something one would expect to find in a circus act.   Should we expect anything less when the main impulse for real economic activity is government spending? 


Lastly, I am starting to ask what inventory-led rise in Q3 output?  Inventory data continue to show draw downs.  Industrial orders are anything but convincing that firms are restocking.  Chicago PMI today (big hit on production) suggests any regional impact from cash for clunkers is minimal.  Wal-Mart’s CEO was downright depressing on retail sales heading into key year-end seasonal peak consumption.  Note too that Canada had a flat July GDP print today…Canada where banks did not morph into hedge funds on steroids and where households did not pawn the future to finance current consumption. 


I have no idea when the crack pipe will be taken away. If I had to guess it won’t be in 2010.  Until then the recovery is only as strong as asset prices and asset prices are likely to remain elevated as long as the cost of crack cocaine is near zero.


David Gilmore




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