Alexandre Kateb's  Instablog

This week will be busy for market analysts with four major central banks' holding their scheduled monetary policy meetings : the Reserve Bank of Australia on Tuesday, the Federal Reserve on Wednesday, and last but not least, the Bank of England and the European Central Bank on Thursday.

The RBA stands predictably ahead of the pack 

The Reserve Bank of Australia is likely to be the only one among these four central banks to raise its interest rate target up by 25 bp to 3.50, following a first hike of 25 bp one month ago. 

This is widely expected and should not have per se a major impact on markets although it can modestly boost the Aussie dollar which has embarked on an appreciation trend against the other major G10 currencies. What will be more market moving for the Aussie and more generally for the FX market is the release of RBA's quarterly monetary statement on Friday. This is likely to shed more light on the RBA's monetary policy strategy for the coming months and put in perspective the string of favorable macro news that signal a stronger than expected economic recovery (together with rapidly building inflationary pressures) in the land down under. 

The FED : the dilemma of excess reserves

The FOMC meeting on Wednesday will be followed with closer attention by market participants all over the world as it could help clarify the exit strategy of the monetary authorities in the world's largest economy. 

Again, this time around there should be no shift in the FED's interest rate strategy. The FOMC is likely to repeat it commitment to maintain "exceptionally low levels of the federal funds rate for an extended period". In addition, the FED has clearly signified last month that it will carry over its long term assets purchase program of a total of $1.25 trillion of agency mortgage-backed securities and $200 billion of agency debt by the end of the first quarter of 2010. Nothings warrants a change in the tonality of this message. 

However, what will be more interesting, and what only the minutes of the upcoming meeting could indicate is the extent to which the discussion among the FOMC members will have clarified the central bank's exit strategy in order to unwind the $2 trillion of assets that the FED has accumulated on its balance sheet over the last two years. 

Does this really matter any way ? Well it does in a number of ways.

First, because as the FED has purchased all these financial assets from commercial banks, the later have accumulated huge excess reserves in the magnitude of 100 times their pre-crisis level. This could prevent the FED from using the Federal Funds rate tool as a an efficient instrument with money market rates staying desperately low in an environment awash with funding liquidity. This could severely damage the central bank's credibility, pushing higher inflation expectations and triggering a return of inflation to levels unseen since 30 years. Alternatively this could end up building another, still larger, financial bubble as the excess liquidity has to be recycled in a way or another. The bubble economy would come back with a vengeance !

Second, the unwinding of all these assets could cause significant volatility on market prices. This is a difficult question but it is clear that with its huge purchases of Agency debt and MBS securities the FED has acted as the lender of last resort on the housing market at the time when this market was "dysfunctional" to say the least. Hence, if the FED "dumps" all this mortgage related debt on the markets this could drive yield higher on mortgage securities and hamper the prospect of a recovery in the housing market. 

The irony is that the FED has to choose between two evils : a potential explosion of its liabilities with a consequent loss of control on monetary policy on one hand, or an asset price deflation as a result of a precipitated exit on the other hand. This dilemma can only be solved in a context of "goldilocks" recovery with firmly anchored inflation expectations. Happily for the FED, this seems to be the case for the moment. But for how long ? 

The Bank of England : are there any limits to debt monetization ?    

The problem for the Bank of England is at once less acute and more complicated than for the FED, both in terms of policy decision and policy communication.

The BoE is likely to announce an extension of its Asset Purchase Program on Thursday as bad news on the macro front (ie. negative Q3 GDP growth) will likely prevent it from any shift in its communication strategy. 

If you think the US is a highly leveraged economy (or was so, before the crisis) than you have not seen the UK. Its economy is highly leveraged on finance and real estate. Any shift in market sentiment or asset prices affects the real economy more than anywhere else.

With a view on stabilizing asset prices, the Bank of England has accumulated close to £150 billion of Gilts over the last six months. While it has been authorized to purchase risky securities such as corporate investment grade bonds, the BoE has instead preferred to buy almost exclusively government securities in order to lower long term interest rates, and to provide an additional stimulus to the economy. This is a strategy that is reminiscent of the BOJ purchase of GJBs in the glorious days of the Japanese quantitative easing experience (2001-2005). 

This has worked quite well as yields are now close to historical lows but there is an inconvenient truth about that : a monetization of public debt in a country that is threatened of losing its AAA rating. The solution to escape this suspicion of monetization would be to swap long term government debt with short term billed issued by the central bank. But this would take time. Hence, there is no possible unwinding for the BoE before a year or two.   

The European Central Bank : Jean-Claude Trichet as the Central Banker of the year ? 

Compared to the FED and to the BOE, the ECB has managed so far quite well to navigate through the worst financial and economic crisis since decades, and to preserve its independence and its credibility in the wake of tremendous political and market pressures. 

The ECB has been built on the legacy of the conservative German Bundesbank and has applied strictly its policy mandate as an inflation watchdog with little appetite for unconventional policy measures. This has not prevented it from flooding the market with liquidity both before and after the Lehman failure, by replacing its short term  lending operations with long term ones. It has also escaped the temptation of massively purchasing risky assets or offering an unlimited liquidity backstop to the modern wizards of finance, such as the securities broker dealers and their "clientèle" of hedge funds and proprietary trading desks. Instead, it engaged in a modest program to purchase select securities (mostly covered bonds).

The ECB was considered too conservative in the pre-crisis times. Now it seems its prudent policy is sparing it much of the dilemmas faced by its anglo-saxon counterparts. As a result, Jean-Claude Trichet may well win the title of "central banker of the year". Let us hope he does not trigger the interest rate weapon too early too fast.     



   

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We are proud to serve the global financial community with a blend of model-based rigorous quantitative analysis and qualitative "big picture" thinking.

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This is an abridged version of our Global Macro scenario. The complete version with more detailed analysis and complete forecasts for a range of economic indicators (GDP, interest rates, inflation) as well as asset allocation recommendations is accessible to our clients.

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Best regards,

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Senior Economist, Co-founding partner at COMPETENCE FINANCE

Check out this SlideShare presentation on LinkedIn. Click on the link below to view the presentation.

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No doubt about that : gold is the flavor of the day. 

Everybody is buying gold from macro hedge funds to retail investors. Gold prices seem poised for an endless increase. What is the limit ? 1500 $ an ounce ? 2000 $ an ounce ? The market sentiment is as bullish as can be.

Well, does it remind you of something ? Have you heard the word bubble before ? 

Personally, when I see everybody buying something I would refrain from doing so. Once there is a shift in market sentiment this could unleash considerable bearish forces.

Let us review the reasons that may drive gold price higher.

1. Gold is a good hedge against inflation

This not entirely true. It is true for periods of hyperinflation or stagflation as in the 1970s. But historically, gold has performed poorly as a hedge against inflation in periods of mild inflation (1945- 1969 and 1982-2009) as the chart below shows. 


Source : inflationdata.com

Hence if you really believe in hyperinflation then you SHOULD buy gold. But if you think like me that this fear is largely overdone, then you would better think twice before rushing into gold.

With sluggish growth ahead in the US and elsewhere in the developed world I don't see the prospect for "core inflation" (purged from volatile commodity prices) to rise higher than the 2 % - 2.5 % range implicitly targeted by the Fed. This is a great deal short from hyperinflation !

If private demand does not pick up with all this massive deleveraging going on, I am more worried about the potential for a protracted deflation and a Japanese "lost decade" scenario. 

2. Gold is a hedge against dollar weakness

True. Gold may be seen as the ultimate store of value. But if you believe like me that the dollar will eventually rebound in the next 3 to 6 months (this would be the case if the Fed, despite its current wait-and-see approach raises its policy rate before the ECB, somewhere between March and June 2010) then you should not be so bullish about gold.

3. Gold is a hedge against uncertainty

Half true. Gold could be a hedge against policy uncertainty but this will eventually recede for the reason indicated above : monetary policy normalization. 

4. Gold is a pure monetary asset

Less true than before. Gold is affected by supply-demand dynamics. After all gold is nothing more than a commodity as "precious" as it is. From the supply side, the investments made in the pre-crisis years by the major gold mining companies could increase capacity by a substantial amount in the coming years. From the demand side, rising demand from India and other developing countries is likely to be a temporary phenomenon. Women in rural India buy gold because the financial system is still underdeveloped over there (only 20% of the people have a banking account in India). 

5. Technical factors support gold

This may be true in the short run. Technical analysis is indeed a powerful tool for predicting market movements at short horizons (10 to 20 days). However, technical analysis is no guide for the long term. Fundamentals will eventually prevail.


All that said, I still agree with gold bulls that the upward price trend  could probably go on for some time (maybe for 2 or 3 months), until the Fed finally decides to "get out of the wood" and states clearly its exit strategy, which I believe will not be very different from previous recessions.  

But I don't buy "the gold rush" story. Eventually all bubbles crash. The current gold bubble is no exception.

Disclosure : No positions
   


















 

It is understood. The FOMC meeting yesterday did not bring much new food for thought to all those market analysts lavishly waiting for a signal from Oracle Ben and his wise monetary fellows. 

Yesterday's FOMC statement confirmed the monetary status quo for "an extended period" of time justified by weak recovery prospects and ill functioning credit markets. 

According to me, the most interesting part in this cautious communique is the last sentence :

"The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted."

I believe this sibylline sentence tells more than can be grasped by the average trading Joe. Indeed, central banking is not just about communicating easy concepts to the public  it can also be very technical and obscure at times.

The most serious issue the Fed faces right now is not the timing  of future interest rates hikes. Although this is important, this is the easy part of the job. Shall it be in March, June, or September 2010 ? Does it really make a difference ?  

The Fed is facing a more serious problem. 

As it implemented a range of unorthodox tools to sedate the financial system in the wake of a market collapse, the Fed created as a by-product a huge wall of excess reserves that it was forced to compensate at market interest rates in order to retain its ability to control the fed funds rate as is explained in a report of the NY fed. 

However, as the economy recovers, the strength of the recovery will depend on the ability of the banking system to meet a growing credit demand. By allowing banks to hoard cash on its balance sheet at market rates the Fed contributes to credit rationing. The only way to prevent that is to keep interest rates near zero. But this in turn puts an unintended constraint on monetary policy. The solution is to maintain low monetary rate expectations long enough to enable a drying out of the excess reserves held by the commercial banks and by encouraging these banks to resume their lending to the private sector by showing a rosy picture of the economy. 

This is indeed a very tricky exit strategy.





 

It may seem highly unlikely to depict the dollar as strong buy, or even as a simple buy, with so many investors, hedge funds and proprietary traders alike, now heavily engaged in dollar-funded carry trades.

As a matter of fact the dollar is currently at record lows against the other major currencies (Euro, Pound, Yen). And there is an entrenched consensus that this situation may last for some time and that the green buck may even endure further losses. 

The arguments for dollar bears abound : rising US public deficit and current account deficit, near-zero short term interest rates on the money market, both onshore and offshore (Libor), the over-extended Fed balance sheet, and weak prospects for the economy. 

These arguments may bear some truth. Yet I believe that a great deal of the current dollar carry-trade rests purely on market sentiment.

Why so ?

First, unlike the Japanese yen, the dollar is not the currency of an overbearingly export-oriented economy as is Japan. The US government has no incentive to keep the dollar too low for an extended period of time. For sure, a low dollar would boost exports but on the other side it is already hurting the status of the dollar as an international reserve currency, which neither the US nor the other countries are ready to accept. At least for the time being.

Talks about an alternative to the US dollar as an international currency are at best premature, and at worst nothing more than politically biased attempts by some countries like Russia to put additional pressure on the US government in the wake of complicated negotiations on WTO access or on the Iranian nuclear issue.

Second, as always I believe the US economy will be the first to recover among the major developed economies (as soft data already indicates), prompting the Fed to abandon gradually its policy of zero interest rate and to prepare the markets for a tightening cycle that could start somewhere between March and June 2010. 

This will mechanically provide a support to the dollar, all the more that the other major central banks (ECB, BOE, BOJ) will have no choice but to keep low interest rates for a longer period than the Fed as their economies are quite not as resilient as the US economy. This is especially true for the Eurozone which may see a worsening of the recession in the coming quarters before eventually rebounding.

For quite a similar reason, US trading partners will not tolerate an exaggeratedly weak dollar as it symmetrically implies exaggeratedly strong pound, euro, yen, yuan and won. This would constitute a severe impediment to recovery for a number of export-based economies such as Germany, Japan, China and South Korea. 

Finally, as the recovery gains steam in the US, foreign investors will rush in to profit from reasonable real and financial assets valuations. This would also provide support to the dollar.

In the long term, there probably ought to be an alternative to the dollar as the global economy becomes more diversified and less reliant on the US economy. But as John Maynard Keynes once said : "in the long run, we are all dead". 

Disclosure : none




 

 

As the Financial Times reports it :

The US administration, with support from Europe, is seeking to reach agreement on a new framework for tackling global economic imbalances at next week’s G20 summit in Pittsburgh.

Or does it really want to ? 

This ugly expression of "global imbalances" coined by some technocrats at the IMF in the early 2K years and subsequently endorsed by academics and policymakers all around the world, refers to the nexus of economic phenomena that have been building up with the advent of globalization and the liberalization of financial markets over the last 30 years. 

Basically it is all about China exporting cheap goods and cheap credit to the developed world to the benefit of the average American family and to the even greater benefit of Wal-Mart shareholders reaping the success of its high volume and low margin business model. 

What went wrong with this model ? Well, the fact that the Chinese factory workers in Shenzen and Shanghai - many of them migrants from the poor rural areas - got only a very small chunk of this pie. Instead, the Central bank of China accumulated huge foreign exchange reserves that were invested in low yielding US Treasuries, thus contributing to very low borrowing costs in the United States, which in turn fueled even more the consumption frenzy of the average American family and the real estate bubble that led to the subprime catastrophe. 

“We hope to reach agreement on a framework for balanced growth, for agreeing on how to address the imbalances that led to this crisis and on some process for holding each other accountable,” Michael Froman, deputy national security adviser for international economics told reporters. 

This sounds more like wishful thinking. It is an illusion to think that these so-called "global imbalances" can be reversed overnight. In fact, it would bring more harm than good.

This political chitchat misses the silent revolution that is currently taking place in the most remote parts of rural China. This silent revolution is bringing millions of farmers out of poverty through a better recognition of their property rights on the land they are established on. As the Journal reports it, more than half of the income gained by Chinese farmers is now derived from other activities than Agriculture, through wages and rent revenues, up from almost nothing 20 years ago. 

The solution to global imbalances will not come from the G20 Summit in Pittsburgh next week, but from Anhui, Sichuan, Hebei and other rural areas in China. The rise of the Chinese rural consumer, which still accounts for 50% of the 1.3 billion Chinese population, is the fastest way for China to consume more and save less. 

The Wal-Mart business model may see its days counted. Unless Wal-Mart accelerates its international expansion strategy with one obvious target for that : rural China. 

Disclosure : No positions