NEW$ TO U(SE)

It is not credible, if not indeed impossible, for countries to engage in competitive devaluation or currency debasement and, at the same time, make good on promises to defend their credit rating. In order to successfully erode debt, nominal interest rates on public debt must be and stay below the rate of growth in nominal GDP. Canada does not appear to have either of these aforementioned diseases.
Accordingly, one should not expect Canada to end-up with accelerating inflation rates. On the contrary, the central bank should be able to keep interest rates on debt lower than the anticipated 5% rate of growth in nominal GDP for years to come.

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The recession and banking crisis have ended and the economic and financial systems are recovering. While it is generally recognized that the effect of an unusually generous monetary stance is the main reason behind the cure like the brutal slashing of the federal fund rates to near zero and glutting purchases of mortgage-backed and treasury securities, it is however understood by all men that an extraordinarily loose monetary policy has to end sometime.

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The Canadian dollar has traded in a range of about 92 to 98 us cents since the Bank of Canada October Monetary Policy Report. The Loonie, facing the roll-over effect of commodity prices that stem from the Chinese and Indian authorities small but repeated moves to rein in bank lending, decreased in the past two weeks to close at 93.50 us cents on last Friday. Speculators, moving in herds, took some Canadian dollar risk off the table. Oddly enough, so did we for a quick bet.

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There is no escaping that monetary policy is a very complex subject matter, difficult to apply and much more than a simple idea of targeting an appropriate inflation rate. The monetary authorities are not innocent for they can easily make mistakes and clearly bear a lot of responsibilities for the consequences of their policies on the behaviour of the financial markets and economic activity.

On the one hand, should the monetary stance be easy at a time when it is tight, market prices of risky assets would rise, government bond yields would increase, the value of the home currency would decrease in term of gold, and inflationary expectations would increase. On the other hand, should the monetary stance be tight at a time when it is easy, market prices of risky assets would decline, government bond yields would decrease, the value of the home currency would increase in gold terms, and inflationary expectations would decrease. Of course, the longer the conduct of monetary policy, and the more far away it is from what it ought to be, the more dramatic will the unintended consequences be.

To properly judge the effect of monetary policy on things that matter to investors, one must know and understand that monetary policy is not asymmetric but somewhat chaotic. A much better way to judge which monetary stance the central bank should conduct is to have the common sense of taking a more macro economic approach.

Based on historical repetition, monetary policy should be neutral when prices are stable, fiscal budgets are in balance, the balance of payments is viable, employment is full and economic growth in nominal terms equals closely, population and productivity changes. There is ample empirical evidence and theoretical validity that for any given deviation in the above factors it should tilt the monetary stance away from even keel. If it`s not done, the Central Bank is not counteracting the pro-cyclical forces of finance, thus creating risks or opportunities to investors.

Palos Management’s US monetary policy index which takes into account all of the aforementioned factors calculates that the monetary stance of the US Fed should be slightly on the tight side of even keel. On January 22, 2010 the index stood at 115. Neutral is 100 and less than 100 is easy. Yet, the US monetary stance is clearly easy for the yield curve is steep, the federal fund rate is way below the rate of inflation and the FRB has flooded the banking system with a massive expansion of the monetary base. If it had not been that the economy was in the throes of writing down huge amounts of bad debts, the money supply (MZM) would have doubled.

Theory predicted correctly the debasement of the US dollar in gold terms, the surge in the market prices of risky assets, the rise in government bond yields and the increase in inflationary expectations in 2009 and the early weeks of 2010. The question is will the monetary stance of the FED turn in 2010. If the FED does not, more of the same can be expected. But, should it adopt a tighter stance, as we believe it will, than a more sober market for risky assets, a more stable US dollar and more increases in government bond yields can be expected.

Consequently, the beginning of the exit from super-expansionary monetary policies will be one of three dominant global macro themes in 2010 along with fiscal and global imbalances. The last weekly letter dealt with US fiscal deficits and next weekly letter will address the global imbalances between the US and the rest of the world. I’m of the opinion that the monetary stance will be gradually moving toward neutrality in 2010 and to an even keel position in 2011. Investors should watch what might happen to quantitative easing for that’s the 800 pound gorilla in the room. The FED, in our opinion, is likely to stick to it’s stated plan to end purchases of mortgages at the end of March and roll back emergency lending programs in February.

The FED will be saved by the private sector and China in that they will take up the burden of financing government budget deficits. Private savings will substantially increase over the next few years because of the ongoing de-leveraging process of households, financial institutions, commercial real estate and non-financial corporations. The private sector could buy as much as $1000 billion of US treasuries in 2010.

The monetary authorities in China abruptly reversed course last Tuesday in a clear sign that they have turned their attention to controlling the repercussions on of a credit explosion by raising reserve requirements on banks and yields on short term bills. The money supply in China is up 35% on a year to year basis. These changes mark stage one and the turning point of China’s exit from emergency policies. Because China, for all intents and purposes, is under a fixed exchange rate in that its currency is linked to the US dollar; a tighter monetary stance should lead to upward pressure on the Yuan and, therefore, lead to more accumulation of international reserves in the form of US Greenbacks. China and other foreign countries may buy as much as $500 billion worth of US treasuries in 2010.

What these two sources of financing means is that the FED will be able to follow a monetary stance that will be more in tune with what it ought to be. The US economy may have ended 2009 with a bang, but the anticipated change in the fiscal and monetary stance means that the 2010 outlook will be mute for a post recovery year.

Hubert Marleau, Chief Investment Officer

Palos Management Inc.

Last week, I argued that if certain structural challenges, legacies of the past financial crisis and the consequences of fiscal and monetary government actions are not met head-on, fear will come and the worst of human nature will emerge in the form of rising inflationary expectations. One of the disputes over the coming year and years will be about whether the excesses resulting from the $1.5 trillion federal fiscal stimulus can be quickly removed and by how much. One may want to take some comfort in the following facts.

1) The US budgetary deficit as a proportion of GDP, in nominal terms, is 9.5%, significantly less than most other OECD countries. (Canada stands the lowest at 2.5%).

2) The US national debt to GDP, in nominal terms, is about 40%, importantly less than most other OECD countries. (Canada stands at 35%).

3) US bank debt management will be easier to navigate than in most OECD countries. To achieve international standards the US banks need to raise about 1% of GDP, nominal terms, in equity capital compared to 3.0% for OECD banks. (Canada is zero).

4) US government spending as a proportion of GDP is 20.5%, significantly less than all OECD countries. (Canada is 27.5% among the lowest, yet it has one of the widest social safety net).

Nevertheless, from the fiscal year 2002 to 2008 the US federal deficit averaged about $300 billion a year for 2.5% of GDP expressed in nominal terms. In the fiscal year 2009, the same deficit as a result of the American Recovery and Reinvestment Act and the Troubled Asset Relief Program, surged to $1.5 billion or 11.5% of GDP. The CBO projects that the budget deficit should total $1.4 trillion in fiscal 2010 and $900 billion in fiscal 2011. Assuming that the FRB wants and will maintain its inflation target rate near 2.0%, the deficit will have to be financed with either higher taxes or by issuing debt to the public at large and foreign investors around the world.

This is why many pundits are worried that projected trend in deficit spending may become difficult to finance. They want policy makers to make immediate changes to the expansionary fiscal stance of the US government and have no credibility in the current market sentiment for they feared that stagflation risks are very serious. They take us back to the 1970’s when the elimination of the "Gold Standard", the burden of the "Vietnam War" and spending spree of the "Great Society" created high unemployment and inflation. Today, the reduced role of the "US Dollar Standard", the financial cost of "US Geopolitical Involvement in the Middle East" and the extraordinary amount of spending on the "Great Recession" could do the same.

They can’t see how the need for the treasury to raise $4.0 trillion a year to finance the projected deficit and replace expiring debt can last without elevating sovereign risk that could end-up in outright debt repudiation or debt restructuring or moratorium on interest payments or currency debasement that could bring about inflation, imposition of capital controls, special tariffs and breach of international contracts. At the moment sovereign credit spreads, default swap rates and differentials between expected and actual inflation rates do not suggest that investor goodwill is imminently at risk. Nevertheless, if the worst is to be avoided, the taming of the deficit will be the defining issue for both the political Right and Left in the upcoming mid-term November election.

While I recognize that liberalism has different meaning to different folks, the distinction becomes less under plutocracy. The Right believes that liberalism has to do with personal freedom and choice while the Left argues that personal freedom comes with decent health care and education. But, both believe in equal opportunities and justice. The emergence of plutocracy in the last decade, where only the smartest and the most cunning among the general population are main and real beneficiaries of globalization and technological advances, is uniting the moderates of both wings in the form of populism and patriotism. There is a growing awareness that Western governments have not worked for the good of the country or the population at large but far more for the special interests of the super powerful rich.

This political dynamic is very pronounced in the US and the impetus to do something about it is rising. The "Financial Times" reported last week that " the top 10% of US earners received nearly 50% of the growth in aggregate real wages and salaries while the top 1% received an astonishing 25%. Meanwhile, the bottom 50% received under 13%, just about half of what went to the top 1%".

Given that social mobility is declining, the increase in income inequality is upsetting to many and troubling both the Left and Right for they share the value of openness as a core political goal. It is not enough that huge income inequalities represent a perversion of democracy, but what we hear in many circles how easy our politicians succumb to plutocracy without consideration to the social cost that their citizens, rich and poor, have borne.

Both political wings will come up with presentations that we are at the cusp of an "Age of Austerity". A bipartisan commission is being set-up with the aim of reducing federal borrowings. Concrete actions and plans will be introduced to prevent the possibility of strikes and protestations on Main Street and avoid bond vigilantes to rule Wall street. It shall be done just to mute the mere anticipations of what huge and sustained deficit could do the financial and economic systems. There is just too much belief that the scale of the deficit problem could pose serious risks and, in turn, undermine the US geopolitical standing. History shows that only with a bipartisan commission can government financial needs be reduced for it is the only way for a divided house to agree through some sort of special process to meet a common goal.

You can be certain that various measures shall be taken with resolve and urgency to achieve a primary budget balance where government spending on current programs equals revenue by 2014. By then, the federal government would still be paying about $400 billion annually in interest on total debt. However, it would represent only 2.5% of nominal GDP. It is true that the US Treasury would still be paying interest on past debt, but both the US debt and interest would cease to rise as a share of the overall economy.

Pressure from all sides of the political spectrum combined with the mid-term election in November should facilitate and sharpen the debate over the hard decisions that must be taken. I do not want to say that it will be a bagatelle to rectify government finance, but it is much more the fear that people may lose faith that their government may not bring the deficit under control than the lack of being able to restore fiscal responsibility. The public will not take lightly the unprecedented size and speed of national debt accumulation. I have little doubt that social and political tolerance for the eventual pain of protracted fiscal restraint may have already been breached. There are numerous actions that can be taken:

1) The retirement age could be raised.

2) Automatic spending reductions could be introduced on certain budget targets that are not met.

3) A medley of middle-class tax breaks are set to expire at the end of 2010.

4) Appropriations could easily be decreased by some four to five percentage points.

5) Appropriations could be under an as-you-go budget rules.

6) The top marginal income tax rate could be increase to perhaps as high as 50%.

7) Spending trade-offs between old and new, poor and rich, social and corporate welfare, guns and butter could be routinely evaluated.

An array of new taxes on energy, banks, speculations could be introduced. Think of the fee
on banks to cover
losses in the troubled asset relief program bail-out fund.

9) What about having a Value Added Taxes. Every OECD country has one.
In order to get public finance on a firm footing it would be necessary to increase taxes and/or cut spending to the tune of 2.5% of nominal GDP. The Right will be eager to reduce spending, the Left to raise taxes on the super rich and the Moderates to increase interest rates to benefit saving accounts.

Hubert Marleau, Chief Investment Officer, Palos management Inc.

The big story of 2009 was the US financial crisis and its economic effects in the real world, and the gradual and spectacular restoration of financial and economic health in March 2009 and July 2009 respectively.

Firstly, the peak to through decline, in real terms, of the US economy was 3.8% (June quarter 2008 to June quarter 2009). US Real GDP increased at the annual rate of 2.2% during the September quarter 2009 and is estimated to increase as much as 4.5% in the December quarter 2009 and is forecast to increase 3.2% in 2010.

Secondly, credit spreads peaked in March 2009 and staged a remarkable comeback in the following nine months. Corporate Bond Risk Premiums narrowed from 600 bps to 200 bps for investment grade corporate bonds and from 1800 bps to 650 bps for high yield junk bonds. Moreover, the S&P; 500 stock index increased about 40% over the last nine months while the CRB Index increased 38%. In this connection, current economic and financial conditions are no longer an impediment to operating profits.

Operating profits after tax, bottomed in the first quarter of 2009 at an annual rate of $912.4bn and have since steadily improved; they should increase around 25% in 2010 and 12% in 2011. In practical terms, the more accurate top-down forecast for earnings per share for the S&P; 500 stock index, the most tracked index in the world, is $73.00 in 2010 and $82.00 in 2011. Margins are expected to thicken because indications are that more productivity increases are in store, wage pressures will remain subdued, hiring will stay slow, federal tax breaks are scheduled and foreign earnings are promising.

Companies are becoming cash rich because capital expenditure plans are moderate elevating the prospect for higher stock buy-backs and/or dividends. Under these circumstances, the financial health of many corporations will be restored to new levels making it credible for the S&P; 500 stock index to trade close to 15 times earnings forecast – a good measure of fair value.

In this regard, investors ought to put their savings in the equity markets with particular concentration in either unique growth stocks or solid dividend paying securities or income paying credit instruments.

Individual fundamentals and broad relative values are going to reassert themselves because the pace of takeover activities will rise as the S&P; must still rise by some 40% to get back to its high. Money will flow to the credit and stock markets away from
1) commodities where prices have outpaced absolute improvement in global industrial production,
2) real estate where the glut is heavy and disposable income is under pressure and
3) government bonds where the outlook for growth and inflation should pick-up steam under reduced quantitative programs and massive issuance’s of debt.

Yet, the story for 2010 will not be about the continuing recovery of the markets but about their sustainability in the years to come. The past few years tested the global financial system, the next few years will test the political will and rationality of western governments. The big narrative will be about the cleaning up of the debris from the crisis and how rational, effective and fast, will the policymakers deal with the following issues; finance regulations, fiscal irresponsibility, the unwinding of Fed easy monetary stance, income and wealth inequalities, global imbalances, geopolitical shifts and demographic trends. These issues will have to be dealt head-on with determination just to sustain economic growth and maintain the rate of inflation around 2.0% over the next decade, a lower overall pace than recorded in the last three decades.

The capacity of the system will not be able to adequately deal with the potential negative consequences of these issues on future financial conditions and economic activity. The recent crisis has taxed the full resources of governments and their citizens. As a matter of observations, the latest credit crisis is part of a serious secular trend of financial crisis. The first one had to do with the emerging market defaults of the early 90’s, the second one was about the Internet economy of the late 90’s and the third one is related to financial innovations of the aughties. It’s not that any of these episodes were not worthy of investors’ consideration but their products were sold widely under easy money, lack of regulations, exaggerated benefits to society and without any reality checks.

If the aforementioned issues that could cause huge future political problems are not rationally remedied, boom-bust will remain an unfinished pattern of ever increasing cycles. In this regard, Palos will pay serious attention, and will look for clues as to whether credible solutions are suggested and timely implementations are applied. It will be necessary on our part to specifically watch the evolution of these major problems so that we may sharpen our risk management. Lack of interest on the part of policymakers to cure theses issues may bring huge differentials, negative or positive, between actual and expected inflation that could create havoc with macroeconomic uncertainties and, in turn, can be very corrosive for the performance of any given market.

The five year expected inflation rate is currently 1.80% comparing very well with the current yearly increase of 1.80%. The wider the difference, the more dangerous the consequences on investments. That is why it is crucial and essential to judge correctly whether resolutions or no resolutions of the aforementioned issues and challenges will bring either price stability, inflation or deflation. It should be noted that the stock and bond markets have fared much better during periods of price stability than ones of inflation or deflation. Palos does not want to be trapped in an echo chamber of conventional wisdom. That is why it will be watching closely the on-going inflation data and expected inflation signs like the growth and velocity of money, among many others to regularly evaluate risk and opportunities.

Hubert Marleau, Chief Investment Officer, Palos Management Inc.

James Grant, editor of Grant’s Interest Rate Observer, composed on December 5, 2009 in the Wall Street Journal the Requiem for the US dollar. A very good article but I disagree. He admits that there is no greater success story in the long history of money than the greenback. It has no intrinsic value for it is collateralized by nothing than the trust that it can be used to buy goods, services and investments at will for as long as there is another confident person prepared to accept the exchange.

The same can be said for gold, and any other currencies. Yet, he mourns, like many gold bugs, the classical gold standard. John Maynard Keynes called gold a barbarous relic of a currency whose price, not value, is determined by the relative supply and demand to any given currency. This is not much different than for the US dollar. Demand is determined by buyers and new supply by miners in the case of gold and by the central bank in the case of the dollar. There is no way that gold will ever replace the US dollar or a basket of currencies for its balancing effect is too drastic on economic activity and too theoretical to practically replace the global foreign exchange market that trades more than $3 trillion a day.

Moreover, half of the $900 billion’s worth of us dollars in circulation is in the possession of foreigners and approximately 65% of all international foreign exchange reserves is comprise of US dollars. For practical purposes, one should be more concern with what is the dollar correlates with. It seems to me that the price of the dollar depends on the narrative of the time.

At the tail ends, dollar price increases with risk aversion and decreases with risk appetite. Under normal circumstances, the dollar fluctuates over the medium term with anticipated and actual monetary stance of the Fed and, over the long term, with changes in world order and trends in the balance of payment. In order to capture significant shifts in currency valuation, it is better not to measure the rate of exchange in terms of gold for it can be misleading. As a matter of fact, just about anything can be subject to price changes in US dollar terms (stocks, real estate, bonds, and commodities). A better measure is the spot price of the US dollar index that is constructed in a fashion to aggregate the value of a basket of currencies weighted by their respective importance in export trade.

In the period leading up to March 2009, the US dollar index shot up to 90.0 reflecting the abrupt stop of the "carry trade" where speculators unwounded their pairs, the sudden sale of risky assets by investors in favour of the "safe haven" of US dollar denominated T-Bills and the loading of US dollar notes by banks and governments for reserves. At that time global economic activity, from industrial production to foreign trade, was literally falling apart. As a result of a large, broad and fast response by the USA and China, a catastrophe was averted. Sure enough, the market sentiment slowly but steadily improved and the dollar index decreased from 90.0 in March to 74.0 in early December.

Private investors borrowed near-zero cost dollars in abundance to buy risky assets and alarmed speculators contented that the US dollar was about to lose its reserve currency status. The latter did not happen for several reasons. Firstly, the role of the dollar, as the world’s reserve currency is not likely to lessen for a long time. There are no alternatives for there are no other currency that offers size, liquidity, military power, political independence and legal stability.

While I recognize that its dominance may be challenged, it is more likely to be shared with other currencies in time. The international financial crisis is proof enough that the world has outgrown the old Powers of G-8. World gatherings have been eclipsed by G-20 making the European Union geopolitically irrelevant. World affairs must include South Africa, Mexico, Indonesia and even Iran, if anything of multinational importance needs to be discuss or done.

What is particularly important is the geopolitical shift to the EAST. China and India are making their presence felt. For 500 years, the boundaries of global power were drawn by the Atlantic. Today they are defined by the Pacific and that is where the USA is concentrating its diplomatic effort. The talk is about a G-2. The USA and China are the essential guarantor of global financial security.

In reality beyond the G-2 things are not that rosy. China and the USA do not face the same major structural problems of other big industrial economies. One has only to think about the demographic problem of old Europe, Japan and Russia, the sovereign debt fears of Spain, Portugal, Ireland, Greece and several OPEC countries are in a tax trap unable to raise revenue to pay their committed outlays. The USA has a positive fertility rate, a steady inflow of immigrants, enjoys institutional independence and a mutual deal agreement with China. This later deal explains why the brunt of the Yuan’s peg to the US dollar was bourn by other currencies. Several investment banks have estimated that the EURO is overvalued by as much as 20% to 25% and GOLD is only the new Tupperware party_a social gathering that is invading America’s living room to buy and sell Gold.

Secondly, it should be noted that past recession was not caused by too much inventory but by too much cheap credit. Americans are in the process of de-leveraging and it’s nowhere near completion and tons of debt is being retired on all sides. In this connection, personal income is saved, bank profits are purchasing government bonds and business profits are retained. This behaviour is reorienting the US economy towards a better internal and external balances where, with the exception of the government, Americans’ finance is based less on consumption and borrowings but more on savings and productivity.

The results have been dramatic, the personal savings rate is up to 4.0%, the money centre banks have paid back what they owed to government and businesses are reaping the profitable benefit of cost cutting. The result is that the current account deficit is now less than 3% of GDP compared to to 6.2% in 2006. One more push, and we could see its elimination and, in turn, a fixing of the global imbalances that are at the root of today’s economic crisis.

Since December 3, 2009, the US dollar index rose to 78.0 and the greenback is up more than 5% against the Euro and 2.5% against the Yen. It looks as if a rally is gaining momentum. Investors appear to be recalibrating their outlook. Leading economic indicators accompanied by improvement in the labour markets are suggesting that the US may turn out stronger growth than either Japan and Europe. Moreover, the Fed has given several hints as to the timetable for the removing of extraordinary monetary stimulus, closing down of most liquidity facilities and normalizing of interest rates.

A change in the discount rate is now imminent because banks’ capital and reserve ratios are appropriate to start liberalize banking lending practices. It is very possible that the tail ends like risk aversion and risk appetite may play a lesser role in the near term. The foreign exchange market may forget the rock-solid relationship of the past two years that dictated dollar performance (risk aversion and risk taking). The new narrative may have to do more with relative value and under a more classic macroeconomic response linking the dollar with normalized monetary policy and treasury yields.

Hubert Marleau, CIO, Palos management Inc

Divided opinions in the global oil complex between commercial and financial participants have kept crude prices, for most part, in a range of $60 to $80 a barrel since June of 2009. Light sweet oil futures were down $6.14 during the past week or about 8.0% to close at $69.59 a barrel. The New York contract has fallen all month under pressure from a sudden strengthening of the US dollar as better-than-expected economic reports in the US stirred concerns that the Fed may raise interest rates sooner than expected and as worries mounted over foreign sovereign debt.

While the dollar has a lot to do with this change in sentiment, there is a narrative that supports lower crude oil prices in the short term.

1) OPEC compliance with its latest 4.0 million b/d quota cuts has been spotty among Angola, Iran, and Venezuela. Nigeria has completely ignored all quotas.

2) The global economic recession has created huge amounts of unused oil surpluses and of spare capacity around the world. A good indication of this situation is that one in twelve of the world largest oil tankers, 129 ships, are being used to store oil. Gibson shipbrokers reported last week that more ships are being used as floating storage unit than at any time in the last ten years. A LRI oil tanker holds around 690,000 barrels of oil products.

3) Geopolitical scares are not packing as much punch as before for they are better contained than they were several ago because inventories and spare capacity are high.

4) Saudi Arabia has developed the ability to ramp up output by more than 6.5 million barrels a day. Meanwhile, Iraq is opening up its biggest and largely undeveloped oil and gas fields, that are technically easy and cheap to exploit, to the large multi-national oil producers. A situation that may become problematic to OPEC as it will face a major conundrum in the future. Geologists believe that in less than ten years, Iraq will be able to boost its current oil production of little more than 2 million to possibly 10 million b/d. That would represent more than 10% of today’s global oil production and, in turn, catapult Iraq into the same league as Russia and Saudi Arabia.

5) Mexico has taken out a $ 1 billion "guarantee insurance policy" on all of its 2010 net oil export of 230 million barrels that will earn a minimum of $57.00 a barrel. It does suggest a pessimistic outlook for both oil price and demand in 2010.

Consequently, there is a likelihood that crude oil prices may trade at the lower end of its recent trading range below its equilibrium price of $70 a barrel for a while. However, it is not very likely that oil prices would trade much lower than the marginal cost of $60.00 a barrel. Saudi Arabia is of the opinion that oil prices at $70.00 a barrel is relatively in sync with global supply and demand fundamentals. The following points should be kept in mind:

1) While petroleum demand remains week and tepid in the US, consumption is rapidly increasing in Asia’ emerging markets. The US has 465 passenger cars for every 1000 people compared to just 15 in China.

2) The one and two year futures are pricing crude oil at $79.63 and $83.19 a barrel respectively suggesting that as the recovery takes hold next year, the spot price could exceed its marginal cost rather than fall short of it. Due to accelerating economic activity in China and firm signals that OECD economies are clearly on the mend, the IEA, the Paris-based oil agency, expects consumers to burn on average 86.3 million barrel a day in 2010 representing a growth of 1.5 million barrels a day from the low of 2008.

3) Contrary to popular belief, there is not excessive speculation on the Nymex oil futures market. Based on traditional metrics, the balance of outright speculators does not appear excessive to commercial hedging needs (US Commodity Futures Trading Commission).

4) The Mexican oil deal is more of an hedge against very bad luck. Mexico relies heavily on oil for it makes up to 40% of government revenues. The Mexican 2010 fiscal budget is based on a price of oil of $59.00 a barrel. Mexico bought protection more than calling a market for it does not want to destroy its current credit standing at a time when it has a sovereign risk and the economy has hit the skids.

5) Combined global oil and fuel inventories are presently and clearly in near-record glut position. However, stockpiles have recently dropped. They are still covering 59.4 days of demand. But, it is somewhat less than it was a few months ago. Next year, after the global economy really starts to roll-out in the early 2010, a lot of the existing reserves will burn off.

6) The concept of "peak oil" is still out there. It’s not that we are running out of oil for there are huge reserves out there, but easy to access and refined oil is declining very fast. That is why very long term futures contracts are pricing crude oil near $100 a barrel.

Hubert Marleau, Chief Investment Officer, Palos Management Inc.

Related post: Iraq Is Wild Card in World Oil Supply

Bull markets need two ingredients – these are a plausible narrative and an abundance of cheap money.

The ‘narrative’ or story is that the banking crisis has given cause to doubt the growth prospects of the OECD countries. These same countries have pushed a huge supply of low cost monies into the global financial system. The combination has driven the Gold, Bond and Emerging Equity markets well above their equilibrium price. The narrative part of the equation is compelling because the difference in the state of government finances and the trend in foreign exchange reserves are huge between emerging and developed countries. However, there are a number of good reasons to believe that central banks in the Western Hemisphere are about to exit their easy monetary stances.

1) Business conditions may be sluggishly in some quarters, but they have generally improved in a sustainable fashion since the end of last winter. Confidence in the economy is steadily improving. The Federal Reserve Board forecast is calling a change of 3.0%, 4.0% and 4.2% in real GDP for 2010, 2011 and 2012 respectively with an inflation pace of 1.0% to 2.0%. In this connection, the Fed will be forced to normalize the target rate to appropriately reflect rising inflation and growth rates.

2) Banking conditions have swiftly recovered from the gravest financial crisis since the Great Depression. By paying back government rescue funds with private capital, confidence in the financial system is rising nicely. Citigroup and Wells Fargo stand alone as the only two giant banks with TARP money. The Bank of America is about to shed the government stigma by year end. In this connection, the Fed will be less compelled to keep the government yield curve steep in an effort to restore banking profitability for liquidity and capital ratios are now good enough to keep them out of trouble.

3) In the diplomatic corridors of G-2, there may be a deal in the making. It is not in the mutual interest of either US or China to allow protectionism, capital controls and competitive devaluation to spread. It could very well be that rate hikes in the US would be matched with corresponding revaluations of the Yuan.

4) The markets are, in effect, daring the Fed to raise interest rates. Stability is still regarded as "an anchor for policy makers". Otherwise increased risk awareness of investors will mount and impose discipline on the Government. That is one thing that the Fed does not want to loose control over. Rate increases typically come after the unemployment rate peaks. This might be based on Friday’s job report. The futures markets are putting a 68% chance that the federal funds rate will be raised to 0.50% by June and more than a 90% probability that it will hit 1.00% by next December.

5) There is a lot of political and investor pressure on the Fed to change direction and be more forward-looking in its actions to protect credibility, keep inflation expectations low, oversee directly the soundness of the banking system and stop the "carry-trade" from transferring precious domestic capital to emerging equity and commodity markets. The Fed may deem it necessary to act in manner to show independence from and resolve to Congress.

6) As we move closer to increased regulations in order to protect the financial system from the excess vagrancy of monetary policies and banking practices, it will become less important to hold interest rates low to mop-up bursting bubbles permitting small and frequent rate increases to tame the markets.

Acknowledging that monetary policy works with a lag on the economy but how quickly markets can respond to it, the Fed has already started to use reverse re-purchase agreements to drain some of the $1 trillion in excess reserves of the banking system and may soon start to normalize the level of short term interest rates. Since inflation is relatively low, even baby steps toward normalcy could cause a surge in demand for US dollars causing changes in capital flows. As a matter of fact, the sooner the Fed backs-off its near-zero rate policy, the more capital will be allocated on the basis of relative value and less with complete disregard to valuation constraints. It seems to us, that both the narrative and the abundance of cheap money are in a process of change.

Even though the repurchase market, where securities are used as collateral for loans by investment banks, shows that the North American equity markets are not in a bubble state, it would be unrealistic to assume that the Fed can exit without some effect on asset prices. We took a few chips off the table in Gold, Emerging and Home markets for good profits and entered into a small short position in the TSX for downside ‘insurance’ protection.

Hubert Marleau ,Chief Investment Officer, Palos Management Inc.

The cost of money is so low that no matter what view an investor may have, there is enough money around to be right over the short term.

Players that are deploying a defensive investment strategy either by buying deflation related trades like bonds or inflation related trades like gold are winning. I argued, last week, that gold is due for a 20% price reduction. By the same token, treasury yields are subject to a similar upward correction.

As of November 27, 2009 ten year US treasuries were yielding 3.25%. A decomposition of this rate reveals that the US economy is not likely to increase much more than 1.25% per year on the long term with an inflationary factor of 2.00%. As an historical rule, US treasury yields have for most part averaged 80% of the growth of nominal GDP. It’s interesting to note that nominal GDP should decrease 1.55% in 2009 and increase by as much as 4.00% and 4.25% respectively in 2010 and 2011. Accordingly, actual treasury yields are bang on with fundamental, equilibrium and fair value.

However, investors are receiving absolutely no compensation for any fiscal risks. The Treasury market is priced for perfection believing that the ’sweet spot’ created by the quantitative and near zero monetary policies of the central bank plus the collapse of credit demand by the private sector and benign inflation will last for a long time. Like gold, there is a huge disconnect here.

Forward-looking bond participants are not considering the possibility that strong headwinds of large debt burden, huge deficit financing and un-relented currency depreciation could bring about responsive money management and/or earlier rate hike by the FRB. Investors cannot hope on huge household savings, albeit much better than it has been for years, to bail out the government.

Based on the recent performance of leading indicators, a 5.00% increase in nominal GDP is not out of the question. A circumstance that would certainly stop QE, raise bank credit demand and increase target rates a few notches forcing yields on ten year treasury notes toward 4.25%. Defensive plays like the purchase of treasuries are good insurances against deflation, but current premiums are expansive for they are not automatically "risk free’. The FED may not believe that an exit strategy is yet warranted. Nevertheless, investors should have one because it may come sooner than expected and it would then be too late to smartly react.

We will always hold bonds for insurance in all of our funds but a lot less than we used to own. Keep a close watch on the weekly ECRI Leading index. It increased to 128.8 for the week ended November 20 for an annualized growth rate of 24.1%. A significant improvement since the bottoming out of last March. The Great Recession ended in late July.

Hubert Marleau, Chief Investment Officer, Palos Management Inc.