Risks, Hedges and Opportunities

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.



(…) the Nationwide Building Society said U.K. house prices rose for an eighth consecutive month in December (…).

The price of a typical home rose 0.4% on a seasonally adjusted basis to £162,103 (about $260,000) in December from a month earlier following an unrevised 0.5% increase in November.

The three-month on three-month rate of increase in home prices, which is seen as a smoother indicator of the near-term trend, rose 2.1% in December, compared with a 2.8% increase in November.

The monthly gain means the average U.K. house price has risen 5.9% from December 2008 and is 8.9% higher than the February 2009 trough. Prices remain 12.2% below their peak in October 2007. In November, prices were up 2.7% from a year earlier.(…)

Full WSJ article

Deleveraging continues:

Homeowners injected nearly £5bn of equity into their homes in the third quarter of the year as record low interest rates encouraged individuals to pay down their mortgages.

The Bank of England figures showed that the amount of money people unlocked from their homes was negative for the sixth successive quarter, although the pace at which householders were paying down their debts was slowing.

The focus of homeowners on repaying debt would continue to constrain consumer spending, analysts said. The current trend to pay down mortgages is in marked contrast with the practice of drawing on home equity to fund other purchases which helped buoy consumer spending for much of the decade.

A net £4.9bn was injected into housing equity between July and September, the equivalent of 2 per cent of post-tax income, the Bank of England said on Tuesday. That represented a decline on the £6.9bn injected in the second quarter and more than £7bn in each of the previous two quarters.

Howard Archer, chief European and UK economist of IHS Global Insight, a forecasting company, said the latest figures brought the cumulative net injection of equity to £33.9bn since the second quarter of 2008. That compared with persistent equity withdrawal between 1997 and the first quarter of 2008, which reached 6.2 per cent of post-tax income in the first quarter of 2007.(…)

Full FT article


The Audacity of Debt

(…) This week Congress will vote to raise the national debt ceiling by nearly $2 trillion, to a total of $14 trillion. In this economy, everyone de-leverages except government.(…)

Our concern is that the Administration and Congress view this debt as a way to force a permanently higher tax base for decades to come. The liberal grand strategy is to use their accidentally large majorities this year to pass new entitlements that start small but will explode in future years. U.S. creditors will then demand higher taxes—taking income taxes back to their pre-Reagan rates and adding a value-added tax too. This would expand federal spending as a share of GDP to as much as 30% from the pre-crisis 20%.

Remember the 1980s and 1990s when liberals said they worried about the debt? (…)

But wait: Those "evil" Reagan deficits averaged less than $200 billion a year, or about one-quarter as large in real terms as today’s deficit. The national debt held by the public reached its peak in the Reagan years at 40.9%, and hit 49.2% in 1995. This year debt will hit 61% of GDP, heading to 68% soon even by the White House’s optimistic estimates.(…)

Today’s debt has financed . . . what exactly? The TARP money did undergird the financial system for a time and is now being repaid. But most of the rest has been spent on a political wish list of public programs ranging from unemployment insurance to wind turbines to tax credits for golf carts. Borrowing for such low return purposes makes America poorer in the long run.(…)

"Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren," Senator Barack Obama said during the 2006 debt-ceiling debate. "America has a debt problem and a failure of leadership. Americans deserve better." That was $2 trillion ago, when someone else was President.

Full WSJ editorial


U.S: Another large positive wealth effect in Q3

Stéfane Marion is an excellent economist and strategist. In 2009, he has been bang on on many important and controversial calls. However, I still do not share his enthusiasm for the US consumer. The Q3 jump in spending was essentially due to the cash-for-clunkers program. So far in Q4, retail sales have been very weak. Employment would need to recover strongly for consumer spending to rise meaningfully (see THE US CONSUMER: WHAT, ME WORRY?)

The latest U.S. flow of funds showed some very positive developments in Q3. For the first time on record, households increased their consumption at the same time that they reduced their debt outstanding.

As today’s Hot Chart shows, debt fell 2.5% (the equivalent of $351 billion at an annual rate) while spending increased 6.1% (or $150 billion at an annual rate) during the quarter. It is thus possible for an economy to deleverage and still post positive growth under certain conditions. A crucial condition is that households’ balance sheets must stabilize to convince them that their savings rate is high enough. Fortunately, there was a very impressive improvement in Q3. The net worth of U.S. households rose by $2.7 trillion during the quarter following an increase of $2.3 trillion in Q2.

Importantly, the amelioration was notable for both financial and residential assets. As a result, the ratio of net-worth-to-disposable income jumped back above its average for the period 1950 to 1997 – chart . If job creation finally materializes (that is the other crucial condition to ease the pain of deleveraging), positive economic growth will be sustained.




Consumer lending shrank 1.7% in October, the ninth consecutive drop, extending the dramatic decline of financing available to help fuel the U.S. economy.

image The $3.5 billion decline, calculated by the Federal Reserve, caps a 4% drop in consumer lending from its July 2008 peak. (…)

The financial markets that support credit-card lending, auto loans and home mortgages not backed by the government are between 10% and 40% smaller than they were in the second half of 2007.(…)

Earlier this year, Visa reported that people for the first time were using their debit cards (which draw cash out of a bank account) more than credit cards (which use borrowed money).(…)

In the past 25 years, household debt has exploded. It now stands at 122% of total disposable income, up from just over 60% a quarter-century ago. At the end of last year’s third quarter, household debt started to decline as Americans began belt-tightening.(…)

Full WSJ article

Chart from David Rosenberg


Is the U.S. Economy Turning Japanese?

Easy money from the Fed hasn’t translated into more consumer lending by banks.

(…)With the U.S. government stepping in to keep markets from clearing, today’s U.S. economy in many ways resembles the post-bubble Japanese economy of the 1990s. Ultra-loose monetary policy and low demand for credit, combined with high unemployment and consumer deleveraging, could lead to a prolonged slump.(…)

The reality of an increasingly command-driven economy in America means that government policy is likely to become the key determinant of where investors should place their money. For example, the near-term prospects for the housing market in the U.S. will be strongly influenced by whether the federal government extends its first-time home-buyer tax credit when it expires in November. Like cash for clunkers with autos, the risk is that such a program is simply buying demand from the future.(…)

All of the above behavior invites legitimate comparisons with post-bubble Japan, where banks took years to be cleaned up as a result of regulatory forbearance. The same kind of forbearance is preventing America’s increasingly distressed commercial real-estate market from clearing. Similarly, as was the case with Japan, monetary-base growth has exploded in the U.S. over the past year courtesy of the Fed, while bank lending is declining. This is why there is every reason to fear that America is already in a Japanese-style liquidity trap. (…)

Full WSJ op-ed

Chris Wood’s today’s WSJ op-ed is a synthesis of a conference he gave in September which I posted in greater details on October 7: US BANKS: LESSONS FROM JAPAN



Seems pretty simple,  or simplistic rather. Is this a zero sum game or not?

(…) One of the biggest clouds on the economic horizon is the vast amount of debt U.S. households took on during the boom years. (…)During that "deleveraging" process, the logic goes, U.S. consumers — whose spending makes up more than two-thirds of the U.S. economy and about one-fifth of the global economy — won’t be able to play a leading role in any recovery.

The gloomy forecasts, though, miss an important point: Debts have value only to the extent that they are being paid, and a rapidly rising number of U.S. households aren’t doing so. Those defaults are leading to losses at banks, a wave of foreclosures, trouble for neighborhoods and strife for families. But they are also providing an immediate, albeit radical, form of debt relief.

"It’s not ideal, because it carries other costs," said Karen Dynan, a consumer-finance specialist at the liberal Brookings Institution think tank who recently served as a senior adviser to the Federal Reserve. But it is "going to help get household balance sheets back to the right place."

[Debt Relief chart]

If one accounts for defaults, U.S. households’ debt burden is shrinking a lot faster than the official data suggest. First American CoreLogic, which tracks the performance of mortgage loans, estimates that some 9.3% of the nation’s 52.4 million mortgage holders were 60 or more days behind on their payments as of July. That represents relief on about $1.2 trillion in loans. The official data miss most of that, because the Fed doesn’t erase debts until banks have foreclosed, sold the homes and taken the loans off their books, a process that can drag out for more than a year.

As a result, some economists are expecting a sharp improvement as widely watched indicators of consumers’ finances catch up to reality. Joseph Carson, director of global economic research at AllianceBernstein, expects the share of households’ after-tax income that goes to pay loans, rent and other financial obligations to fall to 16.3% by the middle of next year, well below the average for the 20-year period leading up to the housing boom. As of June, it stood at 18.1%.

"It’s part of the cleansing process of a downturn," he said. "And it’s happening a lot faster than people realize."(…)

Beyond that, the U.S. government, in its efforts to bail out banks and rescue the economy, is building up debt as fast as households are shedding it. Net U.S. government debt could reach 85% of annual economic output by 2014, up from about 58% now, according to the International Monetary Fund. If people recognize that paying down the national debt will likely require them to pay more taxes in the future, economic theory suggests they will be wary about spending today.(…)

Full WSJ article