Get Ready for a Little Emerging Markets Inflation

Friday, March 12th, 2010

Today I was thinking about tightening cycles in emerging markets, and more specifically about those in China. Because let’s face it, China matters. China matters to the rest of Asia via competition for export income. China matters to Europe via competition for jobs. China matters to Brazil via domestic production via imports. China matters.

The inflation pressures are building in key emerging economies, especially in the BIICs (Brazil, India, Indonesia, and China) - see this previous post regarding my new acronym, and this article at the Curious Capitalist (curiously posted just shortly after my post), which leaves my omitted “R” but relays the intuition behind the second “I”.

Although the inflation is not prevalent in any BIIC except India, really, I wanted to comment about why it will build…quickly.

First round, the construction of consumer prices is heavily weighted towards food and energy costs across the BIICs. Indonesia, India and China are highly susceptible to food price shocks (either driven by shortages or demand growth). Expect this as a first-round driver of inflation as the global economy recovers further. It’s already  happening.

Second round, the BIICs are growing quickly and nearing, or are already at, potential. Annual industrial production growth has recovered or surpassed its pre-crisis rate in China, Brazil and India - 19%, 16% and 17%, respectively. This is expected, given the drop-off in world trade (an illustration can be found from this May 2009 post), but unsustainable as the output gap closes.

Third round, interest rate differentials. This year, the BIICs’ central banks are expected to raise policy rates. In fact, Brazil, China and India have already boosted reserve requirements. But with US rates expected to stay low for an “extended period”, international interest rate differentials will change and monetary flows will shift. Capital inflows can lead to inflation if not properly sterilised.

To date, inflows have not been properly sterilised, as evidenced by the ongoing accumulation of reserves and rising money-supply growth (again, I refer you to my previous post on M1 growth rates.

The chart above illustrates the one-year-ahead nominal interest rate differential between the two-year forward government rate for each respective BIIC country versus the two-year forward US Treasury rate. The forward differentials for China and India are on a steady upward trajectory, while those for Brazil and Indonesia are simply steady. I believe this appropriately represents the sterilisation efforts and monetary policy management on the part of the BIICs’ central banks: more managed in Brazil and Indonesia, not as much in China and India.

So where does this analysis leave us? With a very interesting policy mix in the emerging-market space. In fact, in my view this is the riskiest part of the emerging-market cycle: the recovery. If policymakers get this wrong, we could see a lot of price action, final goods and assets alike, on the horizon.

Source: Rebecca Wilder, News N Economics, March 11, 2010.

* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

Tags: Acronym, Biic, BRIC, Capital Inflows, Central Banks, China, Curious Capitalist, Emerging Economies, Emerging Markets, Energy Costs, Export Income, Food Price, Gap, Global Economy, Illustration, India, India Indonesia, Indonesia, Inflation Pressures, Interest Rate Differentials, International Interest, Intuition, Jobs Brazil, Monetary Flows, Output Gap
Posted in Emerging Markets, India, Markets | No Comments »

Gold bullion – advancing in all currencies

Thursday, March 4th, 2010

The gold price is not only making headway in US dollar terms, but also in most major (and minor) currencies as illustrated by the table and graph below. Bullion veterans will recognise this phenomenon as a manifestation of solid investment demand (and a vote of no confidence in fiat paper per se).

The picture and the numbers tell the full story.

Source: Plexus Asset Management (based on data from I-Net Bridge).

Source: Plexus Asset Management (based on data from I-Net Bridge).

Illustrating the message even more vividly is the chart below of gold expressed in a basket of emerging-market currencies by dividing the dollar bullion price by the Wisdom Tree Dreyfus Emerging Currency ETF (CEW). Also note that the chart has again climbed back to above its 50-day moving average line.

Source: StockCharts.com

I remain bullish on gold in the medium term, especially as I believe the vast money printing by central banks could set off strong inflation pressures down the road. I will not be surprised to see bullion remaining in a secular uptrend for some time to come. Add bullion to your portfolios but, given the notorious volatility of the metal, only do so on pullbacks.

Tags: Bullion Price, Central Banks, Dollar Terms, Dreyfus, Emerging Market, ETF, Gold, Gold Bullion, Gold Price, Headway, Inflation Pressures, Investment Demand, Line Advertisement, Line Source, Medium Term, Minor Currencies, Money Printing, Pullbacks, Solid Investment, Story Source, Uptrend, Vote Of No Confidence, Wisdom Tree
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Chinese Yuan v The U.S. Dollar: In The Case of Global Reserve Currency

Wednesday, March 3rd, 2010

By Dian L. Chu, Economic Forecasts & Opinions

The practice of accumulating dollar reserves by the central banks has become more pronounced after the 1997 Asian financial crisis, when currency speculators hastened a balance of payments crisis in Thailand, Indonesia and South Korea by demanding dollars for local currency, depleting the central banks’ dollar reserves.

Fast forward 13 years later, the dollar’s status as the world’s preferred reserve currency has come into question amid a ballooning budget deficit that keeps the U.S. dependent on foreign financing. Both Russia and China last year suggested a type of “super-sovereign reserve currency” to challenge the dollar, while Brazil and India also discussed substituting other assets for their dollar holdings.

IMF - “That Day Has Not Yet Come”

Reigniting the argument, Dominique Strauss-Kahn, the head of the International Monetary Fund (IMF), said last Friday that it would be “intellectually healthy to explore” the creation of a new global reserve currency to reduce dependence on the dollar.

Mr. Strauss-Kahn did say there could be a globally issued reserve asset some day, but “that day has not yet come.” However, his remarks signaled broader concern over the dominance of the dollar, and “the extent to which the international monetary system as a whole depends on the policies and conditions of a single, albeit dominant, country.”

All these beg the question - Who could be the next global reserve currency succeeding the dollar?

Dollar Reserve - A Decade of Decline

The most recent foreign exchange report from the U.S. Treasury Dept. shows that the dollar reserve holding percentage has been on a steady decline - even before the financial crisis. As of 2009, the dollar still comprised about 60% of foreign reserves, compared with less than 30% for the euro, followed far behind by the pound and the yen. (see graph)

According to the Peterson Institute for International Economics, although the dollar remains the most important reserve currency over the last ten years through the first quarter of 2009, adjusting for the exchange rate effects, the dollar’s share in foreign exchange reserves has declined on balance 4.3%.

Reserve Currency Factors

The U.S. Treasury report points to several key factors identified by economists that determine the use of a currency for reserves:

• the size of the domestic economy
• the importance of the economy in international trade
• the size, depth, and openness of financial markets
• the convertibility of the currency
• the use of the currency as a currency peg
• domestic macroeconomic policies

PIIGS Decimate Euro

Based on these criteria, the euro zone, similar to the United States in size, share of global trade, and currency convertibility, makes the euro a viable contender for the dollar’s crown. And in contrast to the dollar, the euro has steadily taken market share regarding global foreign reserves during the past ten years, and has become the second most popular reserve currency. (see graph)

Unfortunately, the debt and budget woes of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) have seriously damaged the confidence and credibility of the European Union and the euro, essentially decimating the euro’s chances as an alternative to the dollar.

The euro has already hit a one-year low against the yen, and nine-month low against the dollar on speculation that Greece’s credit rating will be downgraded further. The viability of the European Union and the euro as a going concern has also come into question.

Dollar Reigns Liquidity Supreme

Even without the Greece debacle, the lack of liquidity within the euro zone also makes it difficult to compete against the dollar.  One important reason the US dollar remains the reserve currency is that the U.S. treasury market is the most liquid market of its sort. A liquid debt market allows central banks to intervene in foreign exchange markets in order to smooth currency fluctuations.

As noted by the U.S. Treasury Dept. report:

“The euro has not become the dollar’s equal as a reserve currency because there is no common sovereign-debt market across the euro zone.”

From that perspective, sterling and yen, the next two preferred reserve currencies following the euro, pale in comparison to the dollar in terms of liquidity and facilitating global trade. Moreover, Moody’s (MCO) warned of possible downgrades on UK and Japan due to high debt, interest payments and slow GDP growth.  (The pound was in virtual free-fall at one stage this Monday and sank to a ten-month low against the dollar on renewed worries about a hung parliament.)

Gold or Yuan?

While there are many advocating an international gold standard, or another international standard currency based on a basket of commodities and/or currencies, it is very difficult to see sufficient international consensus for this to be practical or feasible.

So, waiting in the wings is the Chinese renminbi (RMB) or yuan. The appointment of Zhu Min, the deputy governor of China’s central bank, as a special adviser to the IMF seems to signal China’s assertion in the global currency scheme. The fund, historically led by a European but dominated by the United States, has tried to engage emerging economies like Brazil, China, India and Russia.

But according to economist Geng Xiao, director of the Brookings-Tsinghua Center for Public Policy, it’s still in China’s—and the world’s—best interest not to dump the dollar just yet.

Yuan Revaluation Solves Nothing

In an interview with McKinsey Quarterly, Xiao noted that there’s no argument on either side about the trade imbalance between China and the US. However, there are some philosophical differences between the two as the US places more emphasis on the short-term adjustment through price and the RMB exchange rate, whereas the Chinese put more emphasis on medium and long-term structural and institutional change.

Xiao finds it quite difficult for the exchange rate to correct the trade balance:

“Even if you change the exchange rate, it will have very little impact on US trade deficit because the US is going to buy from some other countries.”

Time To Reform & Float

China needs time to push through difficult economic reforms at home before it can allow its currency to float freely against the dollar, as Xiao explains:

“China needs a benchmark so that the price can be compared to the global price, to the price structure, compatible with efficiency. That’s why price reform is more important than exchange-rate change… Exchange-rate change would not really change the inefficiencies … [as] the internal subsidies are still there.”

Xiao estimates it’s going to take 5 to 10 years for China to correct its distortions - land reform, reform of the energy sector, state-owned-enterprise reform, and social welfare. Only when the productivity of China reaches that of the United States will the two countries’ price structures converge.

The Worst-Case Scenario

A worst-case scenario might come to fruition if China allows RMB appreciation expectation to continue, building up more foreign-exchange reserves, as Xiao cautions:

“I don’t see that there’s any way that China can significantly reduce its holding of the dollar assets….But if pushed hard, China can always do more. And even marginally, a little bit more is going to have a big impact in the market.”

Dollar Rules … For Now

Indeed, overtime, China should be able to transform into a modern market economy. And if the Chinese economy continues to grow at its current pace, the RMB will eventually become one of the important reserve currencies, just like the US dollar.

But for now, there are several factors strongly supporting the dollar. In addition to a liquid debt market, many commodities, including oil and gold, are quoted in the US currency. Roughly 88% of daily foreign exchange trades involve US dollars. One currency essentially facilitates global trade, and commodities can be priced homogenously wherever traded.

And China, the top U.S. debtor with a massive holding of $894.8 billion in Treasury securities at the end of last December, is shifting to longer-term US treasuries and at the same time accumulating US stocks, raising its overall holdings of long-term American securities.

China’s huge holdings of dollar reserves in the form of Treasury securities has become a concern for officials on both sides of the Pacific. However, the fact remains that the dollar is still the most liquid, the most stable currency, comparatively speaking. In that sense, it is unlikely for China to significantly reduce its holding of dollar assets in the foreseeable future.

Dethroned By 2050?

Most Western experts seem to agree that the prospect of a dollar replacement for a new world reserve currency is unlikely to materialize anytime soon because there is no serious alternative on the horizon.

Doubts also remain that the Chinese can challenge the greenback. Nevertheless, there seems to be more or less a consensus forming among many Western experts that the Chinese are on an unmistakable path toward challenging the dollar in a transition period of 10 to 15 years, roughly coinciding with the projections of Mr. Geng Xiao.

British economist Angus Maddison predicts that China will surpass the US by 2015. Drawing historic parallels of the last switch in reserve currency (from pound sterling to the US dollar) would imply the Chinese renminbi may be expected to replace the US dollar as a reserve currency around 2050, the mid-21st century.

Dollar Demise by A Greece-Like Crisis?

Meanwhile, even though the debt crisis of troubled southern European nations have taken hold of headlines lately, Moody’s and its peers have expressed concerns about the financial health in Japan, UK and the U.S., mostly centered around debt and debt service in these larger nations.

For instance, interest paid on U.S. Treasury debt has been soaring the last two years and is expected to reach over $700 billion a year by the end of the decade. The U.S.’s ratio of total debt to GDP is likely to exceed 90% this year, making it more indebted even than Spain and Portugal.

While the US has been enjoying the reserve currency status, this is by no means assured for the future. For now, investors are seeking refuge in the U.S. Treasury market. However, a broken-down political system, the debt and the deficit inevitably could sink America into a Greece-like crisis, nudging the dollar’s demise sooner, rather than later.

Tags: Asian Financial Crisis, Balance Of Payments, Budget Deficit, Central Banks, China, Chinese Yuan, Currency Speculators, Dian, Dollar Terms, Dominant Country, Dominique Strauss Kahn, Economic Forecasts, Exchange Report, Gold Price, International Monetary Fund, International Monetary Fund Imf, International Monetary System, Investment Demand, Minor Currencies, Reserve Asset, Reserve Currency, South Korea, Steady Decline, Story Source, Treasury Dept, U S Treasury, Vote Of No Confidence
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IMF Gold Sales v. the Alchemy of Gold Futures – What’s the Impact on Gold Prices?

Thursday, February 18th, 2010

This article is a guest contribution by J.S. Kim, of SmartKnowledgeU™.

The recently announced IMF sale of 191.3 tonnes of their gold reserves, though it caused an immediate sharp knee-jerk reaction in gold futures markets, will have a negligible effect on the long-term price of gold. Here’s why.

In December, 2009 the commercial bullion banks that serve as agents for the leading Western Central Banks were net short 303,791 contracts of gold. Each COMEX gold futures contract represents 100 troy ounces, so the Commercials were net short 30,379,100 troy ounces of gold. With the average price of gold $1,134.72 per troy ounce in December 2009, this net short commercial position represented $34.47 billion worth of gold. There are 32,150.74533 troy ounces in one metric tonne. So 30,379,100 troy ounces/ 32,150.74533 troy ounces = 944.90 metric tonnes of gold. Since gold contracts are supposed to be good for physical delivery, the commercial bullion banks that were short nearly 38% of annual world production of gold this past December should have had 944.90 physical metric tonnes of gold in their vaults to back up their short position at that time. In reality, this situation never exists.

The amount of physical gold that the COMEX delivers on a daily basis is negligible compared to the massive historical short positions that have existed for decades. For example, during a two-week span across January and February, COMEX arranged for the physical delivery of 543,500 troy ounces of gold with their contracted warehouse depositories, a figure that represents an average of just 38,786 troy ounces of gold per day. At this rate of daily delivery, it would take the COMEX more than two years to deliver all the gold represented by the current net commercial short position should the holders of long contracts ask for settlement in physical delivery.

Through the use of futures markets, the Commodities Futures Trading Commission (CFTC) has granted bankers a mechanism to perform alchemy and turn paper into gold on the COMEX by allowing them to establish obscene short positions that represent 25% to nearly 40% of annual gold production at times while simultaneously allowing them to renege on their fiduciary responsibility to actually physically possess the gold represented by their short positions. In other words, the CFTC has allowed gold to operate under the principles of the fractional reserve banking system on the COMEX futures markets. As I stated above, the net short position of the commercials in gold represented more than 30 million troy ounces yet for the past few months they almost never exceeded delivery of 0.2% of their short position on a daily basis. Many people would refute this argument by stating that COMEX only delivered a minute fraction of physical gold represented by this obscene short position because no institution asked for substantial physical delivery of their long contracts. While it is true that less than 1% of most commodity futures contracts are ever settled by physical delivery, futures markets should not exist to serve the purpose of distorting the underlying reality of supply-demand fundamentals of the actual physical commodity. With gold and silver, this has been the case for decades.

However, the real question should be, “If I asked for physical delivery of an amount of gold that I should be able to receive, would I receive it?” Why? If you were India, China or the United Arab Emirates and you wanted to buy 200 tonnes of gold at the price established in futures markets, but you knew that there was no possible situation whereby 200 tonnes of gold would ever be delivered to you via the futures markets, what would you do? Would you buy 200 tonnes of gold in the futures markets only to know that you would suffer a default of this delivery and likely be forced to pay a much higher price in the open market in the future or would you try to arrange to buy 200 tonnes of gold NOW from the IMF or another Central Bank? Of course, you would choose the latter tactic. The fact that gold cannot be printed out of thin air is the essential quality that makes gold as a form of money much more sound than the Euro, the dollar, the Yen or any other form of fiat currency.

However, tens of billions of dollars of gold exist only in digital form on the COMEX and the CFTC has allowed bullion banks to indeed achieve alchemy with gold (and silver) in the futures markets. By allowing these mechanisms to persist that have absolutely zero to do with physical supply and demand of gold and silver, bullion banks can suppress the price of paper gold and paper silver in futures markets. But in the end, they will never be able to perpetually suppress the price of real physical gold and real physical silver. There will come a time when the prices for real physical gold and real physical silver completely sever the already tenuous umbilical cord they maintain to the suppressed prices of gold and silver established by the agent bullion banks of the US Federal Reserve and the Bank of England in futures markets.

As of February 17, the CME warehouse report stated that their depository warehouses contained 1,645,000 troy ounces of registered gold and 8,292,887 troy ounces of eligible gold. Only two of their depository warehouse have significant amounts of physical gold worth mentioning, HSBC, with 4,311,493 ounces of eligible gold and 266,677 troy ounces of registered gold; and Scotia Mocatta with 3,826,013 ounces of eligible gold and 936,855 troy ounces of registered gold. What does “registered” and “eligible” gold mean? As in everything bankers do, these terms are meant to confuse the average person. Central Bankers have used the same tactics to obscure their true holdings of gold reserves by alternately labeling their gold reserves as Bullion Reserve, Custodial Gold Bullion Reserve, and Deep Storage Gold, without granting any transparency to the definitions of their gold stores whenever they arbitrarily reclassify them with different names.

“Registered” gold is gold that has been assigned ownership and cannot be sold to another party while “eligible” gold is gold awaiting registration or delivery. In other words, a large portion of “eligible” gold may not be eligible at all. Furthermore, there are many questions regarding the “registered” gold that these depository warehouses hold as to whether multiple claims exist upon this “registered” gold. Many may say that questioning the validity of “registered” gold is non-justified paranoia, but the historical deceit of bankers justifies our skepticism, not our trust, in them. Just as multiple claims exist upon every single dollar, Euro, pound and yen that shows up in your savings or checking deposit bank passbook, I still believe that the gold listed as “registered” gold may have multiple owners as well (When it comes to the money in your bank savings and checking accounts, you may have the only claim on the digital representation of the cash money that exists in your bank savings and checking accounts, but that digital representation, since it has not yet been printed in cash, is an abstract concept that exists only in your mind and not in real life).

Though “registered” gold represents gold that has already been assigned to someone, unless that physical gold is in your hands, this does not preclude the fact that bankers may have assigned this “registered” gold to “multiple” owners no matter what they claim. Remember if one reads the fine print of the prospectuses of the GLD and SLV paper ETFs, it seems very likely that multiple claims exist on the physical gold and silver that back both the GLD and SLV even though the vast majority of buyers of these ETFs believe otherwise.

Last week’s Commitment of Traders report indicated that commercial bullion banks were still net short 21,342,700 troy ounces of gold. Given the definitions of “registered” and “eligible” gold, and the amounts of registered and eligible gold that exist in COMEX depository warehouses, it is obvious that bullion banks short gold with zero intention of ever physically delivering well over 90% of the gold ounces they short, even though market mechanisms require them to have the physical capacity and means to do so. Thus, if China, India or any number of Sovereign Wealth Funds wanted to buy another 1000 tonnes of gold, it would be physically impossible for them to even partially fulfill this desire. The 663.83 metric tonnes of gold that are currently represented by the physical offset of the current net short positions of the commercials that is supposed to be physically sitting in the vaults of depository warehouses contracted out by COMEX simply is not there. Furthermore, what is “eligible” for delivery may not even be eligible, and multiple claims may exist on both “eligible” and “registered” gold that exists in the contracted depository warehouses.

In the end, the announced IMF sale of 191.3 tonnes of their gold reserves, though it caused an immediate sharp knee-jerk reaction in gold futures markets, will have a negligible effect on the long-term price of gold. The IMF stated that “it would stagger the sales in order not to affect the markets too much”. However, since sovereign state buyers of gold can not get anywhere near the tonnage of gold they desire from the futures markets, the reality is that the IMF could probably dump all 191.3 tonnes on the market in one month and it would be instantly absorbed by China, India and Middle Eastern sovereign funds before any other Central Banks that also wants in on the sale could get their hands on any of it.

More than a year ago, I wrote an article describing the beginning of a disconnect between gold futures markets in Asia with those in London and New York, as well as the disconnect between physical gold and silver prices with the spot prices established in the futures markets in London. Eventually, due to the fraudulent nature of the gold and silver futures markets that have nothing to do with the physical supply and demand of the underlying commodities and everything to do with the desire of the US Federal Reserve and the Bank of England to suppress gold and silver prices, I believe that this disconnect will widen until there is an eventual total disconnect between the AM and PM London Price Fixes for gold and silver and the actual prices demanded by bullion dealers for real physical gold and real physical silver.

About the author: JS Kim is the Managing Director & Chief Investment Strategist for SmartKnowledgeU™, a fiercely independent wealth consultancy company with zero affiliations with the commercial investment and banking industry. Our independence allows us to critically analyze macroeconomic conditions with a completely unbiased eye, a crucial factor in a market where government intervention into free markets is heavily influenced by their friendly relationships with the investment and banking sector.

Tags: Bullion Banks, Central Banks, Comex Gold Futures, Commercial Position, Commodities Futures Trading, Commodities Futures Trading Commission, Daily Basis, Emerging Markets, ETF, Futures Commodities, Futures Contract, Futures Markets, Futures Trading Commission, Gold, Gold Prices, Gold Reserves, Imf Gold Sales, India, Knee Jerk Reaction, Metric Tonne, Metric Tonnes, Physical Delivery, physical gold, Price Of Gold, Troy Ounce, Troy Ounces
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Canada Moral Hazard Corporation?

Monday, February 15th, 2010

As the world’s spotlight turns to the Vancouver Olympics, all eyes will be on Canada. Our nation suffered comparatively less than other G7 economies during the last recession, and our banking system has received praises for being good and boring (read the Sceptical Market Observer’s comment on this).

To be sure, our economy is adding jobs, our stock market has rallied sharply, our currency is close to reaching parity with the USD, commodity exports are up, everything looks great. A buddy of mine even told me that our currency is being bought by central banks around the world. Canada seems to be on a tear.

But things are far from perfect. For one, there is a housing bubble in the making that could last a lot longer than people think. Stephen Jarislowsky, one of Canada’s best known investors, says he believes government measures aimed at juicing the housing market has put the sector in a bubble:

“I am convinced there is a housing bubble in Canada,” Mr. Jarislowsky told Bloomberg News. “… I conclude that the prices of housing today in the U.S. are cheaper than they should be, and that the prices in Canada are far more expensive than they should be.”

Mr. Jarislowsky is not alone. Other economists have also fretted about a bubble given the stunning rebound in real estate after the slump, and projections for record sales and prices this year. Ottawa is now considering tightening some rules. Said Mr. Jarislowsky: “They have basically encouraged people to buy houses based on cheap mortgages. That has created the opposite effect of what was desirable.”

Then, there is what Peter Foster of the National Post calls the Canada Moral Hazard Corporation:

There has been much official chest swelling over Canada’s relatively strong performance during the financial crisis, but perhaps Canadians shouldn’t — if you’ll excuse the mixing of metaphors — be counting their chickens until they are sure that there are no black swans present. And in fact there does seem to be one dark, plump, bird looming around the back of economic barnyard: the Canada Mortgage and Housing Corporation. Or is that a turkey that should be renamed the Canada Moral Hazard Corporation?

The CMHC was never given a cutesy acronym like its U.S. equivalents, Fannie Mae and Freddie Mac. But why not “Morrie Haz,” acknowledging that it has always been an instrument of moral hazard, the situation where insurance makes the insured-against event more likely?

As we know, Fannie and Freddie — which were privately-owned but “government-sponsored,” which meant they inevitably got bailed out — were front and centre in the U.S. housing market meltdown, which in turn precipitated the global financial crisis.

There are increasing concerns that the Canadian housing market is headed the same way as that of the U.S., stoked by the same factors: artificially low central bank interest rates, and the government insurance/promotion of risky mortgages.

This policy double whammy explains the growing calls for somebody — banks? CMHC? Carney? Flaherty? Anybody else? — to tighten mortgage regulations. These requests appear puzzling until we realize the role of the CMHC in encouraging perverse behaviour.

In a free market, if banks felt a housing bubble building, they would simply tighten standards themselves, either by demanding higher credit qualifications, hoisting rates, or shortening amortization periods. Hoisting rates is out of the question, since rock bottom mortgage rates are now considered by the Bank of Canada to be essential to national economic recovery and protection of our export industries. That leaves Morrie Haz waiting there to insure mortgages, and gives the banks every incentive to hand out any loan that can get insurance. However, they obviously grasp that such cosmic policy fecklessness will ultimately come back to haunt them.

A couple of weeks ago, Peter Routledge of credit analyst Moody’s pointed out that the overheating of the housing market was goosing an unsustainable increase in household borrowing more generally. “As witnessed in the United States,” he wrote, “this movie does not end well.” Specifically, once the punchbowl of low interest rates disappears, households find themselves in trouble, and so do their bankers.

Mr. Routledge noted that Canadian banks likely wouldn’t wind up in the same depths as their U.S. counterparts, but that is only because their riskiest mortgages are backstopped by CMHC. But this makes the systemic threat to the Canadian economy greater.

The U.S. crisis was massive but did not fall entirely on Fannie and Freddie. It was shared with other financial institutions. Nevertheless Fannie and Freddie both failed and had to be taken into government “conservatorship.” Mr. Routledge suggests that the situation is more “secure” in Canada, but as a recent report from the Fraser Institute points out, what this really means that the Canadian system features “massive taxpayer exposure.”

Mr. Routledge suggested that CMHC should tighten its insurance criteria, and this week he was seconded by former Governor of the Bank of Canada David Dodge.

The Fraser study, by Neil Mohindra, confirms that the taxpayer risk from a housing collapse is greater in Canada than elsewhere. He notes that a stunning 90% of all insured residential mortgages in Canada are covered by the CMHC. This amounts to an estimated $480-billion for which Canadian taxpayers would be on the hook if the housing market tanked (although any loss would obviously only be a fraction of this amount).

The study suggests that the CMHC’s activities should be privatized, but that possibility appears a long way down the road, both for practical and political reasons. The biggest problem is that nobody is going to want to privatize a property which harbours a potential time bomb.

The whole thrust of CMHC insurance is to encourage banks to make riskier loans. Normal insurance provisions are based on actuarial principles. CMHC insurance is based — like the activities of Fannie and Freddie — on promoting home ownership. Mixing social and economic objectives usually ends in taxpayer tears.

There is no indication that the Canadian mortgage market has been subject to the lunacies of the U.S., where — for a while — anybody with a pulse could get a home loan. Still, high ratio mortgages — that is, ones with down payments as low as 5% — inevitably carry a hefty risk of default when a bubble bursts. That default then becomes the CMHC’s problem.

As such, notes Mr. Mohindra, Canada is not a model for anybody. Morrie Haz has always been an accident waiting to happen.

According to Moody’s Mr. Routledge, “If policymakers deploy the appropriate tools early rather than late in this period of household credit expansion, perhaps the Canadian movie will end differently.”

But Finance Minister Jim Flaherty knows that ending the party is not going to be popular, which is where inevitable political self-interest compounds those practical problems. Meanwhile CMHC isn’t just a provider of potentially reckless insurance and the depository of last resort for mortgage assets the banks don’t want. Yesterday a representative of Diane Finley, Minister of Human Resources and Skills Development, who is also responsible for CMHC (go figure), was in Montreal handing out stimulus slush under Canada’s Economic Action Plan.

Mr. Flaherty doesn’t want to see a bubble, much less a bomb. But when it comes to which movie we’re coming to the end of, maybe he should check out The Hurt Locker. Just in case.

Of course, lenders like ING, oppose any clampdown to rein in mortgage borrowing. Sound familiar? I agree with Stephen Jarislowsky and I also fear that this movie isn’t going to end well. Enjoy the Vancouver games, because I feel a post-Olympics winter chill headed our way.

Tags: Banking System, Black Swans, Canada, Central Banks, Cheap Mortgages, Chickens, Commodity Exports, Financial Crisis, Government Measures, Housing Bubble, Housing Market, Jarislowsky, Metaphors, Moral Hazard, Parity, Praises, Recession, Record Sales, Slump, Swans, World Canada
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Hugh Hendry and Joseph Stiglitz Duke it Out Over Greece and the Euro

Wednesday, February 10th, 2010

This article is a guest contribution from The Business Insider.

Joe Stiglitz and Hugh Hendry duked it out last night on BBC’s Newsnight.

Stiglitz says that betting on a default is absurd. Hendry is betting on exactly that happening in Greece.

From Hendry’s opening line you can tell this is going to be a good fight:

“Um hello? Can I tell you about the real world?”

Then the BBC anchor asks (at 7:28): “So you would see Greece tumble and the Euro currency tumble?”

Hendry: “Absolutely.”

He goes on to say that it’s recognizing the unsustainable debt and then Stiglitz cuts him off:

“That’s absurd.”

Watch the video after the jump. Here’s a bit more transcribed:

BBC anchor (around 5:00): “But isn’t the truth, Hugh Hendry, that if Greece defaults, that you, that hedge funds like you, make millions?”

“…Some hedge funds make millions. Yeah, the hedge funds who - hedge funds, speculators, and independent central banks are what stands between an economy and hyper-inflation.

“It’s very hard to create inflation when you have free markets. When you have the discourse and dissemination of information.

“Look what happens - you get into difficulty and these guys over here [pointing at Stiglitz and Spanish Ambassador to the UK, Carles Casajuana] say, “hey we don’t like it.”

“Suddenly the truth hurts! Suddenly we want to abandon the truth. Suddenly speculation becomes a pejorative term!”

Casajuana: “No no no, we don’t want to abandon the truth. We admit we have a problem…”

Video:

Tags: Anchor, Bbc, Business Insider, Carles, Central Banks, Discourse, Dissemination Of Information, Duke, Euro Currency, Free Markets, Good Fight, Hedge Funds, Hugh Hendry, inflation, Joe Stiglitz, Joseph Stiglitz, Newsnight, Spanish Ambassador, Speculation, Speculators
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Investing for 2010: Ideas from Gross, MacAllaster & Witmer

Monday, February 1st, 2010

Three members of Barron’s roundtable, Bill Gross, Archie MacAllaster and Meryl Witmer shared their views on market outlook and investment ideas with Wall Street Journal.

The following is a recap with video links of the interviews.

Gross’ Three Market Drivers for 2010

Bill Gross, founder and co-chief investment officer at Pimco, believes the direction of short-term interest rates, inflation and quantitative easing will be the driving market forces in 2010.

Inflation: Contained & moving lower

Short-term Interest Rate is Central banks response to inflation.  He expects them to maintain the current near zero policy amid low inflation.

Quantitative Easing - Central banks withdrawal from buying mortgages and treasuries will have great impact on stocks, bonds and other riskier assets.

Note:  Bill Gross’ February 2010 Investment Outlook: The Ring of Fire is available at Pimco.com here.

MacAllaster Sees A “Good Size” Correction Coming

Archie MacAllaster, chairman of MacAllaster Pitfield MacKay, believes there will be a “good size” market correction in 2010 before rebounding later in the year with a possible 15% upside. He expects financials, particularly life insurance stocks to rise.

(MacAllaster interview video link here)

Witmer Expects Compass Mineral to Outperform

Meryl Witmer, general partner at Eagle Capital Partners, likes Compass Minerals (CMP), a salt and specialty potash maker. She expects its shares to have above trend growth over the next several years as it has one of the few expandable salt mines in the country.

Witmer sees Compass making $8-9 a share in 2011 or 2012, and should trade north of $100 in a year or so.

(Witmer video interview link here)

Video Source: WSJ.com

Tags: Archie Macallaster, Bill Gross, Central Banks, Chief Investment Officer, Compass Mineral, Compass Minerals, Eagle Capital, General Partner, Insurance Stocks, Interview Link, Investment Ideas, Investment Outlook, Market Drivers, Meryl Witmer, PIMCO, Salt Mines, Stocks Bonds, Video Link, Video Source, Wall Street Journal, Wsj
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Stock Market Leadership Points to Risk Aversion

Wednesday, January 27th, 2010

As far as leadership since the start of the nascent US stock market correction on January 20 is concerned, it is interesting that cyclical sectors such as the Materials SPDR (XLB), Financial SPDR (XLF), Energy SPDR (XLE) and Technology SPDR (XLI) have been leading the market lower. Traditionally defensive sectors such as Consumer Staples SPDR (XLP), Utilities SPDR (XLU) and Health Care SPDR (XLV) also declined, but to a lesser extent than the S&P 500 Index as a whole (-5.1%) and the cyclical sectors.

This is the type of pattern one would expect typically to emerge during a correction phase.

Source: StockCharts.com

Turning to the broader market, Adam Hewison (INO.com) provides a short technical analysis and poses the question “Is the Dow in trouble?” Click here to access the presentation.

The final words go to David Fuller (Fullermoney) commenting as follows from across the pond: “Why might this be no more than another correction rather than the beginning of a new bear trend? Unless the modest global economic recovery is about to slide back into another slump, which I doubt, I do not see the catalysts for another stock market collapse. Instead, and despite the current uncertainty, I think this could still be an economic sweet spot for stock markets characterized by modest global GDP growth, reasonably accommodative monetary policy and generally low inflationary pressures.

“Yes, there has been some overheating in emerging Asia, especially China where the PRC’s monetary authorities have moved early and incrementally to contain this problem, as I have said before. In North America and Europe central banks are talking about ending quantitative easing but that is not the same as a monetary squeeze. Historically, the US stock market has usually continued to rise during the early stages of a cycle of higher short-term interest rates from the Fed, and this has yet to commence.”

Tags: Central Banks, China, Consumer Staples, Correction Phase, David Fuller, Emerging Asia, Emerging Markets, Energy Spdr, GDP Growth, Global Gdp, Inflationary Pressures, Leadership Points, Market Collapse, Market Leadership, Monetary Authorities, Stock Market Correction, Stock Markets, Us Stock Market, Xle, Xlp, Xlu, Xlv
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Byron Wien’s Ten Surprises for 2010

Tuesday, January 5th, 2010

Dead on target at the beginning of the new year, 76-year-old Byron Wien again published his annual list of surprises to expect in 2010. Wien, Vice Chairman of Blackstone Advisory Services and one of Wall Street’s best known veterans, has been publishing his list of economic, market and political surprises since 1986.

Reviewing Wien’s 2009 list, he was very accurate with the direction of most of his predictions.

He foresaw a second-half recovery in the US economy, and the S&P 500 Index rising to 1,200 (up from 903 at the end of 2008 to 1,115 by December 31, 2009). He also predicted: “The ten-year US Treasury yield climbs to 4% [up from 2.24% to 3.84%]. Later in the year, as the economy shows signs of recovery, economists and investors shift their mood from concern about deflation to worries about inflation. A weak dollar, rapid growth in money supply and record-setting deficits (over $1 trillion) are behind the change.” Spot on.

Wien also expected the gold and oil prices to climb to $1,200 and $80 respectively - a feat accomplised in December.

He believes his ten surprises have at least a 50% chance of occurring at some point during the year. Although this is not a very high probability, his predictions nevertheless make for stimulating reading. His list for 2010 follows below.

1. The United States economy grows at a stronger than expected 5% real rate during the year and the unemployment level drops below 9%. Exports, inventory building and technology spending lead the way. Standard and Poor’s 500 operating earnings come in above $80.

2. The Federal Reserve decides the economy is strong enough for them to move away from zero interest rate policy. In a series of successive hikes beginning in the second quarter the Federal funds rate reaches 2% by year-end.

3. Heavy borrowing by the US Treasury and some reluctance by foreign central banks to keep buying notes and bonds drives the yield on the 10-year Treasury above 5.5%. Banks loan more to corporations and individuals and pull away from the carry trade, thereby reducing demand for Treasuries. Obama says, “The suits are finally listening”.

4. In a roller coaster year the Standard and Poor’s 500 rallies to 1,300 in the first half and then runs out of steam and declines to 1,000, ending where it started at 1115.10. Even though the economy is strong and earnings exceed expectations, rising interest rates and full valuations present a problem. Concern about longer term growth and obligations to reduce leverage at both the public and private level unsettle investors.

5. Because it is significantly undervalued on a purchasing power parity basis, the dollar rallies against the yen and the euro. It exceeds 100 on the yen and the euro drops below $1.30 as the long slide of the greenback is interrupted. Longer term prospects remain uncertain.

6. Japan stands out as the best performing major industrialized market in the world as its currency weakens and its exports improve. Investors focus on the attractive valuations of dozens of medium sized companies in a market selling at one quarter of its 1989 high. The Nikkei 225 rises above 12,000.

7. Believing he must be a leader in climate control initiatives, President Obama endorses legislation favorable for nuclear power development. Arguing that going nuclear is essential for the environment, will create jobs and reduce costs, Congress passes bills providing loans and subsidies for new plants, the first since 1979. Coal accounts for about 50% of electrical power generation, and Obama wants to reduce that to 25% by 2020.

8. The improvement in the US economy energizes the Obama administration. The White House undergoes some reorganization and regains its momentum. In the November Congressional election the Democrats only lose 20 seats, much less than expected.

9. When it finally passes, financial service legislation, like the health care bill, proves to be softer on the industry than originally feared. There is greater consumer protection, more transparency, tighter restriction of leverage and increased scrutiny of derivatives, but the regulatory changes for investment bankers and hedge funds are not onerous. Trading volume and merger activity increases; financial service stocks become exceptional performers in the US market.

10. Civil unrest in Iran reaches a crescendo. Ayatollah Khameini pushes out Mahmoud Ahmadinejad in favor of a more public relations adept leader. Economic improvement becomes the key issue and anti-Israel rhetoric subsides. Talks with the US and Europe begin but the country remains a nuclear threat. Pakistan becomes the hotspot in the region because of the weak government there, anti-American sentiment, active terrorist groups and concerns about the security of the country’s nuclear arsenal.

Source: PR-inside.com, January 4, 2009.

Tags: 10 Year Treasury, Advisory Services, Blackstone, Byron Wien, Central Banks, Deflation, Economic Market, Federal Funds Rate, Federal Reserve, Gold, Interest Rate Policy, Money Supply, oil, Oil Prices, Rapid Growth, Reluctance, S 500, Target, Unemployment Level, United States Economy, Us Treasury, Vice Chairman, Weak Dollar
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Roundup: Gold Market

Monday, January 4th, 2010

Gold Market

For the week, spot gold closed at $1,096.65 per ounce down $8.75 or 0.79 percent. Gold equities, as measured by the XAU Gold & Silver Index, fell 2.19 percent for the week. The U.S. Trade-Weighted Dollar Index gained 0.28 percent.

Strengths

• According to a report in the China Daily, Chinese citizens have been rushing to buy gold after major department stores cut the price of jewelry by around 3 percent in year-end promotions for the Chinese holiday season. Gold jewelry sales increased by about 30 percent or more over the previous weekend.
   
• The International Monetary Fund has said the dollar’s share of global currency reserves fell in the third quarter to the lowest level in a decade. The currency’s portion fell at the end of the third quarter of 2009 to 61.6 percent from 62.8 percent in the previous quarter. Data collected by the World Gold Council showed that central banks collectively bought $28 billion of gold at an average price of $978 ounce.
   
• MasterCard released a report showing jewelry sales in the U.S. rose 5.6 percent for November and December. Luxury retail, excluding jewelry, increased slightly by 0.8 percent during the holiday season compared to last year, due to an extra day of holiday shopping and a spike in online shopping.

Weaknesses

• According to Reuter’s calculations, the value of the U.S. dollar’s net long position was around $700 million in the week ending Dec. 22, up from a net short position of $1.98 billion the prior week, and ended 32 straight weeks of short dollar positions.
   
• Data from the Mines and Geosciences Bureau of the Philippines showed that investments in the mining industry fell short of an already downscaled $650 million full year target from its original target of $1 billion. The latest actual investment figure is $375 million this year, a fraction of the downscaled target due to tight credit for developing projects in emerging markets.
   
• The New York Times has reported that New York State’s courts are feeling the legal fallout of the recession as they are closing the year with 4.7 million cases, the highest tally ever, with cases ranging from contract disputes to home foreclosures.

Opportunities

• Philip Klapwijk, chairman of Gold Fields Mineral Services, has stated gold will probably extend its longest winning streak in at least six decades next year on inflation concerns and dollar weakness. Klapwijk most accurately forecasted the average gold price for 2009 among his peers, being only 0.2 percent from the actual average.
   
• Esteemed hedge fund manager Eric Sprott has said the S&P 500 Index will collapse below its March lows when an expected rebound in economic activity fails to materialize. Sprott has said the market’s rally is attributable to the misinterpretation of economic data and forecasts a 40 percent correction.
   
• Similarly, Jim Sinclair, a much respected and followed bull on the gold price, disagrees with analysts predicting a stock market rally in 2010, and instead remains confident in gold, looking for new highs above $1,224 then moving on to $1,274 before reaching $1,650.

Threats

• Research from Sprott Asset Management indicates that out of three of the largest Treasury buying groups, including the Federal Reserve itself, households bought the most in government debt in 2009 which totaled $528.7 billion as opposed to only $15 billion in 2008, a 35-fold increase. The issue going forward is who will pick up the demand of Treasury auctions if the household sector has been tapped out and foreign buyers are reluctant to add more dollars to their reserves.
   
• The U.S. government has bailed out GMAC, the ailing former finance arm of General Motors, for the third time by injecting $3.8 billion in capital, increasing the U.S. Treasury’s stake in the lender to 56 percent from 35 percent.
   
• Morgan Stanley is forecasting yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the largest annual increase since 1999, also pushing interest rates higher on 30-year fixed mortgages to 7.5 percent to 8 percent, the highest in a decade.

Tags: Central Banks, China, Chinese Citizens, Chinese Holiday, Currency Reserves, Dollar Index, Emerging Markets, Global Currency, Gold, Gold Equities, Gold Jewelry, Gold Market, Holiday Shopping, International Monetary Fund, Jewelry Sales, Quarter Data, Short Position, Silver Index, Spot Gold, Straight Weeks, Target, Tight Credit, World Gold Council
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Keep Your Eyes on the Yield Curve

Thursday, December 24th, 2009

Stocks are trading at or close to 2009 highs, being helped along by a record steepening of the yield curve. Put simply, on Tuesday the gap between 10- and 2-year US government bond yields hit its widest spread ever – 286 basis points, beating last week’s 276 basis points and the previous record set in August 2003 of 274 basis points.

From across the pond, David Fuller (Fullermoney) said: “Veteran subscribers will recall a remark often used on this site [Fullermoney]: Bull markets do not die of old age - to which I will add warnings by Roubiniesque economists. Instead, they are assassinated - usually by central banks. So how many rate bullets does it take to fell a bull? You may not be surprised to hear that there is no precise answer, because it depends mainly on sentiment and liquidity. We know when central banks start to reduce liquidity, or at least increase its price, but we do not know precisely when that will affect sentiment adversely.

“Note the still widening spread between US 10-year yields over 2-year yields, otherwise known as the yield curve, on this historical. It is still rising, indicating to me that quantitative easing continues. The time to start thinking about closing long portfolios in anticipation of the next bear market, I suggest, will be when the yield curve next inverts by moving below zero. However, the lead was so early last time (early 2006) that some of us became complacent about it.”

Source: Fullermoney

Tags: Anticipation, Basis Points, Bear Market, Bond Yields, Bull Markets, Bullets, Central Banks, David Fuller, Economists, Fullermoney, Gap, Government Bond, Inverts, Last Time, liquidity, Portfolios, Precise Answer, Quantitative Easing, Sentiment, Yield Curve
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2010 Economic Outlook: From Exit to Exit

Tuesday, December 22nd, 2009

This post is a guest contribution by Joachim Fels* of Morgan Stanley.

This year was all about the exit from the Great Recession - and, as we had expected at the start of the year, it worked courtesy of massive global policy stimulus. Next year will be all about the exit from super-expansionary monetary policy - we expect the major central banks to start exiting around mid-2010. Yes, they will likely be cautious, gradual and transparent. However, the prospect and process of withdrawal may have unintended consequences: we think government bond markets will be the first victim. While we believe that the exit will be the dominant macro theme next year, we identify five important economic themes in our global economic outlook that, in our view, will be highly relevant for investors in 2010.

A tale of two worlds: We forecast 4% global GDP growth in 2010, up only marginally from three months ago (see the previous Global Forecast Snapshots: ‘Up’ Without ‘Swing’, September 10, 2009).  True, if this turns out to be about right, it would be a fairly decent outcome, especially compared to the widespread doom and gloom earlier this year. However, it falls short of the close to 5% growth rate in the five years prior to the Great Recession, and it will be the product of unprecedented monetary and fiscal stimulus, which poses substantial longer-term risks on various fronts. Moreover, our 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies - the ‘triple B’ recovery we discuss below. The other is a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% in 2010 (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% this year. A rebalancing towards domestic demand-led growth in EM is well underway. Moreover, as our China economist Qing Wang has been pointing out for a while now, the official statistics are likely to vastly underestimate the level and growth rate of consumer spending in China. In short, we think that the theme of EM growth outperformance has staying power and has even been bolstered by the crisis.

A ‘triple-B’ recovery in G10: In contrast to our upbeat EM story, we forecast barely 2% average GDP growth in the advanced G10 economies in 2010 - a triple B recovery where the three Bs stand for bumpy, below-par and boring. On our estimates, GDP growth has averaged around 2% in the G10 in the second half of this year and won’t accelerate much from that pace next year - hence our ‘up’ without ’swing’ characterisation from three months ago remains valid. The two reasons why we think the recovery in advanced economies will be of the ‘triple B’ type are that it is likely to be creditless and jobless. Creditless recoveries - defined as a situation where banks are reluctant to lend and the non-bank private sector is unwilling to borrow - are the norm following a combination of a credit boom in the preceding cycle and a banking crisis; and creditless recoveries typically display sub-par economic growth as credit intermediation is hampered. Moreover, we expect a jobless G10 recovery, with unemployment in the US declining only marginally next year and rising further in Europe and Japan. Unemployment may well stay structurally higher over the next several years in the advanced economies as many of the unemployed either have the wrong skills or are in the wrong place in an environment where the sectoral and regional drivers of growth are shifting.

More growth differentiation within the G3: Beneath the surface of what we call a lacklustre ‘triple B’ recovery in the advanced economies lies a differentiated story for the three largest economies within this block - the US, the euro area and Japan.  We expect significant growth differentials between these countries in 2010, which may well become a topic for currency, interest rate and equity markets again. We see the US as the growth leader among this group next year, with output expanding by 2.8% in the annual average of 2010. The euro area economy looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) next year and is forecast to actually fall back into a technical recession in 1H10. One reason for relative US outperformance is that the creditless nature of the recovery affects the US private sector by less because banks (as opposed to capital markets) play a smaller role in financing the economy than in Europe or Japan. Another reason is that US companies have been much more aggressive in shedding labour this year than their European or Japanese counterparts, so the US labour markets looks set to recover (albeit slowly) next year, while we expect unemployment to rise further in both Europe and Japan.  Further, European and Japanese exporters should feel the pain from this year’s currency appreciation, whereas US exporters should benefit from this year’s dollar weakness.

Crawling towards the exit, but triple A liquidity cycle remains intact: As stated above, we expect the beginning of the exit from super-expansionary monetary policies and its implications to be the dominant global macro theme in 2010. We will discuss details of the likely monetary exit strategies across countries in next week’s year-end Global Monetary Analyst. Here, it suffices to say that we expect the Fed, the ECB and the PBoC to move roughly in tandem and raise interest rates from 3Q10, with the Bank of England following in 4Q. Some, like the central banks of India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. Generally, given the remaining fragility in the financial sector, central banks are likely to approach the exit in a cautious, gradual and transparent manner, so any hikes will likely be telegraphed well in advance, partly through appropriate twists in the crafted language, and partly through some cautious draining of excess bank reserves. Importantly, while the end of easing and the beginning of the exit can be expected to cause wobbles in financial markets, and this is one reason why we see bonds selling off sharply next year, we point out that official rates are likely to stay well below their neutral levels (even factoring in that these themselves are likely to be lower now than they have been in the past) throughout 2010 and, probably, also in 2011. Hence, monetary policy is only expected to transition from super-expansionary to still-pretty-expansionary. This would leave what we have dubbed the ‘triple A’ liquidity cycle (ample, abundant and augmenting), which we have identified as the main driver behind this year’s asset price bonanza and economic recovery, fairly intact next year. The metrics we follow to validate or refute this view is our global excess liquidity measure depicted in the chart below, which is defined as transaction money (cash and overnight deposits) held by non-banks per unit of nominal GDP. This measure exploded this year and we would expect it to rise further, though at a much lower pace, through 2010.

Sovereign and inflation risks on the rise: Fifth, but not least, we think that sovereign risk and inflation risk will be a major theme for markets in 2010. The current issues surrounding Greece’s fiscal problems are only a taste of things to come in many other advanced (note: not emerging) economies, in our view. We note that fiscal policy looks set to remain expansionary in all major economies next year, as it arguably should be, given the ‘triple B’ recovery which still requires support. However, markets are likely to increasingly worry about longer-term fiscal sustainability, and rightly so. Importantly, the issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: most of the government debt outstanding in advanced economies is in domestic currency, and in the (unlikely) case that governments cannot fund debt service payments through new debt issuance, tax increases or asset sales,  they can instruct their central bank to print whatever is needed (call it quantitative easing). Thus, in the last analysis, sovereign risk translates into inflation risk rather than outright default risk. We expect markets to increasingly focus on these risks in the year ahead, pushing inflation premia and thus bond yields significantly higher. Put differently, the next crisis is likely to be a crisis of confidence in governments’ and central banks’ ability to shoulder the rising public sector debt burden without creating inflation.

* Joachim Fels co-heads Morgan Stanley’s Global Economics Team (with Dick Berner) and is the Firm’s Chief Global Fixed Income Economist, based in London. His research focuses on monetary policy, the global liquidity cycle, and inflation. Joachim edits The Global Monetary Analyst, a weekly Morgan Stanley Research publication.

Tags: Canada, Central Banks, China, Doom And Gloom, Economic Themes, Emerging Markets, Expansionary Monetary Policy, Fels, First Victim, Fiscal Stimulus, GDP Growth, Global Economic Outlook, Global Gdp, Global Policy, Government Bond Markets, India, Morgan Stanley, Official Statistics, Positive Outlook, Qing Wang, Rebalancing, Two Worlds, Unintended Consequences
Posted in Emerging Markets, India, Markets | No Comments »