Wednesday, 18 August 2010

The Endgame - Fin de partie

The current attitude of Central Banks and in particular the Fed is reminiscent of Samuel Beckett's Theatre of the Absurd play called Endgame, hence the title of this post.

Beckett's play, is also a reference to Chess Endgame. Beckett was an avid Chess player.

Endgames can be divided into three categories:

Theoretical endgames – positions where the correct line of play is generally known and well-analyzed, so the solution is a matter of technique.

Practical endgames – positions arising in actual games, where skillful play should transform it into a theoretical endgame position.

Artistic endgames (studies) – contrived positions which contain a theoretical endgame hidden by problematic complications

Martin Sibileau on the 12th of August published a very interesting post which I highly recommend reading. He goes through on how the game has changed dramatically recently and why the Fed has got it dangerously so wrong again. Martin Sibileau is currently a Director for the Loan Portfolio Management Team of a major Toronto headquartered financial institution.

"Simply, the Fed decided that instead of allowing its balance sheet to shrink, as the mortgage backed securities and agency debt it holds are repaid, it will reinvest those amounts (which are not minor, estimated at $200BNover the next 12 months) back into the Treasuries market. We understand it will target purchases in the 2-7yrs range, which caused the 10-30yr to steepen sharply in the last two sessions. The spread between costs of liquidity in the Euro and USD currency zones, discussed a week ago, continued to widen also for this same reason, but the sensitivity of risk assets to it reversed. Another thing to keep in mind: If the Fed purchases Treasuries directly from the Treasury, it will not only be keeping the size of liquidity available in the system steady but also, it will be monetizing fiscal deficits. The street is watching…"

"One of the first rules any student of Economics learns is that if a monopoly controls quantities, it cannot control prices and vice versa, if it controls prices, it cannot control quantities. Until Tuesday, the Fed was targeting the price of its liabilities. It was concerned with the so called general price level. Since Tuesday, it is concerned with their quantity."

Like a broken record, I kept saying that the only results that will be generated from an extension of QE is inflation down the line. We are still in a deflationary environment but the EndGame will be Stagflation.
It is becoming more and more obvious we are heading towards stagflation. Martin Sibileau also comes to the same conclusion on his blog.

I also recommend you read the following post from David Goldman:

"Bloomberg today reports that the first rise in CPI in four months has reduced fears of deflation. This is silly. Between 2000 and 2008, the Federal Reserve ignored the bubble in home prices because rents failed to rise, and CPI measures rent (or home rental equivalent) rather than home prices. Now that home prices have collapsed, and homeowners are being turned out of their dwellings, rents have stabilized, because fewer people can buy houses and must rent instead. This is the consequence of a 22% all in unemployment rate. The only thing that has reflated during the dead-cat bounce that earlier masqueraded as recovery was the corporate profit picture, achieved largely through cost-cutting (more unemployment) or financial manipulation by the Fed, which handed banks the steepest yield curve in history.

Asset markets, though, reflect considerable deflation risk. A preference for cash and fixed-income assets over brick and mortar is a statement that physical assets are more likely to be cheaper in the future. There is a huge demographic tailwind behind fixed income markets, as I mentioned on the Kudlow Report Wednesday evening. The population is aging rapidly: between 2005 and 2020, the proportion of Americans aged 60 and over will rise from 16.7% to 22.8%, according to UN data. For “more developed regions,” the increase will be from 20% to 28%. That generates a huge demand for savings instruments. And that is inherently deflationary: aging savers buy future goods (securities) rather than present goods."

David concludes his post from the 13th of August with the following comments:

"Absent a fiscal reform that provides incentives to entrepreneurs to shift into physical assets, the Japan scenario is likely. There’s no more striking sign of deflation than private equity and real estate funds turning money back to investors. If the fund managers can’t find projects worth buying (which pay them handsome fees), it’s likely that corporate managers can’t either."

Although David sits tightly in the deflationary camp, while like Martin Sibileau, I still believe in a Stagflation scenario due to the inefficiency of QE to generate growth(please see previous posts), David is also playing defence:

"I own plenty of inflation-hedge equities (against the possibility that my core expectation of deflation turns out wrong), but I’m happy with the bulletproof tax exempts I bought at higher yields than are presently available"

"In short, the economy is going nowhere, and the stock market doesn’t have a second act after the heroic cost-cutting of last year."

From my point of view, we are still in a deflationary environment. This is due to the massive amount of deleveraging that still needs to go through. Banks are still busy using the steepest yield curve in history to repair their balance sheets, and many banks are effectively not lending due to risk aversion and lack of risk appetite due to heavier regulations as well as to very stringent credit standards.

But, given the propensity with which the Fed is likely to be using QE to tentatively boost the US economy, it will be inflationary down the line.

To conclude Andy Xie has very well written on the inflation coming in the near future, please see below link (Andy Xie is an independent economist based in Shanghai and was formerly Morgan Stanley’s chief economist for the Asia- Pacific region):

Inflation, Not Deflation, Mr. Bernanke
By Andy Xie 08.16.2010 18:12

"The globalization reality is that developed economies like Europe, Japan, and the U.S. will suffer slow growth and high unemployment. Stimulus is the wrong medicine for solving problems. Believing this will lead to excessive stimulus, which causes inflation and bubbles in emerging economies first and inflation in developed economies later. The wrong policy prescription pushes the global economy through unnecessary gyrations, stagflation and possibly another major financial crisis in the emerging economies. It's high time for Mr. Bernanke to wake up from his stimulus obsession."

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