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« Higher stocks on weaker fundamentals: You should not be surprised
The Fed’s purchases of Treasuries keeps driving the markets »

Two main market theses

Published on April 21st 2009

In previous letters, I had proposed the following hypothesis:

1.-“…as long as the Fed and all the other central banks keep flooding buckets with liquidity and feed us with daily announcements, we can see prices NOT falling…” (April 14th, 2009)

2.-“…All currencies are being debased in calculated order. It is precisely this order that is denying gold the chance of playing a safe and lucrative asset. If the debasement had not been orderly, if it had been amid uncertainty and chaos, gold would have had a chance…” (April 16th, 2009)

Yesterday was an interesting day, because it afforded the chance to refute the two hypotheses.

In the world of finance, Karl Popper is perhaps best known thanks to George Soros, who was one of his students (refer Soros’ website: http://www.soros.org/about/bios/a_soros). Karl Popper was a 20th century philosopher, who wrote about the Philosophy of Science. In Popper’s words: “…the scientific status of a theory is its falsifiability, or refutability, or testability…” (Karl Popper, Conjectures and Refutations, London: Routledge and Keagan Paul, 1963).

In previous letters, I had proposed the following hypothesis:

  1. “…as long as the Fed and all the other central banks keep flooding buckets with liquidity and feed us with daily announcements, we can see prices NOT  falling…” (April 14th, 2009) Read the article.
  2. “…All currencies are being debased in calculated order. It is precisely this order that is denying gold the chance of playing a safe and lucrative asset. If the debasement had not been orderly, if it had been amid uncertainty and chaos, gold would have had a chance…” (April 16th, 2009) Read the article.

Yesterday was an interesting day, because it afforded the chance to refute the two hypotheses. At about 5:00am ET, Bloomberg was reporting Mr. Trichet, the President of the European Central Bank (ECB), saying that a zero-rate policy was not appropriate for the Euro area. In addition, The New York Times later published an article saying that the Treasury is seeking to stretch what is left of the $700 billion financial bailout fund by converting the government’s existing loans to the 19 biggest banks into common stock…Before the markets opened, the damage had been done…European stock markets were down and North American futures were following the trend. Everything reverted, as in the tale of Cinderella after midnight: Treasuries regained what they had lost on Friday (30-yr closed at 96-23; 10-yr at 99-08), the VIX Index was returning to the 40s (closed at 39.18) and the S&P500 finished -4.28%, at 832.39 points. Credit spreads also widened; with the CDX IG12 index closing at 186/187.5 (+9.5) bps…and oil fell to $45.65/bbl.

Let’s analyze the news. Trichet’s comments above suggested a clear lack of conviction to undertake a quantitative-easing policy (In another letter, I will explain the relationship between zero-rates and quantitative easing). Simply put, the ECB may not follow the Fed’s approach. This was a surprise and I doubt it had been “calculated” or coordinated.

Perhaps the second news was more negative. There had been plenty of rumors and speculations very early in the day on the results of the banks’ stress tests and future capital funding needs. You may disagree here with me, but I think the negative stress tests or additional capital funding needs should not surprise anyone. The real surprise was the suggestion that the Treasury may shift from an asset purchase to a capital injection approach. It reminded me of November 12th 2008; when Henry Paulson said he was veering from the original plan to use the $700 billion to buy illiquid mortgage assets, to shore up more capital for non-banks and banks. A week later, the S&P500 had lost about 17%. Capitalizing banks and buying their distressed assets are two very different things. Banks capitalization is a more “levered” solution, but it does not create a bid for distressed assets. It does not solve the root of the problem. Capitalizing banks is similar to building walls against an enemy besieging a town. As long as the enemy is out and alive, the town has a problem!

In summary:

  1. The axiom that the Fed and all the other central banks will keep flooding buckets with liquidity was challenged yesterday, and asset prices fell. Following Popper’s approach, the hypothesis’ prediction (i.e. when the Fed injects liquidity, asset prices rise. When the Fed does not inject liquidity, asset prices fall) was tested and could not be refuted. Does this mean the hypothesis is verified? No, we simply corroborated it, and we cannot abandon it until we have a better substitute (Readers’ feedback is very welcome).
  2. The axiom that currencies are being debased in calculated order was challenged yesterday too, and the price of gold rose from 872 to 884 USD/oz. The hypothesis’ prediction (i.e. when there is global coordination of inflationary monetary policies, gold cannot be a safe and lucrative asset. When inflationary monetary policies are not globally coordinated, gold is a safe and lucrative asset) was tested. However, since the adjectives “safe” and “lucrative” are subjective and temporal (returns depend on time horizon), I am hesitant to say that this hypothesis could NOT be refuted. If the lack of coordination in monetary policy persists, we will observe the price of gold again and reach a conclusion. But unfortunately, until we find a better substitute for Hypothesis 2, we must keep it

« Higher stocks on weaker fundamentals: You should not be surprised
The Fed’s purchases of Treasuries keeps driving the markets »

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