” The first effect of the increase of productive activity, initiated by the policy of the banks to lend below the natural rate of interest is to raise the prices of producers’ goods while the prices of consumers’ goods rise only moderately. . . But soon a reverse movement sets in : prices of consumers’ goods rise and prices of producers’ goods fall, i.e., the loan rate rises and approaches again the natural rate of interest.”
L. v. MISES, “Theorie des Geldes und der Unlaufsmittel”, 1912, p. 431.
Please, click here to read this article in pdf format: july-8-2009
The retrenchment in risk assets continues. Yesterday, stocks sold off again (S&P 500 closed at 881.03 or -1.97%) while Treasuries gained (30-yr yield ended at 4.304%). The chart below says it all. The Libor-OIS spread we discussed yesterday continued to compress, with 3-mo Libor now at 53.75bps. It is a trend, certainly, but without the violence we got so accustomed to see in 2008. It looks like the markets are under anesthesia, provided by central banks, while everybody waits for a surgeon to show up and do the dirty job…
I have the feeling that I could safely say that nobody can affirm with certainty today where markets are headed to (Except of course the usual bearish voices, the same ones that missed the huge rally of 2009). We cannot blame analysts for their lack of certainty. However, perhaps, there is value in acknowledging ignorance. What do I mean? I could argue that today there may be more merit in acknowledging ignorance than betting on a path. But, if forced, one can always go back to the comfort of those self evident truths. Whenever I need to understand something new, I just go back to reading classics. For instance, let’s rescue Mr. Keynes’ thoughts back from oblivion. If we want to be consistent, we need to recognize that the goal of every government’s interventionist policy since 2007 is to increase output back to a “full employment” level. What should the world look like, if their efforts are successful? At the end of the 3rd section, Chapter 13 of “The General Theory of Employment, Interest and Money”, Maynard very succinctly told us that: “…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest...” Keynes could not have been clearer on this. The only possible way out of a financial crisis is to inflate the way out of it (By the way, that’s why we have central banks). Anything else is pure hypocrisy and a painful and unnecessary delay.
In the meantime, the painful and unnecessary delay is caused by inconsistent intervention that dislocates and segments markets. We discussed the issue yesterday, in relation to the compression of the Libor-OIS spread and risk assets dynamics. The intervention is very harmful, because it affects price relationships. The pricing system is nothing else than a communications system. In fact, it is not the only one we have to signal gaps between supply and demand in every market, but it is also the best one we have within all our imperfections. Thus, every regulation, every exogenous purchase or sale of assets done by any government distorts this signaling system and we end up getting the wrong signals. We then have to hear mainstream economists say that “equities got a bit ahead of themselves”. This is nonsense. This school of thought is the same one that sustains that markets are not rational. See, if you sense a monster in your room and you run away, you are not irrational, for escaping monsters is precisely the rational thing to do! What is the problem then? The problem is that there are no monsters in your room. You simply had the wrong information. And so do markets today! Who provides it? Governments! The sooner their intervention ends, the sooner we will recover.
Chart 1: 30-yr Treasury (white) vs. S&P 500 Index (orange), intraday (Source: Bloomberg)
