Please, click here to read this article in pdf format: august-12-2009

Back from a brief vacation, I have more questions than answers. Since last week, it is obvious the general outlook is more uncertain. I’ve been endlessly trying to figure out how a recovery can take place when aggregate demand doesn’t seem to be picking up, interest rates can only rise and defaults are materializing.

What has saved us so far? The injection of liquidity via quantitative easing. Perhaps that is the indicator we must watch like a hawk. Here, I follow the already famous 3-mo Libor – Overnight index swap spread, or the cost banks face to rent their balance sheet (Feedback on this metric is welcome). Once again, I am including its corresponding chart below (source Bloomberg). As you can see, this spread has been making lower lows every day, which is an amazing fact. And I am inclined to believe we will not see a material sell-off in equities or a material widening in credit as long as this spread remains falling:

Another thesis I’ve been giving credit to is the importance of global coordination in monetary policies. However, last week, the Bank of England surprised with the announcement it would extend its quantitative easing transactions, to GBP175BN. This move, I think, shows a fracture in the front. That it happened should surprise nobody, particularly when it involves the British government. Great Britain showed independence when it decided not to join the Euro back in the ’90s; it showed it again when it took the lead last year announcing the capital injections to financial institutions and it shows it again with the latest move. Will the Fed follow? Some analysts expect the Fed to keep silent on this tomorrow, at the close of the FOMC meeting. That may be true, but I think that there is a lot of anxiety around the extension of the $300BN Treasury purchase program and silence will be costly.

In any case, the underlying lesson here is that as countries see themselves past the liquidity crisis of 2008 and each of them faces different challenges for their respective paths back to growth, they will more and more openly dissolve the coordinated front that we witnessed last year, taking their own roads, scratching their own backs. As long as none of them takes the wrong road, the path to recovery should be clear. However, that is not guaranteed.

What this new reality certainly brings is higher volatility in capital flows and hence, in the FX market. The latest depreciation in the CAD constitutes, in my view, a good example. Although impossible to prove, I don’t think the CAD is weaker because the USD is stronger, but because of domestic uncertainties in terms of fiscal and monetary policies, the latest of which is the embarrassing announcement that the Nortel transaction will be reviewed.