Please, click here to read this article in pdf format: october-5-2009

If the release of employment data) we had on Friday (i.e. change in non-farm payrolls, which surprised to the downside, would have taken place a year ago, I am sure we would have seen a rush to the exits. Even more so, given the recent trend in the 3-mo Libor – OIS spread, which showed another increase to 13.19bps in the early morning.

But what did a rush to the exits look like a year ago? In general, for instance, you would have seen an INCREASE in the value of the USD, a decrease in the value of commodities, a widening of the CDX IG index and an increase in the value of Treasuries. What happened instead? Stocks finished lower (S&P500 at 1025.17 pts, -0.45%), the USD lost against the Euro and the CAD (DXY closed at 77.09 ), both oil and gold finished higher at $69.67/bl and 1,002.32/oz respectively, the CDX IG Series 13 tightened from 111/112 to 105/106 while the 30-yr Treasury closed -0.9%.

How should we read this? In my view, this is unanimously speaking of a bearish view on the USD. In other words, this speaks to more monetization of fiscal deficits, which by the way is NOT necessarily bearish of stocks. This view would be consistent with early Friday morning’s statements by Eric Rosengren, President of the Federal Reserve Bank of Boston, as well as efforts of world leaders to stress the need for a strong USD.

It would also be very consistent with the tightening move we saw in credit. It is true that the technical picture there is supportive, given that issuances are expected to slow down for the remainder of the year. But it is also true that if liquidity conditions are to remain USD bearish, there will be enough liquidity to keep jump-to-default risk in check, even in the face of unwinding of quantitative easing programs by the Fed. Perhaps an early indicator challenging this conclusion is the trend to the upside in the 3-mo Libor – OIS spread. Since September 22nd, when “A View from the Trenches” turned neutral on stocks (www.sibileau.com/martin/2009/09/22 ), this spread has been making higher highs, clearly on the rise, and is now 20+% higher. I know, I know, 3 bps should be no big deal, but until September 22nd, the trend was from the upper left to the lower right, and since then the trend has changed. And I pay a lot of attention to this metric, as well as to changes in its trend.

In conclusion, the market seems to be only and exclusively trying to figure out what will happen with rates. Rates, rather than currencies, are the priority for central bankers. As long as non-negative fundamental macroeconomic data is taken for granted under this liquidity perspective, surprises like the employment data we saw on Friday are going to test our nerves, as we weight them vs. our expectations on the liquidity picture. If we are constantly changing these expectations, our nerves may not make it!

What is the risk to this status quo? As we highlighted on Monday 21st (www.sibileau.com/martin/2009/09/21 ), the risk consists in a sudden currency shift that might destabilize the existing managed set of currency crosses, driving gold to the status of a deflator for some of them (= reserve asset) in the beginning, and to all of them in the end. I am not a gold bug. I truly believe that if central bankers are consistent, they can inflate our way out of this mess. By denying us a way out via currency swaps and coordinated reserves manipulation, they may succeed in forcing us to hold their notes. The problem thus lies in fiscal policy. Given the non-neutrality of money expansion, if on top of the dislocations created by central banks governments further enact legislation that hurts price flexibility or supports higher fiscal deficits, the little successes central bankers might obtain will be wiped out with violence and desperation will win the day.