Please, click here to read this article in pdf format: november-4-2009

Yesterday’s session was not crowded with important macroeconomic data releases or major central banks’ interventions. There were, however, three important events.

The first one was the increase of Australia’s overnight cash target rate to 3.5%. This is the second consecutive 25bps increase since October 6th. What is so relevant about this? The market did not react (i.e. the AUD did not appreciate on the news).
The second event was the sale of 200 metric tons of gold by the IMF to the Reserve Bank of India, which paid $6.7BN for the bullion. What is so relevant about this? The Indian Rupee did not react (i.e. appreciate on the news).

The third event is related to my two previous letters. As I wrote earlier, my view is that governments absolutely have to refrain from causing any noise during this difficult week. They must neither confirm what they are doing nor deny what they are rumored they may do. However, in the UK, authorities disagree. Overnight, it was reported that the Royal Bank of Scotland and Lloyds Bank, in aggregate, would receive an additional (i.e. second) GBP 31.3BN bailout from the UK government. What is so relevant about this? The British Pound closed higher (i.e. 1.643USD).

To me, none of the reactions to these three events seems to have IMMEDIATE DIRECT logical explanation. Thus, there must be a counter intuitive, under the radar, explanation. The relevant reaction however, seems to have taken place in the gold market, in USD terms in particular, with the ounce reaching 1,087.80 intraday. How do we interpret all this?

The indifference in the AUD could mean firstly that this consecutive increase was somehow expected and secondly that it is considered ill advised. The indifference in the INR can be understood: The purchase of bullion was an off-the-market transaction. USD reserves (I assume) in the balance sheet of the Reserve Bank of India that are not circulating in the market are going to be transferred to the IMF. Therefore, no impact in the value of the rupee in terms of USD should be expected. It does not matter that gold, which is now backing an increasing portion of the Rupee, gained +2.3% intraday.
The intraday volatility in the British Pound is nothing else but the reflection of the confusion in terms of the final capital structure the banking sector will have there, the final cost for the taxpayer and how, whatever the outcome, the bailouts will be financed (i.e. with or without quantitative easing).

I also checked the sovereign credit default swaps market, to see if the indifference seen in the land of foreign exchange was also ruling the land of credit. The result was positive: sovereign credit default swaps barely moved.

Finally, I realized that in US Treasuries, the yield curve finished steeper on the day (2Y10Y at 255.4 bps or +5.3 bps). That was perhaps when I first put the two and two together…

In my view, yesterday’s action was all about the fear that the Fed will have no alternative but to delay any increase in rates. It may be as simple as that. Thus, the vote of non-confidence on the AUD. Thus, the Reserve Bank of India seeks to protect its reserves. Thus, the British Pound did not plunge, credit default swaps did not reflect much and the so-called bear flattening trades in US rates were challenged. Thus, lastly, gold reached 1,087+ and stocks stopped their free fall.

Was there some kind of indifference after all? I don’t think so. What I think is happening is that unlike last spring, investors are now realizing that this situation will only lead to overextended imbalances, which if allowed to develop, will cause a catastrophe when rates finally rise. Therefore, investors move with caution, which may be wrongly interpreted as “indifference”.