Please, click here to read this article in pdf format: november-11-2009

Today is Remembrance Day in Canada and markets are closed. Today marks the anniversary of the armistice in 1918, and my thoughts go out to all those who made the greatest sacrifice for the defense of our individual liberties. A View from the Trenches will not be published tomorrow.

Yesterday was a quiet day, so I will be brief today and take the opportunity to discuss one of the latest trends I see in the collective economic thinking. With the indisputable fact that the US is ready to sacrifice the value of its currency for the illusion of full employment, many market analysts are concerned about the long impact of this move on investors’ expectations.

Personally, I think it is misleading to frame the analysis of markets’ developments in terms of expectations. What do I mean?
I have recently started to note that some analysts seek to explain, to forecast, future asset prices or speculate on the evolution of the yield curve in the US, based on their own assessment of investors’ expectations. There are models that analysts can use to address this issue. If things have not changed since my Undergraduate days, one can think of three types of expectations: Regressive, adaptive and rational. I don’t intend to get into details here, but I want to say that this is an analytical approach I would not want to take.

What we are witnessing in the markets today has nothing to do with expectations, but with flows: Supply and demand.  Get the right picture on supply in the government debt, corporate, agency and mortgage securities market, net it of the funds flowing to these markets, and you will have the correct answer on where prices are going. Look what central banks buy and they buy that with, ask yourself what happens to the notes they give the market and you will get the right trend on prices.
Of course, I do not carry out this quantitative work myself, but the results on the same are available.

When investors use the expectations perspective, ignoring flows and the corresponding distortions in relative prices, they may be lucky or not. It is really of no consequence to us. But when politicians use this perspective, it is a calamity. Politicians believe that expectations, not their actions, are what drive prices. Therefore, when they reach the point where they realize such expectations go against their view on economic problems, they regulate. This is sad, but I am convinced is the path developments will take in the not so distant future.

I don’t have a lot of personal experience on the consequences of this type of reactionary regulation. But individuals always win if they channel their civil disobedience through the sale of their respective fiat currencies. In Latin America, it is usual to see the sale of the “pesos”, in exchange of dollars, to express civil disobedience. In the developed world, I imagine currencies will be sold for gold. Yes, the gold boat is overcrowded and yes, expectations may be pricing too much into this asset. Never mind. As long as the supply of government debt is alive and increasing to fund fiscal deficits, gold will be used to express civil disobedience. Trade accordingly.