…If you want to be consistent all the way on this subject, excess supply is eliminated with asset sales, not necessarily with interest rate increases… If you target excess reserves, you can play with interest rates. If you target excess supply, you must sell assets in the balance sheet of central banks. It makes sense. When central banks buy assets, they inject liquidity that creates asset bubbles. To keep them muted, central banks must sell assets….Will central banks sell assets? Not initially, but eventually. Why should we care about this? Because it should provide us with a good tool to assess when the bubbles will go bust.
Happy Thanksgiving to all the readers in the United States that follow “A View from the Trenches”. Even though this is a short week, what we witnessed yesterday makes it impressive, indeed.
Yesterday was full of macroeconomic data (overall positive, with new jobless claims in the US dropping below 500k), but two events really stole my interest.
Early in the morning, the news out of that Dubai announcing the restructuring of Dubai World, which is state-controlled, seemed that it would add more stress to the sovereign credit default swap market, after last week’s concern over the health of Greek banks. Dubai World was going to ask all providers of financing to Dubai World and Nakheel PJSC to standstill and extend maturities until May/10. With this press release, Dubai’s credit default swap widened 116bps to 434bps, but without impacting the sovereign market. Truly unbelievable, if you compare this to other past debt crisis in emerging markets.
The other (by now not so unbelievable) event is related to my last comment, on Tuesday, about my view on how the exit strategy by the Fed will play. The main point I made was that contrary to what many analysts predict, I believe the Fed will not target a level of excess reserves. In my view, it is more consistent with the policy developed so far to target a level of “excess supply of liquidity”. The problem here is how to define “excess supply”. Liquidity measurements have always been a concern, and perhaps deserve a special chapter in the theory of statistics rather than monetary theory. This problem is faced by every central bank. Therefore, we may not be able to measure the excess supply, but we can see its impact. This is similar to Heisenberg’s principle in Physics. For instance, yesterday we had the 7-yr Treasury notes auction, which took the total issuance during this short week to $118BN!!! It was a complete success, with the yield closing down -4bps and a flatter curve.
What does this have to do with excess supply of liquidity? The solid demand for this issuance did not affect at all the equity market. At all! Let me repeat this: Yesterday, we had the explicit insinuation of an upcoming sovereign default coming out of an emerging market, a successful auction of a US Treasury 7-yr issuance, an increase in equity prices and an increase in gold! Amazing! Who was the big loser? The US dollar!
This is an example of the impact of excess liquidity (as I write, Gold is trading at $1,194/oz.). Below is a chart, showing the 30-yr Treasury (in white) and S&P500 Index(in orange)prices during the session yesterday (Source: Bloomberg). The change in dynamics after 1pm, when the auction results were announced is very, very clear. And both the 30-yr note and S&P500 Index rose in conjunction. Under “normal” conditions, a increase in bond prices (higher interest) rates, should have the opposite effect on equities. These are certainly not normal times…
Yesterday too, an interesting note on Quantitative Easing by Prof. Charles Goodhart, from the London School of Economics (Mr. Goodhart was also member of the Bank of England Policy Committee from 1997 to 2000), was published by Morgan Stanley (“The Global Monetary Analyst”, Nov. 25th). In it, Prof. Goodhart indirectly sides with the notion of excess supply, suggesting that “asset markets (…) determine the end of QE”. I fully agree.
Now, the important issue here is that if you want to be consistent all the way on this subject, excess supply is eliminated with asset sales, not necessarily with interest rate increases. Please, take a good note of this. If you target excess reserves, you can play with interest rates. If you target excess supply, you must sell assets in the balance sheet of central banks. It makes sense. When central banks buy assets, they inject liquidity that creates asset bubbles. To keep them muted, central banks must sell assets.
Will central banks sell assets? Not initially, but eventually. Why should we care about this? Because it should provide us with a good tool to assess when the bubbles will go bust. You can trade gold accordingly!