Please, click here to read this article in pdf format: december-3-2009

I know I could start discussing the macroeconomic data releases from yesterday, or the news out of Venezuela, where it seems banks may be nationalized, or the follow up on Dubai, or gold going beyond $1,200/oz. But such news would only be…well, they would be news which are available elsewhere to read. My wish is always that this letter can add value by providing unique insights.

On this note, I think it was of particular interest to read yesterday that Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said during a press conference after a speech to the Charlotte Chamber of Commerce that to his mind “…a natural place to start is asset sales…”. Mr. Lacker’s view is that the Fed should start removing the ongoing monetary stimulus by selling the mortgage debt it is STILL acquiring. Of course, he had to address investors concerned that such a move could work against the fragile recovery. Mr. Lacker is not alone here, for Mr. James Bullard (St. Louis Fed) shares his views. Nevertheless, still the majority of Fed officials seem to prefer to either raise the interest rate on bank reserves, or drain reserves.

Mr. Lacker mentioned this option yesterday. However, the readers of “A View from the Trenches” are ahead of the curve, for on November 24th, I introduced Thesis No. 3 (“Introducing Thesis No. 3” www.sibileau.com/martin/2009/11/24 ), which I further wrote about on November 26th (“Witnessing the impact of excess supply of liquidity” www.sibileau.com/martin/2009/11/26 ).

On Nov. 24th, I wrote that: “…My view is that if Bernanke follows Keynes, the Fed will withdraw liquidity in the quantities that it sees in excess of demand (=excess supply). As long as it sees demand for a certain quantity of liquidity, that quantity will not be reduced and of course, further liquidity will not be provided. Let’s call this Thesis No. 3…This view significantly differs from the mainstream opinion, which holds that the Fed, once it starts unfolding its exit strategy, will seek to return the level of bank reserves, which are expected to rise to $1.35 trillion, to the historical average of $10 billion (i.e. normal levels prior to the crisis; this strategy consists therefore in eliminating excess reserves)….”

And on Nov. 26th, I continued saying 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”…”

I cannot stress enough how important is for investors to understand this difference. The consequences of one strategy or the other are radically different (not necessarily opposed) and they will certainly define who makes money and who loses it in 2010/11.

To that effect, I further said that: “…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!…”

…And since then gold rallied beyond $1,200/oz. in the face of Dubai’s default and we started hearing Fed officials speak of asset sales. Feedback here is very much appreciated.

(Note: “A View from the Trenches” will not be published tomorrow, Friday Dec. 4th).
Martin Sibileau