Please, click here to read this article in pdf format: december-8-2009

We closed tighter in credit yesterday, with the IG13 index (tracks the credit spread of 125 North American investment grade firms) losing about 2 ¼ bps intraday. It seems that credit is “getting it”, while equities and commodities are struggling.

What is credit getting? That liquidity is available and will be available for a long time. But, to be fair, the relationship between credit spreads and liquidity is very straightforward, very simple. It is certainly not that simple with equities and commodities, because inflation is a non-neutral monetary process, where the prices of assets do not change simultaneously (i.e. not simultaneously, as the mainstream theory states).

However, the world is worried about a potential sudden decrease in liquidity. On this front, I am only concerned about the situation in Europe. In the sovereign risk market, players in the Euro zone are starting to distinguish between the strong countries and “peripherals”. I really do not know whether there are in fact any strong countries, to begin with. Nevertheless, let’s accept the distinction… Greece is of course a peripheral, together with Portugal, which yesterday morning was put on negative watch, for downgrade, by S&P. It is not clear yet what would happen, should any of these “peripherals”, which include Italy, engage in an upward deficit spiral. I doubt we would get to that point because these countries would neither leave the Euro zone to practice a debasement of their own currencies nor would the European Central Bank deny liquidity lines for their respective deficits. Therefore, the Euro loses ground, and this is more evident when one sees the cross with the Canadian dollar: In the last two sessions, the Euro has lost 3 cents against the CAD.

Thus, while we are led to believe that Europe practices some sort of restraint, the opposite is certainly taking place in the export countries of Asia, awash with liquidity that looks for yield. As you can see, in perspective, the slow but certain debt deflation (or inflation) is taking place worldwide. Should we believe then the market, when it implicitly expects things to get tougher?
The US yield curve has steepened significantly since the end of November, but Fed’s Bernanke repeated yesterday, in a speech to the Economic Club of Washington, that “…interest rates are likely to remain low for an extended period”, and that “the U.S. economy faces formidable headwinds, including a weak labor market and tight credit that are likely to produce a moderate pace of expansion…” I agree on the diagnosis, but disagree on the medicine. However, I am more inclined to believe Mr. Bernanke than those who didn’t believe him and let gold drop to below $1,150/oz.

These are times of confusion and I will wait until January to make a strategic allocation of my capital, when I have more clarity and less end-of-year noise.

Martin Sibileau