“…And when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…” (J. M. Keynes, “The General Theory of Employment, Interest and Money”, Chapter 13, Section III, 1936).
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We finished last week with a steeper yield curve and tighter corporate spreads. This is consistent with the chart below (source: Bloomberg), our already famous 3-month Libor – Overnight Index Swap spread. The chart shows how the cost of renting bank balance sheet has been steadily declining. It declined in the face of Dubai’s debt restructuring. It declined even as Greece and Portugal are threatening the Euro and it declined with the ratings downgrade of the State of Illinois.
The message is clear. For new government debt issuance, the market demands more and the curve will steepen. But the effect of liquidity is still significant and perhaps even increasing, because last Friday, the 3-month Libor – Overnight Index Swap spread reached 9+bps, a record level that we had not seen since 2006. Under these conditions, 2010 should be a year of changes in the capital structure of firms, with the continuous deleveraging and search for lower cost of capital structures, including mergers. Perhaps that is enough to avoid deception.
As we wrote on Friday, we may see a shift of consequence in 2010, to give the market a signal that fiscal deficits are manageable, sustainable. If this shift is successful, the $1,226/oz level that we saw in gold only days ago will prove a formidable top.
A final thought here. Every analyst agrees with the view that, given the severe slack in the world, inflation in the developed world, as measured by the Consumer Price Index, will not be a problem in 2010-11. It is true. Consumer prices will not increase in the short term. But asset bubbles have been a reality during the last decades, even if consumer prices have not been a concern. Yet, the dotcom bubble morphed into a real estate value, which morphed into a commodity bubble, etc. etc., which makes me think that if you consider inflation “the” problem and describe it within the narrow definition of a consumer price index, you lose sight of the main problem. The main problem is that in the last decades, resources have not been allocated to efficient use, addressing authentic demands, because of the continuous distortion in relative prices, caused by active monetary policy. In the next years, the scale of these policies will keep growing, making matters worse. If labor markets are flexible, the unemployment rate may not be severe. But I believe unemployment will be more resilient than expected.
Martin Sibileau