Please, click here to read this article in pdf format: december-16-2009

All of a sudden, the world seems to be paying attention to fundamentals, rather than liquidity. It is strange, because I think that there is widespread consensus that liquidity or the lack thereof will play in 2010 a role as important as it did in 2009.

Yesterday, the markets traded on the Producer Price Index (PPI), which surprised to the upside, with a 2.4% change year over year. When you think about all what happened in 2009, including the first three months, a positive change of this order seems relevant, at least before revisions. On that note, the market sold the long end of rates, the USD appreciated and stocks had a range bound session, closing down (S&P 1,108pts or -0.55%). The 2Y10Y curve steepened +3.5bps. Investors immediately associated this reading of the PPI with inflation and crude oil could reach again the $72/bbl level.

On my preceding two letters, I proposed shifting in 2010 to USD denominated assets, favoring equities as an asset class. I do not like thinking this way, but I have no choice.

In the interest rates markets, there could be two drivers. The first one would be the credit multiplier in action, as activity and lending pick up. The second one could be an increase in rates, either directly caused by central banks or by an oversupply of sovereign debt. These two drivers would continue to compress corporate spreads and, given the perception of lower default risk, investors would have to shift their monies to equities, if they need higher yields. At the same time, with the increase in lending and spread compression, companies may seek alternative sources of capital (dynamic), as well as capital structures (static). This could be achieved via equity buybacks, with debt. In a way, the financial sector is leading this trend, as financial institutions have been repaying TARP funds.

Simultaneously, with the increase in rates, the USD would become more attractive, ceteris paribus and a flow of foreign capital would return to the US to further fuel the spread compression in corporate credit. In summary, the problem with this picture is that debt is cheap. I call this a problem because it shows that we would be printing our way out of the mess triggered in 2007. Debt has to be expensive, in order to avoid this. How can you make debt “expensive”, or at least stop it from cheapening? With central banks selling assets, touching relative prices in the same fashion they did back in the spring of 2009. Will they do it? I hope for the best, but fear the worst.

Having said this, I must now dig deeper and ask myself what assumptions are behind this logical thread. The first one is the assumption of “stability” in benchmark, sovereign rates, with independent central banks. This means that there will be enough demand for both sovereign and corporate debt. This assumption is always challenged. Yesterday, for instance, we learned that the Government of Greece did a EUR2BN private placement with five local banks (National, Alpha, Piraeus, EFG and Imi) at 250bps over 6-mo Euribor. This is very serious and I am surprised to see that the Euro still trades at USD1.45+. The last time I saw a government placing (forcing) debt among local banks was in Argentina, before 2001. The other important assumption here is that as activity picks up, commodities, raw materials or wages (in Emerging Markets) do not rise. I am not too comfortable with this notion for now.

Finally, the main issue here is that I think that we are heading towards this cycle of higher rates, lower spreads, higher equities and higher USD, which is not sustainable in the long term, unless as I said, central banks engage in “asset management” (asset sales). This should keep volatility floored at a certain level and should prove a formidable challenge on gold bulls.

Martin Sibileau