Please, click here to read this article in pdf format: january-14-2009

Yesterday, the People Bank’s of China went further with its tightening move, raising reserve requirements. Raising reserve requirements is “wrong”, in my view. If a central bank wants to really stop asset inflation, all it has to do is withdraw liquidity. Raising reserve requirements does not withdraw liquidity. It only makes it more expensive, and only in nominal terms!!! What if banks in China manage to transfer their higher costs to borrowers? As borrowers see the monetary expansion clearly unfold in front of their eyes, what will happen if they accept higher borrowing rates, with the expectation of also higher NOMINAL profits? (In Economics, we say that agents “validate the rate of money supply”. It happened in Argentina in the 1980s and it led to hyperinflation!)

With the news out of China, the European Central Bank’s negative comments on Greece’s loan-relief program, Moody’s statement on Greece’s “slow death” and the resulting 49bp widening of the country’s 5-yr credit default swap, when at last the 10:30am oil inventory data was released, I thought a major correction in stocks would follow…And I was wrong, oh so wrong….However, I did not take profits in my equity positions because there was something that had caught my attention from the start: The strength of the Canadian dollar.

As you can see in the first chart below (source: Bloomberg), after 10:30am stocks actually started to recover, while Treasuries began selling. The inventories of crude oil, gasoline and distillate had risen beyond expectations and yet, stocks started to recover. With these negative news, on the other hand, the Canadian dollar was steadily firm. Oil is lower so far this week, having dropped from 83.50/bbl on Monday to $79.77/bbl yesterday in the afternoon. The Canadian dollar, managed to reach 97+ USD cents intraday (second chart below, source: Bloombreg). What is behind all these intuitive contradictions?

First, the market may be realizing the liquidity drain may not come in 2010, regardless of what central banks tell you. Hence, the drop in Treasuries and steepening yield curve (=inflation on the way) and recovery in stocks. Second, something must be cookin’ in the Canada. The action seen yesterday clearly speaks of a large “long Canada” position. Perhaps to profit from upcoming commodity rallies? Perhaps escaping Euro weakness? A mix of the two?

Martin Sibileau