Please, click here to read this article in pdf format: february-11-2011

Just after our last letter on Monday, when we wrote that “…out of  China, we expect no news on rates or credit manipulation (i.e. reserve requirement ratios) until March…” we were surprised by a 25bps increase. The fact that the increase took place during their holiday was also part of the message. But for the rest of the week, the markets chose to ignore it, with a lot of resilience.

Since our last comments, a few things appear to have changed. As time goes by, it is more apparent that the political situation in the EU is far from being conciliatory. The decision on the proceeds from EFSF funds has not been postponed. Simply, there is no agreement on whether to use them to finance ongoing deficits, to buy back sovereign debt from banks or to buy it from the European Central Bank, let alone on its final size. In the meantime, yesterday we saw that a 5-year bond sold by Portugal on Monday was being tossed off the proverbial cliff in the early hours (it widened from 360 bp to 420 bp), forcing the ECB to intervene.

The other issue that gets murkier by the day is the future of EU bank debt. On February 7th, Morgan Stanley’s Investment Grade Credit team published a note (under “European Banks”) titled: “Senior Debt: The path to all or nothing”, which for obvious reasons we cannot reproduce here, but which we highly recommend. In summary, funding difficulties are the path of least resistance, unless the EFSF funds are wisely put to use.

With all this in mind, one can hardly see a risk to the upside in the markets. However, the markets seem to shrug off any bad news, sell rates and support commodities. Jobless claims in the US continue their downward trend and all signs point to a “recovery”.

Should we be bearish or bullish? Neither, we think, is the answer. In our view, we are in a context, globally, of “passive money”. We wrote about this idea on Nov. 1st, 2010, when we said:

“Nobody seems yet to be aware of the “dynamic” nature of the problem. As we wrote before, macroeconomic theory should not be about real income determination, but about coordination. We are not concerned with determining how many bps the 10-yr Treasury yield will tighten if $100BN rather than $500BN are purchased by the Fed. What concerns us is that the market will progressively adapt to the new “rate of money supply”.

The developed world is still not used to the idea of “passive money”. Passive money is a relatively foreign concept to most contemporary economists, but its research began as a consequence of the problems Latin America faced in the ‘60s and ‘70s, when monetary policy turned accommodative, responsive to the unemployment rate. The concept of passive money was, in our view, the foundation to what was later called the “structural” explanation of inflation or the notion of “structural inflation”…(…)…We think the review of this concept is worth understanding, because we have no reason to doubt the Fed is taking the path of passive money (i.e. labour standard) and other central banks will have to soon follow. Gold, therefore, is bound to go higher…”

If, as we advised back in November, you reviewed and understood this concept, it will be clear that no matter how Ben Bernanke spins it, we are only seeing the beginning of the inflation story. Much has been and is being said on “food inflation”, being blamed upon demographics, weather, income differentials between the developed and emerging markets, etc. It will not be long until brilliant mainstream economists begin attaching the adjective “structural” to the noun “inflation” and price controls pop up everywhere. But it will be increasingly clear that the only structural thing is that central banks will be financing structural fiscal deficits.

Martin Sibileau