Please, click here to read this article in pdf format: february-16-2011 Perhaps the most relevant factor shaping the action this week is the absence of a significant, market moving event. Investors seem to just be marking time. Every major decision is being postponed by policy makers and the drift higher in stocks is simply following [...]
Please, click here to read this article in pdf format: february-16-2011
Perhaps the most relevant factor shaping the action this week is the absence of a significant, market moving event. Investors seem to just be marking time. Every major decision is being postponed by policy makers and the drift higher in stocks is simply following the quantitative easing of central banks. In the US, this easing is explicit. In the rest of the world, it is not.
What decisions are being postponed? Some of them had been put off with anticipation, like the reform of government sponsored mortgages in the USA or the gridlock in the US Congress regarding the budget, or the rate hikes in Canada, to favour a lobby group. Other decisions are more uncertain. The first one, which we have discussed at length in previous letters, is related to the future of the European Financial Stability Facility. The second is the monetary policy of China itself, which of course, is not anticipated to change, but is “fine tuned” in small shocks.
Let’s profit therefore from this relative calm to think of a relevant issue: The unwinding of quantitative easing policies. Why would we want to discuss this issue today? Because there is no doubt in our mind (in fact, there never was, as our very first letter attests) that worse times are to come, shaped by the unfair touch of inflation.
Just as we wrote last week that the idea of a structural aspect to inflation will soon resuscitate, we came across two research notes published by Morgan Stanley’s Global Economics Team (see: “The inflation merry-go round“, of January 26th and February 9th). In these notes, it is suggested that to keep inflation within limits, coordination among central banks is required. The underlying point here is that inflation may be managed. To a certain extent, it may be true. However, when we look at it from a practical point of view, the real solution would be a world where only flexible exchange rate regimes exist. That way, if Helicopter Ben feels like printing $600bn to finance Barak’s social justice agenda, the dollar suffers a violent and swift currency crisis. That, in our view, is the only solution to global inflation, and it is anything but coordination. It’s monetary freedom!
We are not surprised to read this nonsense which, if left to run its own course, will inevitably lead to international summits where a global reserve currency, possibly managed by the IMF, will be debated. We are not only anticipating, but preparing ourselves for it, by being long of gold in our personal account.
The final solution to the problem, we think, will depend on how central banks manage the asset side of their balance sheets. Currently, those which are engaged in the business of “quantitative easing”, are steadily increasing their holdings of sovereign debt. How can they get rid of it without impacting interest rates? We think an innovative approach would be to exchange that sovereign debt for non-financial assets (real estate, infrastructure assets able to collect tolls, etc.) of the respective governments, along the lines of a massive privatization of governments’ assets….only to transfer their ownership to an independent central bank. The second step would be to gradually auction those non-financial assets to the public, withdrawing liquidity in the process.
What would be the advantage of this? First, it would preempt the market from speculating on bond sales or any other exit strategy that would bring higher yields. Secondly, when governments sell their non-financial assets, they simultaneously reduce deficits and improve their credit profile, bringing rates lower. At the same time, as the sovereign debt increases in price, financial institutions that hold it can see a capital gain. Lastly, the later auction of these assets would bring foreign direct investment, strengthening the currency and without crowding out other financial assets.
We recognize this proposal sounds creative, but if central banks were creative boosting their assets, they will need to be creative to reduce them when the time comes. In the meantime, we think any other solution would be suboptimal, with global coordination an impossible.