Please, click here to read this article in pdf format: january-20-2009

In my view, we have two forces today, shaping the market scene. These are “dimensional” forces. The first force or dimension is associated with capital flows. I will call this force the non neutrality of money. The non neutrality of money, as we wrote many times already, is evidenced by the fact that, when central banks inject liquidity, relative prices are distorted. This distortion depends on the markets that receive the liquidity first.

During 2009, the first market to receive this liquidity was the Agencies debt market (Fannie Mae, Freddie Mac). Consequently, the spread between Agency debt and Treasuries tightened violently, appreciating this debt vs. other assets. Another way of looking at this is by comparing it with the mainstream view, that money is neutral (implicit in Krugman’s and David Rosenberg’s works). The neutrality of money is expressed in the famous equation, called the exchange equation:

Money in circulation * Velocity of circulation = Price level * Output level

This is why economists like David Rosenberg or Krugman tell you that you should not worry about inflation (Price level), because even if Money in circulation grows, the velocity of circulation is low. They told you precisely that while markets rally, spreads compress or gold goes from $854/oz to $1,138/oz in the past twelve months. These same economists will now increasingly ask you to worry, because the rally is not justified by the output level vs. its potential level (whatever that is). And of course, they have been wrong since the whole inflationary process began, on an afternoon of Dec 5th, 2008, with the first purchase of Agency debt by the Fed.

Having said this, and back to my main theme, I see the non-neutrality of money shaping 2010, as follows:

Assumptions: a) The Fed will maintain a steady supply of liquidity (not touching policy rates) and b) the US fiscal deficit will not fall

With these assumptions and given the unwinding of quantitative easing by the Fed (i.e. will stop buy Agency debt by this spring), I expect Treasury yields to rise with a steeper curve. The steepness in the curve will be driven both by a compression in the front end, as well as a sell off in the long end (For those interested in the reasons, pls. write back. I’ll be happy to further elaborate and have your feedback).  The rise in Treasury yields should compress corporate credit spreads. The impact of this compression can bring three consequences: a) Further debt refinancings; b) share buybacks with leverage, and c) capital expenditures. These three channels should provide further fuel to the equity rally, commodity prices, and finally, activity.

If you believe in this story, a beta strategy, where you invest in liquid instruments as indices, should do well. I began the year firmly believing in this story, but as with any good story, there’s always a risk, a “bad guy”. In this case, the bad guys are sovereign risk and political risk in every relevant currency zone. I thought these would become relevant later in 2010, but here we are, facing them in January.

These sovereign/political risks constitute the second force shaping the market scene that I referred to above. Tomorrow, I will elaborate on this second dimension: Time. Why time? Because these risks affect every monetary zone today, but with different degrees of “imminence” or urgency. The degrees of imminence affect the foreign exchange crosses, which define the second dimension.

Martin Sibileau