Friday, 29 May 2009

Flights of the imagination in the gotcha economy

Tim Bond is an asset allocation manager at Barclays Capital and has recently issued an upbeat note about the global economic outlook. To Mr. Bond it appears that the recovery is on track and we should take comfort from the fact that those who could not get enough of safe haven assets until the end of Q1, 2009 - such as Treasuries and US dollars in general - are now rushing headlong into more adventurous asset classes again.

His argument essentially is that the drop in Treasuries this week, the ailing dollar and the reflation in the commodities market is actually a reason to be bullish. He doesn't quite get around to talking about trillion dollar deficits and the possibility of sovereign defaults but, to be fair, you can't cover everything in a note to clients.

Here is the abstract from his piece which is worth reading and a link can be found here .

Some market participants appear to have misinterpreted the fundamental factors behind recent trends in US treasury yields and the dollar. The negative correlation between these two assets, with the dollar falling even as government yield rise, has been taken in some quarters as indicative of a looming US funding crisis. In reality, these coincidental moves, in our view, reflect a global economy that is gradually returning to normal.
If the Looking Glass economy is the new normal then Mr. Bond may well be right. For others reluctant to benchmark against Alice's make-belive inside-out world (however much fun it is for lively imaginations) his comments suggest outright denial of the fact that last October the financial system was on the verge of meltdown and had to be rescued by a massive transfer of liabilities from the private to the public sector. But undaunted by economic history (well it was seven months ago - and will soon be eight) Mr Bond concludes on a very cheerful note.

Recent market chatter about the dollar and US treasury yields has managed to muddy the waters of what was a fairly simple and economically positive story. While we would never under-estimate the market’s ability to entirely misunderstand what is happening in the macroeconomy, the current example of inverting a positive into a negative is particularly egregious. Post hoc rationalisations usually get the story wrong, but they rarely get them upside down.

Transforming an uncomplicated bullish story into a convoluted systemic threat to the capitalist system requires a really very creative feat of imagination. To be sure, treasury yields are likely to continue rising and the dollar is likely to continue falling against more cyclical currencies as evidence for an economic recovery expands. However, such trends should be seen as a reflection of a world that is gradually returning to normal, not as portents of impending disaster..This evidence of a qualitative anchoring of bearish opinion would seem to have very bullish implications for ‘risk’ asset prices (my emphasis).

Mr. Bond strikes me as a clever chap and knows how to equivocate elegantly. One phrase I particularly liked was the following - "While we would never under-estimate the market’s ability to entirely misunderstand what is happening in the macro-economy" (my hyphen and emphasis).

So he's not quite going out on a limb because markets (and that presumably includes him) could be reading it all incorrectly. To use his own terminology how should we interpret the market's post-hoc rationalizations if it has got it wrong? When will we know whether they have got it right/wrong? Will we know after they crash or after they require another massive injection of liquidity?

And how do we square these doubts with the notion that markets are always right, through their discounting acumen, at the time that such judgments are made?

To coin a phrase from Alice - it is all very confusing.

I would classify Mr. Bond's opinion as that of a Through the Looking Glass Bull which is a species currently in the ascendancy - but which might eventually become extinct.

Just one final thought about the sagacity of markets and their discounting ability. If the bond vigilantes are taking the reflation scenario seriously (and as I have previously indicated, it is my belief that born again hedge fund re-flationists are really out to ambush the Fed's constructive stance towards equities) then they should be looking more at the end game for Quantitative Easing and beginning to discount the possibility of a less accommodative monetary policy. The next wave of market chatter could, under this interpretation, suddenly switch to mounting pressure on Mr. Bernanke to ease up on supplying endless liquidity at the long end of the curve and start paying more attention to the short end. If, on the other hand, major bond investors are demanding higher rates not so much because of fears of reflation but rather a perception that the risk of holding US Treasuries is increasing, then in hindsight the turbulence this week in long dated Treasuries and mortgage backed securities may have been more designed to express their displeasure at the tendency of governments and central banker's to bail out anything that wobbles.

Returning to Mr. Bond - if he is right - then the Fed will need to start sending signals about their exit strategy and dropping hints about short term rates - in which case he will be wrong.
I'm afraid I can't put it more clearly,' Alice replied very politely, `for I can't understand it myself to begin with; and being so many different sizes in a day is very confusing.'
But for Dr. Bernanke it's less a terrain of make-believe and more a minefield of gotchas.

Surely Fed chairman have always been subject to this conundrum? What makes it different this time is that for years to come trillions of dollars of IOU's need to be sold in a market that's already drowning in an ocean of government debt. Further aggravating the scenario is that Treasury forecasts are based on servicing that debt through a combination of rising incomes and/or low interest rates.

I'm sure Mr. Bond or one of his colleagues will figure out how to spin record foreclosures, slumping real estate and escalating unemployment levels.

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