Declarations of war, by Cees Bruggemans

 We live in interesting times, indeed unprecedented ones. The Federal Reserve has effectively declared war, on deflation but by implication also on global neighbours.

US CPI fell by –1,7% seasonally adjusted month-on-month in November, and core CPI remained unchanged, but this is clearly a moving target in the short term, with an apparently downward bias. European CPI fell by –0,5% month-on-month in November.

The Fed on December 16 cut its intervention (repo) rate, the fed funds, to effectively zero. In addition, it has already tripled its balance sheet to $2,5 trills within a year, but apparently (much) more is coming.

The Fed is buying government paper, commercial paper, mortgage, credit card and study loan debt at a terrifying pace, thereby pushing the US yield curve towards zero.

You read that correctly.

The US yield curve is being compressed towards the zero boundary. Anchored in 3-month Treasury bills and sloping outwards to 30-year Treasury bonds (marker for fixed home loans), the short end is already at zero yield, the 10-year has moved below 2,5% and everything else in between is being suppressed at a rather intimidating pace.

This is the mother of all bubbles, a publicly inspired and funded bond bubble, as bond prices explode higher and yields drop. A terrifying ride, for at what point does one abandon ship, as the Fed is ultimately going to reverse direction after private investors have blinked and commence diversifying back into the real economy?

That is, if anybody is still ‘blinkable’, as compared to being so bomb-shocked they will only opt for guaranteed bank cash and just settle down to wait for the end of time, if need be at zero return, for such is the anxiety.

This is one of the most terrifying games of chicken ever played, where the Fed insists on preventing deflation taking hold, in the process apparently prepared to play brinkmanship with inflation, or certainly with inflating paper bubbles, if need be infinitely.

Private investors make terrific paper profits as bond prices rise and yields fall. But when this process reaches its natural limits and inflation starts to turn (with the deflation threat temporarily overstated by the big role of the short-term collapse in commodity prices, followed ere long by massive fiscal spending injections), this bond-based bubble should implode once again.

By then, if cash hasn’t captured everybody, the wholesale abandonment of fixed-income assets (bills, bonds) for more risky alternatives may be far advanced, if only because all safe alternatives will have been eliminated (save for cash if you can live without a return and betting inflation won’t suddenly return).

You can’t hide in this game of chicken. You have to declare or be broiled.

In addition to declaring war on deflation, by implication the Fed has also declared war on all those countries not walking in lockstep with it (nearly everybody).

As the Fed balloons its balance sheet and distorts bond prices, excess Dollars start to flee for the exit, only partially because foreign bonds and central banks lag the US example and condition (arbitrage potential suggesting to the early bird there are more worms to be had globally before this is finally over).

In the process, European, UK, Canadian, Aussie, Euro and other bond yields (SOUTH AFRICAN?) can get leveled with the gravel, too, even as the Dollar heads south and everyone else heads north.

The Dollar these past three weeks went from 1.27:€ to 1.40:€ and to 89:Yen. Both surges appear far from finished. The Dollar will go weaker, just about everyone else is heading (much) stronger.

As John Connolly, US Secretary of the Treasury under Nixon in mid-1971 said so memorably: “It is our Dollar and your problem”.

And it is happening again, only much bigger, but only indirectly. Instead of the world having to actively announce currency revaluation (the reality of the 1970s) in response to global balance of payments imbalances, we now get indirect currency consequences because of central bank actions aimed at their domestic monetary conditions.

But however you dress it up, beggar-my-neighbour it remains. You don’t want to apply my brand of monetary policy, defeating deflation by all and any means? By all means, but stand aside to have your real economy swamped by my Dollar depreciation.

By the way, I need to co-opt your financial asset markets and thereafter your economy (“may I borrow your husbands, please?”) for the duration of this crisis to get demand back into my economy, and all oars are needed, including yours. So stand aside or co-operate, as you wish.

As to your economy, good luck, you may need.

One more consequence, of course, is that the Dollar hedges don’t only include foreign bonds and currencies (first trance) and US and global equities (second trance). There is presumably one other hedge beneficiary – commodity prices.

Oil has been uppity of late, fluctuating in a $40-$50 range. That could partially reflect coming OPEC actions to cut output by another 2mbd (if they can live up to their promises) and get a floor under oil, but preferably recover back towards $70.

But any oil liveliness could also represent reflected light from this monetary supernova initiated by the Fed known as ‘quantitative easing’ (buy every bond paper in sight until expectations capitulate, liquidity preference is broken and the breaking spillover into the real economy turns the deflationary tide).

One other beneficiary could be gold, already trading above $800 with more upside potential for as long as the Fed is in this belligerent mood and the world flees for its financial life.

How will all this change financial prices, in the short term and in the long term?

Difficult to say where things will ultimately settle, and for how long. For the world is inherently unstable and lurching from one unstable ‘equilibrium’ to the next, like a seasick sailor forever trying to find that one spot in a roaring gale where happiness can be found.

In the short term, global bond yields and the Dollar are headed lower, and global equity and commodity prices are headed higher, supported by the Fed’s implacableness (and very serious throw-weight) and lagging actions nearly everywhere else in the central bank universe, but with substantial government supports coming ($1 trill of global fiscal injections annually through 2010).

Look for the US 10-year yield to move towards 1%, and the Dollar to enter 1.50-2.00:€ and 60-80:Yen territory.

Global equity prices and commodity prices could rise substantially as well, given bond price increases and yield declines. As to how much, the next three to six months could prove educative.

This has all kinds of implications for the Rand. Initially, the first trance (Euro and Yen appreciation) means the Rand sinks against those currencies but holds itself against the Dollar. Third trance benefits (equity price rises and commodity gains) could also push the Rand stronger, back up against Euro and Yen, and potentially much more against the Dollar.

That is, if risk aversion in this troubled world underwrites all these actions, as compared to prescribing other alternatives.

Where does that leave the Rand in 2009? Presumably somewhere in 6-13:$ territory.

Once the Fed is declared the winner (could there be any other outcome?), things will change again. One would expect inflation in the industrial countries to settle back around 1%-2% in 2010-2012, and 10-year US Treasury bonds to go back over 3.5% eventually.

That, though, sounds so terribly conventional, the territory we have just vacated, but will we see it again? Or more importantly, any time soon?

The Dollar’s level is going to be determined by global appetite for US paper. Risky paper such as equities. There will be a Dollar rebound as extreme conditions turn, but for now that’s way over the horizon.

First the bungee-jump proper. The bouncing comes later.

As to our realities, could the RSA153 and other long rates be heading for 5% (or lower?). Where would that push equities? Where would resources settle? And financial services? Industrials? The Rand?

Will oil bounce more than the Rand, or will Rand/Dollar firm more than oil? Will CPI really reach 6% by mid-2009, or in fact by that time reach 3%?

What will in the meantime be happening to our exports and terms of trade, and our GDP growth?

All of this will prove challenging to the Monetary Policy Committee of the SARB, which will sit in February, April, June and August.

Things could get a lot more exciting, the least of which will probably be what the February budget could still be pumping into the May general election campaign.

We thought 2008 was hectic, but 2009 could yet outdo it.

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