Below is a recent ex script from Hong Kong's "GaveKal Daily" regarding the most repeated questions being asked by their global clients today. (An interesting piece I found most appropriate as we approach the end of 2008):
“I just don’t get it! The Fed is out there printing US$ as if paper and ink were about to run out, and yet the US$ surges, oil plummets, gold sucks wind and gold mining shares collapse and yields on long dated US government bonds reach levels that I had never thought I would see in my lifetime! How does this all add up? It makes no sense!” As we see it, there are three potential explanations to the above dilemma:
Option #1: As much as the Fed is printing, the velocity of money is collapsing even faster than the money supply is increasing. As such, the total amount of liquidity in the system is still shrinking, thereby bringing down prices (explaining the low bond yields and the low gold) and activity (low oil). Of course, this situation will not last forever and, once the banks get back on their feet (which admittedly may take some time), velocity will bounce back. At that point, the risk is that the excess liquidity provided by the Fed and other central banks will be multiplied aggressively and that we will move from a deflationary bust to an inflationary boom scenario very rapidly; it will then be very important for the world’s central banks to aggressively withdraw the liquidity that they provided or inflation will become a real economic problem.
Option #2: Looking to markets for any kind of confirmation of deep macro-economic trends today makes little sense as markets are still under heavy duress from forced selling in the riskier assets (i.e., oil, gold…) and forced buying of others (US$, US government bonds…). Indeed, how else could we explain that 3-month bond yields were actually negative earlier this week? If this is not a sign of a bond bubble, then what is? And as we all know, the late stage of a bubble is always characterized by “forced buying”; investors know that valuations make no sense but they are forced, either because of regulations, or simply to keep their jobs, to pile into an asset class. In early 2000, all the indexers and closet indexers had little choice but to buy Nokia, Cisco and JDSU. In the first half of this year, oil and commodities were driven higher by Chinese forced buying ahead of the Olympics (see our book A Roadmap for Troubling Times). And now, government bonds are being bought by banks, insurance companies and pension funds in an obvious attempt to “window dress” the books before the year-end. Thus, in the new year, once the need to “window dress” is behind us, we should expect capital to flow out of bonds and into riskier assets.
Option #3: Contrary to popular belief, the Fed actually has not been printing nearly as aggressively as everyone believes. Indeed, as we tried to show in our latest Quarterly Strategy Chart Book, borrowings from the Fed now exceed the total amount of bank reserves, and thus the reserve component of the monetary base is now entirely borrowed money. The monetary base itself is now a levered figure. Thus, non-borrowed reserves growth has been negative; Bernanke, the pre-eminent scholar of the Great Depression, who knew that the contraction of the monetary base was possibly the most significant policy blunder of the 1930s, sat back and let the unlevered monetary collapse by a third. Fortunately, however, that trend has recently been reversed with the Treasury injecting more than $150bn into commercial banks and taking equity stakes.
As we see it, these are the three possible explanations to the dilemma above. Now the interesting thing is that, whichever option you decide to go with, it will tell you that getting out of government bonds today is not only necessary, but could be urgent.
Something to ponder as you follow your path of due diligence...
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