• 3M Co (MMM)
• AMCOL International Corp (ACO)
• Archer-Daniels-Midland Co (ADM)
• Arena Resources Inc (ARD)
• Bell Microproducts Inc (BELM)
• Bio-Rad Laboratories Inc (BIO)
• BNP Paribas (BNPQY)
• Boston Beer Co Inc (SAM)
• Conmed Corp (CNMD)
• Crosstex Energy Inc (XTXI)
• Deutsche Bank AG (DB)
• Dover Corp (DOV)
• Dow Chemical Co (DOW)
• Eaton Corp (ETN)
• FBL Financial Group Inc (FFG)
• Fuel Systems Solutions Inc (FSYS)
• Genoptix Inc (GXDX)
• Information Services Group Inc (III)
• International Bancshares Corp (IBOC)
• Jo-Ann Stores Inc (JAS)
• Kohl's Corp (KSS)
• Life Technologies Corp (LIFE)
• Masco Corp (MAS)
• MDU Resources Group Inc (MDU)
• Nordstrom Inc (JWN)
• Parker Hannifin Corp (PH)
• Rofin-Sinar Technologies Inc (RSTI)
• Ross Stores Inc (ROST)
• Royal Gold Inc (RGLD)
• Santarus Inc (SNTS)
• Sealed Air Corp (SEE)
• Solutia Inc (SOA)
• Starbucks Corp (SBUX)
• Tenet Healthcare Corp (THC)
• Waddell & Reed Financial Inc (WDR)

Obviously, the discussion which we hope to initiate here comes in two phases. First, there is the question of whether or not the ECB should be considering QE at all? I am sure that there is plenty of people out there disagreeing with the sentiments expressed below. Secondly, there is then the issue of how exactly the ECB would conduct QE. Once again, I should warn you; this is a bugger and, at times, also somewhat technical.

---

Most sports coaches - irrespective of whether they work in soccer, baseball, rugby or even American football - have playbooks; small books or pads filled with notes, decision rules and strategies for each and every possible situation they can envision. Of course, in some cases the playbooks are mental rather than physical, but every good coach lives and dies by his ability to adapt and react to new and changing situations and in order to do this effectively what he needs above all is a good playbook.

So what has all this waffle about football, baseball and whatever got to do with the ECB and how it should respond to the Eurozone's "fluid and evolving" economic and financial crisis? Well, the point surely would be that whatever playbook the ECB works with (and it is sometimes pretty hard to see clearly which one it actually is) they do not seem to have included a section on what to do when interest rates finally hit the zero bound (not this month evidently, but maybe, or possibly the one after....as Bank President Trichet said after today's decision to reduce the rate to 1.5%: “We didn’t decide ex-ante that this was the lowest point that we could attain” ). Nor do the ECB seem to have a page which explicitly handles the currently fashionable state of the art set of tools known collectively as quantitative easing. And this omission may, as the zero bound looms and outright deflation threatens, turn out to be a rather large and unfortunate one. The question is, what exactly are we going to do if (or even when) the Eurozone as a whole enters a deflationary rather than a disinflationary dynamic, and even more importantly, what happens if price movements fall into deflation mode and stay there?

 But before we get ahead of ourselves, let's go straight to the horses mouth (as it were), and take a brief look at what it is exactly the ECB has been doing all this time in order to alleviate the credit crunch and reverse that depressing cycle of decline and deterioration which currently seems to hold the Eurozone economies so tightly in its grip. Speaking at the European American Press Club on the 20^th of February ECB President Jean Claude Trichet laid out in some detail the considerable variety of measures the bank has been taking since the crisis broke out in August 2007. Reading through the text of the speech, one major detail immediately strikes the eye, and depending on your point of view the omission is a more or less disturbing one.

The fact of the matter is that at no point in his entire speech does the Central Bank President get to mention (not even once) the effects the crisis has been having on the real economy. His entire attention is focused on measures that the bank has been taking in order to ease the crunch by improving funding conditions in the interbank market, and in particular he enumerates in some considerable detail all the various classes of credit the ECB has been making available to Europe's banks. Now, you could argue that this absence is hardly surprising given that Trichet was not invited to give a talk about the state of the European economy, but rather about the steps the bank was taking to address the impact of the financial crisis and the credit crunch. But this would be precisely the point, since at the present moment in time the two are inextricably intertwined, with the credit crunch driving the real economy down, even as the rising unemployment this produces sends risk sentiment in the banking sector to ever lower levels.

This being said, the more disturbing part of the whole speech is the sense of complacency it conveys, with the impression being given that Trichet by and large believes the ECB has things nicely under control with a nominal interest rate (then) running at 2% and that despite the awkward hurdles which may still lie out there in front of us, no extraordinary measures are needed. If this is the case, maybe someone needs to pick up the phone and give the gentlemen in Frankfurt Ivory Tower a call suggesting they take a long hard look out of their window to see just what is happening in the world that lies beyond.

Possibly some may feel that the dichotomy being made here is a false one since the ECB always held that the measures it was taking to normalize conditions in the interbank market were also de-facto intended to cushion the effects of the credit crunch on the real economy. However, using this argument in the current situation is not only misleading, it is also dangerously complacent. Put in more prosaic fashion; this is all soo pre H2 2008.

The facts of the matter are all now pretty much unequivocal, and really speak for themselves (or at least they should do).

• In the first place the problem in the banking sector and the wholesale money markets was never really the main issue. This, undoubtedly real, problem was merely the outward and evident symptom of a much deeper structural problem concerning how the whole (global) economy needed to deleverage, and how the systemic character of the money market breakdown would ultimately require government and institutional intervention on a large scale.

• Secondly the crisis has now very much become an economic and not simply a financial one. We won't belabour the reader here with all the gory economic details which you are all already so familiar with, but we would like to stress that it is now pretty evident that the global economy is taking a hit on the scale that has not been seen since the first half of the last century, and most specifically, since the years of The Great Depression. So this is not a matter to take lightly, even if some economies are hit worse than others. We should also not fail to take notice of the fact that, despite many early assurances to the contrary, while the United States is certainly busily fighting its own private economic demons, the locus of the crisis has now slowly but surely moved in Europe's direction, first via the Southern and Eastern periphery and then entering into that very bastion of the Eurozone itself - the German economy.


• This is not either the time or the place to examine all the chain-links and mechanisms through which crisis transmission operates, but we should all be aware that the force of the blast we are taking at the present time is such that the very foundations of our common economic edifice - of the Eurozone and even the European Union - are now at risk. When the simple act of transferring deposits from bank accounts in one member state to those in another (in order to speculate on the future stability of a currency) becomes (and by some multiples) a potentially more profitable investment opportunity than building a factory and creating employment then the seeds of financial crisis are well and truly sown, and action needs to be taken to prevent the implicit peril coming to fruition. We simply don’t understand how anyone can deny that this problem exists at the present juncture, and that something needs to be badly and urgently done to secure the foundations of our edifice before the worst is, by omission, allowed to happen. The economies of the EU and, in particular of the eurozone, need to see the return of profitable investment opportunities as an alternative to idle speculation, and the ECB has a key role to play in this process, by returning price stability, by stimulating growth possibilities, and above all by encouraging a return of confidence to our somewhat battered and beaten economic system.

In order to address the rather urgent task which now faces us we should not, in principal, exclude the use of extraordinary action and recourse to what have come to be known as "unconventional tools" on the part of the ECB. Indeed in the difficult battle which now confronts us, no door should be closed, and no stone left unturned. Yet, all of this still remains on the level of "in principle" and in theory. Since despite all the evidence, indeed the facts on the ground speak for themselves, which strongly suggests that the Eurozone now faces not only a strong disinflation process but the advent of outright deflation (as defined by a sustained period of price declines in the core HICP index, see here and again here) we are still wallowing around in hypothetical discussions with no one actually prepared to strongly push for a very rapid biting of the most badly needed bullet. Furthermore, a new problem now presents itself, since the wreckage which is rapidly piling up in Eastern Europe risks destabilizing the whole system through the deep financial linkages which exist between the banking system in the Eastern countries and those very Western banks which have already been beaten to pulp by equity losses and debt defaults in one corner of the globe after another.

Indeed, some of us would claim that once the wheels of the present train crash were set in motion a year or so ago it was not particularly difficult to see that the lions share of the problem would end up in Southern and Eastern Europe, and in this fashion would arrive beating and hammering at the doors of the ECB in the form of both a severe Eurozone recession and a near-systemic collapse in the economies of Eastern Europe. If there was a danger of a repeat of the 1990s Asian style contagion anywhere it was always going to be in Emerging Europe, as the Bank for International Settlements and those much maligned ratings agencies never ceased to point out.

However, if we come to look at the responses to date from the ECB, we find that these have in no way been either as drastic or as urgent as those initiated by counterparts like the Bank of Japan and the US Federal Reserve (or even, come to that, by the Bank of England and the Swedish Riksbank). In fact, far from reacting rapidly and vigorously, ECB council members have repeatedly voiced concerns about the dangers of letting interest rates drop too low too quickly, and even warned of the dangers of reproducing yet more bubbles. This "conjuring of demons" seems to us to be soo terribly Japan in the 1990s-ish.

In fact the whole crisis reponse and reaction process seems to have revealed more a feeling of confusion and disarray, than one of order and "everything under control". Back in December 2008, the councils self-proclaimed hawk, Axel Weber, was busy worrying us all with his discovery of the "horrifying fact" that lowering interest rates below 2% would have implied the application of negative real interest rates (citing the fact that inflation expectations at that point for the medium-to-short term were themselves hovering at around 2%. He seemed to be blissfully unaware that with economies like the German and Spanish ones registering annual contraction rates in the 5% region, negative interest rates might be just the recipe the doctor was ordering. Just over a month ago Greek council member George Provopoulos added his voice to the chorus, cautioning that there was only limited scope for further rate cuts (towards 1%), citing among other reasons his expectation that the Eurozone economy would begin to recover by the time we reached 2010. Specifically, he noted that while there was room for interest rates to go lower if the economy and inflation expectations were to deteriorate further, this would in no case imply a move towards 0%.

This view was reiterated some weeks later by Luxembourg's representative on the Council, Yves Mersch, when he stated that he was completely opposed to the idea of the ECB adopting a Japanese (or US) type policy of ZIRP (zero interest rates). The reasons normally cited for such continued caution were what one might call the "usual suspects" - namely that while inflation was expected to reach very low levels due to the drop in energy prices it would subsequently rebound in late 2009 (due to the so-called base effects), or that the economic outlook in the Eurozone was fundamentally different that in Japan and the US where the respective central banks had gone much further in the direction of aggressive monetary policy.

Most ECB watchers view the continuing cautious stance over on Kaiserstrasse with a growing sense of unease and bewilderment. In light of the daily slew of incoming bad news it has seemed pretty odd (to say the least) for the ECB to maintain its focus on measures which were clearly lagging the pace of economic development rather than trying to get out in front of the problem and head it off. In fairness, it does now seem that some members at least of the Governing Council may belatedly be moving closer to a recognition of the full scale of what we are up against. Recently, council member Guy Quaden pointed out that it was perfectly possible for the ECB to lower rates well beyond 2% and that, in his view, there were no taboos whatsoever. Such statements certainly constitute a starting point, but still perpetually create the feeling of "too little too late", and in fact have done little to persuade financial markets that the ECB is actually in control of the situation.

This problem was further highlighted at the February meeting when rates were kept on hold and where Trichet, in his usual charming manner, simply noted that ZIRP (and thus QE) had several inappropriate drawbacks, although he did not see fit (at that point) to go further, and elaborate on what he thought these were. The markets responded as might have been expected to such obfuscation, and the yield on two year German bunds was pushed to its lowest level since 1997. Symptomatic of the then prevailing "zeitgeist" was the statement of Austrian council member Ewald Nowotny to the FT that the ECB would not move into ZIRP as this would imply negative real interest rates, apparently not understanding that this may well be precisely what we needed given the strength of the contraction.

As BNP Paribas's senior economist in London, Ken Wattret, said at the time:

“We’re desperately spinning around to get a proper handle on the issue,” (...) “The worst-case scenario is that the ECB is hoping they don’t need to do things like this because the economy will pick up again. If that’s plan A, then that’s rather disturbing.”

Part of the problem here, of course and as ever, is that there is far from unanimity on the ECB Governing Council. With the stream of council members lining up to give their own personal views to Bloomberg in recent weeks, one might easily be let to utter that famous "would the real spokesperson for the ECB now stand up"! The latest "dissenter" in the long line who have been queuing up to expound on their "nuanced view" was Athanasios Orphanides, Governor of the Bank of Cyprus, who in a speech the 28th of January made plain his opinion that:

The suggestion that monetary policy becomes ineffective when rates are close to zero is a “dangerous” fallacy.

That this sounds vaguely reminiscent of the message which has long been coming across from the other side of the pond should not surprise us too much, since as Bloomberg reporter Ben Sils has pointed out, he is in fact a former Federal Reserve economist (who made a name for himself, apparently, by telling his superiors they were wrong, go to it Athanasios). Sils suggests that events are now moving rapidly on the Council (although not that rapidly, judging by this week's outcome), and that Orphanides might actually be the one emerging with the upper hand in the near term. And don't for a minute believe Orphanides is merely doing a bit of headline grabbing. There is a real theoretical argument behind his position, one which he, himself, elaborates in this paper which discusses how, in a deflationary situation, the central bank should attempt to steer expectations towards inflation by "promising" very low interest rates for an extended period of time. (For some considerably more wonkish material on all this, try the Lars E. O. Svensson paper from 2001 or Gauti Eggertsson and Jonathan D. Ostry's IMF paper on the importance of communicating clearly when you want to make a "credible threat of irresponsibility").

What are Others Doing Then?

With the ECB being so cautious and unsure about whether or not to engage in what has now become known as Quantitative Easing (QE to its friends, for a pretty detailed discussion of QE in Japan and the US try this post here) why don't we take a look and see just what the rest of them are doing.

Morgan Stanley's Stephen Jen had a very useful piece on the Federal Reserves' entry into QE in late November 2008. In the first place it is important to note that QE comes in two stages (although these will now need to be collapsed into one here in Europe given the looming deflation threat). The first stage is to attack the credit crunch, and when that attack fails (as it evidently has done, virtually everywhere) the second stage is to try to halt the slide into outright price (and then debt) deflation. In fact, for some time we have been operating a kind of modified version of QE in the Eurozone (without, of course, the presence of the "lower bound") based on a division of labour between the bank (which has ballooned its balance sheet in order to provide short term liquidity to the banking sector) and the national governments who (following the Paris meeting of October 12) have worked on the fiscal side with initiatives to try and move credit by guaranteeing bank loans or buying commercial paper. Now we are about to move into the second stage, which involves first and foremost trying to "steer" inflation expectations. According to Jen there are three key elements in any comprehensive system of QE.

• Communication policy is vital, in order to steer expectations and in particular in convincing market participants that short term interest rates will be held low for a prolonged period of time, even as governments print money on the fiscal side, and even at the risk of "monetising" the growing debt. The point here, naturally, is to try to thrust rather than jolt inflation expectations strongly into positive territory. Judging by all the yelps of pain we are hearing from US market participants about looming inflation Bernanke seems to be having some success here (at least for the moment), and it is a pity we are not able to say something similar about their European equivalents, who, it seems to us, are gradually being steered towards reluctantly accepting either deflation, or at the least very low inflation, as now more or less inevitable.


• The central bank can also increase the size of its balance sheet, and this is a tool that the Fed has been using extensively in an attempt to increase the money supply. For a visual illustration of the process, check out this graph . As for the mechanics, this piece by John Kemp is a good starting point. One significant way in which this can work is, as Kemp notes, by matching increased lending to financial institutions with an increase in deposits these same financial institutions hold with the Fed (a bit wonkish, but still).


• A central bank can also alter the composition of its balance sheet by purchasing securities in an attempt to directly affect the prices of financial assets. This measure is of course intimately connected with the previous point, since without the former there is no great likelihood that the latter will work. In fact, the ECB has already doing something like this for some time now, since it is not at all clear just how many of those assets currently parked over in Frankfurt (and which have been exchanged for liquidity) will ever actually get to leave again. In a general sense, there also seems to have been a rather radical change with respect to the kind of assets the central banks have been willing to accept as collateral for liquidity.

One of the basic cornerstones of QE that has so far been implemented both at the Federal Reserve and at the BOJ has been the aggressive expansion in the purchase of unconventional securities. This could for example be corporate debt as well as, in the US' case, agency and mortgage-backed securities (together with a veritable myriad of other assets). All of this marks a considerable evolution of the "traditional" QE measures (as practised during an earlier period in Japan) whereby the central bank engages in heavy purchasing of t-bills in order to "manage" the yield curve on the short end and thus allow the government to conduct fiscal expansion at lower cost. Effectively, what we have at the Fed and the BoJ is both an asset and a liability approach where the former takes the form of the central bank accepting the purchase of an ever broader range of assets while the latter takes the form of expanding excess reserves held by banks at positive interest rates.

So, What should and could the ECB do?

Well the answer to this question clearly depends on where you think the Eurozone's real economy is at right now. In particular, if you are willing to entertain the idea that the bank needs to bring interest rates near to zero and start operating a more aggressive version of QE then you also need to buy the idea that there is a significant and impending risk of deflation in the Eurozone. Basically, M. Trichet's recent comments to the effect that there is no present danger of deflation in the Eurozone seem to fly in the face of everything we have on the table in terms of economic data, and that we are still a long way from doing the necessary.

However, and in fairness to their point of view, we might start by taking a look at the various reasons which have been offered attempting to argue why it would be inappropriate for the ECB to engage in QE and why some continue to argue that the risk of inflation is still imminent. In order to get to grips with such arguments there is, of course, no better route than by listening to the ECB itself, but since its council members all too often simply offer us their own highly distinct form of newspeak, the following pieces (one by Robert Ophèle Deputy Director at La Banque de France, the other from Sylvester Eijffinger, professor at Tilburg University) are quite useful.

Ophèle rightly tries to highlight the distinction between deflation and disinflation, pointing to the fact that what we are currently experiencing is the latter and not the former. Judging by the recent data it is not certain that this view is entirely correct, but he does highlight an important issue in the sense that the key question here is the extent to which one expects rapid disinflation to turn into deflation.

Ophèle uses two arguments in defence of the idea that what we may currently be experiencing is disinflation and not deflation. The first is the fact that the current sharp drop in price levels mainly comes from energy and food prices, and are thus largely giving back the price gains that were so instrumental in driving global monetary policy only a year ago. The second is a much trickier issue, and concerns the degree to which nominal wage rigidity may actually be a virtue in the context of disinflation since it acts as a structural hedge against a collapse into deflation.

This is an extraordinarily powerful and, as it were, convenient argument for those who would defend the current posture of the ECB. In this context it is perhaps worth going back to all those endless disquisitions we were subjected to about the potential for those horrid second round effects as energy prices shot up ever higher and one might thus assume the argument to be a symmetrical one now that energy prices are dropping sharply. However, the presence of nominal wage and general core price ridigity might mean that wages and prices are not sent on a downward spiral by the negative energy proce shock and if one expects the downtrend in energy prices to be merely temporary then, arguably, the monetary stance should not be changed on this account alone.

However this argument may not be entirely valid in the current context. Firstly, it should by now be pretty obvious to everyone that the current correction will have to be deflationary in its consequences those economies in the Eurozone who have accumulated sizeable imbalances over the last eight years. This would then exactly suggest that whatever the trend in energy prices it is the forward looking trend in the core price index we should be looking at. However, Ophèle has an argument ready to hand even in this case:

We should recall that deflation is not possible while households and enterprises continue to expect price rises. This is incontrovertibly the case at the moment. Business surveys, measures derived from market rates, and forecasting experts surveyed by the ECB all point to five-year inflation expectations remaining anchored around 2% for the euro area as a whole.

Shall we run that one by again: deflation is not possible as long as inflation expectations remain positive? This is evidently wrong, since it is basically circular (since prices can't deflate because households don't expect them to, and households don't expect them to because they are running at x% a year), and it does serve to highlight the care one needs to take when interpreting those dreaded (rational?) expectations models. Basically, just because one expects inflation does not mean that you are going to get it and furthermore, expectations may change over time. It is a question here of which is the leading indicator and which the lagging one. There is much more evidence to support the idea that strong inflation expectations may, in some circumstances, be self fulfilling and fuel future price increases, than there is to support the idea that people always and everywhere don't get deflation because they are expecting inflation. That is, there is a certain asymmetry in the situation. During rapid economic contractions, where excess capacity tends to lead to sharp and unanticipated price reductions, it is far more plausible that expectations follow prices downwards, and this is what we suspect is happening now.

As ever when we have this discussion of expectations the time horizon is the problem. Ophèle is talking about 5 years horizons, and these implicitly embody a high level of uncertainty, especially in an environment like the current one. Quite simply, the key problem for the Eurozone is to keep the edifice together over the next 6 months, not to quibble over some kind of perceived steady state five years from now, and it is this much shorter time perspective which should be in the forefront of ECB thinking right now.

Turning to the case made by Sylvester Eijffinger, an even stronger argument is fielded against the deflation risk in the Eurozone since he not only believes the risk of deflation is slight, he actually thinks the risk of inflation is much higher than that of deflation. Like Ophèle, Eijffinger initially points towards the structural aspects of wage rigidity citing as authority European Union economy and Finance Commissioner Joaquim Almunia who has also advanced the idea that nominal downward wage and price rigidity constitutes a strong line of defense against deflation. This argument would seem to us to be a self defeating one, since if it is valid the future of countries liike Spain, Ireland and Greece within the Eurozone must come under an immediate question mark, since without such downward corrections it is impossible to see how they can ever hope to achieve the competitiveness their economies need in order to grow again. Further, it sees to us to be much more plausible that downward wage rigidity may be much more an issue than downward price rigidity, which means quite simply that as prices fall unemployment simply rises and rises as the recession deepens. In other words the difficulty people have in reducing wages simply means those very same people get sent home rather than working, and thew consequent drop in demand only serves accelerate deflation rather than avoid it. That it, this kind of argument, in a major recession like the one we have now, is totally and thoroughly false.

Basically, the whole problem here boils down to the tricky question of implementing a common monetary policy in the absence of a coordinated fiscal policy not to mention a unified treasury. In this sense and while it is straightforward to see that the Fed should buy US treasuries to conduct QE it is not entirely clear what exactly the ECB either can or should do. For one thing, it is strictly forbidden according to the ECB's own rules for the bank to enter the primary market to directly purchase securities (read print money) in order to finance fiscal deficits in any member country. Moreover, and if we assume that this small niggle could be dealt with; whose bonds should the ECB buy and how many from each country?

But what if, instead of directly purchasing individual country bonds the bank were to purchase EU bonds explicitly created for the purpose, and what if the produce of the same of those bonds were to be deployed by the commission across the Union to fulfil pre agreed objectives. But wouldn't those bonds be inflationary in their consequence? Of course, we would answer, that is precisely the objective.

Time to Add More Pages to the Playbook?

We realize that this has been somewhat of a whopper of a blog post and if you have made it this far then congratulations, since you obviously have a good deal more stamina than most. Our argument is fairly modest in its aims, since we are absolutely clear at this point that we do not have all the answers. What we have tried to do here is simply draw an initial tentative sketch of what the ECB might do to move forward towards a process of quantitative easing and we have offered some suggestions about how to do this. Clearly, not everyone will be ready to agree with the initial premise that the ECB should consider QE at all. Looking at the incoming data however this move does seem to be increasingly becoming a foregone conclusion even if the ECB itself is not ready to entertain the idea. As such we hope the ideas here expressed may contribute to a wider ongoing debate about what to do about Europe's present economic and financial crisis, and what kind of measures and tools we have available to deal with it.

Unfortunately, the ECB, and most recently and specifically bank President Jean-Claude Trichet, have been ardently defending a viewpoint based on the non-existence of deflation risk. Today's, decision to cut interest rates by 50 basis points constitutes nothing more than the expected (not even surprising us with a bold move down to 1%) and this on a day when the BoE seems to have accepted the severity of the UK situation as it bit the bullet and moved itself over to QE. We are not arguing here that the ECB should turn itself into some sort of a rubber stamping clone following blindly along a path laid down by its peers, but rather, that the ECB decision makers should reflect very carefully about the arguments which have lead others along the QE path, since quite frankly, at this point in time the ECBs "originality" is beginning to turn into a liability rather than an asset, and one really has to wonder just how much credibility the institution will have left as and when it really decides to jolt itself back into action. In particular, if it has through either inaction or negligence lead the countries in its charge into a negative deflation cycle, will it still have the credibility left to convince market participants that it has the ability to lead us back out of the mire, into the inflation and into the sun.

Hungary's biggest problem at the moment is how on earth to stay worried about a dropping Forint while at the same time realizing that the country is headed towards the worst recession in several decades. As some readers will remember the reason that the Forint today is subjected to full force of currency punters is to be found one year ago. Back in February, Hungary as well as other emerging markets opted to loosen their pegs towards the USD, the Euro or both in an attempt to "allow" the currency to appreciate to quell the inflation everybody was so focused on at the time

The Hungarian forint tumbled to a record low against the euro as risk aversion spread and concern deepened the economic slowdown will worsen. The forint extended this year’s decline to 11.4 percent, the second-biggest drop among emerging-market currencies tracked by Bloomberg, as Hungary heads towards its worst recession in 15 years. The country was the first European Union member to seek international aid to avert a default last year, prompting a 20 billion-euro ($26 billion) emergency loan from the International Monetary Fund, the World Bank and the European Union.

“The forint is being dragged down by negative regional news,” said Nigel Rendell, senior emerging-markets strategist at RBC Capital Markets in London. “The weakening of the Russian ruble and the bank nationalization in Kazakhstan are weighing on the markets. They “may test the resolve of the central bank in Hungary” and in Russia, he said.

The forint dropped as much as 1.5 percent to 300.37 against the euro and was at 299.60 at 12:54 p.m. in Budapest. It earlier broke through the key 300 per euro level, where option barriers were set, according to BNP Paribas. The level at which the forint is trading is of “extreme concern,” Prime Minister Ferenc Gyurcsany said yesterday after a meeting with central bank President Andras Simor.

As we can see from the added graphics, the Forint has indeed taken a solid beating and in light of the fact that Hungary still have those Swiss denominated mortgages makes the depreciating currency sheet poison.

What happens next is indeed a good question. According to Danske Bank the Eur/huf may very well go beyond the 300 mark. Meanwhile, the daily plight of the economy muddles along with S&P announcing the downgrade to BBB of one of Hungary biggest insurance companies Generali Providencia. And the reason ... well because the investment portfolio of the company is heavily exposed to Hungary's sovereign risk of course, and speaking of which; financing conditions remain rather difficult for the the Hungarian government agency. Earlier today (Tuesday), the government agency received 37.8 billion HUF worth of bids for a pool of 40 billion HUF issuance of 3 month t-bills; yields were 26bps higher than for a corresponding auction a week ago.

And in Russia ...

If 2009 looks set to be a year to regret for the global economy it may be the year to forget for Russia. As Edward pointed out recently, the manufacturing sector in Eastern Europe has been jolted into near depression territory. However, the problem for Russia and by derivative for the rest of us, given the size of the Russian economy, may be great indeed. One particular thing which caught my eye recently was for example a small snippet from the Economist Intelligence Unit that laid out the disturbing facts (hat tip: AFOE). The EIU initiates its argument by noting that in mid 2008 Russia still had enough reserves (US$600bn) to cover the total sum of foreign debt (US$527.1bn) and although the debt was primarily held by companies the EIU makes the valid that;

(...) whereas the bulk of the debt was the responsibility of Russian companies and financial institutions, Russia’s huge commodity exports and its widening current-account surplus acted as an implicit guarantee for creditors (...)

Now, one key part of this guarantee was of course oil price of 100 usd a baril and thus the boost this gave the Russian external balance.

The rest, as they say, is history. There was a while when Russia stood tall and spent the reserves to defend the hitherto band of the Rouble but that quickly was abandoned for a policy of deliberate devaluations to restore competitiveness as the external balance heads towards deficit. So far the Rouble has lost more than 30% of its value against the USD and the central bank has expanding the trading range of the currency no less than 20 times since November. This sharp correction in the Rouble, although perhaps necessary to restore competitiveness, has not come without a cost since most of the before mentioned debt is denominated in foreign currency (USD and Euros) naturally making the liabilities for Russian companies increasingly unsustainable. In the context of hard currency reserves to cover increasingly hard currency liabilities the following point by the EIU is important;

State handouts cannot continue indefinitely, not least because reserves no longer cover total foreign liabilities: on the basis total debt was US$540bn at the end of September 2008, and that US$73bn was repaid in the fourth quarter, total debt is now US$467bn and private-sector debt US$425bn. Russia entered the crisis with the world’s third largest cache of central bank reserves, but it has been dwindling at an accelerating pace. By mid-January, reserves had declined to just below US$400bn, meaning that more than a third of the total was spent over the past five months.

So, once again reserves are less than the total stock of foreign liabilities and the mismatch does not seem set to get smaller as we progress into 2009. As Brad Setser points out this comes against a backdrop of a forecast by Danske Bank that Russia may contract a full 3% in 2009. Edward carries a much fuller analysis of over at GEM which focuses on a wide array of recent Russian data points; I can tell you that it is not pretty.

Emerging Markets; Decoupling or not?

In a more general light I would like to finish this small pot boiler with a point made by Brad Setser recently that, as the global recession tightens, we cannot look to emerging economies for good news. One part of this is naturally derived from the plight of Russia and the CEE, but also as Brad Setser points Asia is struggling too. Most significant in this regard is clearly the mounting evidence that China is headed down the roller coaster too. Has anybody really considered what will happen when they announce that the Yuan will be going down, not up, agains the USD. Good luck Geithner!

More specifically, Brad elaborates on the Asian situation in a recent very informative writ. It is a wonderful story really, building on top notch punditry by the Economist, about reliance on foreign demand and the connection between domestic investment and capacity elsewhere. The bottom line is that Asia needs to find a new way to grow and thus a new way to steer their economies; the question is of course which of these economies that can actually pull it off. The most recent significant data print came from South Korea's external balance in January; exports are down 47%(!) and as Macro Man succintly puts it;

So the theme of collapsing global trade looks to be alive and well.

Alive and well indeed, alive and well indeed; and with 2009 set to become a real bone cruncher all economies reliant on exports to grow are set to suffer, suffer a lot.

It is funny to think about all this in the context of the (in)famous discussion about de-coupling. The original discourse was cast in the light of a veritable switch-of-batons as the US economy slowed and thus how the rest of the world would aid to propel the global economy to a constant growth rate even as the US economy faltered. This was clearly not possible. Now it remains to be seen whether some economies can decouple not to the extent to contribute to a global recovery but to avoid a sharp recession in their own domestic economies.

Six global exchange-traded funds track Islamic indexes, according to Chicago-based data researcher Failaka.

Nasdaq OMX Indexes is about to break into the already crowded field of index providers targeting Islamic investors.

Versions of the flagship Nasdaq 100 Index and Nasdaq Biotechnology Index are to be launched in the first quarter 2009.

Dow Jones, MSCI, FTSE Group and financial services firms including HSBC and Citigroup have long lists of stock indexes, and to a more limited extent bond indexes, refashioned for the Islamic world.

Currently, there are six exchange-traded funds globally tracking Islamic indexes, according to Chicago-based data researcher Failaka.

Three are from Barclays Global Investors' European iShares ETF family based in London. The iShares track the MSCI Emerging Market Islamic, USA Islamic, and World Islamic equity indexes. BNP Paribas has an ETF based on the Dow Jones Islamic Titans Index, while Daiwa Securities launched an ETF based on a FTSE Sha'riah Japan 100 Japanese equity index.

As an exchange which a growing profile in the Middle East, Nasdaq has an immediate beachhead for its first Islamic indexes, in contrast to the stand-alone index providers.

Nasdaq recently rebranded the Dubai International Financial Exchange as Nasdaq Dubai, after purchasing a one-third stake in the exchange earlier in the year (see story here).

What's more, Dubai is the largest market in the world for structured products linked to Islamic law, according to Failaka.

Dubai is the largest part of an Islamic investing universe estimated at as much as $700 million globally. There are industry projections that it will grow to as much as $1 trillion in the next few years.

There has been a good deal of recent activity related to the Islamic indexes also.

Dow Jones recently released its first Islamic index for Southeast Asian equities, or the ASEAN counties (see story here).

Meanwhile, MSCI recently added both emerging market and frontier market sha'riah compliant indexes (see story here).

Nasdaq expects that the indexes will serve as the basis for products from both local Gulf players and international asset managers, said John Jacobs, chief marketing officer at Nasdaq.

While the Dubai market may be the most obvious market in which to introduce the planned Islamic versions of the Nasdaq 100 and Nasdaq Biotechnology indexes, Nasdaq expects the indexes to be popular in Southeast Asia also.

"The most populace part of the Muslim world is Southeast Asia, and lots of firms want to bring out Sha'riah compliant index products there too," Jacobs said.

HA! Had you there for a minute! The dollar rallied once again, when the deep, dark, dangerous clouds returned, and the risk takers…

Bank Rossii began managing the ruble's exchange rate in February 2005 against a
currency basket comprised of about 55 percent dollars and 45 percent euros.
Policy makers let it trade within a fixed range in mid-May. Since then, it has
dropped 2.1 percent against the basket to 30.4020. Though the central bank
doesn't reveal the limits of the band, BNP Paribas considers 30.40 to be its
weaker end.

This from Today’s Financial News:

Our sources indicate that Apex Silver Mines (NYSE:SIL) might be a promising short play at this point in time.

Crashing commodities prices are not just putting hedge fund managers into a jam, they’re also putting resource producers at risk.

The price surge triggered by the commodities super-cycle had been a boon to large-scale miners in particular. Soaring prices for oil, nickel, copper, molybdenum made the exploration and development of marginal sources not only feasible but…

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......

Prime Brokerage Market Share

A Brief Overview of Industry Market Share

A good read titled "Battle of the Bulges" pointed out that competition for gaining prime brokerage market share is growing fiercer with more than $11 billion in expected hedge fund revenues in 2008, a 15% increase over 2006 (reported by TABB Group). The fight for market share is even more intense among the industry's top players.

For years the prime brokerage industry has been dominated by three firms—Goldman Sachs, Morgan Stanley and Bear, which collectively owned about two-thirds of the market. As of year-end 2006, the Lipper HedgeWorld prime brokerage league table ranked Morgan Stanley first (with 23% of the market and $153 billion in assets), followed by Bear (21%, $136 billion), Goldman (18%, $119 billion), UBS (7%, $47 billion) and Credit Suisse (4%, $25 billion), in terms of market share based on assets.

As Bear collapsed in March 2008, and Morgan Stanley and Goldman Sachs struggle to maintain their dominance in the industry, other major financial services firms are stepping up their prime brokerage efforts, including JPMorgan Chase, Deutsche Bank, UBS, Credit Suisse and BNP Paribas. JPMorgan Chased was only ranked eighth in the Lipper survey with just a 2.3% market share, now it is given a quick entry into prime brokerage as long as Bear's hedge fund clients are successfully locked down. BNP Paribas bought Bank of America's equity prime brokerage division that was ranked the sixth-largest in the country by assets at the end of 2006 by Lipper HedgeWorld, thus was instantly made one of the largest prime brokers in the U.S.

The recent turbulence in the prime brokerage industry also accelerated the trend of hedge funds moving away from replying on just one prime broker. Traditionally hedges funds are unwilling to switch prime brokers or increase the number of their prime brokers (TABB report). As Michael Guarasci, partner at hedge fund Indus Capital Partners said, "We have long-standing relationship with our prime brokers, so if a new company wants to come in and do business with us, it may not get anywhere because we're pretty happy with our service. It's not easy to switch prime brokers." (full article). Now more and more hedge funds are adding prime brokers to limit counterparty risk since the fall of Bear (ref). This created considerable opportunity for new players to enter or existing players to take a bigger piece of the market share, as pointed out in an article by Merrill Lynch: "The multi-prime broker environment overcoming the challenges and reaping the benefits" (download the pdf).

Interested in learning more about prime brokerage. Please checkout the new website - http://PrimeBrokerageGuide.com.

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I think it is important to bear in mind here that Russia's economy actually grew at an annual 7.5% in the second quarter, while manufacturing growth was nearer 5%. Which means that in a "newly industrialising country" the weight of industry in the economy is declining. This is obviously unsustainable, since however resource rich Russia maybe, you cannot live from oil alone, especially when your oil output has a ceiling. Basically the more living standards in Russia rise, the less important oil will become as a percentage of GDP, and the more dependent the Russian economy will become on other sectors. This is why the current consumer price and wage inflation levels are no mere trifle.

Obviously the Russian authorities have deperately needed to get a grip on the inflation problem, and this is just what the central bank has clearly failed to do, with the annual rate rising again to 15 percent in August, up from 14.7 percent in July. So one part of the present financial crisis is clearly an institutional crisis of confidence. With the benchmark interest rate at the central bank currently at 11%, Russia has negative interest rates of 4% which obviously make it very easy to fuel a lending driven consumer and construction boom, but very much more difficult to communicate to observers that you actually know what you are doing. So while the fx muscle that the central bank can put to work in the short term to stamp out the present will in all probability work, they are clearly not able to prevent such forest fires breaking out in the first place, and we should, of course, expect more. Brazil's central bank which currently has interest rates at 13.75% while inflation is just over 6% (ie 7.5% positive interest rates) is currently justifiably earning for itself a reputation as Latin America's new Bundesbank, a way in which it would never ocur to anyone to refer to the Russian equivalent. And the comparison I would make with Brazil is not meant idly, since Brazil is, of course, also an oil and resource rich emerging economy.



So it is clear that Russia has special problems, which set what is happening in Russia rather apart from what is currently happening in a lot of emerging market economies.

Rout On The Bourses

Both Russia's MICEX and RTS exchanges remained effectively closed first thing this morning following trading being suspended again yesterday (Wednesday) - they were in fact open for less than two hours - in order to prevent a further sell-off on top Monday's record-breaking falls. The ruble-denominated Micex Stock Exchange did resume some very limited trading at 11:00 this morning, but only limited operations were authorsied - the decision was effectively simply to allow participants to close repurchase deals still outstanding from Sept. 16 and Sept. 17.

Russian stocks have now plunged around 60 percent since their May peak, and while the Micex did initially gain 7.6 percent in initial trading yesterday, this gains were very rapidly erased and then turned negative, as the index plunged as much as 10 percent before a halt was called. Russia's dollar-denominated RTS index stood at 1,058 points when trading was halted, nearly 58 percent down from its peak of 2,498 points reached in May.

Emerging Market Woes

In part Russia's problems only reflect more general "risk aversion" issues which are facing all emerging market economies. Emerging-market stocks have fallen the most in 11 years this week, their currencies have been falling, and the cost of insuring emerging market bonds has rocketed as rising lending rates and tumbling commodities have prompted investors to sell riskier assets.

Every emerging stock market in MSCI indexes has been retreating this month, and the MSCI Emerging Markets Index fell 2 percent yesterday to 768.92 a time, its lowest level since October 2006. The index is now down 19.59% since the start of the month, and 29.27% over the past 3 months.



The Russian MSCI index, in comparison, is down 36.1% on the month, and 54.2% over the past three months.



Of course, to put the recent fall in perspective, this recent fall follows several years of rising stock values, and thus is to some extent cyclical, as can be seen from the 4 year MSCI index chart (below).




Falling Oil Prices


In the forefront of the fall in Russia share prices have been energy stocks, including Russian oil producers like OAO Gazprom and OAO Rosneft, who have declined substantially following the sharp drop in crude prices. Gazprom, the world's biggest natural-gas producer, lost 18 percent to 158.41 rubles in the latest turmoil, while Rosneft, Russia's largest oil company, sank 22 percent to 132.20 rubbles.

Oil prices were down again this morning, after bouncing back somewhat yesterday. Light, sweet crude for October delivery fell 97 cents to $96.19 a barrel in electronic trading on the New York Mercantile Exchange midafternoon in Singapore. Overnight, the contract rose $6.01 to settle at $97.16, after having dropped $10.03 the previous two trading sessions. But the trend is decidedly down, and crude has now fallen more than $50 — or over 35 percent — from its all-time trading record of $147.27 reached July 11.




Urals crude peaked at $140.80 a barrel on July 3, and has fallen about 36 percent to $90.01 since then. Still, the oil price averaged $108.65 a barrel so far this year, compared with $63.54 a barrel January 02 through Sept. 18 last year.


Foreign Exchange Reserves


Evidently the Russian economy is in no evident danger of short term default, and foreign exchange reserves, which stood at $560.3 billion on September 12 (according to data from the Russian central bank) - the third largest globally, after China and Japan - are evidently ample. In addition Russia has a $163 billion SWF (the National Welfare Fund), which is split into two parts, $130 billion in a reserve fund, and $33 billion in the National Wealth Fund (the SWF proper).




Nonetheless, the reserves have dropped quite sharply since early August, and are now down some $37 billion since their August 8 peak, and reserves declined by $13.3 billion to $560.30 billion in the week ended Sept. 12, after falling $8.9 billion in the previous week. About 47 percent of Russia's reserves are held in U.S. dollars, 42 percent in euros, 10 percent in pounds and 1 percent in yen, according to the most recent figures released by the central bank (June 30, 2007.

Part of this reduction in reserves is a result of central bank intervention in support of the ruble, since Russia operates a policy of trying to maintain the currency steady within a trading band set against a basket of euros and dollars. Evgeniy Nadorhsin, a senior economist at Trust Investment Bank in Moscow, estimates that the central bank sold approximately $3 billion in fx reserves last week.


So Where Do We Go Now?

This is very hard to say. Clearly we should expect the economy to slow substantially in the last quarter of 2008 and the first quarter of 2009, as credit conditions tighten for households, and the decline in oil prices restricts revenue flows. As just one indication of the worsening credit conditions we could note that Russian 5-year credit default swaps are trading with a spread of around 253-255 basis points, little changed this week but more than double the level seen before the start of the conflict with Georgia.


On the other hand Russia is hardly the Baltics, so we should not expect the economy to go into a nosedive. A lot depends on the view you take about the future of energy prices. Since my own view is that the global economy will slow down considerably - in addition to the reduction in growth rates we have seen so far this year -following the most recent bout of financial turmoil, and this will serve top bring oil prices down even further, but we should see a floor, at around $80 perhaps.

More importantly I am not expecting a long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009.

As we can see in the JP Morgan EMBI+ index (see below), bonds from these economies have taken one hell of a battering in September. Looked at the other way round, the extra yield investors demand to own developing nations' bonds instead of U.S. Treasuries has been going up, and today rose 2 basis points to 4.24 percentage points, the widest spread since September 2004, according to the EMBI+ index. So EM bonds have been taking a battering but they have taken a battering because of nervousness about the implications of a financial crisis in the developed economies, rather that as the result of any inherent problems in their own ones. That is what sets this crisis apart from the 1998 one, and that is what means that the financial markets in these economies will in all probablilty bounce back again quite substantially once all the nervousness dies down. Basically most of these markets are neither "oversold" nor are they "maxed out".

What is interesting about the above chart is the way in which things seem to have really taken a decisive turn for the worst in late August, and it is curious to note on the chart below that the Russian MSCI index also started to deteriorate further starting on or around 2 September (see chart below which is from May 2008 to date). So while the Georgia factor may have made people nervous, other, deeper, structural factors are obviously at work.

And while I am on deep structural factors, and the MSCI Emerging Markets index, I would like to conclude by pointing out that the decline since mid May has been pretty generalised, and in some sense is obviously cyclical. The point is that this fall will at some point hit bottom, after which time we should be ready to see a rebound, as investors move in and snap up what will obviously be seen as very attractive buying opportunities.

In case you did not notice, the Eurozone recently slipped into a near recession and so did Japan. Together with an already limping and essentially recessionary US economy this has prompted some analysts to ponder the probability of a global recession or more aptly; a significant and serious widespread global slowdown. Nouriel Roubini, who recently got some fine words in the NYT by Stephen Mihm (hat tip: Stefan Karlsson), massages the probability of a global recession in a recent piece. This is a topic also taken up, in a US context, by Joachim Fels in his recent installment over at Morgan Stanley's Global Economic Forum.

Now, as Roubini points out, the global economy would "officially" be in a recession, according to the IMF, if global GDP were to decline to below 2.5% y-o-y. In general, one certainly has to agree with the main thrust of Roubini's argument in the sense that it is becoming increasingly difficult to spot the upside in what is increasingly becoming an all out hard landing across the board. In the context of this argument, I would add my own point which emphasises the extent to which the slowdown initially set in across countries with external deficits. It should be quite clear that surplus nations will suffer accordingly too. As such, the global economy is experiencing a widespread decline in the willingness and ability to absorb investment and credit (this really is the ultimate game of old maid) which in turn is naturally hurting both excess capacity and liquidity providers.

However, there are of course economies out there who may be able to weather the storm better than most in terms of the ability to maintain headline growth. This is to say then that there are some economies who, regardless of global credit and liquidity conditions, will have sufficient internal momentum to stay at reasonable growth rates. This, at least, is my hypothesis. I would highlight three economies (Turkey, India, and Brazil) here in particular, all of them singled out due to their relative clout in the global economy and the fact that they are, in these very years, experiencing their demographic dividend. In this small piece, we shall be looking at Brazil.

Recently, in an economic outlook on Brazil I emphasised how Brazil naturally was going to slow down due to the global correction, but also how I was more sanguine than many analysts with respect to Brazil's ability to avoid a sharp and volatile correction. Moreover, I have also detailed in a more general context how I really did not feel that Brazil could be branded as an "emerging" economy any more.

But is all that optimism really warranted?

In an analysis from Morgan Stanley, Marcelo Carvalho is not very optimistic when it comes to the immediate outlook for Brazil. The key component in Carvalho's analysis is the link between Brazil's growth performance and her export prices. More specifically the argument lays out how weakening commodity prices would strongly feed into export prices and subsequently rob Brazil of an important income effect. Moreover, it could also tip over the external balance into negative as the hitherto positive goods balance almost certainly would swing into negative. Of course, there is no such thing as unambiguouty in economics and in this way, weakening commodity prices would most likely ease the pressure on the Real's appreciation as the central bank would be able to leave its hawkish stance. This means that Brazil would be set to gain some lost competitivness against a rising USD.

Yet, retorts Carvalho. This is really a question of choosing your poison, since in the event of a resurgence in commodity prices the central bank would be forced into tightening even more to reign in runaway prices. This certainly seems to be true. At the last meeting, central bank governor Mereilles, along side his council, consequently opted to hike interest rates 75 basis points to bring the nominal rate to 13%. Furthermore, and even though headline inflation has shown signs of abation lately, it is widely held that Meirelles' gaze is firmly set for a target at around 15% to halt a core inflation rate running close to the threshold upper limit of the 4.5% target.

This specific set of fundamentals has obviously mad Brazil a virtual magnet for international funds and with a booming stock market [1] and a real rate on government bonds at around 7%, it is not difficult to see why one would want to park a bit of money in Brazil at the moment. A continuation of the central bank's hawkish position is likely to keep the fire going under the Real for a while although it does seem to be running a bit out of steam as commodity prices have fallen steadily. However and even though the Real looks set to lose some of its strenght, its recent impressive run is indicative, I think, of the role Brazil, whether it likes it or not, seems to be playing in the global economy.

In a more general perspetive, I find it difficult to disagree with Carvalho's main conclusion in the sense that Brazil looks set to slow down. However, I don't think that this point is particularly interesting in itself. More interesting is the point that while global economic conditions since 2003 have been very accomodative for Brazil, they are now set to become less so. I completely agree in the sense that Brazil, like everybody, else has been riding the recent expansion and perhaps benefitted more than most. The key question that remains though, is the extent to which Brazil has internal momentum to keep on going on its own. In this way, Brazil does not seem able to escape the fact that as long as the central bank stays in a hawkish mode, the currency will be supported and so, by derivative, will the consumers' purchasing power. Coupled with a potential drop in the windfall from oil in the form of a demand and valuation (income) effect it would tip over the external balance.

But would this be so bad or more aptly; should we expect it to be any other way? One interesting way to illustrate this would be to scrutinize the underlying argument for the central bank's hawkishness. A while back, economist Antonio Carlos Lemgruber consequently critisized the central bank's policy because he thinks it is based on a potential growth rate which is too low. According to Lemgruber the central bank is operating with 3-4% as the potential growth rate while he himself believes it to be closer to 7%. Accordingly, the central bank is keeping nominal interest rates high to reflect the perceived existence of a positive output gap. However, is this really the appropriate way to interpret the signal emmitted from Brazil? Not all think so. In a recent analysis Pablo Bréard from Scotiabank suggests that the high nominal rate maintained by the central bank, in part, is a hedge of future risk aversion and subsequent retrenchment of capital flows from emerging markets. I don't agree.

Personally, I would turn the conventional arguments around and claim that a high interest rate, in the context of Brazil, is a de-facto sign of the economy's high potential growth rate or at least this is the way capital flows react in the current global economic edifice. We could then consider a high nominal interest rate as a sign of capacity to grow and ultimately capacity to offer whatever yield the given nominal rate prescribes. Or put differently; if you offer high interest rates, you better be sure that you are able to suck up the ensuing inflows. Otherwise, the whole edifice may end up catching fire. I would peer wearily across Eastern Europe for confirmation on this.

This means that the effects from a high interest rate and subsequent strong currency is ambiguous when it comes to inflation. It is true that it makes imported goods cheaper, but it does not necessarily halt capial formation or build up of credit since these two components may well be supplied from external sources regardless of domestic capacity to muster the inflows.

Of course, some countries such as e.g. Iceland have recently (and will need to in the future) upped interest rates in a classic attempt to defend the domestic currency and the financing of the external deficit. We would thus always need to consider the risk of any given amount of yield. In this context, many have cautioned the recent upgrade of Brazil's local currency debt to invesment grade. It comes at a bad time they argue as Brazil may, at precisely this point in time, be on the verge of transisting towards a less favorable set of fundamentals than the ones which prompted the upgrade in the first place. This may be true or, at least, it does not seem to be completely wrong. Yet, I also have to say that the whole international global rating edifice is beginning to smack a bit of insignificance, in the sense that if India can receive a downgrade at the same time as Italy's and Japan's ratings are maintained, I really would like to know where capital is supposed to flow in order to reach its most efficient destination.

What all this means for Brazil in the coming slowdown is too early to say at this point. My guess is that the central bank, absent any major global deflationary rout, will maintain its hawkish position. In July, inflation rose another notch to 6.4% which is close to the upper range of the central bank's formal 4.5% target. Both JPmorgan and BNP Paribas expect the SELIC rate to move as far up as 15% (which is my formal target) due to recent data from Q2 pointing towards a continuation of inflationary pressures.

Generally, most of the sell side research I have been looking at suggests that Brazil probably peaked in H01 2008 with respect to headline GDP growth. Most analysts also concur that a likely halt in the appreciation of Real coupled with a slowdown in commodities will make for is likely to put a downward pressure on Brazilian growth. The argument here would be that a depreciation currency would stoke inflationary pressures even as commodities slowed which in turn would make the values of Brazil's exports lower. In this context, the worst scenario for Brazil would be a case where a slowdown coincided with a sharp retrenchment of capital to support the negative external balance (note that the while the goods balance is in surplus the current account is in the red mainly due to the income balance). This could force the central bank to keep rates higher than domestic inflationary pressures would otherwise merit.

In conclusion, there can be little doubt that Brazil, as with the rest of world, is heading for more lacklustre times with respect to economic growth. I am not sure however that Brazil may be in for such a tough time as many predicts. I would especially emphasise Brazil's ability to maintain growth on its own regardless of external factors. I consequently think that there are two crucial points to consider as we move forward.

• One would be the meaning and interpretation of the central bank's high interest rate and indeed a high interest rate in general. In this way, we could also see Brazil's yield advantage over many of its peers as a simple reflection of the economy's capacity to grow. At least, I think this is an important perspective held together with the more traditional, and indeed valid interpretation that the central bank is trying to keep inflation in check. I would consequently argue that if you accept the tenets of my analysis (to some degree or the other), Brazil would be one of those global economies to which capital would simply have to flow. In fact, and this is ultimately what Lemgruber is talking about. I think that he (and others) worry that a high interest rate in the current global environment could lead to too much inflow of funds and thus a serious overshoot of the domestic currency. The risk is certainly there that Brazil may be taking on too much weight within the whole global imbalances structure, but my argument would simply be this is structurally buil into Brazil's growth path. Ironically of course, this general point means that a low potential growth rate would call for a lower nominal interest rate, but since this is currently unfeasible due to the global surge in headline inflation many central banks are finding themselves between a rock and a hard place.
  

• The second point would be a simple test in the good spirit of falsification. My question would then simply be the extent to which we will see risk aversion shoot up to such a degree that an economy such as Brazil would find it difficult to finance a negative external balance. How much would those dreaded credit default swaps really rise and would it make sense at all to imagine that Brazil had to raise rates, 1980s style, to avoid a capital flight. Clearly, if we assume that Eastern Europe, Iceland, etc are already dead and gone at this hypothetical point, even a retrenchment of funds from the likes of India, Brazil, and Turkey would mean a rather violent surge in traditional safe havens in the form of the US, Japan, the Eurozone. I guess, what I am really asking is whether Brazil could be seen as a safe haven in what comes next or more precisely how will Brazil's relative standing in the global economy look during and after what is clearly a quite severe global slowdown?
  

Now, as Roubini points out, the global economy would "officially" be in a recession, according to the IMF, if global GDP were to decline to below 2.5% y-o-y. In general, one certainly has to agree with the main thrust of Roubini's argument in the sense that it is becoming increasingly difficult to spot the upside in what is increasingly becoming an all out hard landing across the board. In the context of this argument, I would add my own point which emphasises the extent to which the slowdown initially set in across countries with external deficits. It should be quite clear that surplus nations will suffer accordingly too. As such, the global economy is experiencing a widespread decline in the willingness and ability to absorb investment  and credit (this really is the ultimate game of old maid) which in turn is naturally hurting both excess capacity and liquidity providers.

However, there are of course economies out there who may be able to weather the storm better than most in terms of the ability to maintain headline growth. This is to say then that there are some economies who, regardless of global credit and liquidity conditions, will have sufficient internal momentum to stay at reasonable growth rates. This, at least, is my hypothesis. I would highlight three economies (Turkey, India, and Brazil) here in particular, all of them singled out due to their relative clout in the global economy and the fact that they are, in these very years, experiencing their demographic dividend. In this small piece, we shall be looking at Brazil.

Recently, in an economic outlook on Brazil I emphasised how Brazil naturally was going to slow down due to the global correction, but also how I was more sanguine than many analysts with respect to Brazil's ability to avoid a sharp and volatile correction. Moreover, I have also detailed in a more general context how I really did not feel that Brazil could be branded as an "emerging" economy any more. 

But is all that optimism really warranted?

In an analysis from Morgan Stanley, Marcelo Carvalho is not very optimistic when it comes to the immediate outlook for Brazil. The key component in Carvalho's analysis is the link between Brazil's growth performance and her export prices. More specifically the argument lays out how weakening commodity prices would strongly feed into export prices and subsequently rob Brazil of an important income effect. Moreover, it could also tip over the external balance into negative as the hitherto positive goods balance almost certainly would swing into negative. Of course, there is no such thing as unambiguouty in economics and in this way, weakening commodity prices would most likely ease the pressure on the Real's appreciation as the central bank would be able to leave its hawkish stance. This means that Brazil would be set to gain some lost competitivness against a rising USD.

Yet, retorts Carvalho. This is really a question of choosing your poison, since in the event of a resurgence in commodity prices the central bank would be forced into tightening even more to reign in runaway prices. This certainly seems to be true. At the last meeting, central bank governor Mereilles, along side his council, consequently opted to hike interest rates 75 basis points to bring the nominal rate to 13%. Furthermore, and even though headline inflation has shown signs of abation lately, it is widely held that Meirelles' gaze is firmly set for a target at around 15% to halt a core inflation rate running close to the threshold upper limit of the 4.5% target.

This specific set of fundamentals has obviously mad Brazil a virtual magnet for international funds and with a booming stock market [1] and a real rate on government bonds at around 7%, it is not difficult to see why one would want to park a bit of money in Brazil at the moment. A continuation of the central bank's hawkish position is likely to keep the fire going under the Real for a while although it does seem to be running a bit out of steam as commodity prices have fallen steadily. However and even though the Real looks set to lose some of its strenght, its recent impressive run is indicative, I think, of the role Brazil, whether it likes it or not, seems to be playing in the global economy.

In a more general perspetive, I find it difficult to disagree with Carvalho's main conclusion in the sense that Brazil looks set to slow down. However, I don't think that this point is particularly interesting in itself. More interesting is the point that while global economic conditions since 2003 have been very accomodative for Brazil, they are now set to become less so. I completely agree in the sense that Brazil, like everybody, else has been riding the recent expansion and perhaps benefitted more than most. The key question that remains though, is the extent to which Brazil has internal momentum to keep on going on its own. In this way, Brazil does not seem able to escape the fact that as long as the central bank stays in a hawkish mode, the currency will be supported and so, by derivative, will the consumers' purchasing power. Coupled with a potential drop in the windfall from oil in the form of a demand and valuation (income) effect it would tip over the external balance.

But would this be so bad or more aptly; should we expect it to be any other way? One interesting way to illustrate this would be to scrutinize the underlying argument for the central bank's hawkishness. A while back, economist Antonio Carlos Lemgruber consequently critisized the central bank's policy because he thinks it is based on a potential growth rate which is too low. According to Lemgruber the central bank is operating with 3-4% as the potential growth rate while he himself believes it to be closer to 7%. Accordingly, the central bank is keeping nominal interest rates high to reflect the perceived existence of a positive output gap. However, is this really the appropriate way to interpret the signal emmitted from Brazil? Not all think so. In a recent analysis Pablo Bréard from Scotiabank suggests that the high nominal rate maintained by the central bank, in part, is a hedge of future risk aversion and subsequent retrenchment of capital flows from emerging markets. I don't agree.

Personally, I would turn the conventional arguments around and claim that a high interest rate, in the context of Brazil, is a de-facto sign of the economy's high potential growth rate or at least this is the way capital flows react in the current global economic edifice. We could then consider a high nominal interest rate as a sign of capacity to grow and ultimately capacity to offer whatever yield the given nominal rate prescribes. Or put differently; if you offer high interest rates, you better be sure that you are able to suck up the ensuing inflows. Otherwise, the whole edifice may end up catching fire. I would peer wearily across Eastern Europe for confirmation on this.

This means that the effects from a high interest rate and subsequent strong currency is ambiguous when it comes to inflation. It is true that it makes imported goods cheaper, but it does not necessarily halt capial formation or build up of credit since these two components may well be supplied from external sources regardless of domestic capacity to muster the inflows.

Of course, some countries such as e.g. Iceland have recently (and will need to in the future) upped interest rates in a classic attempt to defend the domestic currency and the financing of the external deficit. We would thus always need to consider the risk of any given amount of yield. In this context, many have cautioned the recent upgrade of Brazil's local currency debt to invesment grade. It comes at a bad time they argue as Brazil may, at precisely this point in time, be on the verge of transisting towards a less favorable set of fundamentals than the ones which prompted the upgrade in the first place. This may be true or, at least, it does not seem to be completely wrong. Yet, I also have to say that the whole international global rating edifice is beginning to smack a bit of insignificance, in the sense that if India can receive a downgrade at the same time as Italy's and Japan's ratings are maintained, I really would like to know where capital is supposed to flow in order to reach its most efficient destination.

What all this means for Brazil in the coming slowdown is too early to say at this point. My guess is that the central bank, absent any major global deflationary rout, will maintain its hawkish position. In July, inflation rose another notch to 6.4% which is close to the upper range of the central bank's formal 4.5% target. Both JPmorgan and BNP Paribas expect the SELIC rate to move as far up as 15% (which is my formal target) due to recent data from Q2 pointing towards a continuation of inflationary pressures.

Generally, most of the sell side research I have been looking at suggests that Brazil probably peaked in H01 2008 with respect to headline GDP growth. Most analysts also concur that a likely halt in the appreciation of Real coupled with a slowdown in commodities will make for is likely to put a downward pressure on Brazilian growth. The argument here would be that a depreciation currency would stoke inflationary pressures even as commodities slowed which in turn would make the values of Brazil's exports lower. In this context, the worst scenario for Brazil would be a case where a slowdown coincided with a sharp retrenchment of capital to support the negative external balance (note that the while the goods balance is in surplus the current account is in the red mainly due to the income balance). This could force the central bank to keep rates higher than domestic inflationary pressures would otherwise merit.

In conclusion, there can be little doubt that Brazil, as with the rest of world, is heading for more lacklustre times with respect to economic growth. I am not sure however that Brazil may be in for such a tough time as many predicts. I would especially emphasise Brazil's ability to maintain growth on its own regardless of external factors. I consequently think that there are two crucial points to consider as we move forward.

• One would be the meaning and interpretation of the central bank's high interest rate and indeed a high interest rate in general. In this way, we could also see Brazil's yield advantage over many of its peers as a simple reflection of the economy's capacity to grow. At least, I think this is an important perspective held together with the more traditional, and indeed valid interpretation that the central bank is trying to keep inflation in check. I would consequently argue that if you accept the tenets of my analysis (to some degree or the other), Brazil would be one of those global economies to which capital would simply have to flow. In fact, and this is ultimately what Lemgruber is talking about. I think that he (and others) worry that a high interest rate in the current global environment could lead to too much inflow of funds and thus a serious overshoot of the domestic currency. The risk is certainly there that Brazil may be taking on too much weight within the whole global imbalances structure, but my argument would simply be this is structurally buil into Brazil's growth path. Ironically of course, this general point means that a low potential growth rate would call for a lower nominal interest rate, but since this is currently unfeasible due to the global surge in headline inflation many central banks are finding themselves between a rock and a hard place.
  

• The second point would be a simple test in the good spirit of falsification. My question would then simply be the extent to which we will see risk aversion shoot up to such a degree that an economy such as Brazil would find it difficult to finance a negative external balance. How much would those dreaded credit default swaps really rise and would it make sense at all to imagine that Brazil had to raise rates, 1980s style, to avoid a capital flight. Clearly, if we assume that Eastern Europe, Iceland, etc are already dead and gone at this hypothetical point, even a retrenchment of funds from the likes of India, Brazil, and Turkey would mean a rather violent surge in traditional safe havens in the form of the US, Japan, the Eurozone. I guess, what I am really asking is whether Brazil could be seen as a safe haven in what comes next or more precisely how will Brazil's relative standing in the global economy look during and after what is clearly a quite severe global slowdown?
  

[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]

THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.

Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.

Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.

Where Art' Thou My Fair Market?

If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.

One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;

As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.

In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."

In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.

The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.

In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.

The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.

Revisiting Old Arguments?

Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.

On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.

Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.

One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.

The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:

The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.

(...)

“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.

Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?

In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.

The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.

With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.

Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.

As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.

To Inflate or Deflate?

If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.

The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.

In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?

As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.

Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:

The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.

So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case.

My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.

Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.

One Year In ... Still Some to Go

Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.

In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.

More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.

In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.

Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.

Post Script

Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services.

On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.

Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.

Liquidity Tug-o-War?

Notes to Self - End Q2 2008

A belated plug I know, but still well worth a look.

[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]

THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.

Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.

Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.

Where Art' Thou My Fair Market?

If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.

One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;

As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.

In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."

In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.

The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.

In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.

The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.

Revisiting Old Arguments?

Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.

On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.

Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.

One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.

The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:

The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.

(...)

“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.

Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?

In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.

The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.

With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.

Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.

As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.

To Inflate or Deflate?

If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.

The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.

In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?

As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.

Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:

The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.

So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case. 

My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.

Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.

One Year In ... Still Some to Go

Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.

In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.

More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.

In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.

Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.

Post Script

Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services. 

On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.

Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.

Liquidity Tug-o-War??

Notes To Self - End Q2 2008

A belated plug I know, but still much worth a closer look.