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VOLUME 2.1
DATE: FEB 3 2010
GLOBAL DISEQUILIBRIA:
Our basic view remains unchanged; always a big part of the game; in today’s
we remain positive on equity markets, credit context, we can’t attach much confidence to
spreads and most commodities because any of them. Rather, it makes more sense to
liquidity flows are still very positive and key think in terms of whether the environment is
indicators discussed below are supportive. favorable for assets or not and to watch for
However, we still are very concerned about benchmarks to gauge when that might
the artificial nature of the economic change and how it would affect the different
Past issues have pointed to the usually painful. However, time lags are
widespread and huge disequilibria in the variable and frequently longer than most
U.S. economy and financial system. That is people can imagine. But when the
also true globally. No one knows what’s real adjustment comes it is usually swift and
and what is not when it comes to the substantial. This makes for an uncertain
economic recovery and market prices for environment because the risks are not easily
Boeckh Investments Inc., 1750‐1002 Sherbrooke St. W., Montreal, Qc. H3A 3L6 Tel. 514‐904‐0551, info@bccl.ca
relate to the sustainability of the economic past letters, the explosion in the deficit and
recovery, the future of the U.S. dollar, the the government debt to GDP ratio is not a
two-tiered unstable global monetary system, problem in the short run when the U.S.
government rigged housing market, near private savings are rising, the dollar is firm
zero interest rates, the $10 trillion private and the existing debt ratios relatively
debt overhang, the hundreds of billions of moderate. But now that the economy is
dollars of underwater and illiquid structured growing, possibly quite fast, financing the
financial products, and many more. deficit may not be easy at existing interest
In this issue, we look at one of the rates as people are looking ahead to
key problem areas - funding the U.S. budget government debt ratios which will be
$1.6 trillion or 10.6% of GDP this year. The Who has been buying the massive
ratios of this deficit and many more into the interesting recent piece, “Is it all Just a
future will have serious consequences. In the Ponzi Scheme?,” Eric Sprott and David
next few issues of our letter, we will look at Franklin looked behind the published
some of the other imbalances and numbers to see who bought the $2 trillion of
disequilibria mentioned above. These must net new U.S. government debt last year to
be addressed if the investment environment finance the budget deficit and other cash
is to have some hope of lasting stability. requirements. The Treasury data shows the
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“Other Investors” sector increased its more as the government sincerely hopes.
holdings of government debt by 200% in Foreign and international buyers, who were
2008 and 2009 (Charts 1& 2). Similarly, by far the biggest purchasers last year, are
flow of funds data shows that the getting noticeably nervous about the dollar
‘Household” sector was the largest net and their U.S. investments. It is, therefore,
purchaser in late 2008 and 2009. These two likely that ex ante demand will shrink
statements and “Households” from FRB have to start falling a little more briskly to
statements are residuals: if the figures don’t clear the markets (i.e. interest rates rising).
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The first option is a pre-emptive one. then become more difficult, setting in
The Treasury via the Administration could motion a vicious circle that would tend to
appeal to Congress to cut the borrowing push prices down rapidly to the point at
raising taxes. In an election year, with the increases would be evenly balanced.
Democrats in a precarious political situation That is the second option open to the
and the Republicans smelling blood, forget Treasury in this event – letting prices fall
it. Congress won’t act until after a debt until the market clears. The risk is that the
trouble funding its cash requirements, by Sovereign credit downgrades is a very hot
definition that means interest rates will be topic in the media these days and a U.S.
rising and Treasury auctions will start to go downgrade would be a disaster. Rating
badly or fail. Because interest rates are agencies tend to react late and pile on to
below equilibrium levels, a moderate rise in protect their eroding reputations. In the
interest rates will not make Treasury bonds event of a U.S. downgrade, expectations
much more attractive unless investors think could become totally unhinged. A world
it is a one off price level adjustment. The which has been getting addicted to near zero
reality is that if Treasury yields start to rise, short-term U.S. rates and 3.5% on 10 year
investors will actually become more bearish Treasuries may not react very well if there is
as they would begin to anticipate further a sudden and large change in rates.
increases in the future and, hence, sustained The third option for the Treasury is
capital losses. Funding the deficit would to shorten the maturities of the bonds they
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sell to points on the yield curve where makes government finances extremely
interest rates are much lower. For example, vulnerable to any bad news.
the two year yield is about .8% compared to The fourth option is the end point;
3.6% at 10 years and 4.6% at 30 years. the Treasury runs out of willing buyers and
Selling short-term bonds because the longer- must sell to the central bank. This has been
term ones can’t be sold would be widely going on for over a year in the U.S.; the Fed
noted as the overall term to maturity would purchased $435 billion in the past 12 months
shrink. At present, government debt held by (Chart 4). These purchases were needed to
the general public is 49 months, a moderate support the Fed’s program of quantitative
but certainly not a conservative figure and easing because the money multiplier – the
much lower than the 70 months average ratio of bank reserves to money supply - had
term in 2001 (Chart 3). It would shrink even collapsed (Chart 5). We call this financial
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constipation because commercial banks watched closely for any sign of significant
liquidity flows.
inflation.
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U.S. and international stock markets were Much of what lies behind the U.S.
amounts, others such as the key Shanghai temporary and it is dangerous to use past
market, by as much as 10%. Shanghai was cyclical experience to project growth in the
hit hard because the government ordered a next few years. It is far from clear that
clampdown on bank lending and increased strong growth can be extended much beyond
reserve requirements to counter too rapid the first half of 2010 when inventory
economic growth and strong asset price adjustments will have been made, the
increases in some real estate markets. stimulus money will be spent, interest rates
Commodities and precious metals also sold will probably be higher and the housing
U.S. 4th quarter GDP data indicate China, however, is likely to remain
almost 6 % real growth and many are an important positive. The authorities are
predicting a mini boom to last for some unlikely to risk a significant economic
time. One of the main arguments used to slowdown. They are still obsessed with the
project strong growth is based on past millions of factory jobs lost as a result of
experience which shows deep recessions are collapsed exports; their objective is to take
followed by rapid recoveries. If this the steam out of excessive growth, not kill it.
money and ultra low interest rates would somewhat stable status quo in financial
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being, probably at least until mid-year, environment will remain conducive to good
subject to the risks outlined above which investment profits for those who do their
everywhere. value.
The overall environment will remain Profits will continue to recover well,
highly liquid and awash in nearly free corporate liquidity is good on balance and
money - not bad for financial and leverage in that sector is falling. But it is no
should slow by mid-year but remain too strongly that the investment and
positive. The Fed will continue to monetize economic world is totally artificial and at
a large part of the Treasury borrowing some point an adjustment will come. Alice-
requirement if need be. Price inflation will in-Wonderland economics don’t last forever.
remain very low, hovering on either side of Keep overall exposure to risk below normal.
On a rate of change basis, the jump in Watch the key benchmarks for significant
energy and food prices will head back negative change. To re-iterate, these
toward zero after mid-year. benchmarks are: the trade weighted value of
The sharp rise in stock, corporate the U.S. dollar, the 10 and 30 year Treasury
bond and commodity markets last year was yield, and the spreads between risky
mainly a catch-up, rebound from very corporate bonds and Treasuries. These
oversold levels. The recent correction is indicators continue to be stable and as long
healthy and gains will be much more muted as this is the case, the overall environment
than in 2009. However, the overall will remain favorable for risk assets. The
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money multiplier is still very weak. When it Tony & Rob Boeckh
info@bccl.ca
starts to strengthen significantly, super BoeckhInvestmentLetter.Com
February 3, 2010
expansionary liquidity conditions will begin
market.
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Stocks
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Commodities
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Currencies
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Interest Rates
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