Notes From Underground

Our readers may wonder why we refer to Mr. Volcker as the greatest optimist. Because at 82 years of age, he has announced his engagement. We wonder if this should put a bid to the bonds because this is a highly optimistic view of the world. If this couple announces the birth of a child, we will become downright irrationally exuberant about all things financial. We have great respect for Chairman Volcker so it is with sincerity that we offer up congratulations to the savior of western capitalism.

Yesterday the FED announced they were going to embark upon a term deposit facility to withdraw bank reserves from the system. This follows upon the use of reverse repos in a limited amount as the Federal Reserve continues to test the two pillars of liquidity withdrawal. Remember, this is just a test. As growth returns to the economy, the FED has a greater desire to apply practice to theory in order to remove the emergency liquidity measures. It is interesting that the FED is sticking to its previously disclosed plan where are seeing it laid out piece by piece. We applaud them for their truth in advertising.

However, several questions arise: Will it be effective and how will it affect the markets we trade? Will the DOLLAR rally as liquidity gets withdrawn and short-term rates increase? Will the yield curves begin to enter a BEAR FLATTENER? How will the equity markets respond? We will analyze these questions heading into the new year as the FED makes it attempt to remove the liquidity it willy nilly applied to the markets. We become skeptical to the positive effects for the DOLLAR because of the move by the Treasury to nationalize Fannie and Freddie. The more we think about this move by the Obama administration, the more bothered we are by how this seizure of suzerainty will lead to a total corruption of the housing market and the greater economy. We are evidently more bothered then the markets but this is certainly on our radar screen for 2010.

In the markets, we saw the Bank of Israel raise interest rates 25 basis points to 1.25 %. Stanley Fischer, the bank head, is widely respected and his moves bear watching as an indicator of global growth. When GOLD was making its highs earlier in the month, Mr. Fischer stated he thought the rally in GOLD was mistaken because there wasn’t the inflation to support the move in GOLD prices. While we disagree with his views on GOLD and inflation at this time (we think it is a deflation story), his thoughts carry significant weight in the world. Just like Norway raising rates earlier in December, we need to be aware that the peripheral economies are beginning to experience enough growth to warrant raising rates. The question we will have is: Why are the banks raising in quarter-point increments? If the economies are truly experiencing growth, then the banks need to raise rates more aggressively. This Greenspanian game of quarter-point increments needs to be put to rest if the central banks are to have any credibility. When the economies were under stress, rates were slashed by 100 basis points, thus creating an assymetric relationship which results in irrational risk taking. To restore some sanity to the global financial system, we need central banks to act more responsibly in stimulus as well as restriction. The consistency of the global monetary authorities is needed to enhance stability, especially as the world comes to terms with dealing with the huge pool of liquidity that has been pushed into the global financial arena.

Yesterday’s 2-year note auction was the yawner we talked about on CNBC to the chagrin of Anchor Michelle Cabrera. Today’s 5-year auction will be much more interesting as we wait to see if investors find value further out on the curve. Tomorrow’s 7-year will be followed to see if the value out on the curve has any legs. This year-end thinned market may create some interesting movements as we will see if the treasury selloff has been enhanced by some market players selling futures ahead of the auctions to have some insurance against a disastrous result. If the auctions come out better, we shall likely see some hedges lifted leading to a short-term rally. We also bring attention to the fact that the British Gilt market is under severe selling pressure and this is in a market where the central bank’s purchasing program is still active, thus alerting us to the possibility that investors have absorbed enough sovereign debt and are satiated. This will be the biggest issue for the financial markets in 2010. But how much is too much?