Monday, November 9, 2009
I’ve long been cautioning that there are no historical parallels to the present that could guide us on whether inflation or deflation is going to dominate the next investment horizon. I’ve recently spent some time arguing that deflationists may have overlooked the impact of allowing financial companies to ignore their losses and pretend that they did not exist.
Even further back, I warned that the signs we were seeing were most consistent with a liquidity flood, which I encourage you to re-read, as it can explain much about where we are headed. I will build on this theme in this report.
Briefly, the signs of a liquidity flood are a rise in those asset classes most subject to the effects of freshly printed money (stocks, bonds, and commodities), a continued expansion of an already bloated Fed balance sheet, and a return of a risk appetite to the investing world. These things all predictably accompany a flood of freshly printed money pouring out of the Federal Reserve.
The Return of Risk
Over the weekend, the G20 pledged to keep stimulus in place until recovery was assured. Accordingly, stocks rose, the dollar fell, and commodities rose. When the G20 comes out and agrees to keep the money gates open, it is a clear sign to traders and investors everywhere to lever up and chase risk. With a clear sign that governments everywhere will continue to bail out bad investment decisions, the only sensible course is to borrow as much as possible and make risky bets.
Why would the dollar fall on this news? Because people are borrowing dollars at obscenely low interest rates, selling them, and piling into countries that sell commodities (driving up those currencies). In short, the risk carry-trade is on.
Some observers, like myself, will note that this makes everyone feel better (rising markets…yay!) at the expense of piling up new risks. Instead of winding down the past excesses, the official response will serve to return us to a world of excess risk and massive imbalances, while hoping that things don’t break (this time). If the definition of insanity is repeating the same actions but expecting a different outcome, then our fiscal and monetary authorities are insane.
I think this is a horrible strategy that is bound to failure, even without considering the resource depletion issues that loom just on the other side of recovery.
by geoman076