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Opinion: A Battle Between Policy and Reality

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Opinion: A Battle Between Policy and Reality

Republished from Reuters Hedgeworld “Hedgeworld”
January 5, 2012
James Saft is a Reuters columnist. The opinions expressed are his own.

There may never have been a worse time to invest based on the fundamentals.

Wherever you look, the underlying reality – of too much debt and potential euro fracture – is negative, and where there are positives they are usually being supported by an unstable scaffolding of exceptionally loose monetary policy. That makes handicapping economic growth and financial markets not just unusually difficult, but very likely a process that offers a lot less reward against risk than we’ve grown accustomed to.

“Now we appear to be morphing into a world with much fatter tails, bordering on bimodal. It’s as if the Earth now has two moons instead of one and both are growing in size like a cancerous tumor that may threaten the financial tides, oceans and economic life as we have known it for the past half century,” Bill Gross of PIMCO, perhaps the world’s most powerful investor, wrote in note to clients.

We can perhaps forgive Mr. Gross the slight tinge of hysteria; he had a terrible 2011, one in which his main call, that U.S. Treasuries would perform poorly as the force of Fed buying eased, proved not just wrong, but very close to dead wrong.

Mr. Gross describes a landscape in which truly exceptionally radical monetary policy is doing battle with the very strong forces that should retard growth. The upshot is a really unusual pattern in the distribution of potential outcomes. A straight analysis of the combination of demographic drift and debt problems would argue for a sustained period of low growth, high unemployment and uninspiring asset price gains. That’s even before you adjust for the deflationary and disruptive effects of the mess that is European monetary union.

We now bank, literally, on extreme policy – from quantitative easing to a European Central Bank which is allowing its banks unlimited funds with which to either keep themselves upright or reinvest in the debt of their own troubled government’s. That keeps financial markets afloat but also brings with it very high costs.

Policy has introduced two wildly diverging and substantial risks on either side of that central muddle-along forecast. On the icy side, we have the potential for mass and uncontrolled debt default – think bank runs in Spain and Italy bringing on a rolling failure. On the fiery side, the risk is that policy actually works to revive growth but brings uncontrolled inflation along for the ride. That could mean not debt revulsion, but currency revulsion, as people with a choice decide to get out.

A Lesson From Soros

The icy outcome, where banks fail to recirculate their funds, unwilling to take risk because of the lack of potential reward, is not just the result of the extremely low interest rates that have been engineered by central banks. Take a step back. If leaders, in the U.S. in 2008 and in Europe now, had been willing to tackle their insolvent banks, those measures would not have been needed and money would be moving faster through the economy.

All of this is not too different from famed hedge fund investor’ theories about financial market reflexivity, which essentially argued that people would sometimes upset the equilibrium in markets through their attempts to take advantage of the actions of others, such as through piling in to stocks or assets that are already going up in value.

Mr. Soros believed that this disequilibrium happened every once in a while, but I’d argue that we are now in an extended state of imbalance – one in which policy makers are pushing desperately against the forces of, for lack of a better term, reality, while we stand on the sidelines trying to decide which side to back.

When Mr. Soros made his famous run on the British pound, it did not take too long before the British authorities blinked, sending sterling crashing out of the European exchange rate framework. While Britain spent a reported $42 billion supporting the pound, and pledged briefly to jack interest rates up to 15 percent, it was all over quickly, the damage being counted and profits taken.

Now the battle rages for literally years on end, and the measures taken by central banks grow increasingly large. The implication is that when the authorities finally do blink, if ever they do, the resulting bust-up will be correspondingly big.

Of course the policy may work, and we may get some gentle, controlled inflation that allows the banks to survive while at the same time gently lightening the loads of debtors. The reward of that outcome for investors probably is overbalanced by the risks of fire or ice.

The key thing to watch will be political constraints on central banks, either via elections coming this year in France and the U.S. or through a democratic revolt in someplace like Germany or Greece. Every battle ends eventually.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.


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