Summing up the week

The chinese revaluation continues to be discussed though some think a devaluation is in the cards rather than an appreciation (see also Goldman saying the Yuan is no longer cheap). With most governments still in competitive devaluation mode scrapping for demand, it is hard to imagine the renminbi not attracting a flight to quality bid on the basis of a domestic economic growth and high savings rates. It is an interesting point of view though and if Chinese growth slows or demand picks up in the rest of the world, maybe the yuan will fall.

Swap spreads turned negative. It is pretty stunning but I can't see it as anything other than a squeeze. There is little logic to banks borrowing at below government rates. The move also coincides with some sharp yield rises across the treasury curve which also looks like liquidation. I expect both the swap spread and high treasury yields will reverse in a couple weeks time after positions are squared and weak hands shaken out. We shall see. I fall into the camp that sees deflation as more of a problem than inflation in the near term (at least a year) due to excess capacity and weak demand.

The economic data still shows the US economy running near stall speed.  Drivers for a slowdown might be 1) growing mortgage delinquencies based on rate resets or 2) a slowing in China (perhaps others too) as liquidity is withdrawn.  To break away from stall speed probably takes a surge in developed world household consumption leading to faster than expected reduction in unemployment.

Watching the rise in stocks against the drop in bonds looks a bit like inflation bets are being put on.  The under-performance in commodities (especially gold) indicates they are no longer the market of choice for such bets.  I tend to think these moves will reverse in the next couple of weeks.  Earnings expectations and multiples still seem to high in stocks, as I said above I don't think inflation is a meaningful threat, and the large debt balances held by governments give plenty of incentive to weaken currencies against commodities.  Of the moves the gold drop is most interesting as clearly a lot of big bets have been placed on its continued rise.

Lastly, on financial reform, I came across some interesting comments in the Aleph blog which makes a fair point that spotting trouble spots is not rocket science:

But, I am sorry, the crisis was anticipated by many of us.  Here is the secret, Alan: the area receiving the greatest increase in debt is the area where systemic risk is growing.  Finance is a mature industry.  Large increases in debt are likely bubbles.  After all, given that the accounting rules allow risky loans to recognize credit margins as paid, in the short run it always pays to write risky loans, until illiquidity kills the lender.

This is similar to the point I tried to make last week, that financial innovation needs to be viewed with more skepticism.  There is very little in the way of diversification, hedging or slicing of risks that is not already being done in a highly efficient way.