PIMCO Disposes of Its Government Debt Portfolio while Bernanke Speaks of an Exit Plan

On the back of some weak data today on the employment and housing markets, and following some disappointing figures from China, stocks and commodities including gold and oil are performing very poorly. Ben Bernanke seems to have contributed his own part to the sudden shift by reassuring us confidently that he and his team of responsible people at the Fed are actually thinking of an exit plan as the economy improves. Expectably he did not make any commitments, but markets apparently don`t enjoy the hints being given so pompously and loudly. 

In Asia, the fact that China has ended up with a small yearly trade deficit instead of an expected sizable surplus is one of the top news items of today. Some have gone so far as to say that this event signals the end of the so-called currency war as the deficit removes the urgency of the need to appreciate the CNY, while others tie it to the government`s conscious efforts to boost domestic spending in order to rebalance the economy. The currency has been slowly appreciating since around June of last year, and a shrinking surplus is natural at this point. However one month`s negative number doesn`t mean much in the long sequence of positive sums stretching back to a long time ago, and if we also keep in mind that the deficit is almost entirely due to the huge jump in commodity prices that followed the Middle East unrest, it becomes clear that the reversal is not a consequence of Chinese actions, but rather of market fluctuations which do not mean much in terms of the USDCNY exchange rate debate. If the worst happens and oil prices skyrocket in consequence of chaos in producing nations, it is obvious that China would be just another victim with exports falling (as demand evaporates in the rest of the world with rising inflation) while imports rise with commodity prices. This is not a China specific event however, and for now its effect must be regarded as temporary because one doesn`t build a base case on a doomsday scenario.

What the Chinese numbers really signify to us is the euphoria that has overtaken the markets on the back of Fed-induced overspending in the U.S., as all the colossal events taking place in the critical Arab World and the chronic problems of European sovereigns were ignored on the basis of momentum trades.

Meanwhile, Bill Gross is preparing his fund for the previous version of the doomsday case, prudently in our view, by getting it rid of its entire government debt portfolio, completing a process that was known to be underway for some time. Mr. Gross apparently wants to play safe for although it is undeniable that any bullishness in the government debt market can last for a while (because it is a bubble), it is also safe to say that the higher it goes the deeper it will plunge, and it will be painful for those who tarry too much in quitting before the masses. We still believe that the U.S. will outperform most developed market economies when the crisis strikes, but that doesn`t mean U.S. paper will do well, only that it will burn with less severity than its less-favored peers in the rest of the world, due to a combination of safety and superpower effects. 

Japan Rallies while Western Markets fall on Sovereign Debt

The Americans and their allies were moving to reduce the intensity of  air strikes in Libya now that the Colonel`s defenses have been mauled, and optimism with respect to Japan`s fortunes in dealing with the nuclear crisis was improving as well, but ironically markets have reacted to the news with sales today. Technical analysis experts, including Laszlo Birinyi, were predicting a fall of around 10% for the entire correction, but even if that were to happen, it will still be a brief reversal in what is essentially an central bank inflated global asset market.

Today`s sales were attributed to the 90-odd bps rise in Irish 2-yr yields, and since Asian markets were doing reasonably well with Japan in a bullish mood after yesterday`s holiday, this explanation seems to make sense. And if we consider how resilient the market has been to what could have been a period of severe pummeling, after a number of massive negative surprises, a little bit of selling should come as no surprise. We believe that stock and commodity markets will continue to remain in a bullish trend for as long as the Fed maintains its easing bias. As such, while the oil shock and the Japanese earthquake are powerful enough to derail any trend in the short-term, the printing press will rule in the longer term.

The main question is whether the Fed will be inclined to raise interest rates at any point as a consequence of the events that we are focusing on at the moment, in part due to emotional reasons. There is little sign that the bank will see the recent fluctuations as an indication of a shift in long-term, multi-year inflation expectations, on the notion that the Libya War as well as the Japanese Earthquake are all one-time events that will not have lasting influence on pricing power or consumption trends. To reinforce this viewpoint, we have some signs that the Japanese people will be even more conservative in their spending habits - a phenomenon that might at best be compensated for by increased government expenditure. Only a sustained bull market in the country would challenge this analysis, but Japan has no grounds to fuel such a trend, outside of the external dynamics generated by global economic growth. It therefore makes sense to expect both the BoJ and the Fed to maintain their present postures.

It is clear that the Asian and Western markets cannot remain decoupled from each other for a long period of time, and if the concerns about Europe intensify there is a good chance that we could see the weakness spread around the world to last till the end of this week. But given how big the incentive is for Europe to avert a breakdown of the E.U., after so much money spent and committed in the past year alone, we believe that the first half of 2011 will be a bullish phase, overall, for the world of finance.