After a week being back from my favorite southern country (Uruguay), I realize not much has changed in G7’s policy stance. At the same time, markets away from the US banking system seem to be normalizing. I think US policy continues to pollute the picture with its lack of clear direction/diagnostics. Every macro tool available is being deployed or its deployment being debated, without much debate if it is appropriate for the problem at hand. Actually, what the problem at hand really is seems to get less discussion than what the size of the next stimulus package should be. At the same time, away from the US, macro themes are driving markets back towards respecting fundamentals more than technicals. The key example is in rates and FX in Latin America, which seem to prove that macro trading is maybe the simplest business this year (liquid, thematic, away from US banks recapitalization woes). Let me elaborate a little on these. [maybe too much sun made me feel pedantic enough to write all this…] Bernanke vs Krugman Earlier this week Paul Krugman wrote an Op-ed arguing not only for a bigger fiscal push, but most importantly for a less transitory one. He explicitly asked Obama to quit using the phrase of ‘jump-starting’ the economy, and wants the President-elect to switch to a rhetoric about sustaining a slow recovery for a long period of time. I think this is a recipe for lowering medium term growth in the US. I go back to a point I tried to make before: is this downturn a more pronounced but still standard business cycle contraction, or are we dealing with a different type of economic problem? Krugman’s view seems to be that of a standard business cycle that should mostly be addressed with an exaggerated fiscal effort (in size and duration). His disgust with the term ‘jumpstart’ seems to indicate he does not believe there is mostly a confidence problem that arises from banks’ balance sheet concerns. His view seems to be more of a traditionally Keynesian demand problem. This sounds to me as a recipe to creating a more permanent fiscal problem that eventually produces higher real rates, lower investment and lower productivity growth (due to rates and crowding out). On the other side, Bernanke’s statements Tuesday morning seem to indicate he is looking more at banks balance sheets, recapitalization needs, asset valutations (thus the confidence issues that ensue). That is where I think economic policy should be looking at and directing efforts. To the extent that open public debate continues to show investors that US policy makers continue to disagree on the nature of the problem and the steps to address it, we should continue to expect volatile markets spooked by each datapoint from the real economy. Moreover, economic decisions in the real economy would also benefit from simpler and clearer signals from economic policy makers. In sum, I like the fact that President-elect Obama seems to prefer to re-direct the fiscal effort to infrastructure/investment/health/education while emphasizing it cannot be forever. All signals that are positive for productivity growth in the medium term. I also like to see the Fed focusing on banks’ balance sheets. However, the debate continues to indicate some basic disagreements about the nature of the problem and the required response, which can detract from efforts to use next week’s change of leadership as a way to improve confidence. Latin American Local Markets Score for Global Macro Interest rates in most of the “good” or “converging” countries have come off significantly since November. This is not difficult to understand: commodities are down significantly, G7 growth is negative and EM growth is slowing, inflation is coming off, and most importantly, in some countries rates were just too high (inflation targeting schemes were still buying credibility as inflation rose). True, during the worst technical deleveraging moments last year, the moves in Brazilian DI interest rates swaps, Mexican TIIE swaps and others were vicious. Risk reduction was broad and deep. But the underlying phenomena are now dominating the recovery. Rates in Brazil have come off from the 15-17% range to sub 12% (the famous Jan10 swap now 11.50% from days above 16% in October and spending November still above 15%), in Mexico 10-year rates spiked at 12% (spent November around 10%) and now sub 8%, while in Colombia Coltes 10-year rates come from around 13% in early November to now slightly above 10%. There are impressive moves, and the direction show these markets have developed enough to react like G7 markets to crises (as opposed to the old fashioned EM crisis). FX rates, which many thought were bound to continue to depreciate, have recovered a still small portion of the ground lost pre-December. True, terms of trade have deteriorated with the correction in commodities, and capital inflows should be expected to slow down, as well as other exports. But the fact that BRL, MXN, COP, PEN and CLP have recovered some lost ground is a testament to the point I tried to make on Nov. 24th about the novelty of real local markets in many of these countries. This means a world of difference to how these countries react to external shocks, even one of the current magnitude. After a very significant shock hit, FX rates adjusted, stabilized and bounced back, without producing severe reduction in local monetary aggregates (no switch out of their currency by locals). This was maybe the most important test these local markets could be subjected to, and for the time being they are passing it. Moreover, policy makers in the “converging” countries continue to make the right moves, like the recent issuance of USD debt in the 6-7% areas. Though these countries had clearly made significant progress in reducing their USD indebtedness as their local markets developed (which is good policy), current conditions make USD issuance as much a no brainer as a policy maker will face. Not only yields are low in absolute terms (though spreads are high), but USD is most likely stronger vis-a-vis their currencies in terms of medium-term repayment costs. At the same time, local rates have not yet fallen enough relative to the most likely end-game. Thus, we should expect more issuance / liability management from the good EM credits. Macro themes away from the US banking system are maybe the simplest liquid asset class to focus on. Note the word “liquid”, because some dislocations in US credit markets are most likely attracting a lot of attention by investors, setting up distressed funds. Just a few thoughts to get going in the new year.

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