Friday, January 27, 2012

The Price of Uncertainty

“People with MBAs”, it used to be said, “know the price of everything, but the value of nothing.”

As an investor, price is the starting point of any decision. Value (though of a different kind from the moral content of the MBA put-down), too is critical: it is when you find a gap between current prices and the fair value of an asset that you make an investment decision. When you have a major disturbance in financial markets, huge price adjustments are required for a new equilibrium to be reached. Unfortunately, these price adjustments throw up many losers, and can lead to massive after-shocks. In order to contain the damage, governments around the world moved rapidly in 2008 to buffer asset prices. There was a certain pragmatic value to this buffering; at the same time, it is delaying recovery.

By their actions following 2008, governments have populated the financial world with fake prices. In our own economy, we don’t know where buyers and sellers would set bond-yields, as the RBI has bought a record volume of bonds from the market, artificially inflating bond prices, and depressing their yields. We don’t know how the market is pricing the rupee vs. the dollar, as the RBI has been selling dollars. We don’t know how demand and supply would price diesel, because the government sets the price. And we don’t have an accurate picture of bank balance sheets, because of the shifting guidelines with regard to Non- Performing Assets.

Last week, Ben Bernanke, Chair of the the US Federal Reserve trumped Indian financial managers, by fixing the world’s single most important price for the next 3 years, namely the interest rate at which his institution will make funds available to US banks. In effect, Ben Bernanke is banker to the world’s banks. He has now committed to a Zero Rate Interest Rate Policy (ZIRP), for the next 3 years, effectively saying that he will flood the world with cash through the end of 2014.

The immediate impact of the extended ZIRP was on gold prices, which soared almost 5% in the wake of his policy statement. That apart, it makes me wonder about the nature of what I would call a ‘Fake Certainty.’ Imagine a scenario in which inflation re-entered the US economy. Since the Fed is committed to holding the annual rate of US price increases to around 2%, higher price rises would force the bank’s hand into lowering interest rates. In that case, the Certainty of ZIRP would have to be abandoned, and I would be justified in calling it fake.

Could this happen? I think so. Consider the following scenario in Europe: the peripheral countries, like Greece and Portugal, realise that their austerity program is not working, and that a German-led Europe is not going to extend them unlimited financial aid; as a result, they take the time-honoured path of deeply indebted nations, which is to devalue their currency. In this case, this means exiting the Euro. If this were to happen (quite apart from the losses to banks, etc.), a Euro without the peripheral nations would suddenly be a very attractive currency, and would get bid up hugely. Commodity prices would rise, and the dollar would come under attack. This would make it very difficult for producers to hold prices in the US, and for the government to borrow funds at its current all-time lows. The certainty the Fed is trying to inject into the system would be out the window. Banks would be hurt, bond-holders would get hurt, and the US government's own deficit would swell.

The underlying point here is that the more artificial price fixes you have in a system, the more prone it is to a brittle collapse. Market players know this, which is why, for example, trading volumes on the New York Stock Exchange are lower than they have been in over a decade.

The present cheery recovery is built on this assembly of rigged prices, fake certainty and poor conviction. Reminds me of Bob Dylan – “something is happening, but you don’t know what it is…”

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