Deflation, hedge funds and the Euro

I have a lot of things going through my mind so please excuse me for being a little rambling in this post.

Couple of things I learned today – a number of hedge funds have de-risked considerably in the last few days. Also the German government will pass the bailout bill comfortably tomorrow as the opposition parties will abstain. So where does this leave us?

The hedgies are now effectively sitting out of the market. As yet volumes are not suggesting that their nervousness has translated into wider selling by individuals and, more importantly, long only funds. Key thing for the direction of the market is how much the market decline fuels redemptions from the liquid long only funds. As fund managers have to be mostly invested they will not yet have had chance to sell much but their hands may be forced by redemptions if fear starts to spread. The next few days will be crucial and hints of wide scale redemptions could be scary for the market given the non-participation of hedge funds.

I am not sure I see real fear yet although LIBOR, Gold and T Bills need watching closely. I can foresee some chioppy action over the next month as hedge funds dip their toes back in the water but also think that each little rally will be faded as there are undoubtedly funds and individuals who feel like they are behind the curve in de-risking their books.

Regarding the EUR the bailout may prompt a short term bounce. However I again think this will be faded in the next couple of weeks as this bailout does NOTHING to address the underlying imbalances in the Euro area. The fiscal austerity which will be needed to create the appearance of fairness for the people of the financing states will cause macro indicators to continue to decline and EUR less than 1.15 seems inevitable.

On a longer term dynamic there have been a number of indicators from US and Europe ex UK that the deflation train is coming to town. Even if this correction does not run much further in the next couple of months I can see some fierce rotation between asset classes. I think that too many investors are positioned far too early for inflation. They made the increased money supply = inflation mistake and have not appreciated the velocity of money.

Despite the efforts of central banks to increase nominal GDP, which is the way they have chosen to “address” the incredible debt destruction ongoing. However despite doubling national debt in the UK and US (and soon Europe) they have barely managed to get nominal GDP positive. This suggests that the velocity of money is still falling as banks keep all the extra money supply as reserves against losses still to be taken. Moreover the uncertainty caused by the poorly planned actions of CBs and Governments is causing the demand for loans to be restrained, even if the banks were in a position to provide them.

Therefore deflation is setting in as the current re-inventorizing cycle comes to an end. The policy makers response will surely, at some point in the next year or so, be to unleash another round of QE. That is potentially when the inflation beast starts to rise and I have no idea where investors will be able to hide