French Finance Minister Christine Lagarde says the world should develop an early-warning system that would alert countries to looming financial threats.

U.S. Treasury bond yields may decline next year to their lowest level since the 1950s, and European debt may do the same, according to Albert Edwards, a strategist at Societe Generale SA.

``We are all Japan now,'' Edwards wrote in a report today. He predicted that U.S. and European 10-year yields will retreat below 2 percent, the ceiling for 10-year Japanese government bonds throughout this decade.

The CHART OF THE DAY shows Treasuries and German bonds, a benchmark for European government securities, both yielded about 3.7 percent yesterday. The yield on Japanese debt was only about 1.5 percent.

``Although bond yields are declining, I am surprised that they have not fallen more,'' Edwards wrote. ``There is now wide acceptance of our long-held view that this is going to be the worst economic downturn since the Great Depression and hence deflation will be the key threat next year.''

Japan's bond-market performance during the 1990s demonstrates that ``fiscal pump priming now being piled upon financial bailouts'' won't keep U.S. and European yields from tumbling, the report said.

Yields on Japanese 10-year debt sank by four percentage points in the decade, to 1.68 percent, Bloomberg's data show. They dropped even as the government increased deficit spending in an effort to revive the country's economy.

Metals

Revising gold price forecasts lower on currency forecast revisions

Revising gold price forecasts lower

We are revising our gold forecasts lower on Goldman Sachs currency revisions as USD shifts are the dominant driver of gold prices, in our view (see Exhibit). Our economists now believe that deleveraging patterns will continue to lend support to the USD in the near term and have revised their EUR/$ forecasts on a 3, 6 and 12 month horizon to 1.20, 1.30 and 1.30 from 1.45, 1.50 and 1.40 (see Goldman Sachs FX Monthly Feature Article: Deleveraging Still Dominates, published November 12, 2008). This shift, as well as other shifts to our currency basket based on the economists' revisions, is leading us to revise our 3, 6 and 12 month gold forecasts to $690/oz, $730/oz and $710/oz, respectively.

The flood of cash into money-market funds that pushed their assets to $3.6 trillion last week amounts to a bubble that's ``fully inflated and ready to burst,'' according to LPL Financial's Jeffrey Kleintop.

The CHART OF THE DAY shows money-market fund assets tracked by the Investment Company Institute as a percentage of the Standard & Poor's 500 Index's market capitalization. Money funds have risen to about 44 percent of the S&P 500's market value from 24 percent at the start of 2008 and the 19 percent weekly average in 2006 and 2007, data compiled by Bloomberg show.

Kleintop, who helps oversee about $274 billion as chief market strategist at LPL Financial, says the rush into money funds mirrors the 1990s increase in technology stocks that pushed their market value to 35 percent of the S&P 500 from a long-term average in the ``mid-teens.'' As the chart shows, technology stocks tumbled after the dot-com bubble burst and now account for 15 percent of the S&P 500's market value.

``The growth in demand for money-market securities is not a typical financial bubble,'' Kleintop wrote in a research note. ``However, a comparison to the dot-com bubble can help illustrate the opportunity cost when the cash equivalents `bubble' bursts.''

The ``classic pattern'' suggests money-fund assets will decline to about 20 percent of the S&P 500's market value, which may boost prices for other assets, Kleintop wrote. ``While bubbles always warrant a close watch, they need not always be feared,'' he wrote.

U.S. Treasury Secretary Henry Paulson plans to use the second half of the $700 billion financial rescue program to help relieve pressures on consumer credit, scrapping an effort to buy devalued mortgage assets.

``Illiquidity in this sector is raising the cost and reducing the availability of car loans, student loans and credit cards,'' Paulson said in the text of a speech today in Washington. ``This is creating a heavy burden on the American people and reducing the number of jobs in our economy.''

Treasury and Federal Reserve officials are exploring a new ``facility'' to aid the market for securities backed by assets, Paulson said. Officials are considering using a portion of the bailout money to ``encourage private investors to come back to this troubled market,'' he said. The Treasury chief said the department is also considering having companies that accept new taxpayer funding get matching private capital.

Buying ``illiquid'' mortgage-related assets is no longer
being considered, he said. ``Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role,'' he said, referring to the Troubled Asset Relief Program.

Paulson has committed all except $60 billion of the initial $350 billion allocated last month to address the collapse of financial institutions and markets, and Congress could reject approval for the remainder. Lawmakers including House Speaker Nancy Pelosi are pushing for aid to automakers including General Motors Corp., pressure that Paulson is resisting.

Recently, I trudged through the mire of a government-run food auction yard, or mandi, in Bangalore, the global economy’s offshoring capital. Piles of supposedly fresh produce lay everywhere, rotting in the sun and competing with mangy dogs and scampering mice for my attention. Huddles of impecunious farmers, wearing the traditional dhoti, looked on with resignation. A government agent, pen tucked behind ear, offered a pittance for the produce on display.

The farmers’ day had started before dawn. Chugging along on narrow so-called highways, they came to the auction yard in ramshackle public buses, bullock carts, trucks, and even tractors. Their produce unloaded, they accepted whatever they got. After snatching a few hours’ sleep in a shady corner, they retraced their steps home.

In India, agricultural mandates have long required farmers to sell their produce through such wholesale yards. Although meant to free poor farmers from the clutches of local moneylenders, the mandi has become a monopoly. The farmer remains exploited, but now by local political interests.

But let’s change the scene from a city market in India to a rural village in China. Not long after I visited Bangalore, I crisscrossed parts of Henan—the name means “south of the Yellow River” (Huanghe). The province, one of China’s most populous, is home to more than a hundred million people. I started in Zhengzhou, the capital, a major industrial center and railway junction, and traveled to Chengguan, a county seat with 100,000 inhabitants. Chengguan was scrupulously clean; municipal services were apparent even in the predawn hours. The city bustled, but there was no squalor in the streets. I then headed to the very small village of Qiu, with a population of no more than a few thousand. The paved roads, in better condition than the Massachusetts Turnpike and other highways I know at home, led right up to the cornfields on the edge of the village. Qiu itself, if not quite prosperous, had none of the desperation so obvious in many Indian villages.

Rural development is crucial for the overall development of a nation’s economy. China’s economic revolution started with the reform of its village enterprises; foreign direct investment followed. Agricultural development in rural areas generated economic surpluses that in turn fed light manufacturing in rural and semiurban areas and, ultimately, industrialization in urban ones. A virtuous cycle ensued. The economic surplus promoted reinvestment in new technology and released human capital for broader development. This was China’s path, as it was Indonesia’s, and Vietnam has taken it since 1989.

India, however, has not. The nation’s government has failed to invest in its villages. The farmers who sold their produce in a mandi in Bangalore live a daily struggle for existence in their home villages. Today, 89 percent of all rural households do not own a telephone, and 52 percent have no domestic power connection. The average village is two kilometers away from an all-weather road, and 20 percent of rural habitations must walk for miles to obtain safe drinking water, have access to it for only a few hours a day for much of the year, or have no access at all.

Nov. 13 (Bloomberg) -- The great and the good of capitalism and free markets held a requiem dinner for the global financial system at a secret hideaway this week. As the waiter decanted a fresh bottle of 1985 Chateau Margaux, the blame game began.

``I blame the central banks,'' growled the bond trader, stabbing the air with a forkful of raw steak. ``If Alan Greenspan hadn't kept interest rates so low at the start of this decade, we wouldn't be in this mess. Talk about refilling the punch bowl when the party guests are already as drunk as skunks!''

``We told you we were not in the business of identifying bubbles, let alone trying to puncture them,'' replied the central banker, nibbling at a lettuce leaf. ``We warned you that credit spreads, emerging-market yields and volatility in stocks and bonds were all too low, and that you were under-pricing risk.''

The central banker took a sip from his refilled wine glass. ``Can you imagine the outcry if we had tried to halt the explosion in home ownership? I think you'll find that the true villains are the mortgage lenders; if they hadn't trashed their standards with self-certified and liar loans, the crisis in the housing market would have remained self-contained.''

``That's not fair,'' said the mortgage originator. ``We weren't on a level playing field. Fannie Mae and Freddie Mac were using their implicit government guarantee to distort competition in home loans. We were forced to take on more subprime borrowers just to stay in the game; if it hadn't been for all those clever derivatives products, we would never have been able to recycle all that toxic waste and keep the pyramid scheme afloat.''

Above Board

``Ah, the derivatives bogeyman,'' chuckled the structured- finance specialist. ``Listen, derivatives don't kill markets. Markets kill markets. Everything we did was designed to promote efficiency by allowing investors to disaggregate their risks. I can show you the bills from my lawyers to prove that every product we invented was legitimate.''

``All we did was offer advice on the best method of structuring securitization transactions,'' the capital-markets lawyer said. ``There would never have been a market for the racier collateralized-debt obligations if the rating companies had done proper due diligence, instead of slapping AAA ratings on anything and everything that offered to pay them a fee.''

``You can hardly expect the finest minds in finance to come and work for us when they can earn gazillion-dollar bonuses doing the same work for an investment bank,'' said the credit-rating assessor. ``We relied on the computer models that the banks helped us build, and those models turned out to be, shall we say, less than perfect. Besides, everything was fine until the money- markets froze. The problem wasn't over-optimistic ratings, it was an over-reliance on wholesale markets to fund leverage.''

On the Hook

The waiter cleared away the dinner plates. The diners all declined dessert -- ``Humble pie? No, thanks.'' -- agreeing instead that a couple of bottles of 1982 Chateau d'Yquem would round off the evening nicely.

``I'd never even heard of Structured Investment Vehicles until they started to blow up,'' said the central banker. ``We believed the banks when they said their business model was based on originate-to-distribute; how were we to know that once the music stopped, they were still on the hook for trillions of dollars of liabilities they'd slipped off the balance sheets?''

``Look, domestic savings rates just weren't high enough to provide the kind of leverage we needed to juice our returns to match those of our peers,'' said the commercial banker. ``We had to rely on money-market funds, rather than our deposit base. And the money markets wouldn't have frozen if it hadn't been for those ridiculous mark-to-market rules forcing all of us to prematurely disclose that we owned huge piles of securities that were rotting, before prices had any chance to recover.''

Capital Inadequacy

``We gave you plenty of leeway to play fast and loose with the truth so that you could stay solvent,'' said the regulator. ``Besides, you were just doing your job of maximizing returns to shareholders. If those greedy investors hadn't forced you to take on more risk, our rules on capital would have been more than adequate to keep the banking system solvent.''

``How on Earth was I supposed to fund the retirements of thousands of ex-employees when returns were collapsing simultaneously in every market?'' asked the pension-fund manager. ``Of course we wanted the banks to work their capital harder. We were in the same boat, trying to move money into new arenas to make a buck or three. We bought derivatives, commodities, we even held our noses and gave money to the hedge funds. That didn't turn out to be such a good idea.''

``Hey, we warned you there would be times like this,'' said the hedge-fund manager. ``If you want years when we deliver 50 percent, 60 percent returns, you have to expect periods when we will lose 20 or 25 percent of your money. You won't see us lining up with our begging bowls at the government bailout window.''

The waiter coughed, proffering a slim leather folder containing the reckoning for the evening's entertainment.

``You are a taxpayer, I take it?'' asked the investment banker. The waiter nodded. ``In which case, we were rather hoping you would foot the bill.''

.

The flip flop on the buying of toxic assets is surprising
either it's common sense or else the feds are running out of ammo ?

I think Bernake and Paulson didn't do too bad in a train wreck sort of way ,
they avoided the 29 scenario only to fall into the 08 movie but nobody gave them the plot ,
they are improvising as they go along , that's probably a good thing too , no sure recipes, no magic solution ... sound reasonable

It looks like we are going for some deflation , is cash going to be king ??

what if there is a run away from the dollar ( but where to ? )

.

Home Front

The long-term battle plan is getting the U.S.'s financial house in order.

In the current crisis, the government is borrowing to invest, not spend. But over the past 50 years the U.S. has borrowed to spend, not invest. It has taken money from younger generations to spend on Social Security, Medicaid and Medicare benefits, while promising to pay the young much larger benefits of their own when they retire. Thanks to this off-the-books pyramid scheme, the U.S. is short $70 trillion, in present value, to pay for future spending not covered by future taxes.

Nothing short of a radical overhaul can eliminate our fiscal gap. The goal is meeting, but also fully paying for, the nation's paternalistic imperatives without destroying incentives to work and save.

We're in a dangerous economic war and need bold plans to avoid a deep recession, clean up the subprime mess and resolve our long-term fiscal problems.

The first step is jump-starting consumer spending, which is 70 percent of gross domestic product. Tax refunds won't help, nor will hiring subsidies. Refunds will be saved, and hiring presupposes customers.

To stimulate spending, Uncle Sam should get the states to begin a six-month, 10 percent sale on retail purchases. The federal government would pay the states to cut their sales taxes by enough to generate a revenue loss equal to 10 percent of state consumption. States with low or no sales taxes would subsidize purchases.

Step two is, at long last, to buy up the toxic subprime assets at dirt-cheap, market prices. No one will trust banks until these contaminated assets are off the shelves. Treasury Secretary Paulson has decided not to buy them through a government-run auction. But there are other purchasing and swap mechanisms available.

Improved trust will help those banks with collateral to borrow and, thus, to lend. But collateral is in short supply. Banks hold some $3.5 trillion in AAA-rated loans, including top- tranche mortgage-backed securities, but they are no longer accepted as security. Uncle Sam should resurrect this collateral by insuring these loans against default. Banks would pay the premiums for this insurance with preferred stock.

Government Insurance

With plenty of collateral, banks will be able to lend to businesses. But will they trust Main Street? Government can help here too, by selling default insurance on the bonds of top-rated companies. Banks that buy this insurance would face no risk lending to these companies. The alternative is lending directly to businesses.

By guaranteeing AAA-rated private-sector loans, the government would be insuring against systemic risk; AAA-rated securities collectively would run into trouble only if the economy collapses. The U.S. can prevent such a collapse.

The government also should purchase corporate stock. If the market continues to crater, the government could borrow to buy futures on a broad index of U.S. stocks. In buying futures, the U.S. gets no voting rights and can't interfere with business decisions. The government already is buying shares of banks and securities firms.

Call this socialism, but it simply rearranges the financial furniture. Panicked investors are selling their assets for Treasuries; the government is using those proceeds to buy the sold assets. When the panic ends, the U.S. will sell the assets and buy back the Treasuries. If all goes well, the government will reap a profit and return it to the public in the form of lower taxes.

Safety Squad

The medium-term plan involves setting up a Federal Financial Authority (FFA) to certify simple, transparent financial products as safe for public use, to rate financial securities and institutions, to audit all major companies, and to require full disclosure of assets and liabilities of publicly traded companies.

The FFA would also restrict financial intermediaries from taking open positions that could jeopardize their ability to channel funds from savers to investors. The role of intermediaries is making markets, not gambling. Fidelity Investments, not Lehman Brothers Holdings Inc., is the right model.

Finally, the FFA would regulate companies based on what they do, not what they say they do. In providing seals of approval, in doing its own rating, and in insuring only those mortgages and corporate bonds that it rates AAA, the federal government needs to establish financial standards and reward good behavior. Liar mortgages and other toxic assets will disappear.

The International Energy Agency (IEA), which advises 28 industrialized countries, on Thursday slashed its global oil demand growth forecasts.

It says demand has grown this year at the slowest rate in a generation and next year it is expected to expand by only 350,000 barrels per day (bpd).

CONSERVATIVE

World oil demand is now expected to average 86.2 million bpd in 2008, rising to just 86.5 million bpd in 2009.

Some analysts say the IEA's assumptions are too conservative and that a dramatic contraction in demand in the major developed economies will offset growth in oil demand elsewhere and produce a rare absolute fall in global demand.

Falling demand forecasts have led to widespread assumptions by oil traders that oil markets will be oversupplied.

The Organization of the Petroleum Exporting Countries agreed last month to cut its oil production by 1.5 million bpd from November 1 and many analysts think it will trim its output further.

An Iranian oil official said on Thursday OPEC members would meet in Cairo on November 29 for "consultation" on the market, a move which temporarily helped push up oil prices off their lows.

Rob Laughlin, senior oil analyst at brokers MF Global, says the market could begin to turn if OPEC, responsible for pumping around 40 percent of the world's oil, trims production.

"Already some OPEC members are struggling to make money at these prices getting oil out of the ground," he said. "Look at Iran and Venezuela where the costs are relatively high. These countries are seriously feeling the pain."

Prices are already well below the average cost for the most expensive new projects -- known as the marginal cost of production -- at about $75-$80 a barrel, according to London-based analysts Bernstein Research.

David Dugdale, London-based energy analyst at MFC Global Investment Management, says future oil production could be curbed if oil prices fall much below $50 as many oilfields, particularly in sub-sea developments such as the North Sea, are more costly to develop.

Dollar Outlook:

``I've been a dollar bear for six and a half years for one
main reason, the massive current-account deficit. ``I don't buy into the view that you should extrapolate the recent improvement in the U.S. current-account deficit. I think it could get worse in the next couple of years and also the budget deficit.

``That puts pressure on the terms in which the U.S. is able to attract foreign capital. The pressure will show up in further downside in the dollar or upside risk to long-term U.S. interest rates. ``The dollar, for all the talk of its recent surge, is still down 15 percent today from its peak in early 2002 in broad trade-weighted terms. It had been down 25 percent earlier, so it has recovered a bit in the past six months. But I would be hesitant to characterize this as a strong dollar period.''

Outlook for U.S. Treasuries:

``The rally in U.S. Treasuries reflects the downward revision in inflation expectations, on-going Fed easing and an economy that is in recession. ``The rally is generally well supported but the question is what happens three years from now when the economy recovers and we have all this liquidity in the system. Do Treasuries then start to worry more about inflation than deflation?''

Asian currencies and central bank interventions:

``This has been a challenging period for Asian central banks. The concern five months ago was inflation and now the fears are deflation. Central banks have been whipsawed back and forth. ``It surprised many including myself, the sharp downward pressure on the Korean won, the rupiah and other Asian currencies.

``The good news is Asia's huge reserves backstop. But when Korea loses 10 percent of its reserves in a very short period of time and it's on the cusp of a current-account deficit, you can conjure up scenarios which are somewhat disconcerting. ``Asia will come out of this okay but not unscathed.''

Extent of global economic downturn:

``Right now it's terrible. We have a synchronized recession not seen since World War Two. It's being exacerbated by the credit freeze although it's slightly thawed. ``The earliest recovery I can envision in the broader global economy would be late 2009, possibly 2010. ``The recovery in the global economy would be a tepid one. It won't be a V-shaped. The improvement will be very, very gradual. To the extent that markets start to price in a more
vigorous recovery, they could be disappointed.''

Commodity Bubble:

``It was a bubble,'' Roach said. ``Commodity prices have a history of some of the most violent fluctuations of any markets in the world, and they have lived up to their reputation.'' The last raw material bubble was in the early 1970s when ``you had the same type of global growth boom that we've had in the last four and a half years,'' he said. ``The boom has gone to bust. The global economy is now growing at 2 to 2.5 percent, less than half the pace that we've been running at.''

``There are early signs'' that commodity-producing nations, such as Russia, Brazil and in the Middle East, are beginning to ``feel acute pressures,'' he said. In commodities, ``two areas where you might run against the grain would be precious metals, which would benefit from a sort of anxiety hedges, and possibly soft commodities like food,'' he said.

Talk of a current account deficit heightened after a report Thursday showed exports shrank 1 per cent. That caused a $1.1-billion decline in the September trade surplus – a key part of the current account calculated by deducting imports from exports – to an eight-month low of $4.5-billion.

There's little hope for a big pickup in exports with the 30-country Organization for Economic Co-operation and Development saying its membership is now in recession.

Shipments to the United States, Japan and the European Union countries all fell in September. Buyers in the United States, still by far the biggest market for Canadian exports, spent 1.3 per cent less on goods from this country.

There's little sign that trend will reverse, with indicators showing that the U.S. consumer is in no shape to continue the spending spree that drove trade for years.

For the moment, the current account is likely to remain in the black through this quarter.

“Next year is a larger concern as capital flows dry up and as Canada feels the lagged effects of the U.S. economic downturn,” said Dustin Reid, a senior foreign exchange strategist at RBS Greenwich Capital.

Not all forecasters reckon that the twin surpluses will disappear completely.

“The fiscal surplus will be gone soon, but on current account there I think we have a big enough cushion that, even in a challenging environment of declining oil prices and the like, I don't think we'll see a current account deficit any time soon,” said Craig Wright, chief economist at Royal Bank of Canada, which predicts a rebound in oil prices that will help pad the surplus.

In the long term, many economists view a decline in purchases by the United States as a good thing because that country ran up a big trade deficit as U.S. consumers bought huge numbers of imports.

“Part of the root of all the global problems has been the enormous U.S. trade deficit, and narrowing that deficit means much smaller surpluses in the rest of the world,” Mr. Porter said.

A current account deficit in Canada would be a symptom of what's going on globally, not something caused by problems at home. Even so, given how much bragging Canadians have done about the twin surpluses, it would sting.

But while the loss of the twin surpluses may be a blow to the national ego, the rest of the world isn't likely to hold it against Canada.

“We talked about it a lot in Canada,” Mr. Wright said, “but I'm not sure around the globe it was noticed much.”

.Just saw Paulson interview on the jim Lehrer show on PBS at first the man seemed barely coherent and J. Lehrer put a bit of mucle in his questions , Paulson basicaly come out O.K. he alluded darkly to avoided dangers the 700 Gigabucks had avoided and said as things were changing fast , he would change with them . can't really ask for more , the tricky question will be new european regulations but I'm not holding my breath.

To pull us out of this downward spiral, the federal government will have to provide economic stimulus in the form of higher spending and greater aid to those in distress — and the stimulus plan won’t come soon enough or be strong enough unless politicians and economic officials are able to transcend several conventional prejudices.

One of these prejudices is the fear of red ink. In normal times, it’s good to worry about the budget deficit — and fiscal responsibility is a virtue we’ll need to relearn as soon as this crisis is past. When depression economics prevails, however, this virtue becomes a vice. F.D.R.’s premature attempt to balance the budget in 1937 almost destroyed the New Deal.

Another prejudice is the belief that policy should move cautiously. In normal times, this makes sense: you shouldn’t make big changes in policy until it’s clear they’re needed. Under current conditions, however, caution is risky, because big changes for the worse are already happening, and any delay in acting raises the chance of a deeper economic disaster. The policy response should be as well-crafted as possible, but time is of the essence.

Finally, in normal times modesty and prudence in policy goals are good things. Under current conditions, however, it’s much better to err on the side of doing too much than on the side of doing too little. The risk, if the stimulus plan turns out to be more than needed, is that the economy might overheat, leading to inflation — but the Federal Reserve can always head off that threat by raising interest rates. On the other hand, if the stimulus plan is too small there’s nothing the Fed can do to make up for the shortfall. So when depression economics prevails, prudence is folly.

If ever the market has rendered a just verdict, it is the one rendered on G.M. and Chrysler. These companies are not innocent victims of this crisis. To read the expert literature on these companies is to read a long litany of miscalculation. Some experts mention the management blunders, some the union contracts and the legacy costs, some the years of poor car design and some the entrenched corporate cultures.

There seems to be no one who believes the companies are viable without radical change. A federal cash infusion will not infuse wisdom into management. It will not reduce labor costs. It will not attract talented new employees. As Megan McArdle of The Atlantic wittily put it, “Working for the Big Three magically combines vast corporate bureaucracy and job insecurity in one completely unattractive package.”

In short, a bailout will not solve anything — just postpone things. If this goes through, Big Three executives will make decisions knowing that whatever happens, Uncle Sam will bail them out — just like Fannie Mae and Freddie Mac. In the meantime, capital that could have gone to successful companies and programs will be directed toward companies with a history of using it badly.

The second part of Obama’s plan is the creation of an auto czar with vague duties. Other smart people have called for such a czar to reorganize the companies and force the companies to fully embrace green technology and other good things.

That would be great, but if Obama was such a fervent believer in the Chinese model of all-powerful technocrats, he should have mentioned it during the campaign. Are we really to believe there exists a czar omniscient, omnipotent and beneficent enough to know how to fix the Big Three? Who is this deity? Are we to believe that political influence will miraculously disappear, that the czar would have absolute power over unions, management, Congress and the White House? Please.

"There is massive deleveraging going on in Russia on all fronts," said Luis Costa, an economist at Commerzbank.

Mr Costa said the oil slide had led to an abrupt change in the fortunes of Russia, which relies on commodities for 80pc of its foreign earnings. "They are not going to have a current account surplus any longer. They could swing from plus 7pc of GDP to minus 2pc to 3pc next year, which is quite a reversal," he said.

Any devaluation is a political risk given fresh memories of the 1998 crisis, when many Russians lost their savings. The state-owned giant Sberbank has lost 2.5pc of its deposits over the last month, while smaller lenders have suffered a classic bank run. Fitch Ratings downgraded twelve banks yesterday, warning of an "increased likelihood of a deterioration in the government's ability to provide support".

Russia still has the world's third biggest foreign reserves, but these have shrunk from $598bn to under $480bn due to capital flight since the Georgia war in August. Crucially, Russia's banks, oil producers, miners, and steel companies have amassed $510bn of foreign debt, mostly in short-term loans.

Kingsmill Bond, from Russia's investment bank Troika Dialog, said the Kremlin has committed $280bn to shore up these companies. While it still has some firepower left, it cannot weather a long slump in oil prices.

If crude drops to around $50 a barrel, and stays there, the combined losses on Russia's current and capital accounts will reach $110bn a year. "We estimate that the rouble could drop by around 30pc", he said.

US and Eurozone inflation markets have been in doldrums since the beginning of the summer with breakevens and inflation swap rates collapsing at an amazing pace, affected by a flight-to-quality move and by the growing deflation threat. In fact, the US inflation market is pricing a severe deflation over a significant period of time (see chart below).

We repeat, as we have many times written in these columns, that such a severe deflation scenario over the next years is unlikely but in these pages we are going to assume that we are wrong. We instead assume that the message sent by the linker market is right and a significant deflation is coming. It raises the question of what is the value of linkers in a deflation environment. And then, what is the best linker to pick up in this context?

US inflation swap curve prices deflation

Source: Bloomberg, Calyon

To undertake this exercise we need to return to basics for the linker market for a moment to understand how inflation indexation works in a linker as this subject is not as easy as most people think and it is the key element in a deflationary world.

Every day, a daily inflation ratio (DIR) is computed using recent CPI indices. It is a kind of daily CPI. Each linker also has a base CPI index which refers to the inflation level at the time it was issued. The inflation accrual is the ratio between the daily CPI and the base CPI. This is called the index ratio.

At redemption, the principal payment is adjusted by the inflation accretion observed all along the life of the bond. Over the life of the bond the real coupon is adjusted by the inflation accretion observed between the issuance date of the linker and the coupon payment date. Therefore in an inflationary world, inflated coupon and principal payment are expected to be higher than the real coupon and the face value of the nominal.

In the Eurozone and US, but not in the UK and Japan, at redemption the principal is protected against any deflation risk or in other words the index ratio cannot go under 1. Therefore a kind of floor option is embedded into linkers.

Naively, the first reaction is to think that whatever happens, if a linker is held to maturity, no money invested will be lost. In fact it is not exactly the case. Investors can lose money if the net inflation accretion between the purchase date and the maturity is negative. When buying a linker on the secondary market, the investor pays the clean price but do not forget that this clean price is multiplied by the inflation accretion observed from the base CPI index. If the index ratio is lower at redemption than the index ratio at the purchase date, a part of the capital invested is lost and the yield to maturity decreases.

Therefore, if you think that a short deflation period is likely, let’s say one year, the linkers with a short remaining time before maturity should be avoided. They have the highest risk to see a negative inflation accretion before maturity but have achieved plenty of inflation accrual such that the index ratio is too far above 1 for the floor option to offer any value. This is why the OATi 2009 or the TIPS 2009 and Jan 2010 are under extreme pressure. Few people want to take the deflation risk (see chart below). If you think the deflation is unlikely then they represent fantastic bargains, offering a high yield with a AAA rating.

Shortest linkers are hit hard (real yield)

Source : Bloomberg, Calyon

Investors have to be aware that the coupon is not protected and the nominal coupon received can be below the stated real coupon. This inversion of nominal and real coupons can affect the youngest linkers even in a short deflationary period. Yet, the real yield will remain constant because the principle/dirty price of the bond will be changing in the same ratio.

Short deflation period

Source: Calyon

We now assume that a significant and long deflation period will occur over the next years.

Again, we would like to point out that such a situation is unlikely. It happened in Japan (see chart below) but the current context is quite different. In the 1990’s, the BoJ did not react promptly and the rate cut cycle was not aggressive enough. The Fed has learned a lot from the Japanese experience and the S&L crisis of the late eighties and so the approach appears to be that policy makers are not going to keep their options pocketed for too long. Bernanke made a speech in November 2002, Deflation – make sure “it” doesn’t happen here - in which he delivers a relevant reflection about deflation and describes the options that the Fed has.

Japan inflation index (ex fresh food)

Source: Bloomberg, Calyon

The value of the floor will principally be influenced by two factors: how far the index ratio is above 1 (how out of the money the option is) and the time left for the index ratio o decline to this level.
It is possible with stochastic model to price the value of the option. Results from our quantitative team show that the value of this option increases with the maturity. It is better to invest in very long
Although the time value for these options have more than doubled since the beginning of September and the turmoil, it still remains at surprisingly low levels of between 0.05bp for the shortest linkers to roug is more significant for TIPS, the value of the TIPS 2032 option is 5bp. The choice is different if you have to pick up a linker at a specific maturity, let’s 5Y for instance. The choice will be driven by the index ratio level.

The option value will be high for a linker with a daily CPI index close to its base CPI or in other words a linker with a low index ratio. Intuitively, with a low its value is high. Long deflation period.

Recommendation summary
Pick up the longest linkerPrefer linker with the linkers with the shortest remaining time to Maturity

In an extreme deflation scenario over many years, the choice is hard. The longest linkers are safer. At a specific maturity, it is better choosing linker with the lowest index ratio. Anyway
serious problems than buying or not a linker.

Natural Gas Weekly

Weakness in the oil complex limiting upside to US natural gas

Weak residual fuel oil prices may prompt fuel substitution

Despite crossing north of $7/mmBtu three times already this month, we believe upside risk for US natural gas prices will likely remain limited as the underlying natural gas balance remains soft. This softness may be reinforced in the near term by increased use of residual fuel oil for power generation.

On top of the broad weakness in the oil complex, which is driving residual fuel oil prices lower, the economic slowdown has also hit fuel oil prices directly, via lower industrial, generation and bunker fuel demand. As a result, residual fuel oil prices have declined sharply, creating an economic incentive for displacement of natural gas for power generation. This downside risk to demand may exacerbate an already well supplied US natural gas market this winter. Hence, we maintain our view and expect NYMEX natural gas prices to average $6.60/mmBtu in the 2008/2009 winter and $6/mmBtu during summer 2009.

Risks to our view remain balanced; weather is the wild card

Downside risks to our view come from further weakness in the oil complex leading to increased fuel substitution for power generation, weaker than expected industrial and generation demand for natural gas and higher than expected 2009 US LNG imports. On the upside, a stronger than expected decline in rig counts and production poses the major risk. As always, weather remains the major wild card.