Saturday, June 30, 2007
The failure of Amaranth is a shameful story of no one standing up and asking the important question of why one firm was holding such large positions in the natural gas markets. The implication of what may be called excessive speculation are hard to answer, but the number of people asleep at the wheel concerning why one firm had so much open interest in some contract months are almost too numerous to list in this case. While the Senate report tries to spark their writing of the story with pithy quotes about speculations, the facts of in-action speak for themselves without any help.
The Amaranth traders did not understand the risks of the sizeable positions that they were holding. It would have been nice to hear more about whet they were thinking in this report. This was not even an attempted squeeze but a bold bet on natural gas spreads which did not materialize. Given the size of the positions, it was a one way road to liquidity hell when they could not unravel their positions. What were these traders thinking when they controlled so much of the open interest in some contracts? Did they really think these trades were appropriately sized? You have to assume that others knew the relative size of the positions and would take their pound of flesh at the appropriate time.
Where were the firm’s so-called risk managers? The report suggests that a 12 member team of weak-kneed milk-toast professionals oversaw these risks. At best, they may have fought with the traders on some of these issues, but they were not strong enough to make a difference. Where was the compliance officer who was reported to be in discussions with NYMEX on position limit issues? He is supposed to stand between regulators and exchanges and the traders make sure that the firm is following the rules, yet we see consistent problems with position limits. Where were the managing partners of the firm? This was supposed to be a multi-strategy firm which started as a convertible bond firm and morphed into an energy trading powerhouse. Didn’t they realize the concentration of their bets? All of these people where focused on the profits. If the traders were making money today, who cares what may happen in the future.
Where was the oversight of the firm by investors? Some due diligence. Didn’t they notice that all of the profits were being generated by energy trading for what was supposed to a multi-strategy firm? If the firm is posting good numbers, I guess it does not matter how it is being done. Do you cut the manger who is laying the golden egg if he is not following his style?
Where were the NYMEX officials? Were they afraid of losing business to ICE? NYMEX continually increased position limits for Amaranth and did not take aggressive action against Amaranth when they controlled the back month open interest in the natural gas markets. They action was too little too late. The number of contracts Amaranth held was staggering. At times, it was over 50% of some contract markets. If they couldn’t make Amaranth liquidate or reduce positions, why didn’t they push the CFTC? The threat of lost business to ICE which did not have reporting and position limits was too much was enough to have them cave under pressure from a large trader.
Where was the CFTC? Granted there is limited staff and resources, which is a key problem, but the size of the Amaranth positions would have raised almost any eyebrow of those who were following trade flows. Given the commitment of traders report, it would seem possible that some regulator would have been pushing the NYMEX for action. If not in this situation, what would it take for the CFTC to do something? Would more resources solve this type of inaction?
The futures markets are useful but who is going to play if there is the perception that the market is one-sided or controlled by a single player. This is not an issue of international competitiveness but keeping a market reasonably fair. That may be hard to do if one party controls open interest even if their speculation is unsuccessful.
While I am a strong advocate of limited regulation in futures markets, this is a shameful display of greed and inaction by too may parties to be left unchecked. Unfortunately, you cannot legislate good sense. Markets loses may be able to teach that lesson. Nevertheless, the government can work to increase transparency in markets so that other will at least know of this type of folly.
Tuesday, June 26, 2007
We are not making light of the housing problem, but for those who purchased their homes more than two years ago, the gains to date are still significant. The Miami market which has been discussed as an area that is being hit hard is up over 23% for the last two years and over 55% for the last three years. To date, the housing problem is not one declining prices but one of significant slowing of price momentum. The recent buyer is at risk or the buyer who was anticipating significant short-term gains.
Now, we may only be at the beginning of the down cycle, but given that housing is usually thought of as a long-term investment, the declines to date are modest. The greatest issue may be liquidity and perceptions. Many cannot sell their houses today at the prices they expect from extrapolating the gains over the last few years. The market has not adjusted to a new reality.
One of the key concerns about carry trades is the belief that they are subject to strong reversals if risk or interest rates change. This is not a unique concern with carry trades. If there is a significant amount of one-way persistence in a specific trade idea, there is a belief that the chance of a violent reversal increases. This has been voiced as a special concern with
Surprisingly, little of the carry flow is coming from the speculative community shorting the yen, but from flows out of
This revision of domestic portfolios is based on two factors. One, changes in the regulatory and structural environment has allowed more rebalancing out of domestic portfolios. With more money allowed to seek other alternatives, investors have been taking advantage of the new environment. Two, the level of domestic risk aversion is high after the long decline in Japanese equity markets. This has had the impact that Japanese investors are less interested in holding domestic equity and looking for what they believe are relatively safe assets in foreign fixed income. These investors may be surprised by the impact of changing exchange rates, but they currently have the belief that holding foreign short-term instruments at higher yields are a good play for additional income.
The fact that Japanese investors are the driver for these carry trades suggests that they will not be as sensitive to yield changes as hedge fund investors. We may not see the quick reversals that have been the hallmark of other carry trades when there is a reversal of interest rate risks.
Sunday, June 24, 2007
ECB head Trichet defended his stance to continue the use of monetary aggregates as a guide for monetary policy. Not only does he still look at M3 while many central banks like the Fed no longer even report it, but he also states that he employs it as a key policy tool. The high growth in M3 was one of the reasons for raising interest rates by the ECB. Either Trichet is a dinosaur from the 1980’s or he has a level of vision about monetary economics that is lacking in many of his peers.
It should be noted that monetarism has never been a policy prescription that has held the fancy for central bankers. The early 1980’s was a period of excitement for monetarists that has never been matched, yet there may have been a feeling by many monetarist that the acceptance of aggregates as a key tool by the traditionalists was closer to a shotgun wedding, a marriage of convenience given the wild changes in inflation. An extreme view would be that the following of money was just a smokescreen to raise interest rate to unprecedented levels. Nevertheless, money aggregates is still fundamental to our thinking about extremes in inflation.
Is there a place for M3 or any monetary aggregate in our current global economy? That answer is hard to say for three reasons. One, financial innovations have changed the velocity of money. Two, the linkages in the global economy have made the flow of money more difficult to monitor. Three, inflation has been low so we have not seen the type of fluctuations in money like the 1980’s.
The use of credit cards and ATM’s by consumers as well as different corporate borrowing behavior means that the use of money has changed and the channels of credit have also gone through significant adjustment. While this is an issue, the focus has to be on whether these changes in velocity are stationary and predictable. The jury is mixed. Much of the velocity work shows a money-GDP relationship which may be a random walk. The casual link between GDP and monetary aggregates has also been questioned. Clearly, changes in velocity mean that the time lag between a change in money and a change in inflation or GDP will differ. Using rules of thumb between money increases and inflation increases is perilous.
The world economy is more open especially with respect to money and credit, so measures of money have less meaning than what we have seen in the past. Money flows can change with financial flows around the globe. Attempts to limit credit through raising rates can result in foreign money entering the economy and diminishing the impact of policy.
Finally, the value of tracking money is reduced because the fluctuations in money and the changes in inflation are less volatile than what has been seen in the 1980’s. Using money to direct policy is a blunt instrument. When inflation is double digits, cutting money will solve the problem. The link between high inflation and money is very strong, but the correlation is much lower when we are at lower and less volatile levels.
The issue is determining the best measure of money through finding the one with the closest link with business and inflation cycles. Is it M3 as suggested by Trichet? Hard to say. There has always been a strong debate between those who suggest a broad money target versus those who want to focus on a narrow definition, but following the monetary and credit aggregate signs should not be ignored. If it is growing quickly and inflation in moving above target, credit aggregates should be examined. While I do not have the expertise of Trichet or his critics, following credit cycles is still fundamental to how the economy should be tracked.
The key to the global trade discussion has been a lowering of agricultural subsidies in the developed countries with a corresponding decline in tariffs in developing countries. The key has been bilateral talks between the
This lack of agreement is especially troubling given the fine shape of the world economy. With growth strong around the world, there would be less impact from an increase of competition. Also, since farm prices are at the highest level in a decade, there impact of reducing subsidies for farmers would be less costly. We will have to hope that a new farm bill will allow these talks to again resume. Movement from the
The next level of carry trades is not looking just for the high yielding currencies but trying to anticipate the change in yields. By anticipating the change in yields, investors are trying to pick up the potential gain in currencies from a further increase in yields or the differential in yields. A simple case can be seen with the move in the Swedish krona which has had the biggest gain in four years in response to the Riksbank raising rates.
The combination of a rate rise with the discussion that there may be further increases has caused money to pore into the currency. Rates have moved up a quarter of a point to 3.5% but there is the anticipation that rates will move up to 4% by the end of the year. While this does not place
Modeling the term structure changes and yield changes does lead to improvement relative to the simple strategy of picking levels, but the gain from following these strategies is highly variable. The impact of the yield change on the currency is not certain. In fact, recent research suggests that currencies still seem to follow a random walk and have not a close link with changes in nominal yields.
Anticipating yield changes is similar to anticipating mergers, there is compensation with making guesses but the level of risk is much higher than a simple strategy of holding high yielders. But, when the gains from carry are diminished in the developed currencies, there is a willing to reach for return.
Monday, June 18, 2007
A premise for efficiency is that markets are frictionless. If the price of an asset moves away from fair value, there will be a flow of capital that will come into the market and force the price back to fair market equilibrium. However, we have many market anomalies which suggest that movement to fair value does not occur immediately. Mispricing can exist for long periods of time and be quite large.
Arbitrageurs are not able to overcome all of the frictions that may exist in the markets. Arbitrage is not always riskless because there may be cash flow uncertainty in constructing trades that move the market to fair value. This allows for market trading opportunities. The frictions that allow for long and large market mispricing have been described as the phenomena of slow moving capital. (See “Slow Moving Capital” by Mitchell, Pedersen, and Pulvino in the May 2007 American Economic Review.) They studied the merger market after the 1987 crash and the convertible bond market during the LTCM crisis and the redemption period of 2005. Their study of these examples concerning market is compelling.
Traders may face capital constraints, information constraints, and liquidity restrictions, Shocks to capital or liquidity can have strong effects especially for specialized markets where the potential arbitrageurs are in some ways constrained. Arbitrage capital is actually limited or a scarce resource which can lead to persistent mispricing in the market. This is especially true in specialized markets such as convertible bonds. When you see mispricing in the market, it may be market frictions make capital movement to eliminate these mispricing slow. Markets that may face frictions are more likely to have premiums for those who are willing to take on their risks.
Saturday, June 16, 2007
One should not forget that the grain markets are weather-related assets. This is what makes them so uncorrelated with stocks or bonds. Changes in rainfall or temperature will have a big impact on crop supplies. This weather effect is very seasonal and we are coming into the height of the seasonal effect during the key summer month of July.
Nevertheless, the impact of weather is highly variable based on the inventory of grain. Grain inventory has the same effect as any product that is storable. The inventory acts as a buffer stock. Shortfalls in production will cause producers to take from the buffer stock. Over production will lead to increases in the buffer stock. Of course, this is simple economics, but the important lesson is to know when the size of the buffer stock matters so you can determine when weather sensitivity will increase.
This year we have low buffer stocks, so prices will be more volatile to any changes in whether conditions. The International Grain Council reports on stock levels in May and the picture is grim. We will have the lowest stock levels in years. Volatility is higher for all of the grain markets this year.
The nearby wheat contract has moved by almost 20% in just a month on what is considered a bad weather year. There is excessive moisture in the
Corn has raced ahead to again reach above $4 per bushel even with reports that there has been even more acreage planted for the crop. Here, the demand for ethanol tied to the high price of gasoline has placed a claim on the buffer stock. This again increases weather sensitivity. While the wheat belt has gotten too much rain, the corn belt is showing dry conditions.
The big moves in grains are uncorrelated with other commodity markets. A key feature of commodities is the low correlation across major commodity groups.
Wednesday, June 13, 2007
It has been while since we have seen central bank intervention used a tool to stop exchange rate moves. This policy alternative has been disavowed by many and now is viewed as ineffective except when coordinated with other central bank or with a change in policy. This is highly unusual for the
The action was taken to halt the dramatic increase in the NZD. A significant portion of this increase is associated with carry trades. The NZD is one of the high yielders and has seen a dramatic increase relative to the yen which is the financing currency. So far the NZD has stabilized after the initial decline on intervention.
Trend-following stories and empirical evidence suggest that extra profits are made during those periods when central banks intervene. Central banks cannot stop the progress of the markets only slow it. However, in the case of trying to drive down exchange rates, central banks have their printing presses on their side. They can sell all of the RBNZ you want and gain foreign assets.
What will be most notable is whether other central banks start to use intervention as a tool to minimize what they perceive as disruptions to their currencies.
Sunday, June 10, 2007
Growth prospects have increased in the US. The housing market problem, albeit not going away, has not carried over to other sectors to such an extent that growth has had a further slowdown in the first half of 2007. The key housing season is the summer. If the market falters with higher mortgage rates during this key period, real yields will have to adjust downward.
The inflation rate has stayed above the Fed target. The chance that the Fed will lower rates to help economic growth seems significantly diminished. The expectations concerning inflation have also changed. Instead of focusing on core inflation, there is a growing interest in overall inflation including food and energy. The cost of gasoline and food is viewed as an area that cannot be ignored when calculating inflation values. People have to eat and drive their cars. There will be more focus on the composition of inflation over the next few months.
The international picture is a concern. With central banks showing less interest in holding US dollars, there has to be a another group that will buy US Treasuries, if they cannot be found at the current yields, the market will have to provide an added premium to provide a reason for private investors to hold treasuries. This will cause the long-end yield to increase. Keep an eye out for who is buying Treasuries to get an idea of the direction of risk premiums.
The size of the Treasury change seems greater than what would be expected given the actual economic numbers. This does not means that yield will show a significant decline in the next couple of weeks; however, any upward trend will be slowed if we do not have more bad news surprises in bond land.
Last week, Chinese officials stated that some health supplements and raisins imported from the United States did not meet Chinese safety standards and had to be returned or destroyed. Increasing health and safety standards has become a growing issue in China. By itself this may not seem to be a global problem, but the safety failure comes after US inspectors have rejected a number of Chinese exports for contamination. While safety standards are paramount, there could be a tit-for-tat type of gamesmanship going on.
The more important issue is with a Canadian request for a WTO panel on US farm subsidies. The complaint by the Canadians, who are asking the WTO for a dispute settlement panel, is that the farm subsidies provided by the US government were greater than allowed. US subsidies are capped at a fixed value of $19.1 billion. The Canadians are charging that the US has exceeded that number by billions. This issue has increased importance as the US reviews the farm subsidies bill this year. The US has lost a cotton subsidy case in 2004. The farm subsidy issue is the major hold-up with the Doha trade talks.
These issues are relevant because they can have an impact on overall trade. They are also important because a change in subsidies will have an impact on the volatility of prices for commodities. More volatile commodity prices provide for greater trading opportunities but also changes the behavior of both buyers and sellers. Watching trade closely is an important indicator of a change in regimes.
Friday, June 8, 2007
In a RBS FX Strategy piece “The carry trade that wasn’t” Adrian Schmidt notes that the carry trade is related to the change in spreads across countries and to equity premiums. He presents some suggestive graphs on the correlation between the changes in exchange rates and the level of interest rates. He contrasts this with a graph on the correlation between exchange rates and the change in spreads. His argument is that, currently, the carry trade is more dependent on the change in yield spreads than the level of rates. This is an interesting argument but misses the point on the driver of carry-type trades.
The monetary relationship is not discussed. Why would yield spread increase in a country? It could be because there is a tightening in monetary policy. This would raise interest rates and cut the supply of money which from a simple monetary model will have the impact of causing a currency appreciation. The carry type trade is related to monetary conditions which should show up in the yield spreads.
The author also shows that carry trades are related to the movement in stock markets. While not made, the argument for this relationship could be through the business cycle. If there is a rising stock market, it could be associated with surprises in the growth rate of the economy. This will cause an increase in the demand for money. A increase in money demand will lead to an appreciation of the currency. There are no surprises here. Carry type trades are suggestive a macroeconomic relationship which could be the root cause of the currency movement.
The carry trade is a market representation of other factors which are not often observable in real time. It is a combination of market views concerning the underlying variables that drive the economy. We would also suggest that change in exchange rates relative to carry can also be explained by the consumption risk asset pricing model as described in our last posting. The mystery of carry is not that it occurs but why investors do not focus on the macro-events surrounding carry returns.
Thursday, June 7, 2007
The FX world has been dominated by the carry trade which is actually at odds with the basic concept of uncovered interest rate parity. Under the theory of uncovered interest rate parity, currencies with high interest rates should depreciate not appreciate. In reality, the opposite effect holds whereby high interest currencies appreciate or do not depreciate enough relative to the gain on interest rates and low interest currencies. The question is why does this carry trade advantage hold. A logical answer is that the excess return has to be related to compensation for risk taken from holding these currencies.
One way to look at this problem is to compare it to traditional asset pricing theory and determine whether these pricing models can explain what is going on in the currency markets. Modern pricing models have moved beyond capital asset pricing to consumption based pricing models. Under the consumption-based approach to asset pricing, the excess returns from an asset should be related to the consumption pattern risk of investors. Investors would like to have assets that will smooth out their income to match the changes in their consumption growth.
An asset that declines in price when consumption is low is risky. To hold this asset, the investor must be compensated for the risk. Investors would be willing to pay more for those assets which provide better return when consumption is growth is low. They will not pay for assets that have low returns when consumption growth is low. Investors want to be compensated with excess return for those assets which have low returns when consumption growth is low.
This concept of compensation for holding risky assets which have low returns when consumption is low can be tested in the FX markets. The key is testing this idea conditional on the level of interest rates. What some researchers have found in an innovative paper (Hanng Lustig and Adrien Verdelhan in ‘The cross section of foreign currency risk premia and consumption growth risk” American Economic Review March 2007) is that the excess return in high yielding currencies is compensation to US investors for taking on more US consumption growth risk. The researchers show that the variation in excess returns for exchange rates conditional on the level of interest rates is related to the consumption betas for the currencies and therefore the pattern of consumption growth in the
The performance of the carry trade is related to consumption risk. The consumption beta for high yielding currencies is high; consequently, investors need to be given a premium to hold this currency. The consumption beta is small or negative for low yielding currencies versus the level for high yielding currencies. Put in practical terms, the high interest rate currencies relative to the
This has interesting implications for carry trades if there is a slowdown in
Sunday, June 3, 2007
The chart presented in the May OECD Economic Outlook takes a simple look at tax rates and revenues. It focuses on what should be the primary government issue, how much revenue rose for a given tax rate.
The chart shows a decline in the tax rate for most corporations across the globe. The expectation by many would be that lower tax rates will lead to lower revenues, but the interesting feature has been the increase in tax receipts. The revenue as a percentage of GDP has actually increased over the same period.
Lower rates and revenue increased, an interesting combination.
The chart from the OECD Economic Outlook provides a good review of consumer and business confidence for the major global economies. This strong global confidence is a key reason for the continued world growth which outstripping what is happening in the
Confidence numbers can be fickle especially in the US where the swing are much greater than in other major economies. Confidence sometimes just describes sentiment to current conditions, but longer-term trends provide a good indication of what consumers and business will do with their wealth. It never makes sense to fight the trend in confidence.
There may not be any hiding through diversification in global housing markets. For some foreign investors, the
It is unusual to have central banks comment on their gold sales. Their gold reserve policies have always been somewhat of a mystery to the market even with a Central Bank Gold Agreement in place since 2004. The ECB announced that they were engaged in active selling over the last two months but have now decided to stop for the rest of the gold agreement year which ends in four months. This caused a $10 rise in price. The reaction was more to the information that no more sales would be held for the rest of the Agreement year than to the past sales.
While European central banks have signed an agreement which has bound their behavior since September 2004 to limit the extent of sales, this activity always causes markets to take notice especially with more gold above the ground in vaults than in the ground. The ECB has sold about 60 tons of gold this Agreement year. Gold now represents about 16% of the total ECB reserves. Banks have usually been active in the lease market for gold where they have driven down yields to levels below short rates; nevertheless, the total central bank gold sales for this year have totaled 242 tons.
With the high price of gold, there is no reason why more sales from central banks will not occur especially if there is continued controlled world inflation. Central bank gold sales place a higher level of uncertainty in this market than would be expected from just the diversification behavior of investors.
Friday, June 1, 2007
The trend-following style attempts to generate return through using simple moving average principles. Long exposure is held in those markets which have an uptrend and short exposure is held for those which are trending down. Positions are a weighted average of cross-over signals with different time lengths or look-back periods. There is no risk management or stop loses with this style, only a trend identification procedure. The style only looks at the value of trending without any other indicators such as relative strength. Signals could be easily replicated with a simple spreadsheet.
The carry style holds long exposure in a set of those currencies which have the highest short-term yield. Short positions are held in those currencies that have the lowest yield. The carry strategy is based on the belief that money will flow to those countries that have high nominal interest rates causing the currency to appreciate. Again there is no risk management and positions are equally weighted without any input on the relative size of the yield positions. Banks will often separate carry models into developed and emerging market portfolios.
The valuation strategy could focus on a number of models but often uses a simple purchasing power parity equation. It buys those currencies that seem cheap relative to PPP and shorts those which are overvalued against relative inflation rates. The long and short positions are based on the assumption that exchange rates will mean revert to their fair value. Positions are only taken in those currencies that deviate by a specific percentage.
The volatility strategy will buy straddle for those currencies that have low volatility and sell those currencies which have high volatility.
The correlation of these strategies or styles is low. A simple correlation table since the end of 2000 shows that each strategy is somewhat unique. There is gain from forming a diversified portfolio of these strategies. Volatility from a combination is lower than would be found from just forming a weighted average of these strategies.
Nevertheless, the performance of these strategies has changed markedly over the last five years. Trend-following which has been one of the best strategies for currencies has shown negative performance over the last five years. Volatility trading has flat-lined over the last few years as volatility in the currency markets has declined and stabilized. Given the decline with inflation around the globe, there has been a limit in the deviations away from fair value for developed currencies. The greater stability in fundamentals, trends, and volatility has made the carry strategy a winner over these same periods. In fact, employing only the carry strategy would have provided the best overall return over the last five years. A mixed strategy would have created a lower volatility portfolio but would have cost investor’s return. Running a simple optimization of these strategies would create a portfolio which is almost completely skewed to carry strategies. There is no need to use anything else, except this is looking back in time. This is the classic corner solution when employing an optimizer.
So what does style analysis tell us about forming a foreign exchange portfolio? A stable market environment means that a high exposure to carry strategies is most effective. The stable economic environment across the globe creates limited appeal for the valuation strategy. Trend-following will only work if there are large dislocations expected in the markets. Volatility strategies will have limited value if there is stable and low volatility.
Nevertheless, it is not clear what will be the market environment in the future. A strategy of holding high exposure to carry over the next five years may not be appropriate. Hence, forming a balanced strategy may still make sense especially if you have clear expectations on the global environment which suggest greater uncertainty.
Preparing for the future may require careful analysis of FX styles and views on the future global environment. It is easy to argue the extremes that carry should continue to dominate or that we will find a less favorable carry environment as strategy performance reverts back to a mean. Markets have a tendency to do the unexpected, so a balance of strategies may be the most prudent.