Thursday, May 31, 2007

Canadian dollar at highest level in 30-years

The combination of strong exports from the commodity markets, good growth in the economy, a central bank that has managed inflation, and a fiscal house in good order has driven the Canadian dollar to the highest levels in 30-years. The continued strength is now causing analysts to talk about parity with the dollar. This is from the .65 level at the turn of the century.

The strong growth has been a concern with the central bank. The Bank of Canada has provided some hints that it may raise rates to quell inflation expectations at their next meeting in July. Short rates are currently at 4.25% which is lower than the US, but inflation in Canada has been tracking at a lower level. Canada growth has been tracking at 3.5% versus a growth rate of about 2.5% for the US.

Interestingly, the Bank of Canada provides a dashboard with the key policy indicators. It shows the inflation-control target, the operating guide, and the target for the overnight rate. Monetary policy could not be clearer.

Canada is a good example of where the exchange rate moves with the fundamentals and is not determined by the interest carry effects which seem to have dominated the behavior of many investors in 2007.

Wednesday, May 30, 2007

Return Distribution and Structural Restrictions: The Case of Short Selling

The asset allocation for a global stock portfolio will be affected by the distribution of asset returns. Structural market features can drive distributional characteristics, so it is important to understand the uniqueness of each market. Short-selling restrictions are an important structural feature. If there are restrictions on short-selling, there can be a noticeable impact on price behavior. The efficiency of markets will be affected by the inability of market participants to sell stocks. For example, the speed of adjustment of prices to bad information may be hindered with short selling restrictions.

The regulatory rules for short-selling differ across countries especially once you enter emerging markets. Research has found a noticeable difference in the distributional characteristics of those markets which have restrictions on short selling. In general, those countries with short selling restrictions have less negative skewness than those which allow short selling. See “efficiency and the Bear: Short Sales and Markets Around the World” Arturo Bris, William Goetzmann and Ning Zhu in the Journal of Finance June 2007.

The authors were able to look at both cross-sectional and time series data to show the impact of short selling restrictions. What is most interesting about their work is the comparison of stock which are dual listed in the US and UK where there is short selling versus behavior in their home countries where there are restrictions. This test comparison clearly shows a difference in the distributional characteristics.

This work is a nice warning to anyone who engages in quantitative analysis that a careful review of the structural environment is needed before investing.

Monday, May 28, 2007

The Power of Inelastic Supply and Demand for Gasoline

Over the last year, the price of gasoline has increased by close to 50 percent while the price of crude oil has only moved by about 5 percent. Some have argued that this difference in price increases is clear evidence of price gouging. What we can tell for sure is that the demand and supply for gasoline is extremely inelastic. Inelastic demand or supply states that production and consumption is insensitive to price. Gasoline has become a poster child for this type of market.

Demand has actually increased over the last year. There has been no cutback in driving by consumers. There has been an increase in the productivity of gasoline usage through purchasing of hybrid and fuel efficient cars but that has not translated into fewer barrels consumed. Hybrid cars are more expensive than normal combustion engines so the payback for a purchase is shortened when the price of gasoline increases, but the fuel savings for the economy will be minimal until there is significant replacement of the existing fleet of cars. In the short-run, there are few substitutes for driving. Consumers have to drive and they are not changing behavior.

Supply is also inelastic. The price of a new refinery can be measured in billions of dollars and takes years to bring on-line. The regulatory review process is significant and there are few communities that want to embrace this industry. Currently, 14 percent of all gasoline is from imports and is rising. If there is high demand from other parts of the work, the slack in the supply chain is nonexistent. Any down time in refineries that are working at 100% of capacity, whether from seasonal conversion or safety, leads to a meaningful supply short-fall. There is no buffer stock from inventory to absorb the shock.

Draw inelastic demand and supply curves for gasoline and the impact will become obvious, volatile prices. The behavior of prices will also be distorted. The upside shock on prices will be greater and there is less likelihood that prices will quickly decline. The distribution of price changes will likely be positively skewed. This will not be solved if more crude is produced or imported. It will not be solved in the price of oil falls to below $60 per barrel. Consumers will have to get used to it.

Back to Basics with Housing

The report last week on the positive increase in new home sales is misplaced. New home sales only tell us the quantity that is sold and not the price that cleared the markets. Of course these sales are related to demand but the important issue with housing for the US economy is the wealth effect, what is embedded in the price of the homes sold.

Prices for new and existing homes have fallen. Focusing only on the quantity side of the equation generates misinformation. The price determines whether there has been a profit generated from the construction and whether future building will be undertaken. The price, in the case of existing homes, determines whether there was any gain on the asset which can be used for other investing or consuming. Prices are more important than quantities.

The macroeconomic focus on housing has been twofold, the impact of new construction on the overall economy and the creation of wealth from investing in housing which drives consumption. The first impact is important but a localized sector effect. This sector effect is fairly easy to measure. The wealth effect is more complex and far-reaching. Wealth creation is a combination of financing or leverage and the price change for the investment. The transmission from wealth increase to consumption is difficult to measure because it is related to whether the home-owner believes the change in the value of his home is permanent or transitory. Consumption should not change significantly with transitory changes in wealth, but will change when the wealth adjustment is viewed as permanent. The economy is still working through this process and one month of greater sales will not move consumer expectations nor should be considered a trend.

Sovereign Wealth Funds (SWF’s) Capturing Attention

We wrote about the growth of Sovereign Wealth Funds last week. Our main theme was called “on the road to financial serfdom” SWF investing is n extension of government intervention in markets and can have a major impact on prices given their size and the lack of transparency concerning their investment objectives.

Both the Financial Tines on May 25 and Barron’s wrote articles on SWF’s and there potential impact on markets. The size of these funds now tops 2.5 trillion in assets. The most interesting feature of both articles is the acknowledgment that most people do not know what are the investments or objectives of these funds. While the focus has traditionally been on fixed income, the latest deal between Blackstone and China shows the desire to move beyond traditional investing in safe assets and into private equity.

The impact from SWF’s may be felt in the coming months. Any continued back-up in fixed income may cause the amount invested in US Treasury securities to slow or reverse. This reevaluation of fixed income holdings will place further upward pressure on rates. The mystery is determining where these funds will go.

Thursday, May 17, 2007

The Road to Financial Serfdom

We are on a road to financial market serfdom. Hayek wrote forcefully on the slide to socialism and the loss of individual freedoms which occurs when government takes on greater roles in the lives of citizens. There is a new analogy with government creep into determining prices of asset markets. This shouldn’t be surprising with the growing importance of asset flows and finance relative to fifty years ago. Unfortunately, there has arisen a forceful advocate for the dangers of government intervention in managing assets.

Thanks to a friend who sent the piece “Russia: The newest member of the SWF club” from Morgan Stanley’s April 27 FX Briefing Note by Stephen L Jen, and spurred me to think on this issue. SWF stands for the Sovereign Wealth Fund. The club represents those countries that have moved their reserves into actively managed risky assets.

The active role of government in trading is moving beyond just the traditional role of price stabilization. It may now be attempting to generate profits for the good of their citizens. This is being done directly or through hiring outside managers but is intended to maximize returns and not just meet simple welfare objectives. This activity can place significant price pressure on markets through their tremendous buying power. Innocents may say that this is no different than a large pension fund. Unfortunately the opportunity for misuse is large especially at times of financial stress. The actual behavior of SWF club members may differ from what may occur if there was a different end client. Market power may lead to new price stabilization policies which are not based on macro policy goals. While we are not trying to conduct a historical analysis, the trends of governments engaged in active trading are compelling:

Oil production is now controlled by a national oil companies who have reserves that exceed those of private companies. The renationalization of Russian and Venezuelan oil are just two examples. The purchase of oil reserves by China is another example of sovereigns indirectly trying to control supply. While stabilization policies of Saudi Arabia may have provided resistance toward rising prices, these same policies may interfere with prices seeing significant declines.

Active management of foreign exchange reserves by some European countries and now Asian central banks is growing. The information on the activities of these central banks is limited. In the case of balance of payment surplus countries, monetary policies have not been used to help mitigate the growth of these reserves or allow for an orderly appreciation.

Strategic purchase and sales of metals has increased with the increases in prices. Arguing for nationalization and better deals with mining companies has increased in the last two years. National companies have also become more active in the upstream marketing and hedging of these commodities.

Agricultural subsidies continue for the major grain markets through direct payments, boards for exports, loan programs, and now subsidies for ethanol production. What would the price of corn be if there were no government subsides for ethanol plant production? What would be the price of corn or ethanol if import tariffs on foreign sugar and ethanol were lifted?

Debt buybacks and switches by governments to manage debt structure have increased. The debt switches to lower financing costs will come at the expense of current bondholders.

Limits and coordination on the sale of gold reserves by central banks to maximize the price received was actively use when gold was at lower price levels.

Monetary policy, while not focused on fixing interest rates, targets inflation and thus nominal short-term interest rates. These policies can affect the supply of inflation protected bonds.

Talk of capital controls which attempt to slow the speed of adjustment of asset prices by foreign buyers is on the rise after a long period of free capital flows.

Discussions of blocking cross-border mergers and acquisitions which are not believed to be in a nation’s interest have also increased with the explosion of non-US M&A activity.

Certainly, we have come a long way from fixed exchange rates, controlled interest rates, and vigorous capital controls, but there is a growing argument that we have seen the zenith of asset market freedom.

The value of option buy-writes

With levels of the S&P 500 continuing to move higher, the chance for a return reversal or a slowdown increases. Strategies that can change the return to risk mix when return plateau can have significant value-added. A simple strategy is a buy-write on the market. The buy-write generates greater current income through booking option premium in exchange for cutting the upside returns.

Over the long-run, 1988 to the end of 2006, the BXM buy-write strategy through the CBOE has performed better than the S&P 500 total return index. A buy-write will not do well if the market is moving up without much volatility. If there are sustained periods of decline or sideways movement, the buy-write strategy will out perform a buy and hold strategy.

More importantly, there is a significant risk reduction from the option writing strategy relative to a buy and hold strategy; however, this comes at some cost. There is an increase in the negative skewness of the return distribution. The upside is capped while the downside is not. The median return will be higher because of the addition of premium to the buy and hold return which is the compensation you receive for the negative skewness.

The value of these options strategies is tied to the utility function of the investor. A good rule of thumb is that investors like large odd moments of the distribution, the mean and skewness. Investors dislike high even movements of the distribution, volatility and kurtosis. Hence, a strategy that can increase the mean and reduce volatility would be preferable, but this has to be compared with the higher moments. The higher negative skew of buy-writes has to be contrasted with the kurtosis that may be found with a buy and hold strategy. Put another way, the issue is whether the added return to risk for employing options is worth the price of more negative skew.

While the buy-write return profile is well-known, it is important to think of the benefit of sculpting the distribution of returns especially if the expectation is that future returns will not have the same positive momentum as seen over the last 12 months.

Wednesday, May 16, 2007

Dollar index nears low and nobody cares

The JP Morgan G7 volatility index hit a low of 6.16 percent. This is significantly off the highs of 2006 which were above 9.5 percent. This volatility decline has come with the dollar near all-time lows on the DXY index and against the Euro. The one direction move of the dollar for most of the year has forced volatility down. A decline without volatility does not capture the attention of the market especially if equities are on a rise.

Volatility is related to market uncertainty or heterogeneous expectations. With a lack of consensus, there is more likelihood that prices will be move back and forth and create volatility. When there is strong agreement on the direction of the dollar, the lack of buyer and seller mix drives volatility lower. This has been coupled with the decline in volatility of many of the macroeconomic variables that affect currencies.

Lower volatility also signals market calm which leads to higher level of risk taking. The G7 currency volatility index is one input in some measures of global risk aversion. The combination of low credit spreads, low VIX index, low currency vol, and low swap spreads all suggest that investors are willing to take on more risk in the markets.

Nevertheless, we have a liquidity environment where all major central banks have either started to tighten or are on hold concerning any interest rate cuts. Risk taking behavior with tightening liquidity is a mix usually not seen in the market and is suggestive that asset prices will not be able to continue their ascent without some correction.

Tuesday, May 15, 2007

Alfred Chandler – the father of business history dies

Bookstores are filled with how-to business books on strategy, management, and marketing as well as tell all stories from corporate chieftains. All try and provide the secrets to successful businesses and yet all, to some degree, fail. They fail in their ability to provide historical context to their work of what has been effective in growing companies. They are unable to move beyond a single story or fad and provide a comprehensive understanding of business structure. Alfred Chandler, professor of history at the Harvard Business School, was able to provide broad stories on the major developments of corporations.

He was able in his three major books, Structure and Strategy, The Visible Hand, and Scale and Scope, to describe the development of corporations around the world as the driver of economic growth. He focused on detailing the ascent of the professional manager class which has been the grease that has grown business over the last century. He described the environmental differences in corporate growth around the world, contrasting the United States with other regions. He was also a visionary on the importance of coordination, logistics, and communication as a key feature in making a large corporation successful. While these books are well-written, they are not filled with pithy statements and solutions but with the careful work of a scholar who wanted to understand the developments in the business environment over the last century.

He impresses on everyone who reads his books that choices of corporations are made by the incentives and motivations of managers. There is a human element with all of the choices of managers which cannot be captured with a single theory but through the study of behavior. He made business history relevant. Perhaps we would be better off if we spent more time on this historical record than trying to glean easy solutions with today’s business books. We will miss this excellent scholar.

Corn prices and trade-offs

The rising price of corn from ethanol demand has been a boom for farmers in the rural Midwest, but price increases is not good for everyone. Traditional grain consumers are hurt. Of course, we may not care about the increasing cost of high fructose corn syrup used in soft drinks, but there are others for which corn is a dietary staple.

The rising cost of corn in Mexico has made it significantly more expensive for poor consumers to obtain food basics. The higher cost of grain will also increase the cost of protein in the form of meat. Granted this cost increase is a little more complex because the residual from ethanol production can be used as high protein feed, but cattle costs will be higher. Milk is also affected. Milk demand is increasing significantly and supply is not matching the increase because the cost of adding to a herd is high. Milk prices are up 60 percent in the last six months at the CME and feed represents half the cost of production. The environmental damage will also increase because one of the greatest harms to the environment is when forest or grasses are destroyed to increase the amount of cultivated land.

We will not review the economics of ethanol production which is heavily subsidized at 51 cents per gallon. Food consumers are paying for the ability of others to drive their cars with higher octane. The demand shock from biofuels is real and will not be eliminated through a one time increase in supply. This will be the most important issue driving commodity prices in the next year.

Monday, May 14, 2007

Inflation news, FX reactions, and monetary policy

We recently posted a piece on the negative reaction of exchange rates to good news on inflation. The reaction of exchange rates to different news can be affected by expected monetary policy reactions, but the incorporation of these expectations is not easy to test. Friends at Barclays Bank referred me to some recent research work on this topic, “Is Bad News About Inflation Good News for Exchange Rates: And If So, Can That Tell Us Anything About the Conduct of Monetary Policy” by Richard Clarida and Daniel Waldman. I was impressed by the careful analysis and empirical testing of this piece which provides some very compelling evidence on the interaction between inflation shocks, exchange rates, and monetary policy. The authors compare the reaction of exchange rates to inflation shock for both countries that have inflation targets and those that do not.

The overshooting monetary model of exchange rates as well as purchasing power parity suggests that the impact of an inflation shock should be unambiguous. An unexpected increase in inflation should lead to depreciation in the exchange rate. However, this reaction gets more complex when you account for the possible behavior of the central bank to the shock. If the shock puts inflation above the targeted rate set by the central bank, there should be a swift policy response. If the policy follows a Taylor rule, the monetary authority will raise interest rates and cut money supply which will have the effect of leading to an exchange rate appreciation. Consequently, the reaction of the exchange rate should be a related to the expected monetary policy response. If investors believe that the monetary authority will focus on inflation targeting and the policy is considered credible, then there should be a different reaction than expected from the traditional overshooting model. While the theory for this story has been developed years ago, the authors provide empirical support for the interaction between exchange rates and monetary policy.

This theory can be tested by comparing the reaction of exchange rates to inflation shocks in those countries that have inflation targeting against those that do not. There should be an appreciation in exchange rates with inflation target countries and a depreciation with those that follow a different monetary policy. The authors find a strong appreciation for inflation targeting countries.

The reaction of the exchange rate to an inflation shock also changed for those countries that moved to inflation targeting over the last ten years. For example, the exchange rate reaction in Great Britain and Norway changed and was consistent with other inflation targeters after their change in policies.

This work could be further refined depending on the credibility of the monetary authority and whether the shock is above or below the target or is viewed as temporary or permanent. However, it provides clear support for stories concerning the interaction between exchange rates and expected policy responses.

Now is the time to end farm subsidies

The farm belt is in a boom. With high prices in corn, wheat, and soybeans, 2007 farm income will be the best in years. Why not cutback farm subsidies in the 2007 Farm bill? It will have to be negotiated in the next few months. Not only can we wean farmers off these programs, but we will be able to move the Doha trade talks forward and provide an opportunity for developing country farmers to increase their farm income.

Farm programs over the last 25 years have been focused on massive subsidies to prop-up a way of life in the farm belt. Yet, if stabilizing the population involved in farming was the objective, the programs have been a failure. The number of workers involved in farmer continues to decline. Farm programs have not hindered the productivity in this sector which has driven the decline in workers.

Why should I care as a trader whether there are farm subsidies? Simply put, you would like farmers to make decisions based on the price of the crops they grow and not on what program the government may give them. Programs can change and this uncertainty actually creates new risks. It may be easier to deal with price risks than regulatory uncertainty. Adjustments in programs lead to large changes in the distribution of resources. The subsidies distort the decision of farmers even if it is in the form for a safety net.

If there is risk with farming, let market tools serve as the mechanism for managing risk. These tools will cost more because the pricing of risk in the private sector will generally be higher than if it is distributed over the entire taxpayer base; however, risk sharing for this length of time and magnitude may not be what the public desires.

The ethanol craze is a good example. Are the current decisions to plant more corn based on the true demand for the grain or is it a function of the large subsidies for energy production of ethanol. Currently, the federal subsidy for ethanol is 51 cent per gallon. Using a base of over 4 billion gallons of production in 2006, the subsidy is over $2 billion.

There will be dislocations if subsidies end, but cutting the subsidies when farmer income is high, prices are rising, and land values are increasing is the perfect time. Especially with the added benefit of increase the chances of getting a new free trade round, if not now when?

Friday, May 11, 2007

Moneyball and Market Efficiency

As the baseball season starts to move into full swing, I start to think about stats and who is playing up to their potential. Are there opportunities to find undervalued players?

One of the best illustrations of market inefficiency and the competitive responses of markets is found in Michael Lewis’s book MoneyBall: The Art of Winning an Unfair Game. The premise in Moneyball was that on-base percentage, a statistical measure of a batter’s value, was undervalued in the major leagues. There was inefficiency in the labor market. This inefficiency was effectively exploited by the Oakland Athletic as a means of leveling the playing field for poor market teams which did not have the money to buy top talent. They were able to successfully form winning teams based on measures that others did not use.

The take-away for investors is straight-forward. You should look for hidden value through using alternative methods of analysis. Unfortunately, when you find this hidden value your success will cause others to emulate your behavior. Markets are dynamic and others will enter the market to also exploit these same opportunities. These activities led to market efficiency. There is no free lunch that can be continuously exploited.

Using a very general definition, market efficiency is the ability of prices to respond quickly to changes in the underlying value of a market. It is the result of a perfectly competitive market. Once this anomaly or opportunity to exploit hidden value is used up, you have to go onto a new strategy that can create value.

If you do not believe in the efficiency of markets like baseball, read Jahn Hakes and Ray Sauer in their Summer 2006 Journal of Economic Perspectives paper, “An Economic Evaluation of the MoneyBall Hypothesis”. They found that the market inefficiency discussed in the book, on-base percentage, disappeared within a year of its publication. Teams found this to be a successful measure of a player’s worth, so they bid up the salaries of those who had high on-base percentage relative to home run hitting. The labor market became efficient or eliminated what was perceived to be cheap value.

Next time you go to a baseball game, think about hidden value and how fast it may be revealed and eliminated. Could the same thing happen with the alpha of many investment strategies?

Thursday, May 10, 2007

Uranium futures – Has the time come for trading?

Uranium prices have exploded over the last two years with the renaissance of nuclear power as a clean alternative. This increase has created a surge in stock prices for uranium mining companies and a desire to trade the underlying commodity. This back drop has led the NYMEX to introduce a uranium futures contract.

A futures market will allow greater price standardization and transparency. These features should facilitate trading and liquidity in this market and provide a mechanism for hedging as well as speculation. Investors will have a mechanism for easily trading the commodity. Producers and users will have the ability to cheaply trade a standardized contract to offset risks.
Nevertheless, the old battlelines from the introduction of a futures market begin again. The development of future markets has not changed for decades in spite of the changes in trading technology. There will usually be two groups fighting over the development of a futures market. The forces for transparency who usually are the buyers of the product will like to see a successful contract. The forces for an opaque market, the sellers who often have market power given their size or have better information about the pricing of the market, may prefer the status quo. This simplistic dichotomy does not fully represent the story for a successful futures market but has played out in the past.

A successful futures market needs enough fragmentation so that some buyers and sellers see the value in marketing and pricing through centralized markets. For example, centralized pricing has been extremely valuable for the competitive crude oil and natural gas markets. Lack of local competition and problems of delivery and standardization have stalled the development of electricity future trading. Uranium which is more akin to other base metals may have a better chance of success.

Some argue that a futures market cannot really develop unless there is a viable spot and forward market. This argument places the development of a futures market as standardization of forward contracting that already exist. Certainly, the success of futures is furthered when there are already exists some hedging and forward contracting mechanism. NYMEX is using UX consulting which is the leading pricing service for uranium yellowcake to help provide a price benchmark. They provide weekly prices and information on forward arrangements.

Unfortunately, a normal scenario is that major players initially sit on the sidelines observing the market which leads to a lack of liquidity. The lack of liquidity does not allow for the development of a two-way market, so the contract dies a quick death. What may be different this time is the strong price move which has caused many traders outside of the nuclear industry to be interested in the market.

There has been growing interest in uranium mining companies, so interest in uranium ore is at a high. A recent survey by a hedge fund blog of a wide range of financial professionals suggests there is more than passing interest in a tradable market.

Let the market begin.

Wednesday, May 9, 2007

Sarkozy – Meddling with inflation targeting

European finance ministers have asked French president elect Sarkovky to back-off from talk about changing the policy objectives of the ECB. It is interesting that this tussle is coming after a period of very effective monetary policy. Instead of monetizing the oil price shock of the last few years, central banks have held fast to their inflation targeting objectives. It is also interesting to see many politicians back independence. This could be a sign of monetary enlightenment.

This steadfast approach may have, in the short-run, cost jobs in Europe which still has relatively high unemployment, but much of this unemployment is due to structural policies within Europe. While the EU has widened, economic benefits have been dispersed based on the productivity differences across countries and their ability to adapt to changing global trade flows. A centralized monetary policy will have differential impact especially if there is not feee flow of capital and labor across all borders. None the less, this is not a reason for changing policy objectives.

Should the ECB change its policy objectives? Theory suggests that central banks have generally been unsuccessful at sustaining growth as well as controlling inflation, but it is a political question of whether people want to change focus.

In the United States, the dual target of growth and controlling inflation has caused considerable confusion. The current discussion of whether the Fed should ease in response to housing problems has caused more uncertainty than any discussion on the core inflation rate over the last six months.

The fight for independent central banks was a long and hard one. We hope that there will be minimal meddling with central banks by politicians, but discussion on this issue is relevant. The hegemony of inflation targeting and independence should be discussed if for no other reason than to affirm good policies.

Tuesday, May 8, 2007

Elimination of 3-year Treasury auction – playing with the unknown

The Treasury announced that they will eliminate the 3-year Treasury note from the quarterly auctions. Yesterday saw its last auction, a lack luster showing. This will be the second time that the 3-year note has been dropped from the financing schedule. There has also been talk of cutting some of the TIPS program especially for the 5-year maturity. The research in this area suggests that the debt management policies of the Treasury have important impact on liquidity, but there has been limited work discussing the policy implications of changing the debt mix.

We are far from the budget surplus problems of the late 1990’s when some pundits discussed a world without benchmark Treasuries. Hence, arguments of shrinking supply would be misplaced, but the impact of lumpier issuance is not trivial. Lumpy issuance may lead to discontinuities in the Treasury curve which can cause more mispricing of private securities. Benchmarking would be more difficult and liquidity would suffer.

The 2001 IMF paper, “The Financial Implications of the Shrinking Supply of US Treasuries” is a good review of all the issues. Unfortunately, it has been a number of years since these topics have been discussed. Their conclusion is telling, “Thus, any benefits of paying down the public debt would need to be weighed against the costs of having to resuscitate public debt securities markets, quite possibly within the next decade.” They go on to state that it is not clear what will be all of the implications of changing the debt mix for investors who may not be able to find private alternatives. While issuing debt to maintain the status quo is not appropriate, these are important issues with serious externalities.

While there is less public issuance of Treasury securities, there has been an increasing percentage of the debt that is held in federal government accounts. Non-marketable securities represent just under 50% of the total debt outstanding. The mix between public, private and government accounts needs to be closely examined. Just because debt does not hit the public auction market does not mean that it has no impact on public interest rates. Liabilities issued by the government and then held by the government are not assets.

Monday, May 7, 2007

Dollar moves and the stock market

The dollar has seen a significant decline since the beginning of the year, yet the Dow has reached levels above 13,000. The argument for the currency decline is that slower growth in the United States and the potential for Fed easing is forcing the dollar down. This seems at odds with the stock market increase which suggests good economic conditions.

This divergence in views suggests that traders in each asset class are discounting information differently. Ultimately, one of these stories will prove true. It is clear that the dollar-stock market relationship is fairly complex and needs careful analysis.

On a macro-level, dollars denominated assets are becoming cheaper and more attractive for foreign investors, but the actual returns for foreign investors already investing in the United Sates have been devastating. For European investors, investing in the S&P 500 continues to be a losing proposition. While US investors have made up for all of the loses since the stock market decline in 2000, European investors are still underwater. There have not been any gains for foreign investors in 2007. Certainly investments in the home equity markets has been a better deal. So is it the attractive cheap levels that will invite more flows into the stock markets that is driving stocks, or are we whistling in a graveyard of loses when translated into their home currency?

On a micro-level, the impact on the stock market from a dollar decline will differ substantially across firms. At first brush, the seemingly obvious difference is that those firms that have more export business should gain relative to those who have a high percentage of import business. Firms with more overseas profits should gain relative to those that have domestic business. This should be good for large cap stocks.

But the analysis gets trickier if you ask why the dollar is falling. If the dollar decline is caused by slower growth in the United States, then earnings will decline in the domestic business of firms. A gain in overseas earnings has to be weighed by the loss in earnings from a domestic slowdown. Here, the impact of dollar decline on an industry grouping may be stronger than the global impact on the market as a whole.

Nevertheless, there is a group of stocks which will be clearly hurt by the combination of domestic slowdown and a dollar decline, importers. Importers which have rising costs and sell into the weaker domestic markets will have a consistent negative effect. There is no ambiguity on the impact of a dollar decline in this case.

A combination of selling domestic importers and buying exporters or firms which have the highest percentage of offshore business would be the best portfolio to play a weaker dollar, but this has to be tempered by the hedging practices of the firms and their ability to pass-through currency prices changes.

While there are plays between import and export firms, the key issue is resolving the difference in opinions between equity and currency markets. We have seen this scenario before and it has not looked good for stocks.

Shipping and market congestion

Foreign Affairs printed an article on the risk to shipping in the oil market by two political
scientists Dennis Blair and Lieberthal, “Smooth Sailing: The World’s Shipping Lanes are safe”. They argue that the risks of shipping being disrupted from some political event are overdone. Unfortunately, the article misses the key issue with shipping and oil markets. Oil shipping is a problem. The issue is infrastructure and this cannot be solved in the near term. Thanks to a recent discussion with an oil shipping expert for focusing me on this issue.

The key shipping problem is port congestion and not the risk from transportation. For example, there is a shortage of gasification ships and port facilities for LNG in the United States. There are limits in the size of ships that can move oil and LNG out of the Black Sea. There are limits and high cost in moving oil through the Suez Canal. Pipeline have to be laid as an alternative to shipping.

The number one problem for the energy industry is infrastructure and not geopolitical. These problems will be tested again during the coming hurricane season. Regardless of the type of season, concentration of facilities in an areas prone to hurricanes and has the potential for disruption.

Logistics in the energy business whether oil, natural gas, ethanol, or electricity will be a key issue with these markets. It is logistics which will actually be the determinant for changes in spreads in futures markets. Price behavior across seasons is an inventory refining problem. Changes in backwardation and contango are associated with changes in supply today relative to what may be needed tomorrow. In a period when there are no looming geopolitical risks, spread trading will be dominated by infrastructure congestion.

Thursday, May 3, 2007

Happy Anniversary Bank of England and the NICE Economy

This week marks the tenth anniversary of independence for the Bank of England. Our hats should be off to the man who has led this institution for most of this period, Mervyn King. In some capacity, he has been present at every Monetary Policy Committee meeting since independence. He is Britain’s Alan Greenspan albeit without the rock star adulation.

King has been instrumental in leading a mighty NICE economy for Great Britain. NICE is the acronym for the Non-Inflationary Consistent Expansion. This British stability is something that all of the developed economies have seen over the last decades. Economists have begun to call this period the “Great Stability” or the “Great Moderation”. It has been an extraordinary period of low and stable inflation coupled with stable growth. It may not be a coincidence that this has been a period of strong independent central bank leadership.

But what is good for the general economy is not always good for traders. A NICE economy is great for buy and hold investors especially in equities. You earn dividend yield and consistent equity appreciation as the equity premium declines. Earnings are stable and predictable. The nice economy has again placed London in the forefront of capital markets. The place of no surprises is a great location for centering a financial business.

For those who make their money through trading volatility or the vagaries of trends and reversals in pounds and gilts, this has been a more difficult time. While the pound has been on a consistent uptrend, volatility has been stable and there has been little in the way of opportunities to move back and forth between long and short positions. Interest rates have seen a moderation in volatility and stayed more range bound.

The economy may move from NICE to nasty and take a DIVE – Disruptive Inflation and Volatile Economy, but right now we should salute the independent central bankers in England.

Geopolitical risks in the crude oil market are still significant

Currently, a half a million barrels of crude oil are off production because of terrorist (militant) activity in Nigeria. This production is supposed to soon come back on-line in spite of the latest round of oil worker kidnappings.

The market seems less concerned about oil geopolitical risk. This optimism may be misplaced. (A good review on the supply and demand issues for crude oil can be found at the following site:

Nigeria has not been the focus of many market commentaries on oil, yet the size of the Nigerian oil market is huge, over 2.5 million barrels of production a day. The strategic importance of Nigerian oil to the United States is also significant. Africa now presents 19% of oil imports, up from 14% a few years ago. Nigeria, at over 1 million barrels a day, is the fifth largest oil importer to the US.

The Nigerian problems are much greater than an increase in the kidnapping of oil workers. The government is a kleptocracy where “officials” have taken oil profits for personal gain and not for distribution to the people. There is a growing rebel movement by MEND (Movement for the Emancipation of the Nigerian Delta) of assassination, hostage taking, and confrontation with the government and oil companies. These rebels think there is nothing to lose from escalation and confrontation. The danger is also greater because much of the oil production is close to the population unlike the Middle East.

This trouble area can have significant ramifications for the price of oil in the next year. The potential for having dramatic impact on oil is significant for two reasons. One, already mentioned, it produces a significant amount of oil and two, the level of awareness of the problem is much smaller than is the case with the Middle East where there has a more focus. The potential for surprise with size is a toxic mix for markets. Any complacency concerning supply risk is unwarranted

Wednesday, May 2, 2007

Presidential Approval Ratings and the Dollar

Barron’s produced a graph showing President Bush’s approval rating and the movement in the dollar. It inferred that the low ratings may explain the decline in the dollar. However, a closer inspection suggests that there may not be a strong story. Correlation does not imply causality. In fact, the Bush approval ratings in 2007 have been relatively stable even with the dollar showing new lows. See Roper Center website

Most presidents have seen large swings in approval. While the negative ratings for Bush are significant, they are not unprecedented. Look at the ratings of Truman. What was extraordinary was the huge positive jump after 9/11. Only in crisis situations do you see these gains.

The decline in Bush’s rating has been on a downtrend since its high in the month after 9/11. Swings in the dollar since 9/11 do not seem to have matched the one direction downward spiral in his presidential approval ratings. A longer history of presidential approval ratings shows large swings in ratings which have often not closely followed dollar moves. Extrapolating this hypothesis to other countries does not seem to work. Tony Blair’s sinking approval ratings saw an appreciation of the pound.

The falling approval rating may be a proxy for a general decline in the belief that the United States is a safe haven for investments. A close look shows that the dollar peak came in September 2001. The security threat to the US may be the proximate cause of the decline.

Presidential approval ratings may also be symptomatic of other fiscal factors which have may be more important to the dollar. For example, the Iraq War has to be financed. Any lengthening of the war will cause a potential strain on the dollar. While this has proven to be true in the long-run, the Federal deficit has not been as poor as expected given the expense of the war. Nevertheless, the fiscal impact on asset prices can be significant albeit hard to measure.

Simple graphs can be dangerous without careful review.