Tuesday, December 29, 2009

The volatility cycle and asset markets

What has been surprising for 2009 has been the strong decline in the volatility as measured by the VIX. Now we may all have agreed that a VIX level above 50% or even 30% wold have been too high, but the VIX is now down to 20% which lowest level since August of 2008. If the trend continue and we do not have any spikes we will be pre-2007 crisis levels. market volatility as measured by the VIX has moved through some distinct periods (thanks to VIX and More blog for cycle analysis):

1990-94 - Decline the savings and loan recession period
1994-96 - Flat - The period of calm with stable US growth
1996-98 - Rising - The Asian crisis and LTCM crisis period
1999-02 - Flat - period of rising tech bubble
2002-07 - Decline - period of cheap money
2007-09 - Increasing - period of crisis
2009 - - Decline - period of post crisis calm

These periods were not without spikes but there was a general direction for volatility. Given the number of problems that may be faced by governments, it is not clear that 2010 will be another year of declining volatility. We expect that the market will be in a period of flat vol around the 20-25% range. We will not go back to the calm of 2004-2007.

Dollar - stock correlation changing

One of the key stories of 2009 was the the risk-on / risk-off trade which closely tied currency movements with changes in the S&P 500. The switch between risk-on and risk-off was probable the single greatest risk for trading currencies in 2009. The stock market DXY index showed some of the highest sustained negative correlations in the decade. The relationship between stock prices and currencies has never been very stable, but 2009 as notable for the strength of the relationship and its relative stability throughout the year. We are starting to see a change in the last month and this may be one of the key trading relationships for 2010.

What was the risk-on trade? Every time the stock market started to move positive, there was a dollar decline as investors believed that a recovery was in hand. Investors moved from the dollar safe haven to other parts of the globe. A stock market decline would pull the global money back into the dollar. Some of these flows were associated with investors wanting to hold higher beta risk. Some was also associated with the belief that emerging markets were gong to do better than the US. This was realized. The total return for the US lagged the rest of the world especially for emerging markets.

SPY - 27.64% YTD
EFA - 28.37% YTD
EEM - 67.63% YTD

In December the picture changed with the stock gains associated with dollar increases. The switch has now been that rising stocks suggest stronger economy which has caused money flows to increase the value of the dollar. So what is difference between these periods? It is hard to say other than the first part of the year was still a reversal of the flight to quality flows from the fourth quarter of 2008. The market is now focused on the US economy as a place for investments and not as a place for safety at this time. Of course, this story is a description not based on actual numbers for the month.

We will have to look at the change in TIC flows to see the change in behavior. The latest Treasury numbers are from October (released on December 18th) and they show a slowdown in the purchase of US securities by foreigners. Stock purchases were down about $5 billion for the month. The net purchase of foreign asset by US investors was down with US investors being net sellers. This is a trend that has picked up. We have clear evidence that US investors have changed direction in the last few months. This is significant and may be the driver we are looking for. The US investor has gone from a net buyer of foreign stocks to a net seller to the tune of almost $20 billion. This change in US investor flow may be worth watching.



The doom loop - are we in one?

Question during the Bernanke confirmation hearings.

Q: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?

A. The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. A. (continued) In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.

Simon Johnson has written on this issue and has been pushing for an answer from the Fed. He argues that the time inconsistency issue is key to the problem. We say we will not bail-out and then we go ahead and do it. The further bail-out of Fannie and Freddie which was announced this week is a perfect example. We will talk tough and then cave-in and everyone in the financial world knows it.

I would argue that the doom loop is more an issue of monetary policy than regulation. If you do not let rates fall to such low levels, there will not be the speculative behavior seen by financial institutions. There is not a need for special regulation and monitoring if there is not loose monetary policy. The time inconsistency policy is also an issue of Fed credibility and whether investors believe there is a Bernanke (formerly Greenspan) put in the market. Whether there is the Fed credibility should be the focus of the confirmation hearings. Put differently, what should the Fed be creditable about?

Speculators don't drive oil prices?

JP Morgan released a provocative study that analyzed oil price movements over the last few years and found that over 90% of the variation was caused by inventory or supply changes. These supply and demand shocks dominated any activity by speculators. Of course, this begs the question of whether the people who have inventory speculate on prices. In fact, the CFTC released trader information which showed that the net positions of financial firms was actually decreasing during the run-up in prices during 2008. It is possible that smart money actually did not believe that prices would reach such high levels.

Most important, this study suggests that the market for oil is more complex than what we believe. Rising prices does no imply that speculators are causing the run-up. You could answer that there is no complexity when price responds to supply and demand shocks, but the difficulties arise from the sensitivity of price to changes in fundamentals. Given the strong need for oil across so many businesses, any change in inventory may translate into a price move that is more exaggerated. The action is in the elasticities of demand and supply which are much different than other markets. The tightness n oil markets can lead to strong price responses when there is an inventory shortage.

Now there will be some that argue that having JP Morgan conclude that speculators do not drive the market is like having the fox guard the hen house, but the burden is now on the CFTC to show what is the the transmission mechanism between speculation and price movement. I look forward to seeing that study.


Sunday, December 27, 2009

Trade finance and export shocks

Global trade since the credit crisis has fallen off a cliff and still has not returned to anything close to what we saw before the crisis. While world GDP has declined 4.6%, trade has declined by over 17%. A recent vox.org study by Mary Amiti and David Weinstein, Exports and financial shocks: New Evidence from Japan suggests that a good portion of the trade decline has to do with a lack of trade financing. The authors specifically look at the Japanese crisis in the 1990's and find that a lack of financing was responsible for about a third of the decline in exports.

Trade finance is very important for cross border transactions. This credit is not for long-term financing but requires capital and skill. With the disruption in banks, there has been a shortage of credit for trade. Financing is improving but still impaired. If trade is to become an engine for growth, this type of financing has to be improved. What is especially relevant is that a growing portion of trade financing is coming from non-bank financial institutions. The commercial paper and shadow banking system has been hard hit which carries over to trade flows. This financing may be more important than mortgages for getting people back to work.

Competing on Analytics - useful for money management ?

The Competing on Analytics: The New Science of Winning by Thomas Davenport and Jeanne Harris describes how companies are using analytical tools to help set strategy and develop better products and services. The combination of exploitation and exploration of analytic measures can provide insights that are not usually available with descriptive work. The authors do a good job of telling the analytic tale of success for many companies bu there is limited specifics of how statistics are used differently than what has been applied by the "whiz kids" of the 1950's and 60's. We have more data than ever before which is different, from a decade ago, but how the analytics are applied to this data is not clear.

Given my focus on money management, I was surprised to see that no companies have been mentioned. I will say that the use of analytics to help tailor products to investment customers is an area which has not been fully developed. Money managers, especially hedge funds, will often have just one product. No matter what the problem there is only one investment solution and you have to pay a premium fee. This does not make sense. If you pay a premium, there should be a higher degree of specialization and customization. One of the problems is that clients will not often provide useful information to money managers. For example, what is the level of risk aversion of a client? Money managers generally have little information. on their clients. There are questionnaires for retail investors but the process of obtaining useful information for institutional clients is still in its infancy.

Tools for money management will be essential for the further refinement of investment products.

The pension problem is only going to get worse

For holiday reading, I picked up While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Loom as the Next Financial Crisis by Roger Lowenstein, the author of When Genius Failed. The story is a sad tale of greed and incompetence.

Unions have used benefits as a way to again more for their members when there was no current cash available for workers. There was no problem with fighting for benefits because the liabilities were out in the future. There was no cost with gaining health care and pensions because it was expected that companies would always grow. The companies and the state were willing to cave on these issues because they did not have to worry about the cost hitting the bottom line. It will be a problem for future management. Well the future is now and it is not pleasant.

General Motors was willing to provide the Detroit compact with workers during the 1950's because it had a dominant business. The dominance is gone and there are not enough workers to support the pension benefits for all of the retires. The pensions are underfunded and the benefits will never pay-off. General Motors has been taken over by the government and the public will likely be stuck with these liabilities.

The NYC subway system workers were given benefits to avoid strikes. The workers got to retire early but the city now has a system that cannot support retires. The population has declined. Ridership has declined and the pensions are underfunded.

San Diego has the same problem and the contract with retirees for pensions cannot be broken. by state law. The citizens will have to pay higher taxes. What happens of the population decides to move?

Pension insurance is not the answer. A government takeover is likely but what about all of the workers who did not get these sweet retirement program? Should they pay for the benefits of others that they will never see? The demographics just do not work. This crisis will be as bad as the health care problem. How are younger workers going to fund these costs?

Will this be a problem for 2010? Unlikely, but it will have to be addressed as we try and deal with the huge budget deficits.

Chinese yuan appreciation unlikely

The Financial Times quotes Chinese Premier Wen Jiabao as saying: ”We will not yield to any pressure of any form forcing us to appreciate. ... The purpose [of these calls for appreciation] is to hold back China’s development."

Nice way to end the year on what may be one of the most important issues for 2010. The global imbalance problem is real and not just a Chimerica problem. The current account has deficit has declined dramatically over the last two year, but the structural reasons for the deficit have not changed.

The relatively cheap yuan affects all trade. Asian competitors have to respond by controlling their currencies. The rest of the world has to deal with China trade. The yuan pressure also is tied to issues of domestic growth in China. The Chinese money supply has slowed and is expected to be below the double digit, close to 30%, rate of 2009. This will slow the asset price bubble in the country but also will slow domestic consumption which is necessary to help world growth.

Regardless of what is said by the premier, the yuan diection will still be a key topic for 2010.

Wednesday, December 23, 2009

Trilemma across countries - a review of the trade-off






The trilemma problem from the Mundell-Fleming framework states that a country simultaneously may choose any two, but not all, of the following three goals: monetary independence, exchange rate stability and financial integration. Aizenman, Ito, and Chinn (AIC) in the NBER paper 14533 Assessing the emerrging global financilal architecture: Measuring the trilemma's configurations over time provides a useful framework for describing countries based on a four point criteria included in the Mundell-Fleming framework with the level of international reserves (IR/GDP) as a fourth dimension. AIC provides a diamond chart as a means of showing the trade-off of the three dimensions of the trilemma and the fourth dimension of the IR/GDP ratio. The four diamond approach can be normalized to provide a relative ranking vector for the exchange rate environment for each country. In each diamond chart, the origin is normalized so as to represent zero monetary independence, pure float, zero international reserves and financial autarky.

The review by AIC concludes that there has been an increase exchange rate flexibility and deeper financial flexibility especially for developing countries. There also has been a decrease in monetary independence but an increase in international reserves for developing countries. The use of greater international reserves is especially pronounced for emerging Asia.

The trilemma is not a set of hard choices but a set of trade-offs on the margin. More financial integration will lead to a loss of monetary independence and more exchange rate flexibility. These trade-offs can be measured to show that change in policy choices through time. The trade-off can be measured through trilemma indices.

Monetary Independence - Independence is based on the correlation between money market rates for a home and base country. A high correlation will mean higher dependence.

Exchange rate stability -To measure exchange rate stability, annual standard deviations of the monthly exchange rate between the home country and the base country are calculated to account for both the volatility and overall direction of exchange rates.

Financial openness/integration - Capital account openness as developed by Chinn and Ito and called KAOPEN is based on information regarding restrictions in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER).

International reserves (IR) - IR/GDP hoarding acts as a buffer stock to help control exchange rates in a crisis. Almost 3/4th of all global reserves are now with developing countries. It acts as a form of self-insurance against sudden stops in global finance especially when there is greater financial integration.

The conclusions of AIC provide a nice frameowrk for thinking about exchange rate behvaior,

The recent trend suggests that among developing countries, the three dimensions of the trilemma configurations: monetary independence, exchange rate stability, and financial openness, are converging towards a “middle ground” with managed exchange rate flexibility, which they attempted to buffer by holding sizable international reserves, while maintaining medium levels of monetary independence and financial integration. Industrialized countries, on the other hand, have been experiencing divergence of the three dimensions of the trilemma and moved toward the configuration of high exchange rate stability and financial openness and low monetary independence as most distinctively exemplified by the euro countries’ experience.

We also tested whether the three macroeconomic policy goals are “binding” in the context of the impossible trinity. That is, we attempted to provide evidence that countries have faced the trade-offs based on the trilemma. ... Our results confirmed that countries do face the binding trilemma. That is , a change in one of the trilemma variables would induce a change with the opposite signin the weighted average of the other two.

Where are we in the financial crisis?

The typical crisis will see debt deflation. The question is whether the debt deflation in the US is over. The market's focus on housing activity is based on the desire to predict the turn in the debt deflation within the housing market. The turn will come in two forms, an increase in sales activity and an outright increase in prices. The turn is sales means that consumers are willing to make a major investment and lock in a mortgage. That tell us that the level of optimism about the economy is increasing. bu that does not create wealth.

Wealth creation has to come from an increase in the value of assets. Home prices have to increase to gain a wealth effect. We are seeing some stabilization but there is not real increase in prices. so there is no wealth effect. In fact, there are still increases in foreclosures which increases the supply of homes. The turnover from this increase in supply has increased which shows up in sales but there is still wealth destruction if the price that clears the market is below the purchase price. Credit expansion actually decreases because there is write down of the old loan at the higher value and a new loan at the lower price. The net impact shows a lower expansion of credit but not from a consolidation but from wealth destruction.

We are still in deflation. This is worse than the case of asset inflation in say commodities because more of consumer wealth is tied to homes. Asset inflation in commodities will increase costs for consumers while asset deflation in homes destroys wealth. This is a poor combination. This combination is happening while interest rates are near zero which means that creditors are not receiving any interest rate cash flows to generate income. One pundit noted that at current T-bill rates it will take over 6000 years to double your money.

Managing exchange rates and reserve diversification adds complexity

Countries are trying to better manage their currencies which adds more complexity to FX trading.

Former central banker Carlos Eduardo de Freitas commented that Brazil should cut reserve purchases now that the real has declined in value. If the currency appreciates, increase reserve buying. If the currency weakens, throttle back the purchases. This will attempt to smooth volatility.

Jim Flaherty, Canada's Finance minister states that he would not be surprised if China and Russia diversify reserves into CAD. Russia last month stated that they would buy CAD for reserve diversification. However, the Bank of Canada suggests that a strengthening CAD may be a risk to growth. China has been interested in Canadian commodity companies. This is a similar play to what has been going on between China and Australia. Russia has also been interested in AUD for reserve diversification.

Along with the currency reserve diversification story in Canada, there also is a better balance sheet than many other developed countries which makes it a good sovereign for central bank reserves. Canada interest rates are in line with the US although slightly lower. CAD has rallied slightly this month.

Monday, December 21, 2009

Forecasting markets in 2010 - thoughts from Herb Stein

"I belong to the I don't know school of economics"

"If something cannot go on forever, it will stop."

"Economists are very good at saying that something cannot go on forever, but not so good at saying when it will stop."

Herbert Stein was an old school economist with a quick wit. These three quotes are always useful as we enter the end of year forecasting season. Market analysts have to provide their views for 2010, yet there will be a good chance they will be wrong within a month or two. The strong convictions of year may sour quickly, or as Charles Darwin stated, "Ignorance more frequently begets confidence than does knowledge."

There are two themes which we think will be very important for the year.

First, market uncertainty may not be diminishing in 2010. Yes, volatility as measured by the VIX has fallen. The movement in daily prices has been less exaggerated, but it is not clear whether the current direction of markets will continue.

Second, the trend is not always your friend. Trends are a good thing to follow but remember that there will come a time to reverse positions because trends will stop. Look at the dollar move in the last month. This may not be a reversal of the dollar bear decline but a one-way market is the exception not the norm.

Watch out for the unexpected which means that maximum diversification should still be the focus of portfolio construction.

Thursday, December 17, 2009

Dollar optimism or Euro pessimism?

What is going on? We are having a dollar rally. The Euro is off approximately 5% from the highs earlier this month. There usually is dollar weakness as we enter the end of the year. There is really no strong change in the economic fundamentals. Yes, there was improvement in the unemployment rate and retail sales as well as a pop in PPI which suggest that the US economy is doing better. Confidence has risen and industrial production is up. Japan and Great Britain have showed numbers which are slightly negative. Europe seems to have slowed its positive momentum, so on a relative basis the US may be doing slightly better. All good signs which would suggests that risk-on trades should be forthcoming, but we are actually seeing positive dollar flows. The emerging market currencies have not seen the same sell-off as the G10. The really decline has been the EUR and JPY.

The current story seems to be driven by the sovereign risk issues of Greece which may also call into question the fiscal business as usual for the Japanese government. Investors are becoming more sovereign risk aware and the EU is being lumped into one big bundle. Looks like we are seeing euro flight and the only alternative is the dollar. Is this a real dollar rally or just s flight to quality reaction? The interest rate headwinds are large. The monetary and fiscal problems are large. The only positive for a continued rally is a a robust economy in the US relative to the rest of the world. I have been in the lazy V recovery camp so I have been skeptical of a dollar rally. I will have to look closely at the economic information in January. Short-term momentum will cause traders to be long dollars. The fundamentals are less clear.

Thursday, December 10, 2009

PIGS going down




Greece has been downgraded by Fitch and put on negative outlook by S&P. Now Spain is in the same spot with Spain on negative outlook.

What is becoming clear is that the AAA rating for a country will become rarer. Note that all of the Aaa rated sovereigns in the Moody's universe are showing increases in debt to GDP and rising interest payments relative to government payments. The one exception is Switzerland. One of the fast declines is expected to be the US. However, before we get to the AAA probme we have other worries.

The current decline in the Euro may be related to the increase in sovereign risk in the EU. While the problem is large and growing for the US, there is at least some flexibility on what can be done with monetary policy. That is not the case of the EU where the ECB controls monetary policy. Money expansion or a bail-out for other EU members is not available for bond investors. his places some unique risk with the PIGS, Portugal, Spain, Italy and Greece.

Is finance of any value?

“I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence,” said Mr Volcker ...

Strong statement by the former Fed chief. Where is the evidence of the contribution of finance to growth? Surely the energy and excesses of Wall Street could be spend better on Main Street. I may agree that some of the extremes have marginal contribution, but that is a far cry from saying that Wall Street has to be dismantled. The well-developed mortgage capital markets have been a blessing for the vast majority of home-owners. The impact of the extreme "innovations" or practices, however, have been significant for the entire economy. These have often involved fraud not a failure of finance. The issue is not whether innovation helps but whether every innovation is useful and whether there should be any controls on the innovation process. This is a better starting point.

The best evidence is in the structure of capital markets between developed and emerging markets. The latest international finance research suggests that one of the reasons for the global crisis and imbalance is because there is a shortage of developed capital markets structures in emerging markets. Yes, sovereign ratings have improved but there is a shortage of risk free assets for investors. This has caused EM investors to move more capital to the developed world at the same time that many developed investors have sought risky investments in the EM world.

The comments of Paul Volcker do not help the global economy. It does provoke but it does not advance the discussion.

Wednesday, December 9, 2009

Back to the well for more stimulus

Japan announced this week that 3Q final GDP will come in at .3% not .7% as predicted or the 1.2% reported last month. The currency has weakened and the Nikkei index has declined. Japan announced a new stimulus package totaling $81 billion this week. It is supposed to take effect in the first quarter of 2010.

The US has also announced new tax credit and jobs program policies to help the economy. These new policies have not been called a stimulus package. Some of the expected savings from the TARP fund will be used to help small business. There is no price tag on these programs.

Government have been overly optimistic about the recovery. They have used unconditional forecasting of past recessions as their guide. Most recessions follow the rule that a sharp decline leads to a sharp recovery. However, this crisis has been a balance sheet recession which usually takes longer and has a slower recovery rate. With governments showing little patience, we are starting to see a second round of spending discussion even while it is hard to track existing spending. Some of the new Japanese spending increases replace dropped initiatives from the last government. We also have not seen all of the stimulative effect of the US plan.

What is missing is a clarity concerning the business regulatory environment. Developed economies need help but the form should be a stable government framework. Institutions do matter. Money will gravitate to the stable countries and in many cases the more controlled emerging markets are a better bet.

Tuesday, December 8, 2009

Taylor Rule and current policy - no change in rates


The chart is from the fine writers at Calculated Risk. The question of when the Fed will raise rates is consuming fixed income investors. There are some simple rules that can be applied to this discussion, past history of the Fed and the Taylor rule. Both of these suggest that we will have some wait before any action is taken. But there is disagreement on how long we will have to wait. For example, Morgan Stanley forecasts the Fed will start to increase rates in the second half of 2010 and be above 1% on the Fed Funds before year-end. Goldman Sachs believes the wait will be longer , until 2011.

There are two rules that could be followed. One is a simple timing rule. The Fed does not start to raise rates until unemployment has peaked after which there is a delay of approximately nine months. If unemployment peaks at year-end, we should see some Fed action in the fourth quarter. This scenario is actually fairly rosy. Of course, the credit easing programs could be cut before an actual rate increase.


While Bernanke has been negative on the economy in his latest speech, the Taylor rule can be used as a good proxy of what the Fed should do to rates. Here, I agree with Paul Krugman who states that the Fed has a long way to go before it tightens. Krugman also champions the Rudebusch version of the Taylor Rule which is easier to implement.

The Rudebusch version of the rule is:

Target fed funds rate = 2.07 + 1.28 x inflation - 1.95 x excess unemployment

where inflation is measured by the four-quarter change in the core PCE deflator, and excess unemployment is the difference between the actual unemployment rate and the CBO estimate of the NAIRU, which is currently 4.8 percent.

The original Taylor Rule is

FF Rate = 1 + 1.5 x Inflation + 0.5 x GDP gap

This is avery simple equation, but there are two merits in Rudebusch version over the original version:

1. Parameters are deduced from actual data, whereas parameters in the original version are rather ad-hoc.
2. Unemployment rate is more straightforward statistics compared to GDP gap.

These rules describe past Fed policy quite well, but if you plug in the numbers the Fed should be running deep negative rates. This was no expected when the rule was originally designed. The only way the Fed can get negative rates is if it inflates the economy. To achieve inflation in the domestic economy, the international financial community will have to see a further dollar decline.

Bank of England willing to comment on fiscal issues

One of the conditions of central bank independence, especially for the Fed, is to not comment on fiscal matters. You leave the government alone and the government will leave the central bank alone. The Bank of England is not take this advice. The Bank of England governor, Mervyn King, said last month that Britain lacked “a credible plan” for cutting its £175bn deficit. This fight is also tied to the potential end of QE by the BOE. The BOE is placed in a difficult situation whereby interest rates will start to rise when they want to stop QE. The recovery may be slowed and the BOE may be forced to continue or add to their QE policy.

GBP is off the lows from earlier in 2009 but it has been stuck around 1.65. It is unlikely that there will be any significant appreciation of sterling when this monetary policy uncertainty overhangs the market. Every time gilts have tried to rally this fiscal problem slaps the market down.

Greece downgrade - the next phase of the credit crisis

The downgrade of Greece is the next phase of the credit crisis. The behavior of governments to use fiscal policy (deficit financing) to help avert financial disasters is now starting to haunt the sovereign issuers. Let's look at the process of government throughout the world during this crisis.

Private borrowers as well as governments were hit hard by the slowdown in the global economy. This was a result of excessive speculation as well as a commodity shock. Defaults started to increase. Banks became more conservative given the risks and tax revenues declined. In an effort to slow this process, governments followed a classic Keynesian combination of loose monetary policy and deficit financing. By front-loading new expenditures with the existing automatic stabilizers the slowdown was arrested. There is no problem with this process. It saves the economy from a steeper downturn. The cost has been a run up in deficits. The problem is pushed into the future. These deficits by themselves would not be significant problem if there were strong sovereign balance sheets. Unfortunately, for many countries this is no the case.

Deficit financing coupled with already high debt /GDP levels means that the ability to pay for this new financing can be called into question. Future tax revenue is related to the future GDP growth. If debt to GDP is greater than 100% and interest rates are higher than growth rates, all incremental tax revenue will have to go to interest payments and not the pay down of principal.

So how do you pay-down the debt burden? You can grow out of the problem which is not possible if you have a slow growth environment. You can increase taxes but there is the side effect of further slowdown in the economy, or you can inflate your way out of the problem. A final solution is a default but we will assume that repudiating debt is a last resort solution.

The problem is that for Greece, as a member of the EU, there is nothing it can do on the monetary policy side to inflate the economy. Greece cannot inflate because the ECB controls monetary policy. In fact, there is a current bias toward raising rates by the ECB.

There is the additional problem that it may not be willing take collateral from with Greek bonds used as collateral if its rating continues to fall. This is not an immediate problem but one that will have to e addressed. It is unlikely that other EU member will be willing to bail-out Greece so there is the added problem that help will not come form their closest friends.

Fitch downgraded Greece to BBB+ with a negative outlook. S&P has Greece on a negative outlook with A- rating. There will be other countries in a similar situation which start to have investors differentiate across sovereign risks. The next phase.

Monday, December 7, 2009

Bernanke and headwinds

In a speech today, Chairman Bernanke argued that there were "formidable headwinds" that will moderate any recovery. After the euphoria of Friday, with unemployment falling to 10, the markets were slapped with a reality check from the Fed chief. Bonds reversed about half the decline from Friday.

The likelihood of a V-shaped recovery has declined. The chance that we will see a rise in rates from the Fed has diminished. The Fed chairman mentioned weak utilization, labor market, and a lack of lending as all contributing to these headwinds. Bernanke also stated that it was possible that inflation could go lower and there is no assurance that the "recovery will be self-sustaining".

This was a sobering set of comments as we start to close the year.

Saturday, December 5, 2009

Credit failure quotes - bond vigilantes live by it

Bond vigilantes will become more important in 2010. Not that they were not important before, but they were ignored. With the expected downgrade of Greece we will see more focus on credit. The overall size of debt to GDP will be an area of increased focus, so there will be more dollar negative talk. As perceptions of a debt problem in the US mount, it will be harder to find the marginal buyer of US debt. Rates will increase.

"Owe the bank $100, that's your problem. Owe the bank $100 million, that's the bank's problem." - JP Getty

Don't lend more to big borrowers whether real estate companies or countries.

Capitalism without failure is like religion without sin - it just doesn't work. - Allan Meltzer

Failures will occur. If failure is part of the ystem, it will happen regardless of what the government wants.




Thursday, December 3, 2009

Fed independence - what might be the most important fight

Fed independence is critical to the functioning of the US economy. This is not overstating the case. The standing of the US in international markets is affected by the perception of the Fed as having control of money without influence from the government. If the Fed is viewed as less independent, or have less creditability, then there will be a greater inflation premium added to bonds. Rates will go up based on the perceived risk that the Fed will allow inflation to increase in order to meet the needs of government for full employment. The requiring of a monetary policy audits will place the Fed under greater control of Congress.

Of course, the Fed is political and not completely independent of what is happening in the fiscal realm. It has a dual role because of the Humphrey-Hawkins Bill which has the Fed base decisions on both inflation and full employment. Nevertheless, the Chariman of the Fed has the special responsibility to hold off desires of Congress to manipulate monetary policy. In exchange, the Fed is supposed to avoid commenting on fiscal matters.

The key issues will not be decided during the Bernanke confirmaton hearings, but this will be the focus of what may occur in 2010. There are two issues that are relevant during the confirmation hearings:

1. Will Congress move to have formal audits of the monetary policy function of the Fed? This oversight would go beyond the normal hearings as part of the Humphrey-Hawkins Bill. Congress is also looking into many issues of Fed structure including the organization of the regional banks and how directors are picked.

2. What should be the regulatory function of the Fed? The issue is whether the Fed should be given additional powers to supervise financial firms. Bernanke argues that this power is essential to maintain control over monetary policy. Congress is arguing that the supervision job the Fed has done in the past may require that a different agency conducts this oversight.

The current system of multiple regulators was inefficient and a contributor to the crisis, but this does not mean that the Fed should have this responsibility. The Fed needs information on the behavior of financial institutions and the economy to understand what actions should be taken in the pursuit of monetary policy, but it is less clear that they need to be the super-regulator.

Who would have thought that these complex issues would be the focus on the Fed chairman confirmation hearings? However, the Fed has put itself in this condition because of the job it has done of the last few years. Could this crisis have been avoided? Unclear. What is clear is that it could have been better at raising rates at the end of the Greenspan era. It contributed to the housing bubble. It should have been better in regulating banks and monitoring the financial system. It could have slowed the speculation. It should have been better at controlling the crisis in the period from July 2007 through the end of 2008. It should have been planning for systemic risks.

Now there is a time for accounting. The audit is on.

Sunday, November 29, 2009

Keynes on uncertainty and risk

Keynes developed his views on risk and uncertainty in A Treatise on Probability. These were further refined in the General Theory. Upon reading more about Keynes and his views. I have concluded that the central thesis of Keynes is about living in a world of uncertainty. It is the uncertainty of what the future may hold which causes the fluctuations in the economic cycle. It was described as "animal spirits", but this simple phrase does not do Keynes or his views justice. Using the view of "Animal Spirits" actually may have been used by the rational expectationist as a way deriding Keynes as being ad hoc. The animal spirits was a plug that could not be explained. A closer reading suggests that Keynes was very thoughtful about risk. It actually focuses in three types of risk.

  • Cardinal or measurable probability. This would be the domain of risk proper. The easiest would be the probability of a dice. This could also be considered actuarial risk. I would also classify this as any risks that are countable. In actual reasoning, exact measures of this kind will occur comparatively seldom. My this reasoning risk management would be very difficult because there are many risks which are just not countable.
  • Ordinal probability or relative position of the event in a ranking. Something is more likely to occur but not how much more likely. This is the domain of uncertainty or vague knowledge. Most of the risks that we face would fall into this category. It is more likely to rain today than tomorrow but I cannot say how much more likely with any precision.
  • Unknown probabilities - the domain of irreducible uncertainty. There is non-comparable premises. We cannot say what the outcome of the Iraq War. We cannot say what type of bank regulation will come out of Congress.
We move from optimism and pessimism as our confidence changes between these uncertain alternatives.

"It depends on the confidence with which we make this forecast or how likely we rate the likelihood of our best forecast turning out quite wrong. The state of confidence as they term it is a matter to which practical men always pay the closet attention."

Uncertainty will affect the impact of any statistical work.

"With a free hand to choose coefficient and time lags one can with enough industry always cook a formula to fit moderately well a limited range of past facts. But what does that prove?"

From Robert Skidelsky, Keynes: The Return of the Master

If we face the uncertainty not the risk of the current economy, it may make sense why there is high unemployment. We cannot measure the impact of the credit crunch, housing market downturn or the global imbalances. The result is a pulling back of any long-term decisions or investments. The government tries to fill the gap through deficit spending, but it misses the point that private investors will not make decisions if there is an uncertain environment. The role of the government is to provide clarity concerning the environment. How can this be done? Clear policies on regulation and rules of the game. There has not been enough discussion of the the institutional environment to provide clarity for investors.

Dubai and Keynes on investing and speculation

The default by Dubai is a significant investment event which while thought about and discussed in the newspapers was never really discounted. The announcement on Thanksgiving did not give investors time to digest the news. Money poured into Dubai even while the real estate boom turned in the rest of the world. Construction continued even when oil prices declined. This should not have been a surprise.

It reminds me of the comments by Keynes on banking and expectations:

"The sound banker, alas is not one who sees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows so that no one can really blame him."

Keynes on expectations:

"The investor will be affected as is obvious not by the net income which he will actually receive from his investment in the long run but by his expectations. These will often depend upon fashion, upon advertisement, or upon purely irrational waves of optimism or pessimism. Similarly, by risk we mean not the real risk as measured by the actual average of the class of investment over the period of years to which the expectation refers but the risk as it is estimated, wisely or foolishly, by the investor."

His view on deflation:

"The fact of falling prices injures entrepreneurs consequently the fear of falling prices causes then to protect themselves by curtailing their operations."

On speculation:

"Speculators may do no harm as bubbles on a steady stream of enterprise. Bu the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino , the job is likely to be ill-done."

On being a contrarian:

"Is not the rule for an investor to be in the minority? It is the only sphere of life and activity where victory, security is always to the minority and never to the majority. When you find anyone agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share that, I am learning from experience, is the right moment for selling it."

"It may often profit the wisest to anticipate mob psychology rather than the real trend of events and to ape unreason poleptically. .. to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years."

From Robert Skidelsky, Keynes: The Return of the Master