Monday, August 31, 2009

Dollar smile story good point of view


We like the dollar story presented by Alan Ruskin of RBS. This dollar smile seems to make sense in the current uncertain environment. His argument is very simple. The dollar will fall into one of four categories. The extremes will lead to dollar rallies and the moderate periods will be dollar negative.

In the first case, a crisis, we will see the dollar rally under flight to safety behavior. This behavior is what we saw last Fall with the strong dollar rally. The market wanted to avoid risk taking so money came to the dollar and dollar deleveraging increased.

At the other extreme will be a strong V-shaped recovery which will also see a strong dollar rally. Under this case, there will be stronger than expected growth, the US deficit will be closed, and the risks of quantitative easing will be diminished. While this may be a low probability event, it would be dollar positive. Money will flow to the dollar because of better investment opportunities.

The two most likely scenarios would be a tepid U-shaped recovery or a slow growth environment. Under the tepid case, there may be increased demand for risky assets in other countries. This may be a good emerging market environment. The other case o slow growth would be a normal recovery where growth fits within what has been expected by the consensus. who is thinking that we will be on a lower growth path. This certainly would not be a V-shaped recovery but a controlled growth. Under this scenario, there would be a desire to find risky assets outside of the US.

A problem with these scenarios is the underlying assumption that there is a decoupling between the US and the rest of the world. We have not seen this over the last few decades. The rest of the world will be able to move ahead without the US and the investors will looking to other parts of the world for the best returns opportunities. Given this world view, the dollar will diminish in importance. While we are not counting the dollar out, the dollar downside is greater if we have a economic muddle.

Trifecta on manufacturing with surveys

The Chicago PMI rose to 50.
Milwaukee NAPM up to 56.
Dallas Fed manufacturing activity down only -9.1 versus expectation of down -14.

These numbers are following a similar pattern found in other countries and is consistent with a recovery. The Chicago PMI is above 50 for the first time in a almost a year. Milwaukee NAPM is at early 2008 levels and the Dallas fed index is at levels similar to the end of 2007. Some of this rally in manufacturing is associated with auto manufacturing. The "clunkers" program worked to give a shot to consumers last week and manufacturers this week. Unfortunately, these are often temporary gains that will not last after the program is over.

Wednesday, August 26, 2009

Merrill Lynch recommends debt default swaps on Mex as emerging market play


Merrill Lynch is suggesting that investors buy credit default swaps on Mexico as a way of protecting against emerging market risk. We are seeing a combination of the fighting the last emerging market war and missing the last battle with this recommendation. Yet, there is a place of buying protection when the market gets ahead of itself.

A look at credit default spreads show a market in a tremendous rally. At spreads below 170 bps we are at levels pre-Lehman; however, we are still way above the price paid earlier in the credit crisis. If we are not coming out of the global recession, then buying emerging market protection makes sense, but that misses the story of emerging markets which may be the leaders in recovery not the followers. History this time is different, but there is still a case for looking at specific country risk and in this case Mexico is a perfect candidate. If the global economy double dips, Mexico is in for a fall. If we do have a continued recovery Mexico may be a laggard given its weak economy. As the globe start to further grow, we may see a shifting of flow effects to stock or balance sheet effects and the numbers do not look as compelling for Mex.

Bloomberg Mexico forecast shows deep cuts in GDP though some recovery in 2010. 2009:4 down 3.1 from don 1.1 for August survey period. The government is also starting to think about raising taxes which is never good in a recession. The market is starting to punish the peso for these policy ides.

Riksbank like Fed - reason for similar rates

The Riksbank announced a temporary credit facility with commercial paper as collateral. This is akin to the loan programs that have been used by the Fed. They refer to it as "credit easing" not "quantitative easing" Obviously, the continued use of these types of programs shows there are still credit problems around the world. The Riksbank has increased their balance sheet by over factor of three from 200 billion SEK to 700 billion SEK.

Interestingly, the central bank balance sheet relative to GDP for a number of the European central banks has been much larger than for the Fed. The ECB, Riksbank, and BOJ have all been more aggressive relative t the Fed. The BOE has been similar in its response while the BOC has been more conservative.

The current Swedish forecast is similar to the US. The recession has hit bottom but the recovery has been weak. This similarity across central banks has been the driver for the convergence of rates, but that may change this Fall if we start to see more changes in GDP. Divergence will be the new rule of the day.

Tuesday, August 25, 2009

Bernanke nominated for second term and deficit forecast explodes

Ben Bernanke has been nominated for a second term as chairman of the Fed. This relieves the uncertainty of who will be at the helm of the Fed. There is an irony that the announcement came on the same day that the OMB announced that the expected Federal deficit will top $9 trillion. This is much greater than expected by the Administration in May and more in line with estimates from CBO. This should not be a surprise but confirms what we may already know.

The irony is that the man who may have to solve the deficit problem is also the person who is supposed to be independent of the political issues on the fiscal side, the Fed chairman. Announcing Bernanke's reappointment early is supposed to eliminate some of the political issues surrounding the Fed, but having it be coupled with the OMB announcement only further focuses attention on the fact that much of the Fed deficit may have to be monetized.

The deficit is not a problem today but weaving through central bank independence and helping to minimize the debt impact will be a difficult job for any central banker. These events are also at a time when there will be more on the plate of the Fed as it takes on new regulatory responsibilities. Is this job someone really wants to have?

Friday, August 21, 2009

More dollar reserve negative talk

“The current reserve system is in the process of fraying,” Stiglitz said. “The dollar is not a good store of value. Right now, the dollar is yielding almost no return and yet anybody looking at the dollar has to say there’s a high degree of risk.”

The liquidity pumped into the U.S. economy may also end up elsewhere, including in Asian property and stocks, Stiglitz said later in Bankgok.

“The liquidity is going to be spent, but not necessarily in America,” he said. Asian economies may have to “protect against an American-led asset bubbles.”

The Stiglitz comments are important on two fronts. One, there is a Nobel Prize winner who has spent important time in US and IMF policy circles telling us to fear dollar losses. This is not coming from a self-interested country that may have something to gain from a change in the mechanic of international finance. Second, Stiglitz focuses in on the bubble issue.

We my not face traditional inflation in goods. We may face asset price inflation as all of the liquidity around the world looks for a home. There is less a a need for new plant and equipment when capacity utilizations are down significantly. Capacity utilization for the US is at post WWII lows at levels less than 70%. The utilization rates are extremely low all around the world so there is less likely that good prices will have much room for growth, but there may till be need for investors to take money out of cash and place it in riskier assets in order to obtain higher returns. This may create asset bubbles especially in the few places where growth looks attractive like emerging markets. Creating new bubble may be the law o unintended consequences. The crisis started from asset bubbles based on loose monetary policy. We may again see asset bubbles from our attempt to end the crisis.

Let's gang up on energy speculators

Another story on blaming oil speculators and the futures markets for the spike in oil prices last year. Dresdner/Commerzbank blames oil speculators is the topic of an FT Alphaville blog entry which states that the bank places the responsibility of excessive price moves at the feet of the NYMEX WTI futures market. The futures, which represents a small portion of overall production distorted the oil market. Of course, the bank provides limited evidence on how the futures market caused this distortion. It is the old argument, "it is clear to everyone", that speculators caused the distortion. If it is that clear, where is the empirical evidence?

There may be a case here but there is no evidence to support the argument. Those same speculators are still in the market so why has the market fallen? They must have driven it lower given their expectations just like they drove it higher given their expectations. I is not the speculators but those pesky expectations which drive markets. If we could get speculators to all believe that the price of oil should be stable, then we would have less volatile oil prices.

Wednesday, August 19, 2009

Putting the hammer to commodity funds

The CFTC ruled that the DB Powershares commodity funds will no longer be exempt from position limits in soybeans, wheat and corn. They have a total of $5.8 billion in invested funds. DB had a no action letter for position limits that allowed for the tremendous growth. in these funds. Without the position limit exemption, there would have been a large constraint on the growth of these ETF's in the grain markets.

There is no question that allowing for position exemptions creates the potential for an imbalance of longs and shorts in the market. Grains are different form oil. The market is not as big. Imbalances will always be corrected in the simplest way, prices will move. The increase in ETF passive buyers will have potential risks. If prices are moving higher and there is more interest in ETF's, there will be increased buying pressure in up market and when sentiment changes the potential for increased selling pressure on the downside. This will increase overall market volatility which may lead to welfare reducing effects. If there is less certainty about price, there will be less usefulness for futures as a hedging tool. It is in the public's interest that the regulator investigates this issue. However the exact behavior in prices is not clear. Having more buyers in the market also allows for more hedgers to enter the market.

A look at prices shows that we is more than 50% down from its highs and below levels seen two years ago. For soybeans the decline has been less dramatic but also large. Prices have fallen from $15.5 to current levels of $9.78 / bushel. Corn is closing in on the Fall 2006 range. This is happening while ETF's have continued to grow.

Now ETF's like commodity indices will often follow specific rules for rolling contracts and for hold exposures outside the delivery month. Their impact should have clear distortions near rolls and delivery. The evidence on whether this has had a price impact has been mixed. It would seam that that a change in policy should be discussed but only after there is a careful review of the facts in this case. The CTFC should provide the economic evidence on why this makes sense and what will happen when this new exemption takes place.

Tuesday, August 18, 2009

Money supply - shouldn't it be growing faster?


The monetary aggregates in the US do not seem to be growing at a pace that would suggest that the Fed is flooding the market. This could be a growing concern. The table shows the M2 money supply. The broader M3 which followed by the ECB was discontinued being measured in 2006. The money supply is actually falling since peaking at the end of January. Some of this is a function of money demand shifts but it is noticeable that the supply growing slower than was the case in the last recession. M1 has sky-rocketed and is only slightly lower then its high of 17% YOY which is more in line what some have expected.

The money velocity for M1 has fallen to levels seen in the mid 2000's period. The velocity of M2 is at the same level as present in the mid 1980's.

M1 includes currency in circulation, traveler's checks, demand deposits, other checkable deposits which include NOW accounts and credit union share drafts. Everyone is holding their money under the mattress.

M2 is M1 pus savings deposits, time deposits less than $100,000 and money market deposit accounts. This represents close substitutes for money.

Could it be that the Fed is not doing enough?

Asking the three important investment questions

There are three important research questions for any investor:

What do you know?
What don't you know?
What are you not sure of?

What do we know is focused on the facts. Do we have all of the facts available about a particular question? Surprisingly, this is often harder to obtain than what we think. Look at the US economy. There are certainly many facts when looking at whether there are "green shoots". Different facts have varying degrees of usefulness.

But to know information is not enough. The fact finding also includes context about a given piece of information. Unemployment could go up, but what does this mean for this point in the business cycle? What does the size of the change mean relative to other business cycles? What is the composition of this number? How does it compare with other pieces of employment data? How does this compare with expectations? All of these question are in the realm of facts without making any judgement about what this may mean for the market. The role of most analysts is providing facts. The above average analysts provide context for these facts. The worse miss some of the facts or just report the bare information.

The second question of what we do not know is often overlooked. Who wants to admit what they do not know yet this can be as important as the facts. In the case of unemployment , there is a delay in the collection of information. We also do not know with much clarity the details of how the data is collected and presented. This can be very relevant in determining what we do not know.

The third question concerns forecasting. What we are not sure of exists in the realm of probabilities. We cannot be sure of any relationship so you have to give it an estimate. Unfortunately, most of the forecasts work provides point estimates and not probabilities or distributions of estimates. With the unemployment example there are two levels of uncertainty. The first level is the forecasting uncertainty associated with determining next month's unemployment number. The second level of uncertainty is associated with the link between unemployment and stock prices. So making a good forecasting on the stock market must look at both levels of probabilities, the forecast uncertainty about the variables that we believe will have an impact on equities and the actual impact of the unemployment change on stocks.

Looking at the three question framework may be helpful in reducing the risk of any investment decision.

ZEW survey explodes on upside

If you want to make more of a case for a V-shaped recovery, look to Europe. The ZEW German and Euro-zone expectations of economic growth survey shows a significant increase above market expectations and well above 50 with the highest level since 2006. All industries show improvement with the biggest gains in chemicals on the positive side. Banks have the overall highest rating which may seem a little strange since EU banks still have problems. The auto sector has become less negative and mechanical engineering is almost in positive territory.

Japan is seeing leading and coincident indicators stay stable even with department store sales still down double digits YOY.

There is growing evidence of a global recovery but does not look like it is taking a lead from the US.

Fed loan survey shows weak demand

Everyone has focused on the supply of credit. The banks have to lend! Yet, a close look at the Fed's Senior Loan Officer Survey shows that the problem is not on the supply side but the demand side.

Lenders want lend as evidenced through a reduction of tightening of loan standards. The banks are reporting weaker demand for corporate loans, consumer loans and a slight increase in prime mortgages. Consumer will borrow to buy cheap assets like homes which have better tax incentives. They will not borrow to buy stuff. Corporations want to hold off borrowing and investment projects. Their focus has been on cutting costs this year.

So what is the policy to get people to borrow more?

Monday, August 17, 2009

Batting 500 on G7 growth

A simple recovery story can be told by looking at second quarter GDP. 6/7 G7 countries have reported their numbers and three are positive and three are negative. In the positive area are Germany, France, and Japan while the US, UK, and Italy are down for the second quarter. Canada has not yet reported. Granted Japan and Germany were the worse performers for the first quarter, but there has been a strong comeback to positive territory. Japan is still Asian focused, so it recovery tells us about the robust recovery in Asia. Germany is export driven especially for capital goods, so an improvement here suggests that investments are being made around the world. This is a positive sign for global growth and should be Euro positive if the trends continue. (We have to discount Italy given its ongoing economic problems.)

TIC data- demand for Treasuries is up

The TIC data shows strong demand for Treasuries even with the large supply increase. The net total of government bond purchases by foreigners was the highest on record since 1977. The private sector has increased purchases after avoiding the US markets at the turn of the year. There are a number ways to look at these numbers.

First, the rise in Treasuries earlier in the year has been enough to attract demand at the auction. The real return for Treasuries is attractive. Under these conditions, there is not a fear of a debt problem The dollar overhang issue of foreigners avoiding the reserve is not present in the June data.

Second, the level of risk aversion is still high. There are many attractive spread products but there still a strong interest for Treasury fixed income. The purchase of stocks was positive but the sale of US corporate bonds was positive. Foreign investors are still avoiding corporate debt risk. US investors are actually taking on more risk by purchasing more foreign stocks.

Taylor's mondustrial policy -where will it take us

The combination of monetary policy and industrial policy has been coined "Mondustrial policy" by John Taylor. We are seeing this at work with the announcement that the TALF program will be continued while the Treasury purchase program will be ending. The TAF loans to banks will also be cut by one-third.

The TALF program will be extended through March 31, 2010 for ABS and there will be given a six month extension for new CMBS. Everything is not perfect in credit markets and the Fed is still needed to provided selected credit capacity for the ABS market and especially for the CMBS market which may be the next problem area. Commercial real estate has been hit hard but has taken a back seat for the rest of the market.

The mondustrial policy becomes an issue because the government has now selected extended and cut programs not based on overall economic price stability but on the needs of the banking industry. This is a slippery slope. Do we do nothing and have a collapse in sector lending or do we allow the government to "fix" specific areas?

Of course there is a need for more credit to the commercial real estate market to prevent defaults but choices will have to be made. For example, more commercial real estate loans are held by smaller banks. You could prevent money from going to these areas and there will be further bank consolidation, or you can allow smaller institutions to be serviced. This is not exactly the case for the CMBS market but allowing for more money to flow through these lending facilities takes pressure off of other institutions.

The overarching theme is what should be the role of the central bank within the banking industry. This is a debate that is not occurring. Politicians are more than happy to be involved with directing programs but should the central bank be the instrument of this industrial policy?

Friday, August 14, 2009

The big debate - "New normal" versus "V-shaped" recovery


A number of economist are starting to join the V-shaped recovery bandwagon. With positive numbers starting to come every month and the stock market having a nice jump, there is a growing group that wants to predict the economy that will explode out of the current deep recession. There is a lot of prior evidence of this type of deep-in-deep-out recovery. The evidence we are starting to see is a jump off the lows and what looks like the beginning of a recovery in many countries. The V-shaped recovery people see a pop in productivity as well as increasing in manufacturing and trade.

The "new normal" group has a different view.We can call this the credit crisis flow crowd. The foundation for the "new normal" is that the recession was a financial banking problem and that these types of crisis take longer to work out because there is a greater wealth effect or realization of losses from bad loan. As long as credit is not expanding smartly, there is little room for a recovery of any strength. The credit expansion will be tied to the balance sheet of banks. If banks cannot improve their balance sheet they will not lend new money. The new normal view takes into account that a strong portion of the growth in the last decade was associated with cash out refinancing which allowed homeowners to take money out of their housing gains and transfer it into consumption. Now the debt has to be paid back and the liquification of wealth will not occur. The latest Deutsche Bank study suggests that in the next few years almost 50% of US mortgages will be underwater. Th new normal suggests that any recovery will be slow. The places where there has been the strongest recovery are countries which did not have the banking crisis problem, for example, Asia.

Another way of looking at this comparison is to say the new normal economists are wealth effect pessimists while the V-shaped recovery are current production optimists. I fall into the new normal camp. History suggests that the credit cycle recovery is long and slow. The V-shaped recovery is still based on future optimism which has yet to be realized.

Inflation down again - bonds looking cheap

Inflation can be a good indicator of economic growth. If growth is above long-term trend, then it is likely that inflation will be rising. If there is a negative output, there will be a bias to deflation. This very traditional Keynesian view still works as an effective rule of thumb. That does not mean that markets will always follow it in the short-run. Look at the increase in inflationary expectations during the Spring. This increase was driven solely by changes in expectations on the monetary side of the ledger. The output gap has a long way to go before it closes. Any thoughts that we are in robust growth should be tempered by the inflation news, down 2.1 greater than expectations of -1.9 and core inflation down to 1.5%. Nevertheless, we are seeing industrial production positive for the first time this year and capacity utilization slightly higher.

This makes for a bond market that is looking cheap. At a 3.59% 10-year, the real rate based on headline CPI is above 5.5%. if you look ta the core rate, we are at 2%. The 2-year Treasury is at 1.12% so the real rate is 3% and just slightly negative if you look at the core rate.

You are inclined to believe that bonds are cheap except for that little issue called the deficit. Recent research suggests that deficits do matter based on the shape of the yield curve. While the central bank may be able to keep short rates low, high deficits lead to a steeper yield curve which is what we are seeing now.

The gradual movement back to positive growth is occurring and being discounted in the market.

Thursday, August 13, 2009

Tax payment distribution - a big problem

The disconnect between service and payment is growing and this means that US citizens are voting for service which are paid for by only a few. No wonder there is a focus on lobbyist to control the process. The majority will ask for services to be paid by a minority. Saying this does not mean that we want a rollback for the rich. It does mean that the not so rich must understand how services are being paid for.

From Charles Murray in the WSJ,

http://online.wsj.com/article/SB10001424052970204313604574328273572673730.html

"Let's start with the rich, whom I define as families in the top 1% of income among those who filed tax returns. In 2007, the year with the most recent tax data, they had family incomes of $410,000 or more. They paid 40% of all the personal income taxes collected.

Yes, you read it right: 1% of American families paid 40% of America's personal taxes.

The families in the rest of the top 5% had family incomes of $160,000 to $410,000. They paid another 20% of total personal income taxes. Now we're up to three out of every five dollars in personal taxes paid by just five out of every 100 American families.

Turn to the bottom three-quarters of the families who filed income tax returns in 2007—not just low-income families, but everybody with family incomes below $66,500. That 75% of families paid just 13% of all personal income taxes. Scott Hodge of the Tax Foundation has recast these numbers in terms of a single, stunning statistic: The top 1% of American households pay more in federal taxes than the bottom 95% combined.

My point is not that the rich are being bled dry. The taxes paid by families in the top 1% amounted to 22% of their adjusted gross income, not a confiscatory rate. The issue is that it is inherently problematic to have a democracy in which a third of filers pay no personal income tax at all (another datum from the IRS), and the entire bottom half of filers, meaning those with adjusted gross incomes below $33,000, have an average tax rate of just 3%."

Fed - the economy is "leveling out"


Fed announced that the economy is "leveling out" It also stated that it will reduce the pace of the Treasury purchase plan started in March and end it at the end of October. The other news from the Fed is that it will continue to keep rates steady for an "extended period" They are not going to take on the issue of raising rates in the near-term even if the economy is showing some signs of improvement.

This news was equity positive, but the impact on the dollar is a little less clear. The end of the Treasury buying program reduces the worst fears concerning quantitative easing and monetizing debt, but the deficit problem is still looming over the market. A portfolio balance model for exchange rates suggest that the continued deficits will be dollar negative unless there is a corresponding gain in the growth. The potential for stronger relative growth versus some of the other advanced economies will place a flow on how low the dollar can go. We do not fall into the dollar rally camp, but also believe that it may be early to see a steep decline in the dollar. Expect range-bound behavior until we start to get Fall numbers.

Wednesday, August 12, 2009

Trade numbers better than expected

Trade gap did not widen as expected. The improvement versus expectations was driven by exports which suggests that global growth is getting better. Of course, total US trade is still down significantly, just under -30 percent across all countries. The US also won a WTO ruling against China which limited sales of US films and music.

The trade improvement was associated with a more competitive dollar which is similar to what we saw in the last years of the Bush Administration, a benign neglect concerning the dollar because there was improvement in the export sector. This is a dangerous game of trying to keep those who buy US debt happy while trying to create jobs in the economy. Global trade has declined much more than GDP around the world. The steep decline is driven in part with inventory management so it would not be unusual to see the trade sector increase first.


Another oil price shock - not likely

There has a a lot of talk about the speculators driving prices up in the oil market but less talk about the root causes for oil price moves. Prices have moved form a low of $45 per barrel to current levels in the high $60's. We are in the 2006 range for oil which is consistent with a global economy that is growing around the longer-term trend. hat may be premature but the numbers seem plausible.

We are not seeing a price shock. Lutz Kilian in the Journal of Economic Literature provided a good breakdown the type of shocks that could occur and there impact one the US economy. He defines three types of energy shocks:
1. Supply shocks from the interruption of oil. These are usually temporary and do not have a lasting effect on h economy.
2. Demand shocks from aggregate global demand for oil. These would be a response to economic activity as opposed to the behavior of the oil market.
3. Oil-specific demand shocks which are associated with political uncertainty. There is an increase in demand to increase inventory as a convenience. This is usually what has been perceived as price shocks by market observers historically, but most of what we have been dealing with has been global demand shocks. These are the shocks which have the most impact on the economy.

So do we have a shock? Most likely we are dealing with the normal increase in demand associated with a turn in the business cycle. No shock. Prices should sty in this range unless there is a significant increase in global growth.

Monday, August 10, 2009

CFTC focus should be on more than energy complex

The focus of much of the CTFC discussions has been the energy markets and position limits but the users and market mechanics of other commodities could be as or more important. Speculative traders who are associated with commodity indices can have an impact on prices from their long-only activity. The wheat contract can be a case in point where we are not seeing convergence of the futures with cash. See: Pressure builds to fix broken CBOT wheat contract.

http://www.forbes.com/feeds/reuters/2009/08/07/2009-08-07T181257Z_01_N07404627_RTRIDST_0_WHEAT-CONVERGENCE-ANALYSIS-REPEAT.html

There are a number of reason for the lack of wheat convergence. Perhaps the most important is the delivery point problem that is caused by the changes in marketing and exporting of grains. Chicago is just not that important for the delivery process of wheat. The CBOT has to make adjustments. The work of Scott Irwin from the University of Illinois is always even-handed and thoughtful on these matters. The lack of convergence is also diminished because of the mix of long and shorts which can be a regulatory issue. Both of these have to be addressed soon in order to have a better working futures market.

Currency trading on Friday was different


Friday was a very different day for currency trading. The stock market rose on good news in the US but the dollar also appreciated. This has not been the pattern that we have usually seen over the last few months. Generally, when there has been a stock market increase the dollar has fallen as money moved out of the safe haven of the dollar and into riskier currencies.

Now there can be a compelling story for a dollar rise given the stronger increase in economic growth. The US could be a more compelling place for direct investment which would be dollar positive. The dollar could also be a better place on a relative basis versus the EU or Japan. This has not be the story followed by the market but a change could be taking place. Certainly fixed income is signaling higher yields which could be caused by a expectations of a growth rise and an end of the easing cycle. There is some talk of an end to the easing cycle during the first quarter of 2010.

We are not convinced that we have evolved to a new dollar - US equity relationship but we view that the buying of equities will continue with gains on any news that looks positive. Emerging market equities have gotten way ahead of advanced economies in the last few months so the knee-jerk reaction to risk seeking may slow.

Thursday, August 6, 2009

Financial integration, financial development and global imbalances - the new story of international finance


I am careful about using the words path-breaking, but I believe that the recent work by Enrique Mendoza, Vincenzo Quadrini and Jose-Victor Rios-Rull (MQR) may be just that. Their paper "Financial Integration, Financial Development and Global Imbalances" in the June 2009 Journal of Political Economy is eye-opening because it provides a different perspective on the global imbalance problem and the credit crisis.

The normal view, that is now generally accepted wisdom, is the savings glut story for global imbalances. The developing world, because of their high savings rate, funded the excessive consumption of the US. The consumer demand by the US created the trade imbalance deficit which was fed by a host of exporting countries which kept currency rates low and collected large increase in foreign reserves which were funneled back to the US. This flow of funds caused interest rates to be lower than normal in the US which served as catalyst for the current crisis.

MQR provides a different but very plausible story and model which can explain many of the stylized facts over the last two decades. The global imbalance issue was more than a savings glut problem but a structural issue. The great increase in financial integration over the last 25 years meant that capital was free to flow around the world. This flow of capital could mean money moving into the risky assets of emerging markets, but it could also mean capital flowing from exporting countries back to the developed world as these investors look for a risk free asset.

The reason for this risk free asset demand comes from the fact that there has not been strong financial development in many of these countries. The capital markets in many countries are illiquid and provide few acceptable low risk assets. The lack of financial development with the doors thrown open for capital to find safe havens was a recipe for the capital account imbalance problem.

Where are assets seeking risk free opportunities going to go if there are no local alternatives and capital is free to move around the world? But of course, they will go to US Treasuries, the safest and most liquid asset in the world. The issue is not that that there was such a great savings imbalance but the fact that the money that was saved in many countries flowed back up to the developed world. Money from the developed world moved down to emerging markets in an effort to gain diversification, but demand for safe assets moved funds back to developed markets.

With all of this money moving to Treasuries, it is no wonder that we had an interest rate conundrum. Instead of rising on a capital shortage, US rates declined from foreign demand flows.

One of the ways to solve the imbalance problem is to increase the development of local financial markets. Of course, if local markets do become more developed, US rates will have to rise because there will be less capital flowing into the safe assets in the developed world.

This new view does not supplant other stories about global imbalances but it places a new emphasis on the structural role of markets. This is an important new perspective which may lead to different thinking about how to regulate and develop markets.

Just-in-time versus just-in-case risk management


Pimco has been marketing a new multi-asset fund based on the idea that broad diversification is the best way to avoid tail risk. Tail risk is any extreme market downside move which is not expected with a normal distribution. They have provided a catchy argument that investors have to differentiate the methods used for risk management into two types.

One can be described as just-in-time risk management. This would be the type of response that is an active reaction to an extreme move. We see the market falling and we hedge our exposure. There is a crisis and an investor reacts with some active strategy to diminish downside risk. This is very effect at minimizing the cost of hedging between these extreme events; however, the price of hedging instruments will clearly increase when there is an ongoing crisis. The cost of insurance is high when the house is one fire or when it is hurricane season. Problems arise if the extreme event occurs very quickly. There is little time to react because there may be a jump in prices. Just-in-time risk management can be very costly if there is a surprise event.

The other alternative is to build portfolios with the view that you want to have diversification just-in-case there is an extreme event. Do not keep all of your eggs in one basket. This would focus on buying assets which have the maximum amount of diversification and will be uncorrelated at the extreme. Under this scenario, the best action would be to hold a broadly diversified portfolio. Of course, there may be costs with this diversification because there may be a drag on performance for purchasing negatively or low correlated assets. This cost may be the case with managed futures which does very well during some extreme events but which may have poor performance during other periods of relatively calm markets. if you believe that extremes are few and far between, then you should focus on just-in time risk management. If you believe that extremes occur more often than what most expect the proper course may be to follow a just-in-case asset management program.

This dichotomy is a good framework for looking at building portfolio to protect against downside; however, there needs to be a little more meat on the bone to explain when and how each alternative will appropriate.

Being fooled by central banks

The Bank of England announced that it will increase their asset purchase plan which was thought by many to be ending. The total plan will be raised to $296 billion with an increase of $84 billion. With this type of surprise, we know what will happen. Bonds rallied and sterling got hammered. This was surprising given that PMI numbers look good and was actually industrial production is higher MOM. PPI is still negative but CPI is still only at the low end of the expected policy range.

The ECB, on the other hand, said that rates are appropriate and that they are satisfied with their asset purchase plan. President Trichet is expecting a recovery for Europe based on the improving economic numbers. This should give a boost to the euro in the coming weeks.

We are seeing the first signs of differences in monetary policy across the G10. For almost the last year, monetary policy was one directional with all central banks lowering rates and providing easy credit. This is not going to change in the near-term but we will start to hear differences in views of what stage the business cycle is at and what should be the monetary stance to reduce strong easing. This may start to cause forward curves to move higher on the front-end. This year yield curves have steepened because long rates have risen and short rates have stayed stable.

Wednesday, August 5, 2009

Why we make mistakes - once more a look at behavioral biases


Why we make mistakes: How we look without seeing, forget things in seconds, and are all pretty sure we are way above average by Joseph Hallinan is another book about how dumb we are as human beings.

These are a few of the interesting or what may be sad facts Hallinan finds:

In one test, 30 percent of people forgot their password after one week; after three month, at least 65 percent were forgotten.

Only one-third of students hon a short film noticed that the main actor had been changed.

In one study, radiologists missed up to 90 percent of cancerous tumors that, in retrospect, had been visible "for months or even years."

O twenty people tested, only one - avid penny collector - could accurately recall and locate eight critical features of a penny.

A recent poll of three thousand people found that one-fourth of them couldn't remember their own home phone number.

Teams that wear black uniforms have been penalized significantly more than average.

"Almost everyone is overconfident - except the people who are depressed, and they tend to be realists"

Handicappers' accuracy was no better with forty pieces of information than it was with five. But an this is an important but - using more information did increase their confidence.


We are biased creatures who are overconfident in our abilities. We do not want to take advice and we do a poor job of seeing or keeping track of details. Seems like we need to be disciplined in how we make our decisions.

Bernanke's Test - He has passed


Bernanke's Test: Ben Bernanke, Alan Greenspan, and the Drama of the Central Banker by Johan Van Overtvelt is as an even-handed discussion of the personalities driving the Fed as any I have read. It also provides a central bank perspective on the credit crisis over the last few years.

It confirms my belief that the Fed has done as good a job as possible given all the twists and turns this crisis has taken. The author makes a good case for Chairman Bernanke being the right man for the right time during this crisis. There is no one in the professional ranks of monetary economists who could have been better prepared for dealing with the combination of a great recession and deflation at the same time. He has also shown good skill at managing the Fed through the current prorblems.

Of course, the Fed is not without fault throughout the last two decades, but most of these criticisms are made in benefit of hindsight. However, there are four critical issues or questions which will have to be dealt with by the Fed as we move forward.

1. Is the Fed up to the task of being the best regulator of banks and other large financial institutions? Greenspan gave this area short shift and we have paid a dear price. It is not clear that running monetary policy requires active oversight and management of the regulatory process.

2. Can the Fed reverse their monetary easing at the right time? Bernanke and Greenspan were effective at lowering rates and providing lots of liquidity during a crisis. The real issue is whether they have the willingness to "pull the punch bowl" at the right time.

3. Is the Fed up for the task of protecting the economy from systemic risk? This is closely tied wit the issue of whether the Fed should try and stop asset price bubbles. The Fed has avoided attempts to control or stop run away asset prices. Isn't this one of the harbingers of systemic risk?

4. Can the Fed avoid the politics of a prolonged recession? The town hall meeting of Bernanke suggests that he is campaigning for his job. Do we want a central banker who wants to be the chairman of the Fed?

The book states that Bernanke has passed his test, but just because you graduate from one crisis does not mean that you will pass all future crisis. We never stop learning and we never stop being tested. We need to know how he will do with future tests.


Monday, August 3, 2009

There is some good and bad news from the Treasury




ISM manufacturing survey up above expectations at 48.9. This is still below the key 50 mark but the level is back to pre-Lehman levels and is consistent with the similar surveys in other parts of the globe. The worst of the current downturn may be over when we get these kinds of number. However, that is different from saying that we will have high growth.

More important than the economic announcements are the Treasury projections for borrowing in the coming quarters. The Treasury only borrowed $343 billion instead of the projected $361 billion in the second quarter. This was 5% under projection. For the third quarter, the Treasury now expects to borrow $406 instead of the $515 billion estimated earlier. This will be just over 20% less. It will also look like the fourth quarter will also see less borrowing. This is good news before the announcement of the quarterly refunding. Some government bail-out programs are using less money than expected.

The bad news is that tax revenues have been falling at a rapid pace. This decline is much greater than the decline in the overall economy. Individual income tax receipts are down over 20% while corporate taxes are down over 50%. Loss carry forwards reduce revenues. Less income reduces revenues. All of the tax breaks for each class and firm start to add up when you are in a downturn. If this continues, there will have to be new methods for raising revenue. The stabilizers in fiscal policy are supposed to help the economy but at the extreme they can have a negative impact on the government. deficit. What is spent today will have to be financed and paid back in the future. Economic growth is smoothed. The issue is still the multiplier effect which needs to be better than one to have a strong impact. The research on the size of multipliers is mixed.