Monday, January 25, 2010

Greek bond spread blow-out

Bond vigilantes are alive in Greece. Chart is from BBH's Win Thin. It is clear than if you have a fixed income choice inside the EMU it is not to hold Greek bonds. Is this enough compensation? It is wider than some similarly rate corporates, but it is not clear how the budget will be balanced and taxed raised to bring this problem back in-line. You cannot inflate your way out of this problem and you cannot devalue the currency. The choices are limited.

Friday, January 22, 2010

Follow bonds or short rates for USD currency play?

Short rates in the US suggests that the dollar should be a funding currency which will continue the downward pressure on the dollar. Rates are decidedly against holding USD versus almost all other interest rates around the world. The short rate story is to sell dollars and buy any other currency.However, if you look at the steepness of the yield curve and the long bond, you are getting a slightly different picture. With 10-year US yields at 3.60, the advantage is for the US versus EUR, JPY and a number of other G10 countries. There is not the same carry story. In fact, there may be a desire to hold US bonds versus other countries. The fixed income markets are providing mixed signals.

This story gets a bit more confusing when you look at the data. Uncovered interest rate parity is more likely to hold for bonds than for short rates. Higher rates suggest you should be a buyer of the currency with short maturities. For bonds, higher rates means higher inflation expectations which will lead to a a currency depreciation. The forward bias puzzle is less apparent. Higher rates may also be necessary to maintain currency levels as compensation for potential bond-holder risk.

Flow dynamics for bonds include concerns over asset substitutability and right now rates are higher in the US to attract the necessary funds to meet shortfalls between savings and investments. The poor performance of bonds during 2009 is telling the market that higher yield are necessary to make Treasury bonds attractive. Carry dynamics have to enhanced or tempered by the shape of the yield curve and views on inflation.

Pro-cyclical growth trends and currency risk

A major FX theme has been to hold emerging market currencies given a global recovery and clear pro-cyclical trends in 2010. Hold commodity country currencies, hold large exporters, hold those which have a higher currency beta. This emerging market story seems to be favored even if there is slower growth since the prospects for EM seem to better than the developed markets. International reserves are higher so that they will be able to sustain a slowdown better then past crises. Yet, this week sees the beginning of currency pessimism. First, the prospect of a China slowdown is expected to have a contagious effect around the rest of the world. Second, there is an increase worry of sovereign risk. Lower growth will lead to sustained deficits.

Cyclical trends and currency risk are closely tied to what will happen to interest rates. The rate changes will feedback on currency markets through capital flows, the carry trade. There are a number of potential scenarios that can be analyzed through growth and policy responses in 2010.

One likely scenario is a currency appreciation signaled through rising rates coupled with strong growth. Tightening monetary policy will lead to appreciation. We have already seen this in AUD and NOK. However, the other extreme would be a lowering of rates and slower growth which will be coupled with currency depreciation. This has been one of the scenarios earlier in the recession. We should expect depreciation under this story.

What is difficult are the two other potential rate-growth scenarios. One would be higher growth but lower rates while the other would be rising rates and slower growth. The higher growth and lower rates scenario is not very likely, but a fear would be a combination of lower growth and rising rates. This combination could occur if there is a financing risk premium in rates or the potential for stagflation. This combination could be realized in the US if we have below trend growth but rising bond rates. This would cause a a currency sell-off and create havoc form many interest rate currency models. The path of rates and growth is one of the key currency risks in 2010.

The one-size fits all problem in the EMU

Europe represents a well integrated trading zone. While there are language and regulatory barriers across the EMU countries, most of their trade is intra-regional. Having a single currency makes sense. Having a single regulatory body to codify rules and standards in the region makes sense. Having a one-size-fits-all system during a fiscal crisis is a problem.

There is a EMU fiscal problem and it is affecting the EUR. Greece is on the brink of a fiscal crisis which they cannot solve through creating inflation. Default is one of the few options. If course, it would be in the form of a restructuring of payments. Given they have lost one degree of freedom through not being able to control their money supply, they will have to either increase taxes or cut significantly expenditures. Fiscal crises do not just occur at extreme debt to GDP levels. Most actually occur at levels of less than 60%.

The impact of fiscal problems in Greece will spillover to all EMU capital markets. Note that earlier this month the EUR was declining while many emerging markets were seeing currency appreciation. We have been watching CDS spreads but they have been giving mixed signals. What is clear is that more investors have concerns that the EMU is riskier that 3 months ago. There may not be a bail-out, but the greater fear is that ECB will react to this problem. The reaction will not come as direct support but a slower response to overall EMU growth. Rates will stay low and there will higher potential for inflation in other parts of the EU. This will be EUR negative.

At the very least, markets abhor uncertainty. There is now more uncertainty on the potential policy reaction regardless of what policy-makers may say. There certainly is a renewed interest in sovereign risk. The markets should not be surprised that with aggressive fiscal deficit policies sovereign risk would increase. During the height of the credit crisis the focus was only on stimulus and not on how all of this stimulus would be financed. Now the focus of markets has changed to ask questions on how deficits will be sustained.

China touches the brakes - rest of the world slows?

China seems willing to slow growth to stop any speculative bubble from their large expansion of credit last year. There fiscal and monetary stimulus has worked. It actually may have been too good. Growth came in stronger than expected at 10.7 percent but we are also seeing higher inflation at 1.9 percent.

The Bank of China is sending clear signals that it wants to control this growth and bring it down to a more manageable level. Granted that to manage their economic growth has to still be by some accounts over 7% to meet all of demands from the population migration. Given a fear of inflation and bubble risk, taking some action during this double digit growth period seems natural.

3-month bill rates have increased over the last few weeks. The cost of credit is rising. The reserve requirement for banks has been raised by 50 bps to 16% for large banks and 14% for smaller banks. There also is a desire to see the capital base for banks increased and regulators have have asked some banks to curtail lending. A slowdown will have negative implications for the commodity currencies and perhaps all emerging markets. Certainly, holding industrial metals has just become riskier.

The slower growth scenario may be the driver for the dollar appreciation as global money tries to find the safe home under a potential global double dip. This could be a variation on the old adage that if America sneezes the rest of the world gets a cold. It could be China that will give the rest of the world a cold.

Thursday, January 21, 2010

Russia to diversify into CAD

The Central Bank of the Russian Federation is going to invest a part of the funds of Russia’s international reserves into investments denominated in the Canadian dollar. This is a further attempt to diversify their reserves. Of course, this is not true diversification. The Canadian economy is commodity based like Russia. No gain there. Canada in many respects is part of the North American currency zone and will always trade closely with the US. The US is its largest trading partner and most of the population moves freeing in and out of the Us and live within 100 miles of the border. Most of its exports are to the US.

This is more of a statement on the negative prospects of the dollar than a comment on the gains from Canada. Nevertheless, Canada has a much better fiscal position than the US and may be able to better control government expenses and inflation in the coming years. One more headwind against the dollar even though Russia has not started to trade in CAD.

G7 vs E7 - the new world order is moving to emerging markets

The G7 - Canada, UK, Germany, Italy, France, Japan, US

The E7 - China, India, Brazil, Russia, Mexico, Indonesia, Turkey

Formed in 1976, the G7 represents the old order. The E7 will match the G7 in less than 10 years and be significantly larger, some say 30% in 20 years. Look closely, the G7 has three EMU countries that do not even have their own currencies. The E7 already has four of the top ten spots with respect to GDP as measured by the IMF. The E7 is generally in current account surplus and are adding international reserves while the G7 are running both large government fiscal deficits and current account deficits. The population of the G7 is shrinking while the E7 is growing. The demographics of the E7 are much better than the aging G7 except for China. The center of international finance will continue to tilt to the E7. Market capitalization of their stock markets will continue to grow.

All of these trends will mean a further shift in finance and investing to emerging markets. Perhaps we have to come up with a new term to describe these countries. They have arrived.

Sunday, January 17, 2010

Argentina will they get the finances right

Just when the markets thought that Argentina, the third largest economy of Latin America, would get out of their debt problems, the president gets into a row with the central bank president. Last year it was the nationalization of pension plans. Earlier this year, it lost its status as an emerging market stock market and became a frontier market with MSCI. Investors are only going to get 33 cents on the dollar from the 2001 default while Argentina will be able to again access international capital markets. The debt restructuring began in 2005.

Does it make sense to use all powers possible to gain access to international markets? Yes. The avenues for gaining access is through increasing revenues through taxes or cutting expenditures. Neither seems like a good idea for the populist president so using international reserves seems to make sense. Raid the central bank. Of course, the central bank is viewed as independent so this taking of reserves would break the sense of Independence. Lenders would also say that if you are going to raid the central bank then you can pay-back more that the 33 cents which was negotiated under the view that international reserves were not available.

This creates again uncertainty about the fiscal behavior of Argentina which may affect its ability to again gain access. The bond investors have been fooled before by the government. They could be fooled gain but they are getting wise to some of these tactics.

EU bond spreads and currecny markets

There has been an appreciation in some emerging market currencies while the value of the EUR has actually declined. The EUR was supposed to be the safe substitute for the dollar as a reserve currency. The story now seems to mixed as sovereign risk is becoming more apparent in the EMU.

The EUR is a liquid and deep market with better developed capital markets than Japan, yet the dollar rally has been mostly against the EUR. Their liquidity is being called into question because there is no way to solve country-specific crises in the EMU. There is no organization to provide stand-by credit accent the ECB. Th ECB has loosened its collateral standards through 2010, but president Trichet also stated that it would revert back to pre-crisis levels of A- ratings. Currently they will accept BBB-ratings but there are some EMU members such as Greece where this may be a stretch at the end of the year. The EUR capital markets may not be as liquid as perceived which may make the dollar more attractive.

A key reason for this decline in EUR demand could be associated with the greater sovereign risks in EU bond markets. Greece clearly is a poster child for greater risk differentiation but we are seeing greater spread differences all across Europe relative to Germany. The ECB has been tracking these developments, see vox.org piece, What explains the surge in euro-area sovereign spreads during the financial crisis of 2007-09 ( Maria Grazia Attinasi, Cristina Checherita, Christiane Nickel,).

They find that the international risk aversion may be the key explanation for the spread dispersion but the second most important variable is the fiscal position or risk within the sovereign. The greater differentiation in the market translate to less liquidity and a general aversion to the EMU which we have not seen in the US. Hence, there is less substitutability from dollars to EUR. Even with the US headways against the dollar, there could be a the makings of dollar rally if the confidence in sovereign risk further declines.

Global imbalances vs flight to quality risks - different stories

One of the key arguments for the global crisis has been the global imbalance story. The large current account deficits of the US helped to create an unstable system. The global imbalance story is based on the emerging market events of the last two decades where current account deficit could not be financed through a "sudden stop" in the economy. Developed countries still need to be on guard if they have large current account imbalances because a change in funding sentiment will create a crisis.

The safe asset shortage story states that the lack of capital market developments in many emerging market countries which limited the risk free assets available to investors including central banks created demand for safe assets in the US. Yes, there were imbalances that would correct if there was not a demand for safe assets by those running surpluses. The strong demand for triple-A rated assets fueled the creation of securitized assets. The strong demand meant that investment bankers could find active buyers for what they created. The story is consistent with many of the empirical facts that we have prior to the crisis.

The crisis came but it did not take the form that the global imbalance story-tellers were expecting. The crisis would come because a sudden stop of investor demand would force the dollar lower and and drive interest rates higher. This would require more savings in the US. The higher rates would also attract more savings. The crisis would be a collapse in the status quo of dollar funding by the rest of the world in current account surpluses.

The reality is that the crisis led to a dollar shortage and a scramble for safer assets. There was nor sudden stop. The current account improved because of a slowdown in buying as US consumers began their deleverage but there was no asset pricing crisis against US assets. The demand for safe assets changed from triple-A rated ABS to Treasuries but there was still a strong demand for dollar assets.

Our current understanding of how the global financial system still needs significant adjustment the global imbalance story may still be relevant but needs further refinement.


Great Moderation and Great Recession are they related?

The post-'85 period until the credit crisis has been called the Great Moderation. The standard deviation for GDP fell significantly. We went from period of calm to the big fall-out with the recession, yet we are still seeing forecasts for relatively stable GDP and little dispersion in forecasts. The market fell but it is not clear there will be a reversal of the great moderation. Is this luck or good policy? We know that policy has not worked given that we had the surprise credit crisis, or did it? We willingness to have strong activist Keynesian policies tied with better macro information may have credit downside protection in GDP. This has created the moderation in the GDP standard deviation. However, a smoother GDP as evidenced by the Great Moderation may have actually increased the risk of a crisis.

The contradiction that more stability creates more risk is the essence of the Minksy approach to crisis. We have reduced perceived uncertainty which meant that more risk-taking was done during the last ten years. More leverage occurred in the global economies so that when a crisis did occur, the impact became larger. Risk taking is again increasing because the response of governments was swift which places a floor on the downside. We continue the cycle.

While the Great Moderation has been viewed by many as a function of good luck, the policies used further enhanced the Moderation to allow for more risk-taking.

Defining terms - recession or depression

From the FT Alphaville, this week's "Brunch with Dave", Dave Rosenberg of Gluskin Sheff:
Now what makes a depression different than a recession is that depressions follow a period of wild credit excess, and when the bubble bursts and the wheels begin to move in reverse, we are in a depression. A recession is a correction in real GDP in the context of a secular expansion, which is what all prior nine of them were, back to 1945.
But this was not a mere blip in real GDP — it is a post-bubble credit collapse. This is not a garden-variety recession at all, which an economic downturn triggered by an inflation-fighting Fed and excessive manufacturing inventories. A depression is all about deflating asset values and contracting private sector credit. In a recession, monetary and fiscal policy works, even if the lags can be long. In a depression, they do not work. And this is what we see today.

This is more than an interesting distinction but important for defining what we should expect for 2010. Some countries may be in a recession while others where in depression. Call it the Great Recession, credit crisis, or a depression there is a difference in what policies will work and not work.

We are not looking at a over-production and inventory adjustment problem. This crisis has been focused on solving a deep seated adjustment in credit expansion and over consumption. We have taken rates down to zero and added over a trillion in stimulus between the Bush plan in 2008 and the Obama plan in 2009. Of course, there has been some effect on minimizing the down-side, but that policy of stopping the worst downside is also different than creating a sustained recovery.

Simply put, the headwinds of higher delevering and adjusting balance sheets cannot be solved by increasing the opportunity for more credit and borrowing more money in the public debt markets. With the real economy trying to adjust balance sheets and delever, we will see some asset markets inflate from all of this stimulus money. Who will that help? Wall Street.

We have to accept that this process is going to take time and require more savings to pay-down debt. The savings is not going to new investments but to pay-down debt or maintain a safety net. Asking people to spend more through this process will not be productive. The problem for 2010 is that as private balance sheets are fixed through a pay-down in debt, the government is increasing public debt so the economy is still in dissavings.

There is no easy solution. We can try another stimulus package but that just shifts consumption forward. We can try to increase exports to capture the growth in other parts of the world but that requires a lower dollar, but other countries are trying the same thing. All developed countries are in the same process so all are competing for the same markets and savings. This is a gloomy forecast, but one that has to be accepted. we are not in the same old recession.




Sunday, January 10, 2010

Asset bubbles and monetary policy

One of the critical issues during this period of easy money around the globe is whether there are speculative bubbles forming in asset markets and how the central banks will address them. There are two opposite camps. The ECB would be the in the "bubble activist intervention" camp. Watch the markets and take action if the markets move to extremes. The Fed has been in the opposite camp of stating that their role is clearly defined and that stopping speculative bubbles is not one of their priorities.

This has been a recurring topic with little progress in finding ways to address the problem. There still is no clear definition of what it means to say that a market is in a bubble. The US market has recovered handsomely since the lows in March. Is that a bubble. The move has been a clear extreme. The Chinese stock market has increased 90% since its lows, but it is still below former highs. Is that a bubble? Is housing in a region in a bubble? Can sectors of the financial markets be in a bubble?

Those who have studied bubbles have found that they follow a very set pattern, First, there is displacement or a shock to the system. It is a change in the status quo that is not easy to understand or has not been seen often. the The shock leads to a narrative to give a reason for why investors should follow the market. For example, there is a new new thing. There is a productivity shock. There is a change in the oil market.

During this process, there is easy access to cheap credit so that the cost of borrowing is perceived to be much lower then the expected return. The easy credit allows prices to move higher which leads to a positive feedback loop. If there is a shock that is different, it is hard to tie the shock to some valuation. Hence, a positive feedback loop can form. The price rise is consistent with the narrative that is being provided in the market. This would be a period of euphoria which may finally lead to revulsion. the revulsion occurs when credit is not as plentiful or prices do not rise as much as expected. It is harder to push the market higher. There is less momentum so that the story or narrative is questioned.

Notice that the stories that are used to explain the shock must be plausible; therefore, it may be hard to identity the bubble. Those who suggest there is a bubble will be branded as using old thinking or told that this time is different. The pressure to confirm with the positive feedback will be strong, so an idea contrary to this old way of thinking will be hard to present.

The simpler way to stop bubbles is not to allow the situation of free money to exist. if the cosy of borrowing is positive, then there will be a cost with following any narrative that suggests we are moving in one direction.

Should the central bank try and control asset prices? No, the focus should be not allowing excessively easy credit to exist. One measure of the excess credit story will be through following the activity of the asset markets, but there is no good reason to try and determine what bubbles exist and then use the blunt instrument of monetary policy that will affect all market sectors as a way of solving the problem.

Bernanke the apologist - monetary policy matters

The discussion on the AEA speech given by Ben Bernanke on the cause of the housing crisis. is very important for understanding the current policy environment The conclusion by Bernanke is that the regulatory environment or the lack of regulation was the main cause for the housing price bubble. This is in contrast to research by John Taylor of Taylor Rule fame who concludes that the Fed funds rate was too low during the 2002-2004 period. The low Fed funds rate or easy monetary policy caused buyers to take on more leverage and risk in the housing markets. If the real rate is consistently negative, there will be a desire to use the cheap money. The low rate environment fueled the speculative excess. Bernanke says no.

His argument is simple. The Taylor rule is subject to estimation error, or put differently, it is subject to a range because the inflation expectations are not precise. Use a different inflation number and you will get a different equilibrium fed funds rate. The Fed did not get it wrong because there use of the Rule or the interpretations of the facts was different at the time. In real-time using the Fed forecasts for inflation, there was a policy that was supportive for the economy but was not excessively easy. You will have to look to other causes for the housing bubble which leads to the regulatory theory.

Of course, we had housing bubbles in other countries that had easy money but that evidence seems to be dismissed without careful inspection. We also have the fact that even Alan Greenspan was an advocate of adjustable rate mortgages which made sense for many buyers who wanted low monthly payments and expected that the low interest rte policy of the fed would continue for a long time. This is not a regulatory issue. of course lax regulation was a contributor, but could lax regulation explain a bubble in a tight money situation? The counter example suggest that money was a contributor. Given that the current chairman was actively involved with the decisions of the easy money period, it would seem natural that the first reaction would be that the fed did not get it wrong.

So why is this important for environment today? We may keep rates close to zero in an effort to get the economy back on track and stop the deflationary expectations in the market. This is the same rationale given for low rates in the last recession. I am not saying that low rates are not needed, but reviewing the chairman's thought process will tell us whether he is willing to hold rates lower for a longer time period. The answer seems to be that the error will not be with monetary policy that stays easy for an extended period of time. Keep money easy and work the regulation and supervision angle to solve any excesses in the economy.

Adaptive decision making - the battle of intuition versus rules

I have a bias toward systematic investing. I like the discipline with this approach. It provides structure that works well yet there is a high degree of uncertainty. Rules provide guides for behavior. Rules control behavior and the potential for excess or mistakes.

Nevertheless, there still is a fair amount of intuition that is used with any model-based system. Data has to be gathered and processed. Some data is used other is discarded. A theoretical framework needs to be employed to determine what should be the appropriate output. Models that do not make sense have to be discarded.

You also have to know how to translate forecasts into decision rules which will size positions. Good forecasters do not always make good traders and good traders are not always good forecasters. You do not have to be right all of the time or even 50% of the time. You have to admit being wrong and scale trades according to the certainty at the moment.

Even if you have two modelers who have access to the same data, the models could be substantially different. This related to the expertise or knowledge of the developer. There is a lot of subjectivity with model building, yet there is little work discussing how intuition is used in decision making. There has to be adaptability with decision making. some would also say you need a naturalistic approach based on the environment and the level of experience faced.

One of the best researchers in the area of adaptive decision making and the the use of intuition is Gary Klein. He is not an academic but a consultant who has been on the front-lines of trying to make professionals better decision-makers. His work is powerful and important in any discussion of how real life decisions are and ought to be made. I was naturally interested when I saw that he had a new book published.

His new book, Streetlights and Shadows: Searching for the Keys to Adaptive Decision Making, may be the culmination of all of his thinking on the development of decision processes. It is not so much a theoretical piece then a response to all of the processes that have been tried to help make better decisions that may be wrong. He discusses ten claims on how to make better decision which he shows are either wrong or have some strong flaws. all of the claims make sense. All of the claims most would agree with, yet Klein suggests that many are wrong or need to be tempered.

I will go through the list of claims; however, you will have to read the book to find out the particular problems with them.

1. Teaching people procedures helps them perform tasks more skillfully. Everyone should agree with this one, yet only emphasis on process will not improve many decisions.

2. Decision biases distort our thinking. Of course, this is the foundation of behavioral finance,yet we need simple rules of thumb to help simplify our lives.

2a. Successful decision makers rely on logic and statistics instead of intuition. Logic helps but sometimes shortening the process also improves decisions.

3. To make decision, generate several options and compare them to pick the best one. Again, we have to develop our decision tree, yet good decision-makers often do not run through this process. They recognize a situation and move straight to an answer.

4. We can reduce uncertainty by gathering more information. No, more information may not always help us especially if we have to make a situation under a time constraint.

5. It's hard to jump to conclusions wait to see all of the evidence.

6. To get people to learn, given them feedback on the consequences of their action. No, we may need feedback on the consequence of our thought processes.

7. To make sense of situation we draw inferences from the data.

8. The starting point for any project is to get a clear description of the goal.

9. Our plans will succeed more often if we identify the biggest risks and then find ways to eliminate them.

10. Leaders can create common ground by assigning roles and setting ground rules in advance. Sometimes the mind meld of different ideas will be helpful.

Even for a quant. Or, more importantly for a quant, there is a need to think about the role of intuition in the decision process.

COFER numbers show same trend

The central banks around the world are continuing to reduce their interest in dollars as depicted in the latest IMF COFER data. The dollar represents 61.65% of the total from 62.82% in the second quarter.The dollar reserves are higher but the overall increases was greater. Now there is some impact from the change in exchange rates but the data suggest there is no change in the long-term trend. Central banks are not getting any return on their money so it is not surprising that there is little desire for the dollar.

The EUR and yen both saw increases in exposure but there is further diversification across currencies which is another continuing trend.

So where is the good news in the employment numbers?

Yes, employment fell even thought the market expected better numbers and other indicators of the economy are suggesting a recovery. Employment is lagging indicator but the market was expected better.

What is very disappointing is that labor force participation has declined from 65.4 to 64.6. 1.3 million have left the labor force since July. This may be the reason for why the unemployment is only 10%. Workers are leaving the labor market. They did not disappear and they are not dead. They just do not have any opportunities. This will weigh on the labor markets just like inventory. If the economy starts to again, these workers will reenter the labor force which will keep the unemployment rate from falling. What is also discouraging about this number is the participation rate for young people. There are no jobs for new entrants to the labor force.

There also is no good news out of the EU. Their unemployment rate has increased to 10%. What is most disturbing about their numbers is the dispersion in the unemployment rate. The lowest is the Netherlands which has a 3.9% while Spain has a rate of 19.4%. Unfortunately, there are no monetary policies that can help with this adjustment because it is "one size fits all" through the ECB. Depreciation of the exchange rate is not a tool that is available to help on the employment front.

Commercial real estate unhealthy

Office vacancy rates have hit 17% which is a 15 year high. The effective rents have fallen 8.9% YOY the greatest since 1980.

Hotel occupancies are at 45.5% which is nothing to get excited about. Hotel foreclosure sin 2009 were up over 300 percent from 15 to 62. Hotel defaults were up over 450 percent from 53 to 307.

Apartment vacancies have hit a 30 year high at 8% as measured by REIS. Asking rend have fallen, the largest drop since 1999. The effective rents have also by 3% for the year. The census bureau states that the vacancy rate is even higher ta 11%.

On top of the commercial problem, Boston Fed president Rosengren thinks that mortgage rates should increase by 75 bps once the Fed stops their buying program at the end of first quarter. They bought over 3/4 of the paper that has been issued. The pressure to raise rates when there is not the Fed buying will be very high.

There is no good reason to hold commercial or residential mortgages at this time. Additionally, REIT's will have significant downward pressure in this market. The spillover to smaller banks where more of the commercial loans are made is also significant.

Thursday, January 7, 2010

Agentina central banks fights for independence

The president of Argentina fired the head of the central bank for "misconduct" because he refused to hand over a portion of the central bank reserves in order to pay-down debt. this will be an important test for the independence of the central bank which may be one of the most credible institutions in the country. A judge on Friday reinstated the central bank head, Martin Redrado, and temporarily blocked the plan to use the reserves to pay-down debt.

There is both a political and economic issue in this fight. The political issue is whether the president by decree can take some of the central bank international reserves. The reserves would be used to pay-down high interest rate debt. The objective of paying down the debt is to regain access to international capital markets. The economic issue deals with how foreign debt will be paid down. The usual method would be to raise revenue for the pay-down through higher taxes or cuts in other spending. Since Argentina is running a budget deficit, the choices are limited. The objective of the decree would transfer central bank wealth to the government to make the pay-down without using taxes. Now it may make sense to use reserves which are only receiving a low interest rate to cut the cost of high deficit, but the international reserves are their to protect the currency from a sudden change. The size of the request was $6.5 billion out a reserve pool of $48 billion, but it would set a bad precedent.

Surprisingly, the market has not reacted stronger to this information. The situation is in a state of flux but it shows what can happen when sovereign debt problems become more difficult.

BIS or US government who do you listen to if you are a bank

The BIS is calling top banks to Basel to discuss "excessive risk taking". They are worried that risk taking may be moving back to pre-crisis levels. On the other hand, the US government has been urging banks to lend more and reduce the amount of excess reserves. It should also be noted that the government wants banks to improve their capital ratios. Depending on who you talk to from government, you will get a mixed message.

So what should banks do? Exactly what they are doing. Hold a lot of cash. Be careful and increase transaction based business to boost profits. Play the yield curve which has gotten steeper and do not commitment to longer-term lending.

The result is tight credit for those who do not have other capital markets options.

So much for Yen overvalue

The new Japanese finance minister Naoto Kan said in his fist interview that he would like a weaker yen. Market has moved up above 93 from a low at the end of November at 87. Kan has talked with exporters and he must have gotten an earful. The exporters have been tired of losing business to other Asian countries.

Exporters are key to the any resurgence in the Japanese economy. The global economy is recovering and Japan does not want to be left behind because of an appreciating currency especially relative to China. Research, of course, states that the impact of price changes on export businesses is complex. The pass-through problem has to be looked at on a micro basis based on the competition of the products; nevertheless, the strong appreciation has hurt Japan. The size of the yen appreciation relative to other currencies suggest that talking down the yen will help.

Good case comparison from Dave Rosenberg


Some times you have to look beyond the numbers and conduct case comparison. This is especially appropriate if you are looking at business cycles because we just do not have that many occurrences of recessions. (Thankfully.) The table above provides a comparison with the '82 recovery with the current recovery. The early '80's saw the worst recession in the post-WWII period prior to our current problem.

The conclusion is that the environment is just not very good for a strong recovery. Every category looks like a problem.

Interest rates have nowhere to go but up.
Budget deficit getting worse with structural problems.
Inflation rising.
Misery index rising.

I could go on but you get the picture. There economy needs a game changer and there does not seem to be one. You have to be defensive in this environment and look elsewhere for opportunities then from being long stocks.

Sunday, January 3, 2010

Currency intervention- Pressure has been reduced with the dollar rally

From FT Alphaville:

"Morgan Stanley has knocked up some currency-intervention models to help guide you through the uncertainty.

These are based on the following four criteria:

(1) market mis-pricing of relative growth outlooks;
(2) significant deviation of the real exchange rate from historical trend;
(3) excessive market positioning;
(4) increased momentum in exchange rate moves."

What the dollar rally has done is take away a significant amount of the pressure for intervention. The currency markets now have a 5% cushion to retrace before central banks start to again have that nervous feeling that the dollar has moved too much. We have not explicitly followed this type of model, but we track many of the components that are used in the MS model.

We ask the following questions to measure the potential for intervention:

  • What is the momentum or trend in rates? Strong directional moves will be the catalysts for action even though it is called "excessive volatility". Range-bound high volatility will not get the attention of central banks.
  • What is the exchange rate direction central banks want?Excessive market positioning is code for carry or short-term capital flows. One way flows will more likely cause intervention by central banks. Carry will often push exchange rates in the direction that central banks do not want.
  • Are there significant deviations from fair value? Significant deviations from real exchange rates especially if the exchange rate is overvalued is a reason for intervention.
In the near-term we think the potential for intervention has declined. This may change if we again see dollar decline pressure.

Saturday, January 2, 2010

What are we doing to help liquidity?

Clearly, the Fed and other central banks have provided huge amounts of liquidity by adding assets to their balance sheets. These efforts have reduced the economic decline but the issue of liquidity is more complex then flooding reserves. The drinking from a liquidity fire hose does not solve longer-term problems of how markets and banks function. In fact, we still have the problem that banks will not lend. For example, the bank reserve addition does not directly address liquidity issues in the shadow banking system which has exploded through the ABS market.

Barron's had a good article in the December 28th 2009 issue called "A Flat Dow for 10 years? Why it could happen" describing the research work on liquidity by some leading economists. The conclusions now seem obvious; nevertheless, we now have to learn to find policies that will solve liquidity problems. Here are some observations on liquidity that I have gained from reading this literature. This is more than a banking issue since many loan products are now traded as securities.

  • Leverage will have a real economic impact. However, what drives institutions to take levered trades is less clear. Lack of regulation may be one part but not the whole story. Think of China where there is a strong state run system that is having a property and leverage boom. Leverage is a function of what abks perceive as the risks. The environment matters and if the government sends signals or behaves in a manner that suggests thatere is limited downside risk, more leverage will be taken on by the market.
  • The shadow banking system and securitization is fundamental to the working of credit markets. Lending is not just a banking activity. Hence, regulation between banks and securities has to integrated.
  • Just because something is securitized does not mean that it is a liquid security. Similarly, just because something has a triple-A rating does not mean that it is liquid.
  • Liquidity spirals are a problem. Whenever there is a capital call in one market, there is the potential for a ripple effect into other markets. The raising of capital in one market will require the selling of more liquid securities.
  • The selling of some securities will lead to more selling if there is a price effect. Feedback effects are real. Price pressure even temporary can lead to liquidity crises.
  • Liquidity is related to the level of information that players have in the market. Less information means less liquidity.
  • Skill effects the liquidity of securities. If the valuation of security requires skill, there will be less liquidity.
  • Simple securities will always have more liquidity than complex securities.
  • Complex securities will require a liquidity premium independent of its level of specialization. More specialized or customized securities require more liquidity.
  • Confidence effects liquidity. If there are loses in a type of security, there will be a loss of confidence which will affect the willingness of investors to re-enter the market. Hence, there will be a loss of liquidity.
  • More data and information on securities will increase the level of liquidity. Data is a public good that helps all market participants even though it may hurt profits for a given market maker.
  • Liquidity will affect arbitrage opportunities. Arbitrage will not take place without a premium if there is a the perception that there is less liquidity in the market.
Unfortnately, there has not been anything done to improve the liquidity in the markets by regulators. This does not seem to be an area of concern.

Quotes to start the new year

There is nothing so disturbing to one's well-being and judgment as to see a friend get rich.
- Charles Kindleberger
The great research on financial panics always had greater insights on the human condition. 2010 will be a period where envy may get in the way of good economic policy. But then that has usually been the case.

Ignorance more frequently begets confidence than does knowledge.
- Charles Darwin
This can explain some of the winners of the Darwin awards.

Panics do not destroy capital. they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.
-John Stuart Mills
This may be one of the best single comments on the impact of panics.

There is only one difference between a bad and good economist. the bad one confines himself to the visible effect, the good economist takes into account both the effect that can be seen and those effects than cannot be foreseen.
-F Bastiat

The essential Greenspan legacy is the idea that the Fed will allow nothing to go wrong.
-James Grant
The Greenspan put is alive and well regardless of what government officials say baout moral hazard problems.


The superior man understand what is right, the inferior man understands what will sell.
-Confusius