Friday, January 28, 2011
Margin setting is an art as well as a science. It should more than cover a one day price move in the market, but it is set on a dollar basis. If volatility which is quoted in percent stays the same but the price of the commodity increases, the dollar value of a volatility will increase. Margin in dollars as a percentage of contract value will fall with rising prices. Hence, there is little choice but an action to increase margin. Nevertheless, increasing margin will make it more expensive to hold any contract. There will be reason to look for other markets to trade even if futures trading is the lowest cost alternative to access the gold market. Liquidation will occur, and it is less likely that a marginal buyer or seller will enter the market. If the cost increase and the marginal buyer is less likely to be found, the price will decrease.
If there is no increase in margin, the risk for the exchange increases. Volatility has been higher over the last year from lows in early September (for 30-day periods) although 100-day volatility has been relatively stable. Given a 17% volatility a one standard deviation move is about $1400. Margin will cover an over 4 standard deviation move. The fear is that volatility will be higher.
The concerns for business have to be balanced against the risks to the exchange. Buyers may flee but the system is more important.
Three speeds also applies to inflation with emerging markets seeing high price increases similar to their growth rates, the G3 still concerned about flat prices because of continued output gaps, and the G7 of the remaining developed world looking at prices in around their long-term targets or slightly higher.
Three speeds and no gear shifter available.
Thursday, January 27, 2011
Parts are made all over the world and may be assembled in one country. China may be the great assembler of the world. So what is the trade deficit? It could be the entire value of the good that is shipped or more rightfully, it should be the valued-added in production. In this second version, the trade valued-added by China is small. Profits are razor then and the deficit with China is not as large a problem as suggested. For example, we book the import of an i-phone for its entire value when the actually valued-added was small. Most of the value added came from design which was done locally. The trade numbers increase fear and makes many want to increase protectionism when trade should be further embraced.
A solution is to squeeze cash to invoke a change. The new president has asked cocoa buyers to stop their purchases to help oust the old president. Many traders have agreed to go along with this scheme. The result has been a very significant increase in price. This will not last, but the shock is real and will cause disruption in the supply chain.
You can guess the reaction in some parts of the country. Smuggling is on the rise. A one month halt will not have a severe impact on price , but a continued political battle may send prices off to the races.
Now, most of the indices say they have some production and or supply component to the changes in weights as well as liquidity criteria but it is hard to determine what will be the actually adjustments. We have presented just one index for review, the largest, DJUBS commodity index. Here gold is the biggest winner with a one percent increase in weight. Natural gas got cut while saw a bump up. If you looked at the GSCI weights there would have been some more significant changes. The Roger's index added some new commodity markets such as milling wheat.
Adaptation is important but these fluctuation in weights have a feel of arbitrariness. There is no one index that dominates and there is no one standard. There is a line between passive and "active" management. Changing weights, adding and subtract markets, can all be viewed as forms of semi-active management.
|DJUBS commodity index change|
If you believe this story, you have to think of commodity investing as opportunistic. When there are supply shortages, be long. When the shortages are eliminated be short. Holding long-only commodities under the idea that there will be a long-term positive risk premium does not make sense.
Can the IMF and the new FSB or Financial Stability Board provide the right guidance? There seems to be some clear priorities with governments and regulators on where there focus will be:
- Maturity mismatches - the bread and butter of banks. Lend long and borrow short. If you change how this is done, the channels of monetary policy will change.
- The links between big banks and other financial institutions. This will effect all financial innovation because many of the advances in finance have come outside the traditional banking model.
- The shadow banking system. Financial intermediation grew because banks were not able to service clients needs. This area should be under closer observation but not dominated by the vested interest of established banks.
In the first case, we are seeing lower inventory levels relative to consumption or use. The level of inventories are low relative to historical numbers. This is not the case for all markets and many markets still show contango which suggest that inventories are plentiful. But the key markets seeing the highest gains seem to be having backwardation in contracts. Second, there is a strong demand shocks which will not be just a temporary shift. The demand shock which is the real driver for the super cycle is coming from the increase in the middle class for emerging markets.
The story of stronger commodity demand is a play on emerging markets. The super cycle is that this demand will not go away quickly because it represents the explosion of a growing middle class which is unlikely to move back to poverty. From the Euromonitor and Morgan Stanley, households with disposable income over $10,000 in the BRIC's now outnumber those in the US, over 100 million. These middle class households will now outnumber those in the EU by the end of this year. Middle class households in China will exceed the number in Japan and will exceed the US by 2014. Middle class is defined as household disposable income above $10,000.
Auto sales in BRIC countries exceeded the US in 2008. The gap is only getting larger with annual sales over 20 million unit versus between 10-12 million in the US. PC unit sales in China increased 13.1% in 2009 versus 2.2% in the US. Income distribution is changing from low income to something more balanced across different income groups. In less than 5 years P&G sales to developed countries have increased from 23% to 32% of the firm total, an increase from $13 billion to $25 billion. Household debt to GDP in many of these countries is below the average for developed countries. The purchases of goods is for cash. If there is more consumer credit, product demand will show further increases.
If you want to call this a super cycle, go ahead. The tailwinds to higher commodity prices are strong.
Wednesday, January 26, 2011
- Increasing US debt /GDP - The average debt/GDP for '60-'07 was 36%; in 2010 the debt/GDP reached 62%. The numbers should hit above 100% before 2020. The key level of 90% debt/GDP has been used by some economists as the threshold where there is a significant drag on growth, (See work by Rogoff and Reinhart). The debt burden is rising, but savings is also increasing in the US. Nevertheless, the size of the rise in debt is unprecedented so past studies on the sensitivity of debt to GDP may not seem relevant. Analysis of other countries which have had deficit problems seem more appropriate and this suggests that there is a higher risk premium in long Treasuries.
- There is an increase in inflationary expectations. Forward rates for 5-year inflation has increased from 2% which was the long-term core inflation target to 2.90%, a 90 bps rise in just a few short months. The increase in longer-term inflation may be key reason for he steepening of the yield curve.
- There has been reduced Treasury demand by foreign buyers. Foreign investors were buying 55% of Treasuries during the fourth quarter of 2008 and have moved to 34% in the most recent numbers. Of course, the strong buying was during the period of flight to the dollar based on safety but the size of the deficit has continued to go up and the demand for safety has passed. Investors are looking to diversify but the link between buying and rate changes is unclear.
- The dollar index have declined to pre-crisis levels. There has not be a strong fall in the dollar and recently there has actually been a rally, but there is a greater potential for dollar decline given the continued savings and debt imbalance. Rates will have to go up to attract capital and allow for a stable dollar.
No one could compete with the debating skills of Keynes. He was a master of language . Hayek, a non-native English speaker with a German thought process, could not win he popular debate. Low interest rates coupled with excessive credit will lead to the misallocation of resources which, in turn will lead to bad decisions and economic failure.
The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.
Tuesday, January 25, 2011
Looking at the simple 2% inflation rule suggests that long-term growth will be about 2% with some room for a risk premium. By this measure the current yields seem to be reasonable. If growth or inflation come in higher, there is actually room for this spread to get wider and for long rates to increase even more. Any flattening may come from the front-end moving higher. If you are in the high growth camp with controlled inflation, there is more bad news ahead for the bond market.
The new paradigm of slower growth and the potential for soft price increases suggests that a rally is ahead. Inflation coming in below 25 with soft growth will mean lower yields.
This is the bond world of two extremes and is one reason for the high volatility. Any change in the marginal investors to one camp or the other will lead to a wild bond price swing.
The tie breaker is the pull of fiscal supply. If the economy does better, here will be a increase in demand for private funding. Pressure will build in the interest rate markets if there is not a decline in government spending. On the other hand, if growth is slow, there will be continued high budget deficits which will provide a headwind from allowing rates to move lower. In all cases, a loanable funds story suggests rates are going higher. Certainly higher growth will mean a decline in savings which again will place pressure on rates.
Though the battle of the two extremes will continue, we still argue that there will be longer-term bias toward higher rates.
Saturday, January 22, 2011
Iceland serves as an interesting comparison with Ireland. Both had severe banking collapse but each was handled in a very different way. This a good experiment of policy differences. Bail-out in Ireland versus no bail-out in Iceland. Devaluation in Iceland versus deflation in Ireland.
In the case of Iceland, the banks were allowed to fail, the currency depreciated, and the economy took a major hit. Debt-holders of Iceland banks were left with nothing as expected in a bankruptcy. Ireland, on the other hand, decided to enlist help and bail-out the banks so that debt was shifted to the taxpayers. The debt burden was not decreased. Hence savings would have to be increased and growth would be cut in order to pay-down debt. The results has been a debt deflation spiral in Ireland versus a devaluation and cleaning of the balance sheet in Iceland.
Of course, the decline in Iceland was severe and painful, but it seems that they have been able to get on with its economic life with a better balance sheet and a trade surplus. Iceland GDP fell by 15% while Ireland fell by 14%; however, Iceland has seen interest rates fall from 18 to 4.5% but the exchange rate has fall by 50%. The inflation rate is falling and unemployment is declining so the misery index of inflation plus unemployment is actually declining and less than Ireland.
Devaluation is tough medicine but has advantages going forward versus switching private debt to public debt and fixing the exchange rate.
Thursday, January 13, 2011
Wednesday, January 12, 2011
Tuesday, January 4, 2011
The monetary policy issue of 2011 will be the timing of any end to asset purchases. The Fed will have to find a glide-path for cutting purchases at the exact moment when the economy ill be able to stand on its own and not return to recession. The current view is that economic growth is not sustainable or at best growth cannot be at a pace that will significantly reduce unemployment. The output gap cannot be closed in a manner that will help employment.
The Taylor Rule does not show any signs that tightening should occur so the economy will continue to depend on asset purchases.
Appearing on ABC’s This Week, Austan Goolsbee spent the hour noting the implications of a failure to pass a raising of the debt ceiling.
“Well, look, it pains me that we would even be talking about this,” Mr. Goolsbee told co-host Jake Tapper. “This is not a game. You know, the debt ceiling is not something to toy with.”
Mr. Goolsbee explained that any chance of failure to pass an increase would amount to a default. “If we hit the debt ceiling, that’s essentially defaulting on our obligations, which is totally unprecedented in American history, ” the chairman said.
The idea that it would pain someone from the government to talk about hitting the debt ceiling is an interesting choice of words. Is the pain coming from too much deficit spending or the fact that we have a debt ceiling? (It has been making the political rounds that Senator Obama voted against raising the ceiling in 2006.
The debt ceiling issue can become one of the key sovereign debt concern for the US. It is supposed o provide some constraint on debt spending because Congress is unwilling to constrain itself. But like many self-imposed constraints it is not binding. "I promise not to eat cake as a new year's resolution until someone gives me a piece of cake."
If government resources are considered common property, special interests can finance expenditures on preferred items. The overall debt will be higher will net transfer payments which will ultimately ed to higher taxes. A debt ceiling an be used to break this fragmented fiscal policy. (Described by A Valasco of NYU and the NBER.)
Special interests, of course, will argue that you cannot play chicken with a binding constraint. The special interests may also include all taxpayers. The issue is whether this is a special situation given the recession. The large deficits were, in part, counter-cyclical policies to minimize the cost of the down-turn. Under this case, a rise in the ceiling may be warranted; however, the recovery has been going on since June 2009 so how much longer should we expect debt increases? If the ceiling is raised then the issue is just pushed forward to another date.
How long should this go on?
There is little that can be done about this. New tax credits will only shift the loses to taxpayers. Rates are rising so cheap mortgages are not likely to help. Inflation would be helpful for homeowners but not at 2%.
This housing market is what we have seen in other countries when there is a balance sheet or financial recession. A recovery takes time.