Monday, May 30, 2011

Reasons for higher commodity prices

After a poor month of index return performance, the story for being long commodities should be revisited. There are five stories for why commodities will go higher and one major story for a continued downturn in commodity prices.

The rationale for higher commodity prices -

The long-term cycle -

The long-term up cycle for commodities is based on emerging market growth. This growth is still dominate for commodities. The improvement in wealth has changed the diet for many in these countries. The increase in overall GDP growth has increased the demand for building materials, energy, and foodstuffs. The growth in the EM middle class is significant and surpassing the size in the US. The marginal buyer of commodities will not be the US or other developed countries but will be the BRIC countries, and non-OECD countries.

The lack of long-term investment in mining agriculture and drilling has meant that supply will not be able to meet the current upsurge in demand. While this is not a peak-oil type story, the cost of finding, extracting and growing commodities has increased significantly. There is a lag between price increases and investment in commodities. There is also a lag between the investment and actual production. Higher volatility has also reduced the amount of investment in many commodities. Higher uncertainty will reduce long-term investments. Finally, in the case of agriculture there is less land available for production and the cost of inputs such as water have increased significantly

Even if there is a slowdown in growth in such countries like China, its overall size will still have an impact on commodities that did not exist even three years ago.

The natural business cycle -

The business cycle has turned up and commodity prices will increase with the surge in global growth. History has found that commodity prices have peaked late in the business cycle and the length of the current recovery is still relatively early. By this simple measure, there should be a room for significant increases in commodity prices.

The monetary policy cycle -

The aggressive easing by the Fed has lead to significant declines in real interest rates. The negative real interest rates have been good for the commodity markets. Analysis finds that negative real rates leads to more purchase of commodities because the cost of holding commodities has decreased. Easing monetary policy also leads to increases in inflationary expectations which will also increase the demand for commodities. A successful monetary easing will also increase overall economic growth which should have a positive increase on commodity demand.

The bubble story -

Tied to the monetary story is the idea that at low cash rates, there is increased demand for risky assets. This demand has gotten out of control and has pushed commodity prices to levels associated with a bubble. The markets have been pushed to higher levels given this unusual demand for risky assets and the lack of any return on cash assets.

The bad weather story -

Many commodity markets have been faced with bad weather which has affected the ability of commodity producers create or generate supply. The global drought in many agriculture markets have been matched by floods in other geographical areas. The poor weather has pushed prices to high levels given the low inventory to usage for many commodities.

The rationale for lower prices -

The false growth story -

The potential for a sustained decline in commodity prices is based on the false growth or recovery story. Reduced fiscal stimulus, ineffective monetary policy, and poor balance sheets in the developed world makes for a slow growth environment and a high likelihood for a double dip recession. There is a strong group of economist who are negative about prospects for the economy. However, the general consensus is that growth will actually increase in the second half of the year, but there do seem to be strong headwinds against a robust growth story.

The long-term trend in the dollar is down

The dollar has had a nice bump higher, but the long-term trend for the dollar is still lower. This is a trend that has been occurring since the mid-1980's. There are four reasosn for the strong negative trend and there is little that the US can do to stop this process.

The ascent of emerging markets -

The growth and wealth creation engine has moved to emerging markets from the developed world. A key catalyst was China joining the WTO in 2001. China joined the global economy. India joined the global economy and a host of other nation have improved their competitiveness relative to the rest of the world. the result has been higher growth and wealth creation that is almost unprecedented on its speed and size. The non-OECD countries now represent half of global GDP. Emerging markets are running trade surpluses relative to the developed world and productivity is improving for their export goods. Factor equalization is occurring.

The US can improve its trade and increase its exports with a dollar decline and productivity increases, but the trend for GDP to be generated in non-developed countries will not change radically. Trade between countries away from the US is also increasing which means that dollars may be less likely needed.

The end of the "Washington Consensus" -

Policy solutions and economic liberalism will not be coming from developed countries. The EM are looking to find alternative policy approaches. The idea that the World Bank or the IMF will call the shots on international financial policy has ended. This is simply a matter of voting blocks. The EM will have more votes on the IMF. The developed world and the US will have less, so coalitions without the US may be able to be formed. There already is the view that EM will not be dictated policy in a crisis like in the 90's. This means it will be harder for the US to impose its policies around the world.

The end of dollar "exceptionalism" -

Central banks around the world have moved to diversify away from the dollar. There has been a general move to hold more Euros, but this has not been an easy choice given the sovereign crisis. It has meant that gold is being purchased by many central banks. Certainly, there is less reason to sell gold from central bank vaults.

The global imbalance -

The US will continue to be a major net debtor.The EM will be major net creditors. The imbalance is being reduced but will still require structural changes which are not dollar positive. The dollar will have to decline to allow for trade improvement. US savings rates will have to increase which means that growth will have to be slower relative to other countries. In this world, the US will be less likely to take currency leadership role.


The dollar will not always go down, but the economic power structure means lower US dominance - a multi-polar finance environment.

QE2 ending may lead to more uncertainty

QE2 is expected to end in a month, but there is still high uncertainty on the potential market direction for the summer given the macroeconomic environment.

There has been a close link between quantitative easing and stock prices. Since the announcement of QE2 last August, the S&P 500 has gained almost 30 percent. A similar gainwas associated with QE1. The dollar has been in decline with the bond purchases from the easing until this month. Strong monetary stimulus lead to a dollar sell-off.

Now we have a more complex risk-on environment. Stocks have moved sideways. The dollar has recovered losses, albeit partially due to Greek problems, and bonds have rallied. With greater certainty that QE3 will not come, the dollar strengthening, lower rates from declining inflation fears, and a more complex equity market seems like the right story. This no monetary stimulus story seems to have taken hold of the market, but the simple risk-on tale is not so easy to deal with given the current economic environment.

Economic growth for the first quarter was only 1.8 percent and the latest economic news does not show that we will have a fast acceleration in the economy. Housing is still a problem and the potential for a fiscal crisis with the debt ceiling vote is real. There may be a need for monetary stimulus given the lack of fiscal help and the fact that core inflation is still very modest. We know there is no QE3 now but the possibility may exist if we see slower economic growth. Without clarity on policy, there will be a monetary ease overhang. Bad numbers, possible help from Bernanke. Good numbers, no help. The dual role of the Fed generates more policy uncertainty.

The ECB crisis and Greek debt

The key to problem-solving is determining who has the problem. The EC and many finance ministers in the EU would like to see a reprofiling of Greek debt. A reprofiling would extend maturities of the existing debt which could also be called a soft restructuring or default. The problem arises with whether the ECB will take reprofiled bonds as collateral. This will have major ramifications for any restructuring. In short, reprofiling will not work if the ECB will not take the bonds as collateral. The ECB is saying that the banks and fiscal authorities will have to find the solution that works.

With inflation above target, there are strong reasons for why the ECB does not want to be in the bail-out business. The ECB has also not bought any bonds for the ninth week running. This was part of their "QE program" to help out during the Eu debt crises; however, it seems to sending clear signals that it is not going to be accomodative of monetizing bad debt.

The Greek problem is not going away

The dollar should continue to see a slide given the overall global economics, but we have seen strong gains against the Euro because the EU debt issues will not go away. Greece credit issues have not been solved and may get worse without another bail-out. The market is pricing more risk with CDS spreads. The Greek credit rating has moved from A- in January 2009 to B this month. It was BB- in March of this year.

There is over $50 billion euros that will be maturing in the next 18 months. Tax revenues are down so costs cannot be covered even with the austerity programs. Greece is in a fiscal death spiral that even selling assets will not help.

The simple problem is that European banks as the some of the largest holders of Greek debt cannot take the losses. Moody's suggests that the European banks hold about 95 billion euro in reek debt, but the real problem will occur if there is a contagion to other debt-ridden countries. German banks, for example, hold $34 billion in Greek debt but also $36 billion in Portugal, $44 billion in Belgium, $118 billion in Ireland and$344 billion in Italy and Spainish debt. European bank stocks have been hit and trail the general stock market. They will not be able to raise capital.

There is talk that the Greek debt will have to be restructured which the rating agencies will view as a default, but in Europe there cannot be a default. We will have to call it a "reprofiling". Reprofiling is still a default and this is where we are going.



IMF voting shares and the managing director choice

The choice of IMF head has not been made but signs are pointing to the Christine Lagarde, the French Finance Minister is the leading candidate. She will likely get the job, but the real question is whether she deserves the job given the changes in economic power. The number one issue for the IMF is the Greece problem and the other sovereign risk in the EU. The EU needs to have a IMF director who is European-focused. Someone who understands their special needs. Certainly that was the case after WWII when the focus of the IMF was on the rebuilding of Europe. This issue is whether have a European focus makes sense today. The IMF will not be unbiased if the another European is the head. If voting shares were distributed by GDP, a European would not be the managing director

The EU represents only 20% of global output on a PPP basis. Places like China and India are way under-represented with voting shares. There have been voting share reforms but there is a huge difference between share of GDP and votes. The fastest growing region for receiving credit is western Europe. It does not make sense that the disproportionate voting also receives good terms for bail-outs. The sovereign risk of the EU has to be addressed fairly and that may mean stricter terms for credit.

Learning from prices - issues of complexity

Learning is supposed to occur with public release of macroeconomic information. A public release of information with have a direct benefit of providing new information on the economy. The unemployment announcement tells us about macro well being. But there can also be indirect adverse effects on a microeconomic basis concerning the loss of efficiency from price system signals. At times, this negative effect may dominate the positive gain of public information release. This is the result of a recent paper by Manuel Amador and Pierre-Olivier Weill in the Journal of Political Economy, "Learning from Prices: Public Communication and Welfare".

A simple example may be the information contained in the unemployment numbers. Clearly, the unemployment rate is high and does not look good for economic growth prospects. However, a portion of the unemployment is not due to just poor work prospects. Some of the higher level is associated with changing demographics. The natural rate of unemployment may have increased over the last few years. An announcement that shows the unemployment rate high may actually generate confusion for the economy relative to what is being told with actual prices. For example, some labor markets are showing tightening ans survey data suggest that the economy is doing better even with the recent plateau in economic data. The unemployment rate may be sending a false signal which will cause a distorting in expectations. The information is released but but the quality is poor. A focus on single announcements can cause signalling trouble.

Friday, May 20, 2011

Quote of the day on education

Albert Shanker the late head of the UFT teachers union once pointedly said, "When shoolchildren start paying union dues, that's when I'll start represneting the interests of school children." from WSJ May 10th opinion piece by Joel Klein, "Scenes formthe New York Education Wars".

The educational system is critical for productivity increases and economic growth. The issue is whether the grwoth engine is from well-funded teachers or well-prepared students. The two may not be mutually exclusive, but it is not clear whether teachers and education objectives are consistent.

Thursday, May 19, 2011

Strauss-Kahn and the politics of the IMF


Strauss-Kahn has resigned as the head of the IMF and there are far reaching implications that go beyond a sex case. The head of the IMF has always gone to a European while the head of the World Bank has been gone to a US choice. Now the abrupt change requires a new head and the creditor countries (emerging markets) have been clamoring for a the head of the IMF to go to one of their own.

This change in power structure results from the change in global financial power. When the World Bank and IMF were organized at the end of the WWII with the Bretton Woods Agreement for fixed exchange rates, the US was the dominant creditor to the world. The fixed rates of Bretton Woods are gone and the US power as a world creditor is gone. The developed world does not have the power to dictate the direction of global financial policy. Hence, the power structure has to change.

The only reason a wholesale change will not occur is that the emerging markets cannot agree on who should be their new representative. Most likley someone from a BRIC, but there is little agreement on who could fit this role. More importantly, it is not clear how a non-European will deal with such issues as the Greece or a bail-out of an emerging market country. Additionally, how much pressure should be placed on the US and their large imbalance.

Wednesday, May 18, 2011

Dollar rally for real?





The dollar bears took a hit from the dovish announcement that the ECB may be hold with raising rates on May 5th. Since that time, we have had a minor dollar rally. We have had these moves before, like the first 20 days of the year, only to see the market move back to the dollar down trend. Nevertheless, there has been more talk that there could be a dollar rally brewing.

This talk is driven by the anti-gravity school which states that what goes down must eventually go up. Unfortunately, there is little that is occurring in the US that will drive the dollar higher. Most of the gains in the dollar have been driven by negative news in the rest of the world.

We still have not pushed below DXY index lows. In fact, the argument that the dollar sell-off has only begun can easily be made given the range-bound behavior between 70 and 90 since the beginning of 2008. With all of the crisis issues and with all of the turmoil concerning the dollar it may easily be argued that the dollar has held up reasonably well.

What is clear is that many of the currencies that have had the greatest appreciation have been the smaller G10 currencies. SEK, CHF, CAD, and AUD have all seen more appreciation than the euro over the last two years. While central banks may want to diversify, they cannot get the exposures they would like in these smaller currencies. Private capital is able to make these moves. A similar story can be told for gold where private money and smaller central banks have driven prices higher.

what do we need to see to say there is the potential for a dollar rally. No QE3 and a run-off of the Fed bond portfolio. Fiscal reform with no debt ceiling default overhang. Fiscal reform means a cut in expenditures for entitlements but not a current cut in programs which provide a buffer from slow growth. A change in policies which generate investment profits.

Tuesday, May 10, 2011

The 1:1 debt ceiling spend cut swap

House speaker Boehner has laid-out what may be the most important government speech for 2011. In front of the Economics Cub of New York, the Speaker suggested that a dollar of debt ceiling could be expended for a dollar of deficit cuts. While this type of constraint would be unusual, there is past precedent for binding behavior. In fact, the only way to control behavior may be through a set of rules which limit activity.

An increase in the debt ceiling without any constraint on spending would mean that the debt ceiling would have no meaning. Any rules-based system has to have some penalty if standards or thresholds are breached. What some would like is a debt ceiling which does not have any consequences. If a new ceiling is hit it should be raised ago because the ill effects of not raising it would be so large. Taken to an extreme, the debt ceiling could be set each month and then raised each month if it is hit. If that would be the case, then there should be no debt ceiling at all. If the government cannot suffer any consequences and the market supposedly does not care, then it should be eliminated. However, the ceiling has been passed by the government in the first place to limit extreme spending behavior.

Reasonable constraints would be to require automatic cuts if the threshold is hit. Since that may occur at the wrong time, the alternative would be to tie cuts to a raise in the limit prior to passage. Since the debt ceiling is supposed to apply for a lengthy period, (in the extreme that should be forever), a cut in long-term spending in exchange for an increase would be reasonable.

The ongoing Greek problem

The choices for solving the debt crisis are actually very clear. Austerity or default. At some level as debt levels reach an extreme, the choice is singular, default. This case is simple. If the size of the debt is greater than GDP and the rate of interest is greater than the growth rate of the economy, all of the economic growth and then some has to be used to pay interest to bondholders. Extending maturities woud not help. Lowering interest rtes would be helpful but only if the rate would be below economic growth.

This extreme is where we may be at with Greece, but we will have to continue to play this issue out because the lenders have an incentive to avoid the default. The Greeks at this point may welcome default as an alternative to more years of austerity. There will be an adjustment but the would like to go forward in a different environment than what exists today. Taxes have to be paid and services reduced in order to pay bond-holders.

A restructuring is needed and bond-holders are going o have to take a hit. This could be pushed forward a little longer but the end result will be the same.

Monday, May 9, 2011

Commodity volatility, cascades, and margin

We should accept the volatility in market which is tied to specific events or announcements. When information changes, markets change. What is harder to take and more dangerous is the risk from price moves that are not tied to specific event or when a seemingly small event leads to a large change. This is what happened in the commodity markets last week.

Commodities were hit with massive sell-offs with strong declines in silver in energy. Everyone was talking about a silver bubble and the sell-off may have been localized because of margin increases, but the general price decline was unexpected. Analysts have to engage in the old game of trying to link news to a market event even if the correlation is tenuous. Nevertheless, we can still try and make a case for a commodity sell-off.

The slowdown in US economic numbers coupled with the lack of action by the ECB were the op stories in economic news. These could easily be argued to be at odds with a commodity sell-off. Clearly a sell-off in oil should be expected if there is a slowdown in global growth, but Libyan production has not been offset by Saudi pumping.

The alternative explanation is that markets are subject to cascades or massive changes in expectations which may feed on themselves. This seems a more likely explanation when a market moves to extremes. With speculative positioning moving to extremes, any small change in the cost of holding position will lead to profit-taking. This may have started in some commodity markets when margins were increased, but carried over to others under the believe that there will further increases in margin.

We could call the sell-off of May as the increased margin cascade. Margins are used to support the clearinghouse, but increases change the calculus of profit. Higher momentum is necessary to support the market.If that higher price action is not expected, profits will be taken and the sell-off will begin. The feedback loop will continue given the cost of trading has increased.

Saturday, May 7, 2011

ECB hold on policy unexpected

ECB president Trichet signaled that rates are on hold until after June. So much for the inflation fighter. The market has been expecting a rate rise to match the higher inflation in the EU. It is going to have to wait. The currency markets reacted immediately with the upward trend in the Euro reversed. Trichet stated that the ECB never "pre-committed" to change. He also did not use the words "strong vigilance" instead he stated that the bank is monitoring inflation "very closely".

After getting ahead of the Fed, with a rate rise, the ECB seems to be more closely following the view of the Fed that commodity prices may be peaking and that the increase in food and energy prices will slow in the second half of the year. If there is a slowdown, there will be less need to raise rates and place downward pressure on European economies.

Core Euro-region inflation is still only 1.3% which is very much in check, but the PPI is hovering around 6% and headline inflation is above the target rate. Given the often loose link between rate changes and inflation, it is hard to fix what should be the right interest rate, but the ECB has other things to worry about. A strong Euro hurts exports and any slowdown will carry over to debt issues.

It seems like the ECB action is more of a stop the Euro rise type of response.