Sunday, June 26, 2011

The myth of shale gas?

The NYT has a front page story on the what could be called the myth of shale gas. Their reporting is that energy industry experts and documents suggest that shale gas will not be as economically viable as originally discussed or as currently presented in the popular press. There is less there there. The wells that have been drilled either are not producing at the levels expected, dry-holes, or have a shorter expected life.

This shale gas boom is now being called a potential dot-com bust for energy. Shale gas has to be tempered by the current price environment where gas continues to stay at low prices given the poor post crisis economic environment. Markets move to extremes and the current boom mentality is at extremes, but that does not change the fact that more natural gas is in the ground.

Saturday, June 25, 2011

Wen Jiabao declares inflation victory - wishful thinking?

China's premier Wen Jiabao declared in an FT editorial that China is winning the fight against inflation. This is wishful thinking. China has made as a strong effort to tighten monetary policy after a surge in liquidity in response to the financial crisis. Reserve requirements and rates have been increased on a steady basis, but inflation has still been rising. The explosion of liquidity allowed growth to be renewed but also caused an increase in speculation and a general increase in inflation. Any cutback in liquidity takes time and China does not want to slow growth below 8 percent.

Any peaking in inflation may have more to do with the slowing of commodity prices. Now the commodity price increases have been tied to China growth, but there is still high demand for better food and energy. This commodity demand is associated with the overall size of the China economy and not just the growth rate. Hence, there will still be price pressure on commodity prices even if there is a slowdown in growth and less liquidity.

Many have declared triumph over inflation only to see it continue. Breaking inflation is never easy and prices have a tendency to move in their own direction. There is still a lot of liquidity in the Chinese economy so it may be premature to announce victory on the inflation war.

Shale gas is changing the world

Shale gas seems to be everywhere and that changes global energy power politics. It is in places all over the US which have not been known as energy centers. The shale gas in Pennsylvania is a case in point. It is close to major markets and does not need to be piped long distances. The same holds for Canada.

Now we are finding shale gas in Europe from France to Poland. There is shale gas in China. Whether this gas is economical is a different story. It is not clear whether fracking technology will work and what are the environmental costs, but it is very clear that gas can be found with the right technology and at the right price.

This means that the world dynamics of natural gas will change radically. Those countries that have been energy dependent on major gas producers will see new competitive forces. The US may become a natural gas exporter not an importer. Russia may not hold Europe hostage for natural gas. Natural gas may become a better alternative than solar or wind during a transition period. There arefew events tha will chnage energy politics and this is one of them.

Uncertainty is not the problem - a view on Cliff Asness

One of the more thought provoking editorials in the WSJ was written by Cliff Asness of hedge fund fame. He argued that uncertainty is not the problem with current poor economic growth but the poor policies that have actually been implemented.

Commentators have argued that the unknown has driven businesses and consumers to hold more cash and that if uncertainty was relieved there would be stronger growth. Asness states that poor growth is not associated with uncertainty but the set of policies that have actually been implemented in the last two years. The poor growth is further associated with the fact that certain policies will be implemented if the choice is given to the administration.

We can resolve current uncertainty very easily. Let's assume we tax the "rich" at a significantly higher rate, we increase financial regulation, we increase health care costs on business, we increase costs on energy usage, we increase regulation for labor to just name a few. These are all worthy policy that would be chosen by the administration if given the chance. Would the resolution of the uncertainty lead to stronger growth?

The conclusion of Asness is that this route clearly would make us worse off. The uncertainty on whether these policies will be implemented have not hurt the economy. In fact, the possibility that other alternatives will be chosen may be helping the economy.

Uncertainty cannot be a catch-all for bad results. Bad policy outcomes are associated with bad policies

What are the safe currency havens?

The dollar may be a safe haven by default. The yen is less likely a safe have given its current recession. The only safe haven choice is to hold small high quality currencies like the Swiss franc.

This is a worry for businesses in Switzerland and all well managed small countries. It is not clear that it can handle further currency increases, yet exports and the economy is thriving. The SNB has tried to keep a loose monetary policy, but that has not caused investors to avoid the Swiss franc. Any tightening to slow domestic growth and inflation may make the franc more attractive to foreign investors. Intervention has not worked. Switzerland may not have control of their currency.

Oil price policy changes

It is hard to say what are the implications of the IEA use of emergency powers to release oil stockpiles. Some have started to call this QE-3 lite. This is a form of "quantitative easing of price congestion. Others have referred to this as a "smart bomb" that will place a threat on the oil market. If oil prices try to rise, the IEA will push them lower. Some have been saying that the IEA coordinated their action with the GCC to increase production. The IEA is short-term. The GCC production increases will be on-line in three months. The IEA supplies will serve as reduce price pressure on Libyan light sweet production.

The important policy change is that oil consuming countries will try and control the price of oil by selectively increasing supplies from their emergency reserves before there is an emergency. It is an odd policy. The oil addicts want oil at a cheaper prices. They will attempt to get it through using more supply, their special supply. This reminds me of the effectiveness of foreign exchange intervention. It will not work if there is no change in demand. This use of emergency supply is not a viable policy.

Corporate bond risk premiums increase

The search for yield may be ending in the corporate bond market as risk premiums have moved to the highest levels this year. Both high grade and high yield bonds have sold-off even with the current Treasury rally. The risk-off trade is present with credit sensitive products. Money is flowing back to safe assets.

Short-term Treasuries are at extreme lows. The sovereign risk problems are carrying over to corporate bonds. First all risk premiums are increasing. Funds are moving to save short-term assets. Second, the threat of a global slowdown is having a negative effect on spreads. Third, money available for risky lending is starting to slow. Capital will be needed so funds will not be available from banks for corporate borrowers.

This is a new version of the Lehman crisis. Liquidity is starting to dry-up. The markets need a solution to the Greek crisis even if it is a default. The is will reduce the current market uncertainty.

Sarkozy and commodity prices

French President Sarkozy has used his time as the head of the G20 to push for a concerted effort among developed countries to reduce commodity inflation. This focus has been on three major areas: 1. better information sharing concerning food production, 2. an overhaul of derivatives markets to reduce speculation and increase transparency; and 3. increases in production to reduce any shortfall.

Is this going to stop commodity inflation? No. Inflation is a monetary phenomena. Is this going to solve higher food prices? Unlikely. The higher food prices of the last few years was caused by a combination of bad weather and poor investment in supply. The government cannot solve these problems. Better information on production will help. Better oversight of derivatives is useful. Increases in production are the most helpful support for commodity prices, but it is unlikely to come from government policies among the G20. Policies to lower food prices and farmer income have not had strong support.

Mamet and the rejection of liberalism

David Mamet has shocked the liberal world with his new views that liberalism is an "expensive habit" not based on reason. His 2008 article in the Village Voice says its all, "Why I am no longer a brain-dead liberal". This view sets the tone of his strong conversion away from liberalism.

It is not unusual to see a move to conservative thinking as someone ages, but these dramatic changes are very enlightening. The liberal agenda has been tried and there has been limited success. We are not headed for a utopia which meets the needs and provides equality for everyone. The costs are high and it is not clear how the bills will be paid. There is a new searching for a third way between liberalism and extreme conservatism. It is not clear where this road will be found.

Flight to quality trumps debt problems

The combination of expected lower growth and flight to quality seems to trump the issue of a US debt downgrade at this time. The short-term nature of traders means that a debt crisis in early August is way out in the future.

Treasuries have continued to rally at the expense of those who have advocated that they are risky. Nevertheless, we are seeing some interesting behavior with long-dated Treasuries. Yesterday, the 30-year bond sold-off while the 10-year and shorter maturities have actually rallied. The seems to be a view that if you want quality it should not come at the back end of the yield curve. 3-month Treasuries have turned negative which provides further evidence that flight to quality is the driver of the markets.

The threat of a European and US debt crisis is again causing a flow into perceived safe assets.

Core versus headline inflation

there is so much talk about core and headline inflation by policymakers, but the actual data suggests that many miss some key points. Over the long-run, headline inflation continues to move higher than core. If the headline inflation is volatile and represents only temporary swings in price, it should move around the core. This does not happen. The core underestimates the actual future inflation. Second, headline inflation has continues to go up even when there has been significant declines in housing prices and other asset prices. Inflation does not account for asset price changes.

Inflation numbers have always been flawed and have limits so it is hard to argue that the key is looking at core over headline inflation. We need multiple measures of price changes.

Friday, June 24, 2011

We are afraid the Fed does not have a clue

Mr. Bernanke was asked why the economy was lagging. "We don't have a precise read on why this slower pace of growth is persisting." The Fed has slowed their growth assumptions for the second half of the year. Many at the Fed would argue that the slowdown in growth this year is associated with one off events, an earthquake in Japan, the oil price shock from Libya and Arab Spring events, higher commodity prices, and the sovereign debt issue with Greece. These negative events are all contributors, but the simple fact is that the QE2 program did not work as well as expected. Flooding liquidity into the system was a viable strategy during a liquidity trap, but there is limited evidence that this would be effective. The wealth effect and inflation effect did not occur as planned.

Economic growth is still based on real effects like consumer and business expectations. Growth is based on innovation and change. Monetary policy has a limited role in these cases and Bernanke knows it. He has run out of new ideas, so the economy will limp along.

Price response to IEA move higher

Take oil from the strategic oil reserve and the market will react. Prices fell by over 4% but the today they are slightly higher. Why? The answer is simple. The stockpile is too small and the the size of the release is worth about 1.5 days of US use, assuming the 30 million barrel US release. The reaction from producers will be simple. Stop helping the west and reduce production.

Saudi Arabia stated that they would add to production to make up the shortfall of Libyan. It has been a slow process because turning on of an oilfield is not a slip of a switch. However, the 4% decline hit all oil producers with a loss. Why not let the US use all of its oil first?

Have oil prices slowed global growth? Of course, but bad governance with the EU and Greece may have had a bigger effect. Do not watch our bad fiscal behavior, we will try and punish speculators.

Thursday, June 23, 2011

IEA releases stockpile - why?

Emergency in the oil market for only third time in the IEA history since 1974. The first occasion as the Gulf war in 1991 . the second occasion was hurricane Katrina. Now this! Oil prices for WTI has fallen from $115 down to $93/barrel. Brent has fallen from $120 in late May to $114 yesterday. It seems odd that the release comes now when the prices have been falling and economic growth has been faltering. Oil prices have been a drag on the global economy, but this does seem odd as a measure of emergency.

Trichet says red for banks

after meeting with the European Systemic Risk Board (ESRB), ECB president Trichet says that he sees risk signals that are flashing red. If there is a dashboard it is not clear what are all of the components. The website does not provide good advice. This will provide more market uncertainty even though the systemic risk issues has to be addressed. Without clear guidance what should the markets think? What is the criteria for red?

Is this new helpful? It cannot be if there is no context.

Tuesday, June 14, 2011

Commodities more equity sensitive



Commodities have become more equity sensitive as measured by the beta over two distinct periods. We have excluded the crash period during the pre- and post Lehman crisis. The beta has moved from close to zero with a high intercept or alpha component to a higher positive beta. A good portion of this beta may be related to macro factors like the growth of the global economy over the last two years, but it is surprising how this relationship has strengthened.

The same effect can be found if the analysis uses the EFA index or an emerging market index. Similarly, there is a stronger negative relationship with bonds than what existed pre-Lehman. The link between asset classes has become stronger and it is more important to think about the relationship across asset classes.

China as a intermediate good producer - the supply chain argument

The trade imbalance between the US and China continues but as more economists study these numbers, the trade issues takes on a higher level of complexity. See Asia's supply chain: Implication for rebalancing in VoxEU.org.

China is increasingly becoming the intermediate supply chain provider for all of Asia. Trade is becoming more vertically integrated which explains the steep changes in 2009 trade flows. Vertically integrated trade also means that the trade activity between China and the US is not just a function of bilateral exchange rates but also related to the costs of goods coming into China. The global imbalance problem is not a bilateral issue, but one for all countries in Asia because they are part of the supply chain. Trade will be less sensitive to the yuan exchange rate. An appreciation of CNY will not mean that the Chinese bilateral trade surplus will decline.

Recent estimates of value added effects on trade also show that the US-China imbalance is about 40% smaller than expected. See The value-added content of trade.Trade is hard to account for in the real world. A cell phone can be assembled in China but most of the parts are coming from anther country. The value-added between the parts and the assembly is what represents the increase in trade but the entire value of the cell phone is what will be booked for bilateral trade. hence, the value-added is much less than what may be reported.

The trade issue has to be viewed through a micro lens of products and dollars moving. Trade also has to be viewed through the macro problem of savings flows. We have to move away from gross trade imbalances.

China tighening - hard versus soft landing?

The PBoC has raised RRR again by 50 bps to 21.5% This is the six time that rates have been increased; however, inflation is still at 5.55%, a rate higher than desired by the central bank. Increasing reserve requirement should reduce excess liquidity. The new rate will take effect on June 20th.

The reaction has been mixed given other news in the markets; nevertheless, we expect that this will have a negative effect on commodity markets. Managing a growth slowdown is very risky. Upside risk is a different story. Who cares if you have excess growth as long as the direction is right. The traditional view is that the economy has to be slowed since inflation is high, but what if inflation is caused by structural issues? If this is a price shock to food and energy and the constraints on trade, then increasing the RRR is not going to be effective.

A reason for further fiscal stimulus

The economists Christiano, Eichenbaum, and Rebelo have developed an interesting paper in the February JPE (Journal of Political Economy) called, "When is the government spending multiplier large?" They argue that the government spending multiplier will change with the market environment.

The spending multiplier is critical for the success of any stimulus program. A low spending multiplier means that there will not be any follow-through from the increase in government spending. Hence, the value of a new spending program should be questioned as unproductive. A high spending multiplier will mean that a dollar of fiscal spending will translate into more than a dollar of GDP. The spending multiplier will be lower if there is an interest rate effect whereby increase spending will lead to higher rates based on the crowding out effects. If rates rise, then private spending may decrease, lower the impact of any government spending. If there was no interest rate effect, then the multiplier will be higher.

The spending multiplier is not stable because the interest rate environment is variable. If the economy is in a zero interest rate environment then there will be less interest rate effect which will drive the multiplier higher. The deflationary spiral or the paradox of thrift will place the economy at risk and there potential move in interest rates will be limited. Hence, this would be the time to use fiscal stimulus to get the economy moving. If there is expected a longer zero bound environment, the multiplier will be larger.

While it is difficult to advocate, there is a reason for controlled policies to help the economy move. The limited rate effect means there will be greater bang for every dollar spent.


Monday, June 13, 2011

IMF candidate conflict of interest?

Mexican central baker Carstens has developed a novel argument that a European head of the IMF would have a conflict of interest given that any bail-out of the EU PIGS would include the IMF. The borrowers will be managing the fund as the lead creditor.

In fact, an IMF second bail-out of say Greece would be a bail-out of the French banks. Candidate Lagarde is the Finance Minister of France. How hard would a European bargain at this time given the EU would be a beneficiary. This argument would not hold for past Europeans since their nomination was not occurring during an EU crisis. Who would Lagarde represent?

Sunday, June 12, 2011

Monetary policy effects may be stronger

On the contribution of monetary policy to economic fluctuations by Olivier Coibion adds to our understanding of monetary policy and its complexity. His work is very simple, take out the Volcker period and see what is the sensitivity of economic fluctuations to monetary policy. He finds the result that monetary policy has bigger impact than expected over the entire period. Previous work by many researchers finds monetary policy effects are limited. There also s a group that finds versus significant effects.

Hence, if you want to have an impact on the economy the size of the stimulus will have to be based on the potential sensitivity. A higher sensitivity will mean a greater impact for any dollar used. Given this information, we should see more real effects from monetary effects. In reality, the sensitivity has been less than expected. The current environment does not fit past behavior; consequently, we have to plan for a different world.

The cost of low interest rates - thinking out of the box

Clearly, someone is paying a price for ultra-low interest rates: the patient and uncomplaining saver. Interestingly, if traditional spenders such as firms and young households are unwilling or unable to take advantage of low interest rates, low rates could even hurt overall spending, because savers like retirees receive lower financial incomes and curtail spending.


Raghuram Rajan, University of Chicago professor

Would we be better off if there was an increase in rates while the Fed buys securities? This would flatten the yield curve but savers would be able to make some money on their deposits and there would be less speculative flows looking to invest in risky assets in search of yield. If this is a balance sheet recession it is not the level of rates which is holding back behavior but the loses on assets. Lower rates are not going to make a dent in the balance sheet of consumers if credit is not extended to borrowers. Borrowers will not take on new investments if rates are 50 bps lower if the project does not make sense. The choice of just keeping rates low may not be a viable option.

Mario Draghi and the ECB

Mario Draghi, the MIT trained head of the Bank of Italy, is likely to be the new head of of the ECB on November 1st. The question is whether he will chart a new course from president Trichet or continue down the current path of pragmatism. He has a confirmation hearing on June 14th and has presented a long testimony which spells out how he plans to manage the ECB.

The words gradualism and pragmatism seems to be the best descriptors. He is unlikely to be viewed as an inflation hawk or someone who will differ from the single objective of the ECB.
From a Bloomberg story:

“The continued high degree of uncertainty on the macroeconomic and financial environment together with remaining vulnerabilities requires a careful assessment of the overall situation and outlook,” Draghi said in a written response to European Parliament questions. “This in turn warrants an element of gradualism in changing standard and non-standard monetary policy.”

Currently, the ECB needs a pragmatic leader who is unlikely to change the current delicate balance of monetary policy and objectives to hold the EMU in stability. The ECB is at the center of any sovereign crisis and a strong "price stability only" approach will hurt and disrupt the markets.


Fed balance sheet after QE2

With weaker economic data, the Fed is placed in a difficult situation. QE2 ends this month but it is unclear what the Fed should do with the roll-off of maturing bonds and principal payments from mortgages. The Fed balance sheet is now at 2.82 billion up from &870 million in December 2007. The bulk is in Treasuries at $1.6 trillion and $920 billion in mortgages.

The passive strategy of letting principal and interest roll-off would seem to be the easiest means of reducing the balance sheet. The mortgage portfolio actually is over $100 billion smaller than a year ago just because of principal and interest declines. Still, the problem will be the speed at which the portfolio will decline. If growth will be slow, there is less desire to have the portfolio decline. On the other hand, cash flow could be used to buy more securities and hold the balance sheet stable. At this time, it s not clear hat is the specific Fed plan.

Saturday, June 11, 2011

EM versus DM – the roles are switched but for how long?

Emerging markets are becoming less risky. On a short-term financial measure, a review of stock sensitivity versus the S&P 500 (SPX) shows a decline in risk. The driver for this decrease in risk is related to the macroeconomics between the developed world and the rest of the world or emerging markets. The volatility of the developed world has generally been less than emerging countries for the entire post-WWII period. The emerging market world has been marked by extreme declines, periods of slow growth, and volatility. Emerging markets have faced "sudden stops" from currency failures, crisis with short-term funding, and outright default. However, these risk have diminished over the last decade. The central banks have followed a policy of growing foreign exchange reserves and controlling inflation.. Governments have followed policies that have been business friendly and have led to more competitive markets. There also has been further integration across countries

A simple regression of beta between the EFA and EEM stock indices and the SPX shows that the beta for developed stock markets has risen over the last two years relative to the five years prior to the Great Recession. At the same time the beta for the EEM index has fallen over the last two years. We took out the volatile recession period as abnormal; however, when the last three years are used the same results apply. There is a marked decrease in volatility with emerging markets.

Breaking the rules and the euro crisis

Jamie Whyte, in an FT editorial, "Why our masters insist on breaking the rules" provides an interesting perspective on the crises within the EU. The EU has tried to provide stability and structure within the union but whenever there have been times to avoid following the rules countries and the group as a whole have always chosen to break the rules.

Remember that budget deficits were never to be above 3% of GDP. Everyone, even those who developed the idea of budget constraints, has broken the rules. If the budget deficits were all below 3%, the crises never could have occurred. There were supposed to be penalties. None were imposed. There were supposed to be no bail-outs, yet they have occurred. There was supposed to be no acceptance of non-investment grade collateral yet the ECB has accepted all bonds.

This gets back to the issues of creditability from governments. There is little. The issue was addressed in the 1980's with research on time or dynamic inconsistency in monetary policy. The basic idea is that if you do not follow the rules that you place upon yourself there will be limited creditability and policies will have to be more extreme. There is no anchor on what could be the actions taken by government other than they will be addressed at the time of a crisis. This is not a system of government or economics but a system of chaos.

There is the hope that governments in their infinite wisdom will be able to provide the right solution that makes sense. The argument that flexibility is good under the assumption that rational decisions can be made. Do we really have confidence that this can happen in a crisis?

OPEC is relevant because it does not work

OPEC is relevant to the world oil price. Its relevance comes from the breakdown between parties concerning any new production quotas. Iran with a coalition of other oil producers, Venezuela, Iraq, Angola, and Algeria have been unwilling to increase production in the face of higher prices. Its argument is that production is high enough and that a slowdown in growth could mean the world will have excess supply. Saudi Arabia wanted to have production increases and reduce the pressure on growth from prices above $100 / barrel.

The lack of an accord between OPEC members mean that unilateral action could be taken by countries which destroys any sense of a cartel. Note that production has generally been above quotas and the current gap is actually quite wide. The issue is not quotas as much as having production match the specific target of the group. This has generally not occurred. The real problem with an OPEC dispute is that it provide another backdrop of uncertainty about the dynamics of global oil supply.


Waiting for Godot (QE3)

Why are equity markets rising on bad economic information? A reasonable story is that the markets are expected a QE3. There were some clear objectives with QE2, raise risky asset prices to stimulate the economy, raise housing prices to help consumers, and increase inflationary expectations to offset the ravages of deflation, and cut the value of the dollar to help exports.

They were successful on some fronts. The dollar is lower and exports have increased. Unfortunately, the higher oil price have hurt the terms of trade and the balance of payments have not improved as much as expected. The housing market has stabilized but there is little improvement. This stability is very tentative given that housing is still on the ropes just not as bad as before. Stocks are higher even though corporations are having a hard time making investments decisions and have continued to hoard cash.

The latest Bernanke speach tlks baout an uneven economy so there is still something needed by the Fed. Theonly real option is buying more securities, so it is just a matterof time. If the eocnomy looks weaker, the chance of QE3 increases and forward looking markets will increase in price.

Brent –NYMEX spread reflects localized market dislocations

The NYMEX crude oil contract reflects the price of WTI delivered to Cushing Oklahoma. Brent is a international reference for North Sea oil that is closer to the light sweet crude coming out of Saudi Arabia. WTI delivery is to a land-locked delivery point tied to a pipeline intersection. It is hard to get oil out of Oklahoma and to the coast so that it can be sold on the international market. Hence, if there is a strong increase in US onshore production as well as more oil coming down from Canada it cannot leave the US. The result is oversupply and a dislocation relative to other oil prices. In fact, the price of oil along the gulf coast better reflects the international price and not the NYMEX price.

In politics, it is often said that everything is local. The same may be said for commodities. Regardless of what is going on in the macro economic environment. Futures will have a localized component that can dominate the broader demand and supply for a commodity. This is one of the key reasons for why contract specifications are so important in the futures markets. The failure of futures contracts will often be associated with contract deliver issues which causes wide fluctuations in the basis of difference between cash and futures.

We expect that this differential will not go away anytime soon, so there is an opportunity for new futures markets to develop. The chance of failure is high, but there will be a growing demand for new options. This dislocation of the US market from the rest of the world also occurs in natural gas. Oddly, all of this fragmentation between the US and the rest of the world is occurring at a time when the rest of the world is becoming more dominant to commodity markets.

What was wrong with Peter Diamond?

There was nothing wrong with Peter Diamond the MIT Nobel prize winning economist being a Fed governor. He is a brilliant economist who has worked to advance our understanding of labor markets and problem of information. He is insightful and well-respected within the academic community. He is not a banker or a regulator, but he has a strong mind with respect to key problems in our economy. The Fed has a mandate to reach full employment and it makes perfect sense to have a labor specialist on the Fed’s Board of Governors. This was a mistake. Politics should not have played a role in the decision. I wish him better.

More China warnings on dollar and debt

China has $3 billion in foreign exchange reserves with 2/3 likely in dollars. There is a going concern that the US government is not troubled about what my happen to the value of these investments held by foreign governments. Why care about foreign buyers? The only thing that matters is whether US voters are happy and the economy is growing.

Still, large buyers on becoming more vocal with their concerns. As quoted by Guan Tao, the head of international payments department of the SAFE (State Administration of Foreign Exchange),’The US may find it hard to resist the policy temptation of weakening the dollar abroad and pushing up inflation at home.” This sums up the argument from the perspective of foreign bond holders.

With the debt ceiling problem coming to a head and Moody’s talking about a rating decline, China is feeling nervous about their US holdings, but there is little it can do about it. There is not a good option with the euro and there is not enough bonds available from stronger currency countries. The comments are meant to sway the US to a more debtor friendly policy, but it is unlikely that the US will adapt this type of view.

This Chimerica issue of China supply goods and credit while the US is a buyer and debtor cannot last. This will be a growing flashpoint in finance which may become more relevant in the course of the next few weeks.

G20 and food price volatility

A new agricultural market information system (AMIS) is an initiative by the G20 to gather and disseminate more information on the production and inventory of grains and other foods around the world. Data will be received jointly from the FAO, international agencies and G20 countries and aggregated to provide a better overall supply picture on critical food markets. (This is similar to the JODI data (Joint Oil Data Initiative) started a few years ago.)

France has been the strongest advocate for this initiative in order to reduce price volatility and premiums associated with the uncertainty concerning what is the supply of different foods. There are wide differences in how information is collected and disseminated in food markets.

The USDA is especially good at providing detailed information on US production, but many countries hold stock information as almost state secrets. The uncertainty about what is the true production and inventories held around the world means that many buyers will purchase first and ask questions later. The result is panic buying that is rational given the uncertainty but in a more transparent market would not make any sense. Markets are more likely subject to speculative attacks when there are large information divergences. If this information gathering is successful, there should be a dampening of prices as the market gains a better understanding of the true supply picture. This will be welfare enhancing.

Whether speculator or hedger, the providing of more commodity information is good for the global economy.

All commodities are not the same

Oil has been up over 21 percent since the beginning of the year as geopolitical risk increased the premium in energy markets. Silver, even with the decline in May, has also increased by over 20% based on strong demand as a substitute for gold. Corn continues its upward movement caused by low inventory and poor planting conditions.

On the other hand, sugar has fallen 25 percent with larger crop harvests that should reduce the supply constraints from last year. Cocoa prices have declined with the reduction in political risk and the flow of supply out of the Ivory Coast. Nickel has seen declines as higher production out of China has increased supply.

Commodities are a diverse asset classes and these broad price differences tell us it is hard to think of this asset class as a single group of markets that move together through time. This differences in correlation is one of the strongest reasons for engaging in active management versus passive long-only buying of an index.

There is no such thing as one size fits all in the commodity markets.

Man-machine argument explains the slow job recovery

Catherine Rampell in the NYT Economix blog presents a good argument for the slow job recovery called Man vs. Machine. The change in aggregate spending on equipment and software far outstrips the the spending on labor compensation, 25.5% to 2.2%.

From the second quarter of 2009, total compensation costs have risen by over 3% while equipment and software prices have declined by over 2%. The key increase in costs has been benefits. This is still associated with health care costs.

Why hire workers with the costs rising when you can buy cheap equipment and try and increase productivity. Worker costs have to be brought under control but this is also one of the great political problems. Government is often driven by support of workers not by trying to control their costs. The government has to provide costs solutions in order for businesses to hire more.

Tuesday, June 7, 2011

Greece financial prospects lowered

EU/IMF will disperse the next tranche of bail-out money and there is a growing consensus that there could be a debt roll-over plan implemented. This type of plan could be supported by the ECB who may not consider restructuring an alternative.

The debt overhang is having real financial affects. Who wants to hold equities in Europe when there is still uncertainty on the cost of a Greek solution and there are constant discussion on how the rules of the game will change.

The current solution is to always move the problem into the future, but at some point the future becomes the present.

Bernanke frustrated on "uneven" recovery

Bernanke states that recovery is "uneven" and "frustratingly slow", but "monetary policy cannot be a panacea", yet "accommodative monetary policies are still needed". This sounds like the Fed chairman is not sure what to do. There is no plan B. QE3 may not work. There is no room to lower rates.

There have to be structural changes to the economy so that businesses believe there is a reason to hire and invest. Tax cuts that are temporary will not solve the problem because they are by definition short-termWhat happens if there is less regulation? This could work but it will not change hiring immediately.

Monetary policy is much more complex then written about in textbooks. Money can be created and provided but there still have to be borrowers who think there is a potential gin from going into debt. This is the issue of "animal spirits".


Thursday, June 2, 2011

Moody's getting tough with US government

A rating agency with a backbone?

If there is no progress on increasing the debt limit, Moody's will place the US government's rating under review. Rating action may be taken by mid-July if there is no progress on negotiations. If there is a debt-ceiling default, Moody's would downgrade the rating from triple-A.

If the rating agencies do their job, there will be less need for the bond vigilantes to have to force activity on the government. Nevertheless, some would argue that there is no need for concern. 10-year rates are now at 3 percent. This level is at the lows for the last six months. If there is a credit problem, rates should not be lower but higher especially with 30/10 spreads. Rates have been fallen on the back of poorer economic news and the announcement of the end of QE2.

Markets can have a strong change in direction. A swift back-up is possible if there is a credit concern and this default risk is real.

Greece downgraded to Caa1

Greece was downgraded by Moody's to Caa1. Only Ecuador is rated lower at Caa2. It defaulted in 1999 and 2008. Credit default swaps on Greece are now more expensive than Venezuela. For this rating, there is a a 50% chance that it will default over the next five years. The chance that Greece will survive is a flip of the coin for Moody's even after all of the help from the other European countries.

How much money is now needed to move the dial toward a lower probability? It is not clear. At this rating, the odds are more likely that a restructuring will be necessary. Little help will come from the ECB who will not take Greek bonds as collateral, and it will be harder for all countries to agree on terms for such low-rated debt.

A "reprofiling" will be necessary. It is just a matter of how much restructuring will be done.

Doubling down on Euro sovereign crisis

ECB president Trichet suggested today that European governments should set-up a finance ministry for the 17 nations in their currency union. It makes perfect sense that if you have a single currency then you should have a more unified fiscal environment. One of the key problems with the current Euro crisis s that monetary unification has not matched unification on the fiscal and banking areas. This type of unified structure would be something more closely resembling a federal system like the US with both local and broader tax authority. Trichet did not go so far as to advocate a federal system but he suggested that a finance ministry would have three functions:

1. surveillance of fiscal and competitiveness policies
2. executive functions with respect to integration of the financial sector
3. the representation of the union with international financial institutions

On all three points, there is a loss of sovereignty. This proposal is unlikely to gain support from either deficit or surplus union countries; nevertheless, it is the plan that makes the most sense to resolve fiscal crises no occurring at the state level.

There has to be better oversight on the budgets of all countries. Most EMU countries have running budget deficits higher than expected by the Maastricht Agreement. There also has to be an integrated approach to bank management and the ability to rise above the self-interest of individual countries.

Still, making major policy changes at critical times is never good. It calls for further integration at the very time that the monetary union has the potential to break apart. This may be the right time to double down on union. Certainly something is needed to change the current system, but further integration may not be the will of the people even though it is a solution to solve the short-run problem of crisis management.