Salmon Futures to Develop

Norway’s fish exchange plans to develop salmon futures. http://www.ft.com/cms/s/2698ca92-f1ce-11db-b5b6-000b5df10621.html. This announcement is an important milestone in aquatic agribusiness. The development of fish farms for salmon has actually led to a market environment that makes futures trading rational. Fish farming has created homogeneous product with salmon. It has also created production risk which needs to be managed and can be hedged.

Fish production through farms is similar to the risk management issues faced by cattle feedlot operators. Along with the price risk during the production phase, there is a seasonal risk when the fish mature and are brought to market. Hedging with futures can lock-in price on production and may allow the further development of aquatic farming. Hedging can lower financing risks. Salmon farmers may be able to receive the same benefits as traditional agricultural users of futures.

The need for salmon futures did not exist until fish farming was created on a large scale. This was not possible a decade ago. Though most futures markets fail, it will be exciting to watch this potential market develop.

The Trend in Violence is Down

In the decade of Darfur and Iraq, and shortly after the century of Stalin, Hitler, and Mao, the claim that violence has been diminishing may seem somewhere between hallucinatory and obscene. Yet recent studies that seek to quantify the historical ebb and flow of violence point to exactly that conclusion.

I was shocked to read this introduction to a piece on Edge.org by Steven Pinker, “A History of Violence” Http://edge.org/3rd_culture/pinker07/pinker07_index.html. After many of the violent events in the United States and around the world in the last few months, you would think that the world has plunged into a darker era of inhumanity; however, from a longer-term view violence is down. We may be suffering from the recency bias. We may be wrongly extrapolating current events to form broad generalization.

Steven Pinker, better know for his work on the mind and language, has always been insightful and this presentation is no exception. He is able to take complex subjects and find clarity and what is relevant. Violence will have ebbs and flows, but the general direction has been toward a decline.

Pinker provides a number of theories for this decline, but one that seems appealing from the vantage of an economist is the value of life. When life is not cheap, there is less willingness to destroy it. When there is value from specialization, violence is costly. As economic progress has increased, we have seen a decline in violence. The places where violence has often erupted are where there has been more economic upheaval or where the prospects to see improvement in life have diminished.

A core objective in economic development should be to further spread the gains of trade especially to those areas which have the poorest prospects for life. This may have the further benefit of containing violence.

Reaction to News – Not Always Obvious - The AUS Dollar

A recent headline this week on Bloomberg stated:

Australia Dollar Drops Most in 7 Weeks on Inflation: World's Biggest Mover Australia's dollar dropped, the biggest fluctuation of any currency today, after a government report showed inflation was slower than expected, reducing the chance of an interest-rate increase.

The headline and story seem at odds. The AUS dollar falls on better inflation numbers.
A simple model of exchange rate economics would have given a different answer. An exchange rate drop should be associated with higher inflation numbers if you follow a simple purchasing power parity story. A more complex exchange rate story is needed to rationalize this story.

The reporter states that the AUS dollar drop is driven by expectation that the central bank will now not raise rates. By not raising rates, the interest differential will not widen in Australia’s favor. This decline in the expected interest differential is what drove the decline. This explanation seems plausible, but will it have merit in other situations? Does the fact that a number of traders tell a reporter that this is the explanation make it valid? Did the report discard other explanation for the AUS dollar decline?

Too often reporters look for causality when it may not exist. In order to write a story, you need an explanation for what drives the market. But having a valid story for a given event is not enough for understanding the movements in exchange rates. The story must have predictive power in other situations. In this case, do expectations of central bank behavior dominate inflation news?

There are a number of ways to test these stories, but it is not as easy as running a simple regression. Expectations and reaction of monetary policy is a key driver in exchange rate dynamics which is often missed in the simple modeling. A simple regression using both including inflation and nominal interest rates can tell us the relative weights on these factors, but it does not include monetary policy expecations and may not explain the market behavior to given news events.

Conflicting but plausible exchange rates stories are what makes this asset class so difficult to understand. Prior to a news announcement there may be a number of alternative explanations which may seem valid. After the fact, one story will be proven to be true, but that does not mean that it is applicable for the next case. Be wary of what you read even if it seems plausible.

Profit-maximizing central bank behavior ?

Central banks have not been traditionally viewed as profit maximizers. This belief has been backed up with research that showed central banks losing money on their adjustments of foreign exchange reserves. Of course, foreign exchange trades were used as a policy instrument to stabilize exchange rates. Central banks would lean against the wind when fundamentals were pushing exchange rates away from the direction desired by the monetary authorities. Intervention has fallen dramatically in recent years.

Behavior has changed. A story in the Financial Times states that Japan is interested in creating an investment arm to actively manage their foreign exchange reserves, (http://www.ft.com/cms/s/c6be88e0-f0f7-11db-838b-000b5df10621.html). This is following in the footsteps of China which also recently announced an interest in starting an investment arm. A number of government authorities have become active at managing their reserves including Singapore and the Scandinavian countries.

This activity make sense for any individual central bank, but when the amount traded gets larger as all central banks jump into the trading game the ramifications on the FX markets will be huge. The "alpha" from FX trading could be substantially squeezed. More importantly, central bank flows, in an effort to seek higher returns, may create price activity significantly different than what has been seen in the market. Trading activity may lead to periods of dampened volatility if the activity is counter to trends in private flows. It can also reinforce markets movement and increase volatility if the strategy of the bank is to be a momentum player. A change in the competitive mix of buyers and sellers may reduce liquidity and spillover to other asset markets. The profit objectives for central banks may be very different than private investors.

While the IMF and central banks have been arguing for more information on the behavior of hedge funds, they may actually want to focus closer to home. Central bank trading activity attempting to generate profits could more than swamp hedge fund trading. Who will police the activities of central bank trading?