Monday, April 30, 2007

Salmon Futures to Develop

Norway’s fish exchange plans to develop salmon futures. 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 by Steven Pinker, “A History of Violence” Http:// 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.

Thursday, April 26, 2007

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.

Monday, April 23, 2007

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, ( 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?

Energy Gloom, Market Forces, and Foreign Policy

The prevailing opinion concerning the longer-term outlook for energy markets is one of doom and gloom. The argument is that the energy security of the United States is at risk on three levels. Supply is declining as reinforced by the stories of “peak oil”. Much of the available supply is left is in places that are geographically and politically inhospitable. This supply is also controlled by national oil companies which may have not so hidden agendas of using oil as a weapon. Those areas of new supply or countries less friendly to the United States are being captured by countries like China through long-term contracts to control the ultimate destination of the oil.

Opinion is falling in line that this inevitable combination will create an environment where there is little chance for significant price declines. The strong stable prices in back-month futures are a manifestation of these views. The issue is whether there is anything that can be done about this situation. Some quarters are pressing arguments that foreign policy should respond to these security threats.

An alternative view is that these energy fears are exaggerated. The response to market forces and the current structure of oil market may be enough to solve problems of supply without the need for more activism in foreign policy. Eugene Ghotz and Daryl Press, writing for the Cato Institute provide a market force argument with Policy Analysis #589 “Energy Alarmism: The Myths That Make Americans Worry About Oil “. Their view is that that the fears outlined above are an overreaction and that they should not be the focus of policy for the United States. Prices are driven by markets forces that cannot be adjusted by an activist foreign policy to stabilize supply and prices. While their conclusions are sound, they do not provide help with solving the gloomy picture and their simple analysis shows that supply disruptions over the last thirty years, while ultimately brought back in line to meet demand, can have a strong impact on price.

The argument for “peak-oil” may be the easiest argument to refute based on market dynamics. Given the economics of extraction, more oil will be found at higher prices and economies will respond through conservation and finding substitutes. The response to prices will occur regardless what are the details of overall supply or whether there is a need for a new energy era independent of oil. However, this belief in market forces does not provide guidance on the mechanics of the transition. The ethanol craze is a perfect example how the transition to substitutes may be long, filled with inefficiency, and a costly drain on capital.

Inhospitable regions stifle investment not just because of geography but the threat of expropriation by governments. While foreign policy activism may not be a solution, there is no simple market solution to supply problems which may exist because of unfriendly investment environments. Market forces cannot work when governments interfere with the extraction process. Cartels have excess capacity which can be used to increase supply when needed, but the behavior of cartel members is not guaranteed in a volatile geopolitical environment. The use of force as a potential threat to minimize oil disruptions is costly and may be ineffective.

The current China policy of strategic purchases reminds one of classic mercantilist arguments. China’s activities in this area may not be a threat to western countries if the net result is more oil produced. The needs of China could be met by contractual investments and the remaining could be used by other demanders. Any increase in supply could be beneficial to all market users.

Geopolitical risk is real and may not be solved with active foreign policy initiatives. Market prices will adjust market behavior to any energy disruption. Unfortunately, these forces will have real effects and costly reactions during the period of transition. There are no easy solutions to energy market problems. Prices will not see strong downward adjustments. The threat of low probability geopolitical risk will imply higher prices in the longer-run even if there are high inventories in the short-run. This is why we are in a period of steep contango for crude oil.

Friday, April 20, 2007

Market Dynamics and Synchronous Business Cycles

A key driver of the current dollar decline is the expectations that the US with see a further slowdown while the rest of the world, especially Europe will continue to grow. Stronger growth in the rest of the world may lead to monetary policy outside the United States that drives rates higher. On the other hand, the expectation for the Fed is that the next move will be to lower rates. An underlying assumption for this story is that the old adage that if the “United States sneezes, the rest of the world catches cold” does not occur. Clearly, if business cycles are synchronized this time, the growth differentials will stay consistent, monetary policy will be similar, interest rate differentials will not change significantly, and investment opportunities will not differ. The issue of synchronous business cycles is a driver of current financial flows.

Is this time different? An answer to this question requires a historical review of the business cycle relationships around the world. The history of whether business cycles were synchronous is not as clear-cut as noted in the cold analogy. First, there have not been many recession in the last 35 years. Second, the mix of trade and financial flows has changed significantly since the last major recession in 1990 and the downturn in 2001. Past history shows that all slowdowns in the US that have not always carried over to the rest of the world. See Chapter 4 of the IMF Economic Outlook, “Decoupling the Train? Spillovers and Cycles in the Global Economy”.

What is needed to have commonality across economies is a global causal factor for the slowdown. We have seen that with oil shocks in the 1970’s and the stock market decline of 2001. This common link may not be the case currently where the US slowdown is being driven by the housing market. Global integration is another key determinant for the cycle spillovers to occur. If economies are more integrated with trade or financial flows there is more likelihood for synchronous cycles. While the US is still the market leader in trade, global trade flows are more disperse than in the past. While economies are more integrated than in the past, the US may not have the same power to drive business cycles. The exception may be with regions such the Western Hemisphere which has become more integrated. Nevertheless, financial flows have become more important as a transmission mechanism. However, in this case, the housing market problems have yet to carry over to the stock or bond markets. The US specific causes of the slowdown may mean that there will be a decoupling of business cycles.

The differences in economic growth will manifest in changing asset prices. Further dollar declines. Changes in relative interest rates. Increased equity opportunities internationally.

Thursday, April 19, 2007

Investors Don’t Generate Security Returns

An important question is what type of returns investors truly generate. We know what the returns for a security return will be. We just calculate the geometric returns from the changes in price. Unfortunately, the returns that are generated by investors have to be dollar weighted by when funds were invested in the market. This represents not the compounded geometric returns but the internal rate of return calculated from the flows of money into the market. The issue seems obvious but is over overlooked in discussions of returns.

Ilia Dichev of the University of Michigan, focused on this issue for the market as a whole for both the United States and international stock markets. (See “What are Stock Investors Actual Returns? Evidence from Dollar-Weighted Returns” American Economic Review March 2007.) He used a large number of countries for as long a time period as possible to calculate investor returns. Perhaps not surprising the returns by investors when time weighted are lower than the measured security returns.

Investors have a tendency to add more money at market highs and take money out at the lows. The phenomena occur across all of the major international stock markets and for very long horizons. There is a clear positive correlation between money invested or added to the market and performance. Some of additions are from new equity issuance. Some additions and redemptions are due to the economic cycle. Money will be added or withdrawn relative to variable consumption needs or wealth changes. Flows are driven by expectations which may be rational relative to the other investment choices or motivated by momentum. The importance of this work goes beyond the simple conclusions that we may be poor investors. It also tells use that the actual excess returns that we generate are less than what has been calculated by many researchers. When we look at actual behavior in the markets, there is a smaller excess return premium. The equity premium puzzle may not exist.

This type of analysis, using internal rate of return calculations, is consistent with what has been found with mutual fund investing. Investors do not time their flows effectively. The advice from this type of work is clear. Security returns are not the same as investor returns and everyone should focus on the timing of their cash flows into and out of the market.

Wednesday, April 18, 2007

Corn Volatility and Planting Seasonality

The grain markets have seen increased volatility since the USDA planting intentions report last month. This should be expected because spring weather determines when crops will be planted, the initial conditions for germination, and whether there is switching of crops. All of these factors will affect supply. A late spring means that some farmers will switch to a crop that can germinate later. A wet spring will affect soil compaction which will cause a decline in yield. The plant may not be able to develop a strong root system in compact soil. Most important is the combination of moisture and warmth which will drive the timing of germination. A bad spring will drive yields lower and the amount that is ultimately harvested. The increase in planting intention may occur on land that is less favorable for corn.

The difference between planting intentions and actual plantings is one form of production slippage. The difference between what is planted and acreage harvested is another form. Bad spring conditions can drop the amount that is planted by up to 5%. Some crops like corn have large production slippage. The last five years shows that the drop in corn acreage harvested relative to what has been planted has been approximately 10%. The closest substitute for corn, sorghum, has seen differences of over 25% between what has been planted and ultimately harvested. This will have an effect on corn prices.

Because of this potential variation in production, corn prices are currently more sensitive to small weather changes. Nevertheless, the variable that has made planting so important is the ending stock balance for 2006-07 corn which is over 50% lower than in either of the last two years. The total use has increased close to 25% in the last five years and is expected to be even higher for 2007. Given current conditions, we would assume that this year will see greater slippage in yields and harvested acreage for corn. With the low ending stocks, any marginal reduction will drive prices higher.

Tuesday, April 17, 2007

$2 Cable – Driven by the Bank of England Letter

The pound has moved above $2 for the first time since the currency crisis of 1992. This surge came after the latest UK CPI report which shows inflation is now above 3 percent. This increase above the inflation target requires that the head of the Bank of England, Mervyn King, to send a letter to the chancellor, Gordon Brown, on the state of monetary conditions. This is the first time a letter as been triggered after ten years and 12o Monetary Policy Committee meetings.

Interestingly, a surge in inflation which is usually considered bad for a currency is the driver for the appreciation of the pound. This seemingly counter-intuitive behavior is related to market uncertainty. The inflation increase may be considered temporary. The market’s expectation is that there will be an almost certain policy response to bring the inflation rate back in-line at the 2% level. “As the remit for the Monetary Policy Committee makes clear, the thresholds for writing an open letter do not define a target range. The target is 2% at all times and is not a range.” How long the current rise in inflation will last is uncertain, but the policy response is considered clearer. The statement from the Bank of England must go out

The expectation is that interest rates will be increased as early as May to stem the rising inflation. While no action was explicitly stated, the expected rise in short rates to stem inflation which will make sterling more attractive on a carry basis.

TIC Data Provides Interesting Trends

The US Treasury International Capital TIC System provides information on the purchase and sale of US long-term securities between US residents and counterparties outside of the United States. TIC data provides useful data on gross and net transaction across borders over a number of different security classifications. Unfortunately, this data is not useful for providing good forecasts of the direction of the dollar; nonetheless, a review of the data provides important historical information and a detailed picture of US capital flows around the globe.

The TIC data released Monday for the month of February shows monthly net capital flows of $94.5 billion. In the context of moving averages, this is lowest three month period of net purchases by foreigners since August of 2005 and matches the dollar decline since the beginning of the year. The private net transactions have fallen significantly. However, the official net purchases are the highest since the middle of 2004.

The differences in the mix does provide information on foreigner investor preferences. For example, there has been a strong preference for corporate bonds. Investors have been chasing yield even with spreads tight. This is even the case for official net purchases. There is a growing preference for corporate bonds and until recently, a significant increase in the purchase of equity.

There is also marked differences in the mix of net securities purchased by region. The mix is tilted more toward corporate bonds and equities for Europe and those locations that domicile hedge funds. Asia and Latin America as well as the oil exporters have a much more conservative purchase pattern.

Perhaps the most important take away from the data is the increase in official net purchases relative to private flows. The decline in private flows which may be more sensitive to expected returns should be a concern. A declining trend means that investors are not expecting returns high enough to move capital into the United States. This backing away from dollar investments will place more downward pressure on the dollar.

Sunday, April 15, 2007

G7 Communiqué – Same as the Past

G7 communiqués create risk. It may suggest a new policy direction or view on exchange rates by finance ministers and central bankers; consequently, it represents a unique foreign exchange risk which cannot be easily measured or modeled. There are limited events (communiqués) to review and there exists problems of interpretation with the wording. Communiqués without clear action steps only create noise.

The best form of communiqué is one of clarity with no surprises. Unfortunately, by definition that means that the message is anticipated and policies should continue as the status quo. By this measure, the current script was a good message.

The wording was not different from what was expressed in February, The dollar and yen should be firmer. Exchange rates should reflect fundamentals, (one sided bets like yen carry trades hsould be discouraged).Price stability continues to be a priority. Talk of global protectionsim is a potential issue, (let's get the Doha Round back on track).

Perhaps most important was what was not mentioned. There were no specific prescriptions for a cure of current account imbalances, although there was again a call for further action from large surplus countries like China. Some recommnedations on local bond market developments will come out after the Frankfurt meetings on May 9-10.

Uncertainty has been resolved and the policy status quo will continue. The focus of the exchange rate markets will be on growth differentials and not the behavior of financial ministers.

Friday, April 13, 2007

The Merchant of Venice and Diverisification of Risk

The opening of Shakespeare's The Merchant of Venice is similar to a chat between a friendly group of hedge fund managers on any street in New York. One of the group is glum and the others want to know why. They share some stories about business risk. Salanio discusses how he has to focus on all of the details to avoid a bad outcome, but even then he faces uncertainty.

Believe me, sir, had I such venture forth,
The better part of my affections would
Be with my hopes abroad. I should be still
Plucking the grass, to know where sits the wind,
Peering in maps for ports and piers and roads;
And every object that might make me fear

Misfortune to my ventures, out of doubt
Would make me sad.

Another in the group talks about the downside if an investment hits the rocks before it arrives in port. But one of the main characters, Antonio, argues that he is not upset about business because he is tries to employ risk management.

Believe me, no: I thank my fortune for it,
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year:
Therefore my merchandise makes me not sad.

Act 1 Scene 1

Centuries later there is no change in how we look at businesses. Even Shakespeare provides investment advice, you have to diversify. Antonio’s problem only focuses on the possible non-diversified risk of love.

Thursday, April 12, 2007

Inverted Yield Curves and Recession Caution

The inversion of the yield curve has always been a good sign of a potential recession. It has been argued by many as one of the best indictors of a coming recession relative to any other set of macroeconomic variables.

The curve continues to stay inverted, but there has not been the expected recession only the “happy slowdown”. However, it should be noted that the yield curve currently has an unusual shape. While the front-end is inverted, there is a corresponding dip in yields to make the longer end slightly positive. This shape may cause a dampened signal.

A knee-jerk reaction to any inversion may be misplaced given the dramatic changes in financial markets. Also, the lag relationship between inversions and the actual recession has been highly variable; nevertheless, there are growing signs of a slowdown in the US economy.

The best work describing the research on yield curve inversions can be found through the question and answers presented by economists from the Fed of New York. (See The use of the yield curve as a signal may have deteriorated in the last 20 years and there have some lapses in the signal, notably recessions which were not signaled; nevertheless, all recessions have been preceded by inversions.

Financial innovations may have muted the relationship between the curve and economic growth. Two transmission mechanisms which have changed may cause the quality of inversion signal to change in sensitivity and timing.

Corporate America and financing. The financing of corporations and banking in America is more global. From a banking perspective, funds can be sourced from all over the world so it is not as relevant that the US curve is inverted as much as if global yield curves are inverted. Financing can occur through carry trades from any country which has rates below the United States. The key for a global slowdown is if there is global inversion, a change in the risk profile of the balance of payments surplus countries who are supplying funds, or if there are restrictions on the flow of capital across borders.

In the case of corporate America, funding can be also conducted on a global basis, but the real issue is whether funds are needed. At this point in the business cycle corporate America is still showing signs of good earnings growth. In fact, there is still a net positive buyback of stocks which suggests that a corporation do not have a need to retain or borrow funds for projects which will change stock valuations.

The FDIC has presented very good evidence on the impact of inversion on the net interest margin of banks and suggests that it is not as sensitive as previously to the shape of the curve. Net interest margin has also converged across banks and large banks are increasing their sources of non-interest income. Large banks have always been more sensitive to the wholesale fund market, but they have diversified their income stream. Fewer profit constraints means there are no problems with supplying credit.

Consumer America is more sensitive to short rates. While corporations and banks may not be as constrained by an inversion of the yield curve, the same cannot be said for consumers. There has been a significant change in the borrowing practices of consumers through the extensive use of adjustable rate mortgages which were not as actively used during the last major inversion of 2001 and certainly not in 1989. Historically, the transmission of inversions was through disintermediation of credit from banks. Inversion with Reg. Q caused the supply of credit to decline. Now the supply is not the problem as much as the cost of the credit. (This, however, may change if there is a change in credit standards from the subprime problem.) Because the price of credit and not the availability is the constraint on consumers, the sensitivity of the economy to an inversion may be less and take longer. Certainly this will be the case for new loans. With more adjustable rate mortgages, there also will be more sensitivity to rate changes and inversion for existing loans which will be repriced. The impact of repricing will be based on the rate caps and the timing of the loan origination. Nevertheless, the rapid increase in rates with an inversion will cause more borrowers to be forced out on the curve at less acceptable rates.

The inverted yield sign is still the best signal for a recession; however, the time delay may be longer. The key will be the consumer transmission mechanism through the mortgage markets.

Wednesday, April 11, 2007

Global Imbalance Optimism from the IMF

The World Economic Outlook: Spillover and Cycles in the Global Economy has been published by IMF in parts last week. Chapter three was a surprisingly optimistic analysis on the global current account problem called “Exchange Rates and the External Imbalances”. As financial shock troops, the IMF has not been known as positive concerning the issue of global imbalances, but this recent research suggests that the currency and growth adjustments necessary to get the current account imbalances to more manageable levels will not be as great as others have argued.

There are two major parts to this work. The first part shows that advanced economies which have had large current account deficits and then adjustments did not require a substantial decline in domestic growth to make it happen. This case study analysis of countries that have had current account adjustments is compelling. Second, a careful review of the elasticity of import and export prices suggests that large currency declines may not be necessary to affect the trade balance. The argument that only large declines in the currency are required to change the trade balance is overly pessimistic and based on possible faulty assumptions and biases. The mirror image also occurs for those countries that have current account surpluses. The currency appreciation and domestic growth necessary to reduce the imbalance may be less that than what some analysts have suggested

The IMF analysis leads to some investment conclusions:

1. The risk of a significant dollar decline is less likely. The size of the dollar decline necessary to drive a significant current account decline is smaller than expected. Nevertheless, a dollar decline is necessary and will take substantial amount of time, but a dramatic change is not a requirement for improvement in the current account.

2. The funding problem of the current account deficit may be less problematic; thus less pressure on interest rates. The current account deficit problem by itself may not drive domestic interest rates higher especially in those economies that have well structured and integrated capital markets.

3. Recession may not be required to solve the current account deficit problem. While slower growth may be necessary to get the current account closer to balance, the size of the domestic decline in GDP to slow demand for imports may not be as large as initially thought. Countries with high current account deficits have made the adjustment without a deep or prolonged recession.

There are a host of reasons for a dollar decline, such as current slower growth in the US and talk of trade wars, but the global imbalance problem may be less serious than feared.

Monday, April 9, 2007

Prediction Markets and the French Election

The French Presidential election will be held April 22. The election focus has been between UMP center-right candidate Nicolas Sarkozy and Socialist Party candidate Segolene Royal. Sarkozy has a slight lead, but 40% of the electorate is undecided. A change in government even if on the surface seems to be similar to the past may cause market uncertainty, but the first issue is determining who will win.

An easy way to handicap an election is through using the results from prediction markets. These trading markets provide a good measure of how dollar votes handicap a discrete event. One place where election probabilities can be measured is at The current numbers in the French prediction market show that Sarkozy will win big with 65% of the vote. This percentage is up from below 20% at the beginning of December in 2006. This gain is clearly at odds with many news reports and should be a good test of a prediction market.

How has this translated into movement in the stock market? The CAC futures on the French stock index can be compared with the German Dax futures market through looking at normalized spreads. There has been a strong downtrend in the French market relative to German stocks since the beginning of the year. The steady increase in Sarkozy’s prediction numbers have coincided with the decline in the normalized spread between the two largest stock markets in Euroland. If this a comment on whether the presidential winner will be more anti-business? Actually, more populist statement from Sarkozy has increased his standing in the polls which may have translated to falling stock prices.

Getting comfortable with prediction markets will be especially useful as we move closer to the 2008 US presidential election. There are currently market prices for both Republican and Democrat candidates. At this stage, the numbers suggest we do not have a clear picture of who either party candidate will be. How this is being discounted in the equity markets has yet to be determined.

Makin, Mischief, and Central Banks

John Makin provided a scathing assessment of the Fed and the Bank of Japan in the weekend edition of the Wall Street Journal. His criticism titled “Monetary Mischief” was focused on the raising of interest rates in Japan with inflation being at approximately zero and with the Fed not raising interest rates with inflation above the suggested target of 1-2%. Wile his criticism is well taken for those who believe that central banks should only worry about inflation and inflation targeting, it misses the point that central banks have multiple objectives. For those who have to forecast interest rates and central bank behavior, understanding the competing demands of the central bank is essential to any analysis. This positive view makes no value judgment concerning central bank behavior only an analysis of what will occur and what are the implications.

The Bank of Japan is currently worried about exchange rates and external effects. Raising interest rates from 25 to 50 bps will not change the overall easy money stance of the BOJ. Granted, reserve growth have fallen, but even with a euroyen rate at 50 bps and inflation at zero, the real euroyen rate is below the current long-term growth rate for the Japanese economy. Real rates are less than one percent with growth showing some signs of strength. A rate raise sends a signal that loose monetary conditions will not be tolerated forever and provides a reason for exchange rate changes to be less one-sided. Central bank policy fears concerning exchange rates are often focused on creating liquid two-sided market which are not subject to excessive swings. This is consistent with the longer-term goals of the G7 finance ministers. The increase is rates in Japan albeit small is a signal that the exchange rate will not be tolerated to move to extreme low levels. There is limited harm with the BOJ’s actions and it at least temporally restores some balance in the global markets.

The lack of Fed action at their last meeting only tells the market that the Fed is willing to delay further increases in interest rates as they assess the recent economic information on housing. This makes sense given the strong declines in stocks associated with sub-prime lending and the issues with potential housing declines. The Fed has a clear requirement to look beyond inflation regardless of the talk from many hawkish Fed presidents. There will be enough information over the next quarter for the Fed to reassess their current position. Is the Fed providing a “Bernanke put” on the housing market? Hard to say, but a postponement in raising rates is a premature signal.

Thursday, April 5, 2007

The limits of arbitrage – explaining divergent market moves

With the strong deterioration in sub-prime lending, there has been a negative impact on the securitization market. Spreads are widening especially for lower rated tranches and the equity portion of deals. This strong negative reaction by markets to bad news is not isolated. There is a general tendency for price action to have stronger down moves versus a slower grind upward in price.

It is worth discussing the reasons why some markets may have significant market declines. While there may be clear economic reasons for a fall in value, markets can also decline because there are limits to the amount of capital that is available to take the other side of trades. We have seen a number of circumstances where a market sector has declines which are greater than what would be expected given economic conditions. Ex post, it always seem like there is an over reaction, but a different strain of thought for why markets may have strong negative reactions has been called the “limits of arbitrage” theory. This theory has also been used to explain a number of market anomalies.

Under the limits of arbitrage theory, steep price declines or market anomalies are associated with the fact that the marginal buyer requires specialized knowledge. Given operational knowledge may only be held by a limited set of market players, there will be a greater chance for an over reaction or for longer periods of dislocation for those markets which require unique analysis skills. When more specialized knowledge is required to make a decision, the chance there will be a shortfall of capital to take the other side of a trade increases. Similarly, if there is more uncertainty surrounding the reason for a price decline, that is, there is not a clear reason for the price move, then there will have to be a further decline to entice buyers to trade. The marginal buyer will have to have the skill to understand the uncertainty and the capital to act upon his beliefs.

Certain markets may exhibit greater volatility during adverse market periods. Some market anomalies may last longer than expected. This was described in the “The Limits of Arbitrage” by Andrei Shleifer and Robert Vishney in the Journal of Finance. This theory was recently explored empirically in the April 2007 issue Journal of Finance through analyzing specialized knowledge in the mortgage market, see “Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market” by Xavier Gabaix, Arvind Krishnamurthy, and Olivier Vigneron.

The marginal investors with special knowledge are also the very participants who may have already been holding these securities; therefore, there will be a negative wealth effect on why it may be hard to find the marginal buyer. These specialists may also be less diversified than other managers because of their unique knowledge. This further compounds the liquidity issue. If prices in the market for sub-prime securitization declines, there will be less capital available for marginal buying by those with good market knowledge. Their knowledge of the potential value is present, but they do not have the capital to invest. New buyers or capital has to be found. Time is necessary to stem the liquidity crisis.

The limit of arbitrage theory also presents asymmetrical information problems for some markets. If there are limited buyers for a specific type of structure, it may occur that all will have similar opinions about the market at the same time. More specialized knowledge may have less likelihood for diversification or heterogeneity of opinions about value. Additionally, when there is specialized knowledge there is the potential for adverse selection problems. Anyone who wants to sell a deal during declining economic times may be thought to have special knowledge about the adverse conditions. Buyers who believe that they do not have this knowledge would require greater compensation before they enter the market. This would also be true for new players who may perceive that they have less specialized knowledge about these markets.

In many market situations, there may not be just a shortage of capital. Markets with liquidity problems could be facing a knowledge shortfall, the ultimate capital.

Wednesday, April 4, 2007

What to expect in crop commodities

There is a seasonal rhythm with commodities which is important to study to understand the markets where there can be the most significant risks and potential for surprises. The USDA provides a nice calendar for all of the major crops around the world each month.

The April crop calendar shows that corn planting may be the most important decision during the month. Cocoa flowering in Africa could provide the greatest event risk. We will also find out about the size of the South American soybean and corn harvests which will have an important effect on supply and prices for these key markets.

Given the size of the grain plantings in Brazil and Argentina, harvest information will provide some early warning on what may be the potential surpluses in these markets. Harvest information also feedbacks on planting intention in the United States. While corn prices fell on intentions, there can be a significant difference between intention and actions. The actions will be driven by current prices as well as weather conditions in the field.

Defining risk and risk management

Elroy Dimson provides a good definition of risk, “Risk means more things can happen than will happen.” It is the more articulate version of the phase, “S--- happens.” Risk is the certainty that we will not be able to anticipate all that may occur or what will occur. In spite of our best efforts, we cannot foresee what may happen. The best we can do is protect ourselves from the extremes which are not expected.

Peter L Bernstein, in an article for a CFA publication titled, “Risk: The hottest four letter word in financial markets” provides a good way of thinking about risk management.

To me, risk management is not about measurement at all. It is about how we make decisions and only incidentally about the math we use in making those decisions. If we stare at just the models and equations, we lose sight of the mystery of life—we lose sight of the unknown. There would be no such thing as risk if everything were known. If only a finite number of things could happen, risk would not exist. Even the most brilliant mathematical genius will never be able to tell us what the future holds. What matters in thinking about risk is the quality of the decisions we make in the face of uncertainty.

The most salient point from Bernstein is in italics. The quality of decision-making is what determines the quality of risk management. There has been too great a focus on the measurement of risk and not the process of how to deal with risk. If Dimson is right with his definition of risk, the measurement problem will not be able to be solved. There will always be things happening which we cannot measure. Our focus has to be on how we deal with the unanticipated. The process of our decision-making is the true value proposition with risk management, yet there has been less focus on this critical issue.

Tuesday, April 3, 2007

Payout yield as an alternative to dividend yield

An important piece of research caught my eye on the back cover of the Journal of Finance, “On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing”. (See the paper for details.) This article by Jacob Boudoukh, Roni Michaely, Matthew Richardson and Michael Roberts (BMRR) is a deep and careful piece of research which addresses an important issue in equity pricing models. 

Significant research on dividend yield has shown that it is an important factor in the pricing of stocks both cross sectionally and through time. Generally, it is viewed that high dividend yield suggests that the market is undervalued while low dividend yield suggest high equity valuation. The dividend yield is fundamental to the Gordon growth model and for the Fama-French three factor model. Nevertheless, there has been a significant fall-off in the significance of dividend yield as pricing factor in the last 15 years. Researchers have been puzzled by this change. Some have suggested that the market has adapted or adjusted to using the dividend yield which is the cause for the declining significance while others state that the initial importance of dividend yield was illusionary. 

BMRR take a different approach through analyzing payout yield instead of the dividend yield. The approach is straightforward. What is relevant is not just the dividend yield but also repurchases which have become to serve as a substitute for dividend yield. Additionally, the net payout which is the combination of dividends and repurchase minus issuance would be a better measure of net cash flows in the equity market. The intuition behind using payout ratios seems to fit the facts for the United States over the last fifteen years at the same time that dividend yield began to diminish in importance. Share repurchases have become a bigger share of payout and the huge issuance of new stock during the technology boom forces the net payout to decline in a manner consistent with market over valuation. 

More important than the stylized facts about payout is the careful empirical work which shows that payout ratios have better explanation power than dividend yield. Payout ratios provide economically significant predictability relative to the dividend yield. The differential between high and low payout yields is a priced factor.

Monday, April 2, 2007

Where are the important financial flows and stocks?

While the media focuses on a single story or a few major themes in financial markets at a given time, it is important to focus on the larger picture of where the largest stocks of financial assets are and where are the greatest cross border flows. The insightful graph from McKinsey & Co provides a good depiction of the world financial picture.

The importance of Europe cannot be underestimated. Nevertheless, it is important to focus on the margin. In this case, the accumulation of wealth in Asia, particularly China is the region of greatest change albeit off a low base. The growth of these new areas of financial wealth is one of the reasons why the comment from some economists that we should describe India and China as “Chindia” make sense.