Bad days for trade

The Doha Round of trade is dead or at least it has been pronounced dead once again. While this does not seem to be on the radar screen of many traders, trade is a very relevant issue if we are going into a global recession. The current breakdown is related to agricultural subsidies. The only bright spot in the US economy has been exports. The EU is much more export driven than the US. Emerging markets have been driven by their ability to export to the G10. Trade is the basis for much of the gains in growth.

However, the first guilty party for lost jobs in most countries is trade and global competition. Restrictions on trade may seem to have a positive effects for saving some jobs but the impact of lost trade is real and substantive.

A movement toward multilateralism or bilateral trade agreements only makes the world more complex and reduces trade flexibility across regions. The threat of tariffs or other restrictions like the 1930's debacle is real.

An additional trade issue is the announcement that Russia plans to control their grain export business through a state grain trading company. Russia is the fifth largest exporter of grain and the current price spike is causing a new level of mercantilism around the world. We have moved from talk of grain OPEC to action by some countries. State control of grain trade will only slow to movement from those who have grain to those that may need it. State considerations may be more important than price.

We are already seeing the terms of trade for grain exporters improve relative to those who are importers. This movement in terms of trade will continue if grain prices remain at current levels.

Inflation is a global problem

Federal Reserve Bank economists in Chicago studied closely the inflation phenomena globally and found some interesting results. Inflation is a global issue. While this does not seem likely a surprising result, the size of the common variance is higher than what many would expect. Additionally, because the common factor is so high, it is hard to isolate the relative inflation effects across countries.

Approximately, 70% of the variance of inflation is associated with a common factor. We are already seeing this common effect with the kind of food and oil shocks around the world. Singular global shocks will cause the high common variance. Additionally, if the monetary policy response around the world i similar there will be a high common factor. If there is a loose monetary policy in response to shock there will be more common inflation.

Yet, there is a mean reverting or error correction component to the inflation rate so that inflation in individual countries will revert back to the longer–term global rate. Any inflation impact in a single country will not be sustainable relative to the rest of the globe. This mean-reversion is affected by the level of openness around the globe and the fact that exchange rates and capital will respond to these differences. The pattern of behavior is very much the same with a real shock in the short run followed by monetary behavior which will drive the inflation action in the longer-run. Inflation shocks and monetary developments are closely intertwined and really cannot be separated.

You cannot separate the inflation in one country from what is happening in the global economy. We can also say that high inflation countries will not sustain this behavior and being a buyer of high real and nominal rates versus a seller of low rates makes sense. This means that carry trades can still exit but the risks are different. Clipping coupons and picking up yield have to be substituted for duration plays where the expectation is that yields will fall or rise with inflation reversion.

The echo effect and the current economy

The echo effect is a well know phenomena in many sciences. Some shock to a system may dissipate through time but may cause secondary effects as the initial impact moves through time and disrupts other parts of a system. You get feedback and distortion. Think of the old wave machine in physics where an initial wave will have new and more complex effects as it comes in contact with other objects. This stylized idea of echo effects and the timing impact of shocks and the subsequent reaction is a concern in the current economy.

The problems of 2007 and 2008 are a result of the action from the last bubble in 2000. The dot.com debacle caused a Fed monetary policy reaction of lowering interest rates to maintain economic growth. The 2001 recession was short-lived because of the swift and strong reaction of the Fed. This set-up the housing market excesses between 2002 and 2007. With rates taken down to such low levels, it was inevitable that some borrowers and lenders would try and exploit the attractive rates and increase leverage.

Given rates were set at lower levels and never really had a chance to grow to the levels that would reduce housing speculation, the US economy’s current problems were potentially exacerbated. The Fed again lowered rates in 2007 but from a lower starting point. We are now at 2% Fed funds but our policy choices are now restricted. This is no different from what happened in Japan during their “lost decade”. A reaction to the first downturn caused limitations in policy choices later on. However, in the case of Japan, the lack of swift action meant a deeper problem later. In the case of the US, swift reaction during the dot.com debacle has generated over speculation in other markets which have to now be dampened. We are affected by our past choices.

The vicious Fed funds capital regulation trade-off

Banks are expected to have a minimum amount of capital in order to be in business. This is for the protection of shareholders, depositors and the economy in general, but the current credit cycle creates a problem where maintaining a minimum capital base will restrict the potential growth of credit even if there are low interest rates from the monetary authority. The Fed has lowered rates, we have an upward sloping yield curve and the Fed a balance sheet is available, but the amount of lending going on in the US is actually decreasing.

It is hard to lend if your capital base is declining and your capital base will continue to decline if you show mounting losses and no new profits to shore up capital. Hence, the current crisis has capital requirements in conflict with the objectives of the Fed which is to have more lending activity. This is a problem in a deleveraging world.

Regulation needs to be in place that will stop the erosion of capital through less marking of losses on existing loans or some relief on capital standard so that new lending can occur. You can lower rates, but that does not mean that loans will be made. This is a variation on the classic liquidity trap problem. The credit crisis will be with us for some time.

Why are banks still paying dividends?

A close look at some bank dividend yields show numbers that are in the double digit range. If these banks are capital constrained and seeing mounting loses there does not seem to be a good reason to continue to pay-out these high dividends. Over five times the Fed funds rate! Three or more times Libor!

Either these banks are extremely cheap on a temporary basis or management has something else in mind. Note that the lower rates and the Fed allowing the banks to use its balance sheet further pushes the question of what is going on in the banking sector. Why would the Fed not use its bully pulpit to get banks to shore up their capital instead of paying off shareholders? Think of it, the Fed is lending at Fed funds and providing its balance sheet so shareholders could be paid instead of making loans off the increased capital base.

An answer could be with the view to stop short selling. The actions taken by the SEC restricts naked short selling for 19 financial institutions. Investors can no longer engage in or selling short a stock which has not yet been borrowed. When you short and borrow the stock, the seller is on the hook for the dividend which means the cost of borrowing is higher when the dividend yield is high. If you keep dividend yields high you punish any short sellers. Nevertheless, the key issue is whether banks are shoring up capital and not paying out yield to shareholders.

History lessons, the last big recession and fixed income

The best way to analyze the present is to look at the past. Ironically, the worst way to understand the present is to filter through the past. We are slaves to our experiences, yet experiences are the easiest way to provide a filter on what is unique to the current environment. The current economic environment is no exception.

We have to go back to at least the 1990 recession to begin some fruitful discussions of the current environment. This comparison provides a lack of comfort especially with bond rates. The CPI has hit 5% for the first time since 1991 and if the pull of commodity prices continues, then there will be further increases or at least an average rate higher than we have seen in years.

The important fixed income issue is that current 5-year Treasury yields are at 3.20% while the yield for the same Treasuries in 1991 was at 7.70%. The real yield today is negative in an effort to stimulate the sluggish economy while the real yield in 1991 was positive. Was the real yield the correct monetary policy for 1991? Certainly, the early 1990’s were a slow growth “jobless” recovery until after the 1992 election, but inflation was on a downtrend post-1990.

The take away is that we have a monetary policy that may be more stimulative but the nominal interest rates today do not fully reflect the inflation that we are seeing in the market. There should be no comfort for bond investors in the current environment.

The SEC naked solution and the impact on markets

New limits on naked short selling have changed the rules of the US stock market. Should there be naked short selling in the market? No. The issue why Christopher Cox and the SEC waited so long for some action and why should it be limited to a set of 19 financial institutions? If the practice is bad, then why not have it applied to everyone. What makes banks so special that they would receive this treatment? There will be a price to be paid for this government action regardless of what is believed to be a good policy in the short-run.

Selective enforcement or changes in the rules calls into question the fairness of the market. Face a bear market especially in financial stocks and the SEC will change the rules for short selling. These 19 financial institutions are all suffering loses and could go down further based on the strength of the credit decline, yet there are other firms including banks which are in similar trouble. How did the list of 19 get created? (I would hate to be the 20^th institution which did not make the cut.)

These new rules will go into effect on Monday but the impact has already been felt with some bank stocks going up over 20% in one day after the announcement of the change by the SEC. The new rule combined with so good earnings number shave stemmed the bank stock decline, but this certainly will not save many banks. Short sellers which just have to borrow the stock first; however, in the world market is clear that the SEC will change the came when it sees fit.

Fannie and Freddie – No losers except the taxpayer

I have commented in the past that there has been an implicit assumption that government will back the debt of Fannie and Freddie Mac. Certainly there may be many investors especially outside of the US who believe that there always was a government guarantee. The GSE’s themselves may have believed that they would always be bailed out. This is why they have driven their balance sheet to such extremely high leverage levels. Shareholders may have also believed that the government would protect the debt. They were willing to invest in quasi-government sponsored firms with accounting irregularities and high leverage that they would never take from other private firms.

The two GSE’s own or guarantee over $5 trillion in mortgage debt which represents about half of all of the mortgages in the US. These organizations are too big to fail, yet there is no reason why there should not be some cost for GSE behavior excesses. The phase that best describes the current GSE model is for “privatized profits while socializing risks” Taxpayers have to pay the bill while shareholders have been paid past profits. In fact mortgage companies created many of the new mortgage products because they could not compete in the conforming vanilla mortgages packaged and bought by the GSE’s.

The extension of the government balance sheet for helping the mortgage GSE’s is a move to nationalization of the mortgage business. Yet for this entire debacle, shareholders have not been punished by the government. Management is still in place. Bondholders have moved from Treasuries to Fannie and Freddie to receive the higher yield and have not been punished for making the bet on a bailout. The bailout is needed and the support of the mortgage market is required but the process makes a difference. There are no losers except the taxpayer.

Risk aversion, the VIX index and the carry trade

Watching carry trades this month would suggest that there is no problem with risk aversion in the currency markets. High yielders are doing well like the best of carry times. This is especially surprising given some of the signals that have traditionally been used to measure risk aversion in the market. The general view is that when risk aversion increases there will be a home bias that will keep funds from moving into carry strategies. For example, the VIX volatility index has moved above 30 which has usually been a sign of heightened risk aversion and an equity sell-off, yet has done well even with the risk jump.

Carry trade dynamics may be changing. In a risky world of credit, trading sovereign credit through carry trades may be less risky than the credit risk of buying debt from a corporation.

Sovereign risk for many high yielders has diminished significantly over the last few years. While sovereign ratings have increased, they may not actually reflect the true positive developments in many of these countries. Current account balances for many emerging markets are in surplus and the economies of emerging market countries also seem less linked with the US. The linked effect for emerging market, expected in the second half of 2007, never truly materialized.

Instead of placing more money in US debt even at the more attractive current spreads, the diversification benefit from carry across a number of countries may be a more controlled bet. While carry trades have underperformed in the last year and are generally correlated with equity returns, the relative underperformance has not been as great as what the markets have seen with global equity indices.

The mood for how the market looks at carry may be changing which means the link with equities may be over and the strategy is viewed as an more effective alternative to corporate spread risk when there is heightened credit concerns.

Frozen Fed monetary policy - Losing a degree of freedom in foreign exchange markets

The US monetary policy choices are frozen. The downturn in the US has caused an aggressive lowering of short rates by the Fed but now higher inflation in US is a growing problem, so there are limited policy choices for the Fed given its dual role of control growth and inflation. Lower current yields to help the recession and you will create the opportunity for higher inflation given the expansion of credit. If you raise interest rates to stop inflation, you will create poorer credit conditions and stifle future growth. The Fed is stuck between two hard choices in the current environment and will have to wait for new information to direct their choices. Until the Fed is driven or forced to make a choice, 2% Fed funds rates will continue.

A limited set of choices for the Fed means that the dollar will be driven more by foreign central bank behavior. Money will flow based on the choices made by other central banks and not by anything that the Fed can do. For example, there will be more focus on ECB behavior where there is the potential for more policy changes. Of course, no action is an action, but the current Fed freeze will place more weight on following the behavior of central banks in other countries and not on the action in the US. The need to focus outside the US for dollar direction will increase.

Fed Congressional testimony – often states what we already know – Now what?

So let’s get this straight, the US economy is facing “numerous difficulties”, growth risks are “skewed to the downside”, restoring the financial markets is “a top priority”, and inflation risk has “intensified lately” The data has already shown this and financial markets have reacted accordingly. The issue is what can be done to change this downward direction. Of course, the first law of problem management is determining what is the problem and in this case there was no sugar-coating by the Fed. Now the issue is what to do about it.
The Fed has lowered rates. The Fed has offered lending facilities in an unprecedented manner. The Treasury has developed housing programs and has provided coordination of activities. Some tax relieve has been given for a stimulus package so Congress is taking some action but all of this is under an environment of rising inflation which may be at odds with the stimulus.
The US economy is in a strange state of disequilibrium. (Disequilibrium is economist jargon for not being sure what can happen next, other that something will change.) There is a lag between any policy action and the response in the economy, so we do not know the true impact of these policy changes. The economy is reacting in real time to events yet the possible policy action has a delayed reaction once we get beyond the announcement effect. Consequently, any change today will not reverse what has already been done and may take time before it will impact trends in financial market prices. Policy-makers have to be forward looking with their choices no different than market players look ahead for price effects. Most legislation will not have any immediate impact this summer other than through a change in current negative expectations. That may be enough to reduce the decline but is unlikely to have a long lasting effect.

Fannie Mae and Freddie Mac - the guarantee always expected

The Treasury announced that it would support Fannie Mae and Freddie Mac through a direct lending facility at the primary credit rate collateralized by government and agency securities. The Treasury is also asking Congressional approval for increased line of credit. These changes do not change the status of these GSE's but provides what was always expected a backstop guarantee from the government.

Nevertheless, there is a level of irony with these actions. These GSE's never got involved in the sub-prime mess. They never engaged in holding the exotic mortgages, so they were never the direct cause of the problem. In fact, they were backing off from the market, but the fall in the housing bubble is having a huge secondary effect on their financing and their ability to maintain their current leverage given an eroding capital base. Their stocks have been decimated. They financing is now in shambles and the taxpayer is left holding the bag. A private entity which generated profits for shareholders is now having the government bear the social costs of their leverage practices. Agency spreads have not widened on this news because the market already believed that this was a likely scenario.

The housing fall-out continues and will have the ramification of increasing the overall cost of the housing debacle while eroding the confidence of investors in the US fixed income market. Even with borrowing lines, the ability of these entities as GSE's to follow business as normal activities will be curtailed.

Poor sign for fixed income

SAC cuts back on its credit fixed income business. An interesting development when a savvy hedge fund manager decides to reduce exposure to credit risk businesses just when you think that there would be strong opportunities in this asset area, or maybe SAC is smarter than most and believes that these credit problems may need years to work out.

Gains in hedge fund are a function of profit opportunities and the efficient use of capital. Lower profits can be taken in a given market sector if liquidity is higher, the portfolio can be turned over more quickly and financing is available. In the case of fixed income credit plays, you have the worst of all three.

There is limited financing available from banks to buy bad credits. They have enough exposure to credit risk without providing lending for customer credit plays. Even if financing is available the financing cost is much higher than a year ago.

Liquidity is limited in the credit area so the bid-ask spreads are very large. The search costs of finding a buyer or seller are higher than in other markets because there are limited players who have the expertise to evaluate these securities. The potential for asymmetric information problems is great when the securities are hard to value. Clearly, there is little meaning to any rating on a asset-backed security. The stress testing from a few years ago may have less meaning in the current foreclosure-delinquency period.

The lack of buyers also means that you will have to hold credit risk instruments for longer time periods, so portfolio turn-over will be low. The return has to be higher because the holding period will be longer. In some case, the value may only be realized if held until maturity.

Credit risk trading in the fixed income market may be the arena only for insurance companies and banks that can buy and hold until maturity; consequently, this may not be a sector for hedge fund participation. Fixed income may not be a place to play until some of the current uncertainty is resolved.