China grows on the financial stage

It was announced that China and Argentina have entered into a $10 billion three year swap agreement that will provide Argentina with a line of reserves to potentially help its currency trade. They were not able to get a swap line form the Fed. China has done this before with other Asian countries but this is the first time with a Latin American country.

This is very interesting because it come on the heels of the discussion for a global currency by the Chinese. The symbolism of this signing is much greater than the actual economic impact but this type of agreements are worth watching because it shows the growing desire by the Chinese to take an active role in international finance.

Stock market and carry

Stock market and carry trades currently look to be linked in a manner not previously seen. When the stock market rallies, there is a pop in riskier high yielding currencies. However inferences on the link should be carefully considered.

There has been more research talk about the beta in carry trades and that high yielders are related to macro variables as measured through the consumption CAPM and also through a changing risk premium that is accentuated in market downturns. That is, the beta or correlation between high yielders and the stock market increases when there is a big market move. The argument also states that low yielders have a negative consumption beta and outperform when we have a fall in consumption. The risk premium in high yielders are counter-cyclical like bonds and equities.

Nonetheless even a simple review of the relationship between equity prices and high yielders is more complex that what some may think. Certainly, the story of higher betas for higher yielders does not fit the facts over the last two business cycles if we look at a carry portfolios and stock indices.

We take a very simple diagram of a carry trade index and three major stock index, the S&P 500, the MSCI EAFA and MSCI World. The graph provides two contrasting positions on the relationship between equity returns and carry. First, there is a strong positive relationship between carry and equities during the current credit crisis. Both have moved down significantly albeit the carry actually faired much better.

However, if we look at the carry trade during the equity downturn during the last recession in 2000-2001 you get a very different story. Here carry was able to ride through the recession and provide a good alternative source of return. The story that high yielder will be tied to an equity or consumption beta does not hold and the graph shows the opposite result.

Equities cannot provide a good measure of risk for carry. There has to be a unique factor that applies to both stocks and carry to explain the more recent relationship. The alternative story is that carry returns are related to liquidity risk. This may be more consistent with the facts because the recent stock market sell-off has been a global liquidity problem while the earlier equity downturn was the unwinding of the technology bubble. In that case, the monetary authorities provided significant liquidity to the financial markets which was taken and used to invest in new trades including carry and real estate.

Carry is a liquidity trade and to the extent that liquidity becomes scarce for both equities and carry, there will be a fall-off in both. Without a liquidity event, they will move in their own directions.

Short-term rates at lows - investors need confidence boost

It is interesting that are supposed to be through the worst of the credit crisis, yet we saw negative interest rates for short-term 4 week Treasury bills in the middle of last week and current yields are at 1 bp. You always hate having to explain why rates go negative even if it is only for technical short-term reasons. Yu pay someone to take your money.

Clearly, there is end of quarter window dressing; nevertheless, this is a sign that the credit crisis is far from over. Money is not moving out to riskier assets with 90-day CP at 100 bps above Treasury rates. The spread between high quality CP and Treasuries are much wider than one would expect given all of the Fed action, but investors have not been willing to reach for these yields. The level of risk aversion is so high that even though investors are getting virtually nothing on their Treasury money market funds after fees, they will not move to other money market alternatives even with implicit principal protection from the government.

The Fed has pushed down the short-end of the curve as much as they believe possible so they are to willing to buy Treasuries with longer maturities, yet even here the curve is steep on a relative basis. For example, the differential between 2 and 5-year Treasuries is about the same as a year again even though we are deeper in a recession and have government buying.

Investors need a shot of confidence or at lest a reduction in uncertainty in the rules of the game before they move money to riskier assets.

FASB ruling very significant for banks

The FASB may vote this week for a change in mark-to-market accounting rules through their overhaul of fair value accounting. The implication for the banking sector is huge. The impact on the PPIP program will also be significant. This will also be a massive a change for investors. 

Think about it. Assets that have been priced today against recent sales based on distressed levels from a lack of liquidity may increase in value tomorrow. There also may be less reason for banks to sell assets which are marked at prices that represent their long-term value and not current expectations. Most banks may prefer to hold these securities against selling them for a loss. Yet what are they really worth? The values will be based on models which may not have a clue of what are the true timing for these cash flows.

But if we change prices today will these banks really be more valuable? What happens to the government stress tests? How are investors going to determine what banks will be worth? Who will approve the models that will be used?  

It is not clear all of this will be good. The law of unintended consequences will be at work.

Treasury-Fed Accord of 2009 - blueprint for the future

The Fed was used during WWII and the post-war period to peg interest rates given the high amount of debt issuance. This lasted until March 1951 when the Treasury-Fed Accord allowed the Fed to gain independence to not have to fix rates. The new joint statement by the Treasury and Fed sets a framework for their interaction.

The credit crisis blurred the roles of the Treasury and Fed. Fed was buying assets and placing them n its balance sheet. The Treasury could have been financing these assets with Treasuries. The ed is supposed to focus on price stability and overall growth but when it is buying assets the objectives of the Fed are less clear. The issue is whether the Fed should hold risky assets from a bail-out. Specifically, the assets of AIG and Bear Stearns should ultimately be held by the Treasury.

The Treasury and Fed agree to four main points:

1. They will work together to improve the functioning of the credit markets and reduce systemic risks.

2. The Fed should use its powers to broadly help credit markets during a crisis as the lender of last resort, but should not use its balance sheet to help specific credit sectors. This should be the responsibility of the fiscal authority.

3. The role of the Fed should still be monetary stability and this should not be affected by or constrained by the specific actions taken under extreme circumstances. The purchase of assets should not subvert its main monetary policy goals. Legislative action should be used to increase the powers of the Fed to meet its overall mission. The Fed would like the ability to issue its own debt as a way of reducing bank reserves. 

4.  The role of the Fed and other Federal agencies should be better defined to minimize the chance of a system failure. 

The scope of this accord is broad and does not have many details but this is an important memo which will better define the roles of each player. This will provide more clarity for both the Fed and Treasury and should ultimately allow the Fed to have more flexibility when it needs to start to reduce reserves. 

Political turmoil increases on the fiscal stimulus "road to hell"

Political risk is gaining on the markets as EU president states that the US in on "the road to hell" with fiscal excess.

UK Prime Minister Brown is having a tough week with pressure both from the Chancellor Alistar Darling and the Bank of England governor Mervyn King to be more cautious concerning fiscal stimulus.

The EU President Topolanek, the Czech republic prime minister, lost a vote of no confidence. This places the EU and the Czech republic in turmoil before the G20 meetings. While we do not model political developments, this reinforces the negative credit news coming out of Eastern Europe. Negative economics calls for demands to change. This turmoil has reversed the currency improvement as uncertainty has increased.


What is going on in economic data -

Fourth quarter final GDP numbers show economy was down 6.3% and personal consumption was -4.3%

Singapore industrial production down 22.4% which is in line with other Asian countries. Hong Kong exports are down 23% which is again consistent with other large exporters.

French and German consumer confidence hovering at low levels. UK retail sales are off just under 2% for February MOM, but if there is any good news in the UK, it is the smaller decline in total business investment which had a decline a lot lower than expected.

Perhaps the most important news was German CPI in North Rhine Westphalia which is now don to zero. This eases pressure on the ECB to hold rates firm. We should expect to see ore movement to lowering rates and discussion of quantitative easing. In fact, this is consistent with comments coming from the ECB.

Failed 40-year Gilt auction is the top story. What happens if the budget deficits cannot be financed? UK government expected to have financing needs of 146 billion pounds in 2009 and they cannot find enough buyers for 2.55 billion sterling. The risk of failed British auctions before were with inflation protected bonds and not nominal bonds. It seems like investors are willing to buy short-dated paper when the central bank is willing to be a stopgap but they are not willing to buy out the curve in a long-term environment which is inflationary.

This will cause more focus on US debt auctions as the market is fearful of supply. The US 5-year auction of $34 billion. The Fed bought $7.5 billion of Treasuries. What the fiscal authority issues with one hand the monetary authority buys with the other.

Words matter and if the Treasury secretary suggests that he is "open" to the Chinese idea for an improved SDR world currency you can expect that traders will listen. Of course, he was referring to the need for international liquidity through the IMF, but the market did not take his comments as a nuanced view on global liquidity.

US-

Durable goods were up big. This was a surprise, but the previous month was revised down which dampens some of the positive effect. New home sales were positive which is another positive sign for the economy.

EU -

German IFO numbers were relatively stable, but still at depressed level. While this is not good, the slowing slowdown theme is positive.

Mixed signals in G7 economies

There continues to be mixed signals in the G7 and global economies which suggest that the one directional downturn may be over. This does not mean that we will see a recovery, but the slowing of the downward adjustment seems to be ocurring. This may allow for a firming of both debt and equity markets.

One country which is an extreme example on the export side of the global economy is Taiwan. Export orders were again down with industrial production, but the numbers were not as bad expected. Still the export decline was over 20% and the fall in industrial production was over 27%.

The PMI numbers for France, Germany, and the EU were all flat relative to the previous report. The indices are suggesting that Europe is no worse although we are not near balanced readings of 50.

In the US, the Richmond Fed manufacturing index shot up to -20 when the market was expecting down -51. This was a sizable jolt to the index albeit we are still much worse than the last recession. We have seen this type of gain before. In the last recession, there was strong rebound in manufacturing only to see the numbers decline again in 2003.

While markets are focused on policy changes, it wil be the rel economy which sets a floor.

Suggestion of new currency regime changes the policy discussion

The Peoples Bank of China governor Zhou Xiaochuan submitted a proposal for a new monetary order, or rather a return to some of the old ideas of the past with a global currency administered by the IMF.

The return of the SDR has some merits and should be subject to some serious discussion on the eve of the G20 meetings in April. The main focus of the meeting should be elsewhere, but revisiting a discussion on a global currency may be appropriate at this time given the strong need for liquidity around the world. The US may be at odds with the rest of the world when its main objective is o help the domestic economy. While spurring the US economy is good for the rest of the world, the objectives and timing of the US may not be aligned with the rest of the world. This is the classic Triffin Dilemma associated with a reserve currency. The US may have less interest in a strong dollar or concern fro developed countries relative to US goals. A method for changing the golas would be through more international control of liquidity.

Yet any fiat money will have some of the same inherent problems that exist with a dollar-based global system. Nevertheless, the world and in particular Chin would not be captured by the objectives of the US and the Fed if there was a new monetary order.

Do the right thing and buy toxic assets

Winston Churchill once quipped that "The Americans will always do the right thing after they have exhausted all the alternatives" Take from commentary by Marc Chandler of Brown Brothers.

Seems to hit the spot when discussing some of the policy alternatives.  

Looking for slowing in slowdown - got a policy game changer

The focus on macro trading is looking for a slowdown in the slowdown, a change in the momentum. We are not getting much on that front but we did get a game changer with the Treasury toxic asset plan. While there are no surprises in the plan and it will not get started for weeks or months, there is the few that the US government is moving in the right direction albeit well after the initial announcement in February.

The market reaction has been a huge rally for stocks with the financial sector of the S&P 500 up over 17% in a day.

Japan -

Japan announced MOF quarterly business conditions survey information. There is nothing good to report although there was slight improvement since the last quarter. The only bright spot were the forward looking projection which show significant improvement at the end of the year. However, the numbers are still negative. This has been the consistent theme in global markets, wait for the fourth quarter for recovery.

Supermarket sales also were negative and much worse than last month by a factor of 2 at down -5.4%. Convenience store sales were actually up 2% but down from 7% last month. This is consistent with the decline in industrial production.

Canada -

Leading indicators are pointing down and have been negative since the and of the summer. The only component that is positive is money supply which has exploded with the BOC moving to quantitative easing.

EU -

Trade balance down significantly. Exports are falling off a cliff like the rest of the world. WTO reports that trade will decline by 9% the most sine WWII.

US -

Existing home sales surge by 5% as affordability increases and the median home price is still in decline. Prices fall, mortgages become cheap, and markets clear. Some of the talked about home programs have not started, so the solution is simple. With greater affordability, buyers will go out and make purchases.  

Tail risk analysis needs preparation

As general rule, the most successful man in life is the man who has the best information.

Benjamin Disraeli

Ian Bremmer in his new book, The Fat Tail: The Power of Political Knowledge for Strategic Investing discusses the current greatest risks:

• Geopolitical risks because the focus has been on domestic economics.
• The new capitals of capital because wealth and money is shifting away from the West.
• Political instability from the current global economic crisis. The economic risks will turn political.

Tail risk was also discussed by one of the leading researchers a PIMCO. They make the important point that hedging tail risk after a crisis is of course too late. Just in time risk management is expensive and does not solve the problem so the the most important issue is trying to find the next tail event. This tail events do not have to be only downside risk or left hand tail events. There can be positive tail risks such as the large move in the stick market. Those we do not anticipate these types of big events may negatively affect their performance through missing opportunities.

The best way to avoid tail risk is through having the best information, but data is not enough. The information has to be processed to anticipate what may happen in the extreme. This requires scenario analysis of what may happen in an unconventional manner or at an inappropriate time. For a global investor, this is the geopolitical risk of a fall-out from a deep recession. 

CBO budget estimates much worse than Administration's view estimates

The CBO budget estimates were announced on Friday and the number are much worse than the projections of the Obama Administration. The current year baseline budget deficit projections will come in worse by $400 billion and will total 11.9% of GDP for total of $1.7 trillion. The deficit will be $1.1 trillion or 7.9% of GDP next year and then will close to 2% of GDP through 2019. This assumes that we will be out of the recession by the fourth quarter 2009 and have positive growth in nominal GDP of 3.8% in 2010.

However, the number actually get much worse when the CBO estimates the President's budget. There is an extra $4.8 trillion in spending between now and 2019. The impact on deficit to GDP will be an increase of 2% so that the projection for 2009 will be deficit to GDP of 13.1% and 9.6% of GDP in 2010.

The impact on overall debt to GDP ill be 56.8% for 2009 and will rise to 82.4% as of 2019. The baseline debt held by the public will be 54.8% in 2009 to 56.1% in 2019. This is against the total debt held by the public to GDP of 40.8% in 2008. 

Crowding out is real and will be worse than expected. If the US was a small open economy, a debt held by the public to GDP of over 50% would place it in a warning zone. Now many European countries have high public debt to GDP, so we cannot immediately assume dire consequences. These projections will rival the post WWII period where interest rates were held down by the Fed-Treasury Accord. We expect that the Fed will have to monetize debt in order to keep this debt under control and avoiding crowding out, but then we will have higher expected inflation.

Rates will have to go higher over the long-run, but we will get to pick our poison. Higher expected inflation or higher real rates.  Nevertheless, with the output gap being over 7% of GDP, there is little to suggest higher overall inflation. We still think that the focus will have to be on asset inflation in the shorter-run which will suggest false rallies. 

Willie Coyote risk and liquidity events

Willie Coyote risk occurs when the bottom falls out of a market usually when there is a shortage of liquidity because of a pullback of credit. 

The number one issue for hedge funds and credit markets will be liquidity risk and the ability to obtain financing to undertake arbitrage trades. Markets will not converge if there is risk of financing over the life of trades. This is one of the reason for why the markets have not cleared for many toxic assets. There is a high probability to that many of these assets will pay-out close to par especially if there are are highly rated but the issue is getting financing for any buy and hold strategy. This is the reason for government financing to unlock credit markets. It can step in during rare liquidity events in order to ensure financing for potential buyers. 

Sage comments on money and deficits

The Old English Dictionary defines “fiat” as: fiat. [a. Latin 'let it be done'; 'let there be made']

Let there be made another trillion dollars in money to buy Treasuries and MBS. Yes we need this to happen. Perhaps not to this level, but quantitative easing has to be conducted with fiat money. The issue is what is the end game on the other side. The Fed has not mentioned what will happen when the economy improves or what are the signs of success or failure. We are trying to create an asset price bubble so using conventional measures of inflation as the policy target will not work. This is what got us into this mess. The focus was on inflation and not on asset prices. 

Lenin was certainly right. There is no subtler, no surer means of overturning the existing
basis of society than to debauch the currency. The process engages all the hidden forces
of economic law on the side of destruction, and does it in a manner which not one man
in a million is able to diagnose.

‐John Maynard Keynes

If there was a greater chance for debauching the currency, we are getting closer to that point. The impact of creating asset inflation and perhaps higher overall inflation is to help debtors and negatively impact savers. You reduce the paradox of thrift if you get people to save less which means that you have to make it less attractive. You want people to borrow and spend and go back to the old ways. The government is savings as the stopgap during the transition to more spending by consumers. This is the goal of printing more money and we should not forget it. 

Alexander Hamilton said: "to emit an unfunded paper as the sign of value ought not to continue a formal part of the Constitution, nor ever hereafter to be employed; being, in its nature, repugnant with abuses and liable to be made the engine of imposition and fraud."

Back to basics on prudent fiscal policy. Do we need deficit financing? Yes, however we are discussing a matter of magnitude with the CBO stating the deficit will be even bigger than expected. 

Keynes on bankers

A “sound” banker, alas! is not one who foresees danger, and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can readily blame him. It is necessarily part of the business of a banker to maintain appearances, and to confess a conventional respectability, which is more than human. Life‐long practices of this
kind make them the most romantic and the least realistic of men.

John Maynard Keynes, Consequences to John Maynard Keynes –
the Banks of a Collapse in Money Values (1931)

This is always a good quote to remember when thinking about policy and problem solving. Do we want to do the conventional thing or take some risks? There has to be a balance between convention and innovation. Right now we have to think about making sure that we do not create zombie banks which stay alive but do not add to the recovery or have a level of risk aversion which will restrict lending. 

We also need to think about using the rest of the TARP money and this will not be effective if policy-makers bash banks. Right now we are seeing institutions trying to determine how to give TARP money back as fast as possible. The only way for this to happen is if the banks cut their lending and shrink their balance sheets. Is this what we want? 

Commodities move higher from quantitative easing

Since the Fed announced that it was going to buy Treasury securities directly, commodity prices have moved higher. The GSCI index is up 3 percent since the move mostly driven by an increase in oil prices and gold. Hard assets have value in a recession if fiat money growth explodes. Because the world price of oil is in dollars, the real value of oil prices has not had as large a move. Dollar declines will usually see an up move in oil prices related to the pricing effect as well as changes in fundamentals.

The size of this up move is small versus the huge decline in commodities over the last nine months. The GSCI has fallen from over 10000 to 3666. Industrial production is still declining at an alarming rate as noted by EU industrial production numbers which declined more than 17% YOY. The GSCI is still down for the year and it will likely take more than the current Fed announcement and action to get a sustained rally, but investors are smart enough to sniff inflation and are looking for alternative investments as inflation hedge. This may be a little early bu the size of the potential inflation problem is significant.

Dollar tail risk from Fed is significant

The dollar has been taking some big hits especially if you look at a flow weighted index. The table shows the Citibank flow weighted dollar index for the last two and a half years. This series starts before the credit crisis. What is as surprising as the dollar rally are the huge spikes down in the dollar index.

These spike are tied to Fed behavior. The decline in September is associated with AIG and Lehman. The decline in December is the announcement of going to quantitative easing and the lowering of targets, and the recent drop with the announcement of buying Treasuries out the curve. While the market has moved back to higher levels in all three cases, it is interesting to see how the dollar sells off hard on these actions. The flow weighting makes it more likely that this is speculative capital movement as opposed to trade related activity.

The Fed tail risk is high and not helping to calm markets. International investors are not happy with Helicopter Ben when they make big announcements.

Quantitative easing in a big way

The Fed announced that it would further expand its balance sheet through further purchases of bonds. This should not be surprising.It is a continuation of the existing Fed policy. Buying more MBS to the tune of $750 billion is an extension of current actions. What was surprising was the inclusion of Treasury bonds. The reaction was swift. Higher stocks, lower bonds, and a dollar sell-off.

While the market was surprised overall by this announcement, it was expected to come later in the Spring, this makes sense from the longer-term policy objectives of the Fed. All longer-term Treasury yields have moved higher since December. Most corporate bonds and MBS are priced against Treasuries so even though spreads have come down as credit markets have improved, the overall yields have held firm.

The higher Treasury yields are strange given the deepening recession so a likely explanation is that Treasury supply is crowding out the market as investors continue to hold short-dated paper. Hence, the Fed has to get yields down through buying Treasuries. We already know that China and Japan will not have the same buying power, so the Fed will be the buyer of last resort and allow asset markets to reinflate.

Who get hurt in this? The dollar, but the government does not seem to care. If the dollar falls exports will get cheaper and the no one in the US cares if foreign bond holder take a hit. There is no dollar policy or at least there is no strong dollar policy. Of course, this may not be an immediate problem since we have been in a dollar rally, but the problem will follow the Treasury and Fed. The worry of inflation will resurface soon.

How stimulative is the stimulus package?

The simple answer is that we do not know, but we have clear evidence that there is not agreement that it will work. This is based on research that analyzes the multiplier effect of the fiscal package using alternative model approaches. Now some will conclude that we will need even more stimulus to jump-start the economy given these results. We do not know how big an impact the package will have especially beyond the initial spending jolt in 2009-2010. This could be one reason for why Larry Summers has been calling for even more stimulus in other parts of the world. We may not be able to do enough in the US.

But let's not get ahead of the economics. We have two important studies that cause us to pause about the stimulus package. The first study was the impact analysis of the stimulus package by the CBO. Their conclusion was that the net effect would be negative because of crowding out. The impact would be positive in the short-run but the high deficits would lead to higher rates which would offset the stimulative impact of the spending.

The more striking analysis is presented in a NBER working paper (#14782) by a set of leading macroeconomic researchers. It is called "New Keynesian Versus Old Keynesian Government Spending Multipliers" The authors take the assumptions of Romer and Bernstein who looked at the impact of the stimulus package for the Administration. Romer is the head of the CEA and Bernstein works for the Office of the Vice President. Romer-Bernstein find a positive multiplier which is long lasting.

The NBER researchers use a different model but one that is consistent with state of the art thinking on Keynesian models and which has been vetted in the profession's leading journal the American Economic Review. They find a significantly lower multiplier which shows a negative impact over time. They do a good job of laying out the differences in the models and suggest that the Romer-Bernstein modeling approach represents old thinking about Keynesian economics.

We can argue about the assumptions but the conclusion from the simulations using the Romer-Bernstein assumptions suggest that the impact of the stimulus package is not robust to changes in the modeling and that there is real danger that the policies in place may have a negative impact on the long-run growth of the US economy. Most important, the crowding out effect is real and cannot be averted. The key to the New Keynesian approach is to impose rational behavior on economic agents. They will understand that spending will have to lead to future tax increases which will cause a change in behavior today.

There is strong reason to be short bonds because rates will go up under this uncertain environment.

Classifying monetary policy - the quantitative easers to constrained easers

With a global recession, every central bank wants to ease. Forget inflation targeting, it is time to get easy with as much money as possible, but this not as easy as one would think when rates move to zero. While inflation may not be a problem in the near-term, for many smaller open economies the movement to quantitative easing will have strong implications for currency rates especially if there are no capital controls in place.

There is a strong global movement to quantitative easing, but countries can be classified differently based on the state of their economy and their position in the global economy. We have classified central banks based on their movement to quantitative easing which is the new central bank trend. We have developed five classifications for central banks related to where they sit on the quantitative easing spectrum.

At one extreme are the current quantitative easers, or those who are not targeting interest rates because they have fallen close to zero. These are the central banks that have announced that they will be using quantitative action to create monetary policy easing and eliminate the credit gridlock. In this category, we have also included Canada which said they will announce their quantitative plan in April and Singapore which has been using their monetary policy to follow currency band against a basket.

The next group of central banks will be those who are moving to quantitative easing but may not have reached the point where the central bank will expand their balance sheet as the means of adding money to their economies. All of these central banks have low target interest rates and have little room to ease further on the interest rate front.

The third category will be the reluctant quantitative easers such as the ECB. Here the central bank has been reluctant to state that they will use quantitative easing tools and have made public statement that they will adhere to their inflation target and try and keep interest rates from getting too low. Given that the Czech Republic is trying to hug close to the ECB, we see them marching to the same tune. Note that the ECB is the only large central bank in this category.

The fourth category includes banks that are flexible easers. These are the central banks which have been lowering interest rates and have the flexibility to continue to cut rates. They may have more flexibility than others because their economies may not have fallen as fast as the quantitative easers. This does not mean that they will not use monetary policy to stimulate their economies just that they have more flexibility at this time.

The final category includes central banks which are constrained easer. These are the central banks which have relatively high interest rates and who would like to lower the rates but may be constrained by their need to protect their currency or at least have the currency follow more controlled behavior. South Africa is a perfect example of a country which has been trying to hold rates higher in an effort to control the decline in the currency. Under a better emerging market environment, we would see these banks ease from their currently high real levels. Of course, some of the constrained easers are still showing higher inflation versus many developed countries. These inflation rates have been falling but not as fast as many of the larger countries.

What does this mean for currency and fixed income markets? The constrained easers will actually follow the behavior we have seen in past business cycles when rates have been held high to control capital flows. The quantitative easers may not have such good behavior and may follow behavior consistent with monetary models of exchange rate determination whereby the quantity of money will determine exchange rates. However, this effect will be muted by the sharp declines in money velocity or the money multiplier. The currency decline will not occur unless the multiplier starts increase before the monetary easing is reversed.

TIC data shows decline - the demand for Tresuries will have to come from domestic buyers

The TIC report from Treasury showed a decline in foreign demand for US assets by over 145 billion. Net long-term TIC flows were negative $43 billion. This decline was much larger than expected with survey data suggesting positive net flow of $45 billion. While there was more buying of Treasuries by foreign private investor as a flight to quality, there was strong selling of corporates and agency securities. There seems to be less willingness to buy anything but the highest quality paper.

Interestingly, the dollar moved higher during January while interest rates also moved higher. The flows suggest that foreign investors are looking for higher compensation to buy US assets. If the deleveraging story was not in place, we would have expected that the dollar would have been lower on these poor numbers. Some of the decline in foreign buying has been clearly offset with the higher savings rates in the US. The fact that current account surpluses in both China and Japan the two largest buyers of Treasuries have declined suggest that these large investors do not have the same buying power.

It is hard to include this information into a model exchange rates, but the data provides a good glimpse of what key buyers are doing. The trend is what is important and the long-term TIC data shows a down direction which will have to be offset by domestic buying.

Currency intervention is back - SNB active

The period of unfettered currency trading may be done for the G10 with the intervention of the SNB to lower the Swiss exchange rate. The CHF had moved higher earlier in the credit crisis with the flight to quality in Switzerland. This move had been great for those that had Swiss deposits but has been clearly hurting the economy. Note that many foreign depositors do not hold their money in CHF so it may not have a significant negative effect on banking services.

The greatest fear in Switzerland is deflation since the monetary interest rates bullet have all been used up. One of the easiest ways to offset deflation risk and make the currency lower is direct intervention.

This is also good for Eastern Europe which has significant liabilities in CHF. This will relieve some of the key pressure in this financial crisis.

The key issue to watch is to see whether this will be a policy followed by other central banks whereby we get into a war of competitive devaluations.

Too big not to listen to - China as a bond vigilante

“We have lent a huge amount of money to the United States,” Mr Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets.” From the FT.

A number of key longer-term events are showing up in the news. The comments from premier Wen Jiabao tell the US quite clearly that as a large bondholder they have concerns about credit quality. Mr Wen is the new bond vigilante. With the Chinese trade surplus declining they will have less money to invest in the US. There will have to be trade-offs between internal growth stimulus commitments and external financing of their trading partner.

The US cannot go to Japan to have them buy Treasuries and they do not want the US consumer to save more. We are left with monetization by the Fed which will not be liked by any of our foreign buyers.

The trilemma problem will not go away

Nobel prize winner Robert Mundell described one of the most vexing issues in international finance and exchange rate regimes, the trilemma problem. A country cannot make three commitments at the same time, control the exchange rate, allow for free capital mobility, and control monetary policy or have economic autonomy. More countries are facing the problem as we move to economic extremes and the likely solution is a lack of exchange rate stability.

Looking back on the history exchange rate regimes we find that the trilemma problem is real and creates significant risks. The Bretton Woods regime focused on FX stability through fixed exchange rates with economic autonomy and restrictions on capital flows. As capital flows increased, the stability could not be maintained. FX stability declined. The three goals could not be reached. Now we have countries that want economic autonomy and no restrictions on capital markets, but who are concerned with exchange rate changes, but you cannot have it all.

Large open economies have free capital markets and economic autonomy but they have to accept the FX instability. This can describe the later part of the Bush Administration where more aggressive easing led to dollar declines. There was no strong dollar policy. The Obama Administration will like to continue the current policies of free capital flows and economy autonomy but if the dollar delevering is reversed we will be back in a situation where FX stability will not be able to be maintained and a fall-off will be expected.

For small open economies there is the attempt to maintain free capital flows and stable exchange rates, but the problem is that economic autonomy is lost and internal economics will be driven by global shocks. We are seeing the impact of this with some of the East Asian export-driven economies.

We cannot get away from the trilemma and have to accept that especially in a crisis we cannot have it all. Of course, the mantra of free capital flows may change which will lead to greater distortions in interest rates around the globe. Short of capital restrictions, foreign exchange volatility will continue to stay at high levels and there will be greater swings in exchange rates as economies try to maintain internal harmony with generally unfettered capital markets.

Most important theme - the loss of our imbalance friends

The trade balance in China moved from a very strong positive number to almost flat with both exports and imports decreasing 25%. This is after the announcement that the Japanese current account balance turned negative.

These two countries have been the two largest buyers of US Treasuries as they recycled their trade surpluses back to US dollars. They financed the US consumer purchases, but now will not be in the market. The rest of the world or the US investor will have to be the buyer of Treasuries, but this is not sustainable at current rates.

First, while US consumers have increased savings and there has been active buying of Treasuries as a flight to quality trade, this may not continue. If the credit crisis is slowed, there will be a movement out of safe assets and into riskier assets which means that the demand for Treasuries will decrease. Second, as long as the rest of the world is in recession, there may not be enough money to invest in Treasuries.

The ramifications are significant. The bond vigilante are back and Obama is going to have to listen. How can you lower mortgage rates if the Treasuries are crowding out the markets and causing a general increase in yields. Monetize everything?

The market knows this. We have seen 10-year yields move from 2.08 to to 2.99 in about 2 and a half months. The 5-year has moved from 1.26 to 1.99 over the same time. Fixed income may be more important than following equity markets.

World trade fall-off ends an era

The deep declines in both exports and imports may end a golden era of trade. The above two graphs tell the story of what happens when you have a financial dislocation. The real economy gets hurt. Industrial production around the globe has not just lowed but actually seems to have halted. The excess capacity around the globe is staggering and will fore price deflation in the goods market. The fear is that we may have asset inflation without goods prices going up. While inventories are declining the inventory to sales ratios in the US are actually going up. The decline in inventories is not fast enough relative to the overall slowdown in GDP.

The decline in industrial production is associated with a sharp all-off in imports and exports. The decline has been especially strong in Asia and Japan which have been major sellers to the US.

One area which has to receive more attention is trade financing which is the greases that moves international goods. Firms are seeing a lack of credit for the shipping of goods across borders. Now, there may be little reason for governments to push this because of the concern for only domestic production but trade has to stabilize or there will be dire ramifications for many of the small open economies. The largest export from the developed world in 2009 may be unemployment if there is a greater focus on trade.

While we expect some stabilization as multinational banks stabilize, small open economies that are export driven will see little improvement in current accounts with an overall fall in trade. Their monetary policy will be biased to lower rates allow competitive devaluations to improve trade.

Size of global fiscal stimulus not clear –

Start with a simple question and you will not often get a simple answer.

We know what the impact of monetary policy will be around the world. We can measure interest rates, look at the money supply, and examine the central bank balance sheet. We may not know the exact monetary transmission but we know what the central bank is doing.

Now, ask the question of how much fiscal stimulus is occurring around the world and we do not have a clear answer. We might know what the government says it will spend or would like to spend but we do not know what will actually be spent. We may not know the timeframe of the fiscal action and we do not always know the form of the spending. We will know after the fact what was the financing required as measured by the budget deficit but the true fiscal stimulus is not an easy issues to address. So, if we ask the question of how much fiscal stimulus is being applied around the global there is no agreement on the numbers. If we cannot agree on the numbers, it will not be clear whether governments are actually following Keynesian stimulus policies.

The Peterson Institute gives a good example of about the uncertainty of the stimulus. The IMF and JP Morgan have both gathered information on what they believe to be the announced fiscal policies. This would be on top of any countercyclical spending associated with declining tax revenues and sticky spending. If we are in a deep recession bordering on depression these numbers should be big. This is not clear. Even if we can agree on the size of the fiscal stimulus we do not know what will be the multiplier effect on GDP. (A similar problem exists with monetary policy because we do not know the money multiplier for a given amount of monetary expansion.)

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An alternative measure of the stimulus can be found on Dani Rodrik’s blog at Harvard University. Someone form the ILO provides their measure of stimulus and their numbers are higher.

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So what is the right number? We cannot get a fix on this so it is unclear whether we are being too cautious. I would argue that the credit transmission mechanism is the most important and easiest to manage and needs to get right immediately. This calls for the US Treasury to provide a clear program. If we miss on the fiscal side, we should be able to fix but if the credit infrastructure is not in place we will not be able to provide growth in the long-run.