Thursday, April 30, 2009

Risk appetite is back, maybe

One of the key issues followed by currency traders is the level of risk appetite in the market. Risk appetite goes up and the money flows into emerging market carry. Risk appetite goes down and the money more back into safe havens. The story makes sense and has served traders well but there seems to be growing increase in the capital flow sensitivity.

The risk appetite sensitivity has moved from looking at credit spread risk curves and volatility to viewing emerging market currency and debt as a substitute for equity, a high beta stock. The market has now moved to using equity returns as the measure of risk appetite. So we have events like today when there is a huge jump in Korean won based on the spike in equities and some positive news in Japan. The assumption that there is a strong correlation between a Japan recovery and a similar surge in Korea.

Carry used to be for buy and hold investors who wanted to creates gains in currency trading. Carry may be back but for these who are nimble traders.

Wednesday, April 29, 2009

Leveling off of the "Great Recession"

Paul Volcker, head of the Economic Recovery Advisory Board, has some unique thoughts about the current economic crisis. He stated that it is "leveling off at a low level", but a second stimulus package may not be needed. He also stated that the recovery may take years. We are still in intensive care.

What a mixed message, and what does the Economic Recovery Advisory Board do? It seems like we are in the new Age of American limits. Limits on power, limits on growth, limits on potential. Yet, the stock markets still rises. In the Age of Limits, this will have to stop. If growth will be curtailed then earnings will have to slow. Once the positive surprise of any corporate announcements end, we will adjust to a flatter earnings growth curve. In the Age of Limits, we will not be able to grow our way out of deficits. The forecasts for the second half of this year and 2010 will be too optimistic.

Heard Niall Feguson give great speech

Niall Ferguson, the leading financial historian, gave a speech at the State Street Bank Spring seminar. It was entertaining as well as sobering look at the events of the day. Needless to say, he is a bear as he reviews some of the history of financial markets. The chance that we could have paralysis is real. We have a chance to have a Slight Depression not a Great Depression. This could be long but not as deep as the the 1930's as we end the Age of Leverage. This is different because we are facing a Crisis of Globalization as the world economy suffers from declining trade and finance and countries turn inward.

He brings home the important point that there can e significant social unrest from this crisis. He calls it the Axis of Upheaval. We have already seen some governments topple and we are starting to see riots in some countries. This will affect the behavior of politicians to the crisis. Dramatic moves will be made but this does not imply that the moves will be correct.

The US is coupled with China through the global imbalances and this will not change. This is a bad marriage between the saver China and the shopaholic US consumer. Or paraphrasing one Chinese official "we hate you guys but there is nothing we can do."

Ferguson makes the insightful comment that the current deficit spending is more like WWII than the Great Depression. We are spending like a war but there is no fighting. The Fed and Treasury will have to work together to make rate stable.

I had a discussion with Niall after the speech and asked whether we have any precedence for the consumer bail-out with the mortgage crisis. He made the good point that the consumers are like the farmers of the 19th century. In deflation, debtors want radical solutions. We are at a time that is similar to the populist sentiment of William Jennings Bryant where he ends his speech:

"Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold."

Substitute the wording of gold for Wall Street creditors and you get the idea that there a class who wants inflation.

His new book The Ascent of Money is a good read.

First quarter GDP ouch!

GDP numbers come in lower at -6.1%. This is lower than expected and is especially negative given the talk about "Green Shoots" in other data. The detailed data is not a pleasant story. Real GDP is down 2.6 YOY; however, the durable and nondurable foods are less negative than the fourth quarter. It is the gross private investment which is the killer. It fell 24.2 percent yoy. Imports and and exports are both off by double digits and even government spending has slowed.

I am going have to wait for May to get some positive numbers.

Tuesday, April 28, 2009

Is something positve going on out there? Consumer confidence up; Richmond manufacturing index up

More good news for the slowdown of the slowdown story. Could it be green shoots!

Consumer confidence is higher with the biggest gain since Nov 2005 and the highest level since November of last year. Confidence is still poor, but this is a start. Note that during recessions the confidence numbers become more volatile as consumer move more quickly between positive and negative views.

We also got less negative news form the Richmond Fed Manufacturing index survey with a nice move up. It is still in negative territory but it provides us with some idea that business is moving

The reaction in the markets is a little muted with the dollar index in a tight range. The fixed income futures saw a rally in 2-year Treasuries while the long-end has not changed its trend lower.

Is Inflation the Answer?

Greg Mankiw had a editorial in the NYT last week that is still on my mind, "Economic View: It may be time to go negative" The argument is very simple. With interest rates close to zero there may be limits to what the Fed can do to interest rates. The objective is to push down interest rates to get savers to spend. If inflation is higher than nominal rates then you can get negative real rates which should be stimulative. The problem is getting inflation to occur hen there is a strong output gap. The US economy is facing deflation so there has to be a change in inflation expectations that would have the economy believe there will be inflation. (We think the long-end of the yield curve knows it, but we have to convince everyone who is holding cash.)

The extreme example by Mankiw is that we just devalue a percentage of all currency by the end of the year through a lottery. This will not happen, but it provide a good illustration of what we want to happen to get people to spend today. Nevertheless, inflation is a tax that devalues a portion of our cash, so lottery example is not that far off.

The more logical and doable alternative is to set a hard inflation target. The target would not be like wart we do in a normal economy but a target which would cause the Fed to pure money into the economy until the inflation rat increases. No matter what happens, money will flow until inflation goes higher.

Now we are having some signs of positive economic news but the scenario of higher inflation is on the table and could represent a choice by the Fed that can be operational.

As James Tobin the Keynesian said, "there are worse things than inflation and we have them." Unfortunately for most americans inflation may be worse than a recession.

Monday, April 27, 2009

Gold demand up during this credit crisis

Gold demand is stronger than ever with the latest report on gold ETF holdings. When an investor buys exposure into a gold ET, there has to be a corresponding purchase of gold for the fund. Investors bought a total of 469 tonnes of gold during he first quarter over three times the high of 145 tonnes in the third quarter of last year. Total gold bullion ETF's are now 1658 tonnes with the GLD SPDR Gold Trust representing 1,105 tonnes. This ETF is now the sixth largest holder of gold in the world.

The ETF market has truly changed the demand for gold. With ETF's being such a large gold holder, we have the potential for even greater volatility in gold prices. Gold volatility is down from the highs last year, but gold ETF buyers will have different behavior from central banks that focused on being buy and hold investors for monetary reserves.

Clearly, China wants to be a larger gold holder. It has now become the fifth largest holder at 1,054 tonnes. There is plan albeit small to diversify their reserves. However, we are seeing the IMF actually try to monetize more of their gold holdings in order to increase credit availability. Th IMF is planning to sell up to 12.9 million ounces. Interesting story on the politics of gold sales in the WSJ, "The IMF's Gold Gambit". We can see the quality of timing of gold sales by some central banks is mixed. G0rdon Brown sold 400 tonnes or 60% of UK gold reserves at near the bottom in 1999-2002. I guess they wish they had that gold back now that they are in a crisis.

Nevertheless, with all of this buying how come gold has not reached new highs above $1,000. who are the sellers? Gold is only slightly higher today than form the first of the year. It is almost unchanged form the beginning of 2008. Our trend indicators show a mixed to slightly down direction. The high for gold was actually in mid-March 2008 and another spike in February, but these were temporary moves. I would like to know who are the sellers with all of this retail gain.

Mexican Peso facing uphill battle

The Mexican economy cannot get a break. First, you have the overall global recession which is worsened by the close connection with the US. Trade flows are down and financial flows from cash remittance back Mexico have decreased. Second, there is the ongoing problem of the drug trade. which has reduced foreign direct investment decisions. Third, they now have a problem of the swine flu scare. Surprisingly, the peso appreciated slightly before the swine flu problem. The peso was firming with a request to the IMF for a $47 billion credit and the tapping of a $30 billion swap line with the the Fed.

A problem with trading some of the emerging market currencies i the need to track the behavior of the IMF and their loan programs. The economics of the country are not enough if there is the potential for large credit line to change the economics of the government balance sheet of foreign reserves. In this case, the swap with the Fed and the IMF line would match the $79 billion stock of foreign reserves which are held by the Bank of Mexico. The credit line is a game changer for the economics of the currency market. This leads to surprise risk.

Friday, April 24, 2009

China loves metals - buying gold to diversify reserves

We are getting a better picture of what China is doing to diversify its currency risk. It is buying hard assets. Earlier this year we have heard that China has been a active stockpiler of copper. In spite of worsening global recession, the price of copper has actually increased. the only reason is that there is demand and that demand is coming form China. Now we find out that China is an active buyer of gold increasing their reserves from 454 metric tons in 2003 to over 1000 tons today. China is now the fifth largest holder of gold in the world. China is the largest producer of gold with production of 288 metric tons or 12.2% of overall output. The Chinese do not have to be active buyers of gold on the open market but it is telling that it is suing more funds to build its portfolio of the "barbarous relic". Another indication that dollars are not the holding thing that China is willing to hold as reserves. 

This just confirms the reports form last year that that PBOC was planning to raise gold reserves by 4000 metric tons as a reserve diversification strategy. This is at the same time that the IMF is trying to reduce their gold reserves through an approval of a sale of 403 tons last year. The IMF wants to sell gold to put itself on better financial footing while China wants to diversify through large gold purchases. One man buys while the other sells.....

G10 bonds and "original sin" - the cost of currency risk

Debt levels in many G10 countries have exploded. This is especially the case with Great Britain who should see debt to GDP levels reach above 75% of GDP. Great Britain is again being called a "banana republic" of finance and the "sick man of Europe", but an FT editorial "Sudden Debt?" focuses on the fact that this is a crisis that can be weathered. Gilt rates have increased during this British recession yet have stayed, to date, at levels that can be financed. However, this may only continue if there is the belief that the current fiscal medicine cocktail will start to have a positive effect.

What Great Britain and other G10 countries do not have is the burden of "original sin". Emerging markets have been forced to issue debt in foreign currencies to attract buyers. Hence, they do have the problem of increasing debt burden when there is a currency depreciation. This may be the most important savings issue for the US as a reserve currency. Emerging markets may be forced to issue in dollars and not in local currencies as the financial crisis continues. This is a reversal of the trend to local currencies during the emerging market cmmodity boom in the 2005-2008 period.

Green shoots and asset markets

Ben Bernanke started the latest round of positive analogies with his comment "I think all of our efforts so far have produced results, and I think as those green shoots begin to appear in different markets, and as some confidence begins to come back, that will begin the positive dynamic that brings our economy back."

Do we have "green shoots"? This question will be the focus of all markets in the coming weeks and the fact that there are not clear signs of growth will mean that many markets will continue to stay in a range.

While equity markets have show signs of a rally, the same cannot be said of currency or fixed income markets. In fact, stocks, which have shown the strongest behavior, have been discounted by many a a bear market rally. Looks like the green hoots may still get a frost.

The fixed income markets have been range-bound because the green shoots story has placed the market between a continued negative growth state and a "slowdown of the slowdown" state. The slowdown or second derivatiev story is not very positive. Large supply overhang from the federal deficit means supply is a strong consideration. While inflation should not be a problem with the large output gap at this time, there is a significant amount of inflation talk that has pushed the long-end of yields higher.

Currency markets have been mixed because the "green shoots" story has been highly variable around the world. There has been a significant increase in risk taking through the improvement of carry trades but the combination of quantitative easing by many central banks with significant declines in exports has laced a high degree of global uncertainty in these markets.

A Prudent Country - Chile and Andres Velasco

Good story on Bloomberg,"Harvard's Peso Doctor Vindicated as Chile Currency Evades Slump", describes the prudent policies of Chile during the run-up of copper price. Copper is the main export of Chile and represents the key driver of government revenues; consequently, government deficits will be fluctuate with the price of copper. The Finance Minister, Andres Velasco, provides for a reserve fund to bank some of the gains from the copper run up. He took a lot of heat on this from the Chilean people, but now the prudence of his policy shows through. The government cut-back far less because the reserve fund can be used to smooth expenditures. The effect has been a more stable currency and a country business cycle that has less extremes. To be sure, the Chilean economy has suffered like other emerging markets but it looks to be in better shape.

This is a good lesson for other countries that are dependent on single exports. In fact, this is a good lesson for even local state governments that never reserved against a recession.

Bank of Canada Cautious QE

The Bank Canada announced last month that they were going to lay-out their plan for quantitative easing or alternative monetary policies. It was expected that Canada would go in the same direction as the US. The market was anticipating some "shock and awe" and was trading at the high end of the range for the last two weeks.

The response from the BOC was meekness as measured by the market. The BOC actually refrained from making a strong policy stand other than to say that if the outlook gets worse it will take some quantitative action. There next meeting is June 4. Of course, you wonder what it will take to get them to move in this direction. First, the interest rate target is now down to 25 bps and is expected to stay there for at least a year. The eocnomy is not looking good but the story is mor emixed than other places. On th negative side, leading indicators have fallen to lower levels than expected. Howeve, retails ales are still positive and slightly higher than expected. Core CPI is still around 2% so the real rate of interest is still negative.

While the market rallied hard on the no news, the BOC did a good job of laying out a fremworks for their decision-making which is clear. Outlined by Reuters:


- Focus on inflation target

- Concentrate asset purchases in a maturity range where they will have maximum impact on the economy

- In private credit markets, focus on those exhibiting market failure, evidenced for example by excessive liquidity premiums, that have significant macroeconomic consequences

- Neutrality across sectors and across similar assets

- Act with prudence by taking into account investment quality and by minimizing operational risks


- Most important would be indicators showing the effect of actions on financing conditions faced by households and businesses, and thus on aggregate demand and inflation

- The flatness of and movements in the yield curve

- The bank's Business Outlook Survey and the Senior Loan Officer Survey

- The bank's new Financial Conditions Index

- Credit and monetary aggregates


The bank outlined a number of alternatives:

- Natural runoff through the maturing of assets

- Refinancing of acquired assets (e.g., financing in the repo market or allowing the runoff of other assets on the Bank of Canada's balance sheet)

- Asset sales, which it said would only be done "at an appropriately measured pace"

If you follow the consensus and it is wrong, the cost can be high.

Monday, April 13, 2009

China and Treasuries an ongoing story

Asked about the balance of financial power between China and the United States, one of the Chinese government’s top monetary economists, Yu Yongding, replied that “I think it’s mainly in favor of the United States.”

He cited a saying attributed to Keynes: “If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy.”

The issue of what to do with the two countries with the greatest financial imbalances will continue. This is the recurring theme of Chimerica. The issue fall into both the real and financial side. The trade surplus of China has fallen with the decline in exports. China will just not be generated the same dollar cash flow for investing in the US Treasuries. Similarly, the trade deficit is falling in the US, so there is less of a current account deficit problem. In a sense, the real economy is starting to adjust. The issue is the dynamics on the financial side of the equation. Here the US is running huge government deficits. This is being offset by higher savings in the US, but the size of the deficits suggest that they will have to be monetized by the Fed which places pressure on the dollar. Of course, this pressure may not occur in the near-term given the size of the output gap, but it will have an impact for China because they are not able to adjust their Treasury holdings in the short-run.

China is stuck with a $2 trillion reserve position that has to be managed; consequently, they will try and make statements to steer US policy to a course that will be protective of bondholders.

Sunday, April 12, 2009

"Glimmers of Hope" could help animal spirits

The President speaks of "glimmers of hope" and Larry Summers says the end of the "free fall" may be near. Not overly optimistic words, but anything will help what may be the most important issue, "animal spirits". Keynes refers to animal spirits as a "naive optimism" which when applied to entrepreneurs is "the thought of ultimate loss which overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death."

Many think of animal spirits in the context of optimism while other have sometimes thought of the animal spirits as irrational behavior. More recently, Robert Shiller has defined animal spirits in the context of "trust"

Keynes also argues that we know little about what will drive investments in the long-run. This is why there is a focus on animal spirits.

"If we speak frankly we have to admit that our basis for knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of patent medicine, an Atlantic liner, a building in the City of London amounts to very little and something nothing ...)"

Some of our decisions are not based on mathematical expectations. Hence, it is confidence that drives the decision to invest.

"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."

"... human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist ... it is our innate urge to activity that makes the wheel go around ..."

It is not clear what exactly Keynes was talking about with animal spirits other than to say that confidence does matter and that an economy will grow if there is a increase in overall optimism or confidence. What has been lacking from government is an attempt to increase confidence and provide a certain environment for players to make decisions. The TARP programs and and the stress testing of banks has actually lead to more uncertainty through a changing views and adjustment of the rules of the game.

These words of encouragement from the Administration which may help sustain the equity rally that we have seen continue for the fifth week. We may need more to move the animal spirits out of cash.

Tuesday, April 7, 2009

"Age of Thrift", really?

"The precautionary behavior of every entity in the global economy has gone up," Mohamed El-Arian, CEO of bond-investment fund PIMCO. "We've gone from an age of entitlement to an age of thrift."

This has been a recurring theme from the bond fund giant, yet you wonder what is actually being said when fiscal spending is going through the roof through deficit financing and the use of the Fed balance sheet. Thrift or savings comes from a number of sources within the economy. These include consumers, corporations through retained earnings, and governments who run surpluses. The consumer savings were depleted or reported to be close to zero, but this is partially due to the fact that we do not count investment in educations as savings. Consumption also was high because of the wealth effect. The increase in wealth from a strong stock market and the cash out of home equity all helped to increase consumption. On the other hand, corporations have in many cases increased their cash hoard. Governments including the US Federal were cutting deficits for most of the 1990's. These savings declined during the last recession through counter-cyclical policies as expected.

So now we are in 2009 and savings have actually increased substantially for consumers. This is in response to the decrease in overall wealth. The Keynesian paradox of thrift is that if consumers all save more the economy will do worse, so the only alternative is to have dissavings from non-consumers, the government. There has been a significant increase in government dissavings to offset the behavior of consumers. The public domain has taken the place of the private domain for spending. If the public domain increases spending and it is not an investment with a return, then the private domain has to save to offset the future taxes that will have o be levied on the consumer. Is this an "Age of Thrift"?

This could be the end of the "Age of Leverage". It could be the end of the "Age of Wealth"? It could be an end of the "Age of the Consumer" or the "Age of New Government", but thrift may have nothing to do with this.

Reversing the export curse with fiscal stimulus

Japan is an export driven economy and these numbers have fallen off a cliff . This has led to what may be the worst recession since WWII. This is worse than the lost 1990's because in that case exports were still strong even though the domestic economy was in shambles.

The response has been to follow the Obama game plan of increasing fiscal stimulus to 2% of GDP through announcing another round of fiscal spending increases (10 trillion yen). This is what President Obama asked for from the G20 and got rejected by the EU. Clearly this is needed with growth in Japan expected to be -6.6 as forecasted by the OECD.

While this is a good stopgap, the rest of the world has to grow to get Japan back on its feet. Interestingly, the NKY is down only 2.99% YTD and the Topix is down 5.12. The market is anticipating that the recent announcements will have a positive impact because it is off the lows since the middle of March. The yen on the other hand has continued to move lower. The combination of QE on the monetary policy and strong fiscal policy is an attempt to stimulate the economy allow and allow the yen to decline to help exporters. Will it work? The 1990's round of fiscal stimulus was not very productive. The key is still coordinated policy across countries.

Thursday, April 2, 2009

Surpise coming out of G20 - More money to IMF

Though many were not expecting much from the G20, we got a huge increase in credit with the announcement of a pledge to provide $1 trillion in credit. The Group will provide $250 billion to help finance trade over the next two years with a commitment to finish he Doha round of trade talks. The trade financing is critical to offset the decline in global exports. Many firms have not been able to gain financing to buy or sell goods, so this pledge will help unlock the shutdown in global commerce. Of course, this is after the World Bank has reported that 17 of the G20 have increased protectionist measures. The G20 also agreed to no new protectionist measures through 2010.

$750 billion will be used to increase the balance sheet of the the IMF. The IMF will have its balance sheet increased by $500 billion with another $250 billion coming through the creation of special drawing rights. This will provide more liquidity for all central banks which may reduce the need for bilateral swap lines.

A Financial Stability Board will be established with the IMF to provide warning of any financial threats. Hedge funds will be subject to greater oversight and tax havens will be monitored. They also suggested guidelines for executive pay.

The most important reaction was an explosion of stock prices on the upside with a dollar decline. The risk from holding weaker currencies was diminished so there was a nice appreciation in many emerging market currencies. Expect to see increases in commodity prices. Why hold fiat money when you can have hard assets.