Tuesday, March 30, 2010

Bad day for European sovereigns

Iceland got downgraded by S&P with a negative outlook. It is barely hanging on to investment grade although it is hard to say what that means or what it is worth.

Ireland has further banking problems with the announcement of the funding requirements of the National Asset Management Agency for buying bad loans from banks. The agency may have to buy loans with book values of up to 80 billion euros.

The new Greek bonds are trading poorly in the aftermarket.

Iceland and Ireland are classic banking crisis problems while Greece is a structural debt problem with the government. The structural problems actually may be harder to solve in the long-run.

Monday, March 29, 2010

Nice parity on what gold does

from John Lothian -

In light of my CFTC metals testimony yesterday and with a wink to country music artist Tim McGraw, here are the lyrics of a song I call "Golden Voice":

Fort Knox Stores it
King Midas Touched it
The Magi Presented it
Thomas More made fun of it
Skeptics bit it
Alchemists tried to make it
The Forty-Niners Rushed it
Olympians Win it
The Noble Prize Awards it
Aristotle Meaned it
Kings are crowned with it
Fingers are banded with it
Old Couples Celebrate it
Ian Fleming Noveled it
The Romans Coined it
The Trojans weighed it
Isaac Newton Fixed it
South Africa Mines it
Governments Standardized it
William Jennings Bryant Mesmerized with it
Bretton Woods Valued it
Mints Bar it
Exchanges Trade it
Options Traders Call it
Jewelers shape it
IRA Accounts Hold it
El Dorado Hides it
Tutankhamun rested in it
Conspiracy Theorists Claim it
Glenn Beck Shills it
Goldman, Sachs it
Gold Diggers Marry it
Miners Dust it
Canadians Leaf it
Designers Lame’ it
Rocks Ore it
Prospectors hope for it
Dentists Drill it
Dealers Scrap it
Recyclers buy it
Brokers convert it
Refiners Acid Test it
Teeth chew with it
Retirees tell time with it
Gold Bond heals with it
Market Technicians Chart it
Ages are marked with it
Boy Athletes are Anointed with it
San Francisco Gates it
Workers are handcuffed with it
Executives are parachuted with it
Oldies Music Do Wops with it
Retrievers fetch it
Old people enjoy years of it

A Golden Voice

Thursday, March 25, 2010

One way to stop the real estate bubble in China

From China Daily -

BEIJING - The Ministry of Land and Resources has ordered a temporary ban on the sale of land for housing in a renewed measure to ease soaring real estate prices.

Yun Xiaosu, vice-minister of land and resources, said local authorities should not sell land for residential purposes until this year's housing land supply plan is released in early April.

Stop all private transactions and create scarcity value for land. Yes, this will work. Sort of like rationing or placing restrictions on how much you can buy. We have seen this story before. However, if you want to top a bubble you have make it expensive to speculate.

Wednesday, March 24, 2010

China CEO's want yuan appreciation - now this is a switch...

Now I have heard everything about China. Just when you thought the yuan issue could not get any more political, Chinese business executives are saying that they would be supportive of a freely traded yuan. How can business leaders be political? This is China which has to be viewed through a lens of all statements having levels of complexity.

They argue that the yuan would strengthen which would be good for consumer purchasing power and cut import costs. For example, a steel maker is arguing that a higher yuan would allow for importing cheaper ore. Bankers are arguing that the yuan peg distorts their money markets. Lenovo's president stated that yuan appreciation would not be a"bad thing". Of course, not all agree with these arguments. Firms which face tight margins could face bankruptcy if there is a higher yuan.

China reported a trade deficit for March of $8 billion.

It looks like China will increase the yuan sooner than expected. I had believed that this would occur during the late summer. Now, I think that the increase will happen sooner as long as the Chinese do not feel pressured by the US government.

Portugal downgrade - more PIGS going to slaughter

Fitch dropped Portugal to AA- with negative outlook. "GDP per capita and trend growth are significantly below what is typical for AA rated country reducing it a ability to tolerate a global economic downturn." This was surprise but not unexpected.

This downgrade is the reason why Germany has been reluctant to bail-out Greece. There is more bad news behind the Greek debt problem. You will have to offer similar terms to other countries. It would be better to save the funds for a bank bail-out then using guarantees to help a specific country. The assumption is that the IMF has the funds to help countries. Let the world organization assist countries and use funds to protect your on industries.

A combination of weak growth and sovereign problems makes the EU an unattractive place to invest.

Monday, March 22, 2010

Rajan on risk shifting

Raghuram Rajan 2005,

"While the system now exploits the risk-bearing capability of the economy better by allocating risk more widely, it also takes on more risks than before. Moreover, the linkages between markets and between markets and institutions are now more pronounced. While this helps the system diversify across small shocks, it also exposes the system to large systemic shocks - large shifts in asset prices or changes in aggregate liquidity."

This is one of the best macroeconomic explanations on why the system did not work.

Tenth anniversary of Irrational Exuberance by Shiller

1o years since Irrational Exuberance and we do not have agreement in what is a bubble. The anniversary should be a time of celebration on our knowledge of how the economy works, yet it seems like we still have a lot of lessons to learn about bubbles. It is 13 years since Alan Greenspan talked about irrational exuberance in the stock market, yet we are at least two bubbles behind in trying to get a regulatory handle on bubbles.

We may have a bubble in Chinese real estate. We are still trying to prop-up the real estate bubble through loan modification programs and accounting gimmicks. What have we done to protect the general economy from the next bubble?

Keynes, Smith, and Galbraith all provide insights on market psychology

The last page of Keynes's General Theory provide insight on some of our policy problems, "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the salves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

An interesting twist on the same theme comes from another old economist.

"The conventional wisdom having been made more or less identical with sound scholarship, its position is virtually impregnable. The skeptic is disqualified by his very tendency to go brashly from the old to the new. Were he a sound scholar... he would remain with the conventional wisdom."- John Kenneth Galbraith The Affluent Society

The current environment is still plagued by uncertainty.

"Our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. We have as a rule only the vaguest idea of any but the most direct consequences of our acts. By 'uncertain knowledge' ... I do not mean merely to distinguish what is know n for certain from what is only probable ... The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence or the obsolescence of a new invention, or the position of private wealth holders in the social system in 1970. About these matters, there is no scientific basis on which to form any calculable probability whatsoever, We simply do not know." - Keynes

Keynes on speculation.

"They are concerned not with what an investment is really worth to a man who buys it "for keeps" but with what the market will value it at, under the influence of mass psychology, three months or a year hence."

Adam Smith the behavioral economist.

The chance of gain is by every man more or less over-valued, and the chance of loss is by most men undervalued." -Adam Smith

Market failure economics can explain a lot

John Cassidy wrote a very good book which look at the credit crisis from a longer-term perspective, How Markets Fail: The Logic of Economic Calamities. He writes about the failure of economics to address these real world problems, in a very clear manner. "For whatever reason, 'market failure economics' never took off as a catchphrase. Some textbooks refer to the "economics of information" or the economics of incomplete markets" Recently, the term "behavioral economics" has come into vogue. For myself, I prefer the phrase 'reality-based economics'."

He takes a strong tour of economics through the last century to address many failing of the free market school of thinking on market issues. Many of these issues are standard discussion in graduate school but have not been emphasized in the overarching issues of describing policy alternatives. The Pigouvian tradition of analyzing welfare economics focused on market failures and imperfections. Here social costs are not trivial. We cannot price the social costs of failure regardless of the elegant arguments of Ronald Coase. Too often we do not discuss social costs because they are difficult to explain.

Cassidy describes the work of Francis Bator, the popularizer of many market failures. For example, time's arrow works against knowing the economy and all potential problems. We cannot know all information in order to make a good decision. There are firms with monopoly or oligopoly power. There are public goods that will not be supplied through normal supply and demand. There are externalities. Chance and network effects mean that the bets technology will survive in the economy.

This is a sweeping book which describes the history of economic thought on the subject of market failure and the Great Recession. I would currently put it at the top of the list of books which provides a foundation for any discussion on the cause and effects of the Credit Crisis.

Greenspan setting the record straight? Not really

"Partially I made the mistake in presuming that the self interests of organizations, specifically banks and others were such that they were best capable of protecting their own shareholders and their equity in the firms.... The problem here is something which looked to be the very edifice, and indeed, a critical pillar to market competition and free markets, did break down."

- Alan Greenspan during crisis hearings last year

In a new paper for the Brookings Institute, "The Crisis", Alan Greenspan lays out his case for an increase in regulatory capital and an increase of collateral requirements for all financial institutions. Seems a little late. His argument rests on the fact that if there is a high degree of uncertainty, that is, there will be regulatory mistakes, the burden should be on the banks to protect themselves from risks. Again, this could have happened before and this is not an argument against regulation. Banks did not do enough to protect themselves. Hence here is a need for better regulatory oversight.

Greenspan also provides a spirited defense of his Fed leadership based on three arguments. First, the end of the Cold War lead to a huge savings glut and change in global economics which created the bubble. Second, monetary policy was working fine even based on his interpretation of the Taylor Rule. Monetary policy was not excessively loose. Third, even if rates were low, there is not a strong link between short-term rates and housing prices; consequently, monetary policy could not have been the culprit.

Each of these arguments are interesting but miss the point. First, the savings glut was well known and identified by the Fed. The Fed could have run monetary policy to offset some of the global imbalances to eliminate market distortions. Yes , there were fears of deflation after the Tech bubble, but the Fed did not have to drop rates inside 1 percent.

The Taylor rule argument is a little more convincing. Taylor rules in real time may give different signals so there would have been some confusion in determining whether monetary policy. as loose or tight. Nevertheless, the housing bubble was going in full force even before the rates were lowered. Monetary policy only further added to the problem.

The link of between housing prices and long-rates does not address the rationing in credit for poor borrowers which was offset through the sub-prime market. The link also does not address the issue of home equity lines which further changes the loan to value ratios for many homeowners.

Greenspan wants to resurrect his legacy s the Maestro but it will continue to take a beating. The bubbles happened on his watch and the view of the Fed has been that bubbles could not occur in the first place. The Fed also did nothing to stop the mortgage market growth and asked for no powers to better monitor the shadow banking system.

US losing status as triple-A credit? Is there a risk free rate?

Story on Bloomberg the yields on comparable Treasuries are higher than for Buffet and some other high credits. I received this story from at least two other sources so it is making the rounds and is causing many to ask why. The simple or obvious reason is that the risk on Treasuries is higher. However, given supply and technicals you can get these types of price distortions albeit not often so you cannot jump to the conclusion that risk is the main reason.

Nevertheless, there is the growing view by both traders and investors that there is something different going on with the world's risk free rate. In fact, can we really say that there is a risk free rte when the debt of the US is exploding? The perception is that the supply of Treasuries will exceed demand relative to the supply and demand for some corporates. You can call this a truism but the need to hold Federal debt may be declining relative to what the Treasury wants to issue.

Friday, March 12, 2010

German export issue at the heart of EU crisis

Germany is often among the top two exporters in the world. Last year it slipped behind China, exporting a little more than $810 bln of goods and this is after a 14.5% decline. Germany exports around 40% of its GDP, which is roughly the same proportion as China.

In 2009, German exports to Greece, Spain, Portugal and Ireland, whose combined GDP is about $2.7 trillion, exceeded its exports to China and Japan, where the combined GDP is more than $9 trillion. And Italy, which also has debt and deficit issues, receives even more of Germany’s exports. The fiscal austerity that has already begun is not simply in the Mediterranean and Ireland, but many eastern and central European countries as well.

Austria and Belgium have high debt/GDP ratios (and their banks have the largest exposures to the Baltics). Taken together these euro-zone countries—Greece, Portugal, Spain, Ireland, Italy, Austria and Belgium absorb a full quarter of Germany’s exports.

Marc Chandler Brown Brothers

There is an imbalance problem that will have to be solved for the EU to get back to a balanced economy. Unfortunately, it requires a change in German behavior to increase consumption and the other debt-ridden EU members cut consumption.

Simple, systematic modeling in a complex world

“It is only by selection, by elimination, by emphasis, that we get at the real meaning of things”, Georgia O’Keefe.[1]

One of the key objectives of systematic modeling is an effort to simplify decision rules to get to the core of what may drive markets. This is a search for meaning. This core objective is based on an assessment of what are expected to be repeatable future events that have a basis in theory or conjecture.

A systematic approach often avoids headline risk and focuses on market fundamentals and price action. In its most simplified form, a systematic model is follows trends as a signal extraction process. We, however, try and form a structure that includes economic fundamentals because we believe that a program of different styles will provide valuable diversification in an unstable world. Behavior is repeatable but also moves through cycles. The focus on longer-term fundamentals as well as other styles captures the changing emphasis on factor risks.

The simplified design of decisions can be condensed into a case, a combination of observation rules, an action, and a result.[2] Systematic investing emphasizes not only finding data relationships, but employing these relationships to take well-defined or described actions within a portfolio. The decision actions are structured rules so that their impact on the portfolio is controlled. Defined market exposures tied to a rule will allow for better risk management.

Simplification and focus will not be successful for some unique situations; nevertheless, it allows for exploiting the best repeatable opportunities which we believe are frequent and measurable.

[1] For a more popular interpretation, “In building a statue, a sculptor doesn't keep adding clay to his subject. Actually, he keeps chiseling away at the inessentials until the truth of its creation is revealed without obstructions.” - Bruce Lee (from Ross Pazzol.)

[2] We have been influenced by the work in cognitive psychology on case-based reasoning. The approach of measuring experiences to use as an event reference catalogue is applicable to finance. Case-based reasoning has been effectively used as a diagnostic tool in medicine and other disciplines.

Quantitative easing – round two, the exit

The mechanics of round two of quantitative easing is a twofold process of strategy and tactics. The strategy is determining when to exit and the tactic is the form of the exit. Global exchange rates will revolve around five monetary players, the G-3, UK, and all of the rest. There also is a growing wild card of the IMF which may have a significant influence on the how the global monetary system takes shape in the coming years, but that discussion will not be as germane to short-term foreign exchange dynamics.

The majority of the world is in a process of normalization. Norge Bank and the RBA have begun this process. Countries have started to discuss ending their easing with rate increases as they normalize their targeting processes. With deflation fears abating and actual headline inflation inching to positive, the policy focus is again on controlling inflation within target bands. This allows for attractive monetary and growth drivers for currency appreciation and was a driver for February performance. However, it is the central bank policies of the G3 which will more decidedly determine global liquidity and currency directions.

Japanese monetary policy is a growing riddle and global outlier. The Finance Minister is calling for an end of deflation, yet there does not seem to be anyone at the BOJ who is listening. The BOJ has rejected inflation targeting which could be the objective of a new easing program. With flight to quality flows pushing yen levels back below 90, there may be growing pressure to take action. This policy need is the polar opposite of the other large QE.

The Fed has clearly laid out tactics for reducing their balance sheet, yet the combination of a large output gap, high unemployment, and a lazy V-shaped recovery continue to push any policy reversal quarters away. The wild card is the reaction to the end of the mortgage purchase program. It looks like an open check book from the Treasury for Fannie and Freddie will allow the Fed to be off the hook this month but will place more pressure on Treasury supply.

The ECB has stabilized its balance sheet over the last year, but any potential PIGS crisis may force the central bank to again step-up to provide liquidity for European financial institutions, significant holders of Greek debt. This creates more downward pressure on the euro.

The BOE is now seeing a worst case scenario of large budget deficits which do not seem controllable, slow growth, and rising inflation. This provides little room for the BOE to significantly reduce their balance sheet. The market is pricing in a further currency sell-off.

The potential for timing and sizing to be wrong during the exits means that the chances for currency dislocations are high. Directional policy errors will be manifested in directional price movements. Additionally, the currency appreciation from “safe” developed to formerly risky EM currencies will continue, albeit contained by the “stabilization” policies of EM central banks.

A “peso problem” and the EUR – another description of carry

The presence of structural/political uncertainty leads to a “peso problem” with the euro. The “peso problem” describes the impact of a low probability yet high impact negative event on asset prices that does not occur in-sample, as some would put, a “Black Swan”.[1] A “peso problem” explanation has been most recently used to describe the returns for carry. The relatively high returns are compensation for the chance of a large negative skew event. These events can be classified as potential regime changes.[2] The expectation of a regime change in the euro may also apply to GBP which has fallen significantly since the surge in Greek risks and the BOE inflation report. A peso problem increases the chance of overshoots or deviations from prior models of exchange rates.

The Greek fiscal crisis may force a regime change to enhance the stability of the EMU. Any potential solutions for how the EU will operate going forward changes the regional risk profile. The profligate spending of some will more heavily weigh on the value of the total. Regime learning concerning the EU will add a risk premium to the euro as well as other currencies which may have a chance of large negative fiscal events.

Sovereign CDS spreads are giving clear signals of change in risk when sorted by relative debt to GDP levels across countries. The prior link between interest rates and the euro has been broken and a new relationship which may not be as highly correlated will determine capital flows.[3]

[1] The “peso problem” was first modeled by Bill Krasker to explain deviations from interest rate parity. It was also alluded to by Milton Friedman and has now been used to discuss the chance of any large negative skew events across many asset classes.

[2] Deviations from market/model efficiency have also been modeled as a bubble or as a learning process whereby the market figures out what is going on over time. The result will be the same as the peso problem solution however the stories are different.

[3] It has generally been the case that the EUR will react to changes in LIBOR spreads with a fairly tight relationship. The risk is that the EUR may not be dominated by German behavior but by a looser weighted average of EU country rates. Note that there is no true EU bond market since the EU does not have borrowing authority.