China yuan change postponed?

Seems likely that the yuan revaluation will not happen in the near-term. The dollar has appreciate about 15% against the euro which means that the renbimbi peg will also see a 15% appreciation against China's largest trading partner, the EU. The cost of imports will be higher which means that the China surplus will decrease. This is what China wanted to avoid. Of course, the exports of the EU will be cheaper so we should see the EU trade surplus increase.

People's Bank of China states that it is committed to investing in Europe, the EU stabilization plans, and that Europe will overcome it difficulties. It would like to see stabilization for the simple fact that China needs a stable world to sell its products. It is becoming a better consumer of goods from the rest of the world but the export-driven coastal economy needs to see global growth.

We do not expect to see any action on the yuan until there is a period of stabilization with the euro. This is consistent with the cautious approach after the US financial crisis. Whether this is foot dragging or appropriate caution is not important. Past history has always shown that as volatility has increased, trade has declined which suggests more conservative government policies.

The problem of zero rates

“By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

Seth Klarman

The reach for yield only increases when financing and cash rates are at zero. Buy gold, the carry is zero. Buy long bonds, the carry is zero. Buy stocks. Limited financing costs. Get out of cash. With inflation you are getting even less for cash and fund costs as a percentage of yield are increasing. There is no financial brake in the system.

So what happens when rates start to move up? This is a key problem for the largest central banks. How do you signal a rate increase without causing a major sell-off? I guess the answer is just to push the decision into the future. At some point, the level of asset prices will be high enough that the reversal in fortune will not be enough to sink the wealth of investors. It is not clear that this is viable strategy.

Sentiment and market news

"Not a time for statistics lovers" - Marc Chandler Brown Brothers

Periods of sentiment driven markets are the worst nightmares for a quantitative manager. When sentiment drives markets, the fundamentals will lose in the short-run. Volatility increases and correlations change. Assets which have value fall as much as those which do not.

In currency markets, there is a contagion surrounding the Greek problem. It has led to depreciation in most emerging markets. Safe assets with strong fiscal balance sheets have not been immune as risk aversion took over the markets. Moves to risk aversion make sense but they dominate other factors at this point.

Still, after an initial shock, there seems to be some order to the markets. Those countries with stronger reserves have fared better. A review of government plans has actually caused selling not because of irrationality but because there is a view that values have changed.

Even in time of sentiment driven markets, there is a reason to hold onto statistics. However, there are ways to protect from these regime changes in behavior. First, there is need for stop-losses. If the markets move against the statistics, take a time-out and wait for the time to past. Second , reduce leverage. There is less need for big bets. Third, include a trend component. In an uncertain time, following the herd makes sense at least at the extremes.

LIBOR -OIS funding situation is dangerous

The difference between 3-month LIBOR and overnight indexed swap spreads for three months are at extremes for the year. We would have to go back to August 2007 to see these levels. Certainly this is a clear indicator of banking problems especially in the EU.

Still we need to place this in perspective. The levels seen today were present when this crisis began with funding problems in August 2007. Losses in sub-prime and Freddie/Fannie were just coming to light. The LOIS levels stayed high and only further increased in 2008 peaking at the end of the year. 2009 was a transition period with calm starting to settle in the banking sector after March 2009. The bottom in LOIS spreads were hit at the beginning of 2010 and has now started to move in the opposite direction. It can move a lot wider, but there is less that the Fed and other central banks can do to lower rates. It is unlikely there will be more bail-outs so investors may have to be more careful about the banks they do business with. Do not expect these spreads to tighten soon.

These time could be different - recession and yield spreads

One of the best indicators of a recession is the shape of the yield curve. If it is inverted, there is a high probability of a recession. It provides about a 9 month lead and has preceded every US recession. When it is steeply positive, the likelihood of a recession is low.

By this measure there is almost no chance of a recession in the US at this time. This is what the Fed is hoping for. This is what the stock market has expected for the last year. Banks are making money on the steep spread. This time the yield curve indicator may be wrong.


The issue is with the type of recession that we are facing. A credit crisis is different from a normal recession. All of the inverted yield curves were associated with inventory builds or tight monetary policy. We do not have tight monetary policy at least as measured by the Fed balance sheet. We may have tight policy based on the lack of actual lending. However, watch short rates closely. LIBOR is moving higher as well as swap spreads while Treasuries are moving lower. We may get a flatter curve yet.

Nevertheless, this time is different. A large balance sheet recession needs a retrenchment in borrowing which may be independent of the yield curve shape.

Euro decline rational or irrational?

Jean-Claude Juncker, Luxembourg prime minister and EU head, suggests that the euro's decline is "largely due to irrational approaches of the financial markets."

The euro declines and policy officials believe it is an irrational response. There could be an alternative explanation. The market has seen the "EU TARP" or stabilization program and note a lack of government coordination and decided that they do not want to hold the currency. The graph shows the program and it is hard to see how this is going to solve the problem.

Growth rates in the EU will decline. Risk is on the rise. Discussions of a break-up have been ongoing. The ECB has bought bonds outright in the market and seems to be shifting policy to be sensitive to fiscal growth issues.

Why should we be surprised about euro decline? The issue on the minds of investors is how much further will the decline go. This is an issue of feedback effects. If the stock and credit markets continue to sell-off, then there will be a feedback away from the currency. If growth slows in the economic data next month, the euro will continue its decline. If exports improve and growth follows the fourth quarter 2009 path, then we will see a euro rally.

Recognition lags and investing

Mohamed El-Erian in Barron's about the "recognition lag"

Cyclical tailwinds speak directly to the market's playbook. Structural headwinds do not. Then, the market has a problem aggregating all these together into a new picture. Human beings are anchored by certain things.

The minute something takes us out of our comfort zone, out of what is familiar, we need overwhelming evidence that it's happening. That leads to a recognition lag. Market participants are challenged because you can be too early or too late.

We should be out of our comfort zone concerning stocks and currencies. With the stock market and euro in strong down-trends, there is a growing realization that the market could not sustain its recovery if the economy was only growing at 3.2%.

The behavioral bias of anchoring is nicely restated as a recognition lag; however, a recognition lag is more than just having difficulty switching regimes or moving out of a comfort zone. I would argue that there are two parts to a recognition lag. One is finding the right evidence to tell you what regime you are in and second is weighing that evidence to realize there is a change in the environment.

Economic evidence is usually not clear-cut. Data comes out almost everyday with different levels, growth paths, momentum, and revisions. Some data can have a strong change but just is not that important. Other data becomes more important at different times in the business cycle. So there first needs to be a recognition as to what is important overall and what is important at a specific time.

The second part of the recognition lag is determining whether the evidence today is enough to change your view over some future horizon.A perfect example is the first quarter GDP number. It grew at 3.2% which was less than the fourth quarter of 2009. It is as positive but not significant enough if you believe a V-shaped recovery. Now, you can come up with explanations for why this number is less than the last quarter but still believe that a strong recovery will occur, or you can believe that growth will be slower based on the actual evidence presented. So what is more important, the evidence or the context of your current views which may explain away aberrations or noise?

The anchoring problem is when we try and explain away the data to fit our current view. The alternative is that we adjust quickly to the new information only to find that it is noise relative to strong trend. Recognition of being too slow or too fast has problems.

The financial wars in Europe

"A currency without a state is difficult to manage" former Italian prime Minister Lamberto Dini

The battle between EU North and South.

The battle between debtor and creditor countries.

The battle between the triple-A credit rated sovereigns and triple-B or going to junk credits.

The battle between a strong hard D-mark and a soft drachma.

The battle between exporter (high productivity) states and importer (low productivity) states.

The battle of sovereign fiscal independence and EU oversight.

The battle of austerity versus public and private spending.

The battle between euro-phoria and dollar dilemma

These are problems that will not go away.

Europe's jerks - this tells it all

“Europe’s jerks once again!” ran the headline today on the front page of Bild, Germany’s biggest-selling newspaper. “750 billion for bankrupt neighbors, but tax cuts canned,” it said. “It’s beyond belief!”

Bloomberg Business Week

Clearly, there is growing tension in the EU over the aid package to Greece. Creditors who have been more conservative and saved have had enough. There is the perception that they have to throw more of their money at the problem without a chance of getting paid back. Greeks riots make it seem more unlikely that the government will be able to force the austerity programs that are need to get control of the deficit.

The ECB has had to step in to purchase bonds to provide liquidity which creates a toxic combination of problems. Monetary policy will have to be eased which means that the ECB will have to be focused on fiscal issues and not price stability. Its creditability is shot. The aid plan does not solve the root cause of the fiscal problems so at best, it is considered a stop-gap.

The reaction is expected. The euro has continued to slide. Credit swaps and bond spreads have tightened but not to levels seen last month. The uncertainty still leaves a premium in the market.

"Shock and Awe" trillion dollar EU aid package

Stock markets around the world exploded upward on the word that the EU has come to an agreement of a aid package to help EU countries that are having borrowing difficulties. The package will include $560 billion in new loan guarantees, $76 billion increase in an existing lending facility, and $321 billion from the IMF. The ECB has also reversed its talk and is now willing to buy government and corporate debt to provide the market with liquidity.

This is a big package and the reaction is understandable, but there are many question of how this will work and who may get the money. That, of course, does not matter. The market got a strong jolt from EU finance ministers and the markets are off to the races. You could call this the EU TARP program for risky credit countries.

Greece will need to take funds this weeks since it has a multi-billion dollar bond issue due next weeks. Greece may actual get $25 billion by Friday to help it through the short-run.

It is less clear what will be the reaction of the market in the longer-run since it is uncertain who may get the help beyond Greece, how the money will be used, when it will be used, what will be the strings attached and how the money will be forthcoming from the more credit-worthy EU members. But those issues will be pushed into the future.

The growing divergence in emerging markets

There is a growing divergence in the EM markets. This is very clear when we contrast the economics in EMEA versus the Asian markets. The EU periphery has been caught up in the Greek fiscal problem in ways that have not been seen in Asia. The borrowing is form the same banks and the most of the exports go to the rest of the EU. Any slowdown or credit tightening will significantly affect this countries. Growth rates were already lower in EMEA versus Asia. The growth will be even slower. given the EU turmoil. EMEA countries have also not raised reserves and run trade surpluses like the Asian tigers.

This does not mean that Asia is without potential risks. China plays the same role to Asian EM as the EU plays to EMEA. These regional and economic fundamentals are significantly different so that a contagion across all EM countries will not be likely. If fact, Asian EM sell-offs may be an opportunity to gain exposure cheaply.

The problem of the Playbook vs Rulebook in today's markets

Whether bank or derivatives regulation, the type of bail-out of Greece, or the amount of taxes faced, one of the key themes in today's markets is that the rulebook keep changing.

There is a difference between the playbook and the rulebook for any game. If the rules are not well known, then a playbook cannot be created and after awhile there will be those who will just not play the game. We may be at this point in many markets. Granted some rules have to be changed. There can always be improvements to make a game fairer and easier to play for all involved. More bank regulation is needed. The rules for action concerning systemic risk have to be articulated. "Too big to fail" needs to be clarified.

This rule problem is one of the strong reasons why money is staying on the sidelines. Investors have a playbook for one set of rules, but the playbook has to be adjusted if the rules adjust. In the uncertain period between rules changes, the best behavior may be to do nothing.

China monetary policy - control of capital not money

There are two major directions for implementing monetary policy. The one that is talked about in all economic classes is the setting of interest rates. The monetary policy is effective through the credit channel by controlling the cost of funds. The central bank can raise or lower rates. It can change reserve requirements, and it can intervene in exchange rates. Open market purchases and sales of securities can also be done to affect rates and the supply of credit.

What is usually not discussed is the the control of capital through regulation. Some have started to call this the macro-prudential approach to monetary policy. By changing regulations and rules credit flows can be adjusted. The Fed has generally not used this approach but the central bank of China seems t be adopting this regulatory or rules-based approach to stem the rise in real estate. Instead of using the hammer of rate changes, the scalpel of targeted regulation is employed. This will be an interesting experiment. Th Chinese would prefer not to raise rates so the targeted approach may be more effective at dealing with specific asset bubbles.

Note that the Fed could have raised margin requirements to stop the sock bubbles and it could have asked for more regulation in the mortgage markets, it did not. The Chinese market may be overheating, but the central bank is trying to stop some of the excesses without cutting money and the economic growth rate. The markets should watch this nuanced approach closely.

The yield curve is king at providing advice

Sometimes you can over think about the direction of interest rates.

Inflation and inflation expectations have bean surprisingly steady over the longer-term for most G10 countries. The Fed has trained everyone that long-term expected inflation will be 2.5%.

Debt issuance matters, but maybe not as much as we think given the open global capital markets.

Real rates are also surprisingly steady and cannot explain much of the variation in rates.

However, the employment and overall credit picture does matter when tied with the behavior of the yield curve.

What may be most important indicator to watch is the shape of the yield curve. The market moves to extremes and then has a systematic adjustment. Follow the yield curve. If it is inverted, there will be Fed action to get it back to positive and there will be a rally. If it is very steep, the opposite action will be called for and there will be a bear flattener. This behavior has been followed for decades. There is mean reversion in the yield curve that you cannot fight. Perhaps the advice is simple, when the curve moves to extreme the Fed will change. Still it works.

The strange world of REIT ETF's

The REIT market has been on a nice run this year and again in April. It is hard to say why. If you compare REIT yields versus 10-year Treasury rates you would have to avoid. There is little yield premium versus a risk-free rates with a comparable duration.

The data on the commercial real estate market is not pretty. It is certainly one of the drivers for declining performance at smaller banks. Vacancy rates and unleased space has been increasing and the rates charged for any new tenants or renewals have been coming down.

Commercial office vacancy rates are 17.2%, the highest since the early 1990's. Regional shopping centers have rates at 8.9% the highest on record sine 2000. Strip mall vacancies are up to 10.8%. Cash flow yields for commercial real estate are also poor with little premium relative to long Treasuries. Granted REIT's have higher betas than the market, yet the fundamentals are poor.

The positive story for the REIT sector is based a stronger economy and a general loosening of credit banks. So what should dominate? A general pick-up in the economy which should be good for real estate or the current poor conditions which have not shown signs of improving. We do not want to fight the tape, but being cautious in this market may be prudent.

Inflation differential between developed and emerging markets

The risk of a large deflation has passed with the growing recovery across the globe. The risk of inflation in developed countries has also passed as the near-term fear that QE would lead to an inflation spiral has also passed. What has gone somewhat unnoticed has been the growing differential in inflation between the developed and emerging markets. The IMF projections provide a perfect view of the growing gap.

Inflation in the G3 is no non-issue. We still see deflation in Japan. The US has shown stubborn inflation of around 2.5%. Now look at the inflation in other parts of the world. It is down from a few years ago, but it now rising and much higher than the developed world by more than two times. The recovery is stronger but the tie to the US exchange rate has allowed liquidity into these countries. This has to be sterilized. Rates are rising in these countries which is starting to affect capital flows and the potential direction of exchange rates.

Greek problem not going away

Germany's Chancellor Merkel commented on the need for "orderly insolvencies". Nothing like spooking the herd just after it as calmed with the Greek aid package.

As we find out more about the details of the Greek aid package and what needs to be done, it is becoming more evident that the 100+ billion euro aid package will only be a stop-gap and that Greece may be in a credit death spiral. Of course talking about orderly insolvencies should not be considered a policy exercise.

The death spiral for Greece is easy to imagine. Cuts in government expenditures lead to lower income and strikes, which lead to lower tax receipts. For example, the traditional 13th and 14th month bonuses to public employees will have to be eliminated but this will only save a billion euros. The budget does not get balanced and more funds are needed which leads to more austerity. The only solution is for debt holders to take only a portion of what they are owed and wipe the slate clean.