Thursday, November 29, 2012

CoCo not RoRo environment

We have been sued to Risk-on/Risk -off trading environment for the last few years, but for the month of December we will have a CoCo environment, Cliff-on/Cliff-off. The markets saw a big move today based on the last remarks on the fiscal cliff.  We run over the fiscal cliff and the market falls. If the fiscal cliff is perceived to be avoided, we have a rally. The rally is based on the fact that spending will not be reduced meaningfully. If we move off the cliff, the expectation is that there will a recession in 2013. The market declines. Expect more of this over the next 30 days.

Saturday, November 24, 2012

Life as arbitrage: Commodity valuation

Life in the commodity markets is based on many forms of arbitrage or relative pricing. Arbitrage determines price in the context of other prices. Of course, arbitrage tells us something about commodity price relative to other market and not completely about valuation.  Relative value arbitrage will tell you about prices differences but not true value; nevertheless, relative value is often the process engaged by most fundamental commodity traders.

As an aside:

Stephen Ross's words that "All it takes to turn a parrot into a learned financial economist is just one word - arbitrage".

Larry Summers pointed out in his wonderful parody of financial economics "Traditional finance is more concerned with checking that two 8oz bottles of ketchup is close to the price of one 16oz bottle, than in understanding the price of the 16oz bottle".

We identify a number of arbitrages that exist through commodities. We will explain and provide examples of types that can be traded or exploited in the futures markets. This does not include all of the combination that may exist in the cash market, but this set provides a robust number of examples of arbitrage.

Quality arbitrage - the relative price of different grades or quality within futures markets. In the cash market, quality or grade is priced as premium or discount versus a standard grade which will be the futures contract traded. Still, there are quality arbitrages across futures. The driver of quality arbitrage will be a shortage or oversupply of the grade of commodity. 

Agricultural markets:

In the case of wheat, there are a number of futures contracts which do not represent the same grade. If there is a shortage, there will be a greater premium for high protein wheat which is used for human consumption. Hence, KC - Chicago spreads will widen when inventories are low or stock to use is low. Kansas city wheat versus Chicago wheat will be an arbitrage based on protein content of the wheat. Kansas City versus Minneapolis or Chicago will also based on type of wheat priced. LIFFE Millers wheat versus Chicago wheat are different grades, (additionally a location difference).

There are differences in coffee quality between Robusta and Arabica. Arabica coffee represent higher quality beans while Robusta beans will be almost like a shrub row crop and not as flavorful. If incomes increase, there will be a higher demand for Arabica beans.


There is little quality difference in the industrial and precious metals futures markets between the London and New York markets. However, the specs for each contract are slightly different.


There are grade differences between brent and WTI but the main differences are locational; nevertheless, WTI will be a light sweet crude while oil coming from most parts of the Middle East will be more sour and heavier. 

Locational or geographical arbitrage

Locational differences are associated with delivery points but more importantly, they can be associated with production or growing locations. Delivery points and contract trade locations means there is not a perfect arbitrage and currency differences can lead to risk unrelated to the underlying commodity.

Agricultural markets:

There are dual NY versus London contracts in coffee, cocoa, and sugar. The delivery differences will be one of the main drivers of arbitrage.

There are locational differences in wheat contracts. There are other futures which are not liquid which can represent locational differences. 


There are differences in New York and London contracts for most industrial metals. There is also an arbitrage between NYC, London, and Shanghai in copper.


The main difference is Brent versus WTI which is a locational difference. The locational differences allows for supply imbalances to drive spread differentials. There will be locational arbitrage between NY and London contracts.

Basis trading is strong between locations in natural gas.  

Product arbitrage - There is strong arbitrage link between the raw material input and the products that come from a commodity. This a key driver of pricing because inputs cannot rise above a level that will make transformation uneconomical.

Agricultural markets: To name a few.

Corn/ethanol - The transformation of corn into ethanol and DDG's.
Soybean crush -The transformation of soybeans into meal and oil
sugar/ethanol - The transformation of sugar into ethanol 
cocoa grind - The grinding of cocoa into butter and powder.
Feeder to live cattle.
The use of corn to feed hogs which is the switch to protein. 
Live cattle to products 


Oil to refined products. Crack spreads. 

 Substitute arbitrage - The use of one product over another based on price

Agricultural markets:

Switch between corn, wheat and soybean meal as feed. There is also  substitution of what will be grown. In the Midwest, there will be switching between corn and soybeans.

If there is a commodity, there is a relative price arbitrage.

The mismatch of time horizons and financial cycles

Claudio Borio of the BIS has provided an interesting paper "On time, stocks, and flows: Understanding the global economic Challenges" which may be one of the most thought provoking research pieces for investors trying to understand the current environment.

We have been through the Age of Stagflation, the Great Moderation, the Age of Turbulence, The Great Recession, but we are now entering a new area, the Age of Policy Drama.  Borio takes a economic historian's view of the crisis and concludes that the time between economic cycles and policy behavior is not in sync, so we have a disconnect that cannot be easily solved.

In Burns and Mitchell’s terminology, economic time has slowed down relative to calendar time. That is, the macroeconomic developments that matter take much longer to unfold...Yet the planning horizons of market participants and policymakers have not adjusted accordingly – indeed, if anything, they have shrunk.

There seems to be less patience with policy-makers. I want a solution and I want it now without any pain.

Stocks build up above trend during financial booms, as credit and asset prices grow beyond sustainable levels, and generate stubborn overhangs once the boom turns to bust. Stocks raise serious policy challenges. In the presence of policy responses that react too little to booms and too much to busts – in jargon, that are asymmetric – stocks grow over consecutive business cycles.

If this diagnosis is right, the remedy is not hard to find, although it may be extraordinarily difficult to implement. In a nutshell, it is to lengthen policy horizons, to put in place more symmetrical policies, and to tackle the debt problems head-on.

Borio argues that the financial busts we saw in 2008 are not dissimilar to what we have seen in other financial crises. These earlier financial crises do not have derivatives or the Wall Street of today, yet there were crises. there is something inherent within the economic system that leads to boom and then busts. Historian have noted this is the past.

There are some similar characteristics to all financial cycles.

First, there are imbalances based on excesses. Excess credit and excess borrowing. The excess could be caused by financial liberalization. This could regulation or it could just be looser credit, but there are fewer constraints on the financial excess.

Second, there is a regime of stable and low inflation which provides the view that the central bank is credible and and there are limited risks in the system, This has been called the paradox of creditability.

Third, globalization makes the world more sensitive to supply shocks. Changes in the global environment can carry over to other parts of the globe.

Government have focused on the micro prudential issues of how to regulate a bank and not on the systematic issue of how the protect an economy. The macro risks of a financial cycle will actually grow. For example, monetary policy focused on the equity markets during the crash of 1987 and the dotcom boom and not on the overall credit conditions of credit expansion and property values. The focus on the micro lead to further excesses toward the financial cycle.

A financial cycle decline leads to a balance sheet recession and not a classic inventory recession. Hence, if you fight with tools and a view toward business cycle problems, you will addressing the wrong problem. The focus has to be on balance sheet repair.

In a balance sheet recession, fiscal and monetary policy may not be effective as in an inventory recession. First, fiscal policy may not prime aggregate demand because balances sheet will be in repair. Spending will decline. Monetary policy will not be effective because the balance sheet of financial institutions will be in disarray. Lower rates will not serve as a solution. Liquidity will be needed but driving rates to zero is not the solution.

Are there clear solutions to the problem. There are clear policies that can help repair balance sheets, but to avoid the financial cycle in the first place there needs to be a macro buffer to slowdown growth and financial excesses during the boom period.

Navigating the tricky waters ahead will require a balance between Gramscian “pessimism of the intellect and optimism of the will”: pessimism to assess the challenges ruthlessly, never underestimating them; optimism to overcome them. And, as the late Tommaso Padoa Schioppa stressed, it will require a long- term view. 

Decline in cocoa grindings may signify industrial change

Chocolate as the poor man's luxury is starting to be affected by the global slowdown especially in the EU. The largest demand for cocoa is in Europe and the latest grinding numbers show another  slowdown. The slowdown in the second quarter was 18 percent while the third quarter declined 16 percent. The North American grindings were down by 9.8 and 2.2 percent in the second and third quarter. This suggests that demand is falling and something to watch more closely over the next quarter. However, like any market, looking at just the simple numbers may not provide the correct insight.

Cocoa beans are grinded into powder and butter. Grinders make money based on the combined ratio, the price of butter and powder divided by the cost of beans. This is a simple arbitrage no different than what is seen in other markets from soybeans where profits are determined by the crush and refiners where profits are based on the crack spread. If demand decreases there will be less grinding yet grindings will also be effected by the amount of butter and powder that this held in inventory. If there is a build of butter and powder and the combined ratio declines, destocking will reduce the grinding for any period. if spreads on products move higher, grindings will increase. The latest combined ratio suggests that grindings will again pick-up. 

The cocoa tree flowers in two cycles of six months the whole year round. Like most crops there will be periods of excess supply based on harvest that have to be controlled to maximize the price to farmers. About 40% of the crop is lost to pests and disease every year. An average tree produces 30 usable pods, which will leads to about 2 pounds of dark chocolate. The weather is critical and the location of production cannot change, although Malaysia is planning to increase production. The producers want to minimize market volatility.

The grindings will also be affected by changes in the market structure for cocoa. There has been an excess of grinding capacity which as caused the build in butter. There is a change in the market grinding capacity and where it is done. The EU and Switzerland usually represents 40% of the world grinding, but there has been a marked switch in grinding locations closer to the source in Africa and the places of new demand such as Asia. Grindings will decline in Europe not  because there is a double digit decline in demand but because grindings are done elsewhere. The grinding decrease in Asia has not been as large as seen in Europe. There are government incentives to have more value-added production in Africa.

There is also a new marketing system in the Ivory Coast, which represents a third of the world production, which has placed more uncertainty in the cocoa industry. The Ivory Coast will be regulated by the Cocoa and Coffee Council who will control the daily auctions which will set a guaranteed price for farmers and the export price. There will be a limit on how much any exporter can buy of the crop. There would be a stabilization fund which is used to minimize the difference between the farmers and export price. These changes in the distribution of cocoa from the farmer to the grinder has caused the market to be more cautious. 

Ghana also runs a state controlled system that guarantees a fixed price for farmers and is the second largest producer while Indonesia is the third largest bean producer although its crops have been of poorer quality with falling productivity from older trees. Nigeria is the fourth largest producer. The top four represent 74 percent of the world's production, so if some of the traditionla sources of production chnages the rules of the game, there will be a market reaction regardless of supply and demand conditions for cocoa and chocolate. 

The wisdom of psychopaths and trading

All psychopaths are evil, or so goes the conventional wisdom. The Wisdom of Psychopaths by Kevin Dutton actually provides an alternative perspective whereby someone who has the characteristics of a psychopath can actually do good, or at least have characteristics which will be extremely useful in some professions and situations. 

Dutton develops his thesis in great detail through case studies and a review of the deep research on the subject. It shows that there is a continuum of personality characteristics which include those of psychopaths. Some of the characteristics which we abhor with criminals are actually very useful in some settings. 

Perhaps the main characteristics of any psychopath is the lack of emotion or empathy in their behavior. They are without the normal sense of human emotions. This could be a hyper-focus on rewards or goals but psychopaths have very little or no risk aversion in many situations. For the doctor who does not get emotional about an operation, for the spy who can mask his behavior, and for the hero who does not think about fear, the characteristics of the psychopath are useful. When tested, many of the best professionals in certain high risk jobs have the same characteristics as the criminal psychopath. The difference is that the focus may be for the good as opposed to evil.

From a trading and investment profession, this may be very useful. The poker player who  can sustain losses has an edge versus other players. Think of all of the behavioral biases that exist or all of the problems with changing or increasing risk aversion. What if the trader can be a risk neutral machine that will not allow emotions to enter his decision process? He would be a better trader. So, it is possible that those traders who minimize their emotions may actually score high on tests which measure characteristics of psychopaths. This does not mean that all good traders are psychopaths, but it is interesting to suggest that characteristics which we may not like in normal behavior will actually be very useful for survival in a trading situation. 

We have just started to scratch the surface of what it means to be a good trader or what it takes to make better decisions and the psychology of the trader may be one of the key components. Of course, the good trader sitting next you may be a psychopath. 

Friday, November 23, 2012

The three FC's: financial crises, flash crashes, and fiscal cliff

The fear of the FC's is gripping the markets. The three FC's are financial crises, flash crashes, and the fiscal cliff. Financial crises are more now on everyone's mind. There will be another EU crisis. There could be a French ratings crisis. There is an ongoing fear of a banking crisis. Crises are now expected everywhere. There is good reason for this view but it has gripped the markets at every turn even in the face of an equity rally. Flash crashes are not only possible. They have occurred with growing frequency. The real problem is that like the sound a crack in the bush which scares animals, investors have to act first and think later. So many will just stay out of the market. Finally, the fiscal crisis is coming soon and there is no answer. 

Beware of the FC's!

Is there such a thing as a bond bubble?

There has been more talk about bond bubbles, but it truly is misplaced. Rates are low because governments and central banks want them low and the markets believe those policies and the effectiveness of the central bank to deliver on that promise. Part of the central bank promise is to push rates so low that market participants will seek higher yields in other asset classes. They have been effective at moving money to riskier assets and have pushed credit spreads down. The result on the other side of the equation is that borrowers are coming to market if they need cash and holding more cash if they have it.

Is this the signs of a bubble? It could be an exaggerated policy but no bubble. It is not irrational to follow the rates lower. However, like any momentum strategy this cannot last. rates will have to move higher. The reversal of policies and inflation is not a bubble but the natural course of events. 

Asset allocation to bonds - jumping off a cliff

Global asset allocations are becoming more biased to fixed income. Global asset allocation has moved above 50% when you look at bonds and cash in some surveys. $4 trillion has moved into fixed income funds versus $400 billion in equities over the past four years. The global pension market has moved from a 61/30% allocation to stocks and bonds to now 41/37%. 

Of course, over this time we have seen a significant increase in equity returns. The real returns on cash are negative. the real returns on bonds are negative. So the current asset allocation is a slow bleed of loses. If you consider that rates move back to longer-term averages of 5% in the US, the bleed is even bigger. The unsophisticated investor in futures and equities is a bad timer. The same may also include fixed income investors. We could be in a bad timing phase for all investors with respect to fixed income. There is limited reason for a fixed income gain except a complete failure in government policies.  

Chinese monetary policy changing

The Ban of China has more actively used open market operations to implement monetary policy. They are becoming more like Western central bankers and less dependent on changes in reserve requirements  or loan policies. This is a natural part of the maturity of financial markets in China and the reduced dependency on bank lending. 

Reserve requirements are a very blunt instrument and not something that can be sued in a complex banking system. Still, capital flows through a limited number of state banks. There needs to be a more open financial system but it is unlikely to occur under the current government. 

Paper Promises - A nice addition to monetary history

Philip Coggan of the Economist has written a good history for anyone who want to understand the nature of a debt crises in his new book, Paper Promises: Debt, Money, Money and The New World Order. He provides a perspective on monetary economics through reminding us that money a paper liability based on trust. 

Debtor and creditor battle have gone on for centuries and you cannot separate money from this old battle. Debtors want cheap money and lots of it and creditors do want to debase their investments. They want to paid back with a real return. The people want cheap money and the wealthy creditors do not. Kings who borrow want cheap money. democracies controlled by the people want cheap money. This is why we constantly have to worry about inflation an monetary control. Monetary control can assessed through a hard currency base don gold. Paper money or a claim on other assets like gold is a recipe for excess. 

Paper money was introduced by the Chinese and may have been imported to the West by Marco Polo. When inflation became a problem the Chinese switched to silver. The west was left with the problems of paper money.

Some one mentioned the philosopher's stone. To the surprise of all present, Law said he had discovered it. "I can tell you my secret, " said the financier. "It is to make gold out of paper."  -John Law by H. Montgomery Hyde 

Marias on the return to metal coinage after Law, "Thus ends the system of paper money, which has enriched a thousand beggars and impoverished a hundred thousand honest men." 

Being on the gold standard is silly, but the potential ravages of paper money have never been controlled. Financial bubbles are always tied to loose money. Bankers, governments and debtors are all greedy but they only act on excesses through loose money. History does not tell any other story. Just ask Coggan. 

Fiscal cliff and Thatcher

Prime Minister Margaret Thatcher's 1976 warning, "socialists always run out of other people's money".

New Zealand as the milk capital of the world

Fonterrra the milk co-operative New Zealand will allow non-farmers investors to buy into the firm. Fonterra is trying to raise 500 mm NZD through a share class offering that will price next week.  The interest is very strong for this offering which will not have nay voting rights but an economic interest in cash flows. 

Fonterra is the 800 lb gorillla of the milk industry and has changed the way bsuiness is done even in the US through its global auction process. Dairy represents 25% of New Zealand exports with inroads all around Asia as well as Latin America and the rest of the world. Milk prices are high in the US but volatility is high. A slowdown in growth or more competition will have a strong impact on this industry. The days of family farmers providing milk to the world are gone. 

Change in China government more important than US election

Xi Jinping is the new head of the communist party in China as the general secretary of the Central Committee and this may be more important than the US re-election of President Obama. China has moved from the six the largest economy to the second largest in the last decade, but growth has slowed and exports as a key driver may be a thing of the past. 

Now the theory of Kexue fazhan guan or the scientific outlook on development developed by Hu Jintao will be put to the test. Economic development is messy and a conservative government may not have the stomach to allow freer markets and less emphasis on state enterprise as a solution to China's problems. 

The ramifications for the rest of the world will be significant. We have gone done the path of controlled or scientific modeling of economic growth. The result has usually been failure, so it will be interesting to see how the internal consumption wealth distribution and growth will be addressed. Will it be through freer expression of capitalism or more state control? This is an Eastern variation of the Hayek versus Keynes battle. 

Buy commodity trading firms?

The Carlyle group has bought a minority stake in the Export Trading Group (ETG) which is the largest trader in cashew nuts. Glencore bought Viterra of Canada, Marubeni acquired Gavilon, and ADM is trying to buy GrainCorp.

Bunge is trading a highs for the year, but Olam is involved is a nasty short fight with Muddy Waters LLC. Trading firms in the commodity markets are a hot area of interest, but for how long?

Tax rate policy - why the muddle?

Stephen Moore wrote an editorial "Why Lower Tax Rates Are Good For Everyone" in the WSJ which lays out a strong case for lower not higher rates. Granted the size of the deficit is high and there will have to be higher tax burdens at some time. However, the burden should be on growing revenue not setting rates. More growth will add more revenue. Fewer deductions will add revenue and reduce distortions. History shows that lower rates have lead to more revenue. This can be achieved even with a progressive tax system. The tax system becomes less progressive when deductions are greater.

When Coolidge, Kennedy, Reagan and Bush lowered tax rates, revenue increased. What is different this time? 

Is there a strong case for gold?

Geopolitical risk and market uncertainty still exist. One could argue that there is always strong geoplitical risks; however, the current risks are increasing and this makes for a better environment for gold.

The fiscal cliff in the US is real -The taxes increases will occur in less than 40 days and investors do not have an idea of what will happen. Planning for year-end 2012 has to take place and selling more likely. If there is a place to put your money, gold seems likely.

EU risks have not diminished - There has been some improvement in the economic conditions of periphery countries like Ireland, Portugal and even Spain and Italy, but the issue of Greece stills exists and France has been downgraded. 

Reflation risks are growing - Deflation never occurred during this financial crisis. Inflation never left the financial system. The level of inflation is till low at around 2% but the threat is on the upside. 

Global growth risk greater - There is the belief that gold is correlated with risk-on behavior over the last few years. But  if there are no good investment projects, the demand for gold will go up. 

What is the cost of being wrong? -The cost of holding gold is low when interest rates are low; consequently, investors can wait for their doom. 

Wheat prices herald a problem

Lenin called grains the "currency of currencies."

Worst conditions in 27 years for winter wheat in the US. Some are invoking the "Dust Bowl" to describe the current environment in the US. Surprisingly, the cereal crop with the greatest price move this year is wheat not corn even though news reports focused on corn during the summer. 

The wheat market is a global market and with stocks to usage forecasted to decline further this year to about 24% we are seeing more price increases. The US is in bad shape, but so are other bread basket areas - Russia, Ukraine, Australia, and Argentina. The 2012-13 season is looking to be 661 m tonnes which is below the current consumption of 688 m tonnes. Places like the Ukraine and Russia which have served as residual exports on the wheat market will be subject to export restrictions. We are seeing these countries actually accelerate corn exports and withholding wheat. 

Wheat prices are near 2008 highs and are more than double the price from ten years ago. This will be the commodity market that will show some of the most price action in the next three months. 

Kasparov and Thiel - on technological progress

Garry Kasparov and Peter Thiel discussed technological progress in a recent FT editorial which is very thought provoking. What is progress and have we moved forward or was the IT boom and dotcom boom of the last twenty years just an illusion? Compare this with the Green Revolution in agriculture, jet travel, or the advances in medicine in the 1950's. We have had technological acceloration but is that the same as innovation? Are we actually caught in a period of stagnation where some of the best theses on growth is to limit it? 

This is not the first time that innovation has been questioned. I am thinking of the "small is beautiful" period. We have to access technological progress and determine whether we are going in the right direction, or more importantly, do we have any direction at all. 

Is there a purpose for a debt celing?

On Bloomberg TV, “Political Capital” host Al Hunt asked Geithner if he believes “we ought to just eliminate the debt ceiling.” “Oh, absolutely,” Geithner said. ... “It would have been time a long time ago to eliminate it. The sooner the better."

Households do not have debt ceilings. Companies do not have debt ceilings. Why should a government have a debt ceiling? The answer is simple. The Congress and the citizens cannot be trusted to hold down spending so this imposes a target on the size of the deficit. Imposing rules on potential bad behavior is time honored. 

The debt ceilings have always been raised, but the discussion about the size of the debt serves a useful purpose. Rating agencies are not upset with the debt ceiling. They are upset with the size of the debt. Hence, it is hard to argue that eliminating the debt ceiling will be good for the country. I would argue there is no need to ban the ceiling. However, a debt ceiling tied to the size of the economy or more regular reviews would make sense.

Thursday, November 22, 2012

Foreign regulators to CFTC - enough!

The CFTC will have tremendous reach into the swaps business through Dodd-Frank. The EU commission is having problems with the regulation. The FSA says that the rules may  not work for year-end. There is clarity to the rules. and this comes from the FSA, The EU, ESMA, BOJ, Bank  of France, Swiss regulators, and Japanese regulators. All argue that there iwll be more market uncertainty. 

What should be the reach of a domestic regulator in an international market when the rest of the world does not want to follow the same standards? The result is deglobalization and a movement back to regional banking. Capital flows will be impeded. French banks will not do business in the US. UK banks may move into different markets. The center of the financial world will move away from New York. Perhaps this is what is wanted? 

Friday, November 16, 2012

Corn belt moving North?

The corn belt is moving North. Climate change is forcing changes in planting. The drought of 2012, the worst since 1954 will have a significant impact on planting next year. It is already affecting the wheat crop, but  this is just part of a larger story of changing patterns in weather and climate. Corn acreage has moved north into Canada and has been reduced in places like Kansas. The longer-term drought makes corn in Kansas less viable, but the change in growing days (number of forest-free weather) is also driving patterns in planting. With a few extra growing days, a region can sustain different crops. Canada can support wheat, corn, soybeans, canola and more. This has resulted in more physical assets to support plant diversity.

The Hardiness map shows a change to warmer climates. This change in climate has an impact on crop insurance standards. While this cannot help predict price, it will tell us there is more at risk in agriculture.

Thursday, November 15, 2012

How good is the news? The problem with reporting

Lorraine Adams, Washington Post reporter, provides an interesting assessment on news reporting in the  blog, The Browser. News is related to a reporter's sifting of facts. Facts that can be placed into neat stories. Facts that are easy to explain with the other goings on in the market.

There is little analysis because that is what portfolio managers do. Managers try and understand the facts reported and find those new facts that do not make sense or were not reported at all. 

I think news organisations are part of a difficult to grasp paradox: They rarely know how to deal with anything completely new. They’re best equipped to promulgate conventional wisdom.

Her assessment of Walter Lippman's Public Opinion is good food for thought.

 It was written in 1922 and is an insider’s view of how news is made. That is, news is a made thing. News is not facts. News is what is easiest for a reporter to recognise, not necessarily most important for the public to know – a kidnapping, a bombing, a court filing, anything that pokes up from the irregular and massive tissue of reality and events.

That famous line – ‘Every journalist who is not too stupid or too full of himself to notice what is going on knows that what he does is morally indefensible’ – is an overstatement. Yet it stands for a deeper problem. 

The news reported is not the truth but just a view and a opinion. The internet has shown that the editing of the news, determining what stories to print or not makes all the difference in the world.

Is the yen slide just another head fake? No

The yen is at the highest levels since the spring. Is the period of endaka or yen strength ending? Certainly, there is a need to have a weaker yen with Japan again recession bound and corporations hurting with their export sales. The Japanese economy is going in a different direction for the US so there is a natural currency weakness. Monetary policy seems to be getting another jolt to be more accommodating. There seems to be an accord between the government and BOJ that they want to get serious about easing. There is a statement that they will "work together". Japan needs to get Swiss serious. 

There also is a higher expectation that any change in the guard at the BOJ will be more willing to raise inflation targets. The potential new LDP prime minister, Shinzo Abe, have been calling for a inflation target between 2-3 percent. Abe has called for unlimited accommodation from the BOJ with a zero interest rate. He would like to see an end of deflation and a weaker yen. Parliament is likely to be dissolved tomorrow which means an election in the next month.

Wednesday, November 14, 2012

The dollar did it? Commodities and currencies

Article in Agrimoney suggests that the decline in commodities is a result of the rising dollar. A dollar rally will cause further commodity sell-off given the higher cost of goods priced in dollars. There is a strong relationship between commodities which are often priced in dollars. The commodity beta using the dollar as the independent variable is slightly above one.  A longer-term number is even higher. If the dollar is going higher, you want to be a seller of commodities albeit the correlation can change and has moved form close to zero to -.5 over rolling 120 periods in 2012. The Agricultural index beta is just less than 1 at .93. For the energy sub-index, the beta is higher at -1.23. The industrial index beta is -1.57. The precious metals sub-index beta is -1.53.

Commodities are closely linked with currencies, so the risk-on risk-off trades in the dollar have carried over to the global commodity markets. 

Monday, November 12, 2012

How independent is the BOJ? How independent is any central bank?

With interest rates pressing lows and governments needing those low rates to reduce the cost of budget deficits as well as investors needing liquidity to buy debt, there is a growing questions whether central banks are independent. There is the facade that there is independence through arguments between the monetary and fiscal authorities and news reports of disagreements, but in the end, the central bank will still be beholding to the government for appointments and its livelihood. Central banks do not want to be blamed for fiscal failures. They have shown a willingness to play for the benefit of the fiscal authorities.

The issue of independence has always been a question for the Bank of Japan. The BOJ has eased for the last two months, but usually shows a level of caution that may be out of place in Japan's slow growth environment. A recent joint statement between the BOJ and the government suggest that they both want to solve the problem of deflation. The statement placed equal weight on the central bank and government doing their parts to solve the deflation spiral and increase growth.  The Bank of Japan is given autonomy for currency and monetary control but having a joint statement suggest coordination and a joint goal.

The new policy of providing unlimited funds to commercial banks is similar to what is being used by the BOE through their Funding for Lending scheme which began in July. Unfortunately, a shortage of loanable funds has not been the problem in many countries. It is an issue of the real costs of those funds. In Keynesian speak, there is not enough aggregate demand for the amount of money outstanding. This is a fiscal government problem and not one of coordination.

Small and young better for hedge funds

Pertrac has done a study of all the hedge fund in their database from 1996 through 2011 and found some interesting results. Small hedge funds, less than $100 mm, do better than large hedge funds. Young hedge funds which are less than 2 years old do better than older hedge funds. For small funds the cumulative performance difference was 558 versus 356 percent. For young funds versus older funds, the cumulative performance was 827 per cent versus 446 per cent for middle aged 2-4 years and 350 per cent for those tenured or more than four years old. 

Most would argue that the difference is partially associated with survivorship bias and the fact that the young and small are riskier, but this may not fully explain the difference. The young and small are hungrier and that matters. 

Should the dollar direction be higher?

So let's figure this out. QE3 happened in the middle of September and the dollar has been moving higher since then. We have moved form 79 to 81 on the DXY dollar index. A currency should be moving lower on monetary action. The economy has gotten stronger. This should reduce the need for holding funds in the safe haven. Earnings and corporate sales are weaker which may cause risk-off trading. The fiscal cliff is a US event yet the dollar is higher even with post-election gridlock. Does this all make sense?

The prrblem is that the key drivers of the dollar are not currently well-defined. This means that it is hard to trade currencies and the result has been a reduction in currency activity. If you cannot determine the drivers, you will exit the market. Increase factor uncertainty and trading will decline.

Should the dollar go higher? This is a more difficult question when the driver of the dollar are not well-defined.

When the cost of capital is low - Zombies come out

There has been much discussion in Japan about Zombie banks and corporations which still exist because they are propped up by the government and financial institutions. The loans are not called and the cost of funding is low. These firms will not go out of business. The move across the land and use resources feeding off of other market participants. There can be sovereign zombies eating off of taxpayers but that is another story.

These corporate zombies continue to exist because the cost of borrowing is so low. There is no discipline from the markets if you are not penalized for your mistakes. Of course, risky institutions are not able to get the lowest funding costs, but rates which reflect credit as a scarce resource would be higher and firms would go under. The problem that existed in Japan now exists in the US especially in the housing markets and it is unlikely to go away as long as the Fed continues to hold rates close to zero.

Maybe we do not want to change the industrial structure. The pain will be too great, but is there ever a right time?

Science and surprise

The end of surprises would be the end of science. To this extent, the scientist must constantly seek and hope for surprises. Robert Friedel

Great quote. we have to be looking for what will surprise us. This is the test of learning and this is the test for advancing knowledge.

Macroeocnomic policy choices - Are we FUQed?

There is a nice terms that explains one of the key problems with answering policy choices for complex problems, FUQed, Fundamentally Unidentified Questions. These are the questions that we do have have any simple answers like, how do we stop global warming. We do not have the ability to test alternatiev ideas and identify solutions.

I would argue that any of the key policy issues that we face today cannot be easy answered because we are FUQed. We do have the ability to run experiments and isolate the impact of our choices. Take the example of tax policy. We have had limited number of tax changes so it hard to measure what will be the reaction to a change in policy given that its is unknown whether it is perm,ant or temporary and we cannot control for other variables. 

Economics is more difficult than any other science because it is hard to run experiments. The most successful and pioneering work in economics is trying to develop testing methods to solve this identification problem.  If we cannot run experiments, we are FUQed.

Success, failure, and adapting

Tim Harford, the "undercover economist", is a good writer who again has presented some complex economic topics to readers is a simple and engaging way. In his new book Adapt: Why Success Always Starts with Failure, he describes how success can come through trying, making mistakes, learning, and finally adapting. Through effective story-telling and case studies, Harford shows how the process of making mistakes we can improve when there is a complex world. This is similar to the work of Malcolm Gladwell in his books Blink and Outlier. Here the message is simple, trial and error works, so make more mistakes.

While this is a nice piece of economics, the real importance of this work is through helping anyone with their decision-making. We will get things wrong in a complex world, but if we except that and rely on experimentation we can improve. Accepting that we will make mistakes is not saying that we should engage in stupid behavior or that we should take risks that will harm ourselves. There has to be balance, but there also has to be the acceptance that there is no one way of doing things. There are multiple approaches for problem solving. There is a need for experimentation. It is this experimentation which leads to success.

The reason why we have to allow for failure or accept failure is that the world is a complex place. Complexity is the result of the interaction of many people and parts. There are no easy solutions so we have to engage in incrementalism through small changes and experimentation. Harford gives the example of the man who tries to build a toaster by himself. He finds that a simple machine like a toaster takes hundred of markets and the input of thousands. The toaster of today is the result of adaptation and failure. "The curious task of economics is to demonstrate to men how little they know about what they imagine they can design",  Hayek.

The world is complex and it is hard to forecast. Most experts do not get it right. They make major mistakes given the complexity of the world, so we have to learn to adapt in the fog of complexity that we face. We have to make peace with loses and mistakes. This could be the most important result of behavioral fiance. We have to avoid changing our behavior with loses. As Daniel Kahneman has said, "A person who has not made peace with his loses is likely to accept gambles that would not be acceptable to him otherwise", and this is when there will be the greatest failure.

We have to accept or understand the knowledge of particular circumstances of time and place and this means that we have to adapt to the situation that we face and not be bound by set rules for our decision-making.

This is a rich book with a lot of important concept. You do not have to be an economist to enjoy this read and anyone who reads this book with think differently about the mistakes they make and how they adapt to change.

Policy uncertainty is at year highs

 We use the policy uncertainty index developed to look at the uncertainty currently facing the market.The index includes news, tax code changes and disagreement of economic forecasters.

The levels have come down since the crisis in 2008 but they are again on the rise. If you look at 2012 we have have hit the highs for the year. The combination of the election and fiscal cliff have provided a Fall of uncertainty and these are not truly captured by the policy uncertainty index. The magnitude of the problem is also not captured. There is a reason for the conservative asset allocations. 

Friday, November 9, 2012

Gold tells the election story

Gold has again been climbing in response to the US election and the continued problems in Greece. Of course, gold is still below the highs at the beginning of October and the end of February, but there seems to be a stronger rally brewing. It is hard to make judgments from the past, but as the Republican hand looked stronger, gold fell. With the likelihood of President Obama retaining office and winning, gold started to rise again.

  • There will be no change in fiscal policy and in fact, there is likely to be more easing from the Fed. 
  • The fiscal cliff is getting closer but the likelihood of large budget cuts has been diminished. 
  • Financial repression will strengthen in the US and banks will be more restricted.

The end result is a better environment for gold.

Thursday, November 8, 2012

China and corn consumption

SGS corn survey for Bloomberg provides insight into a key player in the global corn markets. China is the seconds largest consumer of corn at over 175 mm tonnes, second only to the US. It is close to three times larger than the EU as a consumer. It should also be noted that the US at over 275 mm tonnes uses over a third for ethanol use. China is the largest true corn consumer for food and feed by that measure.

Most of the corn that is grown in China is in the Northeast section of the country around Beijing. The China corn belt has similar weather to the US Midwest. The productivity of their farming is much below what is found in the US, but the farm sizes are smaller with over 50% being less than a hectre. China faces significnat weather conditiosn with thier corn crop. drought is an ongoing problem in the interior while typhoons can provide too much water on the coast.  

Weather conditions for 2012 were worse than 2011 with the survey suggesting that 38% believed that conditions were bad for growing mostly because of high winds and insect damage. Nevertheless, the amount of corn acreage planted increased around 4.71% and the increase in production is expected to be 3.61 percent from 2011 to 2012 harvest. The conditions were not good so the match match in production was not one for one with the increase in acreage. Production increases came from more land used for corn and not an increase in yield. Given the higher prices, acreage for 2013 is expected to increase 19%next year.

What the survey suggests is that deamdn for corn may still be strong until next year's crop comes based on the higher acreage. Exports to China will occur but there may be gaming on when to make those purchases.

The drought that keeps giving - the tight wheat market

The harvest is in for corn and most of soybeans  but that does not mean that the drought is over for grain markets. US winter wheat conditions are poor. The amount in good to excellent conditions is only 39%, the worst since 1985.This means that we will have tight conditions for wheat in 2012/2013. The Australian harvest is expected to be poor, so world wheat production is already coming in 5.7 million tons lower. The projected ending stock for 2012/2013 are down 44 million bu from September and are supposed to decline 89 mm bu from last marketing year. The market for May -July 2013 is in backwardation and may move to more extreme.

US wheat exports are supposed to be lower given the strong dollar and lower production. There is also expected to be lower exports for the EU-27, Australia, and Canada. There is expected to be higher exports from Russia, Argentina and India. Unfortunately, the policies of those governments may effect the ability of grain to move out of the country.  

Wheat is trading at a greater premium to corn. This may increase further under the current conditions.

Commodity index changes create new demand

Th GSCI index committee has announced a change in the composition of the commodity index with an increase in the allocation to Brent crude and a reduction in WTI. Brent is more of a world benchmark so this will make the index more representative of the true world market. However, changes in the composition of the index will create new demand for commodity and change spread relationships. In this case, there will be an increase in demand for Brent at the expense of WTI which should increase the Brent -WTI spread.

The changes for 2013:

                          2013         2012  Change Vs 2012
 WTI Crude              24.71%       30.96%             -6.25
 Kansas Wheat            0.68%        0.88%             -0.20
 Live Cattle             2.62%        2.71%             -0.09
 Sugar                   1.85%        1.90%             -0.05
 Cotton                  1.07%        1.12%             -0.05
 Gold                    3.00%        3.05%             -0.05
 Soybeans                2.62%        2.63%             -0.01
 Coffee                  0.82%        0.83%             -0.01
 Natural Gas             2.02%        2.03%             -0.01
 Zinc                    0.51%        0.52%             -0.01
 Cocoa                   0.23%        0.23%              0.00
 Nickel                  0.58%        0.58%              0.00
 Silver                  0.49%        0.49%              0.00
 Aluminum                2.13%        2.12%             +0.01
 Lead                    0.40%        0.38%             +0.02
 Corn                    4.69%        4.66%             +0.03
 Feeder Cattle           0.52%        0.49%             +0.03
 LME Copper              3.28%        3.24%             +0.04
 Lean Hogs               1.58%        1.52%             +0.06
 Chicago Wheat           3.22%        3.04%             +0.18
 Gas Oil                 8.56%        8.11%             +0.45
 RBOB Gasoline           5.90%        5.02%             +0.88
 Heating Oil             6.17%        5.13%             +1.04
 Brent Crude            22.34%       18.35%             +3.99

Along with the oil change, there were increased weights for gasoil, heating oil and RBOB gasoline by the GSCI index committee. A similsr move occurred with the DJUBS index. The Brent weight will move from 5.3 to 5.8% while the WTI will be cut form 9.7 to 9.2 percent.

The Roger's index has also announced change in their index with a switch form New York to London coffee. This will be a switch from Arabica to Robusta beans,. there will also be a switch from New York to London cocoa.

These changes will all cause adjustments in volume and open interest next year.

Tuesday, November 6, 2012

Oil and the medium term

A thought provoking presentation for analyst John Kemp of Reuters called "Medium-term trends in the oil market: Putting uncertainty at the heart of the analysis" focuses on the value of technology in determining the future of oil. Most of the technology currently being used on the cutting edge of production had been developed decades prior. There is a long lead time before technology is effectively employed. The important point is that you need higher prices to allow technology to be cost effective. The graph shows the prices necessary to bring reserves on-line. If prices fall, the supply will decrease as the economics become ineffective.

Bill Gross - bonds burnt to a crisp

Bill Gross is at it again with strong pronouncements concerning the risk of bonds. He is putting the US in the ring of fire, the combination of high annual deficits and large structural fiscal gap. Growth is not going to solve this problem because the structural issues need policy change. This is what the current election is all about and this is what will have to be addressed.

If you hold government bonds in the ring of fire, it is time to get out.

What is happening with commodities

The dispersion of commodities shows that if we take away grain markets this has not been a good year for holding commodities. So what is the cause?

Slow growth. Monetary stimulus has not inflated commodity prices like financial assets. Equities have seen  strong  increases because valuations are up and earnings have been up even on slower sales. The earnings are higher based on the control of costs and limited investments with cash holdings. There is a search for higher yield in financial assets but the search has not moved to commodities outside of the long-term uptrend in precious metals.

The cost of holding commodities is lower with interest rates close to zero, but the funding costs have not been enough to force commodity prices up across the board. There is a decoupling between financial and commodity real markets.