Monday, March 25, 2013

Dumping gold - it may be early

ETF's have been called the People's Central Bank. They are the world's third largest gold holder against the US and Germany. Still, money is starting to flow out of gold as investors seem to be giving up on this store of value.

Some are calling this the end of the gold bull market. There seems to be a good reason for leaving gold if you focus on inflation. There is no strong inflation from the QE programs; consequently, there is less reason to hold gold as an inflation hedge. Even the threat of a bank run in Cyprus has not caused gold prices to move higher. The floor seems to be around $1660, but it is unclear what will move it higher. The market has soured on gold given the nice run on stocks, but it is not clear these equity gains will continue. Even without a equity forecast there are reasons to hold gold. 

It is early to exit gold based on recent price declines and outflows. Further weakness provides a buying opportunity. With financial repression, banking problems, more QE, and the potential for higher inflation expectations, gold may still be a good investment. The sensitivity to these events has declined because we have not seen as much follow-through after the strong gold gains. The current rest may set-up the market for new gains if there is a flight to quality catalyst.

Is the wealth effect working?

The Fed has caused asset prices to increase in an effort to improve wealth. This increase should lead to the rebirth of consumer spending. This is what was the policy in place after the Tech decline. The Fed drove down interest rates to create a wealth effect; however, the result was a bubble in housing that may have pushed spending higher but then lead to the reverse effect post 2007. Are we making the same mistakes again?

 Researchers have found a weak effect between stock wealth and consumption and stronger effect with respect to housing wealth increases. The elasticity with respect to housing in down markets has been measured to be about .1 so a housing decline of 30+% should lead to a decline in consumer spending of about 3%. The sensitivity to up markets has been measured to be less and there has been less of a wealth effect since 2008. The may be associated with the greater uncertainty about wealth gains. Note that the VIXX volatility index has actually declined over this period. Nevertheless, given the lower sensitivity, there needs to be more of a wealth increase to get consumption higher. If the Fed tries to engineer this increase in wealth, we may be left with another bubble.

Sunday, March 24, 2013

Red-blooded Risk - not your ordinary risk book

Aaron Brown, the author of Red-Blooded Risk: The Secret History of Wall Street, is not your ordinary risk manager. He is  an expert poker player, trader, and academic who knows a thing or two about how to manage the real risk in a portfolio. This is not your ordinary risk book but a history of risk management, the musings of the author, an academic march through some of the important history and concepts behind risk management interspersed with cartoons. If you want a simple book with a well defined outline, this is not the place. However, Brown has some of the most interesting things to say about risk management that I have seen in print.

Brown thinks of risk through play within a game. Knowing the game helps tell you baout the risks thatc an be taken and how they can be measured. He also makes a strong distinction between frequentism and bayesian analysis. A problem that can be counted can use fundamental probabilities to measure risk, but most of the problems we face are hard to count and have limited data so we have to develop some priors on how to answer the question. Thus, you need a bayesian point of view. More importantly, you have understand how to bet and what to wager in order to be a good at managing risk. Measurement is one thing, but interesting what it means to wager and how to size these correctly is critical. Knowing the pay-off is critical if you want to bet.

Brown discuses his key seven principles of risk management:
1. Risk duality - the idea that you have to understand and exploit the unexpected;
2. Valuable Boundary - it is necessary to set risk boundaries;
3. Risk Ignition - if you set the right level of risk taking you will be able to grow returns exponentially, the Kelly criteria;
4. Money - money is not the only way to measure or should be thought of when measuring risk;
5. Evolution- there is natural selection when taking risk because we have different utility or sensitivity to risk;
6. superposition - some things and activities cannot be measured with money;
7. Game theory - we are playing games against others.

This is not an easy book. brown discusses a lot of important philosophical topics on risk with a flair of story-telling. It is a good read but requires some very careful thought.

Abraham Wald and statistics

There is a great story about Abraham Wald, the great statistician and measuring the right thing in statistics problem. The Air Force in WWII wanted to determine how they should add armor to their bombers to ensure they would survive. They gathered statistics on all of the bombers that came back after missions and looked at the probability of being hit on certain areas of the plane. The idea was to add armor to those areas most often hit with flak.

They gave their evidence to Prof Wald and asked him to validate their thinking on where to put the most armor. He responded in a very simple way by saying that armor should be placed where there was no record of damage. This was just the opposite of what was expected. His answer was simple, "The bombers hit in those places never came back." 

What an interesting answer to a complex question. This tell us that it is critical to ask the right question. 

Risk spectrum - danger versus opportunity

Aaron Brown develops a nice concept on how to look at risk. Risk is just the combination of danger on the downside and opportunity on the upside. If risk can be represented by the bell-shaped distribution of pay-offs, then you have to look at both side of the distribution to determine what action should be taken. 

The problem is that danger and opportunities cannot often be measured and if they can be measure they are often in different units. The bell-shaped world of the normal distribution is the exception not the norm. Dangers and opportunities are inherent in nature, but risk is how these interact within the actions we take. Dangers exist but or not relevant until we take an action. We have opportunities but these do not occur until we try to seize them. This is what makes risk management so difficult. The choice of the individual is whether dangers should be avoided and whether opportunities should be seized. 

The risk-taker has to ensure that he has a positive expected return, that his bets are independent and not taken over and over, and he must size risks so as not to cause undue harm. This is applied to all parts of life and is not an issue that is just relegated to finance.  

The value of the fractalist maverick

Benoit B. Mandelbrot was a visionary and a scientific maverick. He liked being a maverick and he wanted to make new science. His autobiography, The Fractalist, is a fascinating read surrounding an extraordinary story of a man who through luck and hard work placed himself in a position to think new thoughts. 

I have followed his work on fractals in finance for 30 years and have always been surprised by the fact that it still has not been embraced as core view of price behavior.  He never felt the need to focus on just one area such as finance. He had some revolutionary views across a number of fields, but was never one to focus on just one revolution. He had greater aims for his work. 

Most interesting, he was conscience in his view to bring big thoughts to some fields of science. What ego! What hubris! Yet, he was successful. He had the confidence of a maverick who was willing to take risks. It is a great story to hear in his own words how he got to this vaulted level of a science revolutionary. It was a lonely journey with ups and downs and could only be made by someone with supreme confidence and conviction in his new ideas. That confidence came from a Jewish survivor of WWII Europe who could have easily lost his life. We should strive to be such a maverick. 

Fed continues to run $85 billion QE

Market views on Fed behavior has moved back and forth quite dramatically in the last few weeks. We started out the year with the view that QE3 would continue for the indefinite future. This changed in February with the release of the Fed minutes which suggested that there was growing disparity inside the Fed on how much and how long QE3 would last. In fact, there was the impression that it could end much sooner than expected. 

This new view was dashed with Fed Chairman Bernanke comments and further speeches by Janet Yellen who argued that the labor market was not providing any signs that would suggest that tightening is in the cards. Finally, there latest Fed minutes suggest that we are back to the original view at the beginning of the year that QE3 of $85 billion is still the prime policy. The idea of Fed tightening helped the dollar, but with current buying held constant at $85 billion there are new headwinds against the dollar. 

Follow the Chairman, the rest is noise when it comes to the Fed. 

Wednesday, March 20, 2013

BOE worried about inflation and exchange rate

The BOE MPC defeated Governor King's proposal to add stimulus through more QE. There is a fear by committee members as written in their minutes from their last meeting that inflation expectations could change for the worse above the 2% target level. The pound has strengthened at 1.512 after breach in the 1.50 level. The costs may outweigh the benefits at this time and there is growing concern that the exchange rate has fallen too much this year.

The idea that QE is the solution to everything is ending. Policy makers are accepting the fact that fiscal policy is necessary and structural issues are important. This may be good for the UK if they internalize this message.

Monday, March 18, 2013

China headwinds

What is going on in China? China growth can be based on three factors: electricity consumption, volume of rail cargo, disbursement of bank loans. This type of simple model was developed after premier Li Keqiang stated economic growth was "man-made" and "for reference only". Well, if the focus is on these three factors we can say one thing for sure. The growth rate is going to be closer to 7% or lower than it will be to double digit numbers. Growth is at the lowest levels in 13 years.

Premier Li Keqiang is getting quite a reputation as a forecaster. (I guess if you control the economy, people will listen.) He is now talking about a "hand" that is attached to the state that needs to be returned to the market. He wants to cut bureaucracy, cut regulation and fight graft to hit 7% growth without the emphasis on state help. he is sounding like a republican, but his work is not going to be easy if you look at his index.

OECD and $190 oil

The OECD forecasts that oil will be up to $190 per barrel by 2020, see The Price of Oil -Will it Start Rising Again? wp 1031. This is much higher than the IEA forecast of $120 per barrel in the same year. The OECD forecasts is based on factors that we have seen before. The demand for oil in China and India and the rest of the Non-OECD will be the key driver. If oil demand returns to anything like what was seen in the pre-crisis period, we should be in for higher prices.

This demand equation is the key to any oil price forecast, will global growth be like the past or are we in a new world where there is less growth a slower globalization and trade. Determining the direction of world growth is what oil forecasts seem to be about. Supply is important, but we are seeing the clear focus on the demand side of the equation. Supply is base don innovation which is much harder to model.

However, if you look ta the futures curve, you will see more focus on supply. The long-tern futures curve is humped with prices in the distant years actually lower than what we see today. The Brent curve is down ward sloping and shows a  price below $95 out in 2020. The WTI curve shows a price of $84 in 2020.

So who are you gong to believe. The sophisticated researchers or the rough and tumble futures market. 

What next for Japanese economic policy?

Abeconomics is taking over the imagination of global investors. The Nikkei is up over 25%  since it has first been mentioned and the yen has declined over 205. The policy talk is to get to 2% inflation but how is it going to get done. First, deflation expectations are very sticky and nominal interest rates are high so real rates are positive. Second, the economy is not going to respond if the BOJ cannot get real rates negative. 

Given forward guidance will not be enough to solve the problem, there has to be a bold move to helicopter money, policy talk like the ECB of saying that the BOJ will do whatever it takes, a floor against yen at some higher level, direct purchases of loans. 

Still, there will also be a need to solve the ongoing balance sheet recession whereby private business have not borrowed money and corporate savings is way too high. In this case fiscal stimulus is needed to step-in where the private system does not seem to work. This is classic Keynesian economics at zero rates. Here the argument is that the fiscal multiplier will work. Finally, there has to be structural reform to make it difficult to hold corporate savings. Money alone is not enough for Abenomics. 

Free lunch and monetary policy reaction function

Seth Klarman of Baupost has written a negative letter of the Fed 's free lunch policy that will have to come due. 

We have heard this free lunch or cost issue before, but it is never easy to know when the day of reckoning will come. However we do have a tool to give us a clue on the timing and the type of cost. The Taylor Rule was developed to provide information on monetary policy reaction functions. The simple reaction function tell us how much weight is placed on controlling inflation versus the output gap. 

Clearly, if there is more emphasis on inflation targeting there will be less inflation risk. Similarly, if there is more weight placed on the output gap there is more room for the inflation rate to increase. To some degree, there is no free lunch between these two. If there is more emphasis on inflation targeting, the cost will be borne by the output gap, and if there is more emphasis on the output gap, there will be a greater cost from higher inflation. Tell us the change in the reaction function and we can tell you something on where the cost of the free lunch will actually be charged. 

Saturday, March 16, 2013

How much stock should we place in metals prices?

Copper and other industrial metals have not seen the same rallies as equities around the world? Should we be worried? The stockpiles of industrial metals are building. This is beyond the piles that are used for financing games. Copper inventories have doubled in three months. Is this the economic reality of today or is it the happy stock market which represents reality. Who is divorced from reality?

Stories are discussing the fight of Dr copper vs Dr. Bernanke? You have to say that Dr Bernanke throws a better punch in the short-run but what about a year from now? 

Deng Xiaoping maxim and global growth

The radical pragmatism as captured in Deng Xiaoping’s maxim that “it doesn’t matter if a cat is black or white, so long as it catches mice” may be needed around the globe. Could this maxim be applied to regulation and macropolicy in the US? How would this maxim be applied to the problem of global growth? 

The elites in finance

"Great Britain and the United States became rich because their citizens overthrew the elites who controlled power and created a society where political rights were much more broadly distributed”

-Why Nations Fail

The authors focus on the role of democracy and right on the development of country wealth. Do we have to look at this more closely today? Is there financial democracy? We are not talking about the socialism of lending or the access of consumer credit but the broader issue of how businesses thrive in a environment of restrictions which place a premium on size. 

Is the US driven by crony capitalism? We are not hearing these questions asked by those who are knowledgeable about finance. 

Anchoring and inflation genies

Do not worry about inflation. Why?  Because expectations are "well anchored" and the "inflation genie" is not out of the bottle. That is today but what about tomorrow? 

The current inflation rates do not look like there is a problem at 2%, but if you look at financial assets like equities and housing there is a different story. This issue reaches back to discussions from 10 and 20 years ago. Should inflation measures include financial assets. Should the Fed focus on financial assets as part of their overall inflation targeting? 

The Fed clearly focuses on financial assets as a measure of their success with monetary policy. See, we are raising the value of financial assets and thus wealth so this will help the economy; nevertheless, you also have to look at the opposite side and ask whether there can be too much increase in prices of financial assets. Can temporary wealth increases be a bad thing? 

Anchoring of inflation expectations is very strange. It is like trust. It is hard to gain, but easy to lose. We have seen that with Fed creditability in the 1980's. So how much stock should be place in anchoring today and what will it get to change? There does not seem to be enough focus on how this anchor will be dragged to a new level. 

The Great Rebalancing - it is all about savings

Michael Pettis has written what may be one of the most important economic books for 2013. He is a former Wall Street analyst, economics professor in China, and an excellent blogger through his China Financial Markets site. What he does is smash a number of myths concerning China and the rest of the world with respect to the international financial system. Policy talk has been all about the huge trade surplus in China and the opposite trade deficit in the US as if this is a war that is fought on the factory floor through cheap labor and undervalued currencies. There are a growing number of stories on currnecy wars when in reality the war is on savings imbalances. What Pettis does is place the main focus back on the imbalance in the current account through looking at the accounting identities associated with trade. 

The trade imbalance is related to the savings and investment imbalance through the simple identity that 

X-M = S-I. 

Exports minus imports have to equal the difference between savings and investments. This has been a focus of discussion by many leading economists. Ben Bernanke wrote about this issue well before the crisis, but for all of the economists who have focused on the identity, there are still many who get it wrong. There is the idea that China may threaten the US through ending the purchase of Treasuries. There is the idea that the US can get out of this problem through simple domestic policies. There is the view that tariffs can be used to solve the imbalance problem. All are wrong. 

Pettis pushes the identities of international trade and finance to the extreme, but he makes the excellent point that to solve any trad problem you have to go back to what is happening to savings and investment. The issue of one country cannot be isolated relative to the rest of the world. This is a global problem that needs correcting or we will have a huge global recession. 

This is not an easy book. The concepts are easy, but Pettis works through the mechanics of the adjustment process quickly and without a formal model. These models exist, but Pettis focuses on story-telling. This requires careful attention by the reader; however, the effort is well-paid for in the end with a clear idea of the problems the global finance system faces. 

Friday, March 15, 2013

Janet Yellen and Fed policy

It looked like the Fed was going to get hawkish last month but with controlled inflation and recent comments by Chariman Bernanke and Janet Yellen, you have to beleive that the Fed tightening is further out in the future. 

Yellen states there are five indicators that form the Fed dashboard for labor markets. If these number do not look positive, the Fed easing will continue. 

1. The unemployment rate - This number is still and while it has seen a steady fall, it is unlikely to hit anything near 6% in the next 18 months.
2. the pace of payroll employment growth - That number is starting to grow but still not able to reach above 200,000 per month on a consistent basis.
3. The hiring rate - This numbeer is sitll depressed at around 3.2% when it should be strongly above 3.6%
4. The job quitting rate - You will only quit a job if you believe you can get a new job. This is not happening.
5. Overall spending and growth - This has fallen to about 2% which is not verys strong versus the ten years before the crisis when grwoth was averaging above 3%.

While the economy is doing better, by the Yellen measures there is still room for strong QE by the Fed.  Buy stocks because the easing will continue.

The dollar and US equities

The correlation between US equities and the dollar has started to turn positive after an extended period of being negative. The usual relationship, pasot-crisis, has been for the dollar to rise when there was risk-off in the market. The risk-off environment will lead to a decline in US equities which will create the negative relationship. There have been short periods of exception to this rule: early 2008, spring of 2010, summer 2011, and first quarter 2012. But we have not had a strong dollar equity positive relationship since mid  2001 to 2003 when equities were rallying and the US economy was responding to fed easing. Seems similar to today?

It seems as though the dollar is not being used as funding currency and US investors have been avoiding foreign stocks. US investors have a preference for US risk assets and foreign investors are also feeling better about the US which translate to dollar demand from foreigners and less selling of dollars by US investors. This is consistent with a US recovery leading the world and risk-takers wanting to hold dollar assets.

Waiting for inflation?

With 2% inflation both for headline and core, there is the recurring question of where is the inflation that was expected with QE. The inflation pick-up has not happened. The world has changed with respect to the link between money and inflation. With slack in the economy, there is little increase in real asset prices. This story is not new, but the size of the money increase as not lead to nominal price gains. We have seen increases in financial assets. We also have seen increases in housing prices, but wages and goods are very stable. We continue to be within the target range for inflation.

Is the party over for industrial metals mining?

With demand declining in many industrial metals as China growth slows, it may be time to ask whether the party is over for mining. EBITDA for the industry is declining but enterprise value has not fallen as fast. Values are starting to look richer. Return on equity has declined by 20-30% for many industrial miners as the spread between price and costs have declined. Prcie to book ratios have, on the other hand, declined to levels seen in early 2009.  The high cost operators will have to think about cutting production as all margins are squeezed.

These negative effects will all have carryover to industrial metals prices which have been soft and may continue to be worth avoiding form the long side. The rationalization in the mining industrial is not something that happens quickly. Production will remain high even with margin declines, so prices will continue to move lower in the longer-run.

Sunday, March 3, 2013

Central banks follow different paths

This is a great time to trade currencies because we are getting true differentiation across central bank policies. Enough of the old 2% inflation target stuff followed by all central banks at the same time. 

Viva la difference because this means trends. It also means that policy will have to shift over time which create turning point opportunities. 

The Fed may be shifting from a strong Quantitative Easer to a central bank which is starting to show concerns for its actions. Right now the Fed is still buying $85 billion a month, but with  the belief that there is some discussion in its minutes about alternatives, the dollar has had a strong upward trend.

The BOJ is being forced into "Abenomics" and has shown a nice decline. If this is confirmed with stronger buying of assets, the weakening trend will continue.

The BoE has mixed vote on more quantitative easing but New Governor Mark Carney is a dove. Maybe not a nominal GDP guy, but MPC is still going to focus on an easing strategy.

The ECB has shown more of mixed record. They have different problem where credit is needed in the periphery and not in the core. With slower growth, we can see more activity to expand credit in tight markets.

Some of the other G7 have stuck to existing policies but we are starting to see movement in merging markets in response to growth shortfalls. Asia is worried about Japan and will start to differentiate their policies. Brazil has a concern about inflation. Commodity currencies have concerns about an end to the commodity cycle. Australia is worried about further increase in it real exchange rate and the impact on the non-mining sector. 

2013 will be the year of monetary policy differentiation.

Back to monetary economics of exchange rates

Currency modeling at one time was very simple. The focus would be on relative inflation rates and by extrapolation monetary expansion. Sell currencies which have higher inflation or higher money expansion relative to other countries. Unfortunately, except at extremes these types of simple models did not do a good job for forecasting. Yes, during hyperinflation, these models did well. Over the longer-run, these provided a good foundation, but using monetary models for shorter-term views of under a year did not work. There was a good reason for this when monetary expansion did not differ greatly across countries. If money growth rate differences were small, the volatility of exchange rates would swamp out any relationship between money and currency prices. But times change.

Currently, monetary models can be seen as more useful. Simply put, if you fade those countries which have been stronger QE expanders, you may be do well. Sell yen. Sell sterling. Careful on euro because while ECB president Draghi said he would provide unlimited OMT, he has not put up the funds. The Fed was a strong QEer, but recent minutes suggest that the resolve is not as stronger. Note the rising dollar. 

Follow the money and use a monetary model for tilt. I do not want to be a buyer of strong QE countries especially if growth is below trend and not moving upward.

Jeremy Stein on credit bubbles

Jeremy Stein is a new member of the Board of Governors at the Fed, but he has a long history of good research on credit markets. He presented a very thoughtful speech on credit bubbles last month called "Overheating in credit markets: Origins, Measurement, and Public Response" which should be read in great detail. It calls for deeper analysis of credit markets and the potential for bubbles beyond just looking at spreads.

Stein starts with explaining the two current schools of thought that try to explain the pricing of credit. The first school is the "primitive preferences and beliefs" view while the other is the "institutions, agency, and incentives" view. The primitive preference view states that the changes in pricing for credit are associated with fluctuations in the preferences and beliefs of end users or investors. These beliefs may change in a way that will not always be rational. There can be extrapolation of good times, a change in wealth, or say a low probability weight placed on poor times. These may be a good model at explaining the technology stock bubble or bubbles in markets which have not seen declines for a long time. Here, over optimism can lead to bubbles. There is little control over the process. 

However, credit markets may be different than stock markets or general markets focused on future expectations through discounting of potential cash flow streams. Credit markets expand or contract because those suppliers of credit are willing to provide funds for lending at lower prices. This is not the same as bidding up the price of a stock. 

Put differently, it takes two to tango in the credit markets. There is a demander of credit and there is the supplier. If the supplier does not want to provide funds, credit cannot be obtained. The price of credit is also related to the incentive and behavior of the suppliers who are managers of institutions and not the end saver. Financial institutions are delegated the responsibility to provide credit, monitor the loans and make a return. In this world, the regulatory or institutional structure which create agency problems will have as big an impact on credit availability as the preferences of the buyers. 

Stein argues that changes in structure such as financial innovation, regulation, and economic environment can all impact the supply of credit at a given price;consequently, a more careful analysis has to be done on who is responsible for the creation of credit bubbles. If you believe this school, which I would agree with, the Fed and regulators have an important role in allowing credit bubbles to grow. They can create an environment that is more open to bubbles or an environment that is more controlled and less susceptible to bubbles.  The regulators should take some responsibility for the housing bubble. 

In the current environment, one that is focused on low interest rates and forcing institutions and households to hold risky assets will create a perfect bubble environment. Regulation can be structured to allow for excessive lending in housing and student loans. The demanders of credit can not be solely culpable. Similarly, banks and other financial institutions who have to hit earning targets can be a root cause for excess. Lenders set the terms of credit so even if prices do not change, banks can change terms to create a bubble environment. 

This is a very refreshing and thoughtful view to credit issues and the potential for bubbles. Lets hope that these views have a wide audience. 

Currency wars and Brazil

Remember Brazil. Its finance minister was the one who started actively using the words currency wars. Brazil was upset about the appreciation of the real and the implications for trade. 

Well now the real is again appreciating because the central bank needs to stem the rise in inflation which is above 5.5% versus a target of 4.5%. To do that, it will have to raise interest rates and cut money growth. The implication of this policy will be a stronger real. This has nothing to do with currency wars but with policies that need to be implemented on the domestic front. The fall-out will be a currency appreciation if they are effective.

The policy wars are often on the domestic front but the impact is in the price of currencies.  

Saturday, March 2, 2013

Focus on sterling - watch the fall

Sterling has been the currency to watch for 2013 not yen. With an 8 percent decline to below $1.50, sterling is taking a pounding. The fundamental suggests that this trend can continue. The UK economy is set to take a triple dip since the Great Recession of 2008. More importantly, this recession fear has caused expectations for more monetary easing to rise. The MPC was mixed in their last vote 6-3 with maintaining policy. Outgoing governor Mervyn King has been one of the MPC arguing for more bond buying. The shift to easing is close and the new Governor seems to be signalling that he will use the means necessary to get the economy going. 

The BoE has admitted that inflation is likely to stay above the 2% target for at least two years. Since tightening is not in the cards, the currency is going to move lower. The BoE has not been able to hit the 2% inflation target since before 2008 so simple currency arithmetic suggests a decline. The BoE has limited creditability as an inflation fighter. This is what we may expect form other QE followers. The rest of the G10 has not followed the inflation path of the UK. The fear is that this may turn into a financial spiral of lower bond prices and currency and the BoE being the buyer of last resort of UK paper. 

Some are arguing that the current situation is part of a policy of nominal GDP targeting and an effort to improve exports. The sterling fall in not some competitive policy for devaluation. It is the result of not hitting targets, a poor economy, and strong QE.

Dollar moving to the upside

The dollar had an extremely strong month to the upside not seen since May of last year when we had ongoing problems in the EU. The combination of the belief that monetary policy expectations may not be as easy as thought earlier and the uncertainty from the Italian election has caused more investors to jump on the bandwagon of holding the dollar. The Fed minutes released suggest that continued buying of $85 billion a month may not be as certain as thought earlier. If this is true, the credit expansion for the rest of the globe will be in jeopardy.

A strong dollar is not what you would find if the world wants to take on more risk. A dollar bull market would be an interesting reversal of long-term trends and not consistent with a robust world economy.  A dollar pull will start to pull money from the other parts of the world into the US. We have seen this story before and it can be bad for leveraged bets in emerging markets. There may be carry-over to risk assets. For example, a stronger dollar with less credit expansion and slower EM growth would not be good for those commodities tied to the overall business cycle. The slowdown in EM equities is also likely. 

UK downgrade from Moody's - who cares?

Moody's dropped the UK from a triple A credit to Aa1arguing that slow growth and austerity will have a negative effect on finances for the country. So austerity will get you downgraded but continued budget deficits will also get you downgrades? 

Policies do not matter, if you have too much debt you are going down in ratings. Sluggish growth puts the country at greater risk of payment of debt but austerity will place a drag on growth so the UK is in a bind that cannot be easily avoided. The trajectory is unlikely to be changed from fiscal policy. This could be the future of many countries if Moody's applies the same logic.

This may place a greater burden on monetary policy which is pushing sterling lower. 

Currency wars and "beggar thy neighbor"

Currency wars have been and will continue to be the focus of FX markets especially with the strong currency moves we have seen year to date. However, there is a distinction between using currency as a policy for domestic improvement and movements in exchange rates which are related to monetary policy changes. some can view the end result as the same but there is a strong distinction and it is non-market related actions which are truly an issue of currency wars. Monetary policy changes will drive exchange rates but that is not the same as systematic policies to exploit export versus import prices. Charts were taken from editorial by Gavyn Davies "Who is afraid of currency wars?" ft Feb 3rd 2013

The beggar thy neightbour form of currency wars tries to improve the competitive trade position of a country versus other trading partners. This would be the policies pursued in the 1930's as an effort to change the terms of trade and then the response in a form of Tit-for-tat strategy by other countries to regain or improve their  competitive position. 

The currency wars of the 1930's was a result of sterling going off the gold standard and the resulting response of other countries to control any sterling advantage through trade restrictions.  Those countries which moved off the gold standard first were to some degree able to better weather the depression than those that used trade restrictions. Moving off the gold standard allowed monetary policy to be used  domestically without regard for currency changes. This has given some the idea that monetary policy changes that lower the nominal exchange rate will be an effective growth strategy. 

In reality the beggar thy neighbour period led to world production actually growing but trade falling. The gap between production and trade resulted in less gains from trade and a world that was economically worse off. The first figure shows the decline in world trade while the second shows the gap between production and trade. 

What is really a currency war to be worried about will be the use of capital controls or other types of regulation to change the flow of goods and money. This is financial repression on an international scope and scale. Linking to financial repression is important because capital flows are more important and larger than trade flows and it is the capital flows through trade finance that facilitate the trade flows. A currency war would exist when a country tries to improve its competitive position while also not changing domestic inflation rates. 

Monetary policy which increases domestic inflation and thus effect nominal exhcnage rates cannot really be thought of as a currency war shot or tool. The decline in the nominal exchange rate is just a result of inflation differences. Bluster may be associated with monetary policy differences but it is not the same as a trade war.