Sunday, August 30, 2020

WEIRD and REAM investment professionals - Thinking the same

Most psychology research is done on WEIRDos. Yes, testing is done on the WEIRD - Western, Educated, Industrialized, Rich and Democratic. Given that most of the research is conducted at leading universities in developed countries, there is a clear self-selection bias. Research conclusions are based on subjects that have world views that do not represent the majority of the world population. This has been pointed out more than a decade ago by Joe Henrich et al. "The weirdest people in the world".

This issue becomes especially important when we measure how WEIRDos look at and solve problems versus other groups or cultures. We are used to westerners who think about using analytic tools to solve problems. The WEIRD breaks problems down into individual parts. For example, when the WEIRD see pictures, they will look at individual objects and not the relationship or connection between objects. It is a culture thing. Eastern cultures will think more holistically and less about the individual. Of course, in spite of our openness to others, the hegemony of western culture pressures everyone thinks through the WEIRD lens. WEIRDness has implications for investment decisions.

I would say that money management and hedge funds are dominated not by WEIRDos but by REAMers: Rich Educated Analytical MBAs. It has been a great investment advancement to have REAMers using their tools and skills to manage money with scale, but there is also something missing with their thinking. Solutions to non-analytic, non-textbook problems may be problematic for REAMers. A REAMer is likely to have problems with innovation. He or she will also have problems with market sentiment that does not fit within an analytic framework. REAMers will herd with others that have the same background. 
The relationship between politics and market behavior will be another area which will be more difficult to understand. 

The comfort zone for REAMers will be with other REAMers, and they will have a difficult time acting in a way that is different from other REAMers. Not thinking like a REAMer is not being contrarian but viewing the world from a perspective different from what was taught. 

None of this should be surprising; however, investors need to have an awareness of their conventional thinking and accept that market behavior may be driven by those with a different framework. Market behavior that does not fit within a model may not be irrational. It does not fit in the world view we would like. 

Friday, August 28, 2020

Exploiting time varying risk premia using the economic cycle (not business cycle)

One the key ways to gain portfolio returns is through exploiting the time-varying nature of market risk premia. Risk premia will change with income and wealth, so it is natural to use the business cycle as a means of dynamically adjusting allocations. Nevertheless, using the business cycle can be difficult in practice. An obscure working paper from Thomas Raffinot, "Time-varying risk premiums and economic cycles", uses a different approach to identifying and exploiting fundamental data through separating the classic business cycle from the economic growth cycle as measured through the output gap. This approach may have added value for macro investors and tactical asset allocation.

Using a very simple model for an equity asset allocation, and then a four-asset portfolio including, equities, Treasuries, investment grade bonds, and high yield bonds, the author finds that an indicator associated with the economic growth cycle (deviations for trend growth or output gap) will do a better for making asset allocation decisions than a model that is focused on the classic business cycle or levels of economic activity. 

The idea behind looking at the economic cycle is simple and intuitive. The economic cycle looks at the economic growth deviations from trend. There can be an economic expansion, but growth below trend should impact risk premia. Similarly, a better economic environment is measured through growth above trend.  The combination of looking at the economic and classic business cycle has been called the ABCD approach for detecting cyclical turning points and has been developed in "Detecting Cyclical Turning Points: the ABCD Approach and Two Probabilistic Indicators". It is practical and relatively easy to implement.

The peak in growth from trend will occur before any recession. The trough in growth from trend will occur slightly later than the trough in the business cycle, so it will cover a longer period but should give an early warning of economic declines. Additionally, since there can be a slowdown in growth without a recession, the economic cycle can provide signals for economic events that can impact risk premia unrelated to a recession. 

The paper shows that there is a distinction between the economic growth cycle and business cycle. The conditional returns and risk are different from the full sample.  

Employing a simple 120/80 rule of levering in good times and cutting exposure for bad times based on growth signals leads to improved returns and lower risk for the growth cycle signal.

The correlation matrix across assets will change with the growth and business cycle which will have an impact on asset allocation.

Of course, there are problems measuring the output gap and getting the timing correct, but overlaying growth slowdown periods will help with asset allocation between recessions. While this work has to be updated for more recent events, we think that it would have added value especially during the slow growth periods seen on 2015-16 and late 2018. 

Thursday, August 27, 2020

A surprise commodity demand shock - the case of lumber

Demand or supply shocks will have big price impacts in commodity markets given short-run inelastic demand and supply curves. In the case of lumber, prices have exploded to the upside based on a big producer mistake coupled with a huge change in home buyer sentiment. 

If I told you, we were going to have a recession from a pandemic, there are certain expected behaviors. Aggregate demand for durable goods would be expected to fall. While this is not the Great Financial Crisis, the general expectation in March was for weak housing demand given past behavior in a recession. Lower interest rates would soften the blow but not offset the decline.

Lumber mills cut production dramatically to get ahead of the expected fall-out from expected lower housing demand. Mills were also seeing labor problems from COVID-19 which affected production. This was just another shock to the lumber industry which has been facing sales declines from the higher China tariffs on US exports.  

The lumber industry got it wrong. Housing starts and permits have shot higher. More households are doing remodeling. Money not spend on other good is being used to adapt to a work from home outside the central city world. The current lumber market has a recipe for extraordinary price moves based on inelastic supply in the short-run with a surprise demand shock

Until order and equilibrium is restored the trend continues. Will it last? Unlikely. Production will respond to the higher prices. The building surge may normalize with time. The signal will be seen in a price reversal and a new trend. 

Wednesday, August 26, 2020

Gold ETFs and the current move in gold prices - The power of innovation

Financial innovation may only generate its true impact when the conditions are right for their use. The first gold ETF was launched in 2003. The growth of gold ETFs has made them the most successful commodity ETFs in the world, yet the size of gold ETF holdings and flow did not it a major factor during the Great Financial Crisis relative to more traditional gold players.

The combination of market conditions and use of the ETF innovation has unleashed demand that has not been seen before. If the meme that gold should be a part of every investor's portfolio is followed, it is unclear how high the price may rise as investors use easy access to introduce gold as a diversifier. 

The traditional methods for buying gold: bullion, coins or jewelry, were never very efficient for most investors. Costs and storage are high, and the bid-ask spread could make any regular transaction difficult. The use of gold futures is a marked improvement with substantially lower costs, but a regular investor in the US would have to open a futures account and buy from a futures broker. Most US investors do not have futures and options accounts. 

Gold ETFs solved the access problem through the simple innovation of allowing investors to buy a security in their brokerage or retirement accounts. No physical or futures transaction makes the purchase very easy. The increase in equity and fixed income ETF usage since the last financial crisis has only further made conditions right for explosive demand once the market created the environment for buying. 

Easy financial access with market conditions of higher uncertainty, a declining, dollar, and negative real interest rates makes for an environment of strong gold demand with a commodity that may not be able to easily generate new supply. 

Gold ETFs holdings now represent 3,808 tonnes of gold.  Gold holdings have increased 922 tonnes since the beginning of the year, 21% percent. 

Global gold ETFs as a group are now the second largest holders of gold next to the Unites States official holdings. US gold ETF holdings alone will be in the top seven official reserve holders. The growth in gold ETF holdings for this year would have easily place it in the top ten holders of official reserves ahead of Japan. It is expected that central banks buying gold will increase this year as reported by the  Central Bank Gold Reserve (CBGR) survey, but ETF buying is greater than central bank buying in 2019 at 668 tonnes versus the 922 tonnes purchased so far this year in gold ETFs.

Yearly product for gold is now at 3534 tonnes, so ETF holdings represent more than one year of total production and the increase this year would represent 25% of all production from 2019. 

Gold ETF holdings are greater than the open interest of gold futures and purchases this year represent over 40 percent of  current open interest. The increase this year is 50% greater than the money manager net long positions in gold. Gold ETF growth this year is still less than half gold jewelry demand for last year, but we are only counting through mid-August.  

We are not making a gold prediction, but changes in the market structure for buying gold means that demand can be much larger than what has been seen in previous crises and similarly any correction may be more violent. Low costs make for increased demand from momentum or discretionary trading. Low cost means flows in and out can be more violent and create a strong feedback loop that will impact price.

Monday, August 24, 2020

Rebalance timing for factor strategies - Luck or skill?

If I invest in a standard well-defined factor strategy such as value, size, momentum, quality, and low volatility, there may be the belief that that some of the construction details don't much matter. There will be a cluster around the "true" returns from a long-only factor strategy, but the construction return differences are small. There is also the belief that some of the rules will matter more than others albeit again the differences are small and may be associated with noise. For example, exclusion rules will have some impact, but other rules like when and how often a factor strategy is rebalanced will have little impact. Wrong.

A recent paper by the high quality researchers led by Corey Hoffstein at NewFound Research suggests that rebalancing is important, see "Rebalance Timing Luck: The Dumb (Timing) Luck of Smart Beta". There is a significant impact from when you rebalance and how often it is conducted. I was shocked by the cumulative effect of random rebalancing. The details matter.

Of course, I should not be that surprised since anyone who has worked closely with data will find that simple changes in rules like even mundane features of start and end dates for back-testing will matter. The art of any model-building is finding features that are stable and consistent while generating strong returns. The desire to find portfolio construction skill not luck. 

Any construction rules will create return differences so the questions are whether it matters a lot and whether there is something in these rule differences that can be exploited. Here is where the research gets interesting and also murky.  The rebalance timing over any short period can be great, and over time the cumulative difference between the best and worst rebalance timing rule seems to be large. If that is the case, then a long-short portfolio between timing periods will lead to significant return differences. Testing for these differences across strategies is less promising. They are generally not statistically significant. This work addresses some very important questions that need to be further researched to determine their value over the long-run. 

Sunday, August 23, 2020

Commodity futures sort dynamics - Different from other asset classes

The return behavior of commodities is different. If you don't believe this, read the recent paper, "Anomalies in Commodity Futures Markets: Risk and Mispricing". This exhaustive research paper looks at a battery of prominent risk factors and premia that have been tested in other financial markets against a large dataset of commodity prices. The authors attempt to catalogue where there are sizable risk premia priced in the market and measure factors which do not seem to be priced in commodities. There is a lot of information to be digested with a wide range of conclusions; however, it provides more information on the uniqueness of these markets relative to equity and fixed income sectors. 

Of course, commodities are diverse and generally have lower correlations across markets than what can be found in equity and fixed income markets. Still, there is a likelihood that risk premia fund in traditional markets should be present in this asset class. The authors look at three major categories for commodity sorts based on risk or mispricing variables, trading frictions, and moments. The research is conducted on 26 commodity markets from data that spans from 1959 through 2015. 

These sorts are categorized by returns as well as factor models which include: CAPM, 3, 4, and 5-factor alpha models, a commodity model and the commodity-focused FFFM alpha model. The details of the sort specifications can be found in the paper. These allow for comparisons against similar analysis done in equity and fixed income markets. We have provided a table of results between the high and low sorts and the level of significance. 

The testing shows that there are significant premia pricing with respect to aggregate jump risk, momentum, historical skew and kurtosis. There is marginal significance with 3 and 5-year reversals and the volatility of volatility. a number of tests prove to be inconclusive. Some of these results have been found by other researchers, but it tells a good story about why certain strategies like trend-following with some form or risk management can be successful in these markets. 

Saturday, August 22, 2020

The complex relationship between banks and the Fed

The last financial crisis was focused on ensuring the integrity of the banking system to support the real economy. Massive liquidity and capital were given to banks to support lending and the real economy. In hindsight, there were missteps with the bail-out and the foundational view that some banks were too big to fail. An opportunity for restructuring was lost. Since the Financial Crisis, banks deposits are more concentrated and the surviving firms have done well without penalties for their excesses. 

The current crisis is different. There was the critical financial liquidity crisis in March, but there was no bank crisis. The Fed effectively managed the liquidity crisis with swift action and no shortage of liquidity, yet the current situation is now one of business solvency and getting a constrained economy growing. Money can relieve financial liquidity pressure, but it cannot remove constraints on aggregate demand and supply. Money can lower rates but not directly engage in lending and supporting business solvency.

The current path of monetary policy over time subverts the ability of the financial sector, banks, to provide effective lending. Lending has to be profitable. Banking needs capital and a return that will attract that capital. 

There are three policy effects that work against banks. We know that the effects are negative both from history and the current languid gains from banks. One, low nominal rates near zero hurts banks as yield spreads compress. Two, any policy that provides forward guidance or attempts to control or flatten the yield curve will only further hurt bank earnings. There is no gain from lending long and borrowing short. Three, a poor economy and little ability to generate earnings from spread and curve differences will only further tighten lending standards. Lower ROE from lower earnings and increased loan loss reserves will not allow banks to more aggressively lend.

The most recent survey of senior loan officers shows a significant tightening of lending standards. Deposits have grown but the money is only being used to purchase government debt at low rates. Given the low capital weighting for holding government debt, new deposits are not going to firms, small businesses, and consumers but for Treasury financing. Banks, at this time, have headwinds that will have both financial and real effects.

The big question is how the Fed will be supportive of banks and the financial system so financial firms are able to generate earnings that can be used to support lending. Without a profitable banking system, any recovery will be muted. This is the forward guidance that is currently necessary.

Thursday, August 20, 2020

"Intuition first, strategic reasoning second" - the reason for market oddities

As an economist, reading more psychology on decision-making has been a very mind-opening experience. Psychology has spent more time and energy researching issues associated with thinking, decision-making, and biases and provides alternative model foundations relative to finance and economic researchers who have focused on behavioral biases. There are great researchers in behavioral economics; however, there just is more work in psychology on how people think and why they choose different decisions. At the very least, there is less focus on finding biases and anomalies from rational utility maximization and more focus just on understanding thought processes. 

Reading some of the work of Jonathan Haidt, the moral psychologist, there arose a phrase that is helpful for all explaining all decision-making problems. It could easily be a mantra that drives investor thinking.

"Intuition first, strategic reasoning second"

Psychologists often use the metaphor of an elephant and rider to describe our thinking. Our intuition is the elephant which has to be steered by the rider, our rational thinking. Behavioral economists and finance-types have been influenced by the fast and slow thinking metaphor of Kahneman, but the lumbering strength of our intuition is often a driver that has to be managed by our strategic reasoning. However, the dichotomy of emotions or intuition versus reasoning has been a more universal problem than one of psychology or economics.

The mantra of "intuition first, strategic reasoning second" also has a long history in philosophy. We can go back to Plato who thought about reasoning as a charioteer who controlled the horses of emotion and reason. From Phaedrus, "First of all we must make it plain that the ruling power in us men drives a pair of horses, and next that one of these horses is fine and good and of noble stock, and the other opposite in every way. So in our case, the task of the charioteer is necessarily a difficult and unpleasant business." Learning and reasoning will strengthen the reins  provider greater grip on emotions. The fight between reasoning and hot emotions is long-standing, but Plato offered a solution. Get smart, albeit this is easier said than practiced. 

David Hume, the great Scottish philosopher of the Enlightenment had a different view and suggested that reason is the slave of passion. "Reason is, and ought only to be the slave of the passions, and can never pretend to any other office than to serve and obey them." His view is the the direct opposite of the classical view. Emotions drive our reason. The Hume view can be viewed as the foundation of behavioral finance. Emotions are justified not overruled. We look for arguments to support our gut and not for reasons that conflict with our feelings. 

Behavioral finance research is an attempt to understand which force is dominant, emotions or reason. The focus of good investing is trying to ensure that reasoning is in control of emotions while appreciating that emotions will still drive the reasoning for many market players. We may like for markets to be rational but sometimes emotions are in charge. Reasoning first and intuition second is rational but it does not allow for the complexity of market behavior.

Wednesday, August 19, 2020

SG Survey Shows Strong Global Macro and CTA Interest

A new survey from SG Prime Services and Clearing shows that there is strong interest in global macro and trend-following CTAs versus other hedge fund strategies. The survey ,which includes 148 unique investors, states that these allocations will be implemented within the next six months for 2/3rds of the investors. 

The survey also focuses on whether on the logistics of getting allocations made. It finds that about 1/3 of investors have already made or will likely make allocations without an on-site due diligence. Allocation life is continuing in a pandemic. The authors also reset their initial questions based on those that are active and able to invest in the current COVID-19 environment. In this case, there is an even stronger focus on global macro and CTAs. 

The important question is why do investors place the strong emphasis on the global macro and CTA hedge strategy space. For some this may seem obvious, yet understanding the market scenarios within the minds of investor is most useful. If trend-followers provide positive convexity and "crisis alpha", an increased desire to hold this strategy reveals a higher weight on a potential macro crisis. There is a likely second down phase to this pandemic. The global macro demand suggests that large asset class switching will be necessary during the coming year. 

These allocations focus on two themes - downside tail risk and a reshuffling of asset class returns. It is expected that global macro and trend-followers will be able to adjust risk exposures quicker than any asset allocation investment committee.

Monday, August 17, 2020

EM stress driven by current account, reserves, debt, and risk aversion

Handicapping EM financial crises is not easy but we have come a long way over the last decade at being able to identify the key vulnerabilities for EM. The recent IMF External Sector Report: Global Imbalances and the COVID-19 Crisis issued this month provides a useful guide on the factors which should be given the most focus. 

The IMF's modeling on EM external stress probabilities shows the sensitivities for some key variables. For example, global risk aversion, foreign currency debt, foreign currency reserves, and the current account are, as expected, key variables. Nonetheless, the combination of foreign currency debt and global risk aversion on two which should be given the most attention. A pandemic shock will lead to higher risk aversion and adverse capital flows. High foreign currency debt will make the EM financial sector vulnerable. 

The preconditions before a global crisis will have a big impact on the EM stress. The trifecta preconditions of reserves, foreign currency debt, and current account deficits have differed through time. For this financial crisis EM economies have been most vulnerable from FX debt positions. This is why dollar swap funding and lowering of US interest rates has been so important. The lowering of global interest rates have reduced the stress of meeting cash financing payments, but it has not changed the ability of countries to meet principal payments

EM stress can often be characterized as sudden stop growth impact (SSGI) events and exchange market pressure events (EMPE). Investors have to realize that the signals for each of these events are different, so one set of factors does not fit all situations. When looking back over research on EM stress and crisis, there are approximately 80 different variables that have been used  to measure or identify EM stress events. 

Fragility still exists even with the improved performance in EM stress. This fragility will slow future capital flows and make EM countries vulnerable to a secondary shock. While EM opportunities may seem abundant, the risks are also significantly higher than more simple developed market equity and bond plays. 

Thinking about trend-following using a binomial tree - Simple model shows strategy value

The binomial tree is a core tool for understanding option pricing. David Modest has written a very skillful simple paper on the value of trend-following using the binomial tree framework. This work takes away some of the aura and mystery of trend-following but also shows its fundamental usefulness. Trend-following generates return shaping through dynamic positioning even in an  efficient  markets. The nature of trend-following (time series  momentum) creates “crisis alpha” even if there is no trend.  (See "Some Observations on Trend Following: A Binomial Perspective")

With any binomial tree, there are well-defined and measurable paths for price moves. The tree can be extended for any number of steps with defined paths up and down. Trend-following can take positions based on the path along the tree. In the simplest case, the trend can just follow whatever happened last period. The distribution of returns can be calculated for trend-following and behold, the value of trend-following, better performance  under adverse market conditions, exists even if markets are efficient and follow a random walk. 

Trend-following changes the shape or timing for when profits occur. There will be more mass during market declines which others refer to as "crisis alpha". This return timing phenomena occurs even if there is no trend and expected profits are zero. Using the binomial tree also allows us to compare the differences between fast and slow trend models. Again, there will be different pay-off functions. A fast model will generate more crisis alpha than a slow trend model. 

Just follow the paths using trends and you will get a timing of returns that provides the desired effect. There is no secret skill or magic formula. A long-only investment, a call option, or a trend model can be compared to show different return patterns. Trend-following will generate the greatest amount of crisis alpha.

This may be a disappointment to managers who want to sell their trading skill or for investors who are expecting some high level of strategy complexity from trend-following. Nonetheless, this is a toy model that looks at some generalized features from trend-following. There are countless ways to fail with systematic trading especially as you increase the set of opportunities. The laws of entropy or trading failure are still alive. Modest has done a great job of cutting through much of the excess verbiage and focused on the critical issue of return reshaping through dynamic strategies.  

Sunday, August 16, 2020

Holding risky assets going forward - Will luck change?

We are in a recession. We are still in a pandemic. Yet, if you are holding risky assets, you are making money. Is this because of luck or skill? 

If you had to make some subjective distribution of probabilities concerning stock returns and current economic conditions throughout the last few months, you would have likely placed a low weight on the current return pattern; up 31% and 46% for the SPY and QQQ since the  end of March.  Even with the flood of central bank liquidity, the mass of probability would still have been centered-around a lower return outcome. 

Chance is not luck. Luck is a favorable outcome from uncertain events. You can think  about luck and skill in the field of games when comparing chess versus backgammon. There is limited luck with chess. You play a strategy against an opponent. If he has more skill, he will win the majority of the time. He can make a mistake, but that is not luck. Backgammon takes some level of skill but the ultimate outcome usually is determined by the cast of the die. Poker has skill, chance within the cards, and the play of others. You can be very skillful, but you also need the right cards.

There is also the view that luck is something you produce, or, at least there is the illusion of control. “You make your own luck.” Or, according to Samuel Goldwin who may have paraphrased Thomas Jefferson, “The harder I work, the luckier I get.” James Watson of double helix DNA fame stated, “Luck is the opportunity. But using it when you get the opportunity - that’s just intelligence.”  

Luck is based on the optimism that things will go in your favor. You want to be lucky. Yet, a good definition of luck by Ed Smith, the author of Luck: What it means and why it happens is that, “Luck is what happens to me that is outside my control.”

There were a set of chances likelihoods with respect to the stock market behavior since March. The path taken was not unheard of but was not the most likely. If you held or added risky assets you played a strategy and received a good path. Call some of that luck. Now is not to the time bask in you luck or skill but to assess the current odds. In simple terms, what are the odds of a 10% up over 10% down move for the next six months? Using you skill to make that choice will determine your luck. So maybe now is not the time to extend your luck.

Friday, August 14, 2020

Fed independence - If it is flexed, markets will suffer

When Fed Chairman Martin accidentally encountered ex-president Truman on the streets of New York years after Chairman Martin split with the Treasury Department on keeping rates low and controlled, Truman greeted him with one word, "Traitor!" So, goes the life of the independent central banker. - Story sourced FT and others

Truman actually appointed William McChesney Martin to the Fed Chairmanship from Treasury where he was undersecretary of monetary affairs. Martin negotiated the Treasury-Fed Accord of 1951, so it was assumed that he would follow the bidding of Truman once he was appointed Fed Chairman after the Accord. Chairman Martin actually guarded Fed independence and took a difference stance from the desire of the President and Treasury. He stopped the inflation of the early '50's but the cost to Treasury financing was significant.

There is currently no appointment or negotiation intrigue with the Fed and Treasury, but war-time budget deficits and the potential for inflation create a potential toxic misalignment of interests. The central bank independence question that is on the minds of most investors is not significantly different today than the policy conflict faced in the early 1950’s. Will the Fed do the bidding of the Treasury Department, or will it break with the fiscal authority and be independent when appropriate? 

In the depth of a recession, policy decisions between the Treasury and Fed are aligned. In the current case, the Fed provided immediate liquidity support to stabilize financial markets. It then provided continued quantitative easing in an effort to keep rates low and support the massive debt issued by the Treasury in order to offset the lockdown created to manage the COVID pandemic. 

The potential discord between the Fed and Treasury going forward is twofold, timing and intensity. One, most Fed officials seem to be believers in the policy choice that inflation should be allowed to overshoot the 2% target. In this case, there will be little immediate break from the Treasury if there is a rise in inflation. Fiscal and monetary policy are aligned although ambiguous. Two, the MMT meme has infected central bankers. That is, there is the belief that monetary policy can follow an approach of continued increase in their balance sheet in order to meet their full employment policy objectives without serious negative economic consequences. Again, Treasury and Fed policies are aligned. 

At what time will these alignments of interests diverge? Perhaps not in 2020, but it is possible in 2021 if the economy starts to return to normal. Given the relative speed at implementing policy, it will always be the Fed that will create policy alignment uncertainty. It will be the focus of all global macro managers to handicap Fed independence and their willingness to weigh inflation versus output gap. This has always been the case for monetary policy watchers, but the stakes are much higher this time.

Thursday, August 13, 2020

Pick your yield poison - credit or prepayment risk - Or, look at other risk premia

The US economy is in a recession; nevertheless, corporate bond yields have continued to decline, albeit after a March spike. Corporate BBB spreads are still wider than pre-COVID levels by about 50 bps, but Treasury yields have fallen by 100 bps. Similarly, mortgage rates have also declined although spreads have increased given the uncertainties associated with prepayment optionality. These levels are attractive versus a measure of SPX dividend yield which is hovering around 1.85 percent and being kept low based on strong equity demand. 

These yield declines have been supported by strong Fed intervention. The Fed mortgage portfolio has increased by over $420 billion in the last year to a record $1.93 trillion. All this increase has been since March. The corporate credit facility has grown by $44 billion in a matter of weeks, although this bond buying support is to large borrowers and not small businesses. Currency swaps from the Fed have declined but are still over $100 billion and support rate stability around the globe.

There is a reach for meager yield with limited assessment of  risks. Foremost, what will happen if there is no Fed buying? Are current mortgage, credit, and Treasury rates just being supported by the central bank? My intent by asking the question is not to make a value judgment but to assess stress points for potential risk. A central bank can continue buying for a long-time, but it is important to appreciate the underlying demand for bonds.  

With "economic repression" from COVID policies, there is excess savings available for debt purchases. However, what would happen to corporate bond demand is there was no Fed facility. There is also excess supply as large corporation lever their balance sheets knowing there is a backstop from both Treasury and credit buying. Corporate debt issuance for many countries has eclipsed what was done for all of 2019.

The core issue is that yield risk is not a micro credit problem but a macro policy problem. Hence, risks are greater and more uncertain. While many have double-down on credit exposure, the contrarian view is to look for other forms of risk premia for return.

Monday, August 10, 2020

The dollar and the "dominant currency paradigm" - There is good news from a dollar decline

When thinking about the dollar investors should understand current thinking about currency economics. There is a new view that has emerged that should drive thinking about global growth and trade, the Dominant Currency Paradigm (DCP). 

Most who have been taught any international trade and finance are familiar with stories of concerning the law of one price, or some version of stick prices which will impact terms of trade and competitiveness. The law of one price means that a depreciation will raise the price of imports relative to exports (terms of trade) and thus increase competitiveness. This has been referred to as the PCP or producer currency pricing paradigm. The alternative or local currency pricing (LCP) paradigm says that sticky prices in the currency of the destination markets leads to lower price of imports relative to exports and reduces competition. The problem is that research on invoice pricing shows neither economic story represents reality.  

Reality can be explained by the DCP, whereby exports are priced with a few dominant currencies and change prices infrequently. In a more complex world of trade with intermediary production, global commodities, and financing in dollars, the DCP can explain the current trade environment and show how the dollar moves can spillover to trade around the world. In a dollar DCP, the Fed is not the central banker for the US, not the financier of the globe,  but the arbiter of profits and trade flow across the world. 

The DCP paradigm can be described through the following stylized facts that have strong empirical support, (See "Dominant Currency Paradigm" American Economic Review March 2020):

  • Firms set exports in a dominant currency and change currencies infrequently. Invoicing in the dominant currency will affect terms of trade and the quantity traded in a manner not expected in traditional models.
  • In the short and medium term, the terms of trade are insensitive to exchange rate changes. It is hard to change the terms of trade when a large proportion of traded goods are priced in the dominant currency.
  • For non-US countries, the exchange rate pass-through into import prices should be high and driven by the dollar fluctuations and not bilateral exchange rates. For the US, the dominant currency, pass-through into import prices will be low. 
  • For non-US countries, import quantities will be driven by dollar fluctuations and not bilateral exchange rates. US imports will be less sensitive to dollar exchange rate changes. 
  • When the dollar appreciates (depreciates), there should be a decline (increase) between countries in the rest of the world. 

Large changes in the value of the dollar will have a major effect of global trade and growth and its move extends beyond US interests; nonetheless, a dollar decline may have positive spill-over effects. A dollar decline will be good for trade across other countries and may be a good signal for increasing non-US equity exposure.