The smiling Chinese Olympic face is gone - now let's talk about our dollar reserves

Good article in the NYT http://www.nytimes.com/2008/09/05/business/worldbusiness/05yuan.html about the potential need for a capital infusion for the People's Bank of China. Their dollar reserves which have been building to over $1 trillion have been losing money. This is what happens when the global capital markets are supposed to eliminate the saving imbalance problem. The yuan is supposed to appreciate, rates in the US are supposed to rise and the imbalances should be reduced. Unfortunately, this type of realignment of currencies has costs. The dollar reserves will decline in value as the yuan appreciates and interest rates rise whether caused from increasing credit risk or expected inflation. This will lead to declines in portfolio values. Capital needs to be raised and it is natural that the holders of these assets will start to complain.

There was no complaining before the Olympics but now we are in the new reality of global finance. The Chinese economy is slowing, their stock market has been falling, and there is less desire to face the cost of a rising yuan.

Central banks stay the course

The ECB and MPC both left rates unchanged in an effort to stay the course for inflation fighting. Look for continued weak economic numbers because no monetary policy help is coming. On the one hand, you have to give a cheer for their fortitude at sticking to the inflation fighting mantra, but the cost will be a continued slowdown in economic growth. Both euroland and Great Britain are looking to be in worse shape than the US. President Trichet is optimistic with a trough in the third quarter and then a "progressive recovery". Given this view, they have a "no bias" view.

The real monetary issue for investors in Europe is the series of changes the financing of asset-backed securities through the ECB in February 2009. A credit crisis is related to the inability of financing to be available to the market, the quantity side of the equation, and not the the pricing of credit, the interest rate. The cutting of credit from the ECB, a shadow monetary easing is more relevant than the lowering of rates. In fact, the stock market sell-off of financials may have been due to this tightening of credit supply. Borrow now because the window is closing early next year.

Investing and why the paranoid survive

A good editorial in the NYT on certainty by Edward Dolnick called "Fish or Foul" concerns whether experts can be tricked through their overconfidence. Some enterprising youths tested the fish sold as sushi in NYC restaurants and found that many of the samples were not what customers were expecting, yet most believed what was on the label and could not determine the difference. The response of a renowned chef was that "It is impossible to mislead people who have knowledge". 

Do we believe ourselves to be experts at anything? Our confidence can allow us to be fooled. We should know by now that it is just the opposite or as the magician Teller has stated "When you're certain you cannot be fooled, you can be easily fooled" Overconfidence is a big problem especially with smart people, so whenever I see a strong trend in the markets I have to ask the question of whether there is something wrong.

Why is the market being overconfident about the direction. In the FX space, I have to ask why are so many confident about a dollar rally. Perhaps it will be the paranoid that survive.

Fannie and Freddie debt take a beating overseas because of government uncertainty

The Bank of China has cut their debt exposure in Freddie and Fannie by 29 percent or $3.14 billion. They have cut their MBS exposure by 22 percent in the past two months. The reason is simple, uncertainty about the risks with these agencies. This has bee nthe case across all fixed income investors but the Chinese have been such large buyers of the debt so their actions have a big impact on spreads. This is at the same time that the dollar is seeing a rally.

The cause is uncertainty about the future of these GSE. Should they be private companies or should they be taken over by the government? Because no one is making the difficult calls, these entities muddle through and continue to add to the already high market uncertainty. If Fannie and Freddie cannot get cheap funding then they cannot meet their mission of providing cheap housing finance. The role of government is to minimize uncertainty and not follow policies that create it.

If the rally for the dollar is to continue, there has to be less uncertainty about the financial stability of the US debt markets