Globla trade derpession here

From www.variantperception.com via john Mauldin's www.frontlinethoughs.com. The chart on trade suggest a global trade heart attack. While the news seems to be overly focused on the US, the real story is with the fall-off in global trade. To date, we have not seen a significant move to protectionist policies or acions to depreciate currencies to help trade, but the biggest impact to the gloabl economy wil not be in the housing market but how firms respond to the trade deficit. Now some economies are starting to make a comback but everyone cannot be a winner if global growth is stalled.

What is a worry in Asia? Monetization of Treasury debt

WSJ interview with Richard Fischer, President of Dallas Fed.

He has just returned from a trip to China, where "senior officials of the Chinese government grill[ed] me about whether or not we are going to monetize the actions of our legislature." He adds, "I must have been asked about that a hundred times in China."

He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. "I wasn't asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about."

This is a clear sign that foreign investors are worried that the Fed will use the time-tested solution to big deficits, inflate The economy may not inflate today or this year, but for a holding of 10-year Treasuries there is a demand for an inflation premium. Unfortunately, there is no way out of his situation without a dismantling of the source of the problem, deficit.

Donald Kohn Vice Chairman of the Fed at Princeton University:

"To ensure confidence in our ability to sustain price stability, we need to have a framework for managing our balance sheet when it is time to move to contain inflation pressures," he said.

The Fed has said it is willing to expand extensive purchases of mortgage-related and longer-term Treasury securities to support any nascent recovery.

"The preliminary evidence suggests that our program so far has worked," Kohn said referring to the commitments to buy securities to date.

Kohn said government spending is likely to have a more powerful effect in helping pull the economy out of recession now -- with interest rates near zero -- than it would if the Fed were still in a position to lower interest rates further.

"In this situation, fiscal stimulus could lead to a considerably smaller increase in long-term interest rates and the foreign exchange value of the dollar, and to smaller decreases in asset prices, than under more normal circumstances," he added.

The most important point in the Kohn comments is that the Fed needs a framework for managing its balance sheet. What, it does not have a plan? The only hope is that the multiplier will be higher so that we will grow our way out of this depression. There is little evidence for the high multiplier. We did not see it in Japan. There may be an inflation problem not because this is the plan but because the Fed may not be able to manage its balance sheet.

What are corporate CDS spreads telling us?

The CDR corporate CDS spread indices are now at levels similar to pre-Lehman days. Does this make sense if default rates are higher than what we expected six month ago. Some would argue that this is a technical rally based on short-covering of CDS positions, but we still have to look at the numbers and wonder whether this is a broader signal of confidence. Its is notable that the corporate spread on actual bonds are still higher and while they have also declined there is a marked divergence between corporate spreads and CDS spreads for a negative basis.

CDR Liquid Corporate CDS spread index



CDR Liquid High Yield CDS spread index

Confidence everywhere, but why?

Green shoots are delicate and can easily be destroyed, yet the green shoots are leading to growing confidence across many economic groups.

We have consumer confidence growing positive which may be the most important. The Conference Board consumer confidence number jumped the most in six years beating expectations and going form 39.2 to 54.9; however, you have to go back to 1992 to be at these same levels.

The Merrill Lynch fund manager survey shows a surge in bullishness with 7 of 10 investors predicting that the world economy will improve over the next 12 months. Cash holds have been cut from 4.9% to 4.3%.

The Yale School of Management Stock Market Confidence Indexes are also showing improvement. The one year confidence numbers have turned positive as well as the buy on dips confidence indicator. The valuation confidence indicator as well as the crash confidence numbers are showing more optimism.

Let's hope that this is well placed.

The cash is starting to move

As Keynes put it, “our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.”

The signs that money is moving and looking for risk are starting to show up in many markets. Equities are higher. Corporate spreads are tighter. Emerging markets are better. Now we will not see Treasury bills at anything like pre-crisis levels but all of the talk is about the growing risk appetite. Unfortunately, I get uncomfortable when the argument hat there is greater appetite for risk is a fact that risk assets are moving higher in price.Risk appetite should be related to a change in future return expectations. Higher expected returns will lead to changes in portfolio composition. Because we cannot observe expectations directly we can only assume that this is occurring when prices move higher. Is this just another momentum story?

Losing a triple-A and the dollar

The dollar had a rough week without too much negative economic data being released. Perhaps investors wanted more green shoots but the real driver may have been the talk about the UK losing its triple-A rating and by extension the potential for the US to lose its triple-A. GBP fell on the news. The dollar was hit hard relative to other currencies.

Now the UK is in worse shape that the US from a rating perspective. but a signal on the UK will by extension affect views on the US. Both have growing outstanding debt to GDP which are currently at 50%. The debt to GDP is at 10% per year with no real end in sight. With the high debt to GDP each year, outstanding debt to GDP will be above 100% in about five years. The UK is also not a reserve currency like the US or to a lesser extent the euro, so a rating change will have a bigger impact than for the US in the short-run.

A ratings decline will usually occur when the outstanding debt to GDP reaches the 100% level. In the case of the UK, the rating agencies do not see the debt to GDP declining and by extrapolation the same could be said about the US. S&P has lowered the medium term outlook for the UK to negative from stable.

Moody's lowered the rating for Japan earlier in the month to Aa2 on foreign currency debt because of the high outstanding debt to GDP. S&P and Fitch had already lowered the rating of Japan to AA. Moody's cited the high level of debt, poor economics, and the expansion of the government for the downgrade. If this happens for a creditor country, it is unlikely that the US will be able to maintain its triple-A if it continues down its current path.

The ratings agencies are usually backward looking but the psychological impact of a dollar downgrade will be significant for world reserve currency. US debt is denominated in dollars so the impact on foreign rated debt will be minimal but the pressure on the dollar will continue. The pressure talk from China on a new reserve currency will be all the more important. President Obama did not help matters with a comment this week-end with a C-span reporter that "we are out of money now".

Will a downgrade come soon for the US. Unlikely, it could be years away and only after it is placed on negative watch. The rating agencies move slow, but it suggest that the focus will be public financing as much as recovery.

What do we call this crisis?

I have been at a loss of determining what to call the global crisis. It does not seem like a recession but it is not a great depression. Is it just the crisis of 2008? Or is it the bank crisis of 2007-2008? After reading excepts from Richard Posner's A Failure of Capitalism. I believe he has a good concise definition.

Posner argues that this is a depression although not a great one. He states that the typical postwar recession is a partly self-correcting disinflationary contraction that subsides often leaving the economy healthier. The present downturn is a self-sustaining deflationary contraction whose costly aftereffects will linger. A typical recession is a market correction to some economic imbalance. A depression is a market failure. Market failure takes massive intervention by the government through fiscal and monetary policy along with regulation to potentially correct the failure.

We had a combination of imbalances from housing to global savings which were coupled with excessive monetary easing and a lack of government oversight. However the oversight problem is more complex than a lack of rules and restrictions on banks and finance. As Niall Ferguson argues in the NYT "Diminished Returns: Why we never learn the right lessons from financial crisis ", we have not learned any lessons from financial regulatory history. We started deregulation in the early 1980's for banks with significant success. The economic failure of inflation and poor growth the 1970's was a result of too much regulation.

If we are facing a depression of market failure, what will we have to do to correct it. The same regulators and legislators who got us into this mess are now the one who are supposed to solve the problem. The market failure of seeing signs of a problem through some early warning system or providing potential solutions may that will not stifle future growth are real and should not be discounted. As Ferguson states at the end of his article, Quis custodiet ipsos custodes? Who regulates the regulators?

However going forward, I will refer to the current economic problem as the Depression of 2008.

Good news and bad news -- contrasting country data and currencies

UK GDP for the first quarter came in at -4.1 (yoy) and has been hit with bad numbers all year. This has been further compounded with political issues, QE problems, a banking crisis, and a potential downgrade of its triple-A rating, yet if you look at the currency, it has been up over 16% since the bottom in mid-March. GBP/Eur is up over 8% and about 12% since the beginning of the year. The UK Green Shoots story is alive even with an economy that needs massive amounts money pumped into the system.

The same can be said for Japan which announced much worse number that UK for GDP on an annualized basis. Here usd/yen is up only 4% and has strengthened since early April. Of course, on a relative basis, Japan is in worse shape than the UK and the currency reflects it.

The currency markets seem to be discounting these first quarter numbers and looking to a revival in the economies based on the more recent survey evidence. Yet there is more than one reason for the currency gains relative to the USD. The rise in GBP could be due to expected improvement later this year, an expectation of poorer performance in the US, on a relative basis or an increase in risk appetite because the US is doing better with the rest of the global economy. Or maybe the markets have gotten ahead of itself. All are plausible stories which makes for a difficult trading period.

Second derivative may not matter when Japan economy is this bad

The Japanese economy shrink at a 15% annualized rate in the first quarter of 2009. These are horrible numbers lead by shrinking export sector. Of course, this is not out of line with some of the other Asian economies. Japan has not found any magic to solve a global trade slowdown. 

Still some of the latest numbers have shown improvement. These are the forward looking surveys like the Economic Watchers, consumer confidence, and Manufacturing PMI. There is a slowdown in the slowdown, the second derivative, which is causing all of the excitement in financial markets. This may not change the fact that any recovery will be slow, but turning point searchers are starting to feel that dollar will have to but to use.

Dollar yen has been more range-bound but the flows to higher yielding risky assets will continue and drive yen lower. 

Good news as bad news and the dollar

“The U.S. dollar is going to fall quite a lot, or at least significantly,” he said. “The demand for dollars has been temporarily inflated by the crisis. Good news is actually bad news for the dollar. If things stabilize, then the safe-haven demand for dollars falls off.”

- Paul Krugman

Krugman makes an important point in a recent speech which explains the difficulty with some fundamental market relationships relationships in exchange rates. Under normal environments, a increase in relative growth in the US would be good for the dollar. Stronger demand will increase the demand for money and increase the supply of capital flowing into the US. 

Unfortunately, we have been in an upside down world where first there was a strong flight to quality into the dollar even though the crisis epicenter was the US. Now that the global economy is starting to stabilize we are seeing a fall-off of the dollar and funds move to riskier assets. The better the news on the US economy and so with it the rest of the world, the more we will see dollar declines. This is the risk aversion story. 

The most powerful man in finance - Zhou Xiaochuan

With the dollar under attack as the reserve currency and the Treasury exploding budget levels to unprecedented levels, the power in finance is shifting. (Unprecedented is becoming over used since it is now always happening.) Power is not in Europe which has the disfunction of a central bank for the EU but a weak EU government. It is not the US where Tim Geithner is perceived as a weak Treasury secretary and Ben Bernenke is up to his eyeballs in problems. It is not England which is falling down under the weight of QE and huge deficits.

The power in finance is the happy man in the picture, Zhou Xiaochuan, the governor of the People's Bank of China. With a his pushing of a review of reserve currencies or his statements on the US economy, he and his crew are the people of finance to watch.

Dump the dollar talk -- a little extreme

China and Brazil announced that they have an enhanced trade agreement that proposes the trade is settled between their currencies. This is not dumping the dollar but more about the growing bilateral trade between the to countries. However, the trade takes an interesting twist. China wants to sell its good in Brazil to have another outlet to the US for their manufactured products. China wants the physical commodities from Brazil. This is the classic relationship between the developed world and Latin America playing with two emerging market powerhouses.

The financial form of the deal will be through swaps so that China will take real for their goods and pay for imports from Brazil with renminbi. Exports to China from Brazil are now over $2 billion per month after a big decline in 2008.

The end of cap-weighting - do not buy lumbering dinosaurs

Buying cap-weighted portfolios whether stock or bonds is like buying the big dinosaurs because you expect them to survive because of their size. Big is supposed to be good with companies. Big is good with corporate debt even though they may have higher leverage. So what about Bank of America? GM? Merrill Lynch? Big is not good yet you have more exposure to bug when you buy a cap-weighted index. This may not be the way to go if you want to be a passive investor. Buy more equal weights regardless of the asset class.

Why you need something other than stocks

From the article "Bonds -Why Bother?" by Robert Arnott in the Journal of Indexes, the case for stocks in the long-run is destroyed. There are long periods where bonds have outperformed stocks. The cu rent period is a perfect example where there is no equity risk premium. But bonds have not been given their due. We usually think of bonds as a diversified and a risk reducer but certainly not a return generator. Yet, if you held bonds over the period of the great moderation until today you would have been much better off than buying a basket of stocks.

Diversification is more than just risk reduction. A mix of assets in a portfolio also provides a portfolio combination which will perform differently from an all stock portfolio under different environments. This is what diversification is supposed to mean, a return pattern that respond to different factors. Diversification is not just a low correlation as measured by the numbers. There should be a unique set of reasons for different portfolio return patterns and this is what the investor is trying to exploit when forming a portfolio with different assets.

Using the yield curve fulcrum to tell us when recovery will come

The shape of the yield curve can be used to tell the market when there will be a recession or recovery. If the yield curve becomes inverted there is or likely to be a recession. If we used the inverted yield curve argument, we would have gotten a good heads-up on the potential for a recession. Interestingly, the recession was delayed longer than expected using this yield curve measure.

We can also look at the flex-point or fulcrum of the yield curve to tell when there will be expected recovery. If there is a extended recession, there is more likely to be be low rates and no inflation. Hence, if rates are continuing to move lower in the front-end then it is expected that the recession will continue. When rates start to increase, most likely because of inflationary expectation, there is a higher probability that there will be economic growth and rising prices. Since December, the fulcrum for the US yield curve has been around 2-3 years. The recovery will likely be delayed until the end of 2010 by this measure.

Now if we look at the European market we will get very different picture. Here the fulcrum of the yield curve is much further out the curve in the period of around 8 years. This suggest that the recovery will take much longer in the EU. This is consistent with the idea that the European banks which are more highly levered than in the US and have not reported as many loses will have a longer period of recovery. The ECB has also been thought to be slower at responding to the crisis so it would be expected that it will take longer to get a recovery.

Follow the prices and you will get a good view of the future.

Yield curve steepness

The yield curve is getting steep again. This is usually good for banks. he classic strategy for borrowing short and lending long will allow for profits to banks. It also tells us that monetary policy is in easing mode. However, the steepness is starting to come at a price. The price is higher inflationary expectations on the long end of the curve. With short rates anchored at close to zero, the steepness can only come one way and that is through higher longer rates. We are in similar territory after the last recession when the Fed lowered rates to one percent except this was the environment that lead to the excesses of the 2007-2008 crisis.

Steep yield curves still produces profit-maximizing behavior. Many will hold ARMs, corporations will borrow short. Consumers will spend more today. We will get the behavior that comes form steepness whether we like it or not.

New data tells a mixed story on green shoots

CPI is down YOY -.7 but the core number is still at 1.9%. Most of the decline is from the reversal of the oil and food shock of last year. We have evidence of the price shock effect when we look at the PPI numbers from earlier in the week. The food and energy component is the only place where we are seeing real movement.

The more important near-term number is the Empire Manufacturing index down only 4.55 from an expectation of -12. Another green shoot but within the green shoots are weeds. This is a positive for the US but when we look around the rest of the world the story in mixed. Europe is behind in the business cycle with poor GDP numbers for the first quarter. Japan machine orders is down 20+ percent from last year and leading indicators are still falling. Now the Economic Watchers survey shows some slight improvement for current and outlook conditions. UK industrial production is down over 12 percent and ILO unemployment rate is rising.

US retail sales declined to negative numbers from positive expectations this was something that was supposed to be counted on to help the equity rally. Initial and continuing jobless claims are still rising. Industrial production was negative though the U of Michigan confidence numbers are slightly higher.

The euphoria of the end of the free fall global economy is over, but this is not the same as a recovery. The US is probably ahead of Europe and Japan in the business cycle. This is point in the cycle is driven by the strong flood of cash from both monetary and fiscal side, yet the stimulus may not be enough to close the output gap.

Obama and deficits - now a hawk?

From Bloomberg -

President Barack Obama, calling current deficit spending “unsustainable,” warned of skyrocketing interest rates for consumers if the U.S. continues to finance government by borrowing from other countries.

“We can’t keep on just borrowing from China,” Obama said at a town-hall meeting in Rio Rancho, New Mexico, outside Albuquerque. “We have to pay interest on that debt, and that means we are mortgaging our children’s future with more and more debt.” Holders of debt will "get tired" of buying it. It will have a dampening effect on our economy."

Wow, can I believe I am hearing those word from the man who gave us what may be a $2 trillion deficit for the new fiscal year? The president believes in crowding out theory. This is more than what some Bush administration officials believed when they said deficits do not matter. But this view came after the deficit breaking budget passed. Of course, the other shoe drops with comments that this can be solved with health care reform; nevertheless, what do we do now?

If you are a bond holder the deficit problem is big. The president is on your side under the belief that rates will go up if this continues, but he is also the person who has the ability to change the current situation. The pressure will be on the Administration to cut the deficit, but where will the cuts from? Also where will the revenue come from during a recession?

So if this does not happen where will rates have to go - higher.

Sovereign CDS spreads and the dollar

Sovereign CDS spreads in G10 countries have moved with the dollar. Once the dollar started to decline CDS spreads moved almost in tandem. This may be a a sign tat the global crisis is thought to be over. US stocks started to rally when the CDS spreads started to come down. The lower perception concerning risk started to cause money to move out of the dollar safe haven causing the dollar the decline.

A cycle of positive behavior is hitting all of the markets. Some economic data is better. Equities around the globe are higher. Sovereign CDS spreads have started to decline. The dollar has fallen with the increase risk appetite.

So now we have to look for signs of a reverse.

Zarnowitz without a V - the shape of recessions will be different

Victor Zarnowitz was the father of business cycle analysis. There were others who came before Zarnowitz but few did as much analysis over the their lives in a single focused subject. Zarnowitz argued that steep recession will lead to steep recoveries. The faster you go into the recession tank, the faster you will exit which is the basis for the V-shaped recovery. Given we have significant evidence of this from past business cycles, it would be very normal to see the stock market start to rocket up and the Green Shoots of a recovery start to have significant impact. Unfortunately, the facts are different in this case.

Credit driven business cycles will last longer and show slower recovery. The normal V-shape would apply for inventory driven recessions. Under the inventory cycle story, inventories will build which causes a swift slowdown. Then there is a cut in the stocks which lead to new production. This could easily apply to the housing market in the US, but you have a different story if there is a credit crunch also associated with the inventory problem. Under the credit crunch banking problem which based on the research of Ken Rogoff of Harvard, there is a longer time for for the the banking sector to be cured and an ex tented time for the credit channel to be fixed. It requires a significant amount of fiscal stimulus and government debt.

While ch story is unique, the banking credit crisis scenario seems to fit the existing facts. The Zarnowitz effect may not apply this time around.

The history of the great inflation

All the policy talk is focused on the lessons from the Great Depression and the current Big Recession, but we should not forget the great inflation period of US economic history. Now the United States did not have the same inflation as the Weimar Republic or any of the other great hyper-inflations, but inflation had a significant cost on all Americans both on the run up and on the way down.

Thanks should go to Robert Samuelson for bringing this timely topic to what should be the front of any current discussion. No, we are still in a deflation period but the seeds of futures inflation are being planted. The most important seed is the complacency concerning its cost.

Most policy-makers are only worried about one thing, full employment. The cost of inflation is a small price to push us closer to full employment. Given the choice, we will be willing to sacrifice the many for saving the few on the road to full employment. We are doing this again in this crisis. There is no question that stimulus is needed and monetary policy had to be eased significantly, yet the talk about inflation during the current crisis is nill. Nill is a strong word but I have not heard anyone from the executive branch of government say anything about inflation in the long-run. This is not about inflation today but what may happen a few years from now.

The cost of inflation is significant especially for the poor and middle class. All of those we are not indexed to inflation will have an erosion of purchasing power. All of those who have nominal assets like bonds in their portfolio, will suffer. Yes, the the debtors will be better off but even here there are problems. More of our debt rolls over at variable interest rate so the cost may increase under inflation. Prices will be distorted. Business will not make the proper investments. The cost will affect employment if business make poor investment decisions. The distortions will exist with the tax system as more are pushed up into higher brackets with no change in their overall real income. The government benefits from the decline in real values for debt but even here the cost will be high as capital moves to other markets and the uncertainty about the economy leads to less overall economic growth. Of course, this may be a problem for someone else down the road.

The Samuelson book, describes the period of great inflation and all of the plans used to stop it. The craziness of price controls or Whip inflation now WIN buttons seems almost quaint now that we look back on that period, but the distortions to the economy at the time were real. Samuelson goes through the history of this period and destroys some of the myths that have developed around our inflation history. As a financial writer, he does a good job of making the story come alive but with a strong knowledge of the economics. If Green Shoots take hold and some growth returns at the end of this year, this book will become even more timely.

Animal Spirits - does it matter?

George Ackerlof and Bob Shiller have a new book which has been getting a lot of attention, Animal Spirits: How human psychology drives the economy, and why it matters for global capitalism. In fact, there is a lot of attention being given to behavioral or psychological aspects of economics. The pendulum has swung from the very mathematical to a new paradigm of less rational behavior, the behavioral revolution. This has been a positive development but there still has t be a lot of of work to solve some of the problems of business cycles.

Capitalism or markets are messy. Anyone who has gone to a bazaar or stood looking down from the visitor's gallery of an exchange to the pit below will know that markets are not easy to explain. There will be winners and losers and there will be emotions. There will also be many examples of behavior that will not fit into a box as rational. Ackerlof and Shiller provide some brad themes where behavior does not fit the test of rationality. These are all well-know problems in economics. Unfortunately, they do not fit the definition of what Keynes was discussing when he described Animal Spirits. This is an important book of interesting issues but this is not the ascent of Keynesian economics during a crisis.

Animal spirits was a concept to try and explain the changes in business confidence that can occur in order to rid an economy of a deep recession. The change in confidence is what drives investment decisions in the long-run when there is not a clear idea of what will happen in the future. The authors broaden this theme to include all behavior that seems to be irrational. This was not the intent of Keynes.

They argue that animal spirits leads to issues of confidence but also corruption, money illusion, and fairness and is all encompassing many of the issues of irrational behavior that have been gripping economics. They analyze a set of key questions concerning the intersect between economics and psychology which provides for some interesting reading but many of these are off point with respect to the overall issue of animal spirits. I may be being too much of literalist, but the issue of consumer and business confidence in a downturn is still a foundational issue for business cycles. When and how will economic agents turn there views on a economy is still very complex and left unanswered.

ECB and BOE moving down the QE path

The ECB cut rates by 25 basis to 1 percent and announced a plan to buy 60 billion euros of covered bonds, pfandbriefes. ECB Head Trichet stated that this was not a floor to interest rates.

The major monetary hawk (or monetary laggard to some) of the developed world has decided to move further into the QE camp. Of course, Trichet has stated that it is not embarking on quantitative easing. While the rhetoric has been about holding the line on inflation through keeping rates above zero, the reality has been that the ECB has been very open about providing funds to banks. Look at their balance sheet. This is not the Bundesbank as consideration away from the largest EU countries has drawn the ECB into active policies based on the output gap. This is a turn around in the policies of the ECB when just a month ago there was talk that direct intervention in the bond markets would not be a priority.

Of course, Trichet also said that it will "never compromise on the anchoring of inflation expectations". Being polite, this could mean many things. It could mean that the ECB is still trying to be hawkish or it could mean that they will increase the money supply to boost inflation back to its target. Some economists say that inflation targeting wold be helpful to ground inflation expectations but this is in the context that there is deflation.

The BOE said that it would further expand its balance sheet through the purchase of 50-125 billion pounds.

"Bullet to the Brain" risk - Ouch

Spending some time down in Texas at a hedge fund conference was very informative. I heard from some of the largest pension funds in the state on how they look at hedge funds in their portfolios and what they think are the most important issues they will be facing in 2009. Clearly, pricing is going to get more competitive.

One issue that was described in detail was the worrisome issue of risk management. In particular, part of the discussion started to focus on Black Swan events or as one manager called it, "bullet to the brain" risk. Other would call this tail risk, if you were from with coast. The issue is how do you protect yourself from these types of events. Actually the risk management issue took two directions. There is bullet to the brain risk from a micro-level of picking the wrong manager. This is an operational and due diligence question that can be contained through the vetting of managers.

The larger issue is the macro bet from a change in the environment that occurs quickly before the portfolio can be repositioned like what happened last Fall and through the last bubble. This is the bullet to the brain risk which may be harder to manage. Managers discussed a culture of risk management, but there really is no way to protect from some of these extreme events other than to increase diversification and to engage in active management through rotating in and out of sectors.

Why has managed futures not sold well in the US?

At a potential client meeting, I faced a very interesting question, "Why has managed futures not sold as well in the US versus Europe to many hedge fund investors?" It was the best performing hedge fund sector in 2008, yet there still seems to be many pension and endowments who will not touch this diversifier.

There is no easy answer to the question but there are reasons for failure by both the managers and the institutional investors. I don't want to advocate one position or another but it is clear that there are roadblocks that have to be addressed before managed futures is embraced by institutional managers.

Institutional managers and the aversion to momentum systems is a significant problem. Anyone trained at a business school or with an MBA has learned that markets are weak form efficient. This is a foundation of the rational expectations-efficient market paradigm. Hence, trading systems using price will not be able to generate excess profits. The argument is that sure they may be able to make profits during some extreme periods but these systems cannot do it consistently. This leads to large drawdowns and low information ratios. Take away the leverage and the occasional large trend moves and there is no basis for consistent profits. (Of course, if you rake away the profitable period for any manager they will not make money.)

It seems that the those investors who do not have the same exposure or belief in the efficient markets paradigm are more willing to accept that trading systems may work. Unfortunately, the behavioral school of finance has not fully addressed why some systems may work other than to embrace the idea that there is market irrationality and that systems may capture this behavior. While the eduction of investors is a problems more of the burden has to be on the managers and their ability to see the process.

Why cannot managers get the business? Money managers who have developed trading systems have a problem because their audience does not like the premise of what they do. There are two ways to handle this problem. One, you can avoid the investors who do not believe in your premise. Of course, this means a whole portion of the institutional market. is eliminated from consideration, or the manager can address the issue head on. This is often not done because the arguments for weak form efficient are strong and the alternative requires some thoughtful analysis. Additionally, the level of transparency to many models is limited which creates more uncertainty with investors.

Nevertheless, there are some themes that can be used to help. One risk management is a value enhancing mechanism. Risk management is not just for stopping loses but choosing opportunities. The environment matters. Some markets are more likely to be driven by price behavior versus others. For example, those markets that have limited fundamental information will more likely have price behavior that can be exploited through systems. Finally, systems are adaptable not like statistical tests. An evolutionary view is helpful when developing systems. This is part of the view of Andy Lo who has developed an adaptive efficient markets hypothesis.

G10 yield compression from similar policies

With volatility falling and our risk appetite index increasing, carry returns have returned. However, the return of carry is a focus on emerging markets and is not associated with the G10.The economics is easy to see once you look at the yield compression across the G10. If there is no yield differential, there is no potential for carry. Our graph shows the difference between the maximum and minimum yield spreads against US rates for 2-year maturities. This could be a good proxy for the differences in monetary policy. Through this proxy, we are seeing a convergence of policy initiatives which makes exchange rates more difficult to forecast.

If everyone is doing the same thing, then relative prices ill not move. Small changes in economics will have big impact on exchange rates.

Quantitative easing and the stock market rally

What is going on with the stock market? We have moved from a low of 672 on the SPX on March 9th to the current level of over 900 in less than 2 months. Could the economy be getting this good so fast? We know that equities usually turn at the bottom of the cycle and there has been some evidence that there is a slowdown of the slowdown but there has to be more going on to cause this change in expectations.

We suspect that the effectiveness of monetary policy is one of the drivers. The market bottom was reversed when Citicorp announced that they would have better than expected earnings; however, we know that this was associated with some smoke and mirrors. While the Citicorp announcement provided some relieve concerning banking problems, there was a further jump when the Fed decided to buy Treasuries and increase their QE program.

The problem is that the link between monetary policy and equity markets is not clear. There is evidence that the market reacts to declining interest rate or monetary easing. The decline could be with the easing policy or with an unanticipated change in rates. Unfortunately, we have less evidence of what will happen when monetary policy is eased but there is not a signal through a rates decline. Now we can look at real rates but here the signal becomes ambiguous especially if there deflation. The lines of causality between monetary policy and other effects are blurred so we cannot say what is driving the stock market.

The only other key QE case is Japan, but again the evidence is not clear. During the 1998-early 1999 period there was a significant Nikkei gain, but the QE period extended a number of year when the market was declining. There have been some studies of monetary environment but again this was measured through the direction of interest rates. Equity behavior during the Volcker monetary period is also mixed. Monetary tightening allowed the Fed to break the back of inflation but this was during a high inflation low growth period not a deflation like today. We cannot say what will happen when the Fed balance sheet explodes. The periods of very high monetary expansion for other countries was also during periods of high uncertainty which provides unclear signals.

Nevertheless, there is some evidence that a monetary policy that tries to smooth the economic cycle will reduce the equity risk premium which will cause a stock market rally. We believe that the stronger action from the Fed is leading to a belief that the economy will turn around sooner regardless of the economic numbers. Equities which have high leverage may see a benefit from higher inflation and P/E with equities is a real measure unlike nominal rates with debt. This has helped the equity rally. The question now is whether adding too much money will lead to higher nominal rates which will have a restrictive effect.

The evidence is not clear but if you are an equity investor do not fight easing.

Policy Iceberg Problem - what is going below the surface matters

A concern is that many policy initiatives which are being employed around the globe will have mixed effects with different time lags. The iceberg effect comes with the announcement of a policy which is above the surface, but the details, timing, and funds still murky and below the surface. No doubt fiscal stimulus will have a positive impact, but the interaction across countries is more complex and causing mixed impact on currency markets. In the case of the US, the stimulus will total $780 billion but will come over a number of years. Consequently, we have the headline announcement effect but the real details is how and when the money will be spent. What happens if we start a recovery in the fourth, yet the stimulative impact of the government will come in 2010. The deficit financing is starting to impact rates markets which feedback on growth. What is the impact of the deficit financing. We are seeing more supply out the curve and longer-term rates are starting to increase.

The policy announcement at the G20 meeting concerning IMF funding is another perfect iceberg example. Providing more funding for the IMF gave emerging markets a boost, but the details of when and how the funding will be provided and the exercise of this new credit power by the IMF is unclear. Hence, the link between the underlying economics and markets is altered albeit in an unclear way. The question for any investor is whether you react to the announcement effect of steer a course based on what you think is below the surface. In this case, liquidity still may be scarce and the amount of money provided by the G20 to the IMF may actually be much less than what was announced.

The iceberg effect is another way of saying that there will be a law of unintended consequences. The unintended effect often comes after we see what is below the surface.

The shape of economic things to come - V,L,U, W and hook-shaped recoveries

The current talk is all about economic recoveries. It may seem a little premature for my taste, but the equity markets are sending quite a strong signal that growth is around the corner. Nevertheless, there is more talk about what type of recovery will occur and it represents almost every shape of the alphabet.

For the pessimists, we have an L -shaped recovery. We have had a significant decline and there is expected little gains as we enter a new world of slow growth. For those who are a negative but see some future, there is the U-shaped. A long period of flat growth before a good recovery. For the eternal optimist, there is the V-shaped recovery. We went down fast and will come out fast with the help of the economic stimulus. This is what every policy-maker wants. A recovery back to normal. For those who cannot make up their mind, there is the W-shaped business cycle. We will have a number of false starts before we have our true recovery. Now we have the hook, a steep decline and and then a steady but gradual recovery. Deutsche Bank, to be more technical, has defined this as the diminished sine wave recovery.

So what is it going to be? Unfortunately, most business cycles have less in common than what we may think. For the strong recovery people, there is the strong monetary effect and and fiscal stimulus. These unprecedented increases will have a stimulative effect and if there is a change in consumer expectations (back to spending), there will be a strong recovery like what OMB has forecasted. However, if the multiplier effect is not as large as expected and there is a new sense of fiscal conservatism by consumers, we will be in a situation were we the hook. The interest rate crowding out effect and the potential for tax increases will place us in a slow growth environment. The worst case scenario is the doom and gloom that leverage will be permanently taken out of the financial system and we will have to get back to a slower long-term growth path. No one wants this scenario but many current policies can move us in that direction.

Right now it is too early to say, but unfortunately, the V-shaped recovery may be the one that has the lowest chance of actually occurring in the G10. The field of alternative scenarios is just too great.

Gold and central banks - don't follow their strategy

The FT provided a good graphic on gold holdings for central banks. The story shows that from the highs during the inflation period of 1980 there has been a consistent policy of selling off gold reserves and increasing foreign exchange holdings. Now this was the period of falling inflation and and declining gold prices so it did make simple sense. The assumption was that central banks could control inflation around the world and that they would have the wisdom not the inflate their money supplies at the same time. One central bank may not follow this wisdom but there was little likelihood that all central banks would increase fiat money at the same time. Under that scenario, holding a paper asset would not make sense. But that could not happen.

Now in 2009 we have found that inflation could be a problem. In fact, there is talk that inflation could be the solution. Under this world , holding gold might be a better strategy. Of course, now we are seeing some central banks getting back into the gold market to increase their gold reserves. We see that with China and with discussion in the Middle East.

Crises occur, but not expecting inflation may be the bigger problem facing the world over the next few years. It is the black swan event thay central bankers really did not expect.