Thursday, May 28, 2009
Wednesday, May 27, 2009
WSJ interview with Richard Fischer, President of Dallas Fed.
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."
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.
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.
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.
Monday, May 25, 2009
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?
Sunday, May 24, 2009
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.
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.
Friday, May 22, 2009
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.
Thursday, May 21, 2009
Wednesday, May 20, 2009
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.
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.
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.
Monday, May 18, 2009
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.
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.
Friday, May 15, 2009
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.
Thursday, May 14, 2009
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.
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.
Monday, May 11, 2009
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.
Friday, May 8, 2009
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 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.
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.
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.
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.
Thursday, May 7, 2009
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.
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.
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.
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.
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.
Wednesday, May 6, 2009
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.
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.