China thinking about basket

Market Watch story says that top Chinese central bank official states yuan should not be benchmarked against dollar but a basket of currencies. This makes sense since the fall in the euro relative to the dollar has hurt the trade balance between China and the EU. While so much of the focus has been on the dollar-yuan rate, trade with Japan and Europe are very significant.

Deputy Gov Hu Xiaolian's comments are on the central bank's website:

Since the RMB exchange rate regime reform that started in 2005, the focus of public communications has been the RMB exchange rate regime with reference to a basket of currencies. But the mindset of focusing too much attention on RMB/USD exchange rate cannot be changed overnight due to behavioral habits and the dominant use of US dollar in accounting and statistics. This underpins the necessity for China to make more efforts to improve the exchange rate regime based on market supply and demand (mainly through the current account and especially the trade account balances) with reference to a basket of currencies.

This will not have an immediate impact on markets but it shows the intent of the Chinese.

Not your normal macro trader - Jm Rogers on GDP

Jim Rogers: I do not pay attention to that sort of thing for the following reasons:

1. The numbers are backward looking;
2. They are always revised;
3. Every government has different methodologies; and,
4. Most governments have no clue so they just make up the numbers.

From Money Game

I cannot argue with Jim Roger's view. The delay in GDP number sis significant so you cannot place a lot of stock in them. They are subject to revision which can be significant. The OECD has made progress in standardizing the numbers, but some governments are better than others. The no clue argument is harsh, but knowing how the numbers are made is like sausage-making, you don't want to know. That is why there has to be a focus on real-time macro data which is the hottest topic for macro forecasters.

New way to say "new normal" from Robert Reich

Robert Reich turned a nice phrase when he said we are not in a double dip recession but a "one and a half dip" recession. You may not know it from the stock market and equity profitability, but the economy is not had a pop as expected from the Zarnowitz rule which states that a fast fall will be matched by a fast recovery.

Housing is an old story but it still convert to a sluggish economy. We know that liquefying housing wealth through home equity loans boosted the economy during the 2000's period. We are not getting a housing boost now. Wealth has been stabilized but not increased. The headwinds are significant, so we have the half dip.

Copper and the Chinese business cycle

Copper, as a base metal follows the long-term trend in the business cycles around the world. If you do not believe it, look at the Deutsche Bank chart from their commodity group. There was a not a strong correlation in the early 2000 period because the Chinese economy was smaller and their as build-up phase, but the recent leading indicators for China when overlaid with copper prices shows that as China slows so will copper.

GM is buying Americredit? what about paying back US Treasury ?

GM which was taken over by the government and is 61% owned by the US Treasury and has yet to payback the Treasury is buying Americredit. Americredit is a sub-prime lender. Does this make any sense? Should auto companies be in the finance business or should it focus on cars? To have a good car company you need a good finance arm to extend credit but one of the excesses in credit over the last 20 years has been in the auto area. Credit has been extended at looser terms and for longer periods which may be the exact thing the government would like to reduce.

While i do not like to comment on politics, this one made me stand-up and notice.

"Unusually uncertain" - Bernanke's call

A great turn of a phrase to describe the current economy by Ben Bernanke. "unusually uncertain". Hard to say what that means, but the markets reacted immediately, risk-off. This certainly was not a confidence builder. The Chairman also said that he is prepared to act, but we do not know what action he will take. A news account mentioned that most of testimony was focused on exit and not on new stimulus. We also know that some Fed presidents want to raise rates. There is no clear consensus on what action can or should be taken. Rates could go to zero and QE can begin again, but the problem is that if the market environment is "unusually uncertain" there is little willingness to lend or borrow. Cash balances will accumulate and the economy will maintain a slow growth posture.

Sen Bunning asked the important question whether the Fed is out of bullet. Using this analogy, I would say the Fed is low on ammo and shooting blanks.

Is everything correlated? - seems that way

Good chart by Jim Bianco on correlations across asset classes. Jim looks at six asset classes and charts the lowest correlation against stocks on a rolling basis. The numbers are at extremes. While calculated on a three-month basis, the correlations minimum has jumped from -.8 to around .70 in about sixty days. This is consistent with the risk-on and risk-off trades we have been seeing, but even that story does not explain why such diverse assets would be so positively correlated.

We are actually having more dispersion with economic data between developed and emerging markets, so this spike is mysterious. We are also at higher levels than during the crisis. An explanation will require deeper analysis.

Hungary -IMF talks breakdown

Just when you thought it starting to get safe to invest in Europe, the Hungary -IMF loan talks break down. Hungary received IMF support in late 2008 to avoid bankruptcy. Now it wants better terms. Unfortunately borrowing from the IMF is like going to a loan shark. You may get your money but they will dictate many of the policy choices that you will have available.

Hungary has not drawn on the funds since last years, so the government is feeling good that they can negotiate harder against the IMF. Hungary believes that more austerity will cut-off their recovery; nevertheless, if there is a decline in the forint, the central bank will have to keep rates up to support the currency.

This is an interesting test case for what may happen in other EU countries that borrow from the IMF. Tings get better and the government wants better terms. Unfortunately, that is not the way term lending or credit lines work.

The change in dollar sentiment

One of the biggest mistakes of the year has been in the forecast of the euro currency demise. Granted the market was dollar bearish at the beginning of the year, but the Greek sovereign problems changed sentiment to being strongly euro bearish. The huge change has caused many to predict a large overshoot for the euro on the downside before year-end. The momentum traders as well as the fundamentalists all lined up for the euro short in the second quarter.

A problem is that the US economy has not cooperated. Sluggish economic numbers and a negative forecast by the Fed has created another dollar sentiment switch. The euro has gained over 9 percent in one month since June 7th. At the same time the short euro positioning has moved to long as measured by the IMM net large speculative trader reports.

The EU has seemed to get the religion of austerity or at least a slowdown in government expansion. This German view has been positive for the euro at the same the US has been pushing more stimulus. Optimism on euro bank stress tests is another reason for the rally. The LOIS spreads have stabilized and have not moved to 2009 levels. The stable EU environment in the short-run even with lower growth expectations has stemmed the tide of euro selling. While moving to euro highs from 2009 is unlikely, the bearish view to the euro has reversed. We will need another negative catalyst to test new lows.

Monetary policy - opinion differences

The BIS seems to be at odds with the IMF concerning monetary policy. The latest outlook piece from the BIS both argue that continued policies of keeping rates near zero will have a detrimental effect on the global economy. Lending at low rates creates more risk taking behavior. This was one of the causes of the last asset bubble in housing. There is a cost with forcing rates to low levels and allowing investors to have almost free money.

The IMF is taking an alternative view of arguing for continued monetary easing.With inflation close to zero, the real rate of interest in many developed countries are not overly stimulative. hence, there is a need to keep rates low in an attempt to stop a deflation spiral. While there may be a cost with low rates, lending at near zero will have the effect of increasing consumption and investment today as opposed to waiting. The need for monetary stimulus is all the greater fiscal stimulus is starting to weaken.

The battle is on. Clearly, low rates in the G3 will have an effect on interest rates around the world. Consequently, price sin the rest of the world may rise even if there is low inflation in the G3. We are already seeing this happen when we look at the inflation difference between the G3 and emerging markets.

The low rate problem will be an issue for any government that is now tracking systemic risk issues. An economy can have asset price inflation even while traditional prices are stable. We have seen that in housing.

While we are in the nervous BIS camp, we still believe there is a need for monetary stimulus and low rates. The near-term harm is low, so we will ride the rate wave until we get a change in sentiment.

Sovereign credit ratings from China's rating agency

China’s Dagong rating agency has moved into the sovereign market with a distinct difference. It has rated the United States at double-A, below China's AA-plus. Also, it rates the UK and Japan come in double-A-minus according to Reuters. While the traditional ratings agencies rely heavily on the country's historical record and culture, Dagong places more importance to growth prospects and the governmental propensity to borrow. Reuters Edward Hadas makes this point: “Supposedly sophisticated Keynesian economists can criticize the mercantilist bias of this thinking, but Dagong may be onto something. Lenders should really prefer countries that are increasing in economic and monetary strength.” Food for thought (or choking) for the US deficit reduction commission.

- Andrew Busch BMO

This is an interesting perspective. Is the ability to pay their bills better in the US or in China? The payment of debt has two parts, the probability of default and the likelihood of payment after default. The first is a function of growth and tax flows. In this case, the US growth is poorer than China. The second is related to the rule of law and bankruptcy. The rule of law has been paramount in the US, but even here there is a level of politics. We do not have to look any further than the bankrupcy issues of Chrysler and GM.

Sovereign ratings have been slow to change. It would be a positive to have more timely market driven ratings. Dagong is headed in this direction. It will be curious to see if others also move to more flexible ratings.

Now that the nuclear option on dollar selling is over, I feel better

China has delivered a qualified vote of confidence in the dollar and US financial markets, ruling out the “nuclear option” of dumping its huge holdings of US government debt accumulated over the last decade.

But the State Administration of Foreign Exchange, which administers China’s $2450bn in reserves, the largest in the world, also called on Washington and other governments to pursue “responsible” economic policies.

From FT

This was never a creditable threat, but no you ave to think through what would happen if they did go in this direction. The real threat is not going nuclear but a low dose of radiation through lower purchases over time. This is more likely and will also have a significant impact. Roll-over risk does not have to come in the form of selling but rather not buying when the bills mature. Declines in trade surplus force a slowdown in purchases. The question for the Chinese is whether on the margin the Us is the bets place to put new funds. The Chinese have been buyers of JGB's. China has a trade deficit with China and has close economic links with its neighbor.

Algorithms/heurisitics - known/unknown risks

It should not be surprising that different decision problems exist once you breakdown the type of problems faced. There is a continuum of knowledge between what we know versus what we do not know. For risk management, this means that some risks are well-defined while other are not so easy to describe For the well-known, we have well defined pay-offs and well defined probabilities for those pay-off. For the unknown risks, the pay-offs are not well-known and the probabilities are not easily measurable.

The type of decision process to be used has to match the information that is available. Decision-makers have to map the process into the amount of information that is know about a particular problem. For those problems where the risks or information is well-know, an algorithm can be used. This can be as easy as following a recipe. When there is a higher degree of unknown risks, it is harder to use a well-defined decision process. Probabilities become more subjective. For these types of decisions, heuristics or rules of thumb may better serve the decision-maker.

For investments, more complex decisions require more discretion and adaptive behavior. Quantitative investing is better served for the knowable risks.

Money, incentives, and motivations - the new complexity

You want someone to work harder offer them more money. Want them to work even harder offer even more rewards. The rational economist will state that every motivation has a price. If someone is willing to work less it is because of the work leisure trade-off. Some makes enough to start to value leisure more.

Daniel Pink's book Drive: The surprising truth about what motivates us looks past the standard rational economic man approach and describes why money may not be the only motivator. In fact, the research is well documents that money does not always make us work harder or think better. It can actually cause the opposite effects. When payment is associated with performance, there are perverse results like less motivation and poorer results. The natural inquisitiveness and desire of humans may be an intrinsic motivator. This is especially true for more complex problems.

While I do not agree with many of his conclusions, the evidence for motivators beyond money are clear However, this does not mean that bonus should be capped or positions. We just have to be aware that rational behavior may put value on more than just dollars. None cash incentives do have value.

Checklists and investing

We are professionals. We do not need checklists to our job. Checklist cut creativity. Checklist force us into routine and monotonous behavior. Checklist may be appropriate for simple tasks but not for such difficult tasks as saving lives in a hospital or investing in the complex securities around the globe. Atul Gawande, a surgeon and author has been pushing the idea of checklists in medical management. His latest book is The Checklist Manifesto: How to get things right. These rules of thumb work. Following a set of procedures with even simple things like introducing all of the team members on surgery can make the difference of life or death. Following the rules of washing hands can make the difference between high or low infection rates.

This idea of of using checklists should also work for investment decisions. There are simple decisions which can be easily followed by a recipe. There are more complicate tasks which may require a cookbook, and here are complex problems where there is limited guide. Investors need to spend most of their time on the complex problems and to do that usually requires following a disciplined approach for the less difficult or routine. Get the simple stuff right. Following a checklist for how you will address more complex problems and use most of your time to focus on those issues which are highly uncertain or unique.

Checklists can be as easy as doing a task and confirming that is done or reading a a task and then doing it. Either way it can marginalize the chance for making simple mistakes. This discipline can save money because tasks are made less emotional and more structure. This should work for everyone.

13 bankers and too big to fail - the problem will not go away

Simon Johnson and James Kwak provide a good history of banking across American history in order to give readers a perspective on how we got to the current environment. They argue that banking has become too large in the United Sates, but this is not a new battle. This power shifting between government and banking has been raging since the the country's earliest history. Historically, the US has never been comfortable with large banks, yet the consolidation and growth has been ongoing to the point that the financial future of America is tied to a mere six large institutions.

Unfortunately, telling us how we got to this point does not mean that we have easy solutions to the perceived problem of a growing banking oligarchy. It is not clear how large is the problem. Other countries have a limited number of banks. Bank failures has been a ongoing problem. Large banks have significant economies of scale. The problem throughout our history is determining how to best regulate banks and how centralized should banking be. Unfortunately , with a limited number of large institutions, there is greater risk of regulators being co-opted by their industry.

The authors do not have good solutions for the "too big to fail" problem. The continuation of privatized profits and socialized risks has not been solved. In fact, current new regulation since the financial crisis only perpetuates or institutionalizes the too big to fail issue. There has been nothing done to reduce the size of large institutions or have them bare the costs of their size. Any increases in regulation can be spread over a large asset basis in ways that cannot be done with smaller institutions. The small will get weaker and the big will get stronger under a protective umbrella.

The financial history of the US is in a state of flux, but it not clear that we will be moving to more decentralized and competitive banking environment.

What does failed intelligence tell us about investing

Problems in decision-making are often universal not just issues for investment professions. It pervades all areas of life where there is uncertainty, limited information, and time constraints. More importantly, the behavioral or psychological problems with making good decision are also everywhere. Behavioral finance and economics is just the application of psychology to a specific social science and is not unique. The biases in economic decisions are found in other areas of decision-making.

The book, Why Intelligence Fails: Lesson from the Iranian Revolution and the Iraq War, by Robert Jervis provides insights on what may be two of the bigger blunder in intelligence and pointedly shows the complexity of making good decisions with limited information. Many would like to believe that these intelligence blunders were simply a matter politics, psychology, and group think. Change the politics and the problem will go away. Jervis an expert in intelligence matters reviews the record and finds that the conventional view of failure are incorrect.

Intelligence problems are more complex because there are a host of decision-making issues. We form plausible explanations given the fact that we have on hand. Those facts are usually inadequate. There usually is an effort to fit a story on what we do know and eliminate the alternatives which do not fit our initial assumptions. The "models" employed can often be flawed because it is not questioned. We are often faced with insufficient imagination, too much certainty, and limitation on the alternative considered. While politics can be associated with the problem, the issue is much deeper and broader within any organization.

In the case of Iran, there were assumptions on mindset of the Shah. He was supposed to be strong-willed and able to make swift decisions. The assumption was wrong. In Iraq, we assumed that it was in its best interest to follow of path of WMD development. Attempts to evade in the past suggest that just because we did not find the evidence did not mean it did not exist. Faulty assumptions.

The same problems of limited imagination exist with investment decisions.

Some interesting quotes from the book:

"If it were a fact, it wouldn't be intelligence" -General Michael Hayden head of the NSA

"We missed the Soviet decision to put missiles into Cuba because we could not believe that Khrushchev could make such a mistake." -Sherman Kent

"Estimating is what you do when you do not know" -Sherman Kent

"There is nothing a government hates more than to be well-informed, for it makes the process of arriving at decisions much more complicated and difficult." - Keynes

The poor state of macroeconomics

Many have written about the poor state of macroeconomics and how it was not able to predict the crisis. I don't think this was as large a problems as stated. Looking at the Taylor rule during the late Greenspan era showed that monetary policy was loose. The result was a bubble in housing because rate weer low. You needed to have innovations like ARM's to capitalize on the low short rates, but the result should not have been surprising.

We have also had bank crises in the past and we know what the impact will be on an economy. If you have one of the largest insurance companies and one of the largest broker-dealers in the world go bankrupt in the same week and you have the largest mortgage market in the world implode with the two GSE's in receivership you should expect a systemic failure.

A more nuanced view on the problem with macroeconomics was stated by Richard Posner. He remarked that the problem is macroeconomics and politics being too tightly interwoven. If you state a set of macroeconomic policies, you can make a good guess on the politics of the economist. The same is true if you start with their politics. The austerity and tax cut camp represents Republicans. The government spending an tax increase camp represents the Democrats. Unfortunately, this simple characterization works.

If you have a strong well-defined science, the models and prescriptions for the economy should be independent of politics. They are not. Of course, it could be stated that there are preference on what is more important, but the basic facts and linkages within the economy should be well understood. Unfortunately, they cannot be divorced from the politics. This is th real problem with macroeconomics. There cannot be agreement on the facts.