China and price controls

When will we learn? China announced earlier this month that they would impose price controls on commodity prices and provide some subsidies to stem their increasing inflation. Inflation has moved to 4.4 percent most on the back of higher food and energy costs. The inflation rate is up only 1.3 percent when food and energy are taken out of the equation.

There has been a clear price shock on food and this has a greater impact on living standards for poorer countries that spend that spend more income on food. However, the textbook response to price controls is clear. There will be shortages and hoarding. This is less likely in a controlled economy but it will still occur. There is a clear reason for why food exports to China have increased.

TIPS and negative yields

TIPS yield have turned negative for about a month. With the expectations of QE2 flooding the market, 5-year TIPS yields now post a negative -.23. You get a 50 bps coupon on the 5-year TIP, but you have to pay a price of 103-05 which means that you will pay the Treasury to hold your money for 5-years.

We know that TIP yields are tied to inflationary expectations. 5-year yields are at 1.51 percent so implied inflation rates are now set at 1.74 percent which is lose to the target rate for inflation at 2%. There does not seem to be a threat of inflation. Nominal yields are so low that you expect to lose on the real returns for these assets. Isn't this what the Fed wants? At negative yields, you will not want to save or hold these safe assets. You will want to buy riskier assets at higher yields or spend the money.

This is a perfect environment for investors to chase yields and create a bubble in riskier assets.

The not so funny comedy of rating agencies and US debt

Dagong Global Credit Rating Co. — the Chinese rating agency downgraded the US from AA to A+

The serious defects in the United States economic development and management model will lead to the long-term recession of its national economy, fundamentally lowering the national solvency. The new round of quantitative easing monetary policy adopted by the Federal Reserve has brought about an obvious trend of depreciation of the U.S. dollar, and the continuation and deepening of credit crisis in the U.S. Such a move entirely encroaches on the interests of the creditors, indicating the decline of the U.S. government’s intention of debt repayment. Analysis shows that the crisis confronting the U.S. cannot be ultimately resolved through currency depreciation. On the contrary, it is likely that an overall crisis might be triggered by the U.S. government’s policy to continuously depreciate the U.S. dollar against the will of creditors.

Ouch. This certainly is a slap at US financial debt management. Where the Fed is not buying Treasuries, (the long-end of the yield curve) there has seen a clear change in trend from the summer with long bond yields up over 40 bps in the last month.

So where are the US rating agencies which have the US at triple-A on this issue?

World Bank's Zoellick and gold as a monetary asset

Robert Zoellick, the president of the World Bank, wrote an article in The Financial Times this week, arguing that it might be time for a new international system of adjustable exchange rates that would use gold as a reference point for inflation and currency values. - from NYT Room for Debate.

It is not clear what the point World Bank president Zoellick was trying to make for gold. holdings Do we want to go back to a gold standard? This would not work and he does not seem to advocate for this type of move. The problems with a gold standard are well known. There is a supply issue and the fact that we would be moving back to a Bretton Woods fixed exchange rate system.

Does gold have a place in portfolios as an alternative store of value. The answer is clearly yes. Gold provides a real asset alternative. As measured by the behavior of many investors and central banks, there is a a demand for a fiat money alternative. Gold, as a store of value, can be what investors want to be a store of value. What is clear is that the world has had enough of fiat money especially if they cannot control it.

A boiling point is occurring with the dollar and this should be a cause for concern. Investors are looking for store of value with stability. The perception is that this occurred under the gold standard. The real price of gold relative to oil, for example, has been relatively stable.The uncertainty concerning the dollar and the size of the US money supply increases the anxiety about holding fiat dollars. Talking about gold just avoids the issues of global imbalances and the value of the dollar.

Oil supply and demand shocks

Hamilton on oil -

Instead attributing much of the historical fluctuations in the price of oil to what he describes as “precautionary demand associated with market concerns about the availability of future oil supplies.” He identifies the latter as any movements in the real price of oil that cannot be explained statistically by his measures of shocks to supply and aggregate demand. Another way one might try to measure the contribution of precautionary demand is by looking at changes in inventories.

...the increase in oil demand is associated with increases in global income levels.

This is an interesting way to think about the oil market. It can encompass the concept of a geopolitical risk premium that is related to holding inventories. Watch to inventories as a means of seeing precautionary demand.

Macro and micro trading in commodities

There is a simple tool used in the stock market to determine whether the environment is good for stock pickers or for macro-traders based on the average correlation of stocks within an index.

The average correlation between stocks is measured through time to determine the type of regime for the markets. When the average correlation for set of stocks is high, it can be viewed as a macro-timing environment. All markets are moving together with a common theme or cause. When the average correlation for the same set is low, it can be considered a commodity pickers environment. Markets are moving independently and do not follow a pattern driven by a single factor.

The height of the financial crisis represents the period of maximum macro-trading. The Great Recession caused all markets to decline and for there to be a liquidity crisis. Correlations all moved closer to one. This is typical of crisis periods. More recently, we are seeing a movement back to a commodity picking environment with correlations declining.There is less correlation across markets because the drivers of return are more localized.

It is now time to be a market picker not just a commodity buyer.

Crude oil as a bellweather for stocks?

There has been a noticeable increase in the correlation between stocks and crude oil. While other commodities have actually seen their correlation with stock decrease, the crude oil - stock relationship has actually increased. This has not been just an event tied with the Great Recession but a correlation which has persisted this year. Without a geopolitical shock, the price of oil will be tied with global income levels which will also be associated with equity moves.

Crude oil and S&P500 do move closely together this year.

	coef. S&P 500	p-value
longest series 1991.01 - 2010.10	0.22	0.00
pre-crisis 2004.01 - 2007.12	-0.30	0.08
crisis 2008.01 - 2009.06	0.63	0.00
YTD 2010.01 - 2010.10	1.08	7.27E-07

Will this relationship continue? History suggests not. When oil prices continue to increase there is greater likelihood that it will start to tax spending in other areas. Additionally, over time there is greater likelihood of a geopolitical risk premium. Oil price shocks are associated with economic downturns.

The network center in international knowledge trade

David brooks provides good editorial called Crossroads Nation

In 2009, Anne-Marie Slaughter, now director of policy planning at the State Department, wrote an essay for Foreign Affairs in which she laid out the logic of this new situation: “In a networked world, the issue is no longer relative power, but centrality in an increasingly dense global web.”

Networking may save the US. We are less dependent on traditional trade through manufacturing, but through trade in ideas and intellectual capital. The transfer of creation of wealth is through the networking of innovation. This networking occurs through the educational system and the free flow of people nd ideas within a common system. In the US this is our graduate university system and the english language. Both allow the free transfer of ideas. Our natins is the crossroads for India, China, and the rest of the emerging markets.

We have to move beyond the manufacturing sector mindset of trade and think more about how to exploit the US as a crossroads nation.

Money fund "micro bailouts" - a negative effect on the credit channel

The SEC is requiring money funds to unveil a net asset value that reflects small previously undisclosed realized and unrealized losses or gins a figure known as the "shadow NAV". Many money funds take loses and gains on individual securities through their trading. Some securities will actually blow-up. All of these price adjustments may have small changes in the price of the money fund. The simplest case is when a securities is sold before maturity at a slight loss. If the loss is not offset by similar gains, there will be a discrepancy with the $1 NAV. Nevertheless, these loses or discrepancies in price may lead to a break in the buck out to some decimal place that will have limited impact. However, there is still a difference in price away from $1.

The SEC'​s New Money Market Reforms explains the current regime, "​In addition, the rule includes certain procedural requirements overseen by the fund'​s board of directors. One of the most important is the requirement that the fund periodically '​shadow price' the amortized cost net asset value of the fund'​s portfolio against the mark-​to-​market net asset value of the portfolio. If there is a difference of more than one-​half of one percent (​or $​0.​005 per share), the fund'​s board of directors must consider promptly what action, if any, should be taken, including whether the fund should discontinue the use of the amortized cost method of valuation and re-​price the securities of the fund below (​or above) $​1.​00 per share, an event colloquially known as '​breaking the buck.'"

This is not a new regulation. Shadow NAV's has been used in twice a year reports to the SEC. The new rules will take effect 60 days after the end of November, with reports starting in February 2011. However, this will make running money funds more difficult and risky. Some funds are getting out of this business and others will have to put up cash to that the shadow NAV does not fluctuate. The impact is that fund companies will have to pay-up for loses.

The bottom line is that a money fund will have to increase its credit quality because it does not want to take the risk of having the shadow NAV fall below zero. Less lending will occur through non-ban sources. The credit channel will be negatively effected and this will affect economic growth.

Leverage cycles, liquidity and anxiousness

The American Economic Review, Fostel and Geanakoplos article, Leverage Cycles and the Anxious Economy provides a good background piece on how markets got into the current financial mess. We are in a classic leverage cycle. This work extends the ideas of Minsky by adding more structure around the idea that leverage follows a natural cycle of increasing extension and then decline. The credit or leverage extension is a result of the increases in prices for assets which are bought on borrowed money. Higher prices leads to more lending with the increased value of collateral. Leverage will increase with price increases. When there is a shock to the price system, there will loans will be called and leverage will have to decline. Like many markets there will be overshooting on the way up and down.

The interesting twists by the authors are to show that leverage cycles are more likely for emerging markets or those that have liquidity constraints based on the lack of general public interest. The marginal buyers have limited wealth and borrow money and are more sensitive to any price shock. They will be more anxious to any price reversal since their purchase was based on borrowed money. These markets, where there is more use of leverage, will be more subject to contagion.

More importantly, levered markets are more likely to have a liquidity wedge between the price willing to be paid. Liquidity wedges based on the differences of opinion between buyers and sellers will lead to more dramatic price changes when there is a change in information. This type of behavior was associated with ABS, CBO's and credit derivatives. There will then be spillover effects to the general economy until the level of anxiousness subsides.

Don't count on the consumer

Excluding the effects of defaults and charge-offs, available data show that non-mortgage debt fell for the first time since at least 2000. Also, net mortgage debt paydowns, which began in 2008, reached nearly $140 billion by year end 2009. These unique findings suggest that consumers have been actively reducing their debts, and not just by defaulting.

“Consumer debt is declining but only part of the reduction is attributable to defaults and charge-offs,” said Donghoon Lee, senior economist in the Research and Statistics Group at the New York Fed. “Americans are borrowing less and paying off more debt than in the recent past. This change, which we continue to study carefully, can be a result of both tightening credit standards and voluntary changes in saving behavior.”

How do you dig yourself out of debt? Stop borrowing money. Consumers are doing their part to right their balance sheets through paying down. This s not from foreclosures and bankruptcy but through making he monthly payments. This will be a natural drag on growth which will lengthen the time before the output gap is closed. Long-tern growth will stay below trend. The only good growth engine will be for a pick-up in exports.

Geithner backs away from current account proposal

Last month Treasury secretary Geithner proposed the idea that there would be current account imbalance targets. Instead of pushing for changes in the exchange rate, there would be a push to reduce the current account imbalance. Deficit countries would try and move to current account balance and surplus countries would try and reduce the size of their trade imbalance. Before the G20 meetings this week-end, Geithner has backed away from pushing the target approach. Clearly, he has not had any takers for his idea imbalances should not exceed 4 percent of GDP.

The drop-back in the position is a result of more push-back n US monetary policy. The US is not thought of as a financial leader. "With all respect, US (monetary) policy is clueless," said Wolfgang Schauble, German finance minister.

Others do not believe the US is clueless, but has fallen into being a a currency manipulator through the dollar decline. The US is extending the currency wars through their excessive monetary actions.

Best investment quotes for the week

The overused phrase that will always get you in trouble. "This time is different" Sir John Templeton. This is always the best quote to use when discussing failure from bubbles. Someone will say "this time is different" when it more likely it will be the same.

"It is a sign of strength not weakness to admit that you don't have all of the answers." John Loughrane.

First law of investing and corollary from Jane Bryant Quinn, "Never buy anything whose price you cannot follow in the newspapers. Don't buy anything too complex to explain to the average 12-year old."

"If everyone is thinking alike, then someone isn't thinking." General George Patton.

Admiral Arthur Radford, former JCS , "A decision is an action you must take when you have information so incomplete that the answer does not suggest itself."

Fed backlash -stop the presses

As an academic adviser on the central bank's monetary policy committee, Xia Bin does not have decision-making power but does provide input to the policy-making process. "As long as the world exercises no restraint in issuing global currencies such as the dollar -- and this is not easy -- then the occurrence of another crisis is inevitable, as quite a few wise Westerners lament,"Xia Bin said.

The G20 has a clear idea what the fed is trying to do. Lower the dollar. This will be good for US exports and for increasing domestic consumption. Domestic prices will be lower and demand may increase if the policy is effective. China and the rest of the G20 is focusing on the dollar decline which they believe ill flood capital flows into their countries.

The Fed is taking heat for their policies because it is not clear QE2 will work. The rest of the world believes they will be the greatest at risk for any failure given a negative impact on the dollar and long-bonds.