Lakewood-Views

Focus on the long-term - forget the news

2012-01-31T08:36:00.003-05:00

Trying to deterrmine what is going on in the world by reading newspapers is like trying to tell the time by watching the second hand of a clock. - Ben Hecht

You cannot help it. Most investors are ffected by the news. If there is good news, you want to immediately go out and be a buyers. If there is bad news, you want to be an immediate seller. Unfortunately, the flow of news is not linear. There will be noise in the information that is reported. News will be subject to revision. It will need to be clarified.

The idea of market efficiency has us focus on immediacy but there is a greater need for a longer term clarity. News must be filtered and placed in the context of a framework or model. Ben Hecht was a newspaperman and if he has problems with the news, you should too.

Local grain effects drive a global market

2012-01-31T08:25:00.000-05:00

There is the adage that all politics are local. This may also be true of commodity markets. The grain markets are a perfect example. In the summer of 2010, there were significant grain shortages because of severe droughts in many key growing areas and strong demand from emerging markets. Russia placed an export ban on grains as it was hit by one of the most horrible droughts in their history. The bottom fell out of the Commonwealth of Independent States as a supplier of export grain when the bans went into effect. World grain importers were sent scrabbling for supply causing even further price increases. Local effects have global implications.

In the 2011 period, there was a complete turn around in the fortunes of grain. Exports from Russia have surged from 4 million tonnes in 2010 from the previous year of 18.6 million tonnes. Now exports are back up to 14.8 million tonnes and growing. However, there may be a cap on how much will be exported as importers destock.

Supplies are up from the lows of two years so the local growing success of key regions has translated into the global market. There is a reason to focus on local events.

IMF does not want to be left behind at the liquidity party

2012-01-29T22:20:00.002-05:00

The IMF is seeking a bail-out fund of $500 billion from central banks. This would be a $300 billion addition to the $200 billion that eurozone countries pledged last month. The US stated that it would not participate in this fund increase. The money will have to come from emerging market central banks.

This fund is supposed to be used mainly for the Eurozone itself. The need for emerging markets to participate is an interesting twist to the bail-out process; however, the focus is clearly on having more liquidity resources. How can the IMF be a player if it does not have the resources to provide money?

Add more money to the gobal financial markets. Who does not want to be at this money punch bowl.

Natural gas production responding to low prices

2012-01-29T22:07:00.002-05:00

ConocoPhilips has said it will cut its North American gas production by 4 percent and shifted resources to oil. Chesapeake Energy announced earlier in the week that it will reduce production by 8 percent and divert drilling to oil. Nevertheless, there are limits to how much production can be cut. First, natural gas is often found with oil so as long as oil prices are high, gas will be produced. Second, many wells are drilled and produced under partnerships so there has to be agreement with partners to shutdown. The partner's economics may be different so that their desire may be to continue production.

Well production is not like a factory which can just be closed. The likelihood of an overshoot is not just a thought but a reality.

Central banks continue to explode balance sheets

2012-01-29T21:55:00.002-05:00

The big central banks of the G10 have exploded their balance sheets and this will continue in 2012. They will continue because there are no other options. The liquidity will continue until it works.

Their timing has been different but the action has been the same, increase the assets. Balance sheets increased in 2008 in response to the crisis, but the liquidity added to financial markets has continued everytime there is a hint that more liquidity may be needed through poor economic numbers. The Bank of Japan has been the exception in terms of size but even here the balance sheet is significantly larger than 2008.

The Bank of England has tried to reduce its assets after the crisis but turned to two large jumps in assets in 209 and again in 2011. The US has followed two rounds of QE and is on the verge of undertaking a third round. The Fed will be hard pressed to not take action now that it has a 2% inflation target and prices have started to move lower. The most interesting case is the ECB which has adhered to their inflation target goals in discussions but have actually show to be the largest quantitative easer based on its loan portfolio. You don't have to buy government bonds to increase the balance sheet. It can come in the form of loans to the tune of $650 billion in three year paper. The ECB is forbidden from financing governments but no one said anything about the banks. They have also negotiated dollar swap lines which also provide liquidity. The ECB is every much the easer like the Fed and Bank of England. In fact, we should see the ECB become the ultimate quantitative easer before the year is over.

Sniffing out the capital flows - use the dogs

2012-01-29T21:34:00.001-05:00

Recent news story suggests that Argentina is using ink sniffing dogs, golden retrievers to stop a dollar outflow by the wealthy. You have to do what you can to impose capital controls. The purpose is to keep dollars from leaving the country and cause a depreciation of the Argentine peso. The history of Argentina has been closely linked to the dollar when there was convertibility to stop inflation. Many have dollars held in safety deposit boxes and many exports of commodities are paid in dollars.

This is just another form of financial repression which will continue as governments try and control wealth flows to pay for their deficits.

Doves eat the hawks over monetary policy

2012-01-29T20:35:00.001-05:00

The Fed's policy announcement of a 2% inflation target and guidance that rates will stay low through possibly 2014 tells us the doves have eaten the hawks of the Board of Governors. It could have been worse with another round of QE immediately taking effect, but it is clear that the Fed is willing to pre-announce that deflation will not happen. This should not be a surprise. It also should not be a surprise that 2% is the target given it has been the de facto target for inflation across the developed world. If we have a 2% inflation target and near zero rates, it locks in a negative real rate of interest for an extended period.

What should investors do? Borrow more money and lever up the portfolio, yet it is not clear this is what we want for the macroeconomy. I thought we wanted consumers to save and reconstruct their balance sheet. A negative real rate means that pensions will be destroyed at a fixed rate of 2%. So let's redistribute wealth from savers to borrowers. Who knows where this is gong to take us. There will be greater distortion in the markets over the next two years.

Origins of contango and backwardation

2012-01-27T11:42:00.002-05:00

We often use terms without understanding their origin. I recently had a question on the origin of the contago and backwardation. Their origins are not related to futures trading at all.

The term originated in mid-19th century England^[12] and is believed to be a corruption of "continuation", "continue"^[13] or "contingent". In the past on the London Stock Exchange, contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.

Like contango, the term originated in mid-19th century England, originating from "backward".
In that era on the London Stock Exchange, backwardation was a fee paid by a seller wishing to defer delivering stock they had sold. This fee was paid either to the buyer, or to a third party who lent stock to the seller.
The purpose was normally speculative, allowing short selling. Settlement days were on a fixed schedule (such as fortnightly) and a short seller did not have to deliver stock until the following settlement day, and on that day could "carry over" their position to the next by paying a backwardation fee. This practice was common before 1930, but came to be used less and less, particularly since options were reintroduced in 1958.

Farm land bubble

2012-01-24T17:08:00.001-05:00

Cheap farm credit is available and this may lead to a bubble. If rates are cheap and farm prices are high, then farmers will borrow money. Farmer borrowing is not for seasonal buying of seed but to expand their farming through buying land. The government may be a primary cause of this potential bubble through the Farm credit system. The farm credit system makes government subsidized loans no different than Freddie Mac and Fannie Mae in the mortgage market. Its policy goal is to provide funding for farmers. It is the same system that needed to be bailed out in in 1987 after the farm crash in the early 1980's.

With farm prices high and few alternatives viable for lenders in the commercial and residential real estate market, money has flowed to the farm sector. Providing money to farmers seems like a good bet in a rising price environment but the seeds of destruction are being planted when the money is used to further lever the balance sheet of farmers. Land prices go up. New equipment is bought. It also seems like a safe bet for farmers because interest rates are so low, but a decrease in prices will make it harder to refinance in the future. This will not be a short-run problem. Farmers should be able to make interest payments at these low rates, but roll-over risk in a falling price environment is real.

Policy uncertainty and employment

2012-01-24T16:51:00.001-05:00

from "Economic Policy Uncertainty and Small Business Expansion" by Mark E. Schweitzer and Scott Shane in the Fed of Cleveland Economic Commentary

The policy uncertainty measure is also a monthly measure. It contains three components. According to its creators: “One component quantifies newspaper coverage of policy-related economic uncertainty. A second component reflects the number of federal tax code provisions set to expire in future years. The third component uses disagreement among economic forecasters as a proxy for uncertainty.”

The components are weighted as follows: 50 percent on the news component and 16.67 percent each on tax expirations, forecaster disagreement about the future CPI, and forecaster disagreement about future federal expenditures.

We believe that the Baker, Bloom, and Davis measure accurately captures policy uncertainty for several reasons. First, it looks reasonable. The measure increases in response to events that most observers believe have increased policy uncertainty and decreases in response to events that most observers think reduced that uncertainty. In addition, the authors show that other measures developed using the same approach accurately predict other types of uncertainty, such as financial uncertainty. Finally, the measure predicts changes in several measures of economic activity, such as employment and GDP.

The uncertainty index provides a good measure of what risks businesses and investors are facing at this time. This uncertainty story that business have avoided investing has been an argument that has been used for some time but has not been quantified. If there is a high degree of disagreement, then there is less likely to be investment funds committed. The uncertainty is often associated with key risk periods but the index shows an extremely high level over the last three years and has not fallen like other periods of uncertainty.

The persistence of uncertainty is creating a global drag on employment and investment markets. This will only be cleared up if there more focused policy proposals.

Facts and opinion

2012-01-24T08:47:00.004-05:00

The Moynihan Principle -The late senator from New York once said that everyone is entitled to his own opinion, but not to his own facts.

One of the issues with we have learned form behavioral finance is that there is disagreement on the perception of what could be considered facts. As important there is disagreement on facts mean or the linkage between a given fact and what it may been about the future. The facts are often not in dispute, it is their meaning.

Macro policies as experiments

2012-01-16T11:47:00.001-05:00

Martin Wolf's January 3rd FT editorial "The 2012 recovery: handle with care" makes clear point that many of the policies that have been followed over the last decade are experiments. Some have failed and some have been successful but they are experiments nevertheless. Financial deregulation was an failure. Housing based recoveries were a failure. Driving rates to near zero pre-2008 was a failure. The injection of public money was a partial failure. The cuts in budgets to stem the sovereign budget deficits are not done. The re-regulation of banks is a work in progress. Currency union is not working well.

Policy failures should be expected. The issue is whether we accept these actions as experiments that may fail and require new options.

The shadow banking system as savior

2012-01-16T11:35:00.002-05:00

The shadow banking system, non-bank lending institutions, was viewed as a problem in the 2008 crisis, yet now it may serve as the savior of the financial markets. Shadow banking is now back to pre-2008 levels and as banks exit markets, it is the shadow system of private equity, hedge funds, and money market funds, which is offering lending facilities.

Regulators and policy-makers want banks to shrink but lending is till the life blood of any economy, so there will be new institutions to take the place of banks. Banks have a high cost structure and are not able to make their spreads given the flattening of the yield curve. Shadow financial intermediaries are not subject to Dodd Frank and Basel III.

In the short-run, this will serve as a safety value for those who need funds, but in the longer-run, regulators may lose the control that they desire.

Grain stocks up - rationing works

2012-01-16T10:52:00.001-05:00

Supply and demand does work!

When prices go higher, there will be demand rationing as clearly note in the USDA higher than expected stocks number last week. When corn prices were above $7.5 per bushel last June buyers back-off. This process actually started the previous year since prices were at record levels in 2010. Demand cuts do not respond immediately, but companies start to look for substitutes and start to squeeze out every last ounce of production. Innovation takes hold and works. The food inflation of last year around the globe is down.

Global consumption is still had high levels and this is not going to change. Price levels will be remain high but a one direction market is off the table until we see developments in the Midwest weather pattern for planting. Corn around $6 per bushel is more likely than any extremes from last year.

China inflation down - stimulus should be up

2012-01-16T10:39:00.002-05:00

Chinese economists may view their work as policy-makers as an engineering problem. This is not dissimilar to the optimal control school of economists in the pre-rational expectations era. Of course, they have a greater degree of control than current Keynesians. What this means is that if we get a slowdown in inflation, there is more room for stimulus from the Bank of China.

Inflation is moving lower in China given the decline in food prices. Food is a more important component in their inflation index. The supply shock of 2011 is starting to be reversed. This leaves room for more aggressive growth policies, or at least this is the hope from the rest of the world. Every central banker is now looking to a,lowering of inflation which will give them the green light for stimulus.

Refiners follow global growth

2012-01-16T10:31:00.003-05:00

Oil refiners are still a local business. If there is a slowdown in the OECD growth rates, there will be increases in idle capacity. All of the new capacity growth will be in the emerging markets to meet their demand. The rationalization of refining market will lead to future volatility if there is an increase in growth. Unlike crude, it is harder to move refined products around the globe especially if margins are weak. The movement of product means that there can be increasing volatility as shortages or bottle-necks will create price spikes.

China demand still key for 2012

2012-01-16T10:23:00.003-05:00

China demand was still strong in December with trade data showing copper imports hitting record levels and increases in demand for both oil and iron ore. Copper demand was up 47 percent to over 500,000 tonnes. China is the world largest consumer of copper, coal, and cotton to name just a few commodities. Of course, the Chinese seem to have gotten fairly smart about when to enter the market. They are looking for weakness to be buyers. The Chinese are also looking to further develop pricing power through commodity futures markets.

China can produce a floor on commodity. They will not be able to stop a price decline, but if the Chinese provide stimulus to their economy there will be a direct impact on commodities which will be much larger than anything that will happen from the Fed. To be a commodity analyst, you have to be a China macro specialist.

Natural gas bubble?

2012-01-16T10:16:00.004-05:00

Natural gas has fallen 32 percent in the last year and now trades below $3 mBTU. Cold weather this week-end will not help the market. The hort-term demand of turning up the thermostat will not solve the problem.

Pricing moving to the marginal cost will not help the market either. Even with price at marginal cost, there are other liquids coming out of the gas wells as the by-product sales make pumping still profitable. Rig counts are down but each rig is able to get more through advanced drilling techniques. Production in the US is at all time highs and foreign companies want into the US market. There is just no place to put the gas.

Demand will increase but not quickly enough. LNG is a possible but there will be a fight as industrial companies who like cheap gas do not want to see this production input move into the global market. The only way this problem can be solved if there are companies which go out of business and there is market rationalization. This has the marks of a bubble.

Language and the Euro-zone crisis

2012-01-15T22:17:00.004-05:00

Article in the FT 1/12/12, "Greeks and Spaniards line up to learn the language of Goethe" is telling of one key monetary union issue. To solve the problem of unemployment across countries within the Euro-zone, there has to be mobility between countries so that there can be equalization of employment. Labor has to move to low unemployment regions. The southern unemployed have to move to the key northern, German, regions.

This labor movement is restricted when there is a set of countries within a monetary zone which do not have common language. There cannot be the free movement of labor like the free movement of capital when there is a language barrier. If those who are unemployed can learn languages, then there can be the potential for labor movement. This is not going to solve the Euro-zone problems but it clearly shows what is one of the key impediments to labor problems across countries. The unemployed know it and are trying to address it through private means.

Disconnects by the decade - economics missing some big moves

2012-01-15T21:59:00.003-05:00

It seem as though each decade faces some key risks which the markets get wrong. If you are able to forecast correctly what others miss, you will be able profit handsomely. The six decades could be characterized as the following:

Underestimating fixed exchange rates - the 1960's. While Bretton Woods international financial system does not fail until the early '70's, the problems of fixed exchange rates and inflation start to develop great fractures in the global economic system during this decade. The dollar dilemma becomes evident.

Underestimated inflation - the 1970's. The commodity supply shocks coupled with loose monetary policy lead to the Great Inflation and stagnation of the '70's. The destruction of fixed income investments and poor equity returns lead to a defensive decade.

Underestimated the Fed's fight of inflation - the 1980's. The tight monetary policy from Paul Volcker with the deregulation revolution were the highlights of the '80's Still breaking inflation and the long bond rally made all the difference for the decade even with the '87 crash which was not a long-lasting drama.

Underestimated of market resilience and the Great Moderation - 1990's. The emerging markets saw large market failures in '94 and '98. The European and sterling managed floats were destroyed, but the real story was one of Moderation and success. However, the decade ended with the internet bubble. The key issue was the macroeconomic complacency that monetary and fiscal policy could solve all problems.

Underestimated mortgage risks, bubbles, and the Great Recession - the 2000's. The first decade of the new century was one of deflation fears which led to the mortgage bubble. Deep business cycles were thought to be a thing of the past given the views developed surrounding the Great Moderation. The end result of policy complacency was the failure of '08.

Underestimated sovereign risk - the 2010's. The current decade will be the destruction of the risk-free asset concept. The idea of market safety assets will end and a new era of financial repression will take hold of the globe.

Fed's interest rate forecasts - will this help?

2012-01-15T16:40:00.001-05:00

From its next meeting at the end of January, the Fed will replace its current guidance of exceptionally low interest rates “through mid-2013” with interest rate forecasts from each Fed policymaker for both the end of 2012 and the “next few calendar years” after that.

http://www.ft.com/cms/s/0/0d81397e-3646-11e1-9f98-00144feabdc0.html#ixzz1iyCXSVGB

The Fed has announced that it will produce interest rate forecasts starting with the next Fed meeting. This is close to announcing an inflation target since nominal rates are just combination of real rates and expected inflation. However, there is more to this than just an surrogate inflation target. There will be a real component that this consistent with its dual policy mandate. It is true that the Fed has not been a good interest rate forecaster and they have not been able to target longer-term rates with any consistency so there is a danger here. The market may perceive they have more power than it actually has at meeting its forecasts.

It will be interesting to see what they will do to actually reach or meet their forecasts. In fact, there is a key distinction between forecasts and targets. It is clarity between forecasts and targets which will be the most important information necessary for the markets. what happens if there is forecast error? How will the Fed adjust? These are issues that need to be addressed soon. It is not clear this will help the markets.

Tight fiscal/ loose money - policy mix of the year

2012-01-15T15:43:00.002-05:00

There are certain policy mixes that dominate in any given period. Most countries are following the same combination, loose monetary policy and tight fiscal policy. This is especially true of developed countries. The result of easy monetary policy is that real rates are being taken to negative levels in an effort to reduce or eliminate the fiscal drag from tight government spending policies. Additionally, the loose monetary policy offsets the large budget deficit problems as negative real rates reduce the cost of budget deficits. This places a negative bias to currencies relative to those countries which follow a different mix and a positive bias toward commodity prices. Bonds will do well as rates are pushed to further negative levels. Equities will be mixed because of the offsetting policies in fiscal and monetary policy. Of course, this a dangerous policy mix because there is potential for higher inflation when economies improve or fiscal policy becomes looser.

The US is following a relatively loose monetary policy which is on the cusp of having another round of quantitative easing. The fiscal side is tightening even with large budget deficits because the stimulus of 2009 has run out. The Euro-zone clearly has a tight fiscal environment to stem the tide of debt downgrades and large budget deficits. The ECB is engaged in a non-announced QE program with strong lending facilities for banks. This will be further loosened if they announce a program of QE. The UK has continued to follow its tight fiscal/loose monetary combination. Japan has tightened ineffective fiscal policy with the monetary policy that should follow further easing. The emerging markets are starting to loosen and have not generally followed easing fiscal policy.

The net result may be slower growth with ambiguous currency markets. Currencies will not able to provide the boost expected if all countries are following the same mix.

German short rates negative

2012-01-12T12:59:00.000-05:00

The German short-term ates have turned negative sending an important signal on credit risks in the Euro-zone. Market rates have been negative since before Christmas but now the German government can auction bills and receive the full benefit. When rates turn negative it is not a positive signal of economic or financial health. It is saying that investors in the Euro-zone do not want to hold cash instruments in other countries at any cost. They do not wnat to hold it any bank in Europe. They are willing to pay the German government to hold their wealth. It also states that there are limited opportunities in Germany.

This is flight to safety taken to the next degree.

Currency intervention in 2011

2012-01-11T08:45:00.000-05:00

Currency markets faced a higher level of intervention than what we have seen in years. Governments are more nervous about their export business and the quality of the global economic recovery. It was surprising how little intervention occurred in 2009 and 2010 even with the comments that we will be entering currency wars, but we are now facing a higher degree of government intervention. It is taking more complex forms instead of outright purchases or sales of currencies. Governments are more willing to use tax policies and capital controls to control exchange prices. The devil will be in policy details.

Irving Fisher and the debt crisis

2012-01-02T18:20:00.001-05:00

Irving Fisher was dismissed during the Great Recession because he made the statement that stocks were at a permanent plateau right before the stock market crash, yet he was one of the most insightful economists on debt cycles.

It is good to review some of his comments on debt deflation which was summarized in his article, "The Debt-Deflation Theory of Great Depressions," Econometrica, 1(4), pp. 337-357

“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.”

“Theoretically there may be — in fact, at most times there must be — over- or under-production, over- or under-consumption, over- or under-spending, over- or under-saving, over- or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.”

In summary, we find that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds; (2) among the many occasional disturbances, are new opportunities to invest, especially because of new inventions; (3) these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness; (4) this in turn, leads to attempts to liquidate; (5) these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owed shrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors; (8) the ways out are either laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place."

The North-South connection for grains

2012-01-02T18:16:00.000-05:00

The most important driver for grain and soybean markets now is not what happens in North America but what is happening in South America. Brazil and Argentina have become key producers in not only wheat (Argentina) and soybeans (Brazil) but also more recently in corn. Argentina is now a major producer of soybeans with 19 million hectares versus 2 million hectares of corn. The size of the LA agricultural market is growing.

Corn production in Brazil and Argentina now total 90 million metric tonnes versus the US of 312.7 million metric tonnes. LA is still a fraction of the US but the number is growing and becoming the key marginal corn producer. For soybeans Brazil and Argentina produced 127 versus 83 million metric tonnes for the US last year.

Dry and hot weather related to El Nina has interrupted the growth cycle of both corn and soybeans. The chart shows why gthe winter months is such a key time for these crops. This is coming at a critical time and will be the driver of prices now but will spill-over to planting intention in the Spring. If the LA crop is poor, more planting will be made in the Midwest. The North-South connection is now the key driver of corn and soybean prices.

10-year anniversary of the euro

2012-01-01T11:16:00.000-05:00

We celebrate the 10-year anniversary of the Euro with thoughts of its potential break-up. Survey show that the people of the euro-zone are in not in favor of it. Governments need to change it and businesses are bracing for a break-up. There is no party.

Was this a failed experiment? Yes, it was an experiment that went too fast and too far over the last ten years. Greece never should have joined. The same applies to Portugal and Spain. Italy should have been disciplined early and there are question as to whether Ireland should have been kicked out. Ireland in a normal world should have been attached to sterling. It would have been better to start with something smaller or even with two currencies. The flaws are now well-known but the solutions require a level of political support which may not be possible. The euro is stronger than expected from its inception but it just does not seem like this is a decade worth celebrating.

Bond vigilantes and timing

2012-01-01T08:56:00.001-05:00

"Who stands at the gates of Rome? Not the Etruscans, who tried to bring the tyrannical King Tarquin back to the city. Not the Carthaginian general Hannibal, whose crossing of the Alps with elephants seems as impossible today as it did to the Romans of 218 B.C. Not the Vandals or the Visigoths, who sacked Rome in the empire's declining days. None of them, nor any would-be German emperors from the so-called Holy Roman Empire. Not Napoleon or any other French commander with imperial aspirations. Not the horde of bureaucrats from the European Central Bank and the International Monetary Fund. And most definitely not the imperial democrats currently leading Germany and France. Today, the civilized people are at the gates of Rome. Unrecognized as saviors, the bond vigilantes are demanding the keys to the Eternal City. If the Italian people are very lucky and very wise, they will allow themselves to be ruled by the bond market." - Thomas Donlan

The quote above is a great way to express the importance of bond vigilantes. Have they helped the Eurozone with their actions? Absolutely. without the bond vigilantes little action would have been taken, but we also have to remember that vigilantes of today were also the buyers of bonds yesterday. The bond buyers allowed Greece to get in its current shape. The banks were the key lenders to Ireland, Spain, Portugal and Italy. They allowed bubbles to occur in the first place. Vigilantes would not exist if there was not an extreme situation which could be addressed through normal means.

While I approve of the need for bond vigilantes to force good behavior on governments, it is the timing that is a major problem. Vigilantes usually come late in the process. They react to a problem that is at an extreme and do not prepare for the future. The willingness to wait creates the problem for markets because by the time the vigilantes start to engage, there will be clear losers; those who are not actively engaged in the process.

Vigilantes would not be necessary if the law was enforced. Vigilantes only exist because there is a failure by governments to use regulations early. Vigilantes are only necessary if the majority are too timid or passive to address the problems that are building.

The timing of vigilantes will be based on their market power and the power of regulation is to thwart the impact of bond vigilantes. this is the objective of financial repression. The government has to try and minimize the impact of private resources to raise interest and impose discipline on governments. The delay of bond vigilantes to have an impact on markets is related to the force of governments to protect themselves from market signals.

Financial amnesia and the need for financial history

2012-01-01T08:55:00.000-05:00

CFA UK discusses costs of financial amnesia. This is a very important lesson for all of the quant technocrats who have invaded Wall Street and London. There are few who can name any of the past financial crises that have befallen Wall Street.

From CFA UK's Response to the Joint Committee on the Draft Financial Services Bill:

Financial amnesia is when financial market participants forget or behave as if they have forgotten the lessons from financial history. Financial market participants are composed of two main groups, regulated financial firms and regulators. Despite the history of bitter experience, the same mistakes occur with alarming regularity (see Appendix 1). The three key lessons that participants appear to forget are:

Lesson 1: "Innovation", the illusion of safety and "this time it’s different": "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version" (Galbraith).The expansion of credit plays a key role in fuelling "innovation" while the creation of an illusion of safety results in a "this time it's different" approach that enables the continuation of unsustainable activity and risk taking. Sadly, each time it is always the same and never different.

Lesson 2: Regulated financial firms are prone to failure: It has been presumed that regulated financial firms by acting in their own self interest and in the interests of their shareholders, impose market discipline. History has demonstrated that because failure to impose market discipline is not uncommon, over-reliance on market forces can be misleading.

Lesson 3: Ineffective regulation. The frequency of market failure places a greater onus on the regulator to be more effective in encouraging and imposing market discipline. Sadly, regulators focus on the symptoms of failure rather than its root causes. Furthermore, regulators often ignore the root cause of their own inability to act promptly and thereby contribute to the risk of systemic governance failure.

It used to be that Wall Street was run by the liberal arts majors of the Ivy League but now the engineers and economics majors rule. There is nothing wrong with economics majors except that thy have focused on quantitative skills over liberal arts and social sciences. Engineers have never been taught the value of history as part of their education. There is only so much time for study but history in finance and economics has not been given any value. Being trained in the late 70's and early 80's, I can say that there was no required course in economic history.

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith

from the investment blog

"Progress is cumulative in science and engineering but cyclical in finance." - Jim Grant

The three lessons from the report are important, but the most important lesson may be that extraordinary profits will eventually be taken out of the market.High returns or profits cannot continue forever. History has proved that high profits from innovation cannot last and competition may mean that the initial or first mover may not be the one who is able to gain all of the profits. High returns can exist for short time periods but cannot last forever.

The key to innovation is that even though it may occur throughout industries and in finance the behavior of investors is still fairly constant. Innovation in finance has increased speed of communication, but not what is communicated or how it is interpreted. Innovation has increased with new financial products, but that does not mean that behavior has changed. Markets are still ruled by greed and fear.

While these ruling factors of greed and fear may not be historical, we come back to the fact that events that occur in finance follow a similar pattern. In the simplest framework, bubbles do occur. The type of bubble may be due to new innovations which may to some make this time different, but bubbles do occur regardless of what we have learned. The laws of economics still prevail. If there are extraordinary profits in some new industry, there will be new entrants and these new entrants from increased competition will force down the prices of overvalued companies.

Lesson 2 may not be that regulated firms are prone to failure but that all firms are prone to failure regardless if they are regulated. The markets are dynamic and those firms that do not change or adapt will be failures if there are regulation. Regulation may slow the process and it may change the mix of failures but it cannot top unprofitable firms that do not have a good business model from continuing.

Lesson 3 is not that regulation is ineffective but that its objectives may not be well-defined or the objectives may be set to solve problem that does not exist. Put still differently, the law of unintended consequences is such that a regulatory solution may create new problems that did not exist before. We may also find that the intent of regulation may be very different from what it turns into years later. The problem of mission of yesterday may be changed for something different years later which creates the chance for failure.

History is a necessary part of finance even if it just used a a form of validation of theory.

Predicting with the right question

2012-01-01T08:44:00.000-05:00

What surprises do you anticipate in the coming year? And the columnistreplies, smiling to avoid seeming snarky: If I anticipated them, they wouldn'tbe surprises. A better question is this: Where is the conventional wisdom mostlikely to be wrong?

- Dave Wessel WSJ December 29th

Beating conventional wisdom or thinking through where average opinion is wrong is the key to success in any investment area. The rational expectations schools states that, on average, the markets get it right. But, on average does not mean that it is always right or that some may be better at forecasting than others. This is the basis for thought on rational beliefs. Current predictions are based on rationality bit that does not mean that these forecasts will be correct. Conventional wisdom is based on rational thought but it should provide returns that will be average. Above average returns have to be based on non-conventional thinking.

Wildest currency prediction for the new year

2012-01-01T08:41:00.000-05:00

In France, the European Central Bank's Christian Noyer defended the currency union, saying the euro could yet become the world's leading currency if leaders of the 17-nation bloc succeed in tightening fiscal integration.

"In 10 years, maybe the euro will be the world's number one currency," Noyer said in an article for Journal du Dimanche to mark the 10th anniversary of the launch of euro notes and coins.

- NYT January 1 2012

What is this central banker thinking? This could be the wildest prediction for the new year given what has happened in 2011 and the continued negative view toward the Euro. Could the Euro become a strong currency? Yes, but it will only happen if there is major restricting which may not include all of the current 17 countries in the monetary union. A more likely scenario is the ascent of the yuan. It is not clear that tightening of the fiscal union will solve the problem if there is not a major move to austerity. The union is not the problem. Spending is the problem.

Still a EU current account deficit problem

2011-12-26T18:59:00.001-05:00

The EU debt problem will not go away because we still have not solved the current account deficit problem. The fiscal deficit was not a problem for many countries before the crisis. The public debt also was not a problem for many countries.

Again, the fiscal balances and net public debt would not be good predictors of the crisis, but the current account deficits tell most of the story. Here is where the problem exists and this means that countries are dealing with a competition problem. What is missing in any discussion is what will be done to make Greece more competitive in the EU marketplace. This is not happening because real wages will have to decline and many services will have to be privatized. This is not as acceptable as the pain of dealing with budget deficits.

Debt adjustment is painful - ask Latin America

2011-12-26T18:49:00.003-05:00

"They don't know how to suffer" Ernesto Zedillo, former president of Mexico.

Latin America has gone through debt crises and hyperinflation. It has seen "lost decades". The process that surrounded these debt crises seem to be playing out in Europe. There is the period of "extend and pretend" but ultimately we get to the point that there is no success without pain. Europe may not be able to take the pain so the final solution may be much worse.

The tail of the trade - EU imbalances

2011-12-26T18:08:00.001-05:00

When you strip away all of the other issues, the financial imbalances is still the problem in the EU and this is a problem of national interest. Germany has to be willing to provide funds and/or take the financial hit for the impact of past lending.

Let's start with the simple fact that foreign, private and government imbalances all have to sum to zero. Before the crisis, fiscal imbalances were normal, no large differences, but current account imbalances were very significant. The private surpluses of some countries were used to finance the deficits of others. When the surplus countries stopped providing funds, the capital importing countries were left with the problem. They have one of two choices, get competitive and grow, or go into recession and cut the value of assets. Government deficits are used to help with the transition but it may never come. Hence, there is the threat of bankruptcy. The private lenders, banks, will have to provide the transition and this means a decline in their capital from restructuring.

Nobody talks about Japan - there is a reason

2011-12-26T17:55:00.001-05:00

The story with Japan is not much better than what is seen in the EU or the US. The trade balance has turned negative which only occurs when there is a global recesison. The large manufacturers business confidence index has also turned negative. The BOJ has downgraded the growth prospects for the economy in the wake of the earthquake in March. Japan is aging and having a flat-line for grwoth. No help for the global economy here.

China is still the key to commodities

2011-12-26T17:31:00.001-05:00

The macroeconomics say that you should not hold commodities in 2012. The headwinds are strong, but you have to adjust to China demand. China just keeps consuming. Over the first decade of of the century Chinese demand for many commodities has jumped:

oil +92%

copper +296%

soybeans +146%

cotton +96%

This demand will not go away even if there is a slowdown in Chinese growth in 2012. Prices have moved up over the last decade so a fall will be in the cards if demand slows, but this should only be temporary. The other issue is that if the other BRIC countries are also growing which collectively adds to commodity demand. Simply put, the demand from the rest of the world will drive commodity prices not US or EU growth. For example, US demand for oil has been stable at a little over 19 mm bl/day while global demand has moved from 65 to over 70 mm bl/day.

Commodity investing is becoming another form of emerging market investing. Notably, commodity investing has outperformed emerging markets stocks significantly this year.

Negative views on Europe

2011-12-26T17:29:00.002-05:00

"Zombification of European economies, sovereign states, banks and financial instruments"

- Gerge Magnus UBS economist

FT headline discusses "Top Manager fears debt 'Crescendo', comments by Doubleline Capital chief Jeff Gundlach, the year's best fixed income manager. He is expecting a fall in 2012 so you better hang on to your dollars. "Capitalism without bankruptcy is like Christianity without hell" Frank Borman quote used by Jeff Gundlach.

This should be the year that the euro fell. There seems to be little to stop the process. Growth is not going to be the savior and taxes will not solve the problem. Restructuring, which means a hit to debt-holders will be the solution.

Africa a bright spot in growth

2011-12-26T15:28:00.001-05:00

There has been so much focus on the lack of growth in developed countries there has been little time spent on the growth in Africa which continues to shine. The growth in Africa outside the sub-Sahara has been generally above 4% and has reached level above 8% for a number of countries over the last four years.

A significant part of this growth is associated with the general increase in commodity prices, but there has strength in many sectors with productivity gains significant and income distribution differences closing. The largest concern is that a decline in commodity prices will lead to an African slowdown; however, there is more investment dollars spent in the last few years to offset a flat price environment. There are still many problems but there is the chance for real gains for the population if this growth continues. Africa is still a small portion of world GDP but growth in this part of the world is not something to ignore.

1930's again - yes says Lagarde

2011-12-16T17:25:00.000-05:00

"There is no economy in the world -- whether low-income countries, emerging markets, middle-income countries or super-advanced economies -- that will be immune to the crisis that we see not only unfolding but escalating,"

It is not a crisis that will be resolved by one group of countries taking action," she said at the State Department in Washington. "It is going to be hopefully resolved by all countries, all regions, all categories of countries actually taking some action."

If the international community fails to come together as one, the risk is economic "retraction, rising protectionism, isolation," Lagarde said. "This is exactly the description of what happened in the 1930s, and what followed is not something we are looking forward to."

IMF Managing director Christine Lagarde

Read more: http://www.upi.com/Business_News/2011/12/16/IMF-head-World-faces-1930-type-Depression/UPI-83971324024200/#ixzz1gharW2RA

Hard to be optimistic with this kind of forecast from the IMF.

The advantage of asset allocation over hedge funds

2011-12-13T11:11:00.001-05:00

During periods of high uncertainty the combination of stocks and bonds may outperform hedge funds. 2011 will be case in point where a simple allocation of 60% equities and 40% bonds was enough to outperform most hedge funds.

US debt deleveraging at slow pace but it is happening

2011-12-12T14:10:00.002-05:00

The deleveraging of the US economy is occurring but the pace is slow. We have seen total debt to GDP hit a four year low to 340% versus a high in the first quarter of 2009 of 373%. Household debt has moved from a peak of 135% at the end of 2007 to 119% currently.

Much of this debt ratio has fallen because there has been retrenching by everyone during the post 2008 fall-out. There have been defaults which cut the debt levels. This has been a significant but negative development. Those who have jobs are cutting back, but more needs to be done. The issues is that it is not clear what the right level of debt to GDP is necessary or appropriate for the US economy to grow at trend. Additionally, when there are negative rates of interest, there actually is little incentive to pay-down debt. The price of money is cheap.

We are below trend and have not closed the output gap. If spending is not undertaken by debt, then there has to be an increase in real wages and productivity to get us back to trend. As predicted by most economists, when dealing with a balance sheet recession, the revival of an economy is a slow road.

The euro is weakening on ECB monetary policy and this is good

2011-12-12T10:40:00.002-05:00

One question has been why the euro has stayed relatively strong through the EU debt crisis. The Euro has fallen since the highs of the year, but euro looks like ti will end the year close to where it started the year at 1.32. Versus the Swiss franc, there is also minimal change versus the strong euro decline in the summer.

The discussions of the dismantling of the euro should have had more far-reaching impact on the currency. Some of the support is technical as flows from banks move back to Europe, but a second reasons has been the strong supportive policies of the ECB, With interest rates higher in the EU and the ECB being less clear on their willingness to open up the printing presses. there has been greater monetary support of the euro.This as changed with the policies of President Draghi who has moved to cut rates and provide better financing to banks through lower collateral.

Trichet moved rates higher in April and July from 1 to 1.5 percent. Draghi has reversed that increase and is expected to have further cuts in the first quarter. The differential between the US and European is closing and the rationale for holding euro high quality paper (if there is a such a thing) has declined.

Looks like the year of the dollar is more likely.

ECB Draghi plays hardball with Europe

2011-12-12T10:29:00.001-05:00

Comments from ECB president Mario Draghi shows that he will adhere to the mandate of the ECB whether for better or worse.

"...the method by which money is being channeled to European countries should not obscure the fact that the treaty says no monetary financing to governments."

"...role in a sense of the guardian of stability..."

He is unlikely to bail-out governments in the near-term.

Serious financing problems at EU banks

2011-12-12T08:19:00.000-05:00

There is a serious funding problem with EU banks and it is not getting better. This is the key problem for the Eu and we will have to come to grips with the choice of whether this is a liquidity or a solvency issue. We already know the answer - solvency. All that bad debt is not going away and investors have choices.

Three month euro/dollar basis swaps have moved from inside -50 bps to over -150 bps before the announcement of the currency swap arrangement between central banks. It is still had high levels over -100 bps. The three month Euribor-OIS spread which is another measure of bank risk is still at approximately 80 bps when most of the year it has been between 20 and 35 bps. The ECB lending to banks is also soaring to above 8 billion euros. There have been moves to relax collateral requirements and cutting initial margin from 20 to 12 percent. The ECB is also allowing more term funding.

The issue is whether the ECB actions are too late. Of course, there can be improvement in the fiscal situation but a European slowdown will only make matter worse and cutting rates another 25- 50 bps will not solve the problem. Banks need recapitalization and it will not come from private sources.

Financial repression for bond buyers

2011-12-11T22:20:00.001-05:00

The most important credit- fixed income meme is the idea of financial repression as a solution for the sovereign debt crisis. It is can come in many forms but the easiest is for governments to keep real rates below zero. Debtors are a beneficiary if the rate of interest is anything below the growth rate in the economy. So we get the central bank to lower rates below the inflation rate. We get negative real rates.

Additionally, we get coordination between the fiscal authority and the central bank. The central bank can buy debt directly and print money. The coordination of the US Treasury after World War II pegged rates to the wartime levels. The Treasury-Fed accord of the 50's ended their coordination but then rising inflation cut the real value of the bonds. The bondholders were the losers and the government was able to being down the debt to GDP levels which reached highs above 120 percent of GDP.

Finally, we regulate banks to keep rates low and make sure that alternative investments are expensive relative to Treasuries. These policies work. They are part of our financial history. It would be very simple to bring them back. Wait we may have already.

Basel rules may be a cause of the current debt crisis

2011-12-11T21:45:00.001-05:00

The capital haircuts for banks will cause portfolios to be skewed in directions that may create risk as well as cut risk. Government bonds have the lowest capital risk weighting. For your home country bonds government bonds are assumed to be risk-free assets. What do you think banks will do? they will load the boat on the risk-free assets even when they have risk versus other assets. Government bonds cannot default because governments have the power to tax. How is that working for Greece and Italy? How about the low risk weightings for mortgages? That did not work very well.

The Basel risk-weighting for sovereign debt is a form a financial repression by governments. By maintaining the fiction that government bonds are safer, they force banks to hold risky assets which they should not. The governments have unwilling but large buyers of their debt. Government bonds may not have significantly more risk than corporates in many cases but banks will not be allowed to decide on those risks when the capital charges are different. Even if the market prices the government debt at a higher yield there will be an incentive to hold the risky debt. What happens now that S&P places so many sovereign on credit watch in the EU? We will have to rethink the idea of government risk weighting. This issue should not wait.

The battle between creditors and debtors

2011-12-11T21:32:00.001-05:00

The debt crises around the world is just a continuation of the battle between debtors and creditors except everyone cannot be a winner in this war. Debtors through at optimism take on too much debt. When their optimism is not realized, they would like to a redo and relieve. That may be fine except the creditors want their money. It is that simple and it has been occurring for centuries. This was problem with the Greta Crash. It was a problem with the oil price shocks. It was an issue with Bretton Woods. It is the focus of all bubbles. (see Paper Promises: Money, Debt, and New World Order by Philip Coggan)

The debtor/creditor battles are not just fought in the banks and in the courts. It is also inherently political. There will usually be more debtors than creditors. the money interest who serve as creditors will be vilified. The rules will have to change to allow for debtors to gain their footings. This is the true nature of populism in elections. We see this being played out in the US with occupy Wall Street and the demonstrations in Europe. The solution will lead to a new order especially with the governments being the ones who are the debtors. The battle of creditor and debtor will be played across the globe between nation-states which will effect the state of globalization.

Getting tough on EU deficits - we have heard this story before

2011-12-11T19:34:00.001-05:00

Markets rallied on the news that the EU is going to get fiscal discipline and provide more help for deficit countries. This is an early Christmas present but it is not clear it is going to last. This is like going to one of those great Christmas parties with lots of cheer only we wake-up the next day and realize we still have to go to work and our co-worker's behavior is still the same.

Le's not forget that the euro-zone governments have self-imposed budget deficit limit of 3% of GDP. This was an important part of the Maastricht treaty. If they followed their targets then the sovereign debt crisis never would have happened. Now the same governments that did not follow their own rules will now get some of that old time deficit religion. Hard to believe. There are reasons why the 3% rule was silly to begin with. It did not allow for large recession where deficit financing could be used to help the economy. Still we are ask to have faith in those who have never followed the rules.

The euro-zone has a whole has not met the 3% rule. The Euro-zone as a whole as a deficit to GDP of -4.1 percent. Out of 17 countries only five are meeting their obligations for 2011. They are Luxembourg, Malta, Germany, Finland and Estonia. Only Luxembourg, Finland, and Estonia have met their obligations over the entire time of their entry in the EU.

Austerity is the talk of Europe but creditability may be more important.

CME and renminbi collateral

2011-12-11T19:26:00.001-05:00

While the focus has been on MF Global, the CME announced that it will allow the Chinese currency to be used as collateral for futures. Symbolically this is very significant. The center of financial trading capitalism will say that a controlled currency can be used to meet margins. This shows how far the renminbi has come and how powerful the Chinese economy and financial system is to the global finance world, but it does seem odd that a controlled currency that does not freely float can be used as viable collateral.

The old game between Saudi's and Iran's oil interests continues

2011-12-09T14:00:00.001-05:00

Reading the book The Oil Kings: How the US, Iran, and Saudi Arabia Changed the Balance of Power in the Middle East by Andrew Scott Cooper it is obvious there is a strong rivalry between Saudi Arabia and Iran to determine who will be the driver of OPEC and the lead regional power. This rivalry is being played out once again in current oil price dynamics.

Saudi Arabia has increased their production, the most in 30 years, to offset any disruption from the Arab Spring as well as any embargo on the Iranians by the EU. Saudi production is above 10 million barrels a day with latest reporting showing a 1.3 million barrel increase form earlier in the year.

OPEC is having their meetings on December 14th and it is unlikely that they will agree on production quotas. Saudi's increased production over the objections of Iran and five other members in June to offset the shortfall in Libyan production. OPEC Production is close to 3 million barrels per day higher than the total target. Everyone in OPEC is a cheater realtive to their targets.

If there is an EU boycott from OPEC's second largest producer there will still have to be purchases made from other countries. The EU accounts for 18 percent of Iranian exports with Asian accounting for the bulk of the Iranian oil sold. Of course, more oil will go to Asia, but the adjustment process can have an impact on prices in the short-run. By producing more the Saudi's do not allow any disruption in oil to convert into greater Iranian revenues which can be used to enhance its regional power. A key policy objective for the Saudi' is to use oil policy to maintain political pressure on Iran. Nevertheless, the impact of an EU boycott is very dangerous to oil markets and will increase the risk premium in these markets.

The shifting geopolitics of oil - the best rocks at the best terms

2011-12-09T12:58:00.001-05:00

The oil world for the last 40+ years have been driven by a search in the Middle East and emerging markets. The cheap oil was outside the politically stable developed world. Cheap oil made the political risks of working in difficult regions of the workable, but the oil dynamics are changing. Political risk has not decreased in many high reserve countries. The cost of oil in these countries are on the rise, but most importantly, the increase in reserves in many developed countries have changed where drilling capital will be committed.

The reserve increase is a direct result of technology. This is the cornucopian story which we have discussed. Innovation will drive real prices. There is natural cycle. As the cost of drilling increases, both actual and political, there will be a change in behavior toward technology and investing. Money will be placed in R&D to reduce production costs. If these technologies are sound, there will be a shift in investment focus. the same will occur with investing around the world. Higher political risks will reduce the amount of investing in any country or region. The fact that many of the cheap sources of oil are controlled by state oil companies makes case for why private companies are moving back to the developed world. Put these two together and you will find that new technology will increase reserves in previously expenses areas and lead to the shift away from politically risky areas.

The technologies of has lead to the vast developments of oil sands, shale gas (fracking), deep water drilling and shale oil through horizontal drilling. The developed world and places outside the Middle East are where new reserves are being found. Australia is becoming a leader natural gas developer. Canada now is second in reserves. The US may become a natural gas exporter. Brazil may become an oil and gas powerhouse in Latin America. The story of oil is - "go west"

All eyes on the ECB?

2011-12-09T12:56:00.001-05:00

The fiscal side of the EU is stating that they have done their part to solve the debt crisis. We have heard that before, but the burden now seems to be shifting to the ECB to take more action. The ECB has lowered rates and have offered some extra liquidity provisions. This may continue over the coming weeks as the central bank determines the market reaction to any sovereign debt deal.

It seems as though the ECB does not want to be dragged in to a solvency policy and will continue to behave like a lender of last resort. All of this makes sense. To early a provider of liquidity will not force other contingencies to develop; however, the current difficult situation of European banks is still growing and being too late to adapt monetary policies could actually be the ruin of the euro.

How do you use data for investment decisions?

2011-12-09T12:42:00.001-05:00

He (Robert Gates) wasn't an investment person, he admitted, but he asked whether the data I had just presented as a reason for my bullish outlook was data that I had selected because it supported my theory. Or was it data that I consistently tracked, hoping to detect signs of change?

from Reading Minds and Markets by Jack Ablin

I have to highlight this passage from Jack Ablin book from a few years ago. It is very important to think about whether we are using or marshaling data to support our view or whether we are drawing conclusions from data that we look at on a regular basis. The right answer is that the data tells the story, but human nature often works in reverse.

Monday - S&P sovereign ratings massacre threat

2011-12-05T16:32:00.001-05:00

S&P issued a sovereign ratings massacre threat as the rating agency has placed all 17 euro nation under review for possible downgrades. There are six AAA-rated EU countries that have been placed on negative outlook. In a highly political move, S&P sends a signal that if something is not done with controlling debt, countries will lose their ratings. While those countries that have lost their AAA ratings have seen large changes in their funding costs, this will be a significant wake-up call of Germany and France to reach some type of debt arrangement and broader fiscal union.

" All Europe all the time" - quote on the investment news focus

2011-12-05T14:41:00.001-05:00

The quote was from Vince Reinhart the new chief domestic economist for Morgan Stanley.With all eyes on the finance ministers, the ECB, and EU presidents, there is little effort being placed on what is going on around the globe. The usual information transmission has been from the US to the rest of the world. Lead relationships both from the central bank and economic announcements came from the US. The ECB took their lead from the Fed. Equity prices often would reaction to US numbers. This has changed significantly with gap risk between the close and open in the US being more important than in the past. Work flow has to now include a greater European component.

Currency swap lines from central banks come to the rescue

2011-12-02T17:09:00.001-05:00

A coordinated effort by six central banks worked to ease funding tensions with European banks through bilateral swap programs so funding could be provided if needed through February 2013. Interest rates on borrowing costs from central banks fell about 50 bps based on the news. The impact on stocks was immediate as the idea that central banks will stand ready to flood the market with liquidity has reduced funding pressure. The dollar dropped hard in response to the the new liquidity. It eased the pressure by European banks to find dollars.

Under the arrangement, similar to programs initially set-up in 2007 and used periodically over the last four years, the Fed will swap dollars (lends) to other central banks which will then lend the money to banks in their countries.

The Fed has an incentive to do this because a decrease in lending within the US by European banks will have a credit crunch effect on the US economy. The swaps were done at flat currency pricing so there is no exchange risk to the Fed. The foreign central bank will only pay interest to the Fed for the length of the swap.

The funding pressure on EU banks has increased as their institutional dollar funding sources have dried up. Money market funds and other banks do not plan to fund EU banks given their higher risk assessment. These banks have significant dollar assets which have to either be sold or funded. There is a clear credit crunch going on with European banks as they tighten credit for anything except funding at home. It would be natural during a crisis that financing will be focused in the home country.

The ECB has already seen an increase in their 7-day financing operations to European banks. At 265 billion euros, it is at the highest levels in two years.

The good news is that liquidity is going to be provided. The bad news is that liquidity is needed and there may be a growing solvency problem with EU banks.

China within the global crisis

2011-11-28T09:31:00.001-05:00

China's Vice Premier Mr Wang issued a bearish forecast, saying he is "certain, among all uncertainties" that a long term global recession is going to happen, that it will be "chronic" and China, which relies highly on external demands, must see the situation clearly and focus on domestic problems (Reuters)

China will have to move on its own and not be dependent on global growth to drive their domestic growth.
This is a strong comment from China. It suggests that domestic growth will be a priority since there is a strong likelihood of global recession. Will this mean a more isolationist economic policy? We will have to see, but the three pillars of economic growth, the US, the EU, and China all look weaker than six months ago.

Greece failure - happy holidays?

2011-11-27T13:58:00.001-05:00

There is in my opinion a very high probability that within weeks, or months at most, Greece will be forced to freeze bank deposits as a prelude to leaving the euro. Mexico in 1994 and Argentina in 2001 chose the Christmas/New Year holiday season to announce their devaluations. Will Greece follow suit?

“If history repeats itself,” footballer Andrew Demetriou once pointed out, “I should think we can expect the same thing again.”

from Michael Pettis Will Greece unravel by Christmas?

It seems likely there will have to be more action taken and the holidays would be a perfect period to get the action and word out without a major market malfunction. A break-up is a possible and it is the logistics which may be the hold-up.

FAO - there is confusion in commodity markets

2011-11-27T09:40:00.001-05:00

The impact of uncertainty in commodity markets is strong. If there is greater price volatility, it will be harder to plan for next year's production. The cost of production will also fluctuate with the price of energy. The cost of buying seeds will also be less certain. Even if prices have fallen from their highs, there is uncertainty with what should be the right crop mix by farmers which creates an impact on food security as reported in the latest FAO study. The impact on certain regions such as Africa are significant. The impact of food price variability is much stronger on the poor because they spend a significant greater portion of their income on food.

Confusion and uncertainty is never good for both consumer and producers of food.

Sugar and corn connection

2011-11-27T09:40:00.000-05:00

"Corn andsugar are becoming increasingly linked in the global markets, something thathas implications for the prices of both commodities." from Agrimoney

Sugar is used as a sweetener and bioethanol simialr to corn. Hence, there is a substitution between these two crops that did not exist in years past.

It may not show-up in short-term correlation but the relationship between corn, sugar, and oil is going higher. The cost of production in corn is more driven by oil. The output is oil driven. The same is true of sugar.

The role of corn as a sweetener is also increasing. Corn syrup has been a cheap substitute for sugar. This relative cost will create a further link.

Solvency not liquidity

2011-11-27T09:39:00.002-05:00

"Four years into the crisis it is surely time to accept that the underlying problem is one of solvency not liquidity – solvency of banks and solvency of countries. Of course, the provision of additional liquidity support to countries and institutions in trouble can buy valuable time. But that time will prove valuable only if it is used to tackle the underlying problem.......But the underlying problems of excessive debt have not gone away. As a result, markets are now posing new questions about the solvency of banks and indeed governments themselves." Mervyn King, Governor of the Bank of England, 18th October 2011.

The balance sheet recession needs liquidity to provide for the fluid transfer of assets, but it cannot solve the recession. The problem is still solvency and that requires time and effort by both government, consumers, and businesses. The cost is lower spending in order to pay-down debt. The can be write-offs which will be helpful only to the extent that the borrowers have a higher propensity to consume and will not make the same mistakes again. Lenders will be hurt which has a direct wealth effect. Governments have to cut services. Businesses will have to delay investments.

Governor King has it right. Liquidity buys time but does not fix balance sheets.

Information and attention

2011-11-27T09:39:00.000-05:00

Herbert A. Simon's 1971 thoughts on the economics of attention: "What information consumes is rather obvious: It consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention, and a need to allocate that attention efficiently among the overabundance of information sources that might consume it."

This has been one of the more interesting quotes that I have read in the last few months. It was picked from a thoughtful article in the Journal of Finance called "In Search of Attention". This is a very innovative research piece which tries to measure the attention that is given a specific stock based on the number of hits on google. The authors find that the stocks that are given more attention will rise and that there will be a subsequent reversal. The important point is that the world of investing is overloaded with information and that investors have to learn or allocate time to any piece of information. If there is more information available, there will be less time that can be spend on any given piece of information.

"A wealth of information will create a poverty of attention." Search is one of the key activities in economics. Search is associated with attention. Attention is a scarce resource because there are limits to the amount of cognitive resources we can use at any one time.

Our attention will be focused on the "chunky news", news that will come with multiple headlines. A specific news topic like the EU crisis will have chunky news. Limited attention will lead to category-learning. (See the research "Investor Attention, Overconfidence, and Category Learning".) Investors will often allocate more time to market and sector-level information instead of firm specific information. Investors who focus on category information will often be overconfident. The overconfidence problem is more severe in diffuse tasks that require difficult judgments and do not provide good feedback. The feedback is noisy and delayed. This can represent macro information when trying to project onto firm-specific behavior. When we have more category information, we will also focus on more firm-specific information. When macro data is easy to obtain, we will then go for more specific information.

One of the reasons why I focus on models is that it can reduce the attention problem because the model will force the focus of attention to key economic variables. While this can cause problems, there will always be a specific amount of time spent on looking at key linkages.

Sherlock Holmes and investment judgment

2011-11-27T09:37:00.001-05:00

"It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts." Sherlock Holmes

Holmes would have been a great investor and provides useful information for any decision-maker.

Low yields and the end of money funds?

2011-11-27T09:37:00.000-05:00

The low yields on money funds are forcing more investors to move out on the yield curve to longer-term bond funds, but these funds do not provide risk-free rates of return. This is changing the risk profile of investor's portfolios and killing an industry. Investors will be taking on interest rate risk that they never expected with their money.

Money market funds cannot compete under this environment and the result will be money flowing back to banks and way from what has been called the shadow banking system. This could be what regulators and government wants, but it will change the forms of financing and will reduce the potential supply of loanable funds. The cost of business will go up for those borrowing money and the rate of return for investors will go down.

Fed as thermostat?

2011-11-27T09:22:00.001-05:00

"The Fed thinks they are playing with a thermostat - the house is too cool so we dial it up a little bit, now it's too warm, so we dial it down," Rickards said. "In reality, they are playing with a nuclear reactor. If you get it wrong, you're going to have a meltdown." - James Rickards author of Currency Wars in NYTimes interview

Rickards, the author of Currency Wars, may be extreme but the idea that monetary policy is a thermostat has been applied to central banks for decades. The idea that the Fed could control interest rates was applied as optimal policy during the early 1970's. The result of research shows that lags, feedback and expectations make trying to control monetary policy difficult. The result was a movement first to monetarism through long-term control of the money supply and then to inflation targetting. We have now moved back to the idea that central banks should control the thermostat and this places a new, but actually old, burden on the central banks. Precise control of monetary policy is dangerous. Asset markets can actually see more volatility given this desire for control.

Gas shortages in the Middle East?

2011-11-23T14:09:00.000-05:00

According to David Barringer, Oil & Gas Leader, Ernst & Young MENA, "While the energy strategies adopted by some countries in the Middle East may help improve their energy independence in the longer-term, in the short-term the region's requirements will also have to be met by imported gas."

There is growing talk that there are natural gas shortages in the Middle East as demand for power has increased. What if there is a natural gas shortage? Or what if there is less gas available for export to other parts of the world? The oil politics will change and the idea that we are ready for a new age of natural gas will only be a good news story.

Gas is supposed to grow at over 6 percent while oil usage may only grow at 2%. 41% of the world's proven reserves are in the region, but 73% are located in two countries Qatar and Iran. Qatar has a current moratorium new filed developments until 2014. There is not an even mix of supply across the Middle East. There are now problems with power and industry usage have to fight for access to natural gas. This is occurring in Kuwait with industrial demand actually falling over the last few years.

The gas bubble in the US is not shared with the rest of the world.

Is there a risk-free rate of return?

2011-11-23T13:48:00.000-05:00

It has always been the case that there is an explicit risk free rate of return for benchmarking performance. It has usually been Treasury bills for the US and short-term rates for domestic G10 countries, but it is becoming clear that in the 21st century there will not be a risk-free rate. There is no meaning to the concept.

The idea is a risk free rate of return is even odder for the EU where there is now a differential between the pay-off of bondholders with a provision of the latest sovereign debt bail-out. The private investors will not get 100 cents on the dollar. They have to take a haircut, but government lenders will receive all of their principal.

A decade ago there was talk that there would be no risk free bonds available to investors. Now there is no risk free asset. There is no greater change in financial markets.

Private equity real estate or farmland?

2011-11-23T12:00:00.000-05:00

Dr. Keith Black of the CAIA Association says for many investors, farmland falls somewhere between real estate and commodities.

"It’s basically private equity real estate,” he explains. “You have a farmland manager who acquires and manages the property for investors in a private partnership for maybe 10 years, owning and operating the farmland. But farmland responds differently to inflation than an office building does. Unlike the fixed leases and maintenance and depreciation costs on an office building thatmake it more like a 10-year bond for investors, with a value that declines with inflation, farmland isleased in one year cycles with income closely correlated to crop values. And you don’t have the depreciation and maintenance you see with real estate.”

World Agriculture Investment Conference October 4-5, 2011

There are significant differences between commercial real estate and farmland. It is simplest to start with supply and demand. Commercial real estate is sensitive to new construction. The supply will grow with construction and fall with depreciation and usage. There may a limited number of good properties but new supply can be be introduced to the market. That is not the case for farmland. There is limited number of acres of farmland and the supply is decreasing with urban sprawl. Farmland is also depreciating because of erosion and soil usage. The supply for new farmland will not get larger. Marginal land could be added but the size is limited. Switching of crops is also possible but again swithcing is limited.

Cash flows will have differences. Farmland will also be more sensitive to commodity prices because lease rates are reset every year. Farmland will also be affected by farm margins, so input costs are more important. This would be the equivalence of maintenance on a building. Farmland has higher risks in the short-run because weather will have a significant effect on the ability to pay leases. Prices can rise but if the quantity is reduced on your specific farmland, the value for income production is lower.

Real estate and farmland should be viewed as separate assets. Farmland is a commodity income and long-term price play and would be different than a commodity or commercial real estate venture.

The changing complexion of farmland

2011-11-22T14:46:00.001-05:00

In 1982, 94 percent of the state's farmland was owned by people who lived in Iowa, according to data compiled by Iowa State University.

But that resolve has waned. When the U.S.'s rural economy eroded in the wake of the 1980s farm collapse, many families encouraged their progeny to leave the land and find their economic fortune in America's cities.

The kids left. Many of them they stayed away. As the years passed, that familial loyalty to the land faded.

Today, about 20 percent of Iowa farm land is owned by people who don't live in the state, according to Iowa State University data. The average Iowa farmland owner is a single woman - often a widow - who is over the age of 70.

from reuters story

The family farm is going away and the land ownership is moving to larger wealthier farmers or land corporations. Will this lead to better farmers? Unclear. It will lead to more opportunities to own land as piece of the production process.

We are running out of soil

2011-11-22T13:57:00.001-05:00

“Taking the long view, we are running out of dirt.” —David R. Montgomery, geologist

"The estimate is that we are now losing about 1 percent of our topsoil every year to erosion, most of this caused by agriculture," said David Montgomery, a geologist at the University of Washington and the author of the book "Dirt."

Jeremy Grantham, the curmudgeonly head of the money manager GMO, wrote about soil depletion in his last quarterly letter. “Our farmers are in the mining business! Yes, the soil is incredibly deep, but it is still finite.”

“Globally, it’s clear we are eroding soils at a rate much faster than they can form,” notes John Reganold, a soils scientist at Washington State University.

There are many reasosn to be worried about the future of agriculture and soil as well as water are near the top of the list. The National Academy of Scinces states that we are losing soil 10 times faster than replacement. The UN would argue that the lose rate to replacement is even higher. It takes 2 bushels of soil to produce one bushel of wheat. The top soil is only about three feet deep around the world so erosion can have a significant impact. The replacement is only about 1- 2 inches per 100 years.

This is not an issue that will effect prices in the short-run, but it will have long-trerm effect and suggests that holding agricultural assets will be a good long-term play.

Central-bank bail-out through buying government bonds

2011-11-22T12:45:00.000-05:00

Let's make this EU crisis hand-wringing easier. Just bail-out the governments by having the central bank buy government bonds. This is the historical tried and true method. Of course, if it gets excessive their will be strong inflation, but this is what governments want anyway.

The interesting comparison is between Britain and Spain. Britain looks like it has a worse gross debt problem and has a similar problem with the budget balance. There is, however, a significant difference between the interest rates that they pay. The British rates are around three hundred bps lower because liquidity can be provided by the central bank through the purchase of bonds. There is less of a risk premium with funding because liquidity can be provided. Given there is a output gap, there is little reason to worry about inflation today so liqudity is still the key consideration.

The latest speech by ECB president Draghi suggests that he is, like other central bankers, are looking for ways to avoid using liquidity in the short-run to solve fiscal problems. There is a clear bias to have the fiscal ministers provide a solution and holdback liquidty as a last resort.

Berkeley Earth confirms warming

2011-11-12T22:48:00.001-05:00

The Berkeley Earth Surface Temperature Group has done an outstanding job at providing a stronger statistical foundation for measuring the historical global warming. One of the largest problems has been the diverse data used to make judgments on global temperature changes. The data has multiple start and end dates. Multiple sites and measurement techniques. The data are from various research sources with different time lengths and reporting stations. They have been able to blend 1.6 billion records from 15 different data sources.

There is the potential for significant error in the data so that false conclusions or counterarguments can be used to draw different conclusions. The Berkeley group uses new methods to fill in the gaps and smooth the rough parts of the data. They are able to draw similar conclusions as other scientist but with greater strength from the data. Global temperatures have increased about 1 degree C since the 1950's. Even though some areas (about 1/3) have showed cooling, 2/3rd of the sample station showed warming and the overall result is consistent with the finding of other researchers.

The implications are strong. We can expect more warming and more weather volatility which will translate into greater commodity risk.

Sargent and Sims win Nobel prize in economics

2011-11-12T22:44:00.001-05:00

Thomas Sargent at podium and Chirs Sims standing to the left.

Thomas Sargent and Chris Sims have truly had a strong impact on macroeconomics over the last four decades. Sargent drove the rational expectations revolution while Sims provided the econometric firepower to get us to understand the implications of shocks to an economy. There is not a macro economist alive today that has used or discussed their approaches to economics. You may not agree with the rational expectations revolution, but you have had to understand it and debate to be considered a serious economist. There have been excesses within rational expectations which are still being dealt with. Shocks will have real effects but the expectations change the behavior of economic agents. Building large econometric models to explain the behavior of an economy will never be done like efforts in the pre-RE environment.

Chris Sims will have as strong an impact as Sargent because techniques can be applied by all schools of thought. Sims, through vector autoregressive models, VAR, focuses on the impact of shocks to the economy. We can now measure shocks through time and see how they will play through the economy. Every econometric course focused on macroeconomics will have to learn the techniques of Sims.

We congratulate both for having a profound change on economics.

The deflation fear bias

2011-11-12T22:38:00.001-05:00

Central banks seems to have a significant almost primal fear against deflation. Central banks believe they can control inflation but they do not have good strategies for dealing with deflation. With deflation, there is a strong decline in financial assets and bank stocks. There are further declines in housing values and overall wealth.

There is no money illusion when there are price declines. Tangible assets clearly will be worth less and all borrowers will be negatively affected. Borrowing or leverage becomes more dangerous. Perhaps more clearly, there is a fear of asset price deflation by central banks which is much greater than any fear of general price increases. Is because central banks are part of the creditor class? Hard to say. It is also unclear that central banks are able to control inflation. Look at the periods of hyperinflation. What is clear is that deflation cannot be easily solved and will have a strong wealth effect and central banks want to avoid this problem at all costs.

La Nina is expected to be back - look out commodities

2011-11-12T22:11:00.001-05:00

Weather is still one of the single greatest impacts on commodity supply. La Nina, the little girl, will again create cooler than normal temperatures in the Pacific Ocean. This will lead to above normal rainfall in south-east Asia and eastern Australia. There is also a higher risk of tropical cyclones in the Pacific. The northern US will be wetter while drought will continue in the south. The southern hemisphere growing regions of Latin America will also be drier than normal.

The impact will be strong on grains and cotton in the US and a greater chance of spring floods. There will be heavy rains for coffee in central America, but dry conditions for the soybeans and corn of Brazil and Argentina.

The weather is not supposed to be as severe as the La Nina of 2010-2011 but we can expect that there is again potential for extremes. This will place added stress on those markets which have low inventory to usage.

Who really controls oil markets? - not speculators

2011-11-12T22:05:00.001-05:00

When we look at global oil companies and interesting dichotomy exists. The largest oil firms are not private but state companies. In fact, the top ten oil companies are owned by governments. Exxon Mobil comes in at number 11 and Lukoil is at 15 in size. The next two private firms are at 19 and 20, respectively Royal Dutch Shell and BP.

So how can speculators control the price of oil markets when the largest firms are all in the hands of governments which may not have the same objectives as private firms own by shareholders and required to maximize profits?

State control of oil is the greatest danger to the oil markets.

Financial repression and asset allocation

2011-11-12T21:39:00.001-05:00

Carmen Reinhart and M Belen Sbrancia have provided a strong argument that finanical repression will be a solution to the government debt problem. They define three characteristics to financial repression:

1. explicit or indirect caps or ceilings on interest rates;
2. cresation of a captive domestic audeince for government bonds;
3. direct ownership of banks or management of financial institutions.

The objective is to get real rates low, so the cost of debt is low. Financial repression is an alternative to pushing economic growth or engaging in surprise inflation. Of course, growth should be preferred solution but governments have a hard time figuring out how to support private growth.

If this is the case, any portfolio based on holding fixed income as a safe asset will be a true danger. The real rates will eventually move higher and if there is ainflation or a loosing of the repression, there will be further reasons for not holding bonds. Real assets will make sense in this type of environment so there is a reason to hold commodities which may not be encombered like fixed income assets. Equities will be mixed. There would be limited reasons for holding financial assets, so banks and other financial itnermediaries will not do well.

Farmland - the next bubble?

2011-11-12T12:45:00.000-05:00

Farmland - "the dark-horse bubble candidate for the next decade " Robert Shiller.

This is an interesting analysis from a leading bubble and housing expert. Still the economics are very different. There will not be any great increases in farmland at any time in the future. Housing can be built. This is not the case for farmland.

The best land is already being used. Any new lands are marginal and have highe risks. Any uncultivated farmland outside the US is also declining. The best land in Latin America is also in production. The best land in New Zealand and Australia which has limited political risk also has been put to use. The only new land that could be employed is in Africa and the "stans". The long-term play is very strong; however, the short-run could be more diffcult.

With price highs in grain hit earlier this year, there is a greater chance of margin compression in the farm industry. Debt levels and interest rates are lower than the last timewe had a US farm land crash, but the price of farm land is still tied to the prices of commodities. Unfortunately, the talk of a bubble is based on the the delinking between land and prices. The growth in land prices has moved ahead of commodity prices and does not reflect the volatility in commodity prices. This is the basis for the bubble story and the reason for short-term caution.

The change in oil geopolitics

2011-11-12T12:22:00.001-05:00

The reserves in Canada are growing as higher prices make tar sands more viable. Deep water off-shore in Brazil should be huge albeit expensive and hard to reach in the short-run. Mexico may see greater drilling to offset the poor US regulatory environment. The US nautral gas business is exploding with new reserves. The rest of Latin America will see more reserve growth.

If all of this comes to reality, there will be a change in the geography of oil. The center of the energy industry will start to move away from the Middle East. The long-term implications are significant. The Middle East will become less important to the US. The political risk of oil will decline. The chance of disruptive policy shocks will decline.

Euro resilience - what will it take to fall?

2011-11-12T12:16:00.001-05:00

With all of the problmes in the EU, it is surprising to not see the euro fall further. It has moved from highs of around 1.50 to 1.35 against the dollar. We saw the euro fall to the 80's in the initial post common currency period. The euro may fall apart yet the delcine is trvial relative to bond prices and equity markets. What gives?

Rates are higher than in the US, but this seems to be silly reason to hold euros. We expect the ECB to be looser and we also expect fiscal policy to be looser to meet the fiscal shortfalls across the EU. The US is having problems, but we should expect a stronger desire for dollars, or almost any G10 currency.

Liquidity like water - necessary for financial growth

2011-11-12T12:04:00.001-05:00

Liquidity is the core issue with the EU crisis. It is like water, a necessary condition for growth in agriculture. The funding cosst are getting tighter. There is a water/liquidity shortage.

The only marginal provider is the ECB and we are unlikely to see then act until it is almost too late. Bid-ask spreads are increasing for all government bonds. Fewer institutions want to make markets or hold inventory for trading. Banks want to get soereign debt off their balance sheets. The Fed has had to provide dollar swap lines to help out EU banks. The lending facilities by the ECB are starting to expand again like earlier in the debt crisis.

The EU needs liquidity in the short-run not restructuring of debt. The restructuring pushes the problem forward but may not solve the liquidity issue.

The Italian job in finance

2011-11-12T11:57:00.001-05:00

The Italian job was a great caper movie about stealing gold in beautiful Italy. I was fun but in the final failure. We will see the same thing happen as the Italians try and steal liquidity from the rest of Europe. At about 125% debt to GDP and rates now at 7% for 2-year bonds, there is little room for a successful solutions. The movie had the stars balancing on an edge of a cliff trying to make off with the gold. The situation is a simialr cliffhanger and PM Berlusconi is unlikley to be as lucky as Michael Caine.

Cannot make money trading currencies if there is no return difference

2011-11-12T11:26:00.001-05:00

This has been a frustrating year for trading G10 currencies because there is little differntial between the strongest and weakest currencies in this group. DB has measured the difference between the strongest and weakest at 8% instead of a normal 23%. The current issue with currency trading is just getting the dollar direction right, nothing else.

Rate differentials are low and intervention has been used to stabilze rates, so it is not clear whether this current tight differential environment will change. We do not like this environment because it places execess emphasis on the flight to quality - risk/on risk/off trade.

Can the US export economy be sustained?

2011-11-12T11:20:00.001-05:00

Exports as a contributor to the current business cyle is better than at any time in the post WWII period. The idea of having a weak dollar to foster export growth has been working even with the flight to quality to the dollar over of the EU crisis.

Exports for the US are diversified and not EU dependent. Our key trading partners are still Latin America and Asia, but we are still dependent on overall global growth. If the rest of the world slows, a weaker dollar may not be enough.

Inflation is not going away

2011-11-12T11:11:00.001-05:00

The core Fed view toward inflation is that it can be controlled around their core policy rate of 2% and that headline inflation shocks are temporary. The data may suggest otherwise. Headline inflation does have shocks that are mean-reverting but the data is more complex. Deutsche bank has shown that we have not seen a decline in food and energy prices since 1986 when we measure the numbers as a five year rolling average. This may represent a complete business cyle. Prices will rise and fall with the business cycle, but the general direction is higher.

More important to inflation is that fact that renter costs which represent about 30% of the inflation index are increasing. with vacancies falling the cost of shelter is going up. This information suggests that it will be harder to keep inflation at 2% if we have any economic growth near trend.

Cleaning up bank balance sheets will make matters worse in EU

2011-11-12T10:50:00.001-05:00

Banks have to clean-up their balance sheets. Regulators are requiring it and shareholders need to have it done.

This clean-up means that banks have to markdown sovereign debt. Greek bonds have declined by 42 percent since July. Banks have to stop buying poor credits, but if this is done the only buyers of last resort will be other sovereigns and the central banks. There is no escaping the economics of bad debt and the sooner governments realize this the better. The cleaning of banks will mkae the system's ability to handle new risky debt weaker. The options get tighter not broader over time.

Government policies matter - the case of livestock

2011-11-12T10:43:00.001-05:00

Argentina is a laboratory of what will happen if you do not get the right policies for Agriculture. Over the last five years we have seen, export bans and regulatory restrictions on livestock production. The results are simple. Argentina has moved from 4th to 7th with respect to beef exports. Per capita beef consumption within the country has moved from 72 kilos in 2009 to 53.2 kilos in 2011. Argentina no longer has the highest per capita beef consumption. 8,000 cattle ranchers have moved to soybean production.

The cost of beef has skyrocketed. Some of this rise and adjustment is associated with drought, but the methods of allowing for markets to work are also critical.

Refining driving dip in oil inventory

2011-11-12T10:38:00.001-05:00

When oil is cheap relative to end distillate products, refining margins will increase. If you can get cheap oil, you will run flat out and try and make as much money as possible. This is what has happened in the Midwest. The result is a fall in Cushing, OK inventory. NYMEX crude has moved from contango to backwardation and the spread between NYMEX and Brent has collapsed.

Refiners who use North Sea oil or OPEC oil are not running at high cap utilization rates and have lower margins. The refining economics are simple, but will not last as inventories get tighter and prices increase.

Keystone XL pipeline - the future of oil dependency

2011-11-12T10:34:00.001-05:00

The Keystone XL pipeline decision has been placed on hold until the end of next year. The will limit the amount of oil that can come from the vast Canadian tar sands reserves. We will continue to be dependent on distant oil. Of course, there are environmental issues which have to be addressed but an energy policy has to be base don multiple sources of oil.

Canadian tar sands are expensive oil with the break-even costs at about $60 per barrel. Those will go up once the easy sands near the surface are used, but at current prices this is a viable and useful source of energy. Not building the pipeline will place stress on the global oil infrastructure. Canada now has the second largest reserves next to Saudi Arabia. It is a natural and a likely better source relative to deep off-shore oil

What happens when wheat prices rise?

2011-11-04T16:16:00.001-04:00

Markets respond to incentives. Higher prices mean rationing on the demand side. Higher prices will cause more supply to be produced. What happens next? prices fall form the over supply. Look at the wheat market. Prices are the lowest in years and have declined form over $10 / bu in March to current prices of $6.36 /bu.

Stocks are rising after what seemed like a crisis last year. Production is outstripping consumption so the price of wheat has come down to a new equilibrium level.

See International Grains Council

Draghi takes action

2011-11-04T16:03:00.001-04:00

Mario Draghi, the new ECB president, has decided to take action almost immediately with a 25 bops cut in the in the ECB benchmark rate to 1.25 percent. He also decided not to ramp up the bond buying program of the ECB. He said the program was supposed to be temporary.

Draghi has now shown that he can be a man of action although 25 bps in a crisis is not overwhelming. He is also a traditionalists by lowering rates instead of buying bonds. He also sounds like a president who will be interested n growth as well as inflation. He will unlikely be a large departure from now former ECB president Trichet. He seems to be a pragmatist who will not be pulled into the fiscal problems of the EU unless absolutely necessary.

Attention deficit or a constant?

2011-10-30T22:54:00.004-04:00

People often argue that we have too much information and too little attention; that this is a condition of being “modern.” But the opposite may be true: that attention is a human constant and that it constantly seeks new forms. Where there’s “surplus attention” we always come up with things to occupy it.

Was the past simpler, with less information to distract the mind and less to worry about? That can’t really be true: there’s nothing simple about farming and the natural world is full of information we’ve lost the capacity to discern.

This is an interesting thesis when you link the recent work in finance on information and attention. We are always trying to fill out attention with information. We generally are not overloaded with information. We can handle a lot.

However, Herbert Simon, the nobel prize winner in economics would say that we have become information rich and attention poor. Information computation transmission and storage has each increased multifold but our attention has stayed stable. We may have switched from depth to speed of acquiring information and knowledge. Knowledge may have moved from a "stock" to a "flow" concept. We consume information at a faster pace regardless of quality.

The type of information could be the issue especially if it is new. The problem is whether there information is useful and can be processed correctly. This is the role for decision sciences.

Headline and core inflation - no link with commodities?

2011-10-30T22:40:00.001-04:00

From the FRBSF Economic Letter: Does Headline Inflation Converge to Core, we see that commodity prices will not drive inflation. In reality, the headline and core inflation mix has changed. Pre-1993 there was a strong movement between headline and core. Inflation persistence was higher than the 70's and 80's and has fallen in the last twenty years. In the post '93 period there is not a close link. The conclusion is that inflation expectations are well anchored, but this is an observation and not an explanation. Some researchers have argued that the delink is caused by the widening employment gap.

I would argue that the decoupling has to do with a greater focus on inflation targeting by the Fed. The Fed will keep rates within a range and not allow the headline effects to be monetized. If there is a change in Fed behavior with less focus on inflation, expectations will become more focused on headline prices. The result may be a return to the '70's.

This delinking also explains why commodity investing has not be as effective hedge for inflation. Inflation expectations are rangebound which results in a lower correlation with a basket of commodities.

Summers on animal spirits and confidence

2011-10-28T16:25:00.002-04:00

"The central irony of financial crises is that while it is caused by too much confidence, too much borrowing and lending, and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending." Lawrence Summers FT 10/24/11

This is a very clear statement on the importance of confidence and credit when addressing a downturn in the business cycle or a financial crisis.

A contrast between US and China

2011-10-27T09:40:00.003-04:00

"We are the United States of Deferred Maintenance. China is the People's Republic of deferred gratification. They save, invest and build. We spend, borrow, and path." Thomas Friedman NYT

Does this need to change? There is no question that both have to adapt.

Orwell on the state of the EU

2011-10-27T09:39:00.002-04:00

Political language is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind. " -- George Orwell, May 1945

"We are all capable of believing things which we know to be untrue. ... The only check on it is that sooner or later a false belief bumps up against solid reality, usually on a battlefield."
-- George Orwell, March 22, 1946

Hard to say whether the current Greek solution will work. There is a lot of money being thrown at the problem which still has to be raised. Creditors have to realize loses.Central banks will have to provide liquidity and monetize some of this debt.

Saying there is a solution is not the same as having a solution.

China food inflation problem will be a gain for US farmers

2011-10-23T23:00:00.002-04:00

China premier Wen Jiabao stated the government must continue to control food and housing prices to ease inflation which is currently above 6 percent. This is going to be an interesting test of the Chinese government against the global commodity markets. It was stated by government sources that corn imports may go from 970,000 tons to over 5 million tons in this year. China is willing to use its cash horde to buy as much food as possible to stop price increases. Of course, if you try and hold prices down inside China through buying in the global market, someone is going to get rich at the government's expense. There will be a cash transfer and it will show up in futures prices.

The current financial age

2011-10-23T22:34:00.003-04:00

There have been a number of key descriptors of the current market. With the shifts and turns in the global financial markets, there have been an ever increasing number of names for this troubled period.

We have called this the AGE OF UNCERTAINTY given the high volatility coupled with the growing unknowns about policy and economic data. We have also characterized this period as a COMMENTARY MARKET where the opinions of policy-makers or comments about policy initiatives have been the driver of market action.

This period can also be called the AGE OF AUSTERITY based on the slow growth in developed countries. The gap between potential and actual output has not been closed since the start of this recovery. The developed markets seem to be in a state of lethargic behavior.

We feel the key problem is the confusion between an environment focused on liquidity or solvency. If this is a liquidity problem, central banks can solve. If these are solvency problems, we are in for the long-term austerity environment. If we have both, governments could be driven to a set of choices which are extremely dangerous.

However, the largest problem for the period could be the descriptor of Reinhart and Sbrancia, the new AGE OF FINANCIAL REPRESSION. This age could be classified through the following three key environmental signals:

Explicit or indirect caps or ceilings on interest rates
Creation of adaptive domestic audience that facilitates credit to the government
Direct ownership of the banks

It is a financial repression age which will be the greatest market scare.

Base metals and the business cycle

2011-10-23T22:07:00.002-04:00

There has been a significant decline in prices which may lead to an eventual increase in demand but it can more immediately change the buffer stock and will lead to an inventory decline. With falling price, the desire to hold inventories relative to financing costs decline, so inventories will be reduced first. The decline in inventory in warehouses will then ultimately lead to demand for metal from miners. This is a consistent and usual inventory cycle story associated with most business cycles. Base metals have become more like equities in the current cycle.

Market power can come from buyers or sellers. In this case, China demand represents the entire deficit in copper relative to production. Nickels is more sensitive to EU and US slowdown given its higher usage at about 1/3 of global demand. Most metals like aluminum copper and zinc are 25%.

Correlation with equities have moved higher from about .3 to .5. Sensitivity to a one percent decline in equities is .8 for nickel and .45 for Aluminum.Speculative copper has fallen off a cliff and has moved from net long to net short.

Base metals are affected by marginal cost curves which makes for uncorrelated markets given the cost curves are different. If prices move above marginal costs based on overly positive expectations, there will have to be a decline when price expectations are revised down. That will occur when global growth is expected to slow.

Copper may be the most sensitive to a slowdown based on the current difference between price and marginal cost of miners. Aluminum which is affected by smelting costs will not have the same price sensitivity. The marginal cost curve is steeper even with the sizable over capacity in smelting. The will be a point where marginal costs will match existing prices at which there will be a change in speculative flows.

Silver bubbles and speculative demand

2011-10-23T21:58:00.001-04:00

It seems like the silver market may have returned to normalcy. The year has been anything but normal. It has been pushed dramatically by speculative flows.

After pushing up toward $50/ oz, we are now in the low $30's/oz. Silver has had a dramatic increase in its beta relative to gold. It has moved close to 2 in the last 2 years from a previous level of approximately 1.35 for the previous five years. More recently, the beta has started to move lower.

Silver has had an unusual year broken into four parts. Part one was the speculative run-up through the end of April. The bubble burst with and diverged from gold. Part two was the consolidation through September when the market broke a second time in concert with gold which was part three. The current part four is the second consolidation. The breaks in price have been associated with CME margin increases. A rapid combination of five margin increases raised margins by 84%. The September break was matched with another margin increase. The COMEX through the CME clearinghouse forced liquidation of the silver which changed the mix of players. This stopped the increases in speculative activity.

What is the feedback between margin increases and market price changes? Margin increases are usually associated with increases in volatility and volatility increases will usually lead to a shake out of speculation. The risk increases relative to reward, but a clear margin increases translate into real cash. There is more money needed to hold any position; consequently, there will be an exit by speculative players.

With an exit of marginal speculative players, there will be a return to more normal relative price linkages. Yet, the issue of why there was strong demand has not been addressed. The demand for poor man's gold still exists.