Thursday, December 27, 2007
You can look at the ending stocks for wheat by quarter from the USDA database to judge the direction in wheat prices. Because the ending stocks are very seasonal, the first quarter pf the marketing year which represents the harvest will show high stocks. These levels will decline as wheat is used. The final balances for the marketing year reflect the ending stock levels.
The stock values follow a similar pattern of decline across the marketing year; however, 2007 data shows that the first quarter did not have a significant decline but the expected decrease in the ending balance is large. This was reflected in prices during the year. The first five months of the year showed almost no change. It was only in the last few months that the market realized that the ending stocks would decline significantly and prices started to take-off.
Using the ending stock changes can provide a good indication of the direction in wheat prices. When stocks are higher than 3-year averages, there is usually a decline in price. When stocks are lower than average there is a corresponding increase in prices.
Reviewing the ending stock balances for the world wheat market tells the story for why prices have hit highs. There is no wheat in storage. We are at all time lows with inventory fast approaching 100 million metric tonnes. Clearly, there is a greater risk premium in the wheat market because there is little room for error when the inventory levels decline.
Production has been up from last year but below the records set in 2004. The world will need continued good crops for more than a year to replenish the inventories, but wheat has to compete with other crops which are also at price highs. We will have to get used to this higher price range.
Futures exchanges are network monopolies, so once established it is very difficult to develop an alternative network. Liquidity is what customers are buying and the cost of liquidity is much higher than the exchange fees. However, once liquidity is established the fixed fees for trading are high relative to the marginal cost of producing or clearing the trade. The value of the exchange is being the marketplace.
Given the dominance of the exchange, the only place to squeeze costs is with the FCM or broker. Brokers have seen their profits diminish while the CME has seen new highs for its stock price. Banks are the biggest customers for the exchange so it is natural that they would want to fight for lower fees. The banks believe that they can take back this business and provide a lower cost alternative for their trading. Success for these new exchange ventures has usually been forcing a lower cost structure for trading. We will see whether this competitive threat works in 2008.
As long as housing prices are still declining. the the value of CDO's with subprime debt willl continue to decline. Any foreclosures will face a poor market for selling the collateral hence there will be less funds available for the holder of the securities. There will have to be more writedowns by financial institutions if this continues. Consumer wealth is declining which will lead to lower sales. Conservative behavior by consumer has already shown up in the tepid Christmas retail sales.
Wednesday, December 26, 2007
Currency strategists, as surveyed by Bloomberg, are calling for a 1.39 euro/usd by the end of the year versus the current forward rates that are calling for a 1.45 euro/usd. The distribution of forecasts is clearly skewed to a lower euro. What a difference a few weeks make. In late November, the dollar was pushing all time lows yet now forecasters are expecting a strong rebound. The yen at the same time is expected to rally over this same period. So what is driving this forecast? Because we do not have access to all of the explanations behind the forecasts, it is interesting to reverse engineer the conditions that may be needed to get a stronger dollar using simple exchange rate models.
The economic drivers from exchange rate models should be consistent with the forecasts. For example, the forecasters must be assuming that there will be a change in the interest differential which will be favorable for the dollar. Since the current interest difference as determined by the forward rates is zero, the median forecast suggests that Euroland rates will have to fall relative to the US. The ECB will engage in actively pushing rates down relative to the Fed. This is only like to happen if there is a substantial slowdown in European growth and less likelihood of a recession in the US. The Fed will either be on hold or only be willing to engage in moderate cutting during 2008 which will be matched by the ECB. Inflation will have to be relatively stable or more moderate in the US.
The outflow from the dollar will have to be curtailed in 2008 or there will have to be a strong demand for investing in the US as measured by M&A activity. The buying of dollar assets may quicken if there is a fall in equity values in the US relative to the rest of the world.
If you believe that traditional exchange rate relationships will hold, then a dollar rally will have to be consistent with some of these fundamentals otherwise the dollar forecast has to be based on sentiment or relationships which are unexpected. We do not believe in either of these two scenario. Over the next year, we do not believe the dollar will be have sentiment leading to a rally or be out of step with fundamental relationships.
The real growth rate in Japan has been below 2% for the most recent numbers. Sentiment as measured by the Tanken report has fallen across the board, so there is little expectation that Japan will be a growth engine in 2008.
One of the major themes of 2008 will be the continuing growth of emerging and developing markets. This growth theme still has skeptics; however, the old rules and assumptions applied to developing markets do not seem to apply. The new emerging market world is characterized by four conditions.
- Sustained high growth rates
- Growth decoupled from United States
- Growth independent of foreign aid
- Current account surplus positions
All four of these conditions are counter to what many have expected. Unsustainable independent growth conditions have been the key arguments for avoiding emerging markets, yet the current economic environment for many countries suggests that all of the old assumptions are faulty.
Growth can occur without the United States being a growth leader. Of course, the reason for the high growth may be that the liquidity has been moving from the developed countries to emerging markets. Growth in the United States has slowed, but liquidity has still grown as measured by the decline in real interest rates. Liquidity increases should continue throughout 2008 even if there is a slowdown in rate cuts. The liquidity issue is more tied to the credit risk taking and not the availability of funds. Trade flows have moved away from the US, so emerging markets are less dependent on the growth direction of the US.
Growth can be sustained at relatively high level for a number of years and not just something that is a short-term phenomenon because the market structures for many of these economies have changed. Current account surpluses are also sustainable for emerging markets because there have not been currency adjustments as would be expected if the foreign exchange markets were freer. Of course, the sustained increases in commodity prices have helped many countries which are more dependent on raw material exports.
Nevertheless, the assumption that developing countries can have sustainable growth without foreign aid is probably the most ingrained in Western thought. Yet, we are seeing many countries start to develop strong growth without aid packages. Countries which have been the bets performers have also been independent of large aid packages. This independent development is having a profound effect on global growth. It is also the premise that is most problematic with many Western economic thinkers.
I found reading William Easterly’s The White Man’s Burden: Why the West’s Effort to Aid the Rest Have Done so Much Ill and so Little Good one of the most important books in 2007 which influenced my thinking concerning developing and emerging markets.
William Easterly, who has also written The Elusive Quest for Growth, may be one of the most insightful researchers on economic development and growth. Certainly, he is someone most willing to confront conventional thought. This willingness to question development orthodoxy through thoughtful gathering of evidence makes him essential to thinking about growth and development.
His premise is that there two schools of thought to development. There are planners, who represent the traditional thought of dealing with emerging markets. Planners believe that growth can be fostered through strong and active intervention in developing countries. More aid is always better than less aid. If we provide enough aid to a country, it will grow. There are also searchers who are the agents of change who look for viable solutions to growth based on the circumstances of the country environment. More aid is not always good. It can be detrimental to development if it is wasted and used unproductively.
Easterly destroys the underlying assumption for aid based on the big push theory. The big push argument has driven all World Bank, IMF, and Western aid in general. For growth to be sustained in developing countries there is required large sums of aid to get countries jump started on a high growth trajectory. Without this aid, growth will only be sustained at low levels.
A careful review of research as well as his experiences at the World Bank has Easterly conclude that countries often do not need a big push. Countries do need the rule of law, strong well-defined property rights based on past precedent, governments that will not steal from the people, and aid that is targeted to specific goals which are measurable. High growth has occurred in those countries where the market structure allows individuals to creatively find solutions to specific problems. A good market structure is necessary to finding good economic solutions.
We are seeing those countries that have followed the outline of Easterly flourishing while those that have not have continued to languish. If the market structure allows for entrepreneurship and innovation, there is growth.
The solution to the commercial paper and subprime credit crisis was supposed to be joint deal between major banks that would fund a new SIV structure that would buy subprime debt from other bank SIV’s. The Treasury was behind this project as a market solution and helped broker the deal, yet on Friday it was announced that the M-LEC deal would not take place.
Cooperation could not be found between the major banks, but the real reason is probably less complex. Swapping funding from one SIV to another does not change the underlying collateral which is where the problem lies. Until the value of the collateral is determined at a market clearing price the sales and funding could not be made. And what is the value of subprime debt? Who knows? The price suggested by buyers is nowhere close to where sellers are willing to part with the debt. The crisis has caused pricing to be made with a broad brush which means that both good and bad debt is lumped together. The only solution is for each piece of debt to be reviewed which takes time. This is the ultimate problem and the issues that will have to be determined as we enter year-end. Unfortunately, there are still too many sellers and not enough buyers and Wall Street does not want to provide liquidity or be an intermediary for this process. Many money funds will have to live with these investments in 2008, so this will be the problem that will keep giving even with the adjustments that have already been made.
Additionally, M-LEC became obsolete because the entire crisis is also moving too fast. Banks are finding their own solutions of placing paper back on their balance sheet. Commercial paper is being retired so that the SIV CP market has shrunk significantly since August. The process is getting done slowly without coordination but through the tedious process of matching buyers and sellers.
Friday, December 21, 2007
Taj Mahal and Gisele Bundchen will not accept dollars for payment. Hard to believe that we are the point that cultural icons are refusing to accept dollars. I was referring to the Taj Mahal. However, some of these news reports are extreme dollar bashing.
The Indian rupee has appreciated nicely over the last few years but its growth is more a function of the Indian economy which has seen significant growth. It would be natural to see the currency appreciation. The Indian government actually wants to slow the appreciation of the currency and has added some capital controls for equity investments. May be they should accept more dollars.
Ms Bundchen, a Brazilian supermodel, has declared that she would like to have her contracts in euros not dollars because of currency uncertainty. Payment of contracts is usually made in a home currency or where purchasing power will be needed. If she is spending more time in Europe over the United States, changing contract terms is appropriate regardless of the dollar direction. (Tom Brady should take note.)
Who is willing to stand up and say they want to hold dollars? We have not heard from the Bush administration, but as we close the year there are some buyers that are coming out for the lonely dollar. The dollar has rallied approximately 3 percent against the Euro. The Japanese yen, Canadian dollar and British pound have all fallen in the last month. While this may be more technical driven, the dollar has started to stabilize for year-end. The key issue is what will investors think when they return from their holidays. January has been a volatile period for currency trading as portfolios are adjusted.
Wednesday, December 19, 2007
The World Gold Council released information on the gold reserves held by central bank in tones as well as percentage of total reserves. This provides one story on how gold is used as a reserve asset. Of course, the data only extends through the first quarter of 2007, but it is the most recent information available. There were two major surprises within the data.
Gold reserves across all central banks over the last reported year declined. There were few cases where gold reserves actually increased. The only large exception was Qatar which actually increased its reserves by 14 times from .6 to 8.4 tonnes. The next largest absolute increase was Russia which increased its holdings by almost 14 tonnes. This increase is consistent with the large inflows from energy production. However, other oil producing countries like Saudi Arabia did not add any gold to their reserves.
Gold as percentage of total reserves also fell but here there was a more variation. The increase in gold prices coupled with the decline in the dollar was the cause for the increase in reserve percentages.
The run up in gold prices over 2007 was driven by private buyers and less by the behavior of central banks at least through the first quarter of the year. The more interesting numbers will arrive in 2008 when we see whether there was a movement out of the dollar and into the hard asset.
Easing by many G-7 central banks has begun to lower economic risks. We have seen the coordinated short-term injection of funds by central banks to provide liquidity over the turn of the year to reduce liquidity needs. We have seen new regulation from the Fed to monitor mortgage bankers. The US Treasury secretary has changed jobs and become the housing and mortgage secretary. What more can be done at this time to solve the credit crisis?
Credit crises are very difficult to solve from both the monetary policy and regulatory perspective. If financial institutions do not want to supply credit, the government cannot force them. Lowering interest rates to provide liquidity is a start but it is a blunt tool and not one that can be easily targeted to a specific sector. Central banks have to worry about the fall-out to the general economy. Providing short-term liquidity is also good but we may not be in a situation yet where the central bank needs to be the lender of last resort; consequently, it is not clear that this is truly necessary. It may not be appropriate to add funds to solve the credit spread problem. The spread widening is a sign that there are risks with banks that need to be disclosed. Regulation is a help, but this policy change is forward looking and does not solve past credit problems. Past credit problems have to be priced in the market and any solution to stop this repricing from happening is not acceptable in the long-run.
Perhaps the best action now is to wait. The markets have increased volatility because it cannot determine what should be done or what is the impact of what has been done. The best Christmas gift may be to let investors reflect on the year and make appropriate adjustments based on the information available.
Tuesday, December 18, 2007
The end of the year infusion of funds by central banks has taken on a much bigger dimension with the ECB providing $500 billion in short-term funding to banks. You talk about money dropping from the sky as a Christmas gift to the global banking system! And, I thought those who are naughty do not get presents.
The reaction in money markets was swift. Short rates have fallen dramatically. While there is still a wide spread between LIBOR and Treasury rates, the infusion of funds is doing what one would expect. Yet, it gives pause to think about the size of intervention needed to get the very short rates to decline for the end of the year.
The current story is one of circular funding. Banks funded credit but did not want them on their balance sheets so they set up SIV’s. The SIV’s cannot sell their commercial paper so the banks have had to put these assets back on their balance sheets. The same institutions that did not want to fund the SIV’s now do not want to fund the banks, so the central banks have to be the lenders of last resort. If they are not providing the funds, the credit markets will have to shrink and credit conditions will have to tighten.
A friend who is a money market manager mentioned that the Fed wants to keep the Fed funds cuts separate from the TAF funding, but a dollar of new money is the same regardless of the source. The economy does not care how the funds are dispersed. The result is the same especially if the market perceives that these funds that will be needed for some time.
This cash infusion is like a cold medicine. It will mask some of the symptoms but it does not cure the cold. Money is being loaned to needy banks, but what does it mean to be in need at this time. More importantly, what will happen in January when some of this short-term funding matures? The root cause of bad credits held by some banks will not be resolved in the next few months. There will not be more liquidity in January and there may not be more buyers of subprime debt after the end of the year.
This money will have way of finding its way to what will be considered good assets and consumer purchases. This will mean greater inflation. Even if it does not show-up in consumer price indices, there will be a problem of asset price inflation as funds are reallocated in ways that may be unintended by the central banks. We are already seeing the reaction in stock indices in Europe. If the intention is to provide needed funds for banks which are not able to raise them at reasonable rates, the reaction should not be an across the board increase in stock prices. Of course, the stock reaction would be expected if the funding is anticipated to last.
Friday, December 14, 2007
The march to fully electronic trading continues with the announcement that the NYBOT which trades coffee, sugar, and cocoa will close its trading floor at the end of February. The NYBOT was bought by ICE, an electronic exchange, in January.
Trading on the floor has dwindled with the introduction of side-by-side electronic trading, so this announcement was expected. The commodity markets have been holdouts for open outcry because of the lower volume and liquidity relative to financial futures, but the growing importance of index trading sealed the fate of the trading floor. Newer market participants do not find the open outcry system helpful and were more comfortable trading from screens. This will shut more of the trading floor at the World Financial Center which is still a relatively new building.
So, what is going to happen to all of the colored trading jackets?
The dollar rallied on the unanticipated increase in CPI inflation today. For some, this appreciation would seem surprising. Increases in inflation are usually expected lead to a depreciation of the currency. Depreciation is what relative purchasing power parity would suggest. PPP models have been the workhorse for many analysts who have been arguing that the dollar fall-off is overdone, yet today was one of the bigger positive dollar moves in months.
The explanation can be found in looking at monetary policy reaction functions. A Taylor rule reaction function would argue for tightening of interest rates if inflation starts to move above target. His would be all the more likely if growth has not fallen significantly. The monetary expectations story is consistent with what happened in the equity markets. Without expected added liquidity, the market does not see a favorable environment for stocks of the next few months.
A significant portion of the recent dollar decline has been interest rate driven. The dollar decline went into overdrive with the cuts from the Fed. With the Fed easing, the interest differential has become less favorable for the US, so the dollar has trended lower especially against the euro. Additionally, the ECB has been firm at current rates even with the increase in supply of funds to meet credit crisis liquidity demands. The higher inflation today suggests that the Fed will be less likely to lower rates early in 2008; consequently, the fall in interest rates should stall. This change in monetary expectations is the current leading driver for the dollar. Whether this will be a short or longer-term dollar rally is hard to say, but there is little changed in the dollar fundamentals except for the possible delay in monetary easing.
Thursday, December 13, 2007
Treasury secretary Paulson was in China as part of the ongoing Strategic Economic Dialogue. http://www.treas.gov/initiatives/us-china/. While there were substantive talks on product safety, regulation, and policy transparency, there was not any improvement on the key issue of trade imbalances and the evaluation of the yuan. This is the number one global issue facing both countries, yet there is a clear impasse. The US would like a higher yuan and China is not ready to move on this issue.
The Chinese economic environment is becoming more complex. Growth has been strong again in 2007 but inflation is significantly higher. Monetary policy is expected to be tightened to slow growth and inflation. There are also some labor shortages with wages increasing. China may lose its status as the low cost manufacturing producer. Any change in the currency level has to be analyzed with respect to domestic issues and not based on what may happen in the US. Consequently, the current go slow approach is most likely. The Chinese are also concluding that the Bush administration is a lame duck and will not use a change in exchange rate policies too early. They may reserve this option for when potential trade issues heat up either in the summer or after the next election. It is unlikely that Paulson will be able to sway the Chinese of anything significant during his tenure.
One of the well known secrets of commodity trading is the gains from backwardation. Because back month futures are usually priced below the current spot price, buyers of futures receive a risk premium or compensation for futures convergence. The traditional story is that long speculators are compensated for taking on the risk of short hedgers. If a commodity market is in contango, the futures price is higher than the spot price. Convergence of the basis or price difference will lead to a decline in price. If you are long the futures there will be a drag on performance.
A number of reasons or effects cause backwardation or contango. It could be that futures have a risk premium. There is also the issue of convenience yield for holding a cash commodity. The cost of carry is also a consideration. Overall the difference between cash and futures will change over time as the economic environment changes, so investors cannot bank on normal backwardation or return for trading against hedgers. Unfortunately, it is hard to tell when the market will prefer to be in backwardation. It is the view by some that determining the cash futures basis may be easier than the outright direction, but research suggests that they would be wrong. While the futures basis is less volatile than the futures price, the returns for trading this basis is also lower and may not be more predictive.
A solution is to trade different maturities to reduce the drag from contango and maximize the effect of backwardation. All things equal, you would like to be long the contracts which have the most backwardation and try and avoid or minimize the effect of contango.
S&P has introduced a new GSCI forward index which tries to alleviate some of the negative effect of contango. This is the second index that has been developed in the last two months to trade contracts further from maturity in an effort to minimize the effect of backwardation or contango. This contract should do well during those periods when the market is in contango, albeit most times the most liquid commodities like crude oil are in backwardation.
Adding more indices provides investors with more choices, but it also adds more confusion to the commodity index market. The choice of index becomes even harder. You become an active manager through making your index choice.
Wednesday, December 12, 2007
An issue is whether we will see more coordination on the credit crisis and the dollar decline. Coordination will force more money into G7 economies which may cause further speculative problems in real estate outside of the US. Coordinating the lowering of interest rates or extending credit in G7 countries will do nothing to solve the global imbalance problem. We also wonder what the Fed may know about bank balance sheets that the rest of the market does not know or has not discounted.
Monday, December 10, 2007
Futures trading is based on the concept of convergence. Futures and cash prices will move to equality at delivery. This convergence between cash and futures is what makes futures a relevant hedging vehicle. The basis or difference between cash and futures is relatively stable and well defined so hedgers know what the relationship between their specific crop and the general CBT contract. Convergence has been a problem for the grain contracts at the CBT over the last few delivery months.
The CBT called special meeting to discuss this issue with users. A similar meeting was held by the CTFC last week. Unfortunately, there does not seem to be any easy solutions to the problem. This is not the first time that this problem has occurred. A similar issue developed ten years ago which lead to some contract changes to adapt to the changing market conditions for transportation and export of grains. The current problems with the basis at expiration are associated with transportation and warehousing costs for grain. With higher fuel prices and low river levels, the cost of transporting grain becomes higher than normal. When there are good harvests, the costs of storage also become extremely high.
This time the issue may be more complex with index users. As users of the market for index exposure have increased, the divergence between cash and futures has also increased. There is tremendous non-commercial pressure pushing prices above the cash price which drives away commercial users. This is an issue that will have to be fixed or there could be contract failure. This would not help anyone.
Sunday, December 9, 2007
It was reported that Iran the fourth largest oil exporter will have all payments made in currencies other than the dollar. Obviously, there is a strong political component to this announcement. The embargo on Iran by the US and the pressure the US has placed on global banks not to deal with Iran has affected their ability to use the dollar acquired from being paid for their oil, but this is just another red flag concerning the decline of the dollar.
If the dollar continues its long-term slide, Iran will look at lot smarter than many of the other Arab countries that have continued to be paid in dollars. There has already been strong talk about diversifying reserves by Arab central banks and the cost of being pegged to the dollar has led to higher inflation.
The declining dollar will continue to have a strain on those countries who have pegged to the dollar. A change in this behavior will have a strong demand impact on dollars and with further deteriorate the financial position of the US. There will be political fall-out from this change in reserve behavior.
The equity markets have been anticipating a Fed cut based on the movement of stocks and a close look at the interest rate options markets tells the same tale. The Federal Reserve Bank of Cleveland reports the probability of a Fed funds change using the Fed funds options market. This information is also available from Bloomberg in a slightly different format.
With the latest economic announcements being relatively benign for a no change in policy, the market has surged to over a 70% probability of a decline to 4.25%. There is also a 40% probability for another cut in January. The market wants a cut for Christmas and they are expecting their present earlier.
The December Fed meeting and the announcements this week get close to closing the books for year. There usually is not a lot of volume and volatility after the 15th of the month. However, it has often been the case the trends that area in place in early December continue until the end of the year. The biggest surprises for the credit markets will still be in subprime – SIV markets. The money markets are still behaving like we are facing millennium year-end risks.
The focus of the capital markets has been on the subprime crisis in the US. This credit crisis is a direct result of the slowing of the real estate market. If you do not have rising real estate prices, borrowers cannot sell their home for a gain to offset the loan values. Foreclosures become more expensive because the home cannot be flipped to another buyer to pay-off the loan.
If you think this is just a US problem, take a look at the gains in real estate around the world. The US has not been at the high end of the bubble. Of course, not all countries that have had large increase are in a bubble. Price increases are up because many countries have opened credit markets to home buyers. There has been a shortage of housing in some areas and growth has been strong in many countries. But there also is a strong case for the bubble story. Look at the demographics of Europe. Populations are aging, and birth rates are down. It is hard to imagine that these economies have seen over 100% increases in prices over the last ten years.
The real estate problem is going to be a global problem. There is the subprime paper from the US that is held around the globe and the potential decline in local markets. The real estate problem is going to take on different flavor for the rest of the world because there has not been as much packaging of loans to investors. The credit crisis will affect bank balance sheets and cutting local lending. The decoupling story for the global economy does not hold a lot of water when it comes to real estate.
A close review of the Treasury “plan” for the subprime mess suggests that not much is going to happen. The Treasury through its “Hope Now” plan facilitated some arrangements with banks to help standardize adjustments to loan arrangements through allowing for no change to lending rate. The number of borrowers this plan affects will actually be small. Also, the arrangement could have been made without the help of the Treasury and there is no current relieve planned for the billions that will be adjusted in 2008. In short, the financial system will have to work this problem out on its own. Foreclosures are going to build and home inventories in many markets are going to increase.
Paulson, who comes from Wall Street, will not take a populist approach of forcing moratoriums on investors as a solution. He is well aware that government intervention in the contracting of lending arrangements will not just hurt investors and affect the working of capital markets. At this point in time, protecting the capital markets from moral hazard problems is more important. This approach may change as we move through 2008 and get closer to the election, but right now, Treasury wants to look like they are doing something without being heavy handed.
This means that this crisis is going to continue for a long time and it will be the burden of the Fed to solve the problem through the use of the ineffective tool of lowering rates. Lowering rate is generally ineffective when there is an unwillingness to lend and the credit of borrowers is impaired. This solution also may be gradual because the lowering of interest rates will have negative ramifications on the dollar and we have not seen the signs of a recession in the rest of the economy. Expect the slow process of 25 bps cuts. The credit crisis will be one of the main themes of 2008
Thursday, December 6, 2007
The dollar has come off its lows since the middle of November because of changing expectations about the direction of interest rates outside of the United States. Up until recently, the United States was alone with its active policy of reducing rates. This lowering of interest rates by the Fed along with the lower rate expectations by fixed income investors caused the interest differential to move either against the US or to less favorable terms. A loose monetary policy in the US relative to the rest of the world will have the impact of increasing relative money supply which will lead to dollar depreciation. The economics are straightforward and transparent. However, the credit issues of the US have spilled over to other countries. In particular, the UK is seeing its own credit crisis issues as measured by short-term LIBOR rates. Consequently, there has been policy change by the Bank of England with a cut of 25 bps by the MPC for the first time in two years. This closes some of the gap that formed between the UK and US. There is similar talk of cutting rates in Europe based on slower growth and there are the longer-term expectations in the US that the economic outside of the housing is doing better than expected.
All these policy adjustments change the future expectations of interest rates which really drive the interest differentials or more precisely the expected interest differentials. If there is less drag from interest differentials, there will be greater opportunity for more dollar upside.
Monday, December 3, 2007
The financial system has fragmented from the days when banks were the dominant force in financial markets. This is the shadow financial system which is not controlled by the Fed. Money funds clearly have an important role in short-term lending. Now we see state money funds, who have been the aggregators of smaller pools of cash being affected by the SIV crisis. With smaller investors pulling funds from larger pools like in the state of Florida, there are bank runs. The only way to solve the problem is to close the window to withdrawals.
Assume that there is some small percentage of a large pool holding sub-prime SIV commercial paper. You are a small investor in the fund and decide to pull your money. The percentage that SIV commercial paper represents in the fund will then increase which may lead to greater withdrawals. Who want to be the small investors left in the larger pool that is getting riskier? Florida may not be alone in the bank run scenario. If fact, this could be a problem in a number of states and could spill over to retail money funds. This would be a blow to investor confidence which will have a strong impact on the rest of the markets. The herd can move fast once it hears shots.
The monetary policy response to the credit crisis has been to lower the Fed funds rate. The monetary channel for increasing credit is to lower rates to cheapen the costs of banks to lend longer-term. A steep curve is a license to print money for most financial institutions. There is only one problem with this scenario, higher risks associated with banks themselves and the risk of lending. If lending is considered riskier, then the rate on LIBOR will increase. This increase in risk premium may be greater than what stimulus the Fed provides.
There also is a strong desire for window dressing at the end of this year. Who wants to hold risky assets at the turn of the year? This is why we currently see one-month LIBOR at 5.25% and yet one-year LIBOR is at 4.43%, an 80 basis point difference. Now if credit is cut-off over the turn of the year, there will have to be liquidation of assets from balance sheets which will lead to depressed prices for end of year price marks. There could be some wild fluctuation of prices with December 31, on a Monday. This end of the year financial zaniness may not be controlled by the Fed regardless of what they do over the next four weeks.
Friday, November 30, 2007
There is the old adage that if an investment story makes it as a cover of a business publication its trend is over. Well, the Economist came out with its cover for the week highlighting the panic of the dollar. What happened today in the currency markets? We had the strongest dollar rally in the last two days since the beginning of the credit crisis. While I still may not be convinced that the cover story adage is worth committing capital, markets do move to extremes and see rebounds. After a strong month, this may have been the time for a small dollar rally.
Surprisingly, the dollar rally has come at the same time as the US economic news has been poor and the Fed has been telegraphing another rate cut. One would expect that the dollar would further decline on the expected further decline of US interest rates but other factors seem to be in play. The dollar rally has been matched by a significant sell-off in crude oil. Crude and the dollar have seen a negative correlation in 2007, so an almost $10 per barrel decline may be the best tonic for an anemic dollar.
Wednesday, November 28, 2007
Carry trades have declined with the increase in interest rate volatility. This relationship is actually predicted when tests of unbiased forward rates are adjusted for changes in volatility. One of the empirical relationships which have driven carry trades is the fact that the forward rate is a biased predictor of future spot rates. Given the strong evidence of this bias, there is a strong level of confidence with the doing carry-type trades. However, recent research from the Koopmans Research Institute suggests that the results that reject uncovered interest rate parity are themselves biased by the differences in volatility of interest rates.
The result of the research by Hadzi-Vaskov and Kool show that uncovered interest rate parity cannot be rejected during those periods when the anchor interest rate is highly volatile. This could simply be a result of the estimation procedures used but previous researchers, but I would suggest that it is also related to the fact that investors do not want to undertake carry trades during periods of high volatility. The risk from holding carry trades is higher so there is less pressure pushing rates away from uncovered interest rate parity.
Currency overshooting was a key area for policy discussions and research concern in the 1970’s and 80’s by government officials and academics. The concern especially in the 1980’s was the significant overvaluation of the dollar in the mid-1980’s. These wide deviations from fair value were the main reasons for the Plaza and Louvre Accord for coordinated central bank intervention. It was believed that the deviations could not be solved without coordinated activity. The talk of overvaluation of the dollar and coordination is again evident.
The figure from Bank of America shows the size of deviations from fair value for the dollar relative to a basket of developed countries. There has been a significant change from overvaluation in 2000 to the current undervaluation. The Bank of America data does not show the dollar to be at all time extremes; however, it has levels which suggest that a revision is much more likely. Nevertheless, one of the problems with finding the fair value of any currency is that there is no consensus on what is fair value. Most banks will use multiple models to determine the deviation from fair value, so, at best, we can say there is a tendency for movement from equilibrium but we cannot say the amount of deviation with any precision.
We can see why there has been a recent strong dollar decline by using a classic overshooting model. The most widely used model of currency overshooting is based on the idea that exchange rates see more volatility as a response to some monetary shock because prices for good are relatively sticky. For markets to clear, there has to be an over-reaction in exchange rates. Some of the recent move down in the dollar is consistent with the Dornbusch sticky-price overshooting model. The Fed has increased money in response to the credit crisis. This monetary shock, it really was not expected before the credit problems of August, caused short-term rates to decline and led to a depreciation of the dollar. We can see that real rates have declined relative to the rest of the world and the dollar depreciation matched the change in real interest differentials. While these links are not perfect, the recent dollar decline should not be overly surprising.
Tuesday, November 27, 2007
Market prices convey signals on what investors are thinking. In the bond market, fixed income traders are not happy. Look at money markets. Short-term LIBOR rates shot up during the credit crisis in August but moved down after action taken by the Fed and a general perception on the limited extent of the crisis. However, credit crisis uncertainty has not abated. The crisis has lead to continued write-downs of CBO’s and a lack of liquidity in the commercial paper market. LIBOR rates are again on the march upward. The spread between Fed funds and LIBOR has actually increased and now moving back to the highest levels since August. Now it is natural that the spread will increase after a Fed action. LIBOR will usually follow Fed funds and not lead the rate, but currently, short-term LIBOR spreads are moving higher on growing credit risk. There seems to be special concern about the year-end turn.
The Treasury curve is signally a significant slowdown in growth. The curve changes have not been driven just in the front-end but have been a general parallel shift down in rates. Treasury yields are actually lower than Fed funds across the board which is out of the ordinary. By this standard, the Fed is actually tight with monetary policy. Put another way, the fixed income markets have a significantly less rosy picture on the economy than anything that is being forecasted at the Fed. We know that the Fed has a relatively rosy picture because their latest forecast as part of the new transparency does not show any recession but just growth below trend for the next two years.
The Fed has responded with a temporary injection of funds of approximately $8 billion which is similar to recent action taken. The objective is to ensure liquidity through the end of the year. Year-end volatility may be especially large this year because of clean-ups of the balance sheet. More Fed action will be needed to alleviate fears in the fixed income market.
Monday, November 26, 2007
China and India are more important than ever within the global economy. With the US starting to slowdown, these countries will now be the global growth engines for the rest of the world. But, the importance of these countries even within the United States because of their job impact on the domestic economy. The outsourcing of jobs is a major domestic policy issue especially if the unemployment rate is rising. While there has been discussion of outsourcing and talk of trade restrictions, there have not been any specific policy actions to reduce the flows in human capital. Finally, the international fiancé implications from savings imbalance are significant especially with respect to China.
So how do you get to know the economics of these countries and the key economic issues? One of the best books on the topic is The Elephant and Dragon: The Rise of India and China and What It Means for All of Us by Robyn Meredith, a well-respected business writer. She makes a balanced presentation on the positive and negatives of the global impact of these countries on the United States and the rest of the world. Meredith does not argue solely for free trade not does she suggest that barriers need to be in place to stop globalization.
China and India are not the same. Their government policies are different and the areas of growth by each have been different. China has become the manufacturer of the world while India has transformed itself into an IT service center. China has been able to build the infrastructure to produce gains in manufacturing. India has not matched this capital expenditure. These are complex countries that cannot be easily described in the same manner.
The continued decline in the dollar and the slowing of the economy is going to make relationships with these countries all the more vital for overall global growth.
Friday, November 23, 2007
Tuesday, November 20, 2007
The Congressional Budget Office produced their economic forecasting record this month and compared its numbers with the Administration and Blue Chip Consensus from 1982 to the present. When looking at their numbers, you see an organization that does a good job of forecasting relative to the other alternatives. In fact, it is impressive that they are willing to do the self-evaluation of comparing their forecasts with other alternatives in an easy to read document. How many banks provide their forecasting record over two decades?
While there are still errors in their forecasting especially when there are business cycle turning points and unique price shocks, the CBO does a very professional job of calling the economy and should be given equal weight to private forecasters. The CBO is worth following.
Monday, November 19, 2007
If you vote with your feet, the financial flows from the Treasury TIC report last Friday shows that global investors do not want to hold dollar assets. While the net long-term inflows were positive, the size was less than expected from survey data prior to the announcement.
It is hard to use this flow data to forecast the direction of the dollar but it does provide strong confirming evidence on the dollar decline. Without new purchases by foreign investors there will be a dollar price decline. The trends are not very positive. Even with a rebound in many financial markets, foreign buyers stayed away from the US. Of course, there has been continued uncertainty over the credit markets, but this data shows that investors have become more risk averse over the prospects for US financial markets. Official net buying of Treasuries was the only bright spot. It rebounded after two negative months, but this change is a long way from saying central banks want to hold dollars.
Trevor Manuel, South Africa’s finance minister and the G20 meeting host, said delegates did not play a blame game but made clear the dollar’s weakness had been hotly debated. “We didn’t give Ben Bernanke [Fed chairman] or Hank Paulson [Treasury secretary] lines to write or make them stand in the corner. That’s not the way these things work,” he said.
Sorry, but there is a lot of blame going around. The Fed and Treasury have just not been interested in a strong dollar. The cutting of interest rates is a reflection of a domestic policy focus and not a concern about the dollar. The Treasury has been involved in the credit crisis and has not commented about the dollar decline with any fervor.
The global imbalances have not been resolved from any action by the United States; therefore, the dollar has trended down. Most of the actions that would solve the imbalances would have included higher rates and slower growth. In fact, we would argue that the administration likes the lower dollars because of the strengthening of exports. A dollar decline was how the current account balance was to be reduced.
Policy dunces – hard to argue that they made a mistake except if you are a foreigner holding dollar assets.
When your currency is trending down everyone wants to get into the act of forecasting. The latest dollar forecasters are the presidents if Iran and Venezuela at the OPEC meetings this week-end which overshadowed the G20 summit in South Africa.
“They get our oil and give us a worthless piece of paper,” Mahmoud Ahmadi-Nejad, Iran’s president said. “We all know that the US dollar has no economic value.”
“The dollar is in free fall, everyone should be worried about it,” Mr. Chávez told reporters here. “The fall of the dollar is not the fall of the dollar — it’s the fall of the American empire.”
Mr. Ahmadinejad said that oil, which was hovering last week at close to $100 a barrel, was being sold currently for a “paltry sum.” And Mr. Chávez predicted that prices would rise to $200 a barrel if the United States were “crazy enough” to strike at Iran, or even at his own country.
“OPEC should set itself up as an active political agent,” Mr. Chávez said, addressing about 1,000 guests in a conference center by the royal quarters.
While these comments were dismissed by the moderates in OPEC, the dollar talk forces the discussion of pricing of oil in dollars. While there is not a desire for OPEC to change pricing policies, the talk of the UAE to switch away from a dollar peg should be concerning for the US. The dollar decline has been less of a major issue for US oil imports because it is priced in dollars. The real price would be ten percent higher if it was priced in euros. Of course, the rising cost of oil for countries with appreciating currencies has been blunted.
Thursday, November 15, 2007
One of the key themes of the Federal Reserve under Chairman Bernanke has been the increase in transparency concerning central bank operations. Greater clarity about policy-making should decrease the uncertainty concerning interest rates and lead to smoother functioning markets. To reach this goal, the Fed announced yesterday that it would increase the number of forecasts from two to four a year. The forecast projections will also be extended to three years from two. Along with these forecasts will be greater explanation and summaries of the numbers. There will also be more detailed descriptions of the risk concerning the forecasts
As stated in the press release, “These descriptions will provide a fuller discussion of the projections, covering not only the outcomes that most meeting participants see as most likely, but also the risks to the economic outlook and the dispersion of views among policymakers.”
The first of these new information packages will be presented on November 20th. You could not ask for a more interesting time to provide more information on Fed thinking. With the current credit and housing crisis still working through the economy, there is a lot of uncertainty on what will be the direction of growth in 2008. While there is general agreement of a slowdown, the size is still uncertain and the potential response of the Fed is also unclear.
Providing more information is a positive, but it will have to digested and discounted by the market. New information is by definition surprising and uncertain information. We also know that the quality of the Fed forecasts are not really better than what we see from other forecasters. It is not clear whether we are better off with three year projections other than we will know what the Fed is basing their decisions.
We expect there will be a strong initial market reaction to the release on the 2oth but ultimately not much change in market directions.
Tuesday, November 13, 2007
“The dollar is our currency, but your problem,” John Connolly, Richard Nixon’s Treasury Secretary famously said. Unfortunately, the financial isolationism of times past by the United States is not going to acceptable to the rest of the world, but rhetoric will not be the solution. Financial leaders are starting to rise up and complain that the dollar decline has gone on too long.
Yesterday, Japanese Prime Minister Fukuda talked about the yen appreciating "too fast" and speculators needed to "be careful" to avoid the possibility of intervention. ECB president Trichet commented last week on the brutal move of the dollar and this should not persist. Anonymous Canadian officials are stating that they are bearing the brunt of the dollar decline and will discuss this at the G20 meetings. President Bush is “satisfied that we have a strong dollar policy” but that the market is the best place to set exchange rates. G20 meeting will be held in Cape Town this week and should have lively discussions on the currency markets, but discussions without action will not change the course of the dollar.
Does this rhetoric matter? In the short-run, yes. The talk of policy-makers will increase volatility and causes some changes in the direction of exchange rates but these changes will be short-lived. These comments may even reduce the view that the dollar decline is a one-way bet, but fundamentals will make the difference in trend. Until there is more clarity on the credit crisis and whether inflation will be controlled, the dollar decline trend will continue.
Sunday, November 11, 2007
Dow Jones reported the launch of a new JP Morgan commodity index. This new index will include 33 commodities and tries to reduce some of the problems that have cropped up with other commodity indices. Bloomberg also reported this week that BNP has launched a new commodity index. Right now, if you are bank and you want to be serious about commodities, it seems you have to have your own commodity index.
The new JP Morgan index tries to solve three problems, diversification, weighting, and rolls. It adds more commodities to increase the level of diversification to the index. There are more markets in it than many other indices. Given the low level of correlation across commodities, there will be a significant risk reduction from adding these markets. Second, the index has a new weighting scheme which provides for more equal weighting across the commodities. This again will increase the level of diversification in the index. There will be less depends on the energy complex. The third major feature is that the allocation within a commodity market is across different contract months which will diversify the exposure to the commodity across time. This time diversification will reduce the problems associate with rolls and issue of contango. Indices which are based on futures will underperform the spot market changes when the futures are in contango and outperform the cash market when futures are in backwardation.
The range in performance of all these indices is large. Year to date, the high return index is the Deutsche Bank liquid index which is up 37.17 percent. The lowest return is with the DJ-AIG index which is up 15.42 percent. There is over a 100% difference from the low to high return. This is a fairly large difference relative to what is seen in the equity and fixed income markets. This is due to the fact that there are no agreed upon standards for an index. Some are liquidity weighted while others are production weighted. Some have a focus on nearby contracts while others are divided across maturities. This hodge-podge of indices will become a greater problem for investors because a true benchmark has not been established.
The commodity markets need some standards for benchmarks which can be agreed upon by all market participants. This will add depth to the market and make it more acceptable to institutions. Adding more indices is not the answer.
One of the most important current issues in international finance is the overvalued Chinese yuan. While there is disagreement on the extent of the overvaluation, there is general agreement that the Chinese currency, by not floating, is affecting the trade and capital flows not only of the United States but now Europe. Unfortunately, this is an issue that will not be easily resolved for the simple reason that a significant change in the currency rate will have a large negative impact on internal growth in China.
The high Chinese economic growth is driven by the strong export business along the coast. High growth expectations with the chance of employment are causing a mass migration from the rural areas to the urban centers. Any slowdown in growth may lead to significant civil unrest from this migration. External pressure on currency reform is not going to solve the migration problem. However, there may be alternative approaches which will help reduce some of the migration pressures.
Land reform can solve some of the problem. While there has been some movement to improve property rights, the current leasing arrangement create a level of uncertainty which leads to migration. If there is uncertainty concerning property rights there will be less desire to stay in the countryside. Property reform laws were enacted in March of 2007 but the most important step is implementation and enforcement of the laws. Laws unenforced continue the cycle of uncertainty. See http://ww.cato.org/pub_display.php?pub_id=8745 for a detailed history and analysis of land rights in China since its inception.
Property rights issues are complex, but increasing the strength of land claims will reduce the desire for many to move and will increase the growth rate of foodstuffs. The reduced migration problem and a means to reduce potential food price shocks will allow an easier transition of exchange rates to something that is closer to fair value and floating with other world currencies.
Friday, November 9, 2007
The dollar decline is having some positive effect on the trade balance. Trade balance does not change immediately, but there has been improvement. Exports are up so the trade gap is closing and the service surplus is widening. The numbers look stronger when petroleum imports are excluded. The trade deficit in good has closed by over $5 billion since a year ago because exports are up over 13% YOY. While food exports are very strong, we are seeing double digit increases in some manufacturing sectors.
Since May exported ex petroleum are up 5.66% while imports are up only 2.34%. The slowing of imports is also associated with our slowing economy but the export business is related to strong growth in the rest of the world as well as the dollar decline.
Seems like we have forgotten the strong dollar policy.
What do policy-makers tell us with their comments? Often, not much. But markets often need government officials to state the obvious to cause a reaction. Sometimes markets do not have enough confidence in the numbers to make their own decisions. Nevertheless, when Fed officials state the obvious we know for sure that they have taken note.
Ben Bernanke stated that the economy will “slow noticeably”. What does it take for a slowing economy to be noticed? Housing in the tank, oil prices near $100 per barrel, and slowing consumer sales would seem to be enough. What were the give-away signs for Bernanke? Asked about stagflation, Bernanke stated,”we don’t see anything approaching the period in the 1970’s”. This is small comfort for home owners or consumers who use food and energy.
ECB head Trichet stated “undoubtedly sharp and abrupt brutal moves are never welcome”.” This is not the type of statement that will calm markets. While the dollar move has been especially strong in the last three months, the decline should not have been unanticipated. The strong decline came with the credit crunch in August. This was the catalyst. The change has not been abrupt as much as relentless. The issue is what can the ECB do about this? With inflation moving upward, a rate decline is not feasible.
Official comments are often just catalysts for what is being displayed in the numbers. Unfortunately, there are limits to what governments can do in the current situation.
Wednesday, November 7, 2007
“We will favor stronger currencies over weaker ones, and will readjust accordingly,”Cheng Siwei, Vice chairman of the standing committee o the National People’s Congress.
“The dollar is losing its status as the world currency,” Xu Jian central bank vice director
While they did not state that they are moving money out of the dollar or whether there is a specific target for dollar holdings, the message is clear. China does not want to hold dollars in their portfolio. Of course, given the size of their positions, they cannot sell their holdings. The impact would be too great and the euro may not be the best alternative. Nevertheless, any cut in the Chinese dollar holdings will have an impact.
Portfolio rebalancing for strategic reasons will drive the dollar lower even if economists suggest that the dollar is currently oversold. This is a classic price pressure liquidity effect. The declining dollar trend will not change until there is evidence for a more stable dollar. That evidence is unlikely until the uncertainty concerning credit issues in the US are resolved. The additional problem is that carry trades do not favor the dollar as US interest rates decline. No change in this trend.
Tuesday, November 6, 2007
If prices go up, demand should go down, right? This is not the case for many countries where the governments subsidize energy. Demand has moved with overall economic growth and been insensitive to the world price of crude. The combination of lower prices not attached to market movements and strong growth has caused higher demand for gasoline. The world is not facing a supply shortage but a demand shock. The current supply cannot keep up world demand. Of course, part of this problem is always supply. Capacity utilization for OPEC oil is down from its high, but if the cartel is wrong about their demand estimates, that is, there is a demand shock, there will be a spike in prices. It takes some time to increase production.
Governments are trying to put market forces back in place by raising the price of gasoline. China announced a price increase of 10% on gasoline because they are in the extreme position of seeing shortages. These shortages are not from the high price but from cut in refining. The refiners take it on the chin when crude prices rise. They buy on the open market and then have to sell at the subsidized price without being compensated by the government for the difference. You cannot make it up with volume, so you might as well cut refining production.
Most of the BRIC’s have subsidized oil prices. Nevertheless, India is also thinking of raising prices. Gasoline is subsidized in OPEC countries which have also seen significant growth. Prices of gasoline in Iraq and Iran are less than 50 cents a gallon. These drivers have not felt the pain of higher prices. (It was reported that Hummer sales in Venezuela were strong because of cheap gas prices.) McKinsey has actually concluded that if subsidies were eliminated in many developed countries the savings would be approximately 3 million barrels a day.
Market forces will allow for demand to decline and force prices down. Any changes in pricing in developed countries will cool the oil market. Look for any news of changing government policies as means of reducing the demand shock.
Monday, November 5, 2007
The new weights for the GSCI have been announced for 2008. There were few surprises accept for the large change in unleaded gas which increased 330% over last year. This will bring sizable amount of open interest to the contract as well as more trading volume especially during roll periods. Grains showed increase percentages across the board except for Kansas City wheat. Softs and live stock markets remained the same. The energy complex overall remained close to last year except for the relative change with gasoline. Gold showed a slight decrease in the metals sector.
While not the same as the issues with additions and deletions of the S&P 500, there will be an effect from changing weights. There should be upward pressure on those commodities that have weight increases and downward pressure on those with declining weights. The impact will be greatest during roll periods.
Index volume has continued to explode with strong interest across all of the major markets
Following is a table showing the commodities weighting in
percent of the total GSCI index for 2007 and 2008.
COMMODITY 2007 2008
Wheat ( Chicago ) 3.14 3.40
KBT Wheat ( Kansas ) 1.12 0.79
CBT Corn 3.27 3.30
CBT Soybeans 1.79 1.84
ICE US3 Coffee "C" 0.70 0.69
ICE US Sugar #11 1.22 1.23
ICE - US Cocoa 0.21 0.22
ICE - US Cotton #2 0.87 0.90
CME Lean Hogs 1.54 1.53
CME Cattle (Live) 2.72 2.74
CME Cattle (Feeder) 0.62 0.54
NYM/ICE Oil (WTI Crude) 35.12 35.32
NYM Oil (#2 Heating) 5.76 4.68
NYM Oil (RBOB) 1.37 4.55
ICE - UK4 Oil (Brent Crude) 14.62 13.04
ICE - UK Oil (Gasoil) 5.01 4.55
NYM/ICE Natural Gas 7.71 7.48
LME Aluminum (High Gd. Prim.) 3.41 3.49
LME Copper (Grade A) 4.05 4.01
LME Standard Lead 0.52 0.52
LME Primary Nickel 1.62 1.64
LME Zinc (Spl. High Grade) 1.28 1.29
CMX Gold 2.04 1.95
CMX Silver 0.29 0.29
Source: Standard & Poor's.