Tuesday, 29 December 2009

Central banks are not putting the foot on the brake

The signs are multiplying that the central banks are readying themselves for mopping up excess liquidity added to the market over the past 15months. Obviously it has a tendency to make the financial markets nervous. I do not think that there is any reason to fear that the central banks will steal the punch bowl right now where the party is in full swing. They are simply preparing how to move the monetary policy from being "extremely accommodative" to just "very accommodative". Once that is achieved, there will still be several notches down to the "neutral" or even "somewhat restrictive". I do not believe that the financial markets will receive any shocks from that side for quite a while.
There has been a lot of talk about the impending hyperinflation. I just do not get it. Of course some vestiges of old monetarist theories can be used to say that if you print money, you will have inflation. This kind of thinking belies the complexity of the current situation. First, there is still a substantial output gap, i.e. difference between what the economies could produce and what they actually do produce. We are nowhere near closing this gap. And in order for the "too much money chasing too few goods" mechanism to work, one would have to assume that output cannot be increased in case demand increases. That is hardly the situation right now. Be sure that the OECD and the IMF will have ample time to warn about it happening. And those institutions are not known for being quick off the mark.

Another issue is has to do with the transmission mechanism from banks to the broader public. There is no direct connection between the liquidity being put at the disposal of the banks and the liquidity available to the broader public. It would be the case if the banks had used the facilities to increase lending. They haven't, and as a result the multiplier effect between the two kinds of money has been breaking down over the past year. This is clearly witnessed by the fact that there has been an upsurge in short term bond issues by companies. In other words, banks use the available liquidity to bolster their own capital by playing the steep government yield curve and companies are increasingly seeking funding outside the banking sector. That does not in any way indicate that the private sector is flooded in liquidity. Of course this situation will normalise over time, but there is still quite a way to go before it happens.

This could indicate that the zero interest rate policy is failing in one aspect, putting cheap liquidity at the disposal of companies in order for them to operate normally or even to resume investing. But the ZIRP is working efficiently in another way. The asset price reflation since March 2009 has made us all feel better. Our pension accounts are not bombed out, our security holdings have recovered a good deal of what they lost, property prices are stabilising, and in general we are not as scared any more. Demand is picking up and corporate managers who hit the panic button a year ago are beginning to see the light at the end of the tunnel.

I do not believe that the central banks are ready to hit the brakes anytime soon. If not for anything else, then because of the health of the banking sector. We have all heard of the high earnings and the ludicrous bonuses. One important element of this development is that the banks were given wide-ranging possibilities of hiding bad loans as when the mark-to-market principle was suspended. But hiding bad loans will not mean that they go away. As the number of corporate bankruptcies has sky-rocketed worldwide, it is safe to assume that delinquent loans are on the rise. They will have to be dealt with later, hopefully when the banks have capitalised themselves better – partly courtesy of the tax payer.

And then there is the Basel II. A lot of technical stuff published by the BIS last week, it essentially contains new and stricter requirements to the capitalisation of banks going forward. In the light of the experiences in the past year, it does not sound unreasonable. However, it means that it will take banks longer to return to "normal" health. It also makes it unlikely that central banks will be quick to revert to a restrictive monetary policy.

Tuesday, 22 December 2009

Back to normal?

2009 has truly been a remarkable year. Pitch-black pessimism in the stock markets was replaced by a powerful rally. The banks were rescued by governments without much demanded in return, and now everybody is surprised that nothing has changed in the banks' behaviour. Or rather in the behaviour of the bankers...

Among all this there have been a couple of changes in the underlying dynamics that just may give some pointers to the events in 2010. The rally that took place from early March is likely to be remembered as a relief rally, triggered by the fact that it became clear that the world economy would not collapse, that the banks would not evaporate, that the truckloads of taxpayer money thrown at avoiding a recession actually did work.

At the end of the day, the entire operation amounted to a massive move of bad assets from the banks' balances to the public sector balances without the taxpayers getting much in return. Apart from the ignominy of seeing the very same bankers walk away with huge bonuses, this time largely owing to public money.

Since October it has been clear that the stock markets moved away from the relief rally kind of thinking and back to a more "normal" focus on growth and earnings. It is no big surprise that the market participants have been rather bad at getting estimates and expectations right, a lot of economic forecasts and sales forecasts have gone out the window and have to be replaced by new ones. However, the fact that the stock markets are turning back to poring over company earnings reports represent a big step back towards the normal state of things.

I believe that "returning to normal" will be a highly important factor in 2010. It does not in any way guarantee a return to stability, though. The next big "normalisation" will be that of the monetary policy and bond markets. While the monetary policy provides explosive levels of liquidity, the excesses are slowly being reined in. Through 2010 or early 2011 we will return to a neutral monetary policy. Central banks may then move on to actually putting the foot on the brake, however lightly. Somewhere along the line the bond markets will have to deal with the fact that massive amounts of new government issues are flooding into the market in order to finance the budget deficits.

Whether that will lead to a major readjustment of bond yields (upwards, that is) will depend on whether the global private sector has increased it savings rate sufficiently to absorb the many new issues. That depends on a lot of factors ranging from the Chinese private sector savings to the spending habits of the American home owners. Having been sidelined by the stock market since the heyday of the dotcom bubble, bond markets are likely to return to take centre stage sometime in 2010. Back to normal, maybe, but without any guarantee of less volatile markets.

Wednesday, 16 December 2009

On dollar, risk models, and market stability

Buy dollar and sell stocks. This piece of advice has been handed out by investment advisers recently. They refer to the correlation between dollar and the stock markets, according to which a stronger dollar automatically should lead to weaker stock markets. I don't think so. The dollar strengthening is likely to be the result of a decreased willingness to carry leverage in a currency already cheap on almost any indicator. The stock markets have not dropped correspondingly because investors increasingly believe that the economic recovery eventually will lead to improved top line growth in most companies. Two entirely different stories.

This belief in a stable connection between dollar and the stock market touches upon one of my main criticisms against the financial institutions, the use of risk models.

Even if this is a subject for an academic discussion rather than a blog post I will try and explain. Virtually every model used to control risk or "optimise return" builds on a number of assumptions regarding the statistical properties of the markets. Unfortunately, two central assumptions have repeatedly been proved wrong. One is that the daily investment returns are log-normally distributed. The other is that correlations between asset classes are stable over time.

If we leave aside the issue of the distribution of investment returns and concentrate on the stability of the correlations, we can take as a point of departure the USD/EUR exchange rate and the stock markets. This observed correlation has been rather stable over the past two years. Episodes of dollar weakening have coincided nicely with periods of increasing stock markets.

In other words, if there are reasons to buy dollar then investors should also sell stocks. Interestingly enough, the causality is not explained. No explanations are given WHY a stronger dollar should lead to weaker stock markets. There is certainly no economic theory supporting this story, because if the a stronger USD were to drive stock markets down, it should only be the markets in the USD based economies as they lose competitiveness. European stock markets should by the same logic fact strengthen.

Lacking a theoretical foundation, one could argue that the carry trades, borrowing dollars to buy stocks has been driving the correlation. That could work for the past 9 months, but certainly not for the time between September 08 and March 09. During this period the explanation should have been that investors were shorting the stock markets in order to buy dollars??? Surely not.

Most likely, the observed correlation between dollar and the stock markets is just spurious – as it has happened many times before. There is no single explanation, just a series of events that have led to this observed connection between the two asset classes.

Risk models are always backward looking, since they are based on historical data – what else? They are constantly recalibrated in order to have the most recent developments integrated. Since the connection between dollar and stocks has been visible for two years, the models will now have picked it up and use it as an element in calculating portfolio risk.

But what happens if for some reason the correlation changes? For the users of the risk models, it means that the risk calculation is wrong for the time it takes for the models to detect the changes. Unfortunately, risk models are complicated and require a lot of daily observations in order to pick up a new trend. In this period the portfolio risk is likely to be much higher than stated by the models. Because a stable correlation between two asset classes can be used to hedge risk.

For the financial institutions that build their advice on the same connection between dollar and stocks something much simpler happens: they simply give their clients wrong advice for the period it takes to realise that something has changed.

The conclusion of all this not only that risk models are inherently misleading, and that they probably underestimate risk. It is also that the financial sector has a tendency to present ill-founded short term observations as undisputable long-term facts. Either way, the investors lose because the habits and the techniques in the financial markets are not tuned towards the detection of changes.

Monday, 14 December 2009


No, it is not a new Flu strain. It is a monster of a package of laws passed by the US House of Representatives on Friday. And it is otherwise a referred to as the Wall Street Reform and Consumer Protection Act. It is a catalogue of initiatives aiming at making the financial sector more accountable, more transparent, and less leveraged. I have on earlier occasions voiced my doubt that anything significant would happen to one of the most profitable financial products namely the OTC products. Such products are also covered in the HR4173.

Among many other things the law package also deals with boring stuff such as accounting practices and what must be counted on the balance sheet of a financial institution. The package also suggests a new role for the FDIC in the dissolution of systemic important institutions and new standards for consumer protection.

Trying to make sense of it leaves the impression that there are ample possibilities of creating loopholes. Not surprising given that the banking lobby has spent more than $300m in 2009 to influence lawmakers.

Take one example, swaps, which have always been OTC products, with no marketplace, little standardisation and non-existing transparency. No more has this been the case than for the Credit Default Swaps. A CDS is a contract between two parties that a third party will not default on its debt. One of the two parties issues the CDS and the other party is said to buy protection. The outstanding volume of CDS's on a given company has nothing to do with the actual volume of debt.

One of the biggest issuers of such protection was AIG and it is still anybody's guess how much money the US Treasury had to give to AIG in order for the company actually to be able to pay to all those who had bet that e.g. Lehman would fail. It would seem highly appropriate to make sure that such products were subject to standardisation and transparency. Notionally, the HR4173 does that in the sense that swaps (if the package is passed by the US Senate) must be traded via a recognised exchange. Unless the company buying it belongs to certain sectors, which are specifically exempt (hedge funds, airlines??) or alternative settlement facilities exist. In that case, no transparency is required.

The HR 4173 will probably not survive in its existing form when it moves on to the senate. What is important is that the areas of reform are now laid out and the Europeans can get going on their own projects. Sadly I have to use this word in plural, as the only sensible solution would be to have a solution for the entire European Economic Area. What we have seen so far from the European governments has largely been pathetic (a 50% surcharge on bank bonuses) and will prove ineffectual in the medium term. While we are waiting for the Americans, probably the European initiatives will be limited to small issues primarily aimed at pandering to public opinion.

For one, I do not understand why the EU has not seized the initiative and introduced a pan-European legislation. The experiences of the futures markets in the '90s proved that standardised contracts traded on a controlled exchange could attract large volumes of trading.

For the investors, the HR4173 contains provisions likely to be passed in one form or the other, and in the longer term the most important is the requirement to carry more instruments on the balance sheets. It means one thing, namely lower gearing. It will undermine the profitability and reduce the size of the banking sector relative to the economy. While many of the provisions in HR4173 will appear pointless, this one makes sense. Investors beware.

Friday, 11 December 2009

Timing a downgrade

On the surface, it looks simple: Independent experts issue reports that a debtor's ability to repay his debt has diminished. This because of overspending and lower income (in this case tax revenue). As a consequence of this, the borrower must pay a higher interest on his loans. This is roughly what has happened to Spain and Greece in recent days. The three (US-based) global rating agencies have issued reports or warnings that these two countries represent an increased default risk.

There is, however, a lot more to this story than meets the eye. Firstly, the stories about reduced ratings are a detriment to the Euro. The main beneficiary is the dollar. Having the world's undisputed reserve currency has over the years given USA a considerable advantage, as the quickly growing world trade required an increasing number of dollars for trade purposes. This role has been increasingly questioned as the Euro has proven stable. Several large development countries have openly talked about using euro for trading and currency management purposes. A healthy dose of euro unrest could stop such initiatives dead in their track.

Secondly, the world is emerging from a deep economic crisis triggered by irresponsible banking practices. Whereas the logical (and comparatively cheap) solution would have been to temporarily nationalise the banks, fire the management, rebuild their balance sheets and, in due time, to reprivatise the banks, no governments chose this avenue. The governments did not have the stomach to take on the banks, which, despite being deadly injured, were allowed to continue roughly as before. Instead governments threw tons of (future tax payer) money at the banks.

The effect was to turn what should have been a balance sheet issue into a strongly negative cash flow for the public sector. In the medium term, the effect is worse, as the refinancing of the banks anyway have caused the public sector balance sheets to deteriorate sharply. So the end effect was anyway to replace the unhealthy bank balance sheets with an unhealthy public sector balance sheet. On top of that the banks reacted by cutting credits, which negatively influenced the economic growth. This could partly have been counteracted by a Swedish-1990's-style intervention.

What the governments could have done differently is uninteresting now, except that we can learn how not to do it next time. The fact is that in order to avoid a collapse of the banking sector under the weight of its own greed and incompetence, the governments HAD to accept a certain erosion of its financial situation. Since a well-functioning banking system is necessity in a modern economy, the governments simply had no choice.

Of course some countries had public sector finances already in a not-so-good shape and Greece is certainly one of them. One thing is that the current public deficit is about 12 percent of GDP. Quite another thing is that its existing debt already stood at approximately 100 per cent of GDP at the end of 2008. This combination does not call for a lot of confidence.

If I had been a conspiracy theorist I would have added a third point: The deterioration of the government finances is nothing new, nothing surprising, and nothing that the rating agencies have not known about for quite a while. So my point would have been that the timing of the downgrades or warnings has a curious coincidence with the apparent attempts from the US political establishment to talk the dollar out of the weakening trend we have seen for most of 2009. And that this timing could form the basis for next round of the battle for having the dominant reserve currency. It obviously would not be nice of me to suggest anything like that.

The loud support for Greece from Germany could indicate that this whole story is not only about what we see on the surface. There are much bigger interests involved, namely the future of the status of the euro.


Wednesday, 9 December 2009

Downgrading Greece

One of the issues not dealt with in the set of agreements that led to the creation of the Euro was a sovereign default. Probably the situation was not taken seriously at that time and it would anyway have led to some seriously uncomfortable questions.

Before the creation of the Euro, a government could issue debt in their own currency or in a foreign currency. Credit rating agencies would normally concentrate on the foreign currency debt, since debt in local currency could always be paid back by printing money. Foreign currency debt, however, has to be repaid (or rolled over) in the same currency. In order to do that one needs some foreign currency income, some government discipline and – in the case of a debt rollover -some market confidence.

With the creation of the Euro, this traditional perception was confounded by the new question: How should a default of government debt issued by a euro member country be dealt with. It is not really local currency debt, since the government has no ability to force the central bank to finance the debt. It is not really foreign currency debt either, since all government revenue and expenditure as well as a large proportion of the foreign trade is in euro.

Ratings agencies have sidestepped this issue by now referring to national debt, and presumably treating all debt as sovereign debt.

The issue remains: Would the members of the Euro-zone allow a national government to default on its debt? So far the official policy is: yes of course. In reality I believe it would be very hard to obtain an agreement to let one of the smaller nations go bankrupt, even if the default would be entirely deserved. The euro-zone members would face the hard choice: let a country default and suffer the blows to the reputation of the euro, or shoulder the bill and bail out the debtor.

My guess is that in the case of Greece or Ireland, a complex series of loan arrangements would be made. The result would effectively be a bailout, engineered to take place over 20 or 30 years. The alternative would, I guess, be too damaging to the entire idea behind a common currency as the ultimate effect might be to force out a membership country.

If this logic holds, the ratings have no relationship to the risk of default. For investors it appears to have more to do with whether Greek government debt is eligible as collateral for repo transactions with the ECB. And here it gets very interesting. Being able to use government debt as collateral is an integral part of the risk management procedures of any bank.

So far, the ECB has used ratings from the three US rating agencies, Standard & Poor's, Moody's, and Fitch. As the independence of these rating companies were shown to be fictional in the sub-prime disaster, several politicians called for the creation of a European rating agency. One could guess that in case the rating agencies were to rate Greek debt sufficiently low that it under the existing definition would not any longer be eligible, the rules would be changed, and a serious effort would be made in order to establish some kind of European rating.

Relying on the three US ratings agencies has long been a thorn in the side of both the French and German governments, since they consider the agencies as potential political instruments for the US government. If a rating would directly lead to a major rearrangement inside the EU or the ECB, my guess is that this issue would be addressed very quickly and most likely, to the detriment of the rating agencies.

So what is all the noise about? Observing that the risk premium in the bond markets had fallen to the lowest since early 2007, I believe that we are heading for a period of general reassessment of the price of risk. But that is a completely different question.



Monday, 7 December 2009

Carry trades to hit a bump in the road or?

A carry trade is if you borrow money to invest. And obviously the cost of borrowing should be lower than the expected return on the investment. The "dollar carry trade" has been very popular in recent months. With dollar interest rates close to zero and the dollar depreciating against most other major currencies it has been obvious to borrow in dollars. This has led to a continued depreciation of the dollar, and so on. The investments? Well, just about anything would do, so let us just assume that investors have been investing in some of the assets that have profited from the recovery. Assets - stocks and corporate bonds - that have increased as the companies moved to rebuild profitability in the wake of the sharp downturn.

This Friday's report about the sudden improvement in the US labour market was a surprise. It was published right in time to improve the mood for the holiday shoppers, and politicians will hype it to make us believe that this was the turning point in the recession. No matter that there will be significant revisions showing that the data probably were erroneous. The revisions will only come after the holiday season...

Whether this is conscious manipulation of data or not, there has been another side effect of the report. Worldwide, central bank officials have been busy over the past two months to make sure we all understand that interest rates will not be tightened until the economic recovery is robust. With the publication of the labour market report the market began to reconsider this. Forward curves show that on average, the market now expects Fed to push up policy rates in August 2010 instead of September same year. As a result the dollar rose almost two percent in trade weighted terms, a quite significant move given the long period of a sagging dollar.

While this is all rather technical, the effects may actually prove to be important, as it is the first indication that the risk appetite may be falling. To those who established their positions in time, having invested in the stock market and borrowing in USD has been a one-way street for much of the year. Friday's strong move in USD served as a timely reminder that the market does not offer any free lunches but that all investments are risky.

The point is now whether this bump in the road is enough to wean investors off the carry trades. Probably not, but the story is out now. Add to this that the USD probably by some measure is undervalued (Just think of the number of Europeans going stateside holiday shopping). Friday's reaction also gave the indication that once investors want to close these trades, the market movement can be swift and merciless. I do not want to sound alarmist, but this issue has the potential to be one that really could roil the market.

Tuesday, 1 December 2009

Regulating derivatives markets

There are signs that the extremely well-organised US banking lobby is successful in killing attempts to introduce more regulation of the derivatives markets. The US regulators have presented a project to force substantial part of the OTC (over the counter) market into becoming a transparent, regulated market.

The advantages of doing this are obvious: By creating a clearing house, the market will roughly know who is exposed as counterparts. By using standard contracts, it will be possible to create a reasonably efficient second market, where buyers of the products will be able to sell their derivatives at a narrow bid-offer spread.

Previous moves in this direction have always seen a positive effect for nearly everyone: Better liquidity, lower prices, improved regulatory oversight. All of those things would have very nice to have during the big bailouts of US banks last spring. So it is not surprising that the suggestions presented by the chairman of the US Commodities and Futures Trading Commission contain exactly these provisions.

Intense footwork from the bank lobby has been efficient. Several major US manufacturing companies have come out in favour of individual, non-standard contracts, citing that it will be cheaper and more efficient to work on the basis of individual contracts. They have even gone so far as to say that if they cannot continue having their individual contracts, it may cost jobs. And these jobs may magically disappear in the constituencies of certain senators or representatives.

Here as in many other contexts, it is about money. Contrary to what the OTC providers claim, they make more money on individualised contracts than on standard contracts, and the big players maintain a huge advantage by knowing more about the flows than other market participants.

The best guess is that the US banking lobby has already managed to kill off the attempt at regulation, thereby protecting the revenue of the big players in the OTC market. A year ago the banks needed rescue. Now they have been rescued, and promptly use some of the money they received to block relevant legislation.

In Europe there has been some hesitation on the part of the EU regulators, there has been a hearing but obviously EU regulators wanted to delay their own proposal until they had indications regarding the US initiatives. Now it will be exciting to see if the EU regulators have the guts to present new regulation in the absence of US initiatives.

Initially one would expect this NOT to happen. However, in this particular case there would be good reasons to do so. Previous experience with regulated and standardised derivatives markets have been encouraging. Loads of players have moved over to the standardised markets and have realised that they were more efficient. The experience of the European markets in bond futures are a good example. So actually here might be a way of attracting turnover by being stricter. It does not happen often, but in this case it appears so obvious that it would work.

Another example where it would be good to see European leadership.

Friday, 27 November 2009

Dubai deserted and again risk systems are left in the dirt

Yesterday's information that a Dubai government-sponsored organisation had asked its creditors for a 6 months moratorium on a huge loan had stock market participants scurrying for the exit. The explanations offered were that a) it would hit European banks, who had sponsored some of the most ostentatious building projects on earth b) that the moratorium was a harbinger of a wave of defaults on sovereign debt c) the US markets were closed owing to the ritual feast that sees upward of 26m turkeys slaughtered or d) "I don't know what is going on, so I'd better sell".

Sure, it is bad enough if a government sponsored entity in a wealthy Gulf country goes belly up. But the amounts involved, apparently some $50bn, are small change compared to what we have gotten used to during the past 15 months, so surely the banking sector could absorb that loss – which anyway appears in fact only to be a demand for a bridge financing. But it is hardly an indication that we are on the cusp of a major melt-down in government debt.

Such fears appear to be built on a misunderstanding of government debt. Most government debt is issued in the country's own currency and can be repaid simply by printing more money – probably increasing the inflation in the passing. Creating inflation would in itself reduce the real value of the outstanding debt, which is probably why most debt defaults are also preceded by a period of domestic inflation.

It is a very different game if a country has issued a lot of debt in other currencies. In that case, the country needs a current account surplus to pay back the debt, and in a situation where the currency is in free fall, this could be very tricky and the debt default theme could become real. Currently there is a lot of talk about sovereign defaults, and Japan is often mentioned because of a skyrocketing government debt. But Japan's debt is denominated in JPY and nearly 95% of it is held by domestic savers. So a government default there would surely be spectacular, but would mainly imply a major redistribution of wealth between the generations.

So we probably should not fear a default on Dubai debt too much.

Something else can be learned from the market reaction over the last couple of days. We have (again) seen a classical "lemming" scenario where suddenly market participants appear to be heading for the exit at the same time. It is precisely such a situation that risk management systems cannot handle. Yesterday we saw the strongest spike in market volatility we have seen for months. The reason was of course that the normal correlation between market segments was cancelled and all segments move in unison. This change in behaviour simply cannot be captured in mathematical models, if those models have to be able to react quickly to changes in market conditions. A day like yesterday was exactly one of those days where all the risk systems in the world aimed at "controlling" risk again had to throw the towel in the ring. The reason is that those models are all based on "normal" situations and cannot quickly enough capture when the dynamics of the market suddenly changes. So for days like yesterday, such models were absolutely useless. Today brought calm back to the markets and the episode is likely to be quickly forgotten. But what if today had seen a similar market fall, and the same on Monday? Then the market could have lost 10 per cent and the risk control systems would still not have had time to react.

I think that it is cause for more than just discomfort that we have built nearly all risk systems in the world on assumptions that over and over again are proven wrong. And that nobody has had the smarts to create risk control on the basis of the fact that market increases, it is mostly accompanied by a falling volatility, but market falls are always coinciding with a strong spike in volatility. Some new thinking is necessary.

Friday, 20 November 2009

How much better will it get for the banks?

In a surprising display of arrogance, banks who owe their very survival to healthy doses of taxpayer money have been quick to return to mega-bonuses for their management and staff. When asked how this was possible, the answer has been that "we are paying back the money we got, so we are free to do what we want".

Bank stocks have rebounded strongly since the dark days of last March, when a wholesale collapse of the finance sector was widely feared. And now they are top of the heap again. One could rightly ask how, since the economy has not exactly been vibrant anywhere in the world with the exception of China.

The answer is of course that some of the measures put in place between October 2008 and February 2009 are still strongly positive for the banks' bottom lines. The direct assistance in the form of loans to the banks or capital injections is obviously politically sensitive and something politicians want to get off the table as quickly as possible.

One massive subsidy that is not offensive to the tabloid press is, however, the yield curve. Currently, banks can borrow at 0 percent at the short end of the curve and place at 3.5% or thereabouts in 10 year government bonds. This interest rate differential is a major subsidy and it is ongoing. It is not classified in any public accounts as "subsidy to banks" and is in this way totally under the radar screen.

Currently the yield curves across the world are at their steepest seen in a decade. A step yield curve at the end of a recession is normal, as the markets are pricing in higher short term interest rates going forward´. It also means that the hidden subsidy to the banks presumably is at its highest right now. The bottom line effect for the banks of this is probably at its maximum right now.

Most banks have trading operations. Even if the banks in their advice to clients have missed out spectacularly on the turnaround in the stock markets, their trading operations certainly haven't. The turnover in stocks which slowed markedly last year, did take off in the second and third quarter this year. While we are likely to see a nice turnover in the months going forward, it is unlikely to show the same growth rates, and this implies that the bottom line contribution from trading will have a hard time to continue it growth.

And finally, the mark-to-market valuation of assets was scrapped. It leaves the banks with a considerable freedom to price assets they hold or have a lien on. In practical terms, it means that they are given the possibility to postpone (or maybe even avoid) loss provisions.

It is my perception that banks right in this moment is moving out of a "sweet spot" that has lasted for months. The hidden subsidy from the yield curve will be reduced once the yield curve flattens, the turnover from trading operations will grow less slowly and the loan provisions will slowly grow. The various initiatives towards new, tighter regulation will most likely leave the banks in a situation where they are forced to deleverage further, making it much more difficult to earn the same money as before the recession started.

All of this is unlikely to create problems for the banks' survival going forward. But I do believe that the party for financial stocks may well be over for this time.

Monday, 16 November 2009

Why the CNY could strengthen

Friday saw a widening of the US trade deficit, which apparently surprised the markets. Proving how short a memory the market has, nobody appeared to remember last month's rather disturbing observations that the US consumers again are again bringing their savings rate down. Paired with increased public spending, there should be no surprise that the trade deficit widens. The only thing that should could about an improvement in the trade balance would be a significant upsurge in US exports.

Which takes me to my other point, namely the Chinese exchange rate. Some days ago I wrote that as long as the Chinese decide to have a fixed exchange rate against the USD, there is no need to worry about the financing of the US deficit: China is simply forced to buy USD denominated assets matching the accumulated surplus. If not, the CNY will appreciate.

There are two reasons why the Chinese may in fact be interested in letting the CNY appreciate. One is the US pressure for this to happen, another is the follow-on effects on the Chinese economy.

The US pressure is probably not causing the Chinese leadership too many sleepless nights. Over the past 20 years, Western corporations have been busy de-industrialising, actively moving production to China. There are many reasons for this, and none of them can be remedied by a slightly stronger Yuan. Structurally, the Western world has been busy moving production to China, enticed by very low salaries, the lure of the productivity of freshly minted production capacities, the productivity of the Chinese workers, an attractive model for reinvesting profits and so on. This trend has certainly also been helped by a growing feeling that here in the West, we don't do dirty hands any more. Producing stuff is simply not cool any more. Banking and other service activities are cool.

I am afraid that the Yuan would have to appreciate very strongly in order to compensate for these factors. The fact that China and other Asian countries have become the primary global manufacturing motor will not change even if the Yuan appreciates by half. In this respect, the Chinese leadership has little to fear from the pressures from President Obama.

The other side of the coin is apparently more worrisome. If country runs a strong current account surplus with a fixed exchange rate towards the deficit country, this surplus will manifest itself in a strong increase in the money stock of the surplus currency. Unless the monetary authorities do something, the increased money circulation will drive up prices and in some cases lead to speculative increases in asset prices.

Usually, the central bank of a surplus country will try to offset this by selling government paper in the market, aiming to "soak up" the excess liquidity by so-called sterilising operations. And here is the rub. China does not have a well-developed market for this kind of instruments. Which means that controlling the domestic effects of the huge accumulated surplus becomes more and more difficult. By letting the Yuan appreciate, the Chinese authorities could at least partially offset this effect.

Recently, senior Chinese politicians have joined forces in warning that the low US interest rates are laying the foundation for a new speculative bubble. They are right. Nowhere is that more correct than for countries with their currency pegged to the USD and an inadequate system to control the domestic liquidity. If the Chinese decide to let the Yuan appreciate, this is the reason. US pressure will have little to do with it.

Thursday, 12 November 2009

Role Reversal

While the financial markets continue to worry about the impending monetary tightening, the world's central banks are busy tightening. This is possible because the various policy initiatives consisted of myriads of activities which each contributed to the overall result. An extended credit line here, a swap line there, a reduced collateral requirement somewhere. And then of course the icing on the cake, the low mainline interest rates. Across the world, central banks are now sending clear signals that they are just about to pare back various elements as it increasingly becomes clear that they are not necessary any longer. Of course, central bankers say that they will not tighten monetary policy until the recovery has taken hold. They are tightening already, they just do not want to unsettle neither markets nor businesses. Obviously, the speed of the tightening will depend on the underlying economic reality.

Which brings me to the next observation. In a past life I was busy marketing products investing in Asian companies, and one of the sales pitches was that the region was moving towards an increased economic integration and hence would become more dependent on domestic demand rather than Western demand as a driver of their economic growth.

It might have been premature 10 years ago, but statements from central bankers over the past week or so are telling a revealing story about the changing roles in the world economy. What we are experiencing is a role reversal on a grand scale. In the past two decades the gospel has been that the US has been the world's growth leader and the rest of us have been pulled along in the slipstream of this technological juggernaut. When looking into the details a lot of this actually proves not to be entirely true – the sub-story of the superior US productivity growth is a case in point. But the storytelling has been clear: USA with its clear capitalistic system has again and again proven superior to any other society in the world.

Dreams are hard to kill, including the American one. But the current situation shows that the US is now lagging woefully behind in recovering from the recession. The growth leaders are the emerging economies, with China as the pace-setter. In between, we find Europe, who was worse hit than I expected, but is also quicker to recover than feared. Yesterday's statements from a raft of US federal bankers and from the German member of ECB's board told a clear story. The US Federal Reserve fears that the recovery will be weak and hesitant, while the German economy is likely to surprise on the upside in the coming quarters. Fresh statistics out of China indicates a GDP growth around 8 per cent.

There are a lot of conclusions to be made from this development. One is that the laggards appear to be the economies where the household sector carries large debts relative to their incomes. Another is that the allegedly bloated public sectors in Europe indeed function as stabilisers. A third lesson is that even command economies are able to react swiftly and decisively in the face of major economic trouble. The most important lesson to be learned is however that the emerging economies are finally delivering on their promise of becoming self-sufficient in terms of growth.

Investors should embrace this new reality. It is unlikely to go away anytime soon. The US may be the world's technology leader. Europe may lead in terms of being clever regarding organisational design and efficient infrastructure. But we are getting increasingly dependent on the ability of the emerging countries to produce the clever devices we surround ourselves with. Who talked about a "post-industrial society"?

Monday, 9 November 2009

Funding dollar deficits

With mounting budget deficits and a fresh fall in the private sector savings rate, quite a number of US commentators have become worried about whether the rest of the world will continue to provide credit for what is apparently an endless overconsumption. In Europe, there has been no shortage of dire predictions that at some point in time, the chronic external imbalances of the US ultimately would lead to higher bond yields in the US and that it would even have an effect on European bond yields. And that the way for the USD to go would be down, down, down.

Yet, there seems to be no drama in the bond market and that the dollar weakening (against the EUR) progresses orderly and not in a collapse.

The factor that most commentators appear to overlook entirely is that half of the world  (or at least half of the world's GDP) has been running on a spontaneous dollar peg for quite a while. With such a mechanism in place, there is no particular reason why there should be no funding of dollar deficits.

10 years ago, in the period between the Asian currency crisis in 1997 and the introduction of the Euro, tons of ink were spilled in arguing the pros and cons of the European currency union. All the right buzzwords were used, and the debate was utterly inconsequential. In that very same period, a number of the Asian countries (and quite a number of Latin American ones as well) quietly established a peg towards the USD. At that period it was a logical choice, as USD was the unrivalled trading and reserve currency as well as the currency of the world's largest single market, the USA.

Typically, a peg to the dollar was a unilateral decision taken by the country pegging its currency to the USD. It is the country itself that assumes all responsibility for maintaining the peg. Given the traditional US attitude: "our currency, your problem", nobody would expect the US monetary authorities to lend a hand to, say, Argentina if her currency were about to weaken or strengthen.

Using the most fundamental of theories about exchange rates, a country that happens to run a current account surplus with the USA can chose two actions. A) to accept that the USD falls against the currency of the country in question or B) to purchase assets denominated USD in order to prevent the exchange rate from moving.

According to US government data through august 2009, the three countries with the largest trading surplus against the US are China, Japan, and Mexico. Canada comes in on 6th place, while Venezuela is 7th.

All of these countries have to a varying degree pegged their currencies towards the US. Japan and Canada have no official peg but are known to manage the float of JPY/CAD, whereas the other countries have rather strong pegging mechanisms.

For the USA it has the huge advantage that the largest surplus countries are forced to re-invest their surplus in USD denominated assets. For the surplus countries, maintaining the peg means that they have only a small currency risk towards their largest export market, and they have only a small risk of seeing their dollar assets devalue.

Against this background it seems almost foolhardy when US lawmakers rattle their sabres and call for a Chinese revaluation or a free float of the currency. It appears that those using such arguments only see the exchange rate as a measure of competitiveness. They fail to see the other side, the dependence of the US on a continued funding from abroad, and that this funding is secured as long as the main surplus countries peg their currencies.

Meanwhile, in a parallel universe, the big losers are the Europeans, who at every turn see their currency appreciate against the dollar bloc. European politicians may enjoy the warm glow of having the manliest of currencies. But in a slightly longer perspective, the fact that the EUR has been the only currency to systematically appreciate is a serious danger for the nascent economic recovery in Europe.

Tuesday, 3 November 2009

Taking on the banks

I have on earlier occasions been ranting about the way the US Administration missed an opportunity to reset the clock on the balance between government and the financial sector. No doubt, I am a great fan of the consequential and straightforward way the Swedish authorities handled the financial crisis in that country in the early '90s. To date, I have still not seen anything that would convince me that the same model could not have been applied in the US.

All of that is now history, and we should look forward to see how the issue of "too big to fail" (TBTF) is being handled. It is widely accepted that large institutions had scant regards for risk, simply because the gambled on being sufficiently big that the US Government would bail them out in case of trouble. Many observers believe this "Moral Hazard" to be the ultimate reason for the banking crisis.

For this reason it is interesting to see how the two governments deepest influenced by the financial crisis, the US and UK governments are handling the situation. There have been no shortage of observers pointing out that even if the financial institutions were TBTF but certainly not "too big to be carved up". The idea is that by splitting up the banks, one would reduce the risk of a systemic breakdown.

Over the weekend, news came out from the UK that the government would use its status as large shareholder to force a carving up of some of the largest banking groups in the UK, namely RBS and Lloyds TSB. It appears that carve-outs from these two banks together with the branches of Northern Rock, will be turned into three new retail banks. Several other business activities will also be sold off.

All in all, the government intends to recover some of the billions poured into the banks by divesting business activities. They will increase competition by bringing in new investors to the UK market (read: decrease the power of large banks in the UK). Further, the intention is to let RBS and Lloyds TSB "pay" for the participation in various elements of guarantee or insurance schemes. This latter element is a smokescreen as the "fees" will come out of dividends that would otherwise have gone to the biggest shareholder – namely the government. General elections are obviously coming up....

The US will likely choose a different way. For one, the Administration is favouring a shake-up of the regulatory bodies and it may end up creating a Financial Stability Council to monitor systemic risk in the economy and identify specific problem areas for attention.

Secondly, the approach to reducing the systemic risk of having a large number of TBTF institutions is aimed at using the market logic. So far it appears that the Administration will have discretionary powers to define institutions of systemic importance. These institutions will have to work with higher reserve requirements. An institution thus defined to be of systemic importance will have serious problems delivering the return on equity obtained by other institutions not defined to be of systemic importance.

Shareholders and management of central financial institutions would then have strong economic incentives to avoid being classified as "important". Trying to regulate by managing the market forces appears attractive to an American culture of leaving the markets to work their magic, but as always the details are important. And that is what remains to be seen. Will this seemingly clever idea make it through Congress intact under the predictable onslaught from industry lobbyists? Or will the financial institutions use every conceivable means of avoid being classified as systemically important?

In any case, regulators will eventually take on the banks and their wayward behaviour. Once all the dust has settled, only one thing is certain: Banking profitability will end up being reduced structurally. Probably we should not mourn this development too much.

Monday, 2 November 2009

On consumption vs business investment

Interestingly, hardly had I pushed the "publish" button for my post on Friday before the markets went into a tailspin. The story was the same as I have touched upon a couple of times in recent weeks, namely the role of consumer spending in the recovery.

On Friday, both Germany and the US reported that consumer expenditure had surprisingly fallen in September. The concrete numbers are probably likely to be changed in due time, but the damage was done and serves as a timely reminder about the uncertainty still haunting the markets.

My point of view remains unchanged. The consumer did not lead us into this downturn, and it is unlikely that the consumer will lead us out of the downturn, either. The downturn gained strong momentum because business managers across the world hit the stop button under the carpet bombing from news media covering the US banking crisis.

It is obvious that without the return of the consumer confidence and spending, this recovery will remain rather anaemic. Alone the weight of consumer spending in the composition of GDP is a guarantee that there will no return to robust economic growth if the consumers remain focused on saving money instead of spending.

This does not change my basic point, namely that the economy is in fact able to pull out on the recession by growth generated in two other subcomponents of the GDP, Business Investments and Government Expenditure.
As for the latter, we know that economic stimulus programs are beginning to work their magic from Beijing over Moscow to Berlin, Paris, and Washington. Depending on the relative size of the public sector in the economy this will have some positive effects in the coming quarters.

Which leads us back to the business investments. Traditionally the smallest part of the GDP, it is also the most volatile part (well, together with the residual known as inventory investments, that is). The beginning of this downturn was no different from any other downturn. Business investments reacted quickly as business leaders hit the stop button. What was, however, different is the depth of the contraction of investment.

Business investment fell sharper than seen anytime else since the war. 1/3 or more of the business investment disappeared in a matter of a few months, leading to suspicion that business leaders did not really hit the stop button. They hit the panic button instead. The same was true for the reduction of inventories.

My point is that the most important dynamic of the recovery comes from exactly the business investments. Inventory rebuilding has already started, while still investment is beginning to focus on yet another round of productivity gains. This goes hand in hand with further job cuts, leading to a continued increase in the unemployment.

So my point about the business investment component of the GDP being the most important in creating recovery dynamics should be seen in the light of increasing unemployment. Consumers are likely to remain uneasy until they see that unemployment is beginning to fall. Whenever that will happen, probably late next year or even later.

But such fine points were lost on the stock markets last week. They were looking for economic news to feed the nervousness that had been building in the previous weeks, and they found it. In the slightly longer term, such arguments are not relevant as the consumers will eventually return to the shopping malls. In the mean time, the stock markets may end up somewhat less bullish than seen in the past months.

Friday, 30 October 2009

The world economy is growing again

With yesterday's announcement that the US economy is now growing, there was a palpable feeling that the economic downturn is now over. Most large European countries returned to growth already in 2nd quarter and the Asian economies did likewise. The laggard is the UK economy, where the consumers are seriously hampered by high (mortgage) debts and falling property prices. Australia and Norway have increased their short term interest rates. So where do we go from here?

The first thing to notice is that everywhere there is evidence that government expenditure is important in pulling the economy out of the quagmire. Secondly, consumer spending is timid, and is likely to remain so for some time. Thirdly – and it should be no surprise – business investments are growing briskly after some quarters with collapse in this spending category. All of this is quite obvious, is well documented, and not surprising.

In other words, the next question is whether the market consensus will continue to run behind the facts. We have had a long season of positive surprises in many ways. First, companies reverted relatively quickly to profitability. Then, we saw that the business optimism returned. Now we see that business investment is becoming a driver of the economic activity faster than expected a year ago.

I admit to having been off the mark in February in predicting the timing of the beginning of the economic recovery. The economic stimulus from public expenditure programmes arrived faster than I expected back then. However, the earnings recovery set in sometimes in March and the market sensed that right. However, as I made clear in my comment of last week, a lot of real-money investors missed the upturn and have been running after the market since then.

It means that the stock market currently is stuck between a number of factors pulling in different directions. There are still some positive surprises to be had, as it will still take time before the consensus catches up with the economic reality. Stock valuations may indeed be stretched – but who knows really what earnings will be in a year from now. There are all the institutional investors who are still underweight in equities compared to their benchmark. Bond yields may be kept artificially low by significant yield curve manipulation in the face of massive emissions still to come.

All of that means that there is enough to talk about when trying to guess where the market will go. I believe that for now the liquidity issue is the most important one and will continue to drive the market in the weeks to come, and that chances for a good rally into the holiday season are high. Some time after Xmas, the economic and corporate news may indeed turn out much better than they are now. But at that point, it will not be a surprise to the market any more, and in order to find the new market direction we will have to look for the next trend.

The recent swings in the market may well be interpreted as being a harbinger of changes to come. Looking at the market volatility over the past two weeks in the market reveals no such thing. The size of the up- and downturns and their speed are identical to episodes we have seen several times since March. So in that respect there was nothing new this week. Except, of course, that it is now official that the recession is on its way to be replaced by economic growth.

Monday, 26 October 2009

A missed opportunity

Sometimes, American attitudes towards the cross field between morals, finance, and politics can be quite exasperating for people not reared in that country. Including me.

Friday and into the Weekend President Obama held several speeches where took the high moral grounds, telling the executives of the financial sector that now is not the time to go back to silly bonuses.

Excuse me! The Obama administration just a few months ago had a once-in-a-century opportunity to force reform upon the financial sector. They let this opportunity lapse, and now we have to listen to ineffectual banging on the drums. Somewhere down the line something must have gone wrong. The way things stand now, it is only a question of time before the financial sector will be back to its bad old ways, possibly with some changes on the margin reducing the obviously dangerous aspects of some asset types (read: CDS's and other OTC derivatives).

Let me explain: Last summer the American banking sector was insolvent because of losses incurred on products that had been pushed without any understanding of the underlying risks. As a modern economy cannot function without a banking sector, the US government stepped in and poured obscene amounts of money into the banking sector in order to replace the lost capital and keep the system afloat.

In a much smaller country far away something like that had happened 15 years earlier. A country supposedly the closest you come to socialism in the post-communist era, Sweden took a very capitalist approach to a crisis that was every bit as serious as the US crisis. The Swedish government took the logical approach that shareholders who had not put a proper oversight in place deserved to lose their investments and the bank managers deserved to lose their jobs. And so it happened. The banks were nationalised with no "compensation" to the shareholders, managers were unceremoniously kicked out, and the impaired balance sheets of the banks were kept as part of the government balance sheets for the time it took to restructure and re-sell the banks in the market. Bad debt was put into a separate company floated on the stock exchange. The banking landscape was changed and the government probably ended up making a small profit on the entire transaction.

This somehow embodied the essence of capitalist ethos: If you win, you get rich. If you lose, you lose.

The American rescue of the banking sector somehow seems a muddled version of a socialist rescue in the sense that a lot of money has been poured into the financial sector, but no real consequences were forced upon the shareholders and the managers. Now that the crisis seems to be all but over, the banking lobby is back with a vengeance trying to block attempts at reforming the financial market legislation. Bonuses are creeping back to pre-crisis levels, and Obama, elected on a vaguely defined platform of "change" has to resort to public speeches in order to try and make the banking sector cooperate. It just will not work. If not followed up with action, such words only serve to give the public an impression that their president is concerned. Otherwise it is empty talk, just showing that at least Obama has the right morals...

Behind all this, there is of course another game going on. It is a power game, a game about influence. When the Swedish government made short shrift of the shareholders' and managers' interest in the early '90s, it was of course because the underlying attitude was that such interests had to be subsumed under the broader national interest of having a well-functioning banking system without tendencies to excesses. In the US, there has been no political will to suppress these interests. As Simon Johnson, a former IMF chief economist noted in a very interesting article in The Atlantic, the financial sector's influence in the US is bigger than in any other civilised country. The influence is in fact so powerful and pervasive that we have to go to Third World countries to find a parallel.

In this respect, the rescue of the US banking system was a muddled one, because it did not attack the root courses of the crisis. The reason is obviously that there was no politician who had the stomach to take on the financial sector, even when it was deadly wounded. So we are now on our way back to a system where the economic interests of the banking sector dominate the interests of the tax payer, and the power of the financial sector is rebounding.

It makes me cringe listening to Obama's moral teachings under these circumstances, knowing that the US Administration missed a chance to grant itself far more power and freedom. Financial sector reform is first and foremost a power struggle and the US Government did not seize the moment. Instead US tax payers will have to pay and pay.

Friday, 23 October 2009

Consumers will not lead this recovery

One of the misperceptions commonly heard in the market these days is that the consumer will lead us out of this recession. It is true that private consumer expenditure is a large part of total GDP and without a rebound in consumer expenditure, there will not be any strong economic growth. However, this downturn did not start with the consumer and the recovery has not started with the consumer.

Rewind to last year in August and September. Bear Stearns had gone, Lehman was going down, the Interbank market was frozen. To most people this would have been distant rumblings had it not been for the carpet bombing with news about the "financial crisis" from every conceivable news outlet. Even the sports pages carried news about the potential impact of the "financial crisis" for the football clubs and the prospective earnings for the highest pays sport stars. Ordinary folk shook their heads and the most rational among them began to cut some of the excess out of their daily consumption.

Corporate executives, however, reacted differently. They heard that their banks would cut dramatically back on credits and that the same would happen to other companies. Faced with an increased uncertainty, CEOs and CFOs across the world reacted swiftly: cancel orders, write down inventories and begin to prepare for further cost reductions (read: layoffs). Given how the corporate world has taken to the "Cisco" model for production and inventories, this effect was rapid and almost coordinated across the world. The effect was a collapse in corporate investments. Together with continued alarming news from virtually all news media, this disturbing news understandably further made consumers nervous and consumption began to give in.

While this is no attempt at underestimating the nefarious effects of a frozen banking sector, there is no doubt that this economic downturn became so rapid and dramatic because modern ERP (enterprise resource planning) systems melded with a 24/7 coverage of the events on virtually every news media. Corporate investments were the leading factor. Everything else followed. Yes, for sure there are subsectors of the US consumer markets also stopped dead in their track as some over-indebted consumers were forced to increase savings. But their effect on the global economy was limited compared to this "CNBC downturn".

It will be the same coming out of the recession. Rapid cost reductions meant that corporate profitability rebounded rather quickly and the stock markets followed. The next thing that will happen is a return to corporate investment and it will be focused on efficiency enhancing investments – i.e. yet another cycle of technology investment. Only then companies will begin to employ. And once the danger of losing one's job in a wave of job reductions, consumers will feel reassured and begin to consume again. The only real exception to this sequence appears to be US consumers, who are currently reducing their savings rates as new consumer credits appear to come on stream.

As many financial market observers use the consumers' sluggish reactions as a "proof" that the stock market rally is overdone, it might be worth noting that when compared to every other post-recession boom this century. There is nothing abnormal about this recovery; it is just a bit above normal, but nothing dramatic. It is quite obvious what is happening at a corporate level. Just check the NAPM or PMI indices: the new order component is increasing strongly. Soon corporate investments will begin to increase strongly as well.

I am usually sceptical of the stock markets' ability to predict anything (it completely "forgot" to predict the current downturn, just to take one example). However, this time it looks as if the market participants are indeed ahead of the economists. Technology and Infrastructure are indeed the winners.

Tuesday, 20 October 2009

When the central banks tighten the monetary policy

One of the Big Kahunas out there in the financial markets is what will happen once the central banks begin to tighten the monetary policy. The simpler version is what will happen once the policy rates begin to creep upwards. Somehow this fear misses the points. We are way past the point of further policy easing and of course the interest rates will begin to climb upwards.

As central banks introduced their various programs to save the financial sector from self-inflicted injuries, they made tons of liquidity available to the banks. And they lowered the interest rates to zero or thereabouts. When trying to follow the various reports from the central banks, it is clear that the banks do not any longer use the total amount of liquidity put at their disposal. It is a good sign since it indicates that the bank's health nominally has moved out of the danger zone and is moving in the direction of normal business.

The next thing that will happen is that the central banks will reduce the amount of extra liquidity available to the banks. I am sure it will be understood as a "tightening move". It isn't – it is just the retraction of extra facilities that nobody uses anyway. And that is not really a tightening.

Once the interest rates begin to move higher it will be almost the same. Interest rates are currently very low and they can increase quite a bit before they begin to bite. The relevant point for the financial markets should not be when the markets move up the first time, nor when they move into neutral territory but when they cross into tightening territory.

However, it is not that clear where that territory is. But it is possible to have a good estimate, since there are more or less well-established principles for calculating the "equilibrium" or "target" interest rates. One of those rules is the so-called Taylor rule (named after John B Taylor, an academic economist who also served as member of the Council of Economic Advisors to US presidents and as an Undersecretary of the Treasury). Taylor proposed that the central banks adopt a rule fixing the target interest rates as a simple function of observed inflation, target inflation, economic output as measured by GDP, and potential GDP.

While these ingredients appear complicated, there are many economists, including those from the financial sector, who do a quite good job of estimating the target rates, using this rule. In general Taylor's rule has proved to be a good indicator of short term interest rates, and economists have in general been on the ball in predicting the change in the interest rate trends. The same thing will happen this time. There will be ample indications of the need to tighten (which is not the same as increasing the interest rates over and above the current very low interest rates), once that begins to emerge.

I am afraid that this point will be missed on most market participants. They have their eye firmly on the short term interest rates, and as soon as they begin to move it will be presented as an impending disaster and what not. It will probably create some market movements but it will only be in the short term. There is no doubt that the world economy is recovering pulled by massive public spending and a profit recovery fuelled by massive spending cuts in the past 12 months. The consumers are not following through yet, spooked by increasing unemployment. So in that sense, the recovery will remain subdued.

All of these factors point to an extended period before the central banks begin to tighten – as opposed to hiking interest rates. My best guess is that H2 of 2010 is the relevant time horizon.
BTW notice that US central bank director Bernanke in this weekend gave a talk, warning about the return of international imbalances, explicitly mentioning the falling US savings rate. To readers of this blog, this should come as no surprise, given our post from 14 October..... I am just afraid that US politicians eager for reelection next year are unwilling to introduce economic and tax reforms in order to increase the Savings Rate. Even if it certainly would be the right thing to do.

Thursday, 15 October 2009

Do fund managers have a crystal ball? Naah...

Merrill Lynch, the US investment bank that lost its independence because of its belated dabbling in Subprimes and scant risk controls, have for years made a survey of a large number of fund managers worldwide, who control huge amounts of invested money (229 managers, $600bn+ of assets). The survey for October has just been released, and it is sobering reading.
To those who have been on Mars for the last year, the stock market turned in March, and has since then seen a bull run a bit stronger than the average post-recession bull runs this century. Now, how have fund managers handled this situation?
The first thing to notice is that in March these good people were divided in two camps of roughly equal size: half believed that economic growth and corporate earnings would improve going ahead.
The other half believed that things would get worse. Since then, things have improved and now about 80% say they are optimists. Earnings and economic growth will improve in 2010.
Nevertheless, fund managers – despite their oft-repeated claim to being ahead of the trends – have been distinctly slow to come out of the starting blocks. It took four months until 50% were overweight in shares. The other 50% were still underweight. In other words, half of the fund managers of this world were still underweight when the market had rallied 35% or more.
Obviously, most of the fund managers now claim to believe that earnings will improve by more than 10% in the coming twelve months and that there is no major risk of a setback anytime soon.
Let us try to present this in a slightly more cynical way. In March about half of the fund managers had seen what where earnings and growth were heading. Four month later, most fund managers had got it right in terms of understanding what was happening. But still only half of them had managed to react to their convictions and raised equity positions to overweight. Half of them had missed the bull market and were still underweight. Fast forward to September and 80% now claim to be overweight.
It means that 20% are still underweight. 30% are overweight but missed out on the rally from March to June. Both of those groups must logically still be lagging behind in terms of relative performance.
And now for the interesting question for the market: what will these fund managers do in the near future? They are approaching New Year, and they did not manage to get in on a regular post-recession rally in time. Shareholders and investors will begin to ask serious questions as the fund managers lost money 2008 and will have underperformed in 2009.
Not a good situation – in fact that is the kind of situation designed to cut a career short. So my guess is that an uneasy feeling is creeping in. This could well confirm a perception that this market rally has good legs because of all those (50%) whose relative performance is still lagging and who see no other means than to increase their equity holdings as the year draws to a close.
So much for crystal balls and being ahead of the trend. Also among fund managers about half get it right and half get it wrong when they guess about the future. And there appears to be a distinct time gap between understanding and putting the understanding into action. Believing that fund managers are ahead of the market could seriously damage your wealth.

Wednesday, 14 October 2009

US consumers on the way back to their old ways?

Today US Retail Sales data gave the markets a positive surprise. It appears that the US consumer is indeed getting back to the old ways, spending when possible and not caring about tomorrow. Or what is going on?
Already late last year I stated that the recovery would be slow and protracted, as the US consumer would have to rebuild balance sheets after a long period of overspending and overborrowing. The positive side of this consolidation was that it would have a positive effect on the US trade deficit. For those of us who believe in some kind of celestial justice, it appeared fully justified that 7 fat years would be followed by 7 meagre years. Indeed, for a while it appeared as if everything would be on track for this scenario to unfold. Modern-day hubris and nemesis, so to speak.
The US trade deficit has indeed narrowed in spite of a record budget deficit. Private households have saved more, pushing the savings rate upwards. Economists were talking about a return to the 7 per cent savings quote within a short period of time. Just before the sub-prime crisis blew up, the private sector savings rate had shrunk below 1 percent and in periods in fact it was negative.
So where does this new rebound in Retail Sales come from. Well, it comes from a falling savings rate. In April of this year the savings rate stood at roughly 6 percent and everything looked fine (at least from this narrow perspective). Since then the savings hate has gone down below 3 per cent and it appears heading lower. At this pace the savings rate may return to the region of 1.5 per already this year, bringing one of the perennial American vices to the forefront: living on borrowed money. If the savings rate does indeed fall that far, the US trade account deficit will widen again. There will not be any improvement in the twin deficits which are ultimately at the root of the current market instability. So maybe we should begin to cry wolf again.
It might be wise, but that is at least not what the markets are thinking. Market participants are notorious for being able to focus only on news confirming their current beliefs. They are interested in seeing a quick return to growth and prosperity in order to justify the continuation of the current market rally. Hence they focus on the headline numbers (in this case the Retail Sales) and on the "surprise" they bring. Nothing could be more irrelevant to the market sentiment than some esoterical accounting entries that may influence us next year or later. It is entirely irrelevant that the effect will ultimately prove a further negative factor for the dollar's position in both medium and long term.
One could wonder what a fall in the Savings Rate would mean for the Obama administration. One could hope that some brave men and women would stand up and try to introduce tax structures designed to increase the Savings Rate – technically not really that difficult, indeed. Chances are that they will not. Obama will be up for re-election in 2012 and most of that year will likely be totally devoted to campaigning. This leaves us with two years to rebuild consumer confidence if Obama is to avoid the fate of being a one-term president. My guess is that consumers (i.e. voters) are easier to convince with the shopping cart in the mall than with some abstract element about the waning economic influence of the US of A. No matter how irresponsible it is, I believe that the political instincts will hail the "surprisingly good" Retails Sales data. The twin deficits will be for later....
Meanwhile, the stock market rally will continue. And maybe even deliver a blow-off into the New Year driven by all those who have been blindsided by the strength of the recovery.

Monday, 12 October 2009

Intellectual flexibility – or plain greed

Sometimes it is hard NOT to smile when confronted with the ability of players in the financial markets to adjust their thinking to the circumstances. Does anybody remember July 2008 when Crude Oil was trading about 140$/barrel. We all had to endure explanations that this phenomenon was based on sound facts (oil reserves were to be depleted next Wednesday) and that speculative moves in the very small market for sweet light crude had nothing to do with it.

Yet on July 14 2009 (Crude oil trading below 50$/barrel) the US Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler presented data to a congressional panel that 71% of the oil futures traded on the NYMEX in 2007 had been speculative. And this number even omitted the trades over the London-based ICE – the so-called London Loophole. One of the peculiarities of the legislation in place was that CFTC allowed exactly oil futures to be regulated by the exchanges themselves instead of following standard trade rules. Another peculiarity was that the mandatory reporting of the oil futures was sufficiently light that it was impossible to establish a normal overview of the total market positioning. The Congress granted the CFTC powers to regulate the oil market - accompanied by a howl of protests from the market players.

But that was then. Now the US congress is struggling with something far bigger, the regulation of Over-The-Counter (OTC) derivatives. Some months have passed since the CFTC hearings, the economy is recovering and the financial market players are trying to display some kind of normalcy. Bonuses at silly levels are but one example of this return to normal.

Obama's administration have committed themselves to introducing legislation to regulate the OTC market. OTC is short for a class of derivatives where essentially no contracts are standardised, every transaction takes place on a bilateral basis, and where transparency is non-existing. One famous type of derivative is the Credit Default Swap, the CDS. A CDS is a contract between two parties that one will pay the other an amount if a third party defaults on repaying its corporate bonds. The nominal value of these bets is often many times bigger than the corporate bond issue itself.

Remember AIG? The main reason for the fall of AIG was exactly that the company had been the issuing counterparty of CDS's to the tune of astronomical nominal amounts. A large part of the government money poured into AIG went towards honouring the company's liabilities related to unregulated OTC products. Tax payer money went into paying off gambling debt.

Now the US Congress is discussing to introduce legislation aiming at standardising the products, making sure they are traded in something akin to a regulated market, and introducing a clearing house, so settlement can happen in a transparent way. The purpose is to make it possible to create an overview of the total number of OTC products – in the honourable intention of exposing the risks taken by the banks active in the market for OTC products.

Guess what. Industry representatives are now lobbying hard to avoid just that. We are now told that OTC products are necessary for the consumers, because manufacturers need the products to hedge their raw material costs. We are told that standardisation is an evil because the markets will then not be able to offer customers precise hedging. In other words, the kind of products that one year ago were clear to have played a pivotal role in disguising the risks taken by banks are now again necessary to reduce market risks??

Using Rule #1 of the Private Snoop: Follow the Money, one arrives at a rather more sobering picture. The largest operators in the OTC market have made tons of money in non-transparent OTC product, simply because the bid offer spread on such contracts is astronomical. Forcing the market into standardised products and an organised market would cause bid-offer spreads to narrow sharply, undermining the earnings of the biggest players. So their sudden concern for the consumers' needs is probably just a way of not really telling that derivatives should continue contributing to their earnings.

One can only pray that the US Congress in this instance is not swayed by highly paid lobbyists. What the world needs now is NOT that the financial markets continue dealing with derivatives in the usual hush-hush way. Derivatives are indeed useful, but there has to be some possibility of overseeing the total exposure, and so on. The financial markets have always thrived on the ability of clients and politicians to have very short memories. This time is no exception to that rule.

Maybe there is some hope. John Maynard Keynes – a UK economist, whose teachings were behind the reorganisation of the world economic system after WWII – was quietly dropped from university reading lists across the world. His books have seen a remarkable pick-up in sales over the past months. It is reassuring that there are people who still believe that the government has an important role to play in regulating the economy and the markets. It is particularly reassuring now that the financial markets are back fighting regulation after a combination of unregulated products very nearly blew us all out of the water.

Friday, 9 October 2009

Will Bernanke steal the punch bowl any time soon?

Remarks by US Federal Reserve Chairman Ben Bernanke regarding the return to more normal monetary policy are quoted widely today. Apparently, quite a number of pundits interpret his remarks as yet another indication that Federal Reserve will begin to tighten monetary policy "soon". Bernanke was thus taken as a character witness for the many strategists who believes that NOW is the time to sell stocks.

I profess to have great respect for seasoned "Fed Watchers", who have deep knowledge of monetary policy and of the political games around the Federal Reserve. Their insights are invaluable when it comes to understanding the current policy situation. Unfortunately, these market professionals had taken a day off yesterday and left the scene to rather more lightweight commentators.

In fact, Bernanke said the following: "My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road". This could have been taken right out of any of his speeches of the past two months or so. There is nothing new in his statement, and no reason to spill tons of ink because of it.

Bernanke marked right from his inauguration a change from his often Delphic predecessor Alan Greenspan. Whereas Greenspan according to his memoir took pride in making statements so convoluted that US lawmakers did not know what he really meant, Bernanke believes in straight talking. With the exception of the onset of the financial crisis where then-secretary of the treasury Hank Paulson did all the talking, Bernanke has indeed mostly been clear in his statements.

Even if Bernanke is a straight talker, he is, however, also a part of the political game. It makes it so much easier to interpret his statements. There is a simple rule that one can apply. It goes something like: If you take a given statement and wonder what it means, try and negate it. If what comes out is meaningless nonsense, then the original statement is simply idle talk. Let us try this on the quote above. The last phrase would then turn into

At some point, however, as economic recovery takes hold, we will NOT need to tighten monetary policy to prevent the emergence of an inflation problem down the road.

Now that would be something. A central bank director stating that he will do nothing to fight inflation? He would be without a job faster than you can say "Federal Open Market Committee".

Try and use this simple principle in other situations. It is a very strong tool to identify idle talk, statements made simply because they have to be made, no matter how obvious they are. It will free up time and energy to focus on what is really important, namely to identify the many elements that together will mark the real turn of the monetary policy. Do not worry too much about Bernanke's various statements. When he wants to make himself heard because he has something to tell the markets, he will do so.

And by the way, no, the punch bowl will not be moved right now. US monetary policy will remain accommodating at least through this quarter and quite possibly through 2010Q1 as well.

Thursday, 8 October 2009

The dollar’s days are numbered, or...

A couple of days ago, UK daily "The Independent" published an article according to which a group of countries, most notably China, Russia, Japan, France, Saudi Arabia and some other Arab states have secretly met and discussed to replace the USD as the main trading currency for oil. Instead they would be interested in using a basket of currencies and to phase it in over a period of nine years.

Predictably, this information created some buzz in the financial markets: are the dollar's days numbered? In response to such talk, the value of the USD fell immediately. It did not immediately recover, and now a couple of days after the event it all looks like an episode in the dollar's weakening trend which has been in place for some months. In this time perspective, the newspaper articles probably have little importance as they do not affect the actual business cycle trends. USA has repeatedly in the past months proven to be lagging the rest of the world in recovering after the downturn. Since many investors had managed to convince themselves that the US would lead the rest of the world back to economic growth, the current situation has created some turmoil. The reaction to the newspaper article was just another example of how the market selects news that fit in with the current thinking.

Yet, the reported meeting has quite an importance for the longer term prospective for the dollar, say, for the next 10 years or so. The reported story about the decline of the dollar is not new, however, except in the degree of details that have emerged, and that it in itself is worrying enough. Led by China, several large and influential countries are openly challenging one of the pillars of the dollar system put in place after WWII. By placing the dollar as the world's reserve currency, USA helped the world economy to pull out of devastations of the war – and granted herself enormous powers of leverage over the rest of the world.

In economic terms, this dominance has for more than 50 years given the USA more leeway to conduct irresponsible economic policies than would otherwise have been the case. The Reagan-Bush era was a first indication of what were to come. The Clinton years were characterised by relatively prudent economic policies that almost balanced the current account deficit, before the George W Bush administration let go completely.

This situation has worried quite a number of observers. The U.S. government's budget deficit together with the current account gap represent "unsound underpinnings" in an otherwise "good" economic landscape, Already in 2006, Robert Rubin, chairman of Citigroup Inc.'s executive committee and former Treasury Secretary in President Bill Clinton's administration, said the following in an interview:

"At some point, these kinds of deficits are not viable," Rubin said. "The probabilities are extremely high that if we don't address these imbalances, then at some point, and it could be years down the road, we'll pay a very big price."

That price is obvious now. After years of living above its means, the US is now losing economic influence, and it is symbolised by the moves by the countries mentioned above to reduce the role of the dollar in trading oil. It is more than a symbolical move. The US has used the fact that oil is traded in dollar as a means to exert influence over the oil producing countries and no single move could do more to undermine the dollar's position as a reserve currency. In other words, the threat to the US economic world dominance is utterly real. Apart from being the result of failed economic policies, it is also a move that will happen as the fast growth of the Asian economies will reduce significantly the relative weight of the USA in the world economy.

The problem is what US policy makers can do. The answer is: very little. Gone are the days where US military power could be used to impose certain policies on reticent states. Posturing angrily would only have negative effects. So apart from some shrill comments from commentators from the more silly part of the right-wing establishment, US officials have wisely kept shtumm. Expect to see a wave of comments trying to persuade us that the US administration is really happy at the current levels of the USD. Such comments will change nothing on neither short nor long term.

Tuesday, 6 October 2009

Australia hikes interest rates

Overnight, the Royal Bank of Australia hiked its money market rate from 3% to 3.25%. This action is being hailed worldwide as a first sign we are moving out of the deep global recession. Some economists even profess to be surprised that the move came now and not in 4 weeks. Apart from the fact that Israel hiked rates already on 24 August, the question is whether RBA's move signals the turning point for anything at all.

We all know that interest rates eventually will go back up. Central banks do not continue rescue missions forever, particularly not as it becomes increasingly clear that the patient, i.e. the global economy, did in fact survive. Recently, there has been a lot of writing about the coming wave of monetary policy tightening and many pundits have concluded that given the interest rates will increase, the stock markets are overvalued, and the only reasonable thing to do is to SELL.

Well, maybe not quite. Yet, at least. It is true that the past weeks have seen some volatility in the stock markets that might give a first indication that the uptrend that began in March is running its course. But in all probability it is too early to panic.

There is no shortage of analyses pointing out that the economic recovery may well be a rather anaemic one, as several of the large economies are saddled with consumer debt that will block the way for a strong recovery. Instead we appear to be headed for a longer period of sub-par growth, as consumers are working to rebuild their balance sheets. This outlook appears to be close to a consensus by now.

Then there is what happened in the stock market. Far from being subject to a U-shaped or L-shaped recovery, the markets have seen a profit recovery that by some measure has been surprising. Obviously, there has been no help from the demand, so virtually all of the good news for the stock markets have come from the massive cost reductions that have taken place – and which were at the heart of the very steep fall in economic activity in Q4 of last year and Q1 of 2009.

As if on cue, companies worldwide cut orders, stocks and production capacity. And thereby they made the first moves to rebuild profitability and profitability did indeed come back almost with a vengeance. Stock markets reacted correctly and we have seen a 50%+ recovery.

And then to the 64 bn question: why would it continue? A 50% recovery after a 50% loss sums up to a 25% loss. Aren't the markets priced fairly for the slower economic growth ahead? Should we prepare for a setback? Probably not. Or maybe just not yet. There are two reasons for that.

One is that the Australian interest rate hike is obviously a signal, but it is no signal that the interest rates worldwide will now be pushed up in and the brakes put on. All indications from G20 and down are that central banks are in absolutely no hurry. And a finer point: the arsenal of weapons put in place by the central banks is so much wider than just interest rates. The term "Quantitative Easing" that was so in fashion long time ago – like last Monday – covers a number of initiatives to create liquidity and to bolster bank's balances. The QE will be phased out slowly before short term interest rates are hiked. It will be a relatively slow process and most market participants will not really notice until the monetary tightening is a reality. And only then the interest rates will begin to hike.

This scenario has not been lost on the bond markets, where the yield curves have steepened in anticipation of the policy changes.

The second reason is that as long as the liquidity boost is intact, investors will remain willing to take on more risk. In the time-honoured way of the financial markets, this implies that arguments will be sought and found that the markets can go higher. It is not that difficult: while cost reductions can restore profitability at a given activity level, they cannot provide for profit growth. Profit growth will in the medium term have to come from top-line growth. There is a possibility that the improved profitability from the cost reductions can carry the better results all the way until demand begins to show some life, probably sometime next year.

So yes, at some point in time this strong rally in the stock markets will end and for all the right reasons. The profit recovery will peter out, monetary policy will tighten, and the risk appetite will drop. It is probably just not now and the Australian rate hike has preciously little to do with it.

Friday, 3 April 2009

Ready to adjust your portfolio

Are you ready for the next piece of chocking news? The financial crisis is over. Well, maybe not quite, but I am pretty confident that the financial markets will beat this drum roll over the next weeks. The result is likely to be that the stock markets will run up further and that there will be significant moves in selected commodities. Oil has started and it will likely continue. Government bonds should technically suffer significantly, but probably will not, as they are subject to central bank manipulation at a historical scale.

All of this sums up to a change in the market sentiment. Governments and financial institutions across the world will latch on to it for reasons easy to understand. But the underlying situation has in fact not changed a lot since, say, the beginning of March.

True, over the past weeks we have seen the first signs of a slowing of the downwards momentum in the US economy. The rest of the world still has not yet seen such signs, but some good news could be in the offing in the coming weeks. Look out for the New Orders component in the ISM statistics and for rebounds in the property market as early indicators.

True, the US has more or less put a banking rescue plan in place. It is a terrible, expensive muddle, but it will eventually work. Yesterday's partial suspension of the Mark-to-Market rule by the FASB is another element in propping up the banks' balance sheets. It has now been replaced by a Mark-to-Whatever-You-Like rule for toxic assets which greatly helps the banks annointed as winners. European governments and banking regulators have also put in place a series of packages that will secure the survival of the banks. None of the plans have attacked the issue of expelling the boards and the CEO's responsible for the mess, so the same people will maintain their influence, once the party gets going again.

Quite significant stimulus packages have been introduced, USA, Germany and China are leading the pack, and some more may come from Europe. Over the past weeks, virtually all economic institutions with OECD in the lead have been revising downward their growth estimates for 2009 but expressed more optimism for 2010.

Last but not least, the stock market rally that began on March 9 has pushed past some important levels. At the beginning of March, the market rallied on a significant short squeeze, and optimism that the US plan to rescue banks would actually work. Since then the rally has been fed by investors who wanted to bring up their equity holdings, and now we are on the cusp of breaking out of the downtrend that has set the tone for the past many months. On top of that, remember the magical 9 months. That is the time the market is supposed to lead the real economy. It just forgot that in early 2007, but it surely has learnt from its own mistakes.

Of course we will now be persuaded to cheer up, things are not that bad. Most people still have their jobs, most houses will not be repossessed: Above all your country wants you! It wants you to start spending so demand for goods and services can grow. Your pension plan will recover.

I believe this rally still has some legs. Unfortunately there is no doubt that the foundation for the rally is not that strong – to say the least. Consumers still need to reduce their debts across the world. The CDS bubble is still out there. So are resets on the US mortgage loans. France, Italy, Spain have not done a lot for their national economies. Eastern Europe is still a mess. Long term interest rates will have to go up worldwide and the Euro-zone will have to come to grips with the fact that the Euro has been the victim of "competitive depreciations" and will eventually have to weaken. Government deficits will have to be curtailed. Banks are still not lending.

In other words, not a lot has changed, except for the subjective perception of risk. But for now, that is not really important. It will be important later.