Currencies – Page 10 – The Aleph Blog

Some Praise and Questions for the US Treasury

Posted on 28 October 2009 by David Merkel

1) Perhaps the US Treasury is getting a few things right.? Let’s start with lengthening the average maturity of Treasury debt.? I have backed this idea in the past.? It is worthy to note that zero coupon yields peak out around 20 years out, and then start declining.? It is quite possible that debt longer than 30 years might price at a discount to 30-year debt, if for no other reason than there is a demand for longer debt as an asset to fund longer liabilities with seeming certainty.

The US Treasury is finally getting some sense in this matter, and is looking to lengthen their maturity profile.? Good for them; let’s see if foreign investors are willing to take down longer-dated dollar-denominated debt.

2) I have also encouraged the concept of liquidating institutions that are “Too Big to Fail;”? I believe they deserve a special chapter in the bankruptcy code.? Well what do you know?? Congress is proposing much the same idea. (Ugh, Barney Frank agrees with me?? But, so does Sheila Bair.? Better company.)? Here are some of the details.? Far better to liquidate such institutions rather than bailing out the holding companies (what idiocy!).? That said, why would we give more money to GMAC?? It is not critical in a systemic sense.? Let it go under.

3) Most stimulus programs waste money.? Better to rebate taxes to everyone equally.? It is fairer than choosing favorite firms or markets.? With that I would argue that it is time for the first time buyer credit to end in residential real estate.? Most of those that bought would have bought anyway, and the credit benefited sellers more than buyers as it pushed prices up for now.

4) The efficient markets hypothesis did not mean that market prices are always right, as if we hit that evanescent neoclassical equilibrium.? No, prices are always wrong to some degree, but that does not mean it is easy to recognize the mistakes.? So I limitedly back Jeremy Siegel, who says that the efficient markets hypothesis was not to blame for this crisis.? That said, common misunderstandings of the EMH did affect the crisis, because markets do self-correct, but over years and decades, not months or days.

5) If you had the ability to ask one question to Tim Geithner, Secretary of the Treasury, what would it be?? I have my list, but maybe I am off base.? As I close for the morning, here are my questions:

Haven’t low interest rates boosted speculation and not the real economy?
We are looking at big deficits for the next seven years, but what happens when the flows from Social Security begin to reverse seven years out?? What is your long-term plan for the solvency of the United States?
We talk about a strong dollar policy, but we flood the rest of the world with dollar claims.? How can we have a strong dollar?
None of your policies has moved to reduce the culture of leverage.? How will you reduce total leverage in the US?
Why did you sacrifice public trust that the Treasury would be equitable, in order to bail out private entities at the holding company well?? People now believe that in a crisis, the government takes from the prudent to reward the foolish.? Why should the prudent back such a government?
If we had to do bailouts, why did we bail out financial holding companies, which are not systemically important, instead of their systemically critical subsidiaries?
We are discussing giving tools to regulators for the tighter management of the solvency of financials.? There were tools for managing solvency in the past that went unused.? Why should we believe the new “stronger” tools will be used when the older tools weren’t used to their full capacity?? (The banks push back hard.)

I doubt that I will get a chance to have those questions answered, but who knows?? From Quantcast, I know that some at the US Treasury and the Federal Reserve (I have my own set of questions there) read my blog regularly, so I leave it up to them ponder my questions, whether I ever get answers or not.

The Good ETF

Posted on 9 October 2009 by David Merkel

What makes a good ETF in the long term?? My, what a question, driven by the ETFs challenging the limits of what is prudent.? Maybe it is easier to start with what makes a bad ETF, then:

Headline risk can be eclipsed by credit risk.? All ETNs, Currency ETFs, and ETFs that use non-exchange-traded swaps, sometimes for commodity funds, take credit risk.? Did you know you were taking credit risk?
Roll risk — for commodity funds, trying to replicate the returns of the spot market using the futures market works only when there aren’t a ton of funds trying to do so.? The flood of funds into front month futures contracts incites other funds to front-run the activity, capturing the profits that the commodity funds were trying to make.? (For storable commodities, better to take delivery and store.)
Market size risk — an ETF can become too large relative to liquidity or regulatory constraints of the market, and it no longer tracks its benchmark well — again, mainly a commodity fund problem.
Irreplication risk — This is mainly a bond market theme, but once the ETF defines the index, only index bonds can be bought in proportion to the index.? I ran into this personally in 2002, when I ask ed why a certain bond traded rich.? The answer came that it was in a common index, but it was a small bond issue in proportion to its weight in the index.? Many investment banks were short the note to provide liquidity, but could not source the bonds to cover the short because most were in index funds.? I would keep an eye out for those bonds, and would sell them to those short for a small markup when I found them.? For ETFs, the trouble is that arbitrage can’t take place, because bond buyers can’t find certain rare bonds in order to create new units in exchange for expensive ETF shares.? That is one reason whey NAVs get stretched versus market prices.
Abnormal or faddish theme — the risk is that they become too dominant in the trading of less liquid companies in their ETFs.? But away from structural risks is the faddish investment risk.? The ETF only gets created as the fad is about to go into decline.

In one sense, the market can reward non-consensus views, particularly when they are small compared to their relative advantage in their sub-markets.? In the same way, the market can punish those that become too large for the pond that they swim in.? Growth will be limited or negative.? Even the efforts to create more capacity, create it at the cost of credit risk.

Good ETFs are:

Small compared to the pool that they fish in
Follow broad themes
Do not rely on irreplicable assets
Storable, they do not require a “roll” or some replication strategy.
not affected by unexpected credit events.
Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

US Dollar: “I’m Not Dead Yet!”

Posted on 7 October 20097 October 2009 by David Merkel

Analyzing currencies is weird, and most people don’t get it.? Sometimes, I think I don’t get it.? There is nothing fixed in our economic world, no fixed measure of value.? Everything trades against everything else.? Currencies exist to make the trading easier.? Imagine a matrix that is millions by millions, with trillions of exchange rates for one good or asset against another.? With currencies, it simplifies.? Each nation prices out goods and assets in their own currency, and then currencies trade against each other, subject to arbitrage with commodities, and commodity-like assets.

Anyone who has read me for a while knows that I am not a bull on the US Dollar.? But where I part ways with the grizzly bears (call me a teddy bear 🙂 ), is that the fundamental accounting identities must be maintained.? Whatever country of our world has the status of reserve currency must issue debt, and a lot of it, that other countries can invest in to park their idle cash balances.

It does not matter what currency crude oil trading, or any other trading, is denominated in; it does matter in what currency the proceeds from the sale of crude oil is invested in.? So long as the US runs current account deficits, foreigners must acquire US assets in order to fill in the gap.? In the past that has mainly been bonds — agency, mortgage, corporate, but increasingly Treasury notes.

It is not that easy to abandon the US Dollar.? Where do you go?? The yen will suffer for years as Japan heads into demographic decline and large structural budget deficits. The Euro is still an experiment; there are many pressures on it; its survival is mot assured. Nothing else is large enough or stable enough, or mature enough to run the deficits necessary to have the debt markets, to be the global reserve currency.? As an example, China does not want to run deficits, nor is its financial system strong enough to bear the wear and tear of global use of its currency.

So, when reporters write pieces indicating the imminent demise of the US Dollar, I don’t buy their arguments:

Other parties disagree with the worry:

If the money is not invested in US Dollar investments, where will they invest? That is the question.

Now, there are other issues. China? could queer global trade by asserting that entities in China could default on obligations from derivative contracts and not worry about it.? Why is this big?? If a major country does not respect contract law, that country will not be respected in global trade.? Granted, China is a creditor, not a debtor on net, but the ability to transfer capital is paramount in the global economy, and if China will not honor contracts, that will bite them.

Away from that, I was fascinated by Australia’s interest rate hike.? It makes me bullish on the Australian Dollar, even after its significant rise.? That said, don’t move too aggressively, because eventually US Dollar rates will rise.

My view is that the US is in a Japan-like funk, which it will not rise out of for years.? I don’t think the Fed will move aggressively — they will be timid.? It is easier to argue to Congress that they did their best but conditions were severe, than to argue that they headed off inflation, but many people were unemployed.

Unless Europe moves to a full political union, or China frees its economy, there is no real competitor to the US Dollar.? Yes, the dollar will likely decline over the next decade, but it will not be likely to lose its reserve status, unless a commodity standard currency comes into being.

Risks, Not Risk

Posted on 3 October 20094 October 2009 by David Merkel

While at our last denominational meeting, I made the offer to the pastors of my denomination that if they needed investment advice, they could contact me for advice.? Out of eighty or so pastors that that could have asked for advice, one e-mailed me.? (The pastors and elders did elect me to the pension board, to help manage the relationships with the defined contribution fund managers.? I’ll do my best for them.) The pastor is young-ish, with a wife and six kids.? He had 60% invested in a broad bond fund which had a high exposure to investment grade corporates and high yield (and AAA CMBS), and 40% in a stable value fund. This is a redacted version of what I wrote to him:

You’ve been playing it conservatively.? At this point conservative is good.? If I were not tardy in responding to you (my apologies), I might have suggested taking a little more risk at the time when you wrote.

This is the way that I view asset allocation:? look at the risk factors in the investment markets, and look at the funding needs of the person or institution that owns the assets.? (I.e., so what are we saving for?)

Most people don’t save enough.? The $4000 per year is good, but most people need to put more of a buffer aside than that, whether in IRAs (for retirement) or in a taxable account (for emergencies, future coollege aid to children, etc.)? You have six little liabilities that may need some help starting out as they reach adulthood.? Consider saving more.

Now for the risk factors:

Equities — somewhat overvalued at present.? (US and foreign)
Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.? There will be more defaults, both in commercial and residential.
Yield Curve — Steep.? It is reasonable to lend long, so long as inflation does not take off.
Inflation — Low, but future inflation is probably underestimated.
Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
Commodities — the global economy is not running that hot now.? There will be pressures on resources in the future, but that seems to be a way off.
Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

What this leads me to is this: I don’t know all of the bond and stock funds you can use at present, though I will after the next pension board meeting.? The bond fund you are using was a great play over the last 9 months, but is probably overvalued now.? If there is a more conservative bond fund, you might want to shift some funds there.? If not, use the fixed fund.? I don’t think we have an international bond fund, or an inflation protected fund?available, but if we do I would add some there.

On a pullback in the stock markets, I would look to add some stock into the mix.? I would add some with the market 10% lower, and would add considerably with the market 30% lower.? If there are international stock funds, I would use them 30/70 with US funds.

Consider this a start of a discussion.? I’m not bullish on much right now.? This is a time to preserve capital, not make returns.? Let me know what you think, and sorry for being so slow to get back to you.

If I were talking to an institutional investor, I would have added illiquidity as a risk factor, which I think is fairly priced right now. I might have also added that I would be bullish on GSE-sponsored mortgage bonds and carefully selected CMBS.

Aside from that, I was pleasantly surprised in Barron’s to see Mark Taborsky of Pimco thinking about asset allocation the way I do.? There is no generic risk.? There are many risks.? Are you getting fair compensation for the risks that you are taking?? If not, invest in other risks, or if there are few risks worth taking, invest in cash, TIPS, or foreign fixed income.

Modern Portfolio Theory has done everyone a gross disservice.? It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray.? These figures are not stable in the intermediate term.? The past is not prologue, and unlike what Sallie Krawcheck said in Barron’s, asset allocation is not a free lunch.? With so many people following strategic asset allocation, assets have separated into two groups, safe and risky.

To this end, it is better to think in terms of risk factors rather than some generic formulation of risk.? Ask yourself, am I getting paid to bear this risk?? Look to the risks that offer the best compensation, and avoid those that offer little or negative compensation.

Name Your Poison

Posted on 25 September 2009 by David Merkel

Last night I wrote a longish post, and the system ate it.? Probably I had not established a firm connection with the server, and when I hit the publish button, it disappeared.? My main point was to ask where the limits were for all of the borrowing and spending? going on from the Treasury, and all of the lending going on with the Fed.

I have talked about this before in articles like It is Good to be the World?s Reserve Currency.? Both China and?OPEC have their political reasons for lending to the US, and those keep the dollar afloat for now.

I began last night’s doomed post by declaring to readers that they were part owners in the largest hedge fund (or CDO) in the world — the US Government.? Very distant from the founders’ designs, the government lends to private enterprises in a big way, clipping a spread, while still being exposed to default.

The US government has absorbed many private debts into the government’s debt in exchange for many private debt and equity claims.? Given that the government is clipping a spread, and borrowers are obtaining better terms than the market could give, could there be any problem?

Yes, there are several problems:

The federal credit is not infinite — dare we risk the survival of our government to rescue special interests?
The ability of the Fed to stretch the currency is not infinite — price inflation has not come yet, but when it does come, it will likely accelerate from all of the promises made.
There is some degree of favoritism in who gets funds.? The larger banking firms have been bailed out at their holding companies, which is a travesty, because only regulated subsidiaries are to be protected, not the interests of holding company stock and bondholders.? Small banks have been left to fail.
Private lenders who would lend at higher rates are getting cheated by the government, who has no business being a lender.? (Yes, I know, they have been doing it for decades, but that does not make it right.)
There is little ability for the government to know whether they are offering fair terms or not as far as the taxpayer is concerned.? What is the right tradeoff between offering more loans, and taxing the populace more?
The FDIC trades on the creditworthiness of the US.? They offer guarantees using the Federal credit, rather than surcharge the banks to make up for losses.? Letting banks lend to them at Treasury rates is clever to replenish the reserve funds, but what happens when there are more large defaults?? The hole will be deeper, and the climb out more challenging.
So long as the productive capacity of the US is not expanding, arguing about how it is financed is not a fruitful endeavor.

Leaving aside the mutual suicide pact of those that own a disproportionate amount of US Treasuries, the risks that exist stem from an over-indebted economy, and the inability of consumers to resume their role of excess consumption, with accumulation of debt.

Aside from that, should we have a resumption in the decline of housing prices, an acceleration in corporate defaults, or commercial mortgage defaults that affect the big banks, it doesn’t matter that the government is clipping an interest spread, because the losses will be worse.

As a final note, let’s watch the end of the Quantitative Easing from the Fed.? Together with the Treasury they already own over 30% of all 30-year GSE-conforming mortgages, if not more.? What?? Do we want the government to absorb every bad debt?? Where is the responsibility to those that contracted the loans, expecting profit or pleasure?

This will not end well. The only question is whether it ends in inflation or greater taxation.? Name your poison.

QUEASY — QUantitative Easing Aids Speculators Yields

Posted on 16 September 2009 by David Merkel

Okay, I am going out on a limb here, so please understand that what I am saying is a bit of an experiment.? When quantitative easing was originally done in Japan, it was after:

a credit-fueled expansion that pushed the stock and real estate markets to new heights, which have not been seen for 19 years.
productive capacity was built up that the rest of the world would not need.
anticipated returns on equity for investment projects were in the low single digits.

Now, during the time of quantitative easing, the following things happened:

money market rates were near zero.
relatively few private investors wanted to borrow money for investments to expand productive capacity.
government deficits expanded dramatically in a futile attempt to simulate an over-indebted economy.
Speculators borrowed money in yen in order to do carry trades.? They borrowed the surplus yen from the quantitative easing, and used the leverage to speculate on higher-yielding debt.? This had little benefit for the average person in Japan, though many played the carry trade game internally, buying investments denominated in Australian, New Zealand, or US Dollars.

Back to the present, and back to the US.? Short-term borrowing rates have been falling, as there is a lack of demand to borrow short-term.? Contrast that with one year ago, where there was no lack of demand to borrow short-term, but no willingness to lend.

An amazing change indeed, but much of it stems from a lack of demand for short-term borrowing. Some attribute the low TED (3-month Eurodollar less Treasury yield) spread to risk-seeking, but I think that banks don’t have many uses for surplus cash now.

As it is, with low US Dollar LIBOR lending rates, it makes the US Dollar a honeypot for speculators.? Borrow in Dollars, invest in your favorite higher yielding currency, or in higher credit risk instruments.? For the foreign currency trade, the added kick is that the US Dollar may decline in value.? That said, many said the same would happen to the yen; that it would decline in value, and it did not.? I have many reasons to think why the Dollar will decline, but the carry trade argument goes the other way for me.

Now, maybe the excess liquidity is fostering day traders as well.? We saw the same phenomenon in 1999-2000.? The liquidity should not have leaked out, but it did, and to those that would only speculate.

So what is the Fed doing?? Is it ending quantitative easing?? It seems not.? They will buy mortgages until they reach their preannounced limit, most likely.? That said, the Treasury might reduce funding to the Fed.? They see less need to fund the Fed, though that will force the Fed to decide how large it wants its balance sheet to be in a time of crisis.

Here’s my concern — having carry traders absorb excess liquidity that the Fed has put out is a waste of Fed resources, and indicates that Fed policy is too loose.? Don’t buy more mortgages and agencies, and consider selling bonds back in to the market.? Let short-term rates rise to reflect the true scarcity of short-term ways to profit.? Let savers earn some money — there is no benefit to having monetary policy so loose.

To summarize: Japan did not benefit from many years of quantitative easing, but it provided a lot of fuel for carry trades around the world until most of them blew up over the last two years.? It seems to me that excess liquidity created by the Fed is going the same way now, because consumers and businesses don’t want to borrow to the same degree as they did during the boom phase.

It will take a long time for balance sheets to heal.? It depends upon the rates of debt forgiveness/compromise, and paying it down.? During the Great Depression, Debt/GDP peaked several years after the Depression started, and after the peak it took about ten years for it to come down to a more normal level in 1941.? I suspect that we will go through this same process again, before the economy grows robustly as it did post-1941, regardless of what the Fed and Treasury do.

Misunderstanding Inflation

Posted on 9 September 2009 by David Merkel

Monetary inflation leads to inflation in goods, services, and/or assets.? We just went through a decade (and then some) where there was low product price inflation, but there was significant inflation in asset values.

What was the response from policymakers?? Aside from a rare comment regarding “irrational exuberence,” most of the time they were fat, dumb, and happy.? Because of their flawed model for understanding monetary policy, they ignored asset inflation, and patted themselves on the back for the lack of goods price inflation.? What little attention they paid was through the weak construct called the “wealth effect.”

Make no mistake — printing money leads to inflation; the question is where the inflation goes.? The loose monetary policy of the last 20 years has definitely fueled an inflation of real estate asset values above that which is sustainable in the long run.

As such, I have little agreement with the following articles:

We have been through a unique era where monetary has had significant effect on the asset markets, but little effect on the goods markets.? Perhaps those effects were affected by demographics, and might change in the future.? Just because good price inflation has been weak in the past, does not mean it will be weak in the future.

Monetary inflation — an increase in the money stock or credit, will have an impact on asset and/or goods prices.? Which gets affected depends on the proclivity to spend versus save.

There is real reason to be concerned about inflation, then.? We face either:

an unsustainable increase in asset values, or
goods and product price inflation.

The former looks for likely for now, but who can tell?? As Baby Boomers tip the balance between saving and spending, goods and services inflation may predominate over asset inflation.

On the “positive” side, some of the troubles of asset inflation get passed on to credulous foreigners because the dollar is the world’s reserve currency.? That weakens the feedback effects in the short run.

My main point is this: there is no free lunch.? Either money buys less, or assets buy less because of monetary inflation.

Questions and Answers

Posted on 25 August 200925 August 2009 by David Merkel

This may become a series, but I’m going to post some questions I have been asked, and the answers that I gave.? Anyway, here goes:

Has anyone prepared a summary of US Treasury bonds, say five years ago and now and looked at average maturity, etc.

GE was taken to task by the investment community in 2002-03 for using very short term money to fund long term lending/capital needs.? Was the investment community right?

Where is the US government right now ? Are they playing the short end of the maturity ladder, if so what could be the reasons why and what are the implications for the investment community?

Thanks for all of your insight.

This is a graph of the average maturity in months of the marketable portion of US Government debt.? Reagan really lengthened the debt, and Bush, Jr. shortened it.? (Just another bad legacy for that economic liberal, Bush, Jr.)? The most notable aspect of that was the elimination of the 30-year bond in 2001, and its subsequent reappearance in 2006.? The Obama Administration is not a known quantity in these matters yet.

The sharp drop from June 2008 to September 2008 I believe is due to the creation of a lot of short-dated debt that was given to the Fed to allow it to grow its balance sheet.

With respect to GE, yes, the lending community was right.? Prudent borrowers match assets and liabilities.? I recently criticized GE for borrowing with too much short-term debt for their finance arm.? As it is, GE has had a wild ride in its stock price, dipping below six this year.? Without the TLGP, who knows?? GE might have had to send GE Capital into insolvency.

In general, I have been an advocate of lengthening the maturity structure of the US government’s debts.? Governments are supposed to try to be permanent; thus they should finance long.? Governments like the generally lower cost of short debt, and so they sometimes finance shorter than they ought to in an effort to save money.? Governments that don’t finance long enough can be subject to runs, such as Mexico in 1994.

I hope the US government takes the opportunity to finance long while it is still cheap to do so.? My guess is that the opportunity gets wasted; not that the average maturity shrinks a lot, but that it doesn’t grow much.

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What does your husband say about this? Small investors don’t bother?

> http://money.cnn.com/2009/07/29/pf/steve_lehman_federated_investors.fortune/index.htm

This one came to my wife for me.? Quoting from the article, my response was:

>>So what’s a retail investor to do? Lehman’s answer: Leave it to the pros. “It’s never been more difficult [to invest],” he says, “and it will remain more challenging than ever. Unless someone really has a flare for investing and enjoys doing it, I would say don’t waste your time.”<<

Small investors should probably use low cost index funds and vanilla Exchange Traded Funds.? That will lower their costs, which will raise their returns.? It is rare for outperformance to persist in funds management, particularly as the funds under management for any manager grows.? There are some value managers that are worthy of being invested in over the long haul for equities, and if you want a list, I will provide one.

David

PS — to the editors at Money — “flare” s/b “flair”

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We have a certificate of deposit that we are cashing out and are wondering if buying some gold would be a better way to protect our savings? Considering the way the government is spending money, it seems the only way to be safe from the inflation that is coming.

This is a tough one. A lot depends on whether the government inflates their way out of this or not. I almost think they have to, but they could have done it in the Great Depression/WWII, and did not. They raised taxes, and the best investment was government bonds for a long while.

This situation is probably different. Gold will preserve purchasing power over the long haul, but it rarely does more than that. Sometimes, that’s the best you can do.

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I don’t have a good place to post this last bit, so here it goes: here is a recent audio interview of me. I only wish we had focused more on investing topics. For those interested, I had my notes in front of me, which cited a number of my articles.

Full disclosure: I don’t own any gold, aside from my wedding band.

Book Review: Making Sense of the Dollar

Posted on 25 August 200912 February 2011 by David Merkel

Many people think in non-systematic terms.? They consider the US current account deficit to be an unmitigated disaster.? They look at one side of the issue and conclude that the US has become less competitive.

Understanding accounting, the books must balance.? Not everyone can run a current account surplus.? Some countries must run deficits in order to purchase goods from those that run surpluses.? Capital account surpluses balance out current account deficits; net foreign investment fills the gap.

Marc Chandler, with whom I became acquainted while writing for RealMoney, has written a book for the average reader to explain the basics of international economics and foreign exchange.? The book deals with common myths that arise in the discussion of trade and currencies.

Why do we lose industrial jobs in the US?? It’s not foreign competition, though that may occasionally play a role when countries subsidize their industries.? We lose industrial jobs because of technological improvements that require less labor in the manufacturing processes.? As I have said, Nucor was a bigger risk to the rest of the steel industry than foreign competitors.

Chandler is a proponent of the turn-of-the-century Open Door Policy, which led the US to be more free market capitalist than the rest of the world, gaining influence through trade.? Together with military victories, this led the US to be the world’s dominant economic power post-WWII.? Given the change in currency regimes, this made the US Dollar the leading reserve currency in the world.

Aside from military superiority, and political calm,? labor market flexibility and a culture of innovation have made the US dominant in global economic affairs.? As I have sometimes said, if the world did not have America, it would have to invest one.? Where else would all of the spare labor, capital and goods go?

There are advantages to being the world’s reserve currency.? The US runs current account deficits, and other nations buy our debts.? Such a deal; every nation should want this (but, as we learn, it is likely only one nation can have this at a time).

Capital flows are much larger than trade flows; it should be no surprise that the US Dollar does not react to the current account deficit.

(An aside: when I was in Grad School, the idea that interest rates drove currencies through arbitrage was new, and gaining favor.? Since then, a blend of the interest rate markets and goods markets driving currencies is the dominant paradigm, with momentum thrown in.)

Chandler deals with these issues, and other myths that plague the discussions around international economics and the currency markets.? In general, I agree with his views, but with a few quibbles/additions:

It is not costless for countries to run current account deficits.? Countries that run current account deficits have to offer attractive opportunities for foreigners to invest in their country, or suffer declines in the value of the currency.
The country taking the non-economic action will eventually pay the price.? Whether hoarding gold in mercantilism, or neo-mercantilism, hoarding US debt assets, whether Japan in the late ’80s or China today, the nation forcing the issue gets hurt more.? China will suffer for over-promoting growth of exports.
It would be reasonable to have a gold standard once more — the trick is setting the initial price level, so that it would not be inflationary or deflationary.
It would have been nice to offer retail investors some theory to explain how currencies move, rather than just dispel myths.? That said, there probably is no such theory, and if it exists, ordinary people probably could not understand it.

Absent my quibbles, on foreign currency Marc Chandler knows far more than me.? If foreign exchange and trade is of interest to you, you will benefit from this book. One more note: this is not a technical book with lots of math, and there is no technical analysis on its pages.

If you want to buy the book, you can buy it here: Making Sense of the Dollar: Exposing Dangerous Myths about Trade and Foreign Exchange

Full disclosure 1: I actually read the books that I review.? Many reviewers don’t.? They read the stuff the PR flack sends along, and read a chapter or two, and write the review.? I throw away what the PR flack sends before I read the book.? I give you my own opinion on the matter, nothing more, nothing less.? Finally, if you enter Amazon through my site and buy anything, I get a small commission.

Full disclosure 2: long NUE

Return of the “Carry Trade”

Posted on 20 August 2009 by David Merkel

The idea of a carry trade is simple.? Borrow inexpensively, and invest at a higher yield.? Make money.

Too easy you say?? Right.? Usually something has to be compromised for a carry trade to work, usually betting on lower rated credits performing, or currencies not moving against those borrowing in a low interest rate currency, and investing in a high interest rate currency.? Or, borrow short and lend long when the yield curve is steep, hoping the situation will correct with the long yield coming down, rather than a 1994 scenario, where short rates outrace long rates higher.

Carry trades blow up during times of high volatility, which typically have high yield bonds or countries seeming to be more risky than usual. Carry trades return when times are quiet, allowing placidity to clip yield.? As the WSJ has commented, that time is now, and the carry trade has returned.

I’m going to use the Japanese Yen as my example here.? Because of the chronically low interest rates there, it is a favorite currency for borrowing, and using the money to invest in higher yielding currencies.

That’s the yen over the last five years.? Wish I could have gotten option implied volatility over the same period, but I got nearly the last two years here, by using the CurrencyShares Yen ETF:

You can see how option implied volatility peaked in late October of 2008.? At that time, with the strength of the yen, which would not crest until mid-December, there was a rush to buy protection against the rising yen, because those with carry trades on were losing money, and wanted to get out.? Momentum carried the yen for another six weeks.

After significant fury, the implied volatility settled out at a baseline level, and the carry trade returns because conditions are more placid.? Implied volatility and the currency have stabilized for now.

As another example. consider this:

The Powershares DB G10 Currency Harvest Fund [DBV] borrows in the three lowest yielding currencies of the ten countries that it tracks, and invests in the three highest yielding.? This is the perpetual carry trade fund.

Note the plunge into October/November 2008.? High yield currencies were getting killed, and low yield currencies were rallying.? Since then, the performance of DBV has improved.? Why?? The currencies are more placid, so clipping excess yield makes sense to some in the short-run.

And so it will be until the next big implied volatility explosion occurs.? Carry trades don’t offer significant profits across a full cycle, but can profit those who time it right, few as those people are, and matched by those who lose.

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PS — Sorry for not writing about commercial mortgages, as I said I would.? I will get to it soon, but I have been hindered by personal issues.