Category: Currencies

Society of Actuaries Presentation

Society of Actuaries Presentation

Posted on by David Merkel

Finishing off the presentation proved to be harder than I estimated, together with all of my other duties.? Well, it’s done now, and available for your review here.? For those looking at one of the non-PDF versions, you might be able to see the notes for my talk as well.

 

I’m writing this before I give the talk.? If I had it to do all over again, I would have made the talk less ambitious.? Then again, of the four topics that I offered them, they picked the most ambitious one.? When you look at the talk, you’ll see that it is a summary of the macroeconomic views that frame my investment decisions.? The presentation will run 40 minutes or so, plus Q&A.? Reading it is faster. 🙂

 

Enjoy it, give me feedback, and I’ll be back to normal blogging Monday evening.

Swamped With Work, but Here’s a Dozen Observations

Swamped With Work, but Here’s a Dozen Observations

Posted on by David Merkel

I’m swamped with putting the finishing touches on my talk for the Society of Actuaries, so this post will be brief.? When it’s done, I’ll be posting it here for all of my readers.? When the transcript gets published, I’ll post that as well, but that takes a while.

A few observations, some of them obvious, because we’re at an interesting juncture in the markets now:

  1. The equity markets are near new highs.? Who’da thunk it?
  2. Equity implied volatilities have returned to a semi-normal state, and corporate credit spreads have tightened, but lagged.
  3. Fixed income implied volatilities look high.
  4. Fed policy, if LIBOR, narrow money, or the monetary base is the measure, hasn’t worked that well.
  5. Fed policy, if the stock market or total bank liabilities is the measure (credit expansion), has worked pretty well.
  6. The dollar has bounced, but I would expect it to retrace the losses.
  7. We’re experiencing a small period of macroeconomic quiet amid the start of earnings season.? Earnings season should be good overall, with weakness in housing-related areas, and strength in export-related areas.
  8. Banks should be able to end the logjam in the LBO debt markets.? The cost is feasible.
  9. Residential real estate prices are still weakening, and provide most of the drag on the US banking system and economy.
  10. Inflation is rising with many of our trading partners; the US may begin absorbing some of it.
  11. Our trading partners are going to have to choose between controlling their interest rates, and following US policy, or letting their exchange rates rise further.
  12. In this environment, I am trimming my equity portfolio slowly as positions hit the upper end of their trading bands.? 20% of the portfolio is within 5% of the upper rebalance point.? Almost nothing is within 10% of my lower rebalance point, so I’m not likely to add anytime soon.
Nine Points on the International Scene

Nine Points on the International Scene

Posted on by David Merkel

1) In an open economy, you can control your exchange rate or your interest rates, but not both.? The first time I learned that was late 1986, when the Dollar crashed, then the bond market crashed (May 1987), then the stock market crashed(October 1987).? This article from Morgan Stanley goes over the same idea.? Pay attention to the investment? implications at the end, though Hong Kong may have already rallied enough.

For a more bearish view, many Asian economies are facing the choice of slowing their economies, or importing inflation from the US. My sense is that we are in an uptrend for inflation globally.? Few central banks are truly pursuing sound currencies.

2)? Europe is no monolith here.? Managing the ECB is some trick, because money is political, and there is monetary union without political union.? The Swiss Central Bank continues to tighten, while the Bank of England effectively loosens, because of the recent panic there, involving Northern Rock.

3) One of my favorite observations about technical analysis is that slow moves tend to persist, while fast moves tend to mean-revert.? Well, the US dollar is having a grinding, slow adjustment downward. ? To me, that is just another indicator that the decline will persist.

4) Will the Saudis drop the dollar peg?? Maybe.? Given the current inflation rate there, I would suspect that they, and other Persian Gulf nations, will move to a currency basket approach that has a high US Dollar weighting.? That will allow themselves the flexibility to make further adjustments that allows them to arrest inflation.? That will lead to further declines in the dollar against other currencies.

5) What makes a currency attractive?? GDP growth and high real (inflation-adjusted) interest rates.? The US has neither of those now.

6) An old dear friend of mine, Roy Hallowell, had two merciful rules: a) We all make mistakes.? We ALL make mistakes. b) Most of them are like the rest of them.? Such is Goldman Sachs Global Alpha.? They played too much on the carry trade and got burned, among other bad trades.

7) I am not a bear on emerging markets as a group.? There are some running bad monetary and fiscal policies that I would avoid (Latvia, Iceland, Bulgaria, Turkey, and Romania are examples).? But in general, many of the emerging markets are not dependent on US conditions to the same degree that they were before.? Many are in better shape to face volatility than the US.


8)? Given the fall in the implied volatility of the yen, the yen carry trade is coming back.? The carry trade works best when implied volatilities are low, because the cost of protection against adverse moves is modest.? But, if low interest currencies persist in tightening, the carry trade could be a bad bet.? My thought : Japan is not tightening anytime soon, and? the carry trade continues there.? Switzerland goes the other way.

9) China is different.? So what’s happening?

That’s all on this topic for now.

Ten Notes on Our Funky Federal Reserve

Ten Notes on Our Funky Federal Reserve

Posted on by David Merkel

1) Fed chatter has gotten a little quieter, so maybe it is time for an update.? Let me begin by saying in an era of detailed press releases from the Fed, many analysts spend more time parsing phrases than looking at the quantitative guts of monetary policy.? This article from Mish, which cites this article from Gary North is close to my views, in that they are looking at what is happening to the critical variables of the money supply.

 

2) For another example, Look at the discount window.? That has faded as a factor over the past two weeks.? You have to dig into Dow Jones Newswires just to hear about this.? The discount window is back to being a non-entity.

 

3) Review his book.? Cite his article.? Though I think the FOMC will loosen more, I agree that it should not be loosening.? The Fed will overstimulate healthy areas of the economy, while sick areas get little additional credit; that’s how fiat monetary policy works.? (Maybe I should review James Grant’s The Trouble With Prosperity?)

 

4)? I may not vote for him, but I like Ron Paul.? He is one of the few economically literate members of Congress. Thus I enjoyed his question to Ben Bernanke.? I favor a sound dollar, and risk in our system.? It keeps us honest.? Without that, risk taking gets out of control.

 

5) Now, onto the chattering Fed Governors.? Consider Donald Kohn, a genuinely bright guy trying to spin the idea that the Fed is not to blame for residential real estate speculation.? He argues that much of the speculation occurred while the FOMC was tightening.? Sorry, but the speculation only cut of when the FOMC got rates above a threshold that deterred speculation because positive carry from borrowing to buy real estate disappeared, which finally happened in September of 2005, when the FOMC was still tightening.

 

Or, consider Fed Governor Frederic Mishkin, who thinks that troubles in the economy from housing can be ameliorated by proactive FOMC policy.? If his view is dominating the Fed, then my prediction of 3% fed funds sometime in 2008 is reasonable.

 

But no review of Fed Governor chatter would be complete without the obligatory, “Don’t expect more rate cuts.”? They don’t want their policy moves to be impotent, so they verbally lean against what they are planning on doing.? This maximizes surprise, which adds punch to policy moves.

 

6)? Consider foreign central banks for a moment.? I’ll probably write more about this tomorrow, but a loosening Fed presents them with a problem.? Do they let their currencies appreciate, slowing economic growth, or do they import inflation from the US by cutting rates in tandem?? Tough decision, but I would take the growth slowdown.

 

7) What central bank has had a rougher time than the Fed?? The Bank of England.? When push came to shove, they indicated that they would bail out a large portion of the UK banking system.? Northern Rock financed a large part of their assets via the Bank of England during their crisis.? This just sets up the system for greater moral hazard in the future.

 

8) Now the CP market is returning to health; almost all of the questionable CP has been refinanced by other means.? Now, money market funds are better off than they were one month ago, but all of the issues are not through yet.? Some money market funds contain commercial paper financing subprime CDOs.? Now, the odds are that the big fund sponsors would never let the ir funds break the buck.? They would eat the loss.? That’s not a certainty though so be aware.

 

9) This article is the one place where the Fed lists most of the Large Complex Banking Organizations [LCBOs — pages 32-33].? Some suggest that this is the “too big to fail list,” though by now, it is quite dated.? On the bright side, it correlates highly with asset size, so maybe a list of the 20 largest bank holding companies in the US would serve as well.

 

10) We end with Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”? My way of saying it is that trying to control a system changes the system.? The application here is that when the Fed tries to affect the shape of the yield curve by FOMC policy, it eventually stops working.

The Four Rules of Currency Intervention

The Four Rules of Currency Intervention

Posted on by David Merkel

With the US Dollar Index taking out an all time low previously set in 1992, I thought I would take this moment to discuss my thoughts about where the dollar is going, and what we might see along the way. If the dollar gets much lower against the major currencies of our world, I would expect to see some currency intervention to try to raise the value of the US dollar.

There are rules to effective currency interventions. There may be more than four, but here are the four that I know.

  1. Do the intervention on a day when the economic releases favor a stronger US Dollar.
  2. Do the intervention when traders are overconfident, and pressing their bearish dollar bets too aggressively. Catch them leaning the wrong way.
  3. Don’t do it alone. You will fail. You must get the central banks of most of your major trading partners to go along to create an impression of unanimity.
  4. Do it BIG. This is not a time to hold back; either do it BIG, or don’t do it at all. You want the currency traders to wish they had never taken up the profession.


You want to have at least three of these in play for an effective intervention. You want to create a genuine panic that feeds on itself, leading everyone to readjust their positions on the US Dollar, pushing it up, and winning the psychological battle against a lower US Dollar.

Easy, right? Well, no. In the short run, interventions work if done properly. They don’t solve the macroeconomic problems underlying the weak Dollar, though, and so toward the end of the shock move upward in the Dollar, I would be inclined to buy more foreign bond exposure. Why?

During the intervention, the participating central banks suck in US Dollars, and pump out their local currencies. In the case of the Fed, they sell foreign currencies and buy US Dollars. Most of these central banks have all of the US Dollar assets that they want already, and they understand the fundamental situation regarding the US Dollar. So, like OPEC in their ineffective days, where they would announce production cuts, and then everyone cheats, in this case, the Central Banks do the intervention, but then quietly recycle the US Dollar assets that they never really wanted to hold.

That leads to a slow retest of the levels that the intervention happened at, and eventually, breaking through the level, at which point, the Central Banks can try again, or give up.? Eventually the response is a “give up,” after which, the US Dollar slowly overshoots and then finds a new temporary equilibrium level, and the rest of the world adjusts to it.

I’m leaving out a lot here.? The internal political pressures to keep the Dollar from falling.? The effects on export industries.? The slowly growing willingness to buy US Goods and services.? Rising interest rates in the US.? Rising inflation abroad.? And more.

The investment implication is this, though.? Until an intervention happens, the path of the US Dollar is down.? After it happens, the path of the US Dollar is down, until a new equilibrium is found.? Economies are bigger than governments, and in the long run, governments can’t affect exchange rates.

Just stay on your toes, and be ready to buy non-Dollar assets after the coming currency intervention.

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