Currencies – Page 6 – The Aleph Blog

The Euros Zone

Posted on 11 November 201111 November 2011 by David Merkel

I want to toss out a half-baked idea for others to play with, criticize, and adjust.

But first, a fully baked idea: the Euro was doomed to fail.? Any core Euro after kicking out the miscreants is also doomed to fail.? You can’t have monetary union long-term without political/fiscal union.? The roadblocks to economic union are cultural issues that express themselves politically.? The upshot is that either you politically merge nations that are similar (and intermarry), or your nation should have its own currency, so that needed macroeconomic adjustments can occur.? A single currency for disparate nations is a decidedly bad idea, and the Euro-sceptics so roundly derided in 1998 have been proven right within 14 years.

So, now for my half-baked idea — it is time to undo the Eurozone in entire, but we will keep the Euro, or rather, Euros.? This would have to be done quickly or it would not work well.? When those in the Eurozone wake up one morning, they find that they do not have Euros any longer, but Greeks have Greek Euros, Germans have German Euros, etc., and they do not trade at parity.

Most of this would take place through bank deposits and savings, which would instantly shift.? Currency is far smaller and would be stamped (for paper bills) or struck (for coinage) by governments that have an interest in having more currency in circulation, but until the stamping or striking, a euro is a euro, and can be used anywhere.? In the short run, that would mean that some currency would leak to core Eurozone countries and away from the periphery.

The pro-rata shares of the ECB would be handed back to the national central banks, and the ECB dissolved.? The national central banks would then be capable of pursuing the interests of their own nations.? What a thought!

But what about existing long term contracts to pay Euros?? If to a nation in the Eurozone, it can be paid in either of the new Euros, that of the payor or the receiver.? If to a nation outside the Eurozone, they get the Euro of that particular nation.? What was a credit loss or gain becomes a currency loss or gain.

Many of the Eurozone nations would have to support their banks during such a crisis for solvency reasons, but their national central banks would once again have the freedom to do this.

Yes, this would be painful, and it would be a mess.? But it would be a “Big Bang” that sets the nations of the Eurozone free from their artificial shackles, and allows the nations in the Eurozone to liquefy, inflate, and reconcile all of the debts built up.? It would also send losses to nations that lent to the Euro-fringe.? After this is done, all of Europe would be in better shape economically, and Europe would be more, not less united, because they don’t have to argue over monetary policy.

Thoughts?? I welcome them. :)? I know I have omitted a lot; I also know this is impractical given the nature of EU/EZ treaties, but I toss it out to stimulate discussion.

Update: thanks to Steve Hamlin for pointing out my typo in paragraph 2 — see his comment below.

Book Review: The Greatest Trades of All Time

Posted on 5 November 2011 by David Merkel

This book grew on me. Think of it as “How I hit a home run in investing.”? Who are the sluggers that earned outsized returns?

But, there is a problem here, and the book would have been better if it had recognized the problem.? In a few cases, the “greatest” made one (or a few) good decisions.? In more cases, they made many good decisions that compounded over time.

Was the first group lucky? Maybe, but when things work out for the reasons that you specify in advance, I think not.? The problem of the first group is repeatability, which for John Paulson, is proving to be an issue for his asset management shop at present.

The investment markets are cruel.? No matter what you have done in the past, the question comes, “What have you done for me lately?” The pressure is high, so no wonder that one of the investors that the book mentioned has gone into hiding.

There are two more dimensions here.? Imagine an investor that made some amazing gains , but then craters.? There are some brilliant investors for which that has been true: Livermore, Niederhoffer, Keynes, and more… how much credit should we give to the gains, if the price is flameouts?

Second, imagine someone who is the best in class at a low-return area of the asset markets, like Jim Chanos in short-selling, or Bill Gross at Pimco.? They may not earn that much, but the skill level is really high.? But is the skill level so high when they chose areas of the market to work in that are low -return?

Maybe the book should have featured private equity players, or real estate investors, or those that have managed university endowments well… there are other investors that would be comparable or better to the returns of some in this book.

Or ask, where is Buffett?? He would deserve a spot here, not for any one trade, but for the multitude of clever trades and mergers he has done over the years.

Quibbles

The book needed a better editor.? Information on Templeton is repeated.? Beyond that, most of the ideas on how an average investor could try to replicate the strategies of the great investors are akin to drinking near-beer.? They are too weak, but on the other hand, without the brilliance of the investors, an average person would not know when to but and sell.

With those caveats, I recommend the book highly.? It is well-written, and it will fill out knowledge gaps in amateur investors.

Who would benefit from this book: Most investors would benefit from this book.? If you want to, you can buy it here: The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today (Wiley Trading).

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Book Review: China and the Credit Crisis

Posted on 4 November 20114 November 2011 by David Merkel

This is a book that is bullish on China; it does not visit any of the arguments of the bears.

That said, there are many reasons to commend the book:

It accurately describes China’s foreign policy including its interactions with the developing world, which are often far more logical and consistent than US policy.
It is fair in its rendering that China may have been a factor in the credit bubble, but was not the primary instigator.
It describes how China has grown to interact with global organization on its own terms.
It describes the history China/US relations fairly, including the rough spots where China and the US don’t see eye-to-eye, and sometimes play dirty.

Places where I think the book misses

It will be difficult to displace the US Dollar as the global reserve currency.? So long as export-driven nations sell goods on net to the US, and want to keep their currencies artificially cheap, they will have to buy US dollar-denominated assets in order to make that happen.

Pretend currencies like Strategic Drawing Rights are a nonsolution.? It has no active market, and reflects a view that one can have a single monetary policy for the world.? If a single monetary policy for the Eurozone does not work, how much less the world as a whole?

Beyond that, though China is a leading nation economically in Asia, Asian nations are more diffident to follow China’s lead politically.? Outside of Asia, China’s diplomatic moves have been received more favorably, say, in Latin America and Africa.? Asian nations have a long history with China, and realize that its size and power needs a counterweight like the US.? I agree with the author that the US lost a lot of credibility diplomatically after 9/11, given the way that we responded, but the US still has a lot of favor among Asian nations in a way that China can’t replace.

Finally the book fails to develop the details of China’s economic/financial system, and as such, falls into the hole that China bulls often do, neglecting the huge buildup of bad debt inside the major Chinese banks.

Yes, China has set up asset management companies to relieve the banks of bad debts, and transfer the losses to the MOF.? The question remains how long can this go on?? Probably a long time, because China discriminates against average consumers for the good of the Party, and the banks that aid the Party’s efforts.

Though on net I recommend this book, you would also benefit from Red Capitalism, and Uprising: Will Emerging Markets Shape or Shake the World Economy.

Quibbles

Date error on P. 38 should have been 1999, not 1990.

Who would benefit from this book: If you want to understand the Chinese economy, you will like this book.? If you want to, you can buy it here: China and the Credit Crisis: The Emergence of a New World Order.

Full disclosure: The publisher asked if I wanted the book.? I said “yes” and he sent it to me.

Please Sell Your Treasury Bonds, China

Posted on 21 September 2011 by David Merkel

This will be a short post.? I am not worried about China selling its US Treasury bonds for several reasons:

As they sell, the Yuan will rise versus the Dollar, which the Chinese Government does not want. Eventually their exports will fall, as US exports rise.
After that, the Chinese Government faces a reinvestment problem.? What do they reinvest in??? The Euro is under threat, the Yen doesn’t want more investors, and the rest of the developed world’s currencies are in the stratosphere.

I think the threat of the Chinese Government to sell US Treasuries is empty.? They can’t do it without hurting themselves significantly.

Options:

Buy storable commodities, gold? Done that.? Hoard more?? At these prices?
Switch to other types of debt than government debt? After the brouhaha with Agency debt, I suspect they would be less than willing to wander off the beaten path.? Besides, they are pretty big, and they are dealing with thinner asset classes.? If they have driven up the prices of Treasuries, imagine what they could do to corporates?
Start buying companies around the globe?? If governments would let them, maybe, but there would be a political stink.
For a weird idea, China could buy surplus US housing and restore liquidity and collateral levels to a market in oversupply.? After a decade they get out at a profit, probably.

Also, the lower level of liquidity could be an issue if actions need to be taken to recapitalize their banks when the next crop of bad loans has to be reconciled in the next few years.

China’s options for holding the proceeds from its trade surplus are limited.? For all of their deficiencies, US Treasuries are a liquid and deep market.? Chinese exporters benefit from keeping the Yuan weak versus the US Dollar.? I don’t see things changing soon, absent a bolt from the blue.

Beggar Thy Neighbor Correlation

Posted on 19 September 2011 by David Merkel

This should be a short post.? There are many reasons proffered for the increase in global equity market correlations — I would like to offer one more: competitive devaluation of currencies, a.k.a., the race to the bottom.? Almost all nations are looking to cheapen their currencies in order to encourage exports.? There is a a global “conspiracy” where consumers are discriminated against by producers and their governments.

The US is involved in this but is more willing to absorb foreign goods than most, making the US is the main reserve currency.? Send us you neomercantilistic goods and services, we will give you promises of future payment.

But when everyone wants to do the same thing, cheapen currencies to promote export-led growth at home, that same thing is impossible, because not all currencies can be cheap at the same time.

But as the process goes on, with so many of the world’s large countries engaged in similar policies at their Treasuries and Central Banks, it is no surprise that with one dominant global policy, there is one global market behavior, oscillating rapidly from panic to euphoria as stimulus measure go from less to more certain.

Book Review: Expected Returns

Posted on 12 August 2011 by David Merkel

How do we estimate what returns are reasonable to expect?? Most investment counselors fall back on easy rules of thumb, but is there a way of doing better?

In this book, the author takes academic research on investment returns, and tries to make it practical.? What are the main findings of the book?

Momentum works.
Value works.
Illiquid assets can work very well if you have a balance sheet that can hold them.
Carry strategies work most of the time, but when they fail, they fail big.? Same for strategies that sell volatility.

The book does a very good job in establishing that the excess returns of stocks over bonds are a lot lower than most believe.? It also supports the idea that moderate risk taking is the superior strategy.? Those that take high risks lose too often.? Those who take no risk don’t make anything significant.? Moderate risk-taking is the sweet spot.

One of the strengths of the book is that it considers almost all assets, and analyzes how many factors affect those asset classes.? The book is comprehensive; it covers everything, even if it is only an inch deep in spots.

I liked this book a lot, but it’s not for everyone.? You won’t find a lot of difficult math here, but you will find a lot of numbers.

Quibbles

I don’t agree with the idea of levering up low risk assets.? Yes, if you are? the only one doing it, fine, be a non-regulated pseudo-bank.? The trouble comes when many do it.? Eventually a liquidity crisis hits, and those levering up low risk assets get hosed.

The same is true of university endowments.? Too many thought it was easy money to invest in illiquid assets, and when the liquidity panic came in 2008-2009, they were forced to borrow, and/or sell illiquid assets at an inopportune time.

The book does cover everything, but it doesn’t cover everything deeply.? I think it is a valuable book to most who do asset allocation, but the author knows his limits, and does not claim to be expert in a number of areas.

Who would benefit from this book: Fundamental investors who want to understand the factors behind return generation can benefit from this book.? If you want to, you can buy it here: Expected Returns: An Investor’s Guide to Harvesting Market Rewards (The Wiley Finance Series).

Full disclosure: The publisher sent me a copy of the book for free.

Debt Junkies

Posted on 9 August 2011 by David Merkel

Our problems today stem from too much debt, both personal and governmental.? When enough of the populace is overindebted, they become conservative in spending.? When corporations see that, they become conservative as well, and cut back on production.? The same is true with governments.? As governments get more indebted, people begin to think they won’t spend as much in the future, which is a reasonable assumption.

But what do the pundits suggest?? Borrow more.? If you only would borrow more, and allocate the money to our favored projects, things would improve.? But that is more of the “hair of the dog that bit you” reasoning.? More debt does not solve the problem of too much debt.

In general, the more of the economy that we hand off to the government, economic growth will be less.? The government rarely grows anything, except itself.

I realize in the short-run that reductions in the growth of debt, much less reductions in debt will be viewed negatively by many.? The question becomes whether you want a solution, or you want to continue the disease, and hope for a miracle.

This problem is not limited to the US.? It extends to the Eurozone and China, and indirectly to the rest of the developed and semi-developed world.? In the Eurozone, the ECB and EFSF buy the debts of the weakest nations in order to back the Euro.? Imagine the Fed buying Puerto Rican and Californian bonds.? Ugly, and I hope the Fed does not become more imaginative.? It is too speculative already.

The Eurozone is transforming what was a fringe problem into a core problem and CDS spreads of Germany and France are greater than those of the UK, which has its own currency.? If the Eurozone were a nation, it would be in roughly the same shape as the US, which means not good.

As for China, the government forces loans that are not economic on the banks.? There are many projects that seem to have no economic purpose, but might have political purpose.? Why build ghost cities?? Why build a highway to Xingjang, and plan a model city there?? For the latter it is to control the Uighurs; for the former, I am not sure, aside from distorting GDP statistics.

China also has its issues with owning US debt.? They have to own US debt to keep their currency cheap for exporting.? This is just another way that China discriminates against their consumers in favor of exporters who are political cronies.

Coming back to the US, the Fed encouraged more debt todayby saying that financing rates would remain low for two years.? That may push up asset prices, and allow the highest quality borrowers to borrow more, but is useless in stimulating the economy, because credit spreads do not respond to the Fed when the economy as a whole is overlevered.

The world is led by debt junkies who think that debt doesn’t matter.? They are leading us to a greater crisis where the only thing that does matter is debt, and for political reasons, some governments will not be willing to pay in full.

On Bond Management

Posted on 3 August 2011 by David Merkel

After the recent piece Waters Uncharted, I received this comment:

Why do you have a large portion of your fixed income portfolio allocated to foreign bonds?

Are you afraid of a large devaluation in the U.S. dollar?

It seems like American corporate balance sheets are very healthy (especially relative to sovereigns and personal balance sheets).

I have a rule.? I look at the spreads offered for various classes of domestic bond risk.? I buy bonds in the areas where I believe the incremental risks are more than adequately rewarded in the spreads.? If few or no areas offer adequate compensation for risk, I invest in foreign debts, because it is a statement that the US Dollar itself is overvalued.

Think of it this way: if I were a Swiss investor looking in at the US, and concluded that the opportunities weren’t great, would I buy anyway?? No, I would look elsewhere in the world for opportunities.

At present, my bond portfolios are invested:

40% in Foreign Bonds
30% in long US Treasuries
20% in preferred stocks, and
10% in US Dollar-denominated emerging markets bonds

There are several forces at play here.? The actions of the US Government and the Fed tend to weaken the US Dollar — it’s the additional debt, and low fed funds rates, as well as the residual effects of QE.? So I invest in foreign bonds; it’s not ideal, but it is the best of a bunch of opportunities.

The US is still a safe haven currency.? With the difficulties in the Eurozone, some are giving up yield to gain safety, or at least predictability for now. That’s why the position in Long? Treasuries, and my, hasn’t it run of late.

The preferred stocks reflect a part of the credit market that hasn’t gotten whacked too bad, offering a decent yield for the junior debt on healthy companies risk.

I used to hold more emerging markets debt, but I have been trading out of it as the momentum has been weakening.? Economic troubles are rising in the emerging markets, and the eventual result might be ugly.

Back to the original question, yes, corporate balance sheets are in good shape, aside from the banks. But spreads reflect that or better, and so I don’t want to play there now.

Will any decrease in the valuation of the dollar be large? No, I expect it to be moderate, but yes, a decline.

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I have a saying, “Fast moves mean-revert, slow moves persist.”? It makes me a little edgy with the long Treasuries, because the move has been so fast.? I may sell some in the near term if prices rocket higher.? If they edge higher, I might not sell.? Flat or slight selloff, do nothing.? Big selloff, sell into it.

Bonds are a funny mix of momentum and mean reversion.? Good bond managers get a sense of when momentum is overdone, and act against it, but follow when the momentum is gentle.

It’s difficult balance.? I remember buying long Treasury bonds in 2006 when the timing was just right.? Hard negative momentum had just broken.? I remember the trader coming back to me weeks later and saying, “How do you do it?” and I said, “I don’t,”? then saying that nothing is certain when you enter into such a trade.? Market sentiment was horrible, so we legged into the trade, nibbling as prices fell, entering the full position as prices began to rise, once the cascade of forced selling abated.? A few months later, we legged out of the position for a good-sized profit in bond terms.

It’s my opinion that bonds trend more than equities, and that it is easier to calculate the downside risk of most positions.? There are cycles:

Credit
Currency
Hedging of interest-rate-sensitivity (otherwise known as duration)
Liquidity

These are not totally independent of each other, but neither are they totally dependent, which makes the game complex.? At present, credit conditions are declining, the US Dollar is not attractive, except compared to the Euro.? There seems to be a grab for the long end of the yield curve, agents buying bit of the far future, perhaps to fund or immunize long liabilities.? Finally, liquidity seems to be slipping — too many markets with abnormalities in the short end of the yield curve.? That will eventually affect the prices of bonds where the value proposition is less than clear, unless the Central bankers decide to do another round of ill advised “stimulus.”

Enough for now, we’re still in uncharted waters, but maybe we have a few guides to aid us in managing fixed income in an era where monetary policy does not work, and governments borrow madly.

Where to Hide?

Posted on 27 July 2011 by David Merkel

We can’t rely on US Treasuries?? If so, what can you do to preserve purchasing power?? I will ignore a variety of exotic strategies/derivatives and focus on things that can be executed by individuals and small institutions.

The first idea that comes to mind is gold, silver and commodities.? Commodities don’t lie, they just sit there.? But the prices don’t just sit there.? They go up and down with demand and supply.? I’m not an expert there, so I would say keep positions small, enough for diversification relative to volatility.

Idea two is foreign debt of unquestionable solvency.? Well, that takes much of the world off the table, leading to investment in the developed fringe currencies — Canada, Australia, New Zealand, Norway, Sweden, and the Swiss Franc.? Toss in the Yen, though it isn’t fringe.? Not a very large group, and their currencies have run like mad.? Could they fall?? Imagine a US default, where aggregate demand drops across the world because the Treasuries in the banks of other nations are only worth 70% of face value.? Deflation would drive commodities and fringe currencies lower.

Idea three is an echo of two — buy the debts of emerging markets with more orthodox economics than the US, Eurozone, and China.? Nice, but their currencies are high as well.? Same problem as two.

Idea four is buy high quality equities that pay dividends.? There’s a plus and a minus here.? Minus: Equities are highly sensitive to confidence / trends in aggregate demand.? Plus: equities, if conservatively financed have positive optionality, subject to the same problem you have: what is a good store of purchasing power?

Even buying needed resources ahead might not work because demand conditions might be lower going forward.

Idea five is buying high quality non-Treasury domestic debt.? Along with ideas 2, 3 and 4, this seems to be Pimco’s strategy.? But our payments system is interconnected.? Any non-payment, or serious threat of non-payment will disrupt the ability and willingness of others to pay.

Idea six is stay in US Treasury debt — where else can you go?? You’ll get paid back eventually, with interest, most likely…? Hey, TIPS could work in an inflationary scenario.

Idea seven is hold physical US cash.? That should retain value of a sort until the debt ceiling situation is settled.

My main point is that there is nowhere to hide with certainty.? There are places to diversify into, and maybe you should consider some of them as part of a broader asset management strategy.? But avoid changes motivated by panic.? They almost never work.

In a debt-driven world, with fiat currencies, everything is confusing because there is no obvious store of value offering some small (but not near-zero) yield.? A small positive inflation adjusted return is healthy for savers, and good for the economy.? Let the Fed adjust its policy, and then the hiding place would be simple — CDs.

The War Against Savers

Posted on 24 June 2011 by David Merkel

Today, Charles Rotblut, CFA who is the AAII Journal Editor wrote:

Federal Reserve Chairman Ben Bernanke continues to be the enemy of savers. Yesterday, the Boston Red Sox fan reiterated his belief that interest rates should be kept at rock-bottom levels for an extended period of time. He views this as necessary in order to keep the economy growing.

When you run an investment group that is largely composed of retirees and near-retirees, it is reasonable to call Bernanke the enemy of savers, because he is the enemy of savers.? When one can’t earn anything over one year without risk, something is wrong.? Better that the economy grow more slowly, than that savers not get their due for not consuming.

Saving deserves a return.? Let the Fed raise the Fed funds rate by 1%, and they will see that there is no harm to the banks, and little harm to the economy.? Once you have 1% slope between twos and tens you have more than enough oomph to make the economy move.? What, does the AARP have to bring a age discrimination lawsuit against the Federal Reserve to make this happen?? The Fed is discriminating against the elderly.

But now consider another issue — money market funds.? I consider them to be superior to banks because their asset-liability mismatch is so small, and they have generated small losses relative to banks and other depositary institutions.

Prime money market funds in the US have been investing 50% of their assets in the Commercial Paper [CP] of Core Eurozone Banks.? Well guess what?? If the Greeks and other fringe members of the Eurozone default, and the core governments don’t bail the situation out, those holding? CP of core Eurozone banks may take a loss.? And this is at a time where French and German Banks are facing liquidity issues.? Take time to review your money market funds.

The problems of the US and China are significant, but the problems of the Eurozone are pressing.?? The endgame there will arrive more rapidly because the underlying structure is unstable.? One currency can’t serve multiple cultures.? Also, there should have been an Eurozone exit plan designed in from the beginning.? It was hubris to think it would never need that level of adjustment.

It seems like the ECB is becoming a repository of euro-fringe debt, and perhaps the IMF as well.? After all, it doesn’t cost the ECB anything to absorb those debts, but it indirectly spreads the risk to the euro-core nations if there is ever a default or unfavorable restructuring.? A central bank can’t go broke, but it can impose problems on those that use the currency if defending the central bank exacerbates other problems in the economy.? (E.g., printing money to cover over bad debts absorbed by the bank, while inflation rolls on.)

On a slightly different level, I’m not sure that the banking regulators in the US or Europe really got the main lesson from the crisis.? Risk management is liquidity management.? I still think that banks rely too much on short liabilities to finance illiquid, longer assets.? One advantage of mark-to-market accounting is that it can reveal those mismatches to investors, or perhaps, to regulators.?? Extra capital can help, but it is usually not enough when there is a run on short-term liquidity, particularly because capital is the excess of assets over liabilities.? If there are not enough liquid assets to meet the redemption of liquid liabilities, the result is insolvency.

“But that’s a liquidity problem, not a solvency problem — just give it time and the market will normalize, the assets are worth more than the liabilities anyway.”? But at such a time, no one wants to buy the longer, less liquid, lower quality assets.? If the bank could raise liquidity, it would.? It can’t, so it is not only illiquid, but insolvent.? It’s always cheaper to issue liquid liabilities, because those are attractive to savers and investors, but they a poison in a crisis.

My fear here is that there may be another call on liquidity that forces the Fed or the ECB to backstop banks.? Not sure what would cause it; it’s always hard to pick which straw will break the camel’s back.

Thus I say be cautious at present; have some safe assets available in case we have a panic that emanates out of Europe, and has second-order effects on the US.