Tuesday, June 05, 2007

The World Turned Upside Down

Popular history has it that when General Cornwallis of the British Army surrendered to the combined American and French forces at Yorktown in 1781, the British Army band played a popular tune called "The World Turned Upside Down." The story has a nice historical resonance, as the world was indeed never the same after the emergence of the American nation-state.

Macro Man has no idea how the tune actually goes, but he can imagine that it's being played today as risk asset bears surrender to the combined forces of low volatility and ample liquidity. Here, too, the notion of the world turning upside down is an apt one. For the entirety of Macro Man's career, he has been accustomed to a return distribution featuring a large number of modestly positive daily returns for risk assets, punctuated by the occasional large negative return- the famous fat tails of the financial market distribution. Or, to use a more everyday metaphor, risk assets tend to go up the escalator but down the lift.

Not anymore, however. The apotheosis of the liquidity glut has evidently turned the world on its head, and altered risk asset return distributions beyond recognition. Consider, if you will, the New Zealand dollar. From early March to mid-April, NZD/USD rallied nearly 12%- very lift-like. The ensuing six weeks saw a corrective decline that totalled roughly 3.5% peak-to-trough. You can almost see the handrail on that escalator! As Chinese equities have tanked over the last few days, however, NZD/USD has clawed back all of the prior six weeks' losses and more. Once more into the lift, dear friends....

What is going on here? How can the correction be so modest, and the re-acceleration of the trend so vigorous? How and why have the fat tails upped and moved house from the left side of the distribution to the right? While there are admittedly factors that argue for NZD appreciation (a potential RBNZ tightening tomorrow night, the ongoing terms of trade boost from strong dairy prices), equally there are fpotential stumbling blocks that could/should constrain the flightless bird (RBNZ preference for a weaker currency, positioning, valuation.)

Clearly there are other forces at work here and the liquidity glut is driving everything. While Macro Man's portfolio is benefitting from the parabolic rise in the kiwi and other risky currencies, he can only shake his head and wonder how and where it will all end.


"Cassandra" said...

Ahhh Macro-Man, Welcome to my world!! Indeed, intimated in my hopeless long-shot forecast of an impending tail event, kurtosis is elevated with a positive skew of daily returns. In otherwords, things are melting UP (!!!) in equityland. In my original lame forecast, I left the reason open, but in the above link I suggest the main culprit is private equity, itself the Frankensteinian result - as you rightly emphasize - of pure unadulterated excess liquidity.

Remember the enigmatic dwarf in David Lynch's "Twin Peaks"? That's where we are now.

How and when will end?? The endgame remains a (a) blowout in the dollar, (b) a blowout in rates - the type that creates high real rates (c) both (d) neither of the above immediately but continuation of status quo with a blowout in inflation;
(e) born-again sense of fiscal rectitude in the US;

We seem to be on the course of (d) which ultimately leads to (b) with a bit of (a), eventually ending in (e) or something akin to the mother of all vomit scenes in "Team America". While possible, (e) is immediately implausible until after the election, for it has been the democrats that have cleaned up the Republican fiscal messes in the post WWII era. However, never, have they been so policy-encumbered in all respects. But if they DO try to fix traditionally, rates will drop with econ activity , (and asset prices) and the dollar will rapidly find a floor, as Americans begin digging their way out of a very deep deep hole. What was the old biblical saw....seven fat....seven lean??!?!

Agustin said...

Macro Man: like Cassandra, I can say "welcome to my world"! (www.liquidityblog.blogspot.com).

Macro Man said...

In your case, Agustin, very literally! Do you perchance have any historical data/charts on your liquidity measure? 'Twould be rather interesting to see how the current ocean of liqudity compares with episodes and bubbles past.

C, I've been a resident alien in your world for a couple of months now, ever since I saw evidence that the gaijin were finally printing yen carry tickets in size.

My money would be on inflation as the catalyst for the end game, yesterday's study suggesting breakevens have a shortrun impact notwithstanding. Perhaps the issue is not so much one of consumer price inflation (though most would, I believe, concur that these measures understate the cost of living, but rather of asset price inflation.

Then again, given that Fed's seeming inability to spot a bubble in any location other than a rearview mirror, perhaps not.

Bitr said...

Hi MM. I wonder if Ben is not going to eventually differ from Alan in this aspect. If nothing else his forecasting record so far beats Alan's hands down. Cheers!

Agustin said...

MM, check out Figure 10 on page 5. That's my baby! (Almost: instead of the U.S. monetary base, I take the stock of Treasuries held by the Fed. I do this in order not to mix apples & oranges, and also to avoid sharp Y2K-style swings.)