Currencies matter

Financial markets were beaten with the ugly stick on Friday, with USD/JPY and the S&P 500 prominent recipients of a good lashing. What's curious is that quant models appear to be breaking down again; Friday saw small caps handily perform large caps, the bank stocks (as proxied by the BKX) post a nice gain, and popular funding currencies surge higher.

Certainly Macro Man's own relatively simple quant strategies have been stuffed like a Christmas turkey so far in November, although he is exiting the carry basket Monday morning. Anyhow, if the models are having a spot of bother once again, we should all probably be prepared for elevated levels of volatility in the period ahead. Indeed, Friday's swoon had all the hallmarks of a margin clerk-driven liquidation, similar to what we saw in August and in May/June 2006.

As markets go haywire, there are nevertheless some interesting macro trends continuing to bubble along in the background. Exhibit A is the impact of the weak dollar and slowing domestic demand in the US. The US trade account posted its smallest deficit since May 2005 in September, with August's deficit also revsied lower. Macro Man was slightly amused to see that Morgan Stanley is now tracking Q3 GDP at a rather robust 5.3%. Didja ever think you'd live to see the day when the Fed cut rates 0.50% in a quarter when growth posted 5% plus and the stock market rallied? Strange days indeed.

Anyhow, recent data has delivered another convincing argument that currencies do indeed matter in impacting global imbalances. At the same time that the US deficit was announced, Canada posted its smallest trade surplus since the 1990's, despite the relatively healthy state of the Great White North's terms of trade. Earlier in the day, the UK had posted its largest-ever trade deficit, at £7.75 billion for September.

The UK now runs a larger visible trade deficit as a percentage of GDP than the United States, has a more overvalued housing market than the United States, has similar credit issues to the United States, and has a much more overvalued currency than the United States. Oh, and the weather's worse than much of the United States. Yes, the UK is a wonderful place to be at the moment!

Regardless, the chart below sets out recent changes in currencies (as measured by y/y change in the latest observation of the OECD's real effective exchange rate estimate) and trade (as measured by the USD change in the latest monthly trade figure from the corresponding month a year earlier) for the US, Canda, Japan, and UK. Perceptive readers will observe a strong negative correlation between the two series. As Brad Setser and I have suggested for some time: yes Virginia, currencies do matter.
Over the weekend, PBOC raised its reserve requirement ratio another half a percent to 13.5%. On would have to posit that reserve accumulation has ticked up sharply in Q4, and raising the RRR is a cheap way of passing on the costs to China's banks. In any event, PBOC has allowd the RMB to appreciate "sharply" since the end of the CCP Congress, though whether this is a temporary phenomenon ahead of delicate meetings with Europe and the US or a new policy remains to be seen.

In any event, one of Macro Man's favourite datapoints has continued a recent trend, as US import prices from China have now risen 2.2% y/y. Of course, insofar as Chinese demand has buoyed commodity prices, the inflationary impact from China could be argued to be closer to the headline import price figure, which in October rose a resounding 9.6% y/y.
Now that China is no longer a source of global deflation/disinflation, could it be that the old models of exchange rate pass-through, neglected in recent years because they didn't seem to work, should be revived? If the Fed ever reaches that conclusion and acts accordingly, perhaps that could be the trigger to get the Treasury to care about the external value of the dollar. Until then, however, dollar weakness will continue to be seen as an offset to frailities in the housing market as the American growth model switches, if only temporarily, to exports. Who'da thunk it?
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Tim Price
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November 11, 2007 at 7:48 PM ×

Hello. Enjoy the blog. Grateful if you could get in touch via http://thepriceofeverything.typepad.com. best wishes tim.

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"Cassandra"
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November 11, 2007 at 11:54 PM ×

Short cable must be the imminent home-run trade. As you mentioned, the fundamentals ex-prevailing yield diff suck; rates have only one to go if the trajectory of US macro trends continues;long spec holders are weak hands indeed not to mention overleveraged; the major source of wealth is likely to hit a speed-bump as a result of deleveraging; and they eat baked-beans for breakfast.

Next on the list would of course be the Spanish unit and though we can't short it anymore, I'm sure CharlesB's got some great names to smack down after IBEX's most-whippingish bear bounce...

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wcw
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November 12, 2007 at 3:45 AM ×

Now, I've had a crappy year, so you probably shouldn't listen to me, but: I'd a thunk it.

A few years back, someone mentioned that he had bid out some manufacturing he needed (plastic bits, if I recall) to the usual Asian suspects and -- just for the heck of it -- had asked for bids from two US companies. He ended up making his plastic bits domestically.

At the time, I figured that if the dollar dropped some more, the US might start exporting more to the but-this-stuff-is-made-in-Asia crowd. I haven't broken down the trade numbers lately, but maybe that is actually happening.

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November 12, 2007 at 1:09 PM ×

One of the weekend Spanish national pamphlets posted a top 10 of countries purchasing U.S. companies this year. Headed by Canada at 50 bn (finding the conversion to the Washington peso real attractive) and with Spain in fourth place, the total came out to about 212 bn, presumably dollars. More at street level, friends in low places report that American businesses of all shapes and below-radar sizes are being snapped up right, left and centre. Sorry, that would be 'center'. The U.S. may be becoming the international investment destination of choice.

Cassandra's kind request will be answered in a post.

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Old'Vet
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November 12, 2007 at 1:36 PM ×

Oh what a happy morning. . . for coordinated reversals in FX markets. Huddle, hype it, slap butts, and hike it on Monday mornings. Is there some massive coordinated CB intervention coming, or is this just the halftime show?

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Anonymous
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November 13, 2007 at 7:18 PM ×

A couple of weeks ago u posted a poll to forecast the evolution of the equity in the states. U favoured a W like shape. Do u think we reached the bottom in the second leg ?

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Macro Man
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November 13, 2007 at 8:18 PM ×

The "letter-shaped" poll was actually in August and the making of a new high was, for the purposes of that exercise, a V-result.

The recent poll was more about where the SPX ends of the year, rather than the path it takes to get there. My (currently dodgy-looking) vote was for >1550, where sub 1450 was the most popular selection.

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Anonymous
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November 14, 2007 at 1:28 AM ×

Mr Macro,

You often make comments about past, present, and future market volatility in different markets, yet I haven't ever seen you use VIX future/options for your alpha portfolio, which would seem, as sitting from the sidelines as a retail investor, to be an obvious and simple tool to help play/manage volatility. You don't seem to make much reference to the VIX either, but given your beta plus equity position it would seem (to me at least) to be an important factor in your investment decisions.

Is it coincidence that the VIX doesn't appear much in your blog? Is it part of your "world view"?

take care

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Macro Man
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November 14, 2007 at 1:29 PM ×

On VIX.....I do look at VIX and use it as an input into my thinking, especially with resepct to divergences and extremes. That being said, VIX futures are a lousy trading vehicle IMHO, as there is no real arbitrage-ability to ensure that the future reflects the actual volatility of the market. So if I think that VIX is going to rise, I feel that it is a much better trade to buy index options; if I think VIX is going to fall, I might sell index options.

I have referred to VIX in the past, for sure...but currently th e correlation with the underlying is basically -1, so I am not sure how many non-obvious insights I have to offer, hence the radio silence on the subject.

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