Friday, November 30, 2007

Dear Prudence

It's been another nice day for equities, and the S&P 500 is rapidly approaching the critical zone at 1490 - 1500. Amazing as it seems, the S&P has already retraced half of its peak-to-valley trough, which took the better part of six weeks, in a matter of four days.

That, my friends, is a market due for a rest, and the looming resistance area offers an obvious stopping point. Macro Man therefore sells 460 ESZ7 contracts at 1485, which hedges half of his beta plus exposure to equities. A quick dip back down to 1440-1450 is eminently possible, particularly ahead of next week's payroll data, and it would be churlish to pass up the opportunity to hedge.

Double Whammy

Q. What is stonger than The Economist cover curse for dollar bears?

A. An Economist dollar cover that they've ripped off from someone else.

Yes, ladies and gents, we have a double whammy potential dollar cover curse this week, as both Der Spiegel and The Economist put the falling dollar on the cover. Amusingly, they both use the same metaphor, that of a plane going down in flames. Note that Der Speigel came out earlier in the week, so the next time an Englishman tells you about the great English wit, ask him why they need to steal ideas from the Germans!
In any case, the dollar on the cover of The Economist traditionally spells the end, if only temporarily, of rallies in EUR/USD. For those who are relatively new to this space, take a walk with Macro Man down memory lane, back to December 2006.....
....December 2004.....
....and February 2004.

At this point, Macro Man is not prepared to say that the buck is going to quit going down, especially given yesterday's open letter calling for a maxi-reval of GCC currencies. By the same token, after a nice run it's not terribly difficult to bank profits on longstanding short dollar exposure.
Macro Man therefore closes EUR/USD at 1.4750 spot, and will bid 109.80 for $15 mio USD/JPY to partially hedge his straddles.
Elsewhere, the risk aversion trade may be slowly morphing, however temporarily, back to a liquidity trade. Yesterday's price action in equities was broadly encouraging....and yet bonds rallied like a banshee. Emerging markets have come roaring back as well. And all of this has happened in a context of broadly poor US macro data!
If it continues, the portfolio should benefit, as Macro Man is long both equities and fixed income. Another day like the last couple, however, and he will probably look to set some hedges and lock down profits. For the meantime, though, he is humming AC/DC under his breath, as the blog portfolio is "back in (the) black" with just the London and New York sessions until month end.
Finally, a milestone of sorts was reached while Macro Man was nursing a modest hangover on the train this morning; fourteen and a half months after he started scribbling his thoughts down in cyber-space, the 100,000th visitor passed through his electronic door. Thanks to all and sundry for reading, and especially to those who thoughtfully pointed out the Economist cover via email or the comments section last night!

Thursday, November 29, 2007

An open letter to the GCC


I wish you all a safe and enjoyable journey to your forthcoming summit meeting next week, and to those residents of the United Arab Emirates I wish you a happy national day this weekend.

Though I would not presume to dictate to you how to run economic policy, I would like to offer a friendly piece of advice on your currency pegs. I write to you from the perspective of a participant in the currency markets, and indeed as someone who has some of the assets that I manage invested in Gulf currencies.

It is quite clear that your peg regime is now suboptimal. I needn't tell you that conditions are completely different now to when your basket pegs were instituted, and that as a result policies which were appropriate in the 1980's and 1990's are now completely wrong for many of your countries.

Simply put, your major export commodity and source of wealth has appreciated to such a tremendous degree that your currencies must appreciate. This can happen in two ways: either the value of your currency must go up against the dollar, or your inflation levels must rise substantially.

While the latter option may seem preferable in the near term, over somewhat longer periods it is much more damaging to your economy and indeed, society. History is replete with angry protests from peasants and workers who cannot afford to feed their families; as far as I am aware, there are no recorded incidents of hotel owners taking to the streets because they've lost a marginal tourist.

All this is probably known to you. What I really wish to bring to your attention is the mechanism of how to adjust your peg regimes. Just about every recent example of a change in currency regime has emphasized gradualism. In recent years, China, Russia, and indeed Kuwait within your own region have changed regimes to what is tantamount to a crawling peg with a slow nominal appreciation against the reference basket.

While it is too soon to judge the efficacy of the strategy for Kuwait, I would suggest to you that the policies have proven to be ineffective in China and Russia. Simply put, the actions required to maintain a slow crawling peg introduce as many if not more distortions to the financial system than not moving the peg at all.

Adjusting a peg, however slowly, is a tacit admission that a currency will move towards its equilibrium value. For the currencies referenced above, as well as the remainder of the GCC, the equilibrium value against the US dollar is far, far away from current levels. By adjusting the peg, however slowly, one encourages a tremendous amount of capital inflow which must be purchased by the monetary authorities to maintain the crawling peg regime. This intervention proves very difficult to sterilize completely, which introduces an even greater inflation threat to the economies in question.

If we consider a simple measure of "excess reserve growth" as the monthly growth in FX reserves in excess of the trade surplus, we observe an interesting phenomenon. In China, after the peg regime was adjusted in July 2005, excess reserve growth slowed for a year or so. However, it has subsequently risen very sharply and indeed, and with it so has inflation.
In Russia, a similar phenomenon has emerged. The rouble was pegged to a USD+EUR basket in February 2005. This initially generated a lower (in Russia's case, more negative) excess reserve growth. However, subsequently excess reserve growth has risen sharply, turning strongly positive this year. At the same time, an eight-year trend of lower inflation has been reversed.

Given that inflation is already a significant problem for some of your countries, I would urge you to look beyond the short term. Yes, a small re-pegging may ease your problems for a few months. In the longer term, however, it will only exacerbate them.
Speaking as a currency speculator, I can tell you that a modest shift in the peg is unlikely to dissuade me from exiting my long GCC currency positions. Indeed, it could well be the case that I and others like me pour even more money into your region on the expectation of future currency appreciation. Were you to shift your pegs 10-20% however, I can assure you that I and others like me will exit our positions and leave your domestic money markets in a state more fitting to your economies' needs.
I urge you to think of shifting pegs like removing a Band-aid. It might seem as if a slow, gradual removal is the appropriate course of action....but in actuality it is much more painful than simply removing it in one shot. China and Russia are trying to take the band-aid off slowly, and are currently paying the inflationary consequences.
Dare to be different. Remove the band-aid all at once.

Macro Man

Wednesday, November 28, 2007

Some unique factors for your next quant strategy

It's been a hard year to reside in quant-land. The ignominy of being the smartest guy in the room and yet underperforming day-traders must gall those financial market participants with more degrees than the Sahara in the summer. Even Macro Man, whose "degree count" is closer to absolute zero than the desert, has seen his relatively simple quant strategies get absolutely butchered this month.

The problem, it appears, is that everyone who is using a model looks at the same things. Goldman Sachs, whose Global Alpha fund is reportedly suffering even more than Macro Man's beta plus portfolio this month, said in August that they'll need to include some more "unique factors" in their model construction. This strikes Macro Man as an eminently sensible suggestion. To help his quant-y friends, and to ensure that Aston Martins stay in the proper hands, he offers herewith some suggestions for unique factors to include in future-generation models. Astute readers should feel free to contribute their own suggestions below.

1) Neptune's moons. Has your 2007 performance left your investors out in the cold? Enlist the aid of the coldest thing in the solar system, Neptune's moon Triton! If the number of Neptune's moons visible from an earthbound telescope is even, go long stocks. If the number is odd, go short stocks. If your telescope is broken, go flat.

2) What book are you reading? If it is non-fiction, that suggests that you are interested in facts and analysis. Construct a bottom-up model that trades primarily from the long side. Are you reading fiction? You are creative and imaginative. Sell a basket of stocks short, contact a friendly journalist, and make up salacious rumours about each. Cover your shorts when you finish the book. If you don't or can't read, trade foreign exchange instead.

3) Flip a coin. An oldie, but a goody.

4) What colour shirt are you wearing today? If it is a primary colour (red, blue, yellow), go short equities. If not a primary colour (everything else), go long.

5) Football. Everyone's kids plays football (i.e. soccer) these days, even in America. If your kids score two or more goals combined this week, go long equities next week. If they score one goal, go flat. If they don't score, go short. If you don't have kids, become a broker- you'll be up all night entertaining clients , but at least you can sleep in at the weekends.

6) Use a dartboard. For those who manage Asian equities, where stocks are typically listed by numbers rather than mnemonics, construct a long/short basket by throwing darts at a dartboard. Not only will this give you an uncorrelated strategy, but the practice you get should enable you take take money off your friends at the pub on Friday night.

7) Use sunspot activity as a variable. Actually, maybe this isn't so unique after all.

8) Use your social network! Find the largest person you know. Ask him what his favourite food is. Go long the commodity used to make that food. Then find the most petite person you know. Go short the commodity used to make their favourite food. Rebalance once a month.

9) Use Mr. Brain! In yesterday's comments section, Macro Man inadvertently noted that he used "mr. brain" to develop the simple VIX model that he had written about. Friend-of-the-blog Charles Butler helpfully found the link above. Macro Man isn't sure what Mr. Brain actually does, but is confident that it can only be of use in constructing financial market trading models.
10) Use realistic transaction cost/correlation assumptions. Yes, it may be more mundane than the previous nine, but on current evidence it might be the most unique of the bunch.

Tuesday, November 27, 2007

Time to act?

Holmes and Watson would no doubt have been pleased by yesterday's price action, as the caning of the S&P 500 injected yet more risk premium into financial markets. The news flow released before and during yesterday's trading- HSBC taking $45 billion of SIVs on-balance sheet, Goldman downgrading HSBC, Chuck Schumer taking a break from bashing China to bash Countrywide, Citi to shed loads of jobs- did not exactly engender a feeling of warmth and stability in the marketplace, and it showed.

The price action in bonds was stunning, with Treasuries rallying hard across the curve. It smelled of capitulation and/or convexity-type activity (and for Macro Man it was, as he was stopped out of the short TUZ7 position), given the extent of the rally. However, since the US market close it's been sweetness and light, courtesy of the news of ADIA's $7.5 billion capital injection into Citigroup.

The deal is strongly reminiscent to two other deals in Citi's history: Prince Al-aweed's famous share purchase in 1991, and before that Warren Buffett's purchase of Saloman preferred stock in 1987. In each of those prior deals, the terms were pretty advantageous to the buyer, and this time around is no exception; an 11% yield and conversion strikes starting near the current price look like a home run for ADIA. Memo to John Thain: if you want any more cash, Macro Man will be happy to invest on those terms p.a.

However, it's almost certainly premature to hail this as any sort of turning point. The Buffett deal with Solly's, for example, was consummated in September 1987, just a few weeks before the crash. Moreover, if Citi needs to shore up its capital base on those terms, it begs the question of just how bad financial market conditions must be.

Over the past few months, Macro Man has been fairly critical of the Fed's relatively aggressive easing of the funds rate. He stands by that view, believing that the funds rate should be used to address macroeconomic issues. The current situation, by contrast, is a microeconomic problem- the non-functioning of certain credit channels in the economy- that threatens to become macroeconomic if not properly addressed.

Consider, if you will, the ratio of 3 month LIBOR to 2 year not yields (looking at the spread between the two yields similar conclusions.) Under normal circumstances, the ratio of the two will be around 1 or so; higher if the Fed is restrictive, lower if the Fed is accomodative. Since 1986 the average ratio has been 0.94, reflecting that the Fed has, in aggregate, eased policy over the last 22 years. The ratio is currently 1.63, higher than in August and much higher than any other period since the BBA began publishing LIBOR fixings.
This is a direct reflection of the non-functioning money markets and reveals the degree to which market liquidity conditions have tightened. It is unsurprising, therefore, that equities and other risk assets (including erstwhile bulletproof EM darlings like Brazil) have come under the cosh recently.

Now perhaps the Fed wants this kind of tightening of conditions, but given the lip service that they've paid to "the proper functioning of the financial system", it would appear not. So these conditions, based on what the Fed has told us, merit a response. Per the above, Macro Man believe the solution should be microeconomic rather than macroeconomic, via aggressive open market operations from the New York Fed, providing the system with as much cheap funding as it needs to restore confidence and normalcy.

And while the NY Fed did announce a term repo yesterday that will extend over the turn of the year, it was almost worse than nothing. An $8 billion repo is a drop in the bucket compared to the demand for funds, and perhaps suggests that the Fed does not understand the true scale of the problem. And if that's the case, things will likely get worse before they get better. For starters, the Fed may want to add another zero to their term repo volumes should they wish to assuage market fears of an implosion of the banking system.

What seems clear is that Treasuries have rallied to the degree that even non-profit maximizers cannot be persuaded to buy them if they have a choice. The Fed's custody holdings of Treasuries for foreign CBs have begun to fall, mcuh as they did in August, even as Agency holdings continue to build up. August's trend was ultimately reversed by the discount rate cut and subsequent follow through; will the Fed act this time around?
If they do, then equities could be in for a nice bounce. Last week Macro Man observed that VIX had failed to make a new high even as the S&P 500 made a new low, and mused whether that was a buying signal. Ex-post, the answer was pretty clearly "no." But Macro Man went a bit further and conducted a simple study to measure the efficacy of a VIX divergence strategy. If, on a given trading day, the SPX closes at its lowest level of the past 25 days but VIX does not close at its high of the past 25 days, the system flashes a buy signal. The market is then bought at the following day's open and sold at the close 5 days after the signal is generated.
Over time, this simple 'divergence play' model does seem to produce profits. The return curve of the strategy is laid out in the chart below, going back to 1990. The hit ratio of the strategy is 59%, with an average winner of 2.2% and an average loser of 1.9%

The strategy is far from perfect, and there have been periods of significant drawdown. Nevertheless, it's not bad for a couple hours' work...and suggests that if the Fed does realize that it's time to act, then equities could fly, if only temporarily.
If, on the other hand, the Fed remains focused on the macro at the expense of the micro...then Macro Man will need to lay even more hedges on his long equity beta plus portfolio.

Monday, November 26, 2007

The curious case of the vanishing bid, part 2

We left Holmes on Friday contemplating the curious case of the vanishing bid for risky assets. We pick up the story the following morning....

The next day dawned gray and cold, but at least the storm had passed. I was surprised to see Sherlock Holmes, normally a late riser, at the breakfast table before me. He was clad in an outlandish uniform that resembled nothing so much as the outfit worn by a professional golfer, except for the blazer worn over the shirt and V-necked sweater.

“Good lord, Holmes!” I exclaimed. “I didn’t expect to see you up at this time of day, and still less dressed like Charles Danforth Ogden!”

“Now, now, Watson,” replied Holmes, “how am I to find out what is ailing Ogden’s hedge fund if I don’t look the part myself? I’m off to a series of bank-sponsored investor roundtables. Perhaps I’ll discover what’s happened to the bid there. Here,” he added, passing a card to me over the table, “brother Mycroft knocked these up for me last night after you went to bed. What do you think?”

The business card, which featured the small likeness of a deerstalker in the upper left-hand corner, read:
“Moriarty Capital Management?” I inquired, raising an eyebrow at Holmes.

“Ah, now, Watson, just a little jest at the expense of an old adversary. Right, I must be off now. It wouldn’t do to be late for my first meeting.” And with that he strapped an unfeasibly large watch onto his wrist and strode out the door purposefully.

I was busy with my medical practice all day and didn’t see Holmes again until it was nearly time for dinner. At a quarter past seven he strode in the door with a weary mien. At my inquiring look he raised a solitary finger, murmured “All in good time,” and disappeared into a back room.

For the next few hours a fug of tobacco smoke and the sound of Saint-Saens on the violin were all that escaped from Holmes’ room. At last, Holmes emerged, a satisfied half-smile upon his face. When I attempted to question him on the case, he demurred with a wave of his hand. “Tomorrow, Watson, tomorrow. It’s been a rather long day and I haven’t the energy to discuss the particulars this evening. However, with a good night’s sleep and one of Mrs. Hudson’s breakfasts in my belly, I’ll feel ready to share the fruits of my enquiries with you and friend Ogden.

The next morning, Holmes awoke at his usual hour and clad himself in more fitting attire. However, he was no more forthcoming on the subject of Ogden’s case than he’d been the previous evening, squirreling himself away for most of the day to work on his latest monograph, which identified the seventy-six separate circumstances in which one might successfully challenge a citation from a City of Westminster parking warden.

As dinnertime approached, the front bell once again announced the presence of a visitor. At this, Holmes sprang from his room with surprising alacrity. “And now, Watson,” he cried, “your patience shall be rewarded!” When Charles Danforth Ogden entered the room, my friend gestured eagerly towards a chair. “Sit, sit, Mr. Ogden! I must thank you, sir, for a presenting me with a most stimulating case!”

“So have you cracked it then?” asked Ogden, a hopeful look upon his face. “Have you found the vanished bid? When will it return?”

“Not so fast, my friend. Allow me to explain my methods before sharing my conclusions.”

“Very well.”

“It was clear to me from the outset, Mr. Ogden, that the research piece upon which you had pinned your hopes was merely a red herring. That it worked for as long as a month is, quite frankly, a surprise."


“While I am not a professional investor, this nevertheless allows me a welcome degree of detachment when observing the behaviours of yourself and people like you. Any clear-thinking person of reasonable intelligence could see that ‘buy stocks no matter what’ is a recipe for disaster, the triumph of hope over reason.”


“Allow me to finish, I beg you. Yes, it’s true that, broadly speaking, the world remains awash with liquidity, and that all else being equal this should underpin risky assets. However, it seems quite clear that all else is not equal at the moment. Developed economies are slowing while food and energy prices are rising all over the world. The implication is that conditions which may have produced a stellar rally in risky assets six months ago will not necessarily do so now.

“I sat in on a number of investor roundtables today, including one, Mr. Ogden, that you were at, hosted by BigI-Bank.”

“What?” gasped Ogden. “But..but...I didn’t see you there!”

“Ah, Mr. Ogden, you were not meant to. I was travelling incognito, as it were. But shall I tell you what I discovered at my roundtables?”

“By all means, Mr. Holmes.”

“Very well. At a credit roundtable this morning, I found a very grave concern that the securitization process, as it has been conducted over the past few years, is very significantly impaired- perhaps permanently. The implication, Mr. Ogden, is that the supply of credit is likely to be more restricted in the future than it has been in the past. And what this means, sir, is that the credit cycle has decisively turned for the decade, and that spreads should trend wider moving forwards.

“Here,” he said, handing a piece of paper to Charles Danforth Ogden. “You see here a simplistic representation of what I refer to. Ten year swap spreads in the US have begun to widen...but history suggests that we are fairly early in the process, both in terms of magnitude and time.”

“But does this mean that the US economy is moving to recession?” asked Ogden.

“Eventually....yes,” replied Holmes. “And Inspector Lestrade of the Yard would probably tell you that we’re already there. But look closely, Mr. Ogden. The last two recessions didn’t begin until after swap spreads had already peaked- it takes time for tighter credit to arrest the economy’s growth. So I’d suggest to you, sir, that recession is more likely for 2009 or 2010 than it is for 2008.

“I then went to a government bond roundtable, which generated a rather interesting discussion about equilibrium rates, inflation, and what is priced into markets. Particular attention was paid to what a 2.5% trend rate of growth in the US might mean. Some participants argued that this downward revision to trend growth has lowered equilibrium nominal interest rates; however, I found much more persuasive the argument that it has actually raised equilibrium real interest rates, given the lower threshold for a growth/inflation trade-off.

“The question was then raised as to why the bond market is ignoring inflation. In my guise as a hedge fund manager, I suggested that the market is not ignoring inflation, but balancing inflation concerns with both recession worries and, in the context of the disappearing equity bid, capital preservation considerations. Unlike prior bond market rallies this year, TIPS are actually outperforming nominal Treasuries; 10 year breakevens are about 10 bps wider since the recent peak in nominal yields. Moreover, the curve has steepened sharply in this move; a wider term premium is exactly what you’d expect from a market concerned about inflation.”

“But Mr. Holmes,” said Ogden, staring intently at the second chart that Holmes had given him, “it looks to me that the last two times the curve has started to meaningfully steepen, the economy was pretty much already in recession.”

“Well spotted, Mr. Ogden, bravo! That’s one reason why I suggest that a recession is more likely for 2009-10 than next year; nothing is certain in this particular line of enquiry and I could of course be mistaken. But I suggest to you, sir, that the inflationary dynamic across the globe is considerably different now than it was in 1990 or 2000, which is why the curve is steepening earlier in the cycle: not only because of growth, but because of a secular change in the direction of inflation pressure.

“Next I went to a currency roundtable. There were a few interesting things to emerge there. The first was a general feeling that, from a medium term perspective, investors are not adequately compensated to finance the US current account deficit, shrinking though it may be; therefore, the dollar is falling. That, at least, must be known to you already. What was curious, though, was the sense that currency markets may be reaching in important inflection point. The carry trade, for example, which I believe you mentioned is in your portfolio, Mr. Ogden...?

“Yes, it is, Mr. Holmes.”

“Yes, well, the carry trade can be expected to work very well indeed during ‘Goldilocks’ periods, wherein growth is reasonably strong and inflation reasonably low. However, both points on the Goldilocks axis are moving in the wrong direction: growth is slowing and inflation is rising. This naturally begets volatility, which makes the carry trade inherently less attractive. If one takes a yen trade-weighted index as a sort of inverse measure of currency market risk appetite, one can see that after falling in more or less a straight line for the past several years, the yen has started to rise recently. As pure carry considerations become de-emphasized, perhaps markets may choose to focus on antiquated metrics such as ‘value’ and the like.

“And of course, sir, the very liquidity which has supported risky assets can ultimately sow the seeds of its own destruction. Consider that a major supplier of liquidity to global markets has been the currency policies of FX reserve accumulators. But look about you now, sir. China has its highest inflation rate since 1996. Taiwan has its highest since 1994. Singapore has its highest since 1991! And of course, the Persian Gulf countries are all experiencing uncomfortably high levels of inflation. All of these countries need tighter policy, which suggests, Mr. Ogden, that global liquidity conditions are likely to be less accommodative in the future than in the past. This should naturally beget a more selective attitude towards risky assets and increase volatility.

“And finally, sir, this afternoon I came from an equity roundtable, where I sat next to you in my guise as a portfolio manager at Moriarty Capital Management.”

Charles Danforth Ogden’s jaw dropped and he gazed at Holmes in amazement. “That was you?”

“It was indeed, sir. In my line of work the ability to appear as what you are not proves useful on occasion. And as you no doubt recall, we discussed a range of topics. Earnings expectations for next year are being marked down; however, the increased uncertainty over those forecasts has meant that, for the time being, index multiples have not expanded at the same time. More fundamentally, a greater degree of macroeconomic volatility may well beget lower multiples on a trend basis in the future than we’ve observed in the past.

“Of course, while credit market disruptions remain significant, the near-term prospect for buybacks has also waned, taking a large, relatively price-insensitive buyer out of the equation as well. The combination of weakening fundamentals, less visibility, and greater macroeconomic volatility are all a recipe for higher equity volatility...which as you know is what we have seen recently.”
“Oh no!” cried Ogden. “From what you say, Mr. Holmes, it sounds like the bid has gone forever! But haven’t told me who is responsible for this catastrophe?”

“Now, now Mr. Ogden,” Holmes replied, a gentle smile on his face, “it’s not quite so bad as that. I don’t think it’s fair to say that ‘the bid has vanished forever’ or draw the conclusion that it is impossible to make money in risk assets. However,” he continued, leaning forward and looking earnestly at Ogden, “it may be the case that for this market cycle, the price-insensitive bid has indeed gone missing. What it means, Mr. Ogden, is that you will have to be more selective in your investments: do your homework, so to speak, be aware of what it is you are buying, who has bought with you, and how large the exit door might be should you all wish to sell at once.”

“But Mr. still haven’t told me who or what is causing all of this!”

“Ah, Mr. Ogden, you’ve still not figured out what’s happened? I’m sorry to tell you, sir, that there is no Moriarty at work, no individual or cabal whose apprehension can restore things to their 2003-2006 norms. Lestrade might tell you it’s the US housing market...but he’d be mistaken. How about you, Watson?” Holmes turned to me for the first time since he began his explanation. “Have you deduced the identity of the culprit?”

“It’s tempting to blame Voldemort or another distorter of market prices, Holmes...” I could detect the slightest trace of a grimace on my friend’s features. “...but somehow I think not. It looks to me like it’s the ineluctable return of...of...a financial market risk premium. The bid is still there, but for the time being it’s buying options, not assets.”

“BRAVO, WATSON!” cried Holmes, leaping to his feet and slapping me heartily on the back. “Spot on! We’ll make a detective of you yet!” This was perhaps the warmest compliment that my friend had ever paid me, and I confess to feeling a bit choked up at finally having fulfilled his expectations for me.

“The answer, Mr. Ogden, is simply that the free lunch is no longer least for this market cycle. Buying the dip across risk assets mechanistically is likely to prove unsuccessful, sir, because undoubtedly some of them are dipping for a reason. Consider that wider credit spreads, steeper yield curves, a lower dollar, higher yen, and higher implied volatility are all symptomatic of rising risk premia. It would seem reasonable, sir, for each of these trends to continue, in one way or another, throughout the next year or so.

“I would suggest to you that the high, almost mindless correlations between risk assets will ultimately break down. We are moving into an environment where the cream will rise to the top, an environment where relative value trades may offer a higher risk adjusted-return than simple directional strategies, an environment where option volatility, rather than risk assets, is the ‘mindless’ buy on dips. In other words, Mr. Ogden, you’ll be required to buy that which is good and sell or avoid that which is bad, rather than merely buying everything.”

“But Mr. Holmes!” cried Charles Danforth Ogden, a tear in his eye, “we’re not a relative value shop! We are equipped to make money in a low-vol world, not a high-volatility world!”

“Then, Mr. Ogden,” replied Holmes as kindly as he could, “I suggest that you shutter your doors and pursue another line of work. I’d be happy to write you a reference to any of the banks I visited today. Perhaps once they’ve finally written off all of their subprime exposure, they’ll be in the market for a sales guy or an analyst. I can easily put your name forward.

“In the meantime, should you need of a bit of cash, I’m sure you and Watson here could come to some arrangement on that Ferrari F430 that I saw you drive up in.”

Charles Danforth Ogden shook his head mutely, and slouched out of our Baker Street rooms. We heard a few months later that his fund had closed, unable to meet a wave of redemptions at the end of the calendar year.

“Well, Watson,” said Holmes after the door had closed behind Ogden, “we can only hope that our pensions are being managed by people more astute than friend Ogden. And now,” he added, reaching for pipe and violin, “how about some Mendelssohn?”

Friday, November 23, 2007

The curious case of the vanishing bid

A late November tempest howled outside in the London night, and the gale rattled the room’s ancient windows, disturbing what had heretofore been a pleasant evening’s reading. Still, the chamber was warm and snug, and a comforting safe haven against the late autumn storm.

“You’re right, Watson,” said the voice of Mr. Sherlock Holmes, disturbing me from my reverie, “it’s a good thing we took out that price guarantee from British Energy.”

“My word, Holmes!” I exclaimed, leaping from my chair. “How the deuce did you know I was contemplating that very thing?”

“Tut, tut, Watson,” came the gently mocking reply from my friend. “Nothing could be easier. I observe that you’ve been perusing the markets section of the Financial Times, doubtless to check on the progress of that South African issue you purchased a few months back. I can see from here that you had turned to the commodity section, where you’ve no doubt read that energy prices are, yet again, threatening to breach all time highs.

“The requirement for adequate heating is painfully obvious on an evening such as this,” he added, glancing ruefully out the window, “as the ferocity of the storm outside cannot elude even your powers of observation. Indeed, I saw you stare outside this very window not five minutes ago, and the disgusted shake of your head told me that you were not pleased with what you saw. When you then glanced at the thermostat immediately thereafter, I surmised that you must be ruminating on the likely rise in heating bills over the next few months, and the serendipity of our having chosen to lock in what I’m sure you’ll agree is a competitive rate. I merely agreed with your rather excellent deduction.”

“Extraordinary, Holmes! When you describe it like that, it all seems so simple. And yet no one but you manages to see what, when you explain it afterwards, would appear to be the most obvious thing in the world.”

“Most of my observations are obvious, Watson, for those who are prepared to see rather than merely look. Unfortunately, many of my colleagues, such as the well-meaning but hopelessly bumbling Lestrade, are only prepared to look for those facts which appear to support their prior beliefs. I, on the other hand, keep an open mind and thus am able to see what others often miss."

It was a measure of the esteem in which I held my friend Sherlock Holmes that I didn’t raise an eyebrow at his description of the Chief Inspector of Scotland Yard as “hopelessly bumbling.”

“And what I see this evening,” he continued, “is a night best-suited to a comfortable chair, a good book, a pipe full of tobacco, and perhaps a passage or two of Mendelssohn upon the violin.”

As if to prove that even the ablest of sleuths can miss his mark on occasion, the bell at the door of 221B Baker Street rang vigorously just as Holmes reached for his violin, announcing the presence of a visitor who no doubt required the services of my illustrious friend.

“Ah, Watson,” remarked Holmes, shaking his head with a wry grin, “I was mistaken. For unless my powers of observation have departed me altogether, we shall have a more stimulating pursuit this evening, courtesy of this gentleman here, Mr....?”

Our visitor strode into the room through the door opened by Mrs. Hudson, but was taken aback to see us both looking at him expectantly. After gathering himself for a moment, he then resumed his forward progress and seized Holmes by the hand. “Charles Danforth Ogden, Mr. Holmes, Charles Danforth Ogden. It’s a pleasure to meet you, sir, but you must help me!”

Mr. Charles Danforth Ogden was a youngish man in his mid-thirties, dressed in crisply pressed chinos, a dark blue jumper over a collared white shirt, and dark blue raincoat, from which he shook the water unconsciously as he stood before us. Although his visage retained a certain boyish aspect, he nevertheless carried himself in the manner of a man who is accustomed to having his orders carried out by others.

“Well, Mr. Ogden, what can I do for you? Is there a problem with your fund that you wish me to help you with?”

“Yes, Mr. Holmes, yes, it’s all gone horribly wrong and I can’t figure out why!” our guest exclaimed, before gaping at Holmes. “ did you know I was a hedge fund manager?”

“Please, Mr. Ogden, you insult me. If I couldn’t spot a hedge fund manager (what with your business casual attire, Rolex, and expensive jacket) from a mile away, I wouldn’t be much of a detective, would I?”

“Ah ah, Mr. Holmes, I see you’re right. Very clever!” Charles Danforth Ogden then straightened up and assumed an air of authority. “Yes, well, I am the founding principal and Chief Investment Officer of the C/D/O Enhanced Multi-Strategy Fund, a diversified hedge fund that seeks to generate stable returns for our investors with moderate volatility and low drawdowns.”

“Yes, yes,” said Holmes, “I’m not a fund-of-funds manager so you can spare us the marketing spiel. Please proceed to describing your problem; the sooner tell us your story, the sooner we can be of service to you.”

Ogden glanced at me uneasily. “Perhaps it would be best if we got you and your friend to sign a non-disclosure agreement. If investors found out....”

“Now really, sir,” burst out Holmes, angrily. “Dr. Watson is my friend and colleague, and you can trust him as you trust me. And if you do not trust me to keep my lip buttoned, then I’ll wish you goodnight and ask you to leave, for I had rather planned to treat Watson to a spot of Mendelssohn.”

Ogden’s shoulders slumped at this rebuke. “I’m sorry, Mr. Holmes,” he said. “I’m just so worried about my fund that I’m not sleeping or thinking straight.” His body crashed into the chair that Holmes gestured him towards. “Here’s the story.

“Our fund has been running for a year and a half. For the first year or so things went swimmingly, with steady monthly returns and a nice growth in assets. Early in the summer, though, we ran into a bit of a bother, as some of our holdings appeared to decline in value; however, they don’t really trade so it was difficult to know exactly what sort of hit we were taking.

“In August things got quite bad, really, with credit imploding and funding rates blowing out. Some of the fund-of-funds investors that we picked up in May and June told us that if we didn’t make money in September, they’d pull their assets.

“Naturally, this was a stressful time for us, and we felt a bit adrift. However, one of my trusted brokers sent us a research piece that seemed to show the way to recouping our losses. Here, here it is.” Ogden’s hand dipped into his jacket pocket and emerged clutching a rumpled sheet of paper, which he handed to Holmes.

Looking over my friend’s shoulder, I read the following pearl of financial market wisdom:



Date: August 31, 2007

Subject: How to make money in equities

Cheat sheet: reacting to data and market releases

1) weak data = Fed ease, stocks rally

2) consensus data = lower volatility, stocks rally

3) strong data = economy strengthening, stocks rally

4) bank loses $4bln = bad news out of the way, stocks rally

5) oil spikes = great for energy companies, stocks rally

6) oil drops = great for the consumer, stocks rally

7) dollar plunges = great for multinationals, stocks rally

8) dollar spikes = lowers inflation, stocks rally

9) inflation spikes = will inflate all assets, stocks rally

10) inflation drops = improves earnings quality, stocks rally

“We were a bit desperate for returns, and this research seemed more insightful than the usual rubbish coming out of investment banks. So in early September we went limit long the S&P, AUD/JPY, EEM, and the Hang Seng. By mid September it was working so well that we figured credit was going to tighten back in hard, so we bought some of the A-rated tranche of the latest ABX index. When the Fed cut 50 basis points on September 18, it was like we’d won the lottery. Stocks moved so far, so fast that by the end of the month we’d made a new high water mark for the fund and were mentally spending our performance fees.

“Sure, the credit trade wasn’t working so well, but we were making so much money in equities that it didn’t matter. We had Fed liquidity supporting the S&P and the carry trade, and de-coupling plus Chinese investment buoying EEM and the Hang Seng. It was bid, no-lid, and we were making money hand over fist.

“But by the time mid-October rolled around, things had cooled off. Our ABX position was sinking like a stone, most of our structured credit holdings had actually been downgraded, the yen quit going down, and then even some of our equity longs started to retreat. EEM and the Hang Seng were the only things keeping our P/L afloat.

“I tried getting ahold of Johnny Wideboy, the analyst who’d made us so much money with that research piece. But my contacts at BigI-Bank said that he’d been made redundant following a $12 billion subprime writedown.

“And now every bit of our portfolio is falling in value, even the emerging market equity position! Mr. Holmes, it’s doing my head in! Our fund-of-funds investors are once again ringing up and threatening to pull their assets unless we right the ship quickly. So I ask you, Mr. Holmes, to tell me: what happened to the bid? Why has it vanished, and when will it come back?”
Sherlock Holmes sat back in his chair and stared earnestly at our visitor. “I must tell you, Mr. Ogden, that this is not my area of expertise. Watson here spends more time reading the financial pages than I.” Charles Danforth Ogden looked crestfallen. “Nevertheless, I will look into the matter. I shall ring you at the number on your card when I have reached a satisfactory conclusion.”

Ogden sprang from his chair and shook Holmes warmly by the hand. “Oh thank you sir, thank you very much! I’m at my wits’ end, and if I don’t discover where the bid has gone to, my fund is finished for sure!” And with that, he turned on his heel and strode out the door, leaving Holmes stroking his chin thoughtfully. Sensing that my friend was entering one of those contemplative reveries that so often yielded fruits of progress, I returned to my pipe and my newspaper. Not a word was spoken in our Baker Street rooms for the rest of the evening.

Will Holmes get to the bottom of the mystery?

Why has the bid for risk assets vanished, and when will it come back?

To be continued.....

Thursday, November 22, 2007

Ten Things I'm Thankful For

Before Macro Man (an expatriated Yank) settles into a day of heavy food consumption and late-afternoon NFL, it's time to count his blessings and be thankful for the following:

1) That he works in an industry that allows him to indulge his intellectual curiosity and competitive instinct while providing a handy method of keeping score (the P/L.)

2) That his real-world portfolio has been empty of CDOs and all manner of structured credit turds.

3) In a similar vein, that he doesn't have to rely on third-party agencies to do his analysis for him.

4) As a UK resident, that he is paid in sterling rather than dollars!

5) To have gotten Q3 and, to date, Q4 right, investment-wise. In future years the second half of 2007 will join October 1987 and August-October 1998 in the pantheon of stress-test environments.

6) That Mrs. Macro, the Macro boys, and he himself are healthy and happy.

7) That he's kept the TIPS position all year. A total return of 11% for a bond-holding in a little more than ten months ain't bad!

8) That he had the foresight or luck (or perhaps a combination of the two) to change his mind on the yen and hedge near the highs in USD/JPY.

9) That he does not have to manage the England football team.

10) That, contrary to all expectations, this space has attracted a modest following and, gratifyingly, reasoned, intelligent commentary from other market participants and observers. Thanks to all who read and share their thoughts.

Wednesday, November 21, 2007

Trust us, we're experts

While one might normally expect Thanksgiving week to be a relatively quiet one, nothing could be further from the case this year. Market participants may not be having a whole lot of fun (then agin, if they've been on the right side of some of these moves, maybe they have), but at the very least they've been kept on their toes. A month or so ago, there was an amusing email the wended its way around the world, with the punchline being that no matter what happens, the stock market goes up. Those days seem like ancient history now...

The big news overnight was the release of the minutes of the Fed's Halloween meeting, complete with an impressive annex detailing their economic forecasts. What immediately struck Macro Man was the relatively downbeat tone of the contemporaneous commentary. The text is replete with "yeah, but" qualifiers and references to downside risks. It's quite a stark contrast to the defiant comments coming from the recent speakers, which reinforces Macro Man's view that the hawkish remarks are an attempt to try and wean the market off of trying to dictate policy to the Fed.

If so, then the campaign ain't working; not only are markets pricing in a virtual certainty of an easing at next month's meeting, but sundry talking (or is that writing?) heads at last night were calling for an immediate inter-meeting rate cut. Given that the S&P 500 is still up year-on-year, Macro Man does have some sympathy for the Fed in resisting the demands of beleaguered equity managers.

Less deserving of sympathy was the Fed's forecast profile, which included the proviso that all forecasts were based on the assumption of appropriate conduct of Fed monetary policy. These, then, are the outcomes that the Fed expects if and as it does the right thing. It's basically the Fed saying "trust us, we're experts." Righhhtttt.....

A couple of interesting nuggets can be gleaned from the forecast profile nonetheless. The first is that the Fed is relying on commodity prices to quit going up. The central tendency for core PCE over the next few years is centered on 1.75%, which more or less confirms that that, rather than 1.5%, is the Fed's implicit price target. However, the central tendency for headline PCE is only 0.1%-0.2% above core.

This despite the fact that the headline PCE deflator has, on average, been 0.5% higher than core over the past three years. Unsurprisingly, the year-on-year discrepancy between the headline and core measures can be explained by commodity prices. So in forecasting virtually no difference between headline and core PCE, the Fed is taking the view that commodity prices will flatline. In a world where demand growth for energy and food continues to outstrip supply growth, feel free to judge for yourself where the risks to the Fed's forecasts lie.
The relatively benign inflation forecasts are all the more remarkable given the apparent further downgrade to the Fed's estimate of trend GDP growth in the US. The chart below lays out the Fed's forecasts for real GDP growth and unemployment. What's interesting to see is that the mode in both 2009 and 2010 is around 2.5% real GDP growth with a flatlining unemployment rate. From this we can distill that the FOMC sees real growth of roughly 2.5% as around trend.

source: Federal Reserve
The implications of this observation are important. First, it represents a remarkable downshift in the estimate of trend growth in the US, from 3.5% in the late 90's to 3%-3.25% just a couple of years ago. It's even lower than the 2.75% or so that most observers have assumed for trend growth recently. What it means is that the Fed sees that inflation will be generated by a lower threshold of domestic growth in the future than has been the case in the past. Now, Macro Man's view here is that they may be overstating the case, and that inflation is a secular global phenomenon rather than a primarily domestically-driven one as was the case in the 80's and 90's.
Another outcome of this implication is that the Fed may be willing to tolerate somewhat lower troughs in growth in the future than has been the cae in the past, given that the estimate of the trend rate has been lowered. This could perhaps explain the hawkish rhetoric that has recently emanated from the FOMC. More importantly, the reduction in trend growth means that the Fed's margin for error has been reduced, that the buffer between trend growth and recession has declined. In other words, the cost of a policy mistake will be felt more immediately in the future than in the past. This suggests that "The Great Moderation" may have run its course and that we should expect both macroeconomic and financial market volatility to be secularly higher moving forwards.
So far, it appears that markets are unwilling to swallow the "trust us" line from the Fed. Equities have fallen sharply overnight, as have yen crosses. More literally, an erstwhile importer of Fed policy has once again loosened its ties to the US, as Kuwait has once again revalued the dinar against its reference basket today. Coming as it does amongst a flurry of comments from the GCC regarding currency policy, the timing couldn't be more significant. As the chart below illustrates, the KWD has now appreciated more than 5% against the greenback since the dollar peg was severed in the spring.
Whether the rest of the week proves to be a holiday, or merely a turkey, of course remains to be seen. But liqudity is atrocious and erstwhile favourites (FX carry, Hong Kong equities, the KRW) are getting ejected from portfolios. Per yesterday's post, fear is pretty clearly trumping greed at the moment, which may ultimately deliver some opportunities for tactical risk trades. However, we may have to let things go a bit further first. Trust me.....I'm an expert.

Tuesday, November 20, 2007

Fear and greed

There's a well-worn market cliche that economic agents are driven by fear and greed, and in particularly difficult conditions they seem to straddle the divide between the two. Indeed, the overlap between fear and greed is one of the primary drivers of market volatility, wherein investors find themselves navigating an emotional minefield and, more often than not, doing the wrong thing.

Macro Man now finds himself in the uncomfortable position of having one foot in each camp. As he looks around, he sees several apparent mispricings which might generate some tasty alpha. At the same time, he has to acknowledge that the fundamental picture as he sees it has deteriorated; disposable income and aggregate net wealth are much more important in determining his worldview than house prices, for example, and the outlook for neither is particularly pleasant at the moment.

Moreover, financial market prices are also determined by the collective result of the fear/greed equation, and in times of severe distress notions of "value" and "ought to" go out the window. The following is a brief, non-exhaustive sampling of some of the issues that Macro Man is grappling with at the moment:

1) VIX suggesting equity sell-off is overdone? Macro Man was quite surprised to see that his favoured indicator of risk aversion barely moved yesterday, despite the sharp sell-off in the S&P 500. The reason is that despite the new recent low in stock prices, the VIX is well off its recent highs, and indeed barely rose yesterday (see below.) Such a divergence, which may suggest that the street has been layering option hedges even as Macro Man's have rolled off, would ordinarily suggest that a near-term bottom is in sight. A similiar phenomenon can be seen in EUR/USD, which, unlike in August, has plowed higher despite weaker stock prices/higher VIX. Indeed, even USD/CHF has finally made a new all time low today. All this would normally make Macro Man relatively comfortable with his new long equity market posture (following the recent option expiry)....and yet...and yet:

2) The credit market is still buggered, and there's still no bid for assets of questionable quality. ABX continues to plummet, including the "high quality" tranches, to a degree that suggests that bidders have completely stepped away from the market. Meanwhile, Northern Rock, which could be considered an equity version of structured credit, is rapidly approaching the price target that Macro Man set two months ago.

The problem with the Rock, summarized here, is that it's unclear who has the authority to dispose of it, and in any case such potential buyers as actually exist simply wish to cherry-pick the less odious aspects of the franchise. So in a very real sense, Northern Rock is a barometer for credit conditions generally: it is a deeply flawed asset, the ownership structure of which is opaque, that in certain aspects appears to have some intrinsic value but in others very little at all. Perhaps we need to see this sucker go bust in one fashion or an other in order to mark a near-term low in sentiment? In that case, there's more bad news ahead- another lender, Paragon, has admitted significant distress just this morning.
3) US consumers finally beginning to feel the pinch? One of Macro Man's firmly held views is that consumer spending is driven by disposable income (primarily) and by aggregate net wealth. Sure, the housing market has a deleterious impact upon this equation, but its impact is surprisingly small relative to the volume of headlines.
However, Macro Man has to acknowledge that the outlook for the erstwhile supportive factors of income and aggregate wealth is looking a tad ropy. Macro Man has already enumerated his concern over energy prices in the recent past, and sure enough retail gas prices have now climbed to $3.13, with Macro Man's model forecasting a move to nearly $3.50. Such a move, if and when it occurs, should apply a very real hit to disposable income, and by extension real discretionary spending.
At the same time, household wealth has weathered the housing storm reasonably well to date. True, the distribution of stock market wealth is not as evenly distributed as housing wealth, but the modellers with whom Macro Man has discussed this issue suggest that the consumption function from equity wealth is broadly similar to that of housing. The situation, as it recently stood, was that y/y housing wealth was at its most negative since the data begins, whereas aggregate wealth was relatively resilient due to stock market strength.
Well, recent stock price declines, if sustained, would surely push gains in aggregate net worth closer to zero. And that also has implications for consumption. While inventories currently look fairly healthy, a disappointing Christmas retail season could change that pretty quickly. And recent earnings disappointments from retail are also not encouraging.
Now, Macro Man still does not expect a recession, and believes that "muddle through" is probably still the best base case for the next few quarters. Gains from trade, for example, are providing a significant buffer to the economy. That having been said, risks from the above issues are clearly rising.
While the Fed seeems happy to acknowledge these risks, for the time being they are equally (and, in Macro Man's view, justifiably) concerned with inflation. Tonight's minutes will be especially significant, containing as they do the first iteration of the new forecast/commentary regime. Hopefully, they will provide some hint about what the Fed would need to see to change its stance in either direction. However, such an outcome might be wishful thinking.
For the time being, this Fed reminds Macro Man of a parent in the process of "training" a spoiled child. As any parent knows, giving in once to a child's request (for treats, to stay up, to watch program X, to play game Y) establishes a precedent; giving in twice establishes a new routine. The Fed gave in on satisfying the market's demand for liquidity in October, and they are trying their damndest to avoid a repeat for next month's meeting.
What it means is that the Fed might need to see the market price out some easing of policy before it feels comfortable delivering said easing. Put another way, it may wish to see breakevens decline and the curve flatten before trimming rates again. If this is the case, then equities could be in for a bit of a rough ride. And yet the VIX is suggesting a bounce may be in the offing.
A more obvious area to look at is the Treasury curve, where 2 year yields fell as low as 3.13% yesterday. To buy 2 years at that level, you pretty much need a recession to make money. As that is not the Macro Man base case, it is a useful place to look for a correction. Macro Man therefore sells 200 TUZ7 at 104-24, risking 105-04. This provides a partial duration hedge of his long TIPS position. True, there's an embedded flattener as well, but for the near term that appears to be what the Fed would like to see.
Seperately, central bank buying has propelled EUR/USD to fresh all time high. The degree to which the market has shrugged off equities is impressive. And yet, in the back of his mind, Macro Man cannot shake a certain amount of fear; gold, for example, remains well, well off its highs. Macro Man has had an excellent run with the short dollar trade, but has to acknowledge that valuation is becoming a bit eye-watering, particularly now that Europe appears to be actively seeking a weaker EUR versus RMB. He therefore banks some profit, selling €20 million versus USD at 1.4785 spot basis.

Monday, November 19, 2007

Last night I had the strangest dream....

Last night I had the strangest dream. I was back in 2007, worrying about things that seemed so significant then but now seem like the slightest of trifles. Remember 2007? That was the last year that we went skiing in France, the last year that we could actually afford to go to Courchevel. Hard to believe that it was more than three years ago; it seems like it was only yesterday.

Remember what they told us when the dollar went to hell? About how it was actually a blessing in disguise, how American companies were going to be able to sell into markets where they’d never done so before? About how it was going to safeguard American jobs, how jobs would be coming home from China and India?

Man, these politicians never tell the truth, do they? (As an aside, do you think the Congress will really try to repeat history and impeach President Clinton for perjury?) I’m not sure what’s worse: that they didn’t tell us that gas prices were going to $5/gallon by the end of the decade....or that they didn’t know.

Anyhow, that Chevy Dreadnought 4x4 that I had just became too expensive to drive, even though it was a hybrid. I loved that car, and the day that I sold it was one of the worst of my life. I guess now I know how my Dad felt when he had to sell the Eldorado back in ’79. There’s one thing for sure, though, and that’s that the kids know how I felt waiting in line for an hour in the back of my mother’s car at the gas station back in the 70’s.

It’s been a couple of years, but as I remember it the dollar was finally let go in the first half of 2008. I seem to recall that the stock market did OK, since everyone talked about how great the foreign profits were going to be. Really, it wasn’t until Hurricane Patrick hit in September ’08 that things started to get really bad.

That’s when gas went from $4 to $5 and the economy went into recession. They’ve been saying for a year that things are getting better. Me, I don’t know. I mean, a guy like me can always find work, always take care of me and mine. But I’ve got plenty of buddies who are still worse off than they were in 2007, even those that have managed to find work again.

Back then you could afford just about anything you wanted, and borrow to buy if you didn’t have enough scratch in the bank. Hmmph, banks. Maybe the only good thing about the last few years is that at least there are fewer banks these days, fewer of these Wall Street jerks and their fancy Italian sports cars. Plenty of good people got ripped off on their mortgages by those guys, so it’s good to know that what goes around comes around, eh?

Anyhow, where was I? Oh yeah, the recession. So the dollar tanked after China and the Middle East quit pegging to it. They made a big deal about it on the news, but things seemed to muddle through OK until the hurricane. After that, everything went kaput. Sure, the Fed cut interest rates, and I mean hard, to try and support the economy.

For some reason, it didn’t seem to work. That bearded guy in charge kept talking about ‘no traction’, like he was driving a car with bald tires or something. I’m not really sure what he was talking about, to be honest. What I do know, though, is that the dollar kept falling...and eventually, so did the stock market. What didn’t fall, though, was the cost of living and the cost of borrowing.

I’m not an economist, so I don’t really understand these things. Maybe you can explain them to me. After the dollar peg broke, the cost of everything imported went up. By a lot. In the paper they said something about “firms protecting margins” or something like that. Anyhow, we all figured that if the cost of buying stuff from China rose, we’d just make it here in the good old USA. Funny enough, though, it hasn’t happened. I just can’t figure it out.

Anyhow, inflation just kept rising and rising, and it made it more or more difficult to maintain a good standard of living. Sure, we got a bit of a raise every year, but with a recession on you have to be careful not to push The Man’s buttons too much. Still, I seem to remember 5% raises being a good thing, not meaning that every Thursday before payday is Spam Night.

In the good old days, we would have just maxed out the credit cards or taken out a home equity loan. But Jesus, have you seen the rates they’re charging these days? It’s 30% now on my credit card, and it’s not worth mortgaging what little equity I have left in the house at 12% rates. I dunno, maybe that’s what that bearded fella meant about “no traction”. The news kept saying that he was cutting interest rates, but all I know is that every time that I look at borrowing, the rate goes up, up, up.

And the damnedest thing is that the jobs still haven’t come home from China. Turns out that even though it costs a lot more than it used to import things from China, it’s still cheaper than it is to make ‘em here. So we still have a trade deficit: what a bummer!

But hey, I’m a patriot. The Toyota Yaris that I bought when I sold the Dreadnought was made right here in America. Trust me, I really wanted to buy from Detroit. But I’m not exactly flush with cash at the moment, so I’ve gotta make every penny count. And the Toyota gets better mileage and is more reliable than anything made by GM or Ford. I’m not counting Chrysler, not since they were bought up by Guangzhou Auto and China Investment Corp.

So yeah, I kind of wish that it was still 2007. Hell, I wish it could be 2007 forever. Instead, I’m stuck here in 2010. Crappy job, crappy paycheck, crappy TV. I mean, it’s a four year old 42” plasma! I can’t remember the last time I had a TV that old in my family room, and I certainly can’t remember the last time all my stuff was this far behind the latest technology. I guess my only consolation is that none of my buddies have gotten a new TV, either. No one can really afford it. For the first time in our lives, we really have to worry about saving.

Still, it’s not all doom and gloom. A couple of months ago I treated the wife to a nice weekend away while her folks looked after the kids. Who’d have ever thought that Clemson would win the NCAA tourney last year? But hey, with 75 bucks on them at 50-1, I’m not complaining. Yeah, I know $3750 is chump change these days, but at least we could afford two nights at a pretty good Holiday Inn and a nice dinner at Applebee’s.

It’s all kind of weird, though, when you think about it. Most of us have never been outside America, never seen how the rest of the world lives. I suppose we all just assumed that a weaker dollar could bring nothing but more jobs and more money. But I guess when you buy a lot of stuff from the rest of the world, a weaker currency makes it more difficult to afford things.

So, too, when Hillary threatened China with those tariffs. Who’d have thought that some guy ten thousand miles away could make a decision that would make it more difficult to borrow money here in the Heartland of America. Not me, that’s for sure. I have to say one thing, though. I felt a little burst of nostalgia when Hillary started the Whip Inflation Now really took me back to my childhood.

Well, I suppose that’s enough of my yakking. I’d better get back to work. It’s more than my job’s worth if this report doesn’t make it to Abu Dhabi by tomorrow morning.

Saturday, November 17, 2007

Weekend special: A True Story

Macro Man's youngest son (age 4) was playing with one of his friends in the back garden earlier in the week. They gathered an assortment of balls and toys by the swingset and opened a "shop." Macro Boy then asked his mother if she wanted to buy anything.

Mrs. Macro tried to take something, but Macro Boy insisted that she fork over some cash. "But sweetheart," she said, "I don't have any real money."

"That's OK," said Macro Boy, "you can pay in dollars."

Friday, November 16, 2007

Story time

It's one of those days again, with markets jumpy and spreading more stories than the Brothers Grimm and Hans Christian Andersen combined. Whether market gossip proves to be accurate or merely the latest financial fairy tale remains to be seen in the fullness of time. In any case, among the talking points this morning include the following:

1) Dude, where's my deed? Another downside of structured credit rears its ugly head as an Ohio court denies Deutsche Bank the right to repossess 14 homes because they cannot prove that they own the mortgages to the specific properties in question. So much for subprime borrowers getting chucked out of their homes!

2) Fannie Mae slides 10%. LIBOR spreads continue to widen (the 3m TED is up 60 bps this month) as the credit crunch, Mk. II continues to escalate

3) IKB has even bigger losses, perhaps requiring even more refinancing? That's the word on the strasse.

4) A Chinese daytime talk show says "Sell, Mortimer, sell!" when it comes to household dollar holdings. One would presume that the dollar really is in trouble when the Chinese Oprah Winfrey starts dispensing currency trading advice.

5) Is a bank other than Northern Rock getting emergency liqudity from the Bank of England? So speculates The Times today.

6) The GCC de-pegging story gets even more press. Friday is the weekend in the Middle East, so bids for dollars are few and far between. Markets are now pricing in a 2% reval in the AED over the next six months.

And of course, today sees the release of September's TIC data as well as equity option expiration. The TIC data could be quite telling, coming as it does after August's epically bad figure. That number helped stoke an accelerated bout of dollar selling, which in turn has got us where we are today. Moreover, the G20 meets this weekend in Cape Town, where it seems likely that China is going to be on the receiving end of a concerted call to quit screwing around with the RMB.

And while CBs continue to sell dollars for euros in the open market, the trend has, for the moment at least, run out of steam. Macro Man suggested earlier in the week that he is getting close to profit-taking mode, and a glance at the gold chart is pushing him even closer to taking something off the table, as it's coming awfully close to crashing through the uptrend line off the August lows. Macro Man will probably look to lighten up his long euro position close to 1.47.

The equity option expiry also leaves him with a conundrum. Having previously expressed a broadly constructive view on risk assets and equities, does he now maintain a "naked" long exposure via the beta portfolio? Such a course of action appears risky given current credit market ruptures, at least until the Fed shows signs of capitulation (at which point the dollar probably gets smoked again, per yesterday's post.)

What to do? On the one hand, recent price action looks to be just enough to confirm that the sell-off from the highs is corrective, rather than the start of a new trend. Wednesday's price action briefly exceeded the October low, which by definition means that the bounce was not Wave 4 of a new 5-wave bear move. Rather, it appears that current weakness is the same sort of A-B-C pattern that Macro Man has written of before.
So a technical framework provides some comfort, and suggests that Macro Man should now be shifting towards a more bullish positioning in equities. On the other hand, the fundamental backdrop is deteriorating: gas prices are rising, housing remains a mess, and money-market conditions are queasy, to say the least. Moreover, for the time being at least, the Fed has withdrawn the near-term prospect for another go at the milk-teat of liqudity (via a lower Fed Funds rate) that the market craves.
Another factor which has been around for awhile but warrants the occasional re-visit is the apparent collapse in corporate profit margins. There is clearly something a touch odd going on: while corporates had, until recently, posted an unprecedented run of strong earnings growth, the macro data has suggested corporate recession for much of the past three years. To wit, looking at the CPI minus the PPI gives us a broad-brush picture of what's going on with margins. Observe how the collapse into negative territory accompanied the last three recessions, circled in the chart below.
However, since 2004 this margin proxy has spent most of its time in deeply negative terrritory, and has made a new low in the October data. What's going on here? Are producer costs overstated? Consumer costs understated? Or does this measure miss out on the whole offshoring phenomenon, and indeed explain the outsourcing of production wherever possible (due to negative domestic production margins.)
Macro Man doesn't know the answer, but it's clearly a cause for concern. He has yet to make his mind up about whether to re-layer equity index hedges; perhaps today's price action will spur some ideas. What is clear, however, is that November has not been a month for beta models: both the equity and FX carry model, which stopped out of its carry positions again this morning, have been butchered.

He will probably decide to layer some type of hedge, if only a partial one. An environment of elevated financial market volatility and poorly performing quant models is not a time to have large nominal risk; this may not be August, but it ain't the second half of September, either.

Thursday, November 15, 2007

Does the Fed's dual mandate spell doom for the dollar?

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

[12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028).]

In the wake of the Fed's 0.75% easing over the past couple of months and the subsequent collapse of the US dollar, Macro Man has been giving thought to the notion that the fundamental construct of US monetary policy is inherently disadvantageous to foreign holders of dollar-denominated assets, and that the apotheosis of this long-term trend may be upon us. He briefly sketches out these thoughts below, and welcomes reader comments.

The Federal Reserve Acts of 1913 and 1977 laid out the policy objectives of the Federal Reserve System. The text of the latter Act, quoted above, spelled out in specific terms what has become known as the Fed's "dual mandate": namely, to promote maximum employment and low inflation. Of course, taken literally, one could argue that there is in fact a triple mandate, with asset-price targeting in the bond market as the third leg of the policy tripod.

Now, whether one assumes a dual or a triple mandate, it is clear that the Fed's policy objectives differ from those of most other major central banks. The Bank of England, for example, has a specific CPI target of 2% over a two year horizon. The ECB has a "primary objective of price stability", which the ECB has chosen to define in its own fashion. There is a secondary objective of supporting the economic goals of the EU (maximum employment and stable non-inflationary growth), but price stability takes primacy. The RBNZ has an explicit policy target of keeping future CPI inflation between 1% and 3%.

The difference here should be clear. Banks like the ECB, BOE, RBNZ, and others have an explicit primary policy target of price stability. That comes first and foremost. The Fed, on the other hand, must balance its focus on price stability, which it shares with other CBs, with an explicit focus on supporting economic activity so as to reach its equally important goal of maximizing employment.

Now many commentators, including Macro Man, have given Alan Greenspan and Ben Bernanke a lot of stick for being serial bubble blowers. But perhaps some of that criticism is misplaced. Perhaps where we should really direct our ire is the Federal Reserve Act itself, which essentially directs the Fed to ignore the inflationary consequences of its actions if it judges those consequences to be less severe in relation to its policy goals than a potential loss of employment. What Macro Man is saying here is that there is no such thing as a "Greenspan put" or a "Bernanke put"; what it is is a "Federal Reserve Act put."

When you think about it, the practical implications of this policy structure are quite significant. The Fed's dual mandate essentially carries with it an implicit promise that Fed policy will be more "dilutive" (to borrow a term from occasional poster Mencius Moldbug) than policy in most other developed economies. While this is not necessarily a bad thing for US residents, for whom maximum employment, broadly stable prices, and moderate long-term interest rates are surely worthy goals, it is a decidedly unpleasant outcome for non-resident holders of US dollar assets.

Simply put, the Federal Reserve, as a matter of policy, is less interested in protecting the international purchasing power of its currency than other central banks are. Such a policy focus is really quite remarkable for the central bank of THE hegemonic reserve currency, and no doubt explains why the FX reserve managers are, broadly speaking, trying to reduce (or at the very least not increase) their dollar holdings as a percentage of their reserve baskets.

It is also a damned good reason why the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc.

Policymakers in these countries are finally becoming aware of this, with the UAE the latest country to suggest a change to its dollar peg- and not before time. Private investors evidently knew the score a year or two ago, which has resulted in a buyer's strike of US dollar-denominated financial assets, leaving the mercantilists and the oil producers holding the bag.

So where to go from here? Unless something changes, it is very difficult indeed to see private sector investors step in to buy dollar assets unless they are allowed to get cheaper (either in dollar terms or via a much lower dollar.) That having been said, a couple of caveats.

The Fed took a small step, in Macro Man's opinion, towards recovering an element of credibility by suggesting yesterday that their medium-term price target is headline, rather than core, inflation. By starting to forecast headline inflation (which necessitates that they pay attention to it), investors can derive at least a modicum of satisfaction that they may not be completely sacrificed at the altar of ex-food and energy.

Moreover, the currencies that have heretofore carried the load in strengthening against the dollar are starting to develop some serious warts. Yesterday's UK inflation report hinted at a significant downturn in growth even if the BOE cuts rates. Unusually, Mervyn King noted that currency tensions will be discussed at this weekend's G20 meeting in Cape Town. EMU monetary conditions are the tightest in 15 years, and surveys are suggesting an imminent downturn. Canada's leading indicator posted its lowest reading in several years yesterday, and BOC deputy governor Jenkins has complained about the strength of the loony recently.

What it all means is that we may be rapidly approaching that Minsky moment when dollar-peggers have to change policy. At that point, we could actually see currencies like the euro and sterling decline against the buck, with dollar weakness manifesting itself most against erstwhile peggers. For the time being, reserve diversification flows should keep the euro broadly supported for the next month and a half, but Macro Man is now entering profit-taking mode on his euro long.

Ultimately, what we are witnessing is a second Nixon shock played out in slow motion. And the Fed's dual mandate ensures that John Connally's remark from 1971 holds true today: "the dollar is our currency, but your problem."