By Claus Vistesen Copenhagen
[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]
THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.
Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.
Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.
Where Art' Thou My Fair Market?
If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.
One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;
As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.
In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."
In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.
The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.
In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.
The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.Finally with respect to the markets and on a more general note I do tend to agree with Steen Jakobsen that the next bout of volatility will (or more aptly should) be in currency markets. At least, one has to wonder why there has not been more action on the back of the Fannie/Freddier debacle. As such, one would have expected risk aversion to have hit currency markets to a higher degree than has been seen (more about that here). However, position taking to take advantage of the expected risk reduction has so far been an ill-advised and actually a quite painful play. In this way and while the USD/JPY did have a go at 104ish it ended the week close to 107. Furthermore, the GBP/JPY clocked in at a healthy 213 while the EUR/JPY continued to flirt with 170 as it ended the week at 169.2. Interestingly and once again this may be up to the rather volatile and uneven way in which equities (e.g. SP500) have been moving down and then up again. In fact, equities ended the week with a rather strong showing which suggest that while risk correlations have not dissipated all together the link has grown weaker. In the case of the JPY, it may also be a sign that something else is going on; pressure from outflows perhaps?
Revisiting Old Arguments?
Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.
On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.
Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.
One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.
The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:
The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.
“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.
Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?
In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.
The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.
With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.
But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.
The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.
Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.
As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.
To Inflate or Deflate?
If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.
The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.
In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?
As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.
Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:
The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.
So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case.
My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.
Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.
One Year In ... Still Some to Go
Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.
In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.
More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.
In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.
Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.
Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services.
On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.
Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.
A belated plug I know, but still well worth a look.