Risks, Hedges and Opportunities

There is no escaping that monetary policy is a very complex subject matter, difficult to apply and much more than a simple idea of targeting an appropriate inflation rate. The monetary authorities are not innocent for they can easily make mistakes and clearly bear a lot of responsibilities for the consequences of their policies on the behaviour of the financial markets and economic activity.

On the one hand, should the monetary stance be easy at a time when it is tight, market prices of risky assets would rise, government bond yields would increase, the value of the home currency would decrease in term of gold, and inflationary expectations would increase. On the other hand, should the monetary stance be tight at a time when it is easy, market prices of risky assets would decline, government bond yields would decrease, the value of the home currency would increase in gold terms, and inflationary expectations would decrease. Of course, the longer the conduct of monetary policy, and the more far away it is from what it ought to be, the more dramatic will the unintended consequences be.

To properly judge the effect of monetary policy on things that matter to investors, one must know and understand that monetary policy is not asymmetric but somewhat chaotic. A much better way to judge which monetary stance the central bank should conduct is to have the common sense of taking a more macro economic approach.

Based on historical repetition, monetary policy should be neutral when prices are stable, fiscal budgets are in balance, the balance of payments is viable, employment is full and economic growth in nominal terms equals closely, population and productivity changes. There is ample empirical evidence and theoretical validity that for any given deviation in the above factors it should tilt the monetary stance away from even keel. If it`s not done, the Central Bank is not counteracting the pro-cyclical forces of finance, thus creating risks or opportunities to investors.

Palos Management’s US monetary policy index which takes into account all of the aforementioned factors calculates that the monetary stance of the US Fed should be slightly on the tight side of even keel. On January 22, 2010 the index stood at 115. Neutral is 100 and less than 100 is easy. Yet, the US monetary stance is clearly easy for the yield curve is steep, the federal fund rate is way below the rate of inflation and the FRB has flooded the banking system with a massive expansion of the monetary base. If it had not been that the economy was in the throes of writing down huge amounts of bad debts, the money supply (MZM) would have doubled.

Theory predicted correctly the debasement of the US dollar in gold terms, the surge in the market prices of risky assets, the rise in government bond yields and the increase in inflationary expectations in 2009 and the early weeks of 2010. The question is will the monetary stance of the FED turn in 2010. If the FED does not, more of the same can be expected. But, should it adopt a tighter stance, as we believe it will, than a more sober market for risky assets, a more stable US dollar and more increases in government bond yields can be expected.

Consequently, the beginning of the exit from super-expansionary monetary policies will be one of three dominant global macro themes in 2010 along with fiscal and global imbalances. The last weekly letter dealt with US fiscal deficits and next weekly letter will address the global imbalances between the US and the rest of the world. I’m of the opinion that the monetary stance will be gradually moving toward neutrality in 2010 and to an even keel position in 2011. Investors should watch what might happen to quantitative easing for that’s the 800 pound gorilla in the room. The FED, in our opinion, is likely to stick to it’s stated plan to end purchases of mortgages at the end of March and roll back emergency lending programs in February.

The FED will be saved by the private sector and China in that they will take up the burden of financing government budget deficits. Private savings will substantially increase over the next few years because of the ongoing de-leveraging process of households, financial institutions, commercial real estate and non-financial corporations. The private sector could buy as much as $1000 billion of US treasuries in 2010.

The monetary authorities in China abruptly reversed course last Tuesday in a clear sign that they have turned their attention to controlling the repercussions on of a credit explosion by raising reserve requirements on banks and yields on short term bills. The money supply in China is up 35% on a year to year basis. These changes mark stage one and the turning point of China’s exit from emergency policies. Because China, for all intents and purposes, is under a fixed exchange rate in that its currency is linked to the US dollar; a tighter monetary stance should lead to upward pressure on the Yuan and, therefore, lead to more accumulation of international reserves in the form of US Greenbacks. China and other foreign countries may buy as much as $500 billion worth of US treasuries in 2010.

What these two sources of financing means is that the FED will be able to follow a monetary stance that will be more in tune with what it ought to be. The US economy may have ended 2009 with a bang, but the anticipated change in the fiscal and monetary stance means that the 2010 outlook will be mute for a post recovery year.

Hubert Marleau, Chief Investment Officer

Palos Management Inc.



(…) The latest IMF numbers are a reminder of how far the dollar has slipped as the default currency for foreign reserves.

Based on 140 countries, which aren’t disclosed but probably don’t include China, the dollar’s share of allocated reserves had fallen to 61.6% by the end of September. At the end of 1999, it was 71%. Among developing and emerging countries, the dollar accounts for 57.5% of reserves, from 72%. The chief winner is the euro. Since 1999, its share of global reserves has risen to 25.5% from just under 18%. For emerging countries, which often pile up foreign reserves quickly, the euro accounts for 31.4%, from 19% a decade ago. So far, so gloomy. But Uncle Sam needn’t panic. With well over half the global total still stashed in greenbacks and the dollar the default currency for international transactions, its reserve status isn’t yet on the endangered list.

Full WSJ article


A Telling Move for the Hong Kong Dollar?

(…) a recent shift in the exchange rate of the Hong Kong dollar could speak volumes about whether money is still pouring into Asia.

For the first time since global stock markets bottomed in March, the honkie, as some call it, has moved off the strong side of its fixed trading range with the U.S. dollar. This is a signal that money is moving out of Hong Kong’s stock market, seen as a safe and liquid way for international investors to play China. Many Chinese companies are listed both in Hong Kong and in mainland markets.

For 26 years, Hong Kong’s currency has been tethered to the greenback. Currently the band is between 7.75 and 7.85 per U.S. dollar, and the honkie has been hugging the strong end of that band — 7.75 — since March. That recently changed, with the exchange rate falling to 7.7570 earlier this month. On Wednesday it was at 7.7548.

Not a big move? Consider that the Hong Kong Monetary Authority — the keeper of the peg — had recently been injecting $1.5 billion of its currency into foreign exchange markets each week, on average, to prevent the honkie from strengthening past 7.75. The implication is that, had market forces been at work, the currency would have been far stronger as funds poured into the city. That the central bank no longer has to intervene means the flows, traveling mostly one way for nine months, changed directions in December.

So investors have had a change of heart about China, particularly as the dollar strengthens and investors find more promising prospects at home?

Not necessarily. One big source of funds into Hong Kong has been investors chasing nearly $30 billion worth of initial public offerings this year. That market has quieted in recent weeks. Squaring up of portfolios ahead of the year’s end — by foreign stock investors who piled into emerging markets is also a plausible explanation.

Another possibility is that, as prospects rise for an interest rate hike in the U.S., rate speculators are moving money from Hong Kong dollars to U.S. dollars where long-term interest rates have turned up recently. While Hong Kong rates tend to match the U.S., there is a lag that arbitrageurs exploit.(…)

The verdict on what’s happening in Hong Kong could come as soon as next week. If the Hong Kong dollar returns to hugging to top of its trading range, the risk trade on Asian assets is still on.

Full WSJ article


Wen Says Inflation Is a Concern, Defends Yuan Rate

Chinese Premier Expresses Worry About Nation’s Rising Property Prices, Sees Need for ‘Balanced’ Bank Lending

(…) Speaking to the state-run Xinhua news agency on Sunday, Mr. Wen also flatly rejected foreign criticism of China’s exchange-rate policy, saying that stability in the yuan’s value helps the global economy and that China won’t bow to pressure to let it appreciate. "Keeping the yuan’s value basically steady is our contribution to the international community at a time when the world’s major currencies have been devalued," he said.(…)

“As I have told my foreign friends, on one hand, you are asking for the renminbi to appreciate, and on the other hand, you are taking all kinds of protectionist measures,” he said.

“The purpose [of these calls for appreciation] is to hold back China’s development,” he added.

China dropped its formal dollar peg in 2005 and has since allowed the renminbi to trade within a narrow band. But since the middle of last year it has operated a de facto peg. This has meant that the renminbi has depreciated about 9 per cent against the currencies of its main trading partners since early this year, even though the Chinese economy has rebounded quicker than any other major economy.

However, Chinese officials argue that its exchange rate against its trading partners is roughly in line with its level at the start of the global financial crisis in September last year, when the US dollar initially strengthened.

Lex ChartMr. Wen said property prices are rising "too quickly" in some cities, a situation demanding "great attention" from the government. He said tackling the high prices includes cracking down on price gouging and land hoarding, and possibly adjusting interest rates. He said in the two-hour interview that too much bank lending earlier in the year may have economic costs.

(…) "China is not facing an inflation issue for the moment," Mr. Wen said. "But we should foresee such a possibility and maintain consumer prices at a reasonable range."

Mr. Wen didn’t explicitly rule out (yuan) appreciation, but instead said that no such change would occur because of foreign pressure.(…)

"It would be good if our bank lending was more balanced, better structured and not on such a large scale." He added that the situation "has been improving in the second half of this year."(…)

Full WSJ article and FT article. Chart from FT Lex


McKinsey Global Survey Results (December 2009)

As a tumultuous year draws to a close, executives are moderately hopeful about their nations’ economies and their companies’ prospects, according to a survey in the field during the second week of December. Just over half of executives continue to say economic conditions are now better than they were in September 2008, and for the first time this year a majority expect customer demand for their companies’ products or services to rise in the near term. In addition, notably more are seeking—and getting—external funding than have done so in more than a year. And after reporting a striking shift in favor of short-term planning early in 2009, executives say their companies are once again able to plan for the medium and long term—but also that they remain wary, assessing more options and checking progress more frequently than they did before the crisis.

Moderated hope
The share of executives with largely positive views on their nations’ image economies has continued to grow slightly over the past six weeks: just over half say economic conditions are better than they were in
September 2008 and nearly 70 percent say they expect economic conditions to be better still at the end of the first half of 2010 (Exhibit 1).


Risks, Hedges and Opportunities

James Grant, editor of Grant’s Interest Rate Observer, composed on December 5, 2009 in the Wall Street Journal the Requiem for the US dollar. A very good article but I disagree. He admits that there is no greater success story in the long history of money than the greenback. It has no intrinsic value for it is collateralized by nothing than the trust that it can be used to buy goods, services and investments at will for as long as there is another confident person prepared to accept the exchange.

The same can be said for gold, and any other currencies. Yet, he mourns, like many gold bugs, the classical gold standard. John Maynard Keynes called gold a barbarous relic of a currency whose price, not value, is determined by the relative supply and demand to any given currency. This is not much different than for the US dollar. Demand is determined by buyers and new supply by miners in the case of gold and by the central bank in the case of the dollar. There is no way that gold will ever replace the US dollar or a basket of currencies for its balancing effect is too drastic on economic activity and too theoretical to practically replace the global foreign exchange market that trades more than $3 trillion a day.

Moreover, half of the $900 billion’s worth of us dollars in circulation is in the possession of foreigners and approximately 65% of all international foreign exchange reserves is comprise of US dollars. For practical purposes, one should be more concern with what is the dollar correlates with. It seems to me that the price of the dollar depends on the narrative of the time.

At the tail ends, dollar price increases with risk aversion and decreases with risk appetite. Under normal circumstances, the dollar fluctuates over the medium term with anticipated and actual monetary stance of the Fed and, over the long term, with changes in world order and trends in the balance of payment. In order to capture significant shifts in currency valuation, it is better not to measure the rate of exchange in terms of gold for it can be misleading. As a matter of fact, just about anything can be subject to price changes in US dollar terms (stocks, real estate, bonds, and commodities). A better measure is the spot price of the US dollar index that is constructed in a fashion to aggregate the value of a basket of currencies weighted by their respective importance in export trade.

In the period leading up to March 2009, the US dollar index shot up to 90.0 reflecting the abrupt stop of the "carry trade" where speculators unwounded their pairs, the sudden sale of risky assets by investors in favour of the "safe haven" of US dollar denominated T-Bills and the loading of US dollar notes by banks and governments for reserves. At that time global economic activity, from industrial production to foreign trade, was literally falling apart. As a result of a large, broad and fast response by the USA and China, a catastrophe was averted. Sure enough, the market sentiment slowly but steadily improved and the dollar index decreased from 90.0 in March to 74.0 in early December.

Private investors borrowed near-zero cost dollars in abundance to buy risky assets and alarmed speculators contented that the US dollar was about to lose its reserve currency status. The latter did not happen for several reasons. Firstly, the role of the dollar, as the world’s reserve currency is not likely to lessen for a long time. There are no alternatives for there are no other currency that offers size, liquidity, military power, political independence and legal stability.

While I recognize that its dominance may be challenged, it is more likely to be shared with other currencies in time. The international financial crisis is proof enough that the world has outgrown the old Powers of G-8. World gatherings have been eclipsed by G-20 making the European Union geopolitically irrelevant. World affairs must include South Africa, Mexico, Indonesia and even Iran, if anything of multinational importance needs to be discuss or done.

What is particularly important is the geopolitical shift to the EAST. China and India are making their presence felt. For 500 years, the boundaries of global power were drawn by the Atlantic. Today they are defined by the Pacific and that is where the USA is concentrating its diplomatic effort. The talk is about a G-2. The USA and China are the essential guarantor of global financial security.

In reality beyond the G-2 things are not that rosy. China and the USA do not face the same major structural problems of other big industrial economies. One has only to think about the demographic problem of old Europe, Japan and Russia, the sovereign debt fears of Spain, Portugal, Ireland, Greece and several OPEC countries are in a tax trap unable to raise revenue to pay their committed outlays. The USA has a positive fertility rate, a steady inflow of immigrants, enjoys institutional independence and a mutual deal agreement with China. This later deal explains why the brunt of the Yuan’s peg to the US dollar was bourn by other currencies. Several investment banks have estimated that the EURO is overvalued by as much as 20% to 25% and GOLD is only the new Tupperware party_a social gathering that is invading America’s living room to buy and sell Gold.

Secondly, it should be noted that past recession was not caused by too much inventory but by too much cheap credit. Americans are in the process of de-leveraging and it’s nowhere near completion and tons of debt is being retired on all sides. In this connection, personal income is saved, bank profits are purchasing government bonds and business profits are retained. This behaviour is reorienting the US economy towards a better internal and external balances where, with the exception of the government, Americans’ finance is based less on consumption and borrowings but more on savings and productivity.

The results have been dramatic, the personal savings rate is up to 4.0%, the money centre banks have paid back what they owed to government and businesses are reaping the profitable benefit of cost cutting. The result is that the current account deficit is now less than 3% of GDP compared to to 6.2% in 2006. One more push, and we could see its elimination and, in turn, a fixing of the global imbalances that are at the root of today’s economic crisis.

Since December 3, 2009, the US dollar index rose to 78.0 and the greenback is up more than 5% against the Euro and 2.5% against the Yen. It looks as if a rally is gaining momentum. Investors appear to be recalibrating their outlook. Leading economic indicators accompanied by improvement in the labour markets are suggesting that the US may turn out stronger growth than either Japan and Europe. Moreover, the Fed has given several hints as to the timetable for the removing of extraordinary monetary stimulus, closing down of most liquidity facilities and normalizing of interest rates.

A change in the discount rate is now imminent because banks’ capital and reserve ratios are appropriate to start liberalize banking lending practices. It is very possible that the tail ends like risk aversion and risk appetite may play a lesser role in the near term. The foreign exchange market may forget the rock-solid relationship of the past two years that dictated dollar performance (risk aversion and risk taking). The new narrative may have to do more with relative value and under a more classic macroeconomic response linking the dollar with normalized monetary policy and treasury yields.

Hubert Marleau, CIO, Palos management Inc



U.S. economic data are firming up and numerous forecasters have admitted being surprised by the vigour of certain indicators. Speculators too are taking note. Using just-released data from the CFTC, we estimate that total net short positions on the USD stood at only $6.2 billion for the week ended August 15.1 Short positions have been trimmed by a whopping $20 billion in the last two weeks alone. As today’s Hot Chart shows, this is the largest reduction since the summer 2008 when safe-heaven flows rushed into the greenback. What is interesting this time around is that interest in the dollar is not dominated by market fears; equity markets are holding up and credit spreads continue to tighten. In our view, current flows reflects the realization that the U.S. economy may actually outperform many of its pears in the coming months.




Budget deficits and rising debt levels are beginning to make headlines. Rating agencies need to rebuild reputations and will be speaking and acting early and harshly. This will have many ripple effects and unnerve investors at a time when most financial instruments are trading at elevated levels. Turbulance ahead, fasten your seat belt!

First, the Globe and Mail runs an article on sovereign risk and spiraling budget deficits (Charts from FT).

The enormous public cost of fighting the global crisis is haunting governments and unnerving investors.

image (…)  international ratings agencies sent shivers through markets with warnings that spiralling budget deficits and soaring debt levels are putting sovereign ratings at risk.(…)

Concerns encompass the U.S., Britain, France, Ireland, Portugal, Dubai and, most notably, deeply troubled Greece, whose credit rating was cut by one debt monitor and put on watch for a downgrade by another.

International ratings agencies are warning that other governments face similar actions if they don’t come up with plans to get their fiscal houses in order.(…)

“The issue for all of them [the Europeans and the U.S.] is that at some point one needs to see credible medium-term consolidation programs that will bring the debt back down again.”

Moody’s Investors Service said in a report Tuesday that the weakening public finances in the U.S. and Britain may “test the Aaa [triple-A] boundaries” for their ratings.(…)

But further worries about the euro zone risks and possible defaults in Dubai and by other heavy borrowers are sparking a new flight by jittery investors toward the perceived haven of the U.S. dollar and the deep U.S. Treasury market. The greenback rose Tuesday.


Then Dennis Gartman raises an important question:

“If Greece is suffering such ill economic news, what possibility is there that the ECB will move in the foreseeable future to tighten interest rates?” That is THE question of the day, and the answer from our perspective is that despite all of the anti-inflationary rhetoric that comes
from the ECB, and despite all of the “hard money” philosophies that the monetary authorities in Frankfurt wish to spew, they cannot move to raise rates when conditions in Greece, or Ireland, or Spain, or Italy are
so desperate. Things may be going reasonably well in France, Belgium perhaps and even Germany, but things are going poorly indeed in these other “nations.” Germany may call for higher rates, but Greece cannot allow that, nor can Spain, nor can Ireland, nor can Italy and nor can most other “nations” of the EU.

This then brings us to the biggest of all questions that beset the Union: How serious are the divides between the member nations of the EU, and when will the ties that have bound Greece to Germany and Ireland to France begin to unravel? If unemployment is rising and debt ratings are falling in Greece, can Greece remain a member of the EU, or will street protests begin in earnest demanding either a split from Brussels or a change in how monetary policies are enacted within the Union? During times of plenty, all goes well of course; but during times of dissension, parties dissent:

(…) image the trend that has been in the EUR’s favour since March now seems to have been broken… definitively so. What had been a bull market has now ended, and where one previously had to buy weakness in the EUR one must henceforth sell strength. Where
one previous sold strength in the US dollar, one henceforth must buy weakness. When trends change… when WATERSHEDS occur… psychology and the manner in which one views things must change. We’ve witnessed a WATERSHED shift in sentiment, and so too must our trading philosophy change accordingly.

Remember Milton Friedman who, in 1999, predicted that the Eurozone would not survive its first economic crisis.

He issued this warning in the belief that, lacking labor and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the U.S. economy. In particular, he strongly believed that at a time of economic difficulty, there would be countries of significance in Europe that would have considerable trouble coping with the euro area’s one-size-fits-all approach to monetary and exchange rate policy.

Lastly and not very dissimilar, Moody’s downgraded Illinois. Gartman again:

Moody’s downgraded Illinois’ general obligation bond rating from A1 to A2 and cited Illinois’ problems stemming from the U.S. recession. Making matters worse, Moody’s also cut other Illinois bond ratings from A1 to
A2 including sales tax revenue bonds, also cut to A2 from A1. In the process, Moody’ has taken Illinois’ rating to the second lowest in the US, ranking it just above California Baa1. In so doing, Moody’s said that the
state has not yet taken action of any sort to deal with the budget gap that it is facing… a gap that Moody’s says shall be on the order of $11 billion, or more than one third of its total expenditures. Moody’s
said that the downgrades are the result of high structural imbalances and little time to effect modifications to the budget in the current fiscal year, which ends June 30, 2010, as well as evidence of significant weakening in the state’s 2009 results.

The problem here is not just one that Illinois is suffering through, for if Illinois, with a double digit unemployment rate is downgraded, what then of Michigan; what then of Nevada; what then of Ohio perhaps? The point here is that “There is never just one cockroach.” This problem in California, now in Illinois, is going to spread to other states very, very quickly, for once Moody’s has the courage to make the credit change there, it will be swift to make the same changes to the credit ratings of these other states too. It is but a matter of time.

Too, now that Moody’s has moved on this issue, the other ratings agencies will have no choice but to follow.