Kenneth Su-Econ 101

Morningstar's- Bob Johnson on Employment Numbers for Jan and Feb

2012-01-29T21:35:00.000-08:00

Employment Growth Could Look a Lot Slower in January

The employment numbers will be particularly hard to interpret as unusually heavy retail hiring (to support longer store hours) and large jump in the number of package delivery people boosted December results. So if the normal trend line is for 160,000 or so new jobs, I suspect that December's number of 200,000 was inflated by 40,000 or so, and that January should be the same 40,000 below trend, or about 120,000 jobs. That 120,000 number also happens to be the consensus estimate. Then, all things equal, February should look closer to the 160,000 trend-line number. Besides retail and couriers, my guess is finance also will look weaker, as will industries that depend on snow and cold weather, but manufacturing and construction will look a little better.

Job growth of 120,000 is still consistent with year-over-year employment growth of 1.77%, slightly ahead of December's 1.75% rate. In fact, job growth could come in well under 100,000 and still improve on December's rate. So don't let those headlines trumpeting, "Job Growth Almost Cut in Half," scare you.

Fourth-Quarter GDP Not a Trendsetter

2012-01-29T21:18:00.000-08:00

Fourth-Quarter GDP Not a Trendsetter

2012-01-29T14:47:00.000-08:00

Isn't this just putting lip stick on the PIIGS?

2012-01-25T00:55:00.000-08:00

In late 2011, the U.S. agreed to lend dollars for euros , and the ECB agreed to lend money to troubled European banks . The positive outcome was the stabilization of the Spanish and Italian bonds. The world has collectively exhaled from the event and is breathing normally again. Before that moment the Italian and Spanish bonds were escalating to epic rates that could have led to a series of defaulting European banks and then who knows what would have happened next?

With the stabilization of the European sovereign debt, the U.S. stock market has turned from red to green. The VIX is down and the positive growth indices are up such as the Dow, S&P, and GLD. Everything looks pretty rosy now, but has anything really changed? Haven’t we just put lip stick on this pig?

The PIIGS are still structurally a mess, and only through recent monetary policy, bureaucrats have been able to successfully calm the markets. The ECB said they were not going to bail out the PIIGS, but doesn’t their most recent policy do so indirectly?

If it looks like a duck and quacks like a duck isn’t it a duck? The ECB is not directly lending money to the PIIGS, but the ECB is lending money to European banks at 1% interest for three years. And in only one month, the Euro banks have borrowed close to 500 billion dollars, which happens to be the size of the Greek debt . Eventually, the European banks will use that money to buy up the PIIGS sovereign debt. This is the short run solution to the PIIGS and Euro crisis. The problem of GDP growth and the lack of incentives to work haven’t changed, but the lip stick sure looks good.

Curb your enthusiasm

2011-12-20T16:09:00.000-08:00

Dec. 20th, 2011

The markets were up sharply today, 3%, on little news.
Typically before a holiday traders close their trading books and hit the slopes. The result is less volume which can exacerbate minor moves. Short covering may have also been a culprit for the strong rally. Short covering occurs when shorts need to reverse their trades and thus go long. When the market started moving north, the shorts began losing money and ultimately they had to close their positions by going long and thus cover their shorts.

Germany has the memory of an Elephant

2011-12-18T18:47:00.000-08:00

The sovereign debt crisis in Europe will create wild gyrations in the stock market for years to
come. Germany is in control of the Euros future and of the fate of the European Union.
Germany must decide whether to hold these profligate countries accountable for their sins of excess or forgive some of the debt in exchange for greater short run stability and growth. If they choose the former, they risk a splintering of the Euro and European Union. If they choose the latter, they risk inflation and kicking the problems down the road.

Germany still remembers the Versailles Treaty and how the world crushed their economy by placing war reparations that the defeated state would never be able to repay. Ironically, Italy was one of the countries they owed money. The Germans were not let off the hook to pay off their debts when they needed the help of their neighbors, and now they are holding their neighbors to the same standard. Moreover, the war reparations debt led to the printing of money that led to hyperinflation. Therefore, there is less hope of the ECB printing money or forgiving debt due the Germans elephant like memory.

Due to these conclusions, in 2012 the U.S. equity market will have wild swings and most likely finish the year flat to lower. The Europeans will have a massive deleveraging exercise and thus liquidity will be lower as will growth. Europe will fall into a recession and that will also slow the Bric countries down possibly sending the world into a global recesssion.

Markets that will do well:

Dollar
U.S. bonds

Markets that will struggle:

Euro
U.S. stocks
Gold
Commodities
Tech stocks -Nasdaq
U.S. exporters

U.S. Economy Projections for 2012

2011-12-18T18:20:00.000-08:00

Gold recently has been selling off. Is this just profit taking or does this demonstrate a structural change in psychology? I believe it's the latter. Stocks will perform poorly next year due to weak GDP. Here are the growth laggards for GDP:

Consumption- The housing market is hurting wealth creation and thus slowing consumption. Real income for income earners making less than $45, 000 is going down. The unemployment rate is still stubbornly higher than the natural rate of unemployment. Structural unemployment is a major issue that will increase the natural rate of employment from 5% to close to 6%. The Nordstrom consumer will prop up retail sales, but the WalMart consumer needs to fully participate to drive retail sales back to trend.

Investment-Companies are reticent to spend or hire due to the lack of transparency from the political environment. The election year will create more uncertainty and thus delay capital projects.

Furthermore, Europe will act as a drag on profits. S&P 500 (NYSEARCA:SPY) companies derive 14% of sales and 18% of profits from Europe, according to a report by Bank of America (NYSE:BAC).

According to Rick Newman from U.S. News and World Report, 40 percent of profit for firms listed in the S&P 500 stock index now come from overseas.

Gov.- Government is cutting their budget federally and locally.

Net Exports- The appreciating dollar will decrease our exports and increase our imports. Europe and the BRICs are slowing and exports to these regions will diminish.

Monetary Policy- Chs 13-15

2010-11-04T13:21:00.000-07:00

Should a Shrinking Dollar Worry You?

2010-10-19T08:16:00.000-07:00

Level 4-Should a Shrinking Dollar Worry You?, WSJ, by Jason ZweigSep 12, 2009

The dollar is falling. Is the sky falling, too?As of this week, a dollar would buy only 0.68 euro, down from 0.80 in March and a peak of 1.21 in 2000. The greenback slid against other major currencies as well.That may be a problem for investors. If most of your assets are in dollars but much of the goods and services you consume are priced in other currencies -- say you like imported cars or regularly vacation abroad -- your future spending needs have just gotten harder to fund.

Fortunately, it's not that hard to protect against further erosion in the dollar. And not all investors need to take action. Hedging would be vital, quips Campbell Harvey, an economist at Duke University who edits the Journal of Finance, "if your mortgage is denominated in euros." But if you make your money in the U.S. and spend it in the U.S., a falling dollar isn't the end of the world. Thus, the slide in the greenback need not prompt every investor into urgent action, but it is an ideal pretext for asking whether you are globally diversified.

Three cures are most commonly prescribed for investors worried about a weakening dollar: foreign currency, gold or a diversified basket of commodities.Trading foreign currencies like Australian or Canadian dollars, both tied closely to commodity prices, sounds appealing. But foreign-exchange trading usually relies on high margin, or leverage, which is risky, and gains are taxed at hefty rates. So an individual investor has to be really right to rationalize doing it, says Mark Kritzman, who helps oversee more than $25 billion at Windham Capital Management in Cambridge, Mass.As for gold and other commodities, they have provided an average return of around 20% in the four quarters following the worst drops in the value of the dollar, according to Michele Gambera, chief economist at Ibbotson Associates.Surprisingly, these glittering returns look tarnished next to those of stocks and foreign bonds.

On average, based on more than 20 years of returns, Mr. Gambera found that in the four quarters following the steepest declines in the dollar, U.S. stocks go up 25%, various baskets of international bonds gain between 21% and 28%, and non-U.S. stocks go up more than 56%.So, with many commodities near record highs, there may be no need to join the stampede into gold or most other hard assets.If the dollar keeps dropping, stocks and bonds priced in euros, yen, rubles or shekels will tend to become more valuable; anything denominated in foreign currency will then buy more dollars. That's why, for U.S.-based investors, international stocks and bonds tend to outperform commodities when the buck falls. Global diversification thus provides an automatic buffer against a dollar drop, unless the fund managers have hedged the holdings back into U.S. currency.By the same token, big American companies that earn much of their revenues outside the U.S. may do better as the dollar drops; kronor and rupees will then convert into a greater number of greenbacks, putting more profit in U.S. shareholders' pockets.But raising your overseas holdings can make sense even if the dollar stops falling.

U.S. stocks represent less than half of the total value of equities world-wide, and yet American investors keep more than 70% of their stockholdings here at home. Although roughly two-thirds of the world's debt is outside the U.S., American investors have less than 4% of their fixed-income portfolios in foreign bonds.For many years, I've kept half of my stockholdings outside the U.S. The more convinced you are that the dollar will fall, the more you should hold in international stocks, ideally through a low-cost index fund that doesn't hedge currencies. Even if your view on the dollar turns out to be wrong, you will end up with a better diversified portfolio.I don't have any foreign bond funds myself; I was turned off long ago by their risk and illiquidity. But choices are better today. If you are especially worried about Uncle Sam, consider T. Rowe Price International Bond or, if you can avoid the sales charge by going through a discount broker, the Class D shares of Pimco Foreign Bond (Unhedged). SPDR Barclays Capital International Treasury Bond, an exchange-traded fund, is another good choice, but only if you can find a discount broker that won't charge commissions to reinvest your interest income.Over the course of time, currency fluctuations tend to wash out. And even a long-term decline in the dollar might not be disastrous; since 1950, South Africa has had one of the world's weakest currencies, but one of the best-performing stock markets. The dollar is falling, but the sky isn't.

QUESTIONS: 1. (Introductory) By how much percentage did the U.S. dollar fall against the euro since its peak in 2000?2. (Advanced) What options are available to investors to protect them against a weakening dollar?3. (Advanced) How do big American companies with overseas earnings benefit from a falling U.S. dollar?4. (Introductory) Does a weak U.S. necessarily imply it is a bad for U.S. stock markets over the long period of time? Why?

Currency Wars

2010-10-07T08:09:00.000-07:00

Wall Street Journal- Currency Wars-A fight to be Weaker; by: Tom Lauricella, John LyonsSep 29, 2010

Tensions are growing in the global currency markets as political rhetoric heats up and countries battle to protect their exporters, raising concerns about potentially damaging trade wars.
At least half a dozen countries are actively trying to push down the value of their currencies, the most high-profile of which is Japan, which is attempting to halt the rise of the yen after a 14% rise since May. In the U.S., Congress is considering a law that targets China for keeping its currency artificially low, and in Brazil, the head of the central bank said the country may impose a tax on some short-term fixed income investments, which have contributed to a rise in the real.
Peter Morici, business professor at the University of Maryland, discusses why he believes China's longstanding efforts to keep its currency cheap have led to huge trade imbalances with the United States and other nations.

Businesses always want to be more competitive and politicians often talk a big game. But in the current environment, as many economies are still struggling to recover from the global financial crisis, worries are growing that policy makers could be more aggressive in protecting their nation's business interests.

Rising protectionism is "a very big risk," says Erin Browne, a macro stock market strategist at Citigroup. "And it's something that could move more into the spotlight after the [U.S.] election."
Currency-market strains could also be a topic of discussion at next week's IMF/World Bank meeting in Washington where central bank and government finance officials will be gathering.
The Japanese government earlier this month stepped into the currency markets for the first time in years. To counter the yen's rise, Japan sold some $20 billion worth of its currency, which traders said was its biggest-ever effort in a single day.

Japan joined many other Asian emerging-market countries that have fighting rising currencies on a near daily basis, such as Taiwan, South Korea and Thailand. In Latin America, Brazil, Colombia and Peru have also intervened to tamp down their currencies.

In the U.S., protectionist efforts have been on the rise, especially when it comes to China, which is widely seen as keeping its currency, the yuan, at artificially low levels in order to boost its exports and make it more expensive for the Chinese to purchase goods produced abroad.
The House of Representatives is expected to pass legislation on Thursday that would let U.S. companies argue that Chinese currency policy represents an unfair subsidy. Democratic Senator Charles Schumer plans to push similar legislation to punish China for currency manipulation in the lame-duck session following the election. But it is considered unlikely the bill will pass.
Even so, the administration could use the threat of congressional action to press Beijing to make further adjustments in its currency, particularly as a summit of the Group-of-20 leaders in mid November draws closer.

IMF Managing Director Dominique Strauss-Kahn said he wouldn't rule out a currency war and that officials at both the fund and the Group of 20 nations were actively working to prevent such a battle of competitive depreciations.

However, in a press briefing in Washington, Mr. Strauss-Kahn said he didn't believe there was a big risk of such a war.

"There is no good to expect from intervention," he said. "History has shown that the effect of this kind of intervention doesn't last for very long."

Part of the challenge is that the moves in the currency markets that are raising the ire of central banks and politicians are being driven by longer-term investors.

Stronger economies in the emerging markets are attracting capital from the developed world, pumping up demand for local currencies. Talk of additional quantitative easing in the U.S. signals to investors that interest rates there will remain close to zero for a long time.
Meanwhile, inflation is building in Asia, forcing interest rates higher. Investors see that mismatch and are shuttling money from west to east, attracted to the higher yields.
"The flows that we're seeing are soundly based," says Richard Yetsenga, global head of emerging-market currency strategy at HSBC.

Some countries intervene more forcefully than others. Technology exporter Taiwan sees little fluctuation in its currency, thanks partly to heavy government intervention. Its currency is up less than 2% against the dollar this year. Malaysia, on the other hand, has allowed a stronger ringgit for the independence a free-floating currency gives its monetary policy makers, and the spur it gives to its exporters to become more efficient.

Government officials outside China for the most part step gingerly when it comes to the region's largest economy and its approach to currency reform, if they say anything at all. Singapore Prime Minister Lee Hsien Loong said last week in an interview with The Wall Street Journal regarding China's appreciation: "I can understand their caution, but on balance they need not go so slow."

The rhetoric was much hotter this week out of Brazil, where its currency has risen more than 30% against the dollar since last year partly because investors flock to its relatively high interest rates.

On Monday, Brazil's Finance Minister Guido Mantega lashed out at the U.S., Japan and other rich nations he says are letting their currencies weaken to spur growth—growth that comes at the expense of other exporters like Brazil.
"We're in the midst of an international currency war," Mr. Mantega said during an event in São Paulo. "This threatens us because it takes away our competitiveness."
The head of Brazil's central bank, which has been intervening in the currency markets to slow the real's rise, was more circumspect on Tuesday.

"There is a very serious currency problem which should be addressed," Henrique de Campos Meirelles said. Mr. Meirelles said that raising taxes on flows into Brazil was a possibility.
Officials say Brazil's 10.75% benchmark interest rate is necessary to squelch inflation and keep the Latin America's biggest economy from overheating. But it attracts a flood of investment from speculators who borrow in the U.S. or Japan where money is cheap, and deposit it in Brazil. The inflows of cash propel the real even higher.

With Brazil's presidential elections scheduled for Sunday, dealing with a strong currency is shaping up as the first major economic issue to face Brazil's next president. Dilma Rousseff, the former Energy Minister and handpicked successor to President Luiz Inácio Lula da Silva leading the polls, is an advocate of Brazil's 11-year-old floating exchange rate. But she is likely to face pressure from economists within her left-wing party, including Mr. Mantega, to intervene more heavily.

QUESTIONS: 1. (Introductory) Why is tension growing in the foreign-exchange market?2. (Introductory) Name some of the countries that have already intervened in the foreign-exchange market to stem the rise of their currencies?3. (Advanced) Cite specific intervention measures that some countries have already taken in the foreign-exchange market to stem the rise of their currencies?4. (Advanced) What is the opinion of the International Monetary Fund with regards to currency wars? Do you agree with the IMF's position? Why?

Death Cometh for the Greenback-Joseph Stiglitz

2009-11-08T14:17:00.000-08:00

Death Cometh for the Greenback

by Joseph E. Stiglitz

10.27.2009

From the November/December issue of The National Interest.

THE DOLLAR is in trouble. That’s clear, and it’s been true for a while.

The cornerstone of the global economic system has long been the greenback. In the aftermath of the Vietnam War and the oil shocks that brought on inflation, the value of the dollar relative to other currencies could not be maintained, so countries moved away from pegging their currencies to America’s. But still, the almighty dollar was used by countries all over the world for their reserves. The reserves provided backing for the currency and the country. They were a bank account that could be drawn upon in times of need. If oil prices shot up, a crop failed or lenders demanded their money back, there was a stockpile of money that could be used.

There was a longtime confidence in the dollar, even more when then–Chairman of the Federal Reserve Paul Volcker brought down inflation in the early ’80s. The dollar was a good “store of value.” And the fact that others were willing to hold American dollars was a big advantage to the United States—it could borrow cheaply abroad.

To assure the dollar’s standing, by the ’90s, America officially had a strong-dollar policy. Speeches by then–Secretary of the Treasury Robert Rubin affirmed our determination to maintain the value of the dollar. And for much of the period, the dollar was indeed “strong.” But it had little to do with the speeches, though I sometimes suspect not only that the secretary of the treasury but also the financial markets thought so.

For the past eight years, the dollar has increasingly become less revered. Its value has been volatile. As the rest of the world saw the United States struggling with a failing war and soaring budget deficits, many who had large dollar holdings began to reduce those reserves (or increase them less than they otherwise would have). All this put downward pressure on the dollar. And thus began the first signs of a vicious circle. The strength of the dollar is becoming riskier and riskier. The growing U.S. deficit and the ballooning of the Federal Reserve’s balance sheets leave many worried that in their wake will come inflation, undermining the long-term attractiveness of the U.S. currency.

In this article, I try to explain why the dollar is in trouble, but ask—should we care? What are the consequences? I will suggest that, for the most part, and for most Americans, it is probably a good thing. But the adjustment to a lower value of the dollar will not necessarily come easily. One of the consequences—already under way—is the fraying of the dollar-reserve system. I argue that a move to a global reserve system would be good for the United States, and good for the world.

OVER EIGHT short years, former-President George W. Bush doubled the U.S. national debt (with little to show for it, except a wrecked economy). With the debt expected to double again in the next decade (in optimistic scenarios), the picture gets grimmer still.

America’s debt-to-GDP ratio is slated to increase from 40.8 percent in 2008 to 70 percent or more by 2019, and if interest rates return to more normal levels of say 5 to 6 percent from their current range of 0.0 to 0.25 percent, it will mean the cost of paying interest on the debt will eat up a substantial fraction of tax revenue (20 percent or more)—unless taxes are raised. The costs of funding programs for the aging baby boomers will only put further strains on the budget.

Granted, deficits by themselves need not present a problem. Deficits are of course only one side of a country’s balance sheet. On the other side are assets. If a company borrows money to make high-return investments, no one is worried—so long as those investments do in fact yield returns.¹ Our soaring deficit is not a concern if the money is spent on education, technology, infrastructure—all investments that historically have yielded very high returns, far higher than the interest rate the government has to pay—because then the returns to our society are far greater than the costs. But, if the money is spent on wars in Afghanistan or Iraq, poorly designed bailouts for banks or tax cuts for upper-income Americans, then there will be no asset corresponding to the increased liabilities, and then there is cause for concern. This seems to be the road we have been heading down for the last eight years and, disappointingly, are to too-large an extent continuing to travel.²

And with it there will be strong incentives to reduce the burden of the debt through inflation because inflation reduces the real value of what is owed. It means the government will pay back its debt with dollars that are worth less than they are today.³

This is how we come to another threat to the dollar: inflation.

THE STRENGTH of the dollar is determined by the laws of supply and demand, just like the value of any asset. The demand for a currency is based on the return to holding the asset relative to other assets, e.g., the interest rate received from a dollar asset, like a Treasury bill, plus the expected capital gain or loss. Demand today (and thus the value today) depends critically on expectations about the value tomorrow, but the value tomorrow will, in turn, depend on expectations of the day after. Prices are inexorably linked to expectations of the future, both near and far. If investors, or even people as a whole, believe that sometime in the future there is going to be high inflation, then those who hold dollars will be able to buy less with those dollars. The demand for dollars then—and now—will decrease, and hence (holding everything else constant) so will the value of the dollar at the present moment.

As market participants have watched the U.S. deficit rise dramatically and the Federal Reserve effectively print money seemingly without limit, fears of that very kind of inflation, not now, but sometime in the future, have grown. The fear is not of immediate inflation; there is so much excess capacity and unemployment that deflation is in fact more a worry. But the longer-term concern is that if and when the economy recovers, inflationary pressures will grow.

THE FEAR from some debt holders (China in particular) is that the U.S. government will purposely try to raise inflation—or be soft in resisting it, for the obvious reasons. I would normally think these concerns to be exaggerated. “Inflating” away debt is not painless. And if the Fed tried to do so, our foreign creditors would immediately demand higher interest rates—the only way to collect the real value of what they are owed.

The Fed, of course, right now wants to keep interest rates low because it is worried about the recovery. The only way to offset our foreign debt holders’ demands of higher interest rates would be to start buying up our own debt (the same T-bills the Chinese buy) to ensure our interest rates stay low. But this would only make the Fed’s balance sheet worse.

There is another reason that I would normally not be so worried about the buildup of the deficit and the Fed’s ballooning balance sheet. It is in the genes of all central bankers, ours included, to fight inflation. It is part of their self-identity. But the situation now is unique, so the Fed might not be as “tough” on inflation as it would normally be. The Fed knows that it is largely responsible for having created the crisis. Like the arsonist who calls the fire department, it has now received kudos for helping put out the fire. In these circumstances, it especially doesn’t want to be blamed for putting the economy back into recession, just as it is climbing out. That suggests that it may err on the side of caution as it contemplates whether to step on the brake now.

There lurks in this morass the possibility of another outcome that will not be good for America: the Fed will allow interest rates to rise somewhat—sufficient enough to stifle the inflation in the short run, but not enough to stifle our creditors’ fears of future inflation. We will pay an “inflation premium,” but not enjoy any benefits from the inflation that would normally reduce the real value of our national debt. Because we will have had to pay higher interest rates, in effect, inflationary expectations will have added to the real value of our national debt.

BUT OUR creditors will have to worry about another possibility as well. And it is equally threatening and probably more likely: the Federal Reserve will not intentionally attempt to hike up inflation, but its incompetence in managing monetary policy will do the same. In the best of circumstances and with the best expertise, monetary policy is difficult. It takes six to eighteen months for monetary policy to have its full effects. The Fed has to forecast where the economy is going, with considerable accuracy. Acting either too vigorously or too soon will plunge the economy back into recession. Delay may lead to an onslaught of inflation. Balancing the risks moment by moment is a Herculean task. Anyone looking at the Fed’s record has to feel some anxiety. It repeatedly underestimated the severity of the problems leading up to our current crisis.⁴ And to make matters worse, we are in uncharted territory: no central bank has confronted a situation quite like ours.

The Fed is walking a policy tightrope. Many banks today have “excess liquidity,” enabling them to lend, yet they choose not to because of fears they won’t get paid back. We wish at this moment in time that they would lend more to get the economy moving again. The difficulty is that once the economy starts to strengthen and recover, that is precisely the time when our banks would decide to start lending more. And that is precisely when we want the banks to stop lending too freely, lest we stretch the economy to the limit once again. The additional lending would risk reinforcing inflationary pressures.

The standard policy prescription for these poorly timed loans is to, somehow, reduce banks’ ability and willingness to lend when necessary. And the Fed says it will deftly do just that, for instance taking out this excess liquidity as needed, or paying interest on deposits in the Federal Reserve so that banks’ incentives to lend will be weakened. But many, looking at the Fed’s track record and its seemingly cloudy crystal ball, are unconvinced.

The most recent episode has shown that markets are often not self-correcting and central bankers don’t always know best. Worries about inflation and the Fed’s intentions and capabilities will continue to decrease the value of the dollar. The dollar is in trouble indeed.

WHY IS the future of the dollar so important? The global financial system has been called a dollar-reserve system, as countries use dollar reserves to enhance confidence in their state and their economy. But the dollar is no longer a good store of value. It provides risk without return. The yield on a T-bill today is around zero, and no one—not even the most confident supporter of the Fed—would say that it is without risk. It is thus understandable that countries which hold large amounts of dollar reserves are feeling anxious. They don’t want to see their hard-earned savings disappear. And some of the moves countries will now take to protect themselves will both weaken the dollar and move the world away from the dollar-reserve system.

China’s Premier Wen Jiabao has already forcibly expressed his concerns (which are widely shared within the country) about the long-term strength of the dollar, and while we have equally forcefully explained that he should have complete confidence in the dollar, most are unconvinced. And with China holding so much of our debt, the impact of its actions will be felt far and wide. Some small countries that can move much of their reserves out of dollars already have done so. Others are likely to follow suit—providing a further reason that the dollar may decrease in value.

Now, China and Japan face a distinct problem: if they sell too much of their reserves too quickly, the value of the dollar could fall dramatically, and that would undermine the value of their remaining dollar reserves. Moreover, it would make exporting to the United States more difficult. That has led some Americans to take comfort, thinking that China, caught between a rock and a hard place, has no choice but to continue with the current system. This is not correct. China does have strategies it can use, many of which make the future of the dollar perilous.

One tack, likely to be followed by Beijing to the extent that it can: continue to buy dollar assets, but look for investments that are somehow protected against inflation and exchange-rate fluctuations, or at least better protected than U.S. T-bills. An example of such an investment is U.S. inflation-indexed bonds (Treasury inflation-protected securities or TIPS). The value of these funds rises with inflation, so they appeal to those wary of being hit with rising prices. While that doesn’t necessarily protect one fully against exchange-rate fluctuations, it at least protects against the correlated risk of inflation. This strategy maintains the strength of the dollar, and for those concerned about that issue, it is the tack they hope the Chinese take.⁵

There is a second tack that is already part of the Chinese strategy and undermines the likelihood the dollar will be kept as the reserve currency: shift the locus of sales. Some have suggested that China is dependent on exports to the United States. But that may be less true than some Americans believe. Formerly, there was the belief that the U.S. financial system and its monetary/fiscal policy were such that whatever was lent would be repaid, and with “sound” dollars. That confidence has now been eroded. Instead, Beijing could provide the finance that would enable Southeast Asians, Europeans or Africans to buy its goods—or even to allow the Chinese themselves to purchase the goods made in China. For when a country provides “vendor finance”—simultaneously selling the goods and financing the sales—it has more choices. The point of vendor finance is that one is not intending to give the goods away, but to get paid at a later date. For the repayment to be made in dollars of diminished value is akin to getting the merchandise at a big discount. Instead, providing funds to Africa and other mineral-resource-rich countries could yield double or triple dividends, including access to scarce resources and enhanced geopolitical influence, especially important at a time when the United States has its focus on other matters. In the end, this simply means the Chinese will buy fewer dollars and the value of the dollar will fall.

The final part of the response, and in some ways the most important for the long run, is a reform of the reserve system, through the creation of a global reserve system. For holders of reserves, this approach lends the prospect of efficient (low-cost) risk diversification. The notion that in this world of globalization, there would be so much dependence on a single country’s currency seems anomalous, and especially so when that country has experienced such economic and political vicissitudes.

The key implication for the global financial system: the dollar will no longer be the reserve currency.

THE CURRENT system is unstable, leads to a weakened global economy and is unfair. It works to the disadvantage of developing countries, but also to the disadvantage of the United States. It is a system that produces only losers.

Developing countries have been putting aside hundreds of billions of dollars in low-yielding reserves instead of undertaking potentially high-yielding investments. Typically, developing countries should be borrowing and spending in order to grow. And this is good for the global economy as a whole. But, they are cautious because of what they saw happen during the East Asian crisis of 1997 when, without enough reserves, developing countries were unable to pay back the money they had borrowed from the West. And the economic policies foisted on them by the IMF and the U.S. Treasury not only led to what many perceived to be a loss of their economic sovereignty but also converted downturns into recessions, recessions into depressions. As the prime minister of one of the East Asian countries that suffered from the 1997 crisis confided in me, “We were in the class of 1997. We learned what happened when you didn’t have enough reserves.” Their response was the familiar: “Never again.” Clearly, these developing countries realize the high opportunity costs of doing more saving than spending, but they are equally aware of the even-higher costs—both to the economy and to their societies—of not having large-enough reserves.

In the end, by building up reserves they enhanced their countries’ economic security, but they also contributed to weakness in global aggregate demand. This is a problem that is likely to persist for years to come. So long as the global economic system is as volatile as it has been, and so long as there are not cheaper alternative ways of obtaining the requisite security, countries that can will put aside money into reserves.

In earlier days, profligate spending by developing countries helped offset the frugality of the better managed. But since those countries learned their lesson, America has become, in a sense, the “consumer of last resort.”

John Maynard Keynes and Yale University’s Robert Triffin pointed out that as countries around the world build up reserves in the currency of a single country, confidence in that reserve currency erodes. Reserves are just IOUs from the reserve country to the rest of the world. As America owes more and more money to others, those nations inevitably start to question whether they will be paid back—or be paid back with dollars that are worth anything. And there is a further political-economy problem: because reserve-currency countries can borrow so easily (other nations are willing to hold the country’s IOUs even when the return is close to zero), the temptation to profligacy may be hard to resist. Certainly America hasn’t been able to resist the temptation. Hence America’s enormous fiscal deficit.

It is a basic economic identity that the trade deficit is equal to U.S. borrowing from abroad.⁶ If foreigners lend us more money (T-bills they put in their reserves), then we will have a larger trade deficit. Running a trade deficit means the United States has a high level of net imports. This, in turn, means people buy fewer domestically produced goods and national aggregate demand (which is simply the sum of consumption, investment, government expenditures and net exports) is weakened. Unless the country is going through a period of “irrational exuberance,” leading for example to a tech bubble (the case of the United States in the 1990s), aggregate demand may be so weak that the economy will be operating below its potential. To combat this low demand and stimulate the economy, the government commonly runs a fiscal deficit—it spends beyond its income. This has the adverse effect of leading, in the long run, to less confidence in the reserve currency. Yet this is the course the United States has typically taken and seems intent on continuing. It is economically unhealthy and creates massive worldwide imbalances.

Over time, the fact that those countries that should have been spending (on investments) were lending, and those that should have been lending were borrowing, created an unsustainable system. In a bizarre way, this has created a kind of reverse foreign aid. Poor countries are lending to the United States trillions of dollars at a zero interest rate.

A GLOBAL reserve system could help address all of these problems. One way of thinking about this system is to think of a massive gold mine being discovered underneath the IMF. It yields, say, $600 billion a year. The IMF could simply ship out the gold to its members (say, in accordance with a particular formula based on their income). Now, instead of shipping the gold, the IMF issues pieces of paper telling each country how much gold they now own underneath the IMF building on 19th Street. Paper gold, we could call this. It’s clear that we don’t really need to have the gold. All that matters is trust, the willingness of governments to exchange the paper gold (Keynes called it bancor; one could call it global greenbacks) for their own currency—and that would be achieved through international agreement. In this situation, everyone has guaranteed reserves.

This would first and foremost help the problem of developing countries that have been hoarding their savings rather than investing. But by helping them, it would help the entire global economy—a new kind of trickle-up economics. They could each hold the paper gold in their reserves as a buffer against all of the risks they face. Consider a country that had been setting aside $50 billion a year in reserves, but now gets a transfer of $50 billion in paper gold, put into its account at the IMF or in a “New Global Reserve Facility” that might be created to administer the new global reserve system. Because their reserves are now sufficient to protect themselves against the global economic vicissitudes, they wouldn’t have to put aside from their current incomes the corresponding amount. They could spend that amount, and that would lead to stronger global demand.

The system has one further advantage. Another basic economic identity is that the sum of trade surpluses must equal the sum of trade deficits; if some country exports more than it imports, some other must import more than it exports. So long as there are some countries that run surpluses (like China and, until recently, Japan), some other country must run deficits. But deficits are like hot potatoes. Countries with too-large deficits have learned the hard way what happens—there can easily be a run against the country’s currency, leading to a currency and financial crisis. But if one state with too big a deficit takes actions to reduce it, the deficit just moves to another country. It was not an accident that after the East Asian governments reduced their trade deficits, deficits showed up in other parts of the world. As all tried to make reductions, the United States became the deficit of last resort—again an unsustainable situation. Under the global reserve system, with an annual emission of reserves from the new worldwide global reserve facility, countries could still run moderate deficits and let their own reserves build up. The system would be far more stable. And the system could be designed to incentivize countries not to have reserves, by, for instance, reducing allotments of new emissions to countries that ran persistent surpluses.

We already have a precursor to a global reserve system, in the IMF “money” called Special Drawing Rights (SDRS). The problem is that the issuances have been episodic, small and the money allocated in ways that are not ideal—America gets the largest allocation.

The UN Commission of Experts on Reforms of the International Monetary and Financial System (which I chaired) has argued that fixing the issuance of the SDRS is perhaps the most important medium-term reform that can be undertaken if we want to have a robust and stable recovery. The new global reserve system is not a panacea for the world’s financial ills, but it could make the global financial system work far better than it has in the past.

SOME IN the United States are resisting the increasing demands for a global reserve system. The adverse effects on the United States (both as a result of heightened global instability and the associated trade deficit that are weakening national aggregate demand) are not always as obvious as the advantages of being able to borrow at a very low interest rate.

What does a weaker dollar really mean for Americans and the global financial system? A weaker dollar means America can export more—and will import less—and that is good for jobs. A stronger labor market leads to increased wages, and that too is good for workers. Export businesses gain, and so do those that compete with imports.

Certainly this will not be good news for everyone. Those who depend on imports—like retailers selling imported clothing—lose. Those on Wall Street who have bet on a strong dollar (and put their money in dollar bonds, say, relative to euro bonds or yen bonds) suffer. The weaker dollar may contribute a little bit to inflation, as the price of imports increases. If the Fed suffers from inflation paranoia, it may respond by increasing interest rates.

Like any major economic change, there are winners and losers. One can’t always tell whether, on average, a particular change is good simply by measuring the volume of noise created by supporters and critics. Wall Street losers may be more voluble and visible than the many workers and main-street businesses that benefit.

But the current system is simply unsustainable no matter how many cries on Wall Street there are to the contrary. Countries will be more and more reluctant to lend to the United States at the favorable terms that they have in the past, while the disadvantages associated with global instability may be mounting. The United States cannot unilaterally declare the dollar the reserve currency. Others have to choose to accept the dollar in their reserves. America may not want to contemplate the possibility of losing its reserve-currency status, just as it’s trying to figure out how to finance a $9 trillion ten-year deficit. But it may have no choice. Overall, a move away from the dollar-reserve system is inevitable—and, contrary to conventional wisdom, it will benefit the United States.

IN SHORT, the dollar-reserve system is already fraying. The question is, what will happen next? Economists are not good at predicting timing—when will all of this happen? And things don’t always move smoothly. During the crisis, the dollar actually strengthened. With the U.S. government providing guarantees on money markets and other deposits—and a U.S. government guarantee having more credibility than that of many developing countries—money sought a safe haven. America, from where the crisis originated, seemed safer than those countries that were the innocent victims.

And the dollar may continue to be strong for some time because what is happening elsewhere could be worse: worries about inflation are also arising in other countries. There may be even less confidence in, say, Europe’s ability to manage its affairs, and if so, the dollar may strengthen further, not because of confidence in the United States, but because of a lack of confidence in other markets. No wonder that, with all these uncertainties, almost the only thing we can be certain of is that markets will be marked with volatility.

As we move (hopefully) toward a global reserve currency, there will be inevitable bumps in the transition along the way. There are, of course, alternatives to the SDRS approach. We may create a multiple-exchange-rate system, in which countries diversify their reserve holdings between the dollar, euro and yen. Over the long run, this system could be highly unstable, as in one period the euro will appear stronger, and funds will shift there, weakening the dollar and strengthening the euro. In another, just the opposite may happen.

Or we may begin to form regional reserve systems. They also manage and dole out reserves for a group of countries but on a smaller scale (along the lines of the Chiang Mai Initiative in Asia, which has been greatly expanded during the crisis). Latin America is discussing doing something similar. One of the ways of creating the global reserve system is through developing and then interlinking these regional efforts.

Whichever path we take, like it or not, we will be moving away from current arrangements, the dollar-reserve system. There are only two questions: will the movement away be orderly or disorderly, and will America play a part in shaping the new system that will emerge? I believe that the transition to the new system will be smoother and that both the United States and the world will benefit if we stop putting our heads in the sand and help create the worldwide reserve system that the globalization of financial markets requires. Keynes recognized the need for such a global reserve currency seventy-five years ago. At the Bretton Woods meeting of 1944, in a costly act of self-interest, the United States blocked the full implementation of Keynes’s scheme. This is an old idea whose time has finally come.

Joseph E. Stiglitz is University Professor at Columbia University. He served as chief economist of the World Bank from 1997 to 2000. Most recently he is the author, with Linda J. Bilmes of Harvard’s Kennedy School, of The Three Trillion Dollar War: The True Costs of the Iraq Conflict (W. W. Norton, 2008).

¹ Our wizards of Wall Street got it all wrong: they seemed unfazed when household debt mounted, pointing out that there was something to show for it, a house whose value well exceeded the debt. But they had helped engineer a bubble, and the true value of the assets was in fact less than what was owed. The result is the economic travails that we are now going through. At this point, many are upset as they see the government’s deficit soar—and they pay no attention to whether there are any assets corresponding to these liabilities.

² Wall Street deficit hawks went on vacation from September 15, 2008, to mid-2009, while the money was pouring into the banks. But as soon as it became clear that there was no more money for the banks, they went back to their usual stance.

³ It is also a way of handling the problem of excessive household indebtedness, and creditors certainly don’t like this prospect.

⁴ It didn’t see the bubble—even claiming there was no bubble. When the subprime bubble broke, the Fed claimed the problems were contained and limited. Just months before the calamitous events of fall 2008, it was claiming, privately and publicly, that we had turned the corner.

⁵ It is unlikely they will try to get around their fears of inflation by buying real assets like real estate or shares in companies. The losses that China experienced on its Blackstone investments (Beijing bought a $3 billion stake in the company) have provided a cautionary note. And will America take well to China buying key assets? It’s one thing to take a loser—like the Hummer—off our hands; it’s quite another to sell an asset like UNOCAL.

⁶ What ensures that it is true is more complicated. It can be adjustments in income or in exchange rates. When the exchange rate (the value of the dollar relative to the euro and other currencies) increases, we export more and import less. When our income increases, we import more.

Questions-Type your answers to the following questions.

1.Do you support the author's position on moving to a global reserve system? Why or why not?

2. According to the author, what are major contributors to inflation in the US?

3. According to the author, how are we "shooting ourselves in the foot," when it comes to confidence in the US dollar?

4. What is the ironic outcome from building a global reserve system?

What is the Dollar Carry Trade?

2009-09-28T10:15:00.000-07:00

Sunday, September 20, 2009, Source: Shocked Investor

The US Dollar Carry-Trade is Financing Dangerous Global Currency Speculation

As readers here know, we are gravely concerned with the current chaos on world currencies and the collapse of the US Dollar. French newspaper Le Monde says the USD is now the "vedette" of speculators. With interest rates so low in the US, it is the chose mechanism, just like Japan's Yen was.The situation is scary for those invested in money markets are other such instruments considered "safe", as we have also mentioned many times.The USD was the currency that was used as the world's refuge and safehaven during the financial crisis, but is now used by carry-trade speculators. This consists of borrowing money in currencies where rates are lowest then investing this money into currencies that pay more. This raises a huge red flag with certain currencies. The emphasis is mine.Since late August, the U.S. interest rates fell below the rates of Japan and Switzerland. They are referring to the practical rates for banks. Speculators who, since the spring, had borrowed money in Yen and Swiss francs to invest it place in markets where rates were higher (such as the Australian dollar or the New Zealand dollar or, and this is my concern, the Brazilian Real - see my post on Brazilian inflows), are now using the USD dollar. The also invested in raw materials and commodities. To implement these "carry trade" strategies, they need to sell the borrowed dollars, thus the USD was under great pressure, and the currencies in which they were reinvested exploded. Le Monde adds: "Since March, the New Zealand dollar has risen 43% against the dollar." The central bank said that if the appreciation of its currency continues, it could jeopardize the country's economic recovery. "A warning should not be taken lightly, say economists at BNP Paribas. ( ...) It would not be surprising to see the central bank intervening in the event of further increases in the New Zealand dollar against the USD. The United States is a major trading partner of New Zealand, unlike Australia, which deals mainly with Japan and other Asian economies. Rates still low, and too lowSo far, the speculators have been unable to make the dollar fall sharply against the euro. While gold has now crossed the threshold of 1,000 dollars an ounce, the dollar has suddenly stalled, sending the Euro to its highest level since September 2008. Le Monde says that economists do not rule out seeing the Euro soon exceed $ 1.50. In fact, "a very big investor blocked for several days the market so that the dollar did not fall below the level of 1.4450 USD for 1 Euro. But this position did not resist, Tuesday, at the power of the dollar selling wave that followed the summit of G20 finance this weekend of September 4 and 5 September, and this has caused a panic, "said Sebastien Galy, currency strategist at BNP Paribas. The bankers have realized that the cost of borrrowing money will stay low for a long time and they could continue to speculate. Dissapointing econimic data might even encourage investors to take risks and make aggressive moves in emerging markets to the extent that there will be no quick exit from the fiscal and monetary policy expansionary in industrial countries, says the BNP Paribas. Thus the prudence of central banks could turn against them. If they leave rates low for too long, they may create bubbles.Following a monetary policy ultra-flexible conducted since 2001, the Bank of Japan long hesitated in 2006 before starting to normalize its monetary policy. They feared causing imbalances in light of the considerable sums that speculators had the time to borrow yen at very low rates in operations of Japanse carry trade. In March 2006, however, it decided to reduce the facilities it gave to banks. A year later, in February 2007, they began to raise interest rates.This is a very risky and unstable situation. Straddles are a favoured way to take advantage of this explosive and volatile conditions. We will be updating our post on USD straddles this week.

2009-09-18T07:16:00.000-07:00

Level 4-Should a Shrinking Dollar Worry You?, WSJ, by Jason ZweigSep 12, 2009

The dollar is falling. Is the sky falling, too?
As of this week, a dollar would buy only 0.68 euro, down from 0.80 in March and a peak of 1.21 in 2000. The greenback slid against other major currencies as well.

That may be a problem for investors. If most of your assets are in dollars but much of the goods and services you consume are priced in other currencies -- say you like imported cars or regularly vacation abroad -- your future spending needs have just gotten harder to fund.
Fortunately, it's not that hard to protect against further erosion in the dollar. And not all investors need to take action. Hedging would be vital, quips Campbell Harvey, an economist at Duke University who edits the Journal of Finance, "if your mortgage is denominated in euros." But if you make your money in the U.S. and spend it in the U.S., a falling dollar isn't the end of the world. Thus, the slide in the greenback need not prompt every investor into urgent action, but it is an ideal pretext for asking whether you are globally diversified.
Three cures are most commonly prescribed for investors worried about a weakening dollar: foreign currency, gold or a diversified basket of commodities.
Trading foreign currencies like Australian or Canadian dollars, both tied closely to commodity prices, sounds appealing. But foreign-exchange trading usually relies on high margin, or leverage, which is risky, and gains are taxed at hefty rates. So an individual investor has to be really right to rationalize doing it, says Mark Kritzman, who helps oversee more than $25 billion at Windham Capital Management in Cambridge, Mass.
As for gold and other commodities, they have provided an average return of around 20% in the four quarters following the worst drops in the value of the dollar, according to Michele Gambera, chief economist at Ibbotson Associates.
Surprisingly, these glittering returns look tarnished next to those of stocks and foreign bonds. On average, based on more than 20 years of returns, Mr. Gambera found that in the four quarters following the steepest declines in the dollar, U.S. stocks go up 25%, various baskets of international bonds gain between 21% and 28%, and non-U.S. stocks go up more than 56%.
So, with many commodities near record highs, there may be no need to join the stampede into gold or most other hard assets.
If the dollar keeps dropping, stocks and bonds priced in euros, yen, rubles or shekels will tend to become more valuable; anything denominated in foreign currency will then buy more dollars. That's why, for U.S.-based investors, international stocks and bonds tend to outperform commodities when the buck falls. Global diversification thus provides an automatic buffer against a dollar drop, unless the fund managers have hedged the holdings back into U.S. currency.
By the same token, big American companies that earn much of their revenues outside the U.S. may do better as the dollar drops; kronor and rupees will then convert into a greater number of greenbacks, putting more profit in U.S. shareholders' pockets.
But raising your overseas holdings can make sense even if the dollar stops falling. U.S. stocks represent less than half of the total value of equities world-wide, and yet American investors keep more than 70% of their stockholdings here at home. Although roughly two-thirds of the world's debt is outside the U.S., American investors have less than 4% of their fixed-income portfolios in foreign bonds.
For many years, I've kept half of my stockholdings outside the U.S. The more convinced you are that the dollar will fall, the more you should hold in international stocks, ideally through a low-cost index fund that doesn't hedge currencies. Even if your view on the dollar turns out to be wrong, you will end up with a better diversified portfolio.
I don't have any foreign bond funds myself; I was turned off long ago by their risk and illiquidity. But choices are better today. If you are especially worried about Uncle Sam, consider T. Rowe Price International Bond or, if you can avoid the sales charge by going through a discount broker, the Class D shares of Pimco Foreign Bond (Unhedged). SPDR Barclays Capital International Treasury Bond, an exchange-traded fund, is another good choice, but only if you can find a discount broker that won't charge commissions to reinvest your interest income.
Over the course of time, currency fluctuations tend to wash out. And even a long-term decline in the dollar might not be disastrous; since 1950, South Africa has had one of the world's weakest currencies, but one of the best-performing stock markets. The dollar is falling, but the sky isn't.

QUESTIONS: 1. (Introductory) By how much percentage did the U.S. dollar fall against the euro since its peak in 2000?2. (Advanced) What options are available to investors to protect them against a weakening dollar?3. (Advanced) How do big American companies with overseas earnings benefit from a falling U.S. dollar?4. (Introductory) Does a weak U.S. necessarily imply it is a bad for U.S. stock markets over the long period of time? Why?

Movement versus Shift

2009-09-10T07:37:00.001-07:00

Why is it important to understand the difference between movement along the curve and a shift of the curve?

Decision makers want to know whether there is a structural versus an ephemeral change in their market. For example, an investor would not sell their entire portfolio if the price of their stock fell or rose during any random day. Now they might sell or buy if something structural was changing such as legislation that would tax profits.

Watershed Moment

2009-04-28T09:00:00.000-07:00

The stock market has hit a watershed moment. The market is looking for direction and it looks like it will be down for a while. The news on mark to market helped boost the market from 6500 on the Dow to 8000. Now the market will have to stand on its own two feet for a while and that should make it tough to move higher in the near term. News on unemployment, retail sales, and industrial production will continue to drive the market down.

Why will layoffs continue?

2009-02-03T06:38:00.000-08:00

Layoffs will continue because the economy is in the process of reaching a new equilibrium based off of spending that is commensurate with income. Over the last several years, spending was greater than income due to the easy money from credit cards and home equity loans. Today the business models still reflect this old economy, and over the next twelve months, businesses will cut production to realign with the new reduced spending economy.

The first task businesses will focus on will be reducing inventory. This process of lowering inventory will lead to job losses. In addition to the job cuts from the inventory process, another wave of job cuts will occur due to the realignment of spending with income. The consumer makes up close to 70% of overall GDP, and thus, the economy will be weak for all of 2009. The fiscal stimulus plan should show positive effects later in 2009, but not enough to make up for the weak consumer. In addition to the weak consumer, the other components of GDP, investment and net exports, are still weakening. For all these reasons, the job market will be weak and job loss is inevitable.

Where is the money flowing to?

2009-01-25T21:21:00.000-08:00

Commodities and Foreign Currency-

Last week was pretty abnormal with the bond and stock market moving in the same direction. Normally bonds and stocks move inversely because when people are excited investors move into stocks and sell off their bonds and when investors get scared they sell their stocks and get into bonds. Oil and gold did better last week and its strength may explain where the smart money is flowing to. To bolster this commodity story, China is expected to start its fiscal stimulus spending in March and this should add fuel to the rally.

Conversely, a cloud still hangs over this bull commodity argument because the dollar is strengthening. A stronger dollar normally mutes the ascent of commodity prices. The dollar should show strength as long as the European countries continue to struggle economically. England had to bail out one of its largest banks last week and Moody's downgraded the debt of Spain and Greece.

Mortgage Rates-

Mortgage rates rose last week due in part to the rise in the 10 year treasury. I still believe mortgage rate interest rates haven't seen their bottom. The Fed will do whatever it takes to keep these markets liquid even if it has to buy 10 year treasuries.

What will the Fed do next now that rates are at zero?

2008-12-28T14:37:00.000-08:00

The Fed has been attempting to resuscitate the deflationary housing market through traditional monetary tools, but recently it ran out of ammunition when Federal Funds rate dropped to zero. The traditional methods of manipulating money supply have been exhausted-open marrket operations, the discount rate, and reserve requirement. These conventional tools are aimed at affecting the short term rates with the hopes that the longer term rates will also adjust accordingly. The hopes never materialized and this left the 30 year fixed mortgage rates stubbornly high relative to the three month t-bill.

The Fed then moved to an unconventional monetary tool called quantitative easing. Quantitative easing is the attempt to loosen the credit markets by purchasing bank assets that are priced at the long end of the yield curve such as mortgage backed securities. The only precedence for this technique in modern history was Japan. They used quantitative easing to help prevent deflation after their overnight interbank lending rates dropped to zero during the 1990’s and early 21st century.

The Fed’s unconventional technique has worked in helping lower the mortgage rates. Recently, the 30 year fixed mortgage rate tested a 37 year low of 5.19%. The Fed has committed $100 billion and spent $15 billion thus far to purchase MBSs from Fannie and Freddie in the hopes of loosening up the mortage markets to spur borrowing again. While the traditional monetary tools have proved ineffective, the Fed has targeted a different means of fulfilling its dual mandate of growth and price level, quantitative easing.

Why did Oil and CRB Index Rise and Fall?

2008-12-24T07:45:00.000-08:00

Remember this summer when it seemed like gas prices were on this perpetual escalator of rising prices? Goldman Sachs was reporting that oil prices were headed to $200. T. Boone Pickens was reporting that oil below $100 was far from likely. In hindsight, they were wrong and very wrong. Oil rose to $145 a barrel in late June and gasoline rose to $4. 75 per gallon. As quickly as oil and gasoline rose they fell even harder.Today, oil trades at close to $39 per barrel and gas is less than $1.80 per gallon.

The following paper will examine when commodities will bottom. To understand the bottom, the road to $145 per barrel will be constructed and then deconstructed. The oil bubble began with sound fundamental principles; in this case, it was the growth of the emerging markets namely China and a weakening U.S. dollar.

China was in the midst of preparing to show off their country to the world for the 2008 Summer Olympics. The event would highlight the years of growth and productivity, which helped contribute to the rising commodity prices. As the European economies strengthened and the U.S. was struggling with a housing related recession, the U.S. dollar lost close to 30% versus the Euro. The weak dollar played a major role in the ascent of oil.It was no coincidence that while oil reached all time highs that the U.S. dollar reached all time lows to the Euro. Unbridled enthusiasm started settling into the oil market in late May early June. Commodities were one of the only asset classes that was still growing, and major hedge funds began massively trading them. The hedge funds brought leveraging into play and generated the main catalyst for oil moving from $75 to $145 in the span of a couple of months.

The inputs that constructed the massive run-up in commodities are the same inputs that have deconstructed the commodity complex. Decoupling, the Euro, and leveraging have all taken a breather for now. Did the astronomical prices drive commodity producers to expand and overproduce? This is the fundamental question that needs to be answered first before the industry is safe to reenter. One metric that an investor may want to examine to determine demand and supply stability is the inventory level of commodity producers. A lazier way to figure out a reentry point is an appreciating Euro and a falling dollar.

The commodities market will bottom toward the first half of 2009. Currently many commodity producers are cutting back on production to prevent overproduction. Archelor Mittal the world’s largest steel producer is slashing production by 35% for the rest of this year. Likewise OPEC has announced production cuts for next year. With these production cutbacks coupled with the fiscal and monetary stimulus, the commodity complex should be ready for a rebound in late 2009.

Gyrations of the U.S. Dollar

2008-12-24T07:21:00.000-08:00

The dollar has continued to maintain strength relative to many foreign currencies since the collapse of U.S. financial institutions. During the summer of 2008, the dollar was trading at close to $1.60 to the Euro and now, on November 24, it trades at close to $1.25 to the Euro.
The rapid ascent of the dollar caught many traders off guard. The cascading fall of major U.S. financial institutions such as Fannie (FNM), Freddie (FRE), Lehman (LEHMQ.PK), and AIG (AIG) was the catalyst that ignited the dollar rally. Panic permeated the economic climate, prompting many financial institutions and main street businesses to question the soundness of the global banking system. Panic stricken investors pulled their money out of their risk infested banks and found calmer waters by anchoring their money in U.S. treasury bonds. With so many foreign investors purchasing U.S. treasuries, the demand for dollars grew to the point we are at today, $1.25 to the Euro.

The strength of the dollar is the result of panic and what is called an event risk. When the event risk subsides and normalcy returns to global markets, the dollar will revert to the secular bear pattern of the past two years. There is little fundamental reason for the dollar to maintain the strength through this event risk. The dollar should be in worse shape after the event risk than before it due to the massive deficit spending and the expansion of our federal debt.

Moreover, this crisis comes at an inopportune time, when our country will be facing larger and larger structural deficits due to the Medicare and associated retirement costs of the Baby Boomers. I would expect normalcy to start returning in 2009. probably around the early spring.
A catalyst to drop the dollar value might come from the recent announcement that China will spend $586 billion dollars to stimulate their slowing economy, which will most likely cause them to sell U.S. treasuries. This action should put downward pressure on the dollar.

Government Bail-Out culture leads to a Sleep-Walking Economy

2008-12-24T07:06:00.000-08:00

Sleep-walking Economy

Our economy will suffer from a sleep-walking type of an economy in the next several years. Everyone is afraid to wake up the sleep-walker, but the faster we can make him up, the sooner we get back to business as usual. Our government needs to allow the free markets to do more of the heavy lifting. Instead the government is becoming the world’s largest hedge fund. Recently John Deere, American Express, GE, and many other blue chip corporations have gotten the U.S. government to back up their debt, and as a result, taxpayers are on the hook for billions of dollars if the economy worsens and these companies default.

The government is backing the debt because corporations are finding it extremely onerous to borrow money. In many instances corporate debt is yielding record highs, and as a result, borrowing costs have doubled and tripled. The higher cost of borrowing for corporations effectively shuts down capital expenditure projects by either delaying them or cancelling them completely. The impact on the economy is reduced employment and GDP growth.

Reduced employment and falling GDP are part of the free market business cycle. They are signals to the economy that it has overshot in one direction. Unfortunately, the law of demand and supply is being temporarily suspended through the FED’s and Treasury’s actions. The natural forces of the market are signaling that corporate projects should be suspended due to possible oversupply.

Right now the government is creating a price floor which is preventing the migration of prices down to equilibrium. Prices need to fall to restore aggregate demand again. Moreover, the expectations of additional money becoming available to businesses and investors from the government are also creating an artificial floor above equilibrium. The longer the government gets in the way of the free market the longer we will be in a sleep-walking sort of an economy. Everyone is afraid to wake up the sleepwalker, but the alternative is an anemic and aimless economy which will last indefinitely.