Yuan Revaluation Effects

Ezra Marbach summarizes a NYT article that lays out some possible effects of a renminbi revaluation.

GM Aftershocks

From the FT($$):

Many funds are believed to have bought GM bonds, which had fallen sharply in March following a profits warning, in the belief that the debt was oversold. Simultaneously, bets were placed short-selling the company's shares.

But last Wednesday, the stock leapt 18 per cent on news of billionaire Kirk Kerkorian's tender offer for shares in the struggling carmaker. On Thursday, Standard & Poor's caught the market off guard by finally downgrading the company to junk, pushing GM bonds sharply lower.

I did not think about this effect but it could be very powerful in the short-term. The risk is similar to the liquidity risk when LTCM went under. In the long-run either your bonds will pay off or the stock goes to zero but margin calls and marking-to-market are very real risks to levered players. Making it to see the long-term is the challenge.

It would need some pretty big knock-on effects into other issues to cause a real problem. Otherwise other funds who were uninvolved would be jumping into the bond stock spread or at least shorting GM stock against the $31 level.

Even easier for F with no looming bid.

*Update 4:00 PM - I having been looking at Merrill Lynch (MER) the last couple of nights and thinking it looked an aweful lot stronger than some other big financials (like Citigroup (C)). Since MER is involved in the GM bid I had kind of an "aha" moment thinking they would be prepositioned to pick up the pieces on a move like today. MER , however, is not holding up so well today so I guess I will just file my thought away for later.

Healthy 3-year Auction

From Reuters:

Treasury debt prices kept a grip on early gains on Tuesday as an auction of new U.S. government debt drew respectable demand, which may bode well for the rest of the week's $51 billion refunding.

The sale of $22 billion in three-year Treasury notes went at a high yield of 3.821 percent. It drew bids for 2.38 times the amount on offer, well above the 2.00 average of previous sales and the highest since the three-year was relaunched in May, 2003.

Indirect bidders, including customers of primary dealers and foreign central banks, picked up $8.66 billion, or 39 percent, of the issue. That was down slightly from February's 44 percent share, but in line with the average of 38 percent and a relief to traders worried that foreign demand could fall sharply. Primary dealers took $12.67 billion of the sale.

Still more auctions to come but this should be reassuring after last week's bond turbulence. I am a bit surprised the market has gotten over the strong jobs report so quickly. More strong data could cause a lot of pain.

Oil Futures Trade Contango

From the FT:

The crude oil futures market has produced plenty of hot news in the past 18 months. However, one of the more recent - and striking - developments has been the widening gap between nearby prices and the longer-dated prices, which has encouraged US refiners to buy oil and store it in the hope of selling it for a higher price later in the year.

This price pattern, known as "contango" - the industry term for when future delivery prices are higher than more immediate transactions - has reversed the normal price behaviour of crude futures markets. Usually nearby prices trade higher than longer-dated deliverable prices because oil markets have seen tight balance between supply and demand, which in turn pushes up nearby prices.
...
"Investors will have to hope that oil prices will have to rise strongly in absolute terms for them to hold on to their investments, because if the price were to remain flat and the steep contango persists, the losses will continue and their overall returns from crude futures will reduce," said Mr Lewis.

A while back I mentioned the spot market's focus on projected future shortages rather than current inventory levels. The market has now worked that out.

Tea Leaves

Looking through the charts today. The strength in housing looks impressive. Toll Brothers (TOL) is one of few charts that is still in position to challenge the March highs. It is especially impressive given that the bonds turned lower on the jobs report. I guess the market likes the construction jobs in spite of the higher rates. Same story in Fluor (FLR).

I also see strength in the Asian ETFs (EWY, EWS), semiconductors (INTC, SMH) and some of the retailers (SMRT, ANN).

Oil stocks look alright but other commodities sectors are still struggling near lows.

I am taking a wait an see approach to the charts. I would expect this rally to lead to some nice shorts in a bit but if home builders can break new highs it might postpone the markets demise by months.

Financial Risk Models

From the Mises Institute blog:

Although the mechanical philosophy is long dead and buried, our age is not without its own dogma regarding properly scientific explanations. Today, the prevailing belief is that any real science must be composed of mathematical models, models which yield quantitative predictions about some class of events based on particular, initial conditions, also specified numerically. Once again, the currently popular methodology has been imposed on diverse disciplines with little regard to whether it is suitable to their subject matter, but simply because it is thought to be the only respectable way to do science. The philosopher John Dupré calls this "scientific imperialism," meaning "the tendency for a successful scientific idea to be applied far beyond its original home, and generally with decreasing success the more its application is expanded" (2001, p. 16). Once again, we see a frantic effort to generate models fitting the accepted paradigm, with little regard for the realism of the assumptions and mechanisms from which they are constructed.

In my mind this relates prettly closely to this post from Brad Setser (be sure to read the comments which wade deeper into modelling and risk measurement). The basic problems in risk management seems to me that assets are assumed to have inherent properties like the physical bodies. Particles have mass, position and velocity while assets have price, varience, and correlation. I call it a basic problem because these aren't really the properties of the asset but are the properies of transactions.

Transactions necessarily have assets, counterparties, prices and times associated with them but assets need not be part of a transaction. A series of transactions in two identical assets need not have a realtionship at all if the counterparties have no contact. The existence of exchanges and the requirments of open-outcry and disclosure get around this basic problem, creating attachment between transactions but I am not sure this does much more than create the illusion that assets always have prices and those prices move in continuous fashion.

China's dilemma

This article provides some good food for thought about the timing of a yuan revaluation and the state of the Chinese economy. Some of the highlights.

Walker sees China hitting a wall, chiefly in the form of a labour shortage; not the much-publicised reluctance of inland Chinese recently to serve as factory fodder in the sweatshops of Guangdong, the industrial province bordering Hong Kong, but supply gaps in skilled workers and managers.
With about 1 million Taiwanese already employed on the mainland - about 10 per cent of the island's workforce and therefore probably close to the limit - newspapers in Hong Kong and South-East Asia are packed with ads for supervisory or technical jobs in China.

...

Nor was the diet of low-yield government paper doing much for profitability in the scandal-prone Chinese banks, whose non-performing loans Roubini and Setser put at somewhere between 46 and 56 per cent of China's GDP.
Also last week, the ratings agency Standard & Poor's said recapitalisation of two of the big four state banks - the Industrial and Commercial Bank of China, and the Agricultural Bank of China - would require injections of between $US110 billion and $US190 billion.

Indeed, the weak position of the Chinese banks and their huge requirements for capital are cited by Xie as one more reason against early revaluation. As well as adding to bad debts by raising domestic real estate and other prices in relative terms, a higher yuan would require more US dollar investment to achieve sound capital adequacy.
Although disposal of bad debts via asset management corporations is lagging badly, Chinese financial authorities are still hoping to bring two large banks - the China Construction Bank, whose assets are mainly infrastructure loans to governments, and the Bank of Communications, which already has a 19.9 per cent "strategic" holding by HSBC - to international share offerings in coming months.

A good general rule in economics is that flexibility and transparency lead to stability. Along those line I guess I can see why China's policies have left it with few good options.

Handy Bond Market Data

Brad Setser stuck in a comment that had me checking out bond data. I still have not found net long-term corporate issuance for 2004 but thought I would organize some of the resources I ran into.

Bond Market Association has a table of outstanding debt by sector from 1985-2004. Other BMA tables here.

Thomson Financial's capital market summary 4Q 2004 (U.S. total debt issuance by sector on page 13 shows long term issuance excluding MBS, ABS, and Munis down 2.5% from '03) and lots of other reports (mostly league tables) here .

The BMA also provides InvestingInBonds.com which is a good starting point for current bond prices and spreads. The corporate page will pop up the most active corporate issues and you can even watch a bond market ticker.

The U.S. treasure curve with swaps included is available at GovPx and there is a bond market outlook and news summary provided by Stone and McCarthy. You can also get economic headlines refreshed every 2 minutes if that is your pleasure.

NPR on Global FX Currency Traders

Five minute audio clip with the more interesting/entertaining stuff coming in the last 90 seconds. Quite a business model.

Summing Up the Week

We end the week weighing the auto downgrades and steepening yield curve (new 30-yr) against an unexpectedly positive jobs report and Kerkorian's bold bottom fishing maneuver in General Motors (GM).

On the auto downgrades it seems very likely that the bond market had already anticipated the downgrade. Its arrival shifts the focus off of the auto bonds and towards the wider bond market. I would not be surprised if GM and F bonds bottom here or shortly while junk spreads continue to widen. A best case would be junk widening while investment grade tightens but I would guess such a trend would be short lived. I am not really sure where Kerkorian's bid fits into this picture other than to muddy the waters. It is not clear what his motivations are and I am not sure that GM's equity is the best risk / reward trade in here.

I said any investment grade tightening might be short lived because the jobs report and new 30-yr created a lot of uncertainty in the long end of the yield curve. On Tuesday I thought the market would start to anticipate an end to the hiking cycle but this jobs report brings us back to considering 50 bp hikes. Easy to see why it was important for the Fed to reinsert a benign long-term inflation outlook. Anyway, the jobs report is just one data point and it needs confirmation in the rest of the data this month as well as next month's report. People were all about the "soft patch" at the beginning of the week so this report should cause a serious reexamination.

At some point between now and August the market will probably have serious doubts as to whether the 30-yr actually comes back. There are also supply constraints until the new bond is a sure thing so if the shorts get too heavy while it is only an idea that could set up quite a squeeze. A decision in August seems to put the new 30's issuance in Nov or Feb.

All this U.S. news has managed to crowd the yuan revaluation out of the news. Asian currencies are still trading strong though. Even though China does not want to reward speculators, the pressure internally are only going to get worse until they revalue. I thought they were coming to grips with that but maybe it takes another couple of months. They would need some help from Japan or Korea to scare the speculators at this point and I don't see much of a cause for that. The dollar also rallied nicely on the back of the jobs data but the theme to me is still European weakness. Gold and silver are focused on USD/EUR rather than JPY/USD. I am not sure why that is.