Eliminating Volatility from Inflation Measures

The FT covers statement's by the BoE's chief economist, Charles Bean, that the U.S. should not strip out food and energy from the inflation measure used to set policy:

The US Federal Reserve is wrong to focus on core measures of inflation that exclude energy prices, Charles Bean, chief economist at the Bank of England, has suggested. It should focus instead on headline inflation, which is much higher, he argued. Including energy and food costs, US consumer price inflation is running at an annual rate of 4.1 per cent, against 2.7 per cent for core inflation.

Mr Bean told the Fed's annual Jackson Hole symposium at the weekend that energy prices were rising for the same reason the price of many manufactured goods were falling: the rise of China and other emerging market economies. Since both price trends had a common cause, he said it makes little sense to focus "on measures of core inflation that strip out energy prices while not stripping out falling goods prices as well."

This debate gets brought up a lot by inflation hawks but I like his reasoning about China being the driver on both fronts. Also I was struck by the idea that while the U.S. eliminates food and energy from the top line to reduce volatility in the data, U.S. overnight rates have been quite volatile.

I guess this stuff is neither here nor there since the data including food and energy is still available and the bond market approves of the FOMC's view by keeping the inflation outlook low.

Renminbi: Less Currency Basket More Dollar Peg

From Bloomberg:

China's central bank said today it will allow the yuan to strengthen by as much as 3 percent from a daily fixed rate against the euro, from 1.5 percent previously. It kept the range against the dollar unchanged. The 12-nation currency is also being hurt by expectations the interest-rate advantage of U.S. government debt over European bonds will widen.

Macroblog has more on the news but Brad Setser had something a few weeks back that telegraphed this pretty well. To me this news means China is not giving up on the dollar peg anytime soon. More important than my interpretation is what the U.S. congress makes of it. A lot on their plates now but protectionism was certainly more popular before China announced its currency basket. Probably bad for stocks if that sentiment returns.

UK Property Derivatives Market

From the FT:

Major players in the financial services industry are to partake in a trading game in property derivatives starting next month in a drive to accelerate the development of the market in the UK.

The initiative, which is being spearheaded by Hermes, the investment fund, is intended to give investors, property companies and investment banks the chance to gain practical experience in trading derivatives in a realistic environment – but on a virtual basis. The exercise is also aimed at gauging the level of potential demand.

Derivatives are financial instruments that effectively allow investors to bet on the direction of a particular market. A property derivative would give investors and companies exposure to the sector without having to own bricks and mortar. Buying derivatives is also often quicker and easier than physical property transactions.

Now that is interesting. I have believed for a very long time that with the massive amounts of wealth tied up in real estate and the normal concentration of risk by geography that a derivatives market was overdue in the sector. I am not familiar with the particulars of the contracts but it will be interesting to see how increased derivatives trading will impact the underlying market.

The Refinery Side of the Equation

From the FT:

Assessing the impact of the storm that closed refineries in the US's most important oil producing region, Europe's second largest oil group said it expected production in the region to reach only 60 per cent of the pre-hurricane levels by the end of the year.

It added that refineries at some sites including Mars, one of the gulf's largest deep water platforms capable of producing 220,000 barrels a day, were unlikely to resume activities this year.

The region, which produced an average 450,000 barrels of oil equivalent per day or about 15 per cent of group production in the first half of the year, is now only producing 160,00 boe/d following the damage caused by the storms.

This is the flipside of the story from last night.

Update: I may have confused some details and I kind of wonder if the author of the story did as well. Despite all the references to refineries and refining capacity near the top, the story closes with this:

In addition, Shell said a third of its refining capacity in the US had been knocked out by Hurricane Katrina. Before the storm Shell refined a million barrels of oil a day at its seven refineries in the US. Two of these sites - Motiva Convent and Motiva Norco had been affected but were expected to return to pre-hurricane levels by the middle of next week.

At this point I am guessing this last section is the only portion dealing with refining and that the deep water platform, Mars, is mistakenly referred to as a refinery.

Watching Oil vs. Gasoline Spread

From the FT:

The US and Europe are releasing more emergency crude oil than refineries in the Gulf of Mexico can handle, reinforcing suspicions that governments are using the crisis triggered by Hurricane Katrina to cap record oil prices.
Data from US oil inventories released on Thursday showed that crude oil stocks had fallen by 6.45m barrels, well below the 13.6m barrels of oil production that by Wednesday had been lost as a result of the hurricane.

This has been pretty well telegraphed with most people being very aware that the hurricane had a bigger impact on refining capacity than oil production. Prior to the hurricane refineries were already being talked about as a bottleneck.

It could still make an interesting situation though as a trader could have been very right and foreseen an inflation spike but still end up being positioned exactly wrong as oil (which has been leading the commodity charge) goes the other way. I don't know the commodity market as well as the credit market but the situation is a bit similar to the wishbone in the automotive sector when the credit downgrade came on the heels of Kerkorian's GM tender.

I haven't been blogging much lately as my views haven't changed very much since early Summer. The continued strength in the equity markets has been at odds with the problems I see so I have done very little. Prior to Katrina I thought the housing market was finally losing steam and leaving little cause for inflation. That is no longer the case as the refining and general transport issues caused by the storm are unknowable at this point.

Got to be one of the more interesting Fed meetings approaching. I lean towards a hike at this meeting.

Currency Story Continued

From Reuters:

MORE TO COME?
The Singapore dollar, widely used with the yen to bet on a yuan move, shot higher to a two-month high of 1.6503 per U.S. dollar, up 2 percent on the day compared with 1.6843 on Wednesday, before dealers reported the intervention.
Singapore said it will maintain its policy of gradual and modest strengthening of the Singapre dollar and said fundamentals of the city-state's economy had not changed.
Hong Kong said it would not consider changing its currency peg to the dollar even if the yuan keep appreciating and said the Hong Kong dollar will remain very stable.
The Indian rupee rose to a six-year peak against the dollar around 43.20, up more than half a percent.
"The move is clearly positive for Asian currencies first, and to some extent the euro. It is pretty clear that the basket will involve a reasonable chunk of Asian currencies," said Emanuele Ravano, European strategist at PIMCO in London.
The Korean won's non-deliverable forward prices, used by offshore investors to trade the won, showed investors are factoring in a 2.2 percent rise in the won/dollar rate in one-month's time.
...

Following the yen's rise of more than two percent, Japan's top financial diplomat Hiroshi Watanabe said he is watching the market carefully and would take action if needed.
Japan has been urging China to reform the rigid FX regime but it had repeatedly said the yuan revaluation doesn't mean a higher yen and it has hinted it would intervene if necessar

Update 2:51 PM: This quote from Nouriel Roubini sums up what I am watching for:

And this could really be the beginning of the end of the Bretton Woods 2 regime of fixed pegs to the U.S. dollar in Asia. Malaysia already decided today to drop its peg relative to the U.S. dollar. This China move may also force Hong Kong to phase out its long term currency board and U.S. dollar peg. And other Asian currencies will soon sharply appreciate, following the yen's lead today. Even currencies at the periphery of this Bretton Woods regime (such as those in Latin America) may sharply appreciate. The systemic consequences of this currency realignment throughout Asia and the world could be radical and have significant impacts on U.S. long-term interest rates, on U.S. financial markets and on the U.S housing bubble.

Asian Currency Revaluations

China and Malaysia both moved their currency pegs last night. The move in the Renminbi was 2% which is smaller than the 5-10% most analysts had been mentioning but the impact could be quite large if other countries follow suit.

From the FT:

The effect of China’s move was expected to spread to other Asian currencies as other countries in the region were set to decouple their currencies from similar pegs to the dollar to make them more competitive.
Shortly after China’s announcement, Malaysia said it would alter its peg and allow the ringgit to fluctuate freely and Singapore, whose currency is tied to a trade-weighted basket of currencies, was also due to make an announcement.

Makes me wonder if the story won't continue to unravel for the next couple of weeks as other government reaffirm or change policy. That is a different story than the smaller than expected Chinese move in the headlines and it is what I will be watching for.

Snow Knows when China will Revalue

From the FT:

The Bush administration has told key senators that it expects China to revalue its currency in August ahead of a planned visit to Washington by President Hu Jintao in September, according to people familiar with the matter.
Senators Charles Schumer and Lindsey Graham, co-sponsors of a bill that would impose a 27.5 per cent tariff on Chinese imports, agreed to delay a vote on their bill after receiving what they regarded as an assurance that China will move on its currency next month.
In a June meeting attended by Alan Greenspan, Federal Reserve chairman, John Snow, Treasury secretary, told the senators that he believed China would allow the value of the renminbi to increase against the dollar in August, the people familiar with the discussion said.

Though I agree with the timing I am surprised they would tell Snow and surprised it would leak. The yen is trading 112.15 so I guess the market is yawning it off. Not sure that will continue.

The dollar seems like it is in a prime spot for a reversal (DXY is sitting below some long-term resistance in the 90-92 range). Also this fits with the current interest rate environment as the Fed has primed traders for more rate hikes while the yield curve threatens to invert. Seems like a bit of a disconnect between the carry traders in currencies and the "conundrumless" bond market.

London Bombings and the Markets

I don't think the markets have ever seen a 15 pt gap in the S&P index with an 11 handle on the VIX. That will probably lead to a gap in volatility prices when option markets open. The heads on CNBC are reminding people of the fast recovery the markets had after 9/11 and the Madrid bombings but the 11 VIX makes today completely different. There is a much higher risk that the vol increases from such a low level will lead to a very deep and sharp pullback that accelerates over the next few days.

More Peer-to-Peer Dreaming

From Marketwatch:

A Forrester Research Inc. analyst thinks Google's plan to facilitate payments on the Internet may go much further than helping people sell stuff at virtual yard sales.

Charlene Li wrote on her Web log that since Google Inc.'s AdSense service already puts links on Web pages, why not add micropayment processing?

"Google (GOOG: news, chart, profile) could offer a subscription 'pass' that grants users access to premium content on multiple sites, with each site getting a share of the payment based on usage," she wrote. Such an idea for bundled Web subscriptions was suggested several weeks ago by Martin Nisenholtz, senior vice president for Digital Operations at The New York Times.

The Forrester (FORR: news, chart, profile) principal analyst reasons that with millions of producers of Web logs and podcasts wondering how to make some money, Google's payment services venture might be a solution.

In remarks Tuesday, Google's CEO, Eric Schmidt, confirmed the company is working on payment services which are "a natural evolution of Google's existing online products and advertising programs," according to a report by the Los Angeles Times.

A service like this could provide serious competition for the current standard of "free" content paid for by advertising revenues. It is not clear to me how many people see this coming but I am guessing it is not too many yet.