Weekend Links

How many years has the economic crisis set back the most affected countries?

China's foreign exchange reserves move the Euro.

Is an engineering degree better than an MBA if you plan to start a company?

Marketing dollars vs. the time spent by consumers on different categories of media.

With more investors entering the market and less interest in homeownership, the US is seeing the number of homes rented increase.

Debt policy follow up

I recently wrote about the importance of the accumulated debt in the worlds current financial troubles and am heartened to learn some of the mainstream is not thinking that differently.

Martin Wolf both agrees that central banks need to pay more attention to aggregate leverage levels and that tax codes should remove incentives that encourage debt.  That these changes made his short list of 7 ways to fix the system is very encouraging.

Paul Krugman also points to the growth of debt as the primary reason the economy was unsound from 2003 to 2007.  Repeating this simple narrative will eventually lead to enacting the prescribed solutions.

Now that the failure of austerity is rapidly becoming apparent, I am hoping new policy measures will be aimed at the structural issues that led to debt build up while returning to the old standard practice (it became unfashionable in 2010 as I recall) of counter-cyclical monetary and fiscal policy.

The MF Global fallout and other links

• I am surprised the markets shrugged off the MF Global loss of client funds so easily.  I am hopeful that the end result will be tighter restrictions to prevent such losses in the future.  Until this happens though I would have thought risk premiums might need to widen generally or a least some other brokers might suffer as customers gravitated towards the strongest.

• A retrospective on housing market declines that looks at where Australia might be in that process.  Real estate still seems expensive in Australia and with China likely to be shoring up its economic growth this year, I don't think AUD interest rates will be adding price support to housing.

• A study that looked back at asset backed securities and their ratings histories found that the securities included in CDOs later experienced worse ratings downgrades.   The conclusion implied that CDO sponsors were exploiting some kind of information advantage to skew the results that the buyers experienced.  This was the case even when controlling for yield which is where I would normally expect default expectations to be priced.  The authors looked at the entire asset-backed universe but CDOs were concentrated in the housing and commercial real estate sector.  I may have missed where the ABS sector was controlled for but if it was not controlled for I could see how warped investor demand for housing CDOs led to warped housing prices and ultimately very poor performance of housing ABS without needing asymmetric information between CDO sponsors and buyers.  I don't know what really happened of course, but the explanation from the authors seems like an elaborate and difficult application of exceptionally good ex-ante judgement.  Such good judgement is both valuable and rare so it is best applied with simpler strategies and fewer moving parts to depend on.

• The Euro is getting whipped around by the vicissitudes of Greek restructuring talks and record short interest in the Euro.  It seems to me the Euro goes down when it appears Greece will stay in the Eurozone. Many news stories seem to be attributing the opposite affect and equating a solution that maintains the current membership as reason for a strong Euro.  Weakening makes more sense to me both with the growth through currency devaluation necessary to stabilise debt to GDP ratios and also the precedent set for the Euro if weak members leave.  (update 28/01/2012: A good example comment on the Euro - "A broadly weaker dollar is being sapped by the Fed’s dovish stance, which is lifting the euro and gold despite there being no resolution on Greece’s debt negotiations."  The Euro is up against the JPY and AUD)

• Apples earnings report was impressive but they might need a new slogan.

Debt and Occupy Wall Steet

I liked this essay's explanation of the zeitgeist behind the Occupy movements.

I think there is a simpler story though to be told about modern economic growth being driven primarily by increased private debt levels.  (Update: my view expressed here is heavily influenced by Steve Keen's writing.)  It is less malevolent than the corruption of politics by money explained by the linked essay and simpler to address.  

My story would be that constantly increasing debt levels of the past 3 decades created false demand that was unsustainable when the debt growth stopped.  The extra demand smoothed out the business cycle while the debt grew creating a self fulfilling "great moderation" of stable dependable economic growth that allowed and incentivising high debt levels.

High debt levels benefit asset owners by driving up prices and lenders by increasing interest payments which also explains the shifts in wealth distribution.  There was also a kicker to the wealth concentration at the end of the debt build up where "the 99%" were convinced to take on large debt loads to purchase houses which, as an un-productive asset, require either the owners salary or price appreciation to enable the interest payments.

Recognising the current imbalances as a debt problem would add "eliminating tax incentives for debt funding" and possibly   add "managing the aggregate debt level" to the responsibilities of the world's central banks.  

I don't think this is a difficult narrative for people to understand and I imagine most are aware of the increased presence of debt in their lives.  While discussion of the government debt level is a popular media topic and the level of education loans is starting to make headlines there is much less discussion of the overall private debt level making me think that the majority of people are still looking for a return to the good old days of steady debt growth.

Weekly summary: Stopped out of gold short

I stopped out on the way back up through 1250 today.  It tested down through its 20 day average on Wednesday but didn't stay below for long.  There is some chance the bounce back was expiry related but gold continued higher after the expiration.  Any trapped longs from Monday's breakout have surely been stopped or replaced by stronger hands by now negating one of the drivers for the trade.

The gold rally might get tested in the near-term with the Eurozone fright having past and China resuming currency liberalisation.  I expected a bit more risk seeking this week as markets moved past the fears of a few weeks back but the results were pretty muddled.

• Bonds are still pressing highs but momentum is ebbing.
• Gold is similar with early weakness giving way to a weekly close near highs.
• Equities are heavy but holding recent lows.  It is tough to gauge the impact of the US financial reform debate, with banks trading relatively heavy but wider market moves not reacting to the news flow on that topic.
• the Australian dollar and Canadian dollar should benefit a lot from stabilising macro news.  Both got dumped more on liquidity than fundamentals when the Euro made lows.  The movements this week support the story that stability is returning but only weakly with movements being a bit lacklustre.  Action in the AUD may be slightly muddled by the Australian leadership change but the big news on that front is probably yet to come as the mining tax negotiations get underway.  

On the Eurozone fright, I don't think I had given enough weight to the idea the Germany could abandon the Euro.  The smaller size of the PIGS, and particularly Greece, made me quickly assume that either Greek debt would be written down or Greece would leave the union.  How can anyone benefit from a currency union where the strong members are encouraged to leave?  Anyway, with the Euro keeping gains and moving up through the week my view may be becoming more mainstream.

On China, it seems like the world is still debating whether the announcement last weekend really means anything (or this).  China is in an odd spot of wanting to dip a toe in with gradual currency movements but knowing that once its intentions clear the market will front run the policy.  This makes timing difficult but ultimately it all appears to be heading toward a stronger yuan and stronger Chinese consumption.  This may uncover some domestic imbalances as it goes forward but near term this also points towards stability.

I also wonder if the traders aren't a bit too negative on the G20.  The view seems to be that either there is nothing to talk about or talks might degenerate into an ugly round of finger pointing.  I expect politicians will err on the side of vague positive statements and keeping disagreements out of the public eye.  Even acknowledging that the world can not return to the pre-2008 configuration of trade and capital flows might be viewed as above expectations.

Short gold on failed breakout and potential for Chinese yuan appreciation

I sold the August gold contract with a stop near today's peak.   There are a few reasons driving the trade

1) I don't think the movements in gold are widely understood.  I mentioned (on Twitter) Fred Wilson's article on why he thought gold was a poor investment.  Fred was looking at gold as an asset and points out that unlike many other assets its only source of return is price appreciation.  I think this misses the point that gold is more like a currency.  Jim Hamilton reaches a similar conclusion, offering that gold's movements might best be explained by government bond purchasers worrying about the value of the money they are repaid in.

2) The typical reserve currencies - the U.S. dollar, the Japanese yen, and the Euro - all have varying degrees of the same problem.  Their debt levels to GDP are historically high giving them incentive to devalue their currencies.  Typically investors would hedge this risk in other currencies that pay interest rather than gold but there is a worry of policy contagion and likely a need to diversify across many currency options (of which gold is one) to find liquidity with the biggest currencies looking dubious.

Now we are getting to why I would short gold, since the statements above are bullish.

3)  China is a large country with a vibrant economy and excess reserves. It is in some ways the opposite of the traditional reserve currencies with no risk of devaluation to meet debt obligations.  Devaluation risks in China stem from its desire to maintain a weak currency to promote exports.  That policy is probably growing less viable.  They addressed this problem in 2005-2008 by allowing the yuan to appreciate.  That policy of an appreciating yuan is likely to resume now.  The yuan pays interest so to the extent investor can utilise it for hedging purposes it is a better alternative than gold.  This should remove some of the hedging demand in gold.  The yuan revalue may go slowly and may not even go at all but as long as investor access grows, Chinese coupon receipts will win out over gold storage payments.  I expect more news on the Yuan over the next few weeks with the most likely thing being some movement in the daily mid-point. (Update: This has now happened while my this post sat in the editor.)

4) The technical picture and sentiment might make for a swift drop.  Gold's recent new highs, signs of increasing retail ownership, and the obviousness of the money-printing-fiscal-debacle discussed above likely have some leaning the wrong way and speculating on price appreciation rather than just hedging.  I expect the hedge flows are bigger and will dominate the price direction while speculators add to volatility and chase momentum both ways.  The COMEX futures are just above their 20 day exponential moving average as I type and a lower low will occur at 1216.  Either of these levels breaking might be enough to cause the momentum to swing bearish in a hurry.

So to summarise, I see the bullish case for gold but the pressure to use gold as a currency hedge should fall on this Yuan move.  Any further price drop might lead to a sharper and longer term fall as weak hands are shaken out and momentum traders change direction.

Weekend links: Australian commodity risks, Permabear update, Record GLD holdings, and the Canadian dollar recovers

A few quick links:

Australia's ability to service foreign debt more dependent on strong commodity prices  than housing.  (datadiary.com)

The permabears: where are they now? (Businessweek.com)

Gold holdings of the GLD exchange traded fund reached a record high. (Marketwatch.com)

The Canadian dollar is recovering better than other risk assets. (financialpost.com)

Enjoy the weekend!

An interesting summary of the May 6th flash crash

This is a very good insiders account of the market microstructure that led to the flash crash and snap rebound.  From an interview with Tradeworx CEO, Naraj Narang:

...So, the market was ripe for a catastrophic event, because it was so saturated with stop orders, all it needed was a catalyst. And the catalyst occurred, according to a couple of Reuters reporters, because a large mutual fund complex, decided to do a $4.5B hedging transaction in e-mini futures contracts, which track the S&P 500 index, when the market was already in that vulnerable state. 

Scott: Most of those were actually transacted on the way up. 

Manoj: Right, but the orders were entered prior to the huge collapse, and that’s the important part. On an ordinary day, an order of that size, and that’s a pretty substantially sized order, would definitely have had a ½% or 1% price impact. But on this day, when volatility was already elevated, and the market was just looking for a reason to take profits, it had an outsize effect, and very likely triggered the first wave of stops, which then turned into market orders, which then led to a gigantic spike in volume. What happened then, in relatively short order, was that the Arca exchange (which is owned by NYSE), fell behind, in terms of its ability to process quotes. Continue reading...

I found it somewhat stunning and slightly amusing that the events above led to a congressional investigation.  Despite all the hand wringing over the "flash crash" it is difficult to view it as more than a distraction for regulators.   These are my reasons:

• Its impacts were solely in the secondary market.  With every winner producing a loser, it is hard to see any market conspiracy to create such events.  The most obvious way this self-corrects is by increasing traders' preference for limit orders over market orders. 
• While liquidity gaps don't happen often in large liquid markets like the S&P futures, they should not take anyone by surprise.  The crash of 1987 is referenced above and is an obvious example.  Another more recent example is the gap that occurred in the Japanese Yen in the fall Autumn of 1998 (from 120 down to 112 without trading as I recall) when a large hedge fund asked for a bid to stop out. *
• The most pressing problem facing regulators is how to identify and react to market dislocations that accumulate over years. Housing prices, the dot.com boom, the Japanese property and equity bubbles in the 1980s...etc.  These market distortions don't focus attention on themselves the way a one day drop does but lead to excess debt and a mis-allocation of resources that reduce growth for years. 

*As an aside, it is interesting that the 1987 S&P crash, the Yen gap, and the 2010 flash crash were all driven by unusually large hedging orders.  When markets make sharp price moves, traders need to make a snap decision about whether the price move represents a signal or just noise.  Usual questions to ask are: 1) How much volume is in the move? 2) Is the seller likely to reverse direction in the near-term? and 3) How many other people are likely to do the same?  A massively out-sized hedging order from a large long-term player following a common strategy will always give the impression that the order is a signal.  In that instance,  men and the machines they build will reach the same conclusion and let prices gap.

Related articles 

• Monsters in the Market (theatlantic.com)
• Kansas Mutual Fund Identified as Trader in Market Plunge (nytimes.com)

Spanish credit curve beginning to invert

Alphaville points out that the Spanish Credit Default Swap (CDS) curve has joined the Greek and Portuguese curves in inverting.  They explain it as the market pricing in a higher likelihood of default in the early years of the curve.

My explanation would be that the market is expecting a restructuring.  Restructurings tend to haircut the payments due at all maturities by a similar amount.  Thinking in simple terms as if all the debt were zero coupon bullets, a 20% loss on principle expected to be repaid  a year from now is more painful than 20% lost on principle due back 10 years from now.

If investors are beginning to fudge their models to account for principle write-offs they will want to pay lower prices for the short-term debt.  Putting these lower prices back into a standard model that still assumes the full principle repayment will show a higher yield to maturity for the short dates.

In such situations it can be useful to compare the bonds on prices rather than yields.  It also makes sense to consider cash neutral hedges rather than duration weighted hedges.

More evidence that I am not alone in expecting a restructuring.  I should add though that the plunge in the Euro this week on news that Germany might not be carry out its part in the bailout points to continued belief that creditors will be protected at the expense of the currency.

Risk aversion ebbing as non-farm payroll approaches

Participants look set to continue adding back the risk jettisoned over the last few weeks.

It will be interesting to see how bonds respond today with non-farm payroll numbers typically bringing the volume that allows for big moves.  I would expect with momentum weakening in the recent rally and some talking of up to 700k jobs added in May that bonds end the day lower.

In commodities, it looks like oil is set to regain some of the ground it lost to gold recently.

Related articles

• Technical Analysis 101: Adam and Eve (globaltrader.blogspot.com)
• Employment Report Prediction: Bad Reporting! (calculatedriskblog.com)
• Thursday payrolla (ftalphaville.ft.com)