The Capital Wire

Every now and then, China’s gradual transformation from a state-based to market-based economy hits a bump – as was the case when the government reshuffled the bosses of three big state-owned, publicly traded, telecom companies which include: China Telecom, China Mobile and China Unicom.

China’s growing prominence as a global economic heavyweight has, to a degree, masked the reality that its economy still functions under the umbrella of state control.

--UK

WHAT EXACTLY ARE THEY DISCOUNTING?

The U.S Treasury market continues to puzzle many. In spite of a feverish equity market, data and rhetoric indicating that foreign central bank purchases are diminishing, recent firm inflation numbers (CPI and PPI), and a strong employment number (although unsubstantiated), the bond market (most notably the long-bond) continues to catch a bid.

Brad Delong:
"I don't, however, understand the bond market. Do they expect the wage share to stay this low forever, and corporate profits are retained earnings to be abundant? Do they expect the capital inflow to continue forever? Do they expect the Bush administration to get serious about balancing the budget? None of these seem plausible as expectations, as modal scenarios, as central cases. But then why isn't the long bond market already pricing the supply-and-demand for loanable funds imbalance that seems inevitable in medium-run equilibrium? It's a mystery.

Perhaps it's as simple as this: in the 23 years since 1981, Ten-Year Treasury positions have yielded capital gains in 17 out of the 23 years averaging more than six percent per year. Those who are by nature likely to be short the long bond have presumably lost heavily over the past quarter century, and are no longer a significant part of the market. We may have selected for a group of long-bond traders and speculators who are powerfully overoptimistic, because optimism has been powerfully rewarded over the past quarter century. "

My own inadequately informed view sees the bond market discounting the possibility of deflation. Sound unreasonable? It was as recent as the fall of 2002 that the Fed cited deflation as a quantifiable possibility. In response, the liquidity spigot opened in the form of cheaper money that lent to epic credit extension to reflate the deflatables. With the underlying hope that this reflation campaign would encourage real price inflation, it instead inadvertently fostered bubbly asset price appreciation by persuading market participants to exhibit an unrelenting preference to take on risk and to leverage their bets accordingly. Just look at the S&P 500 which trades at 21x earnings, real estate/GSE portfolio growth, and the commodity binge to get an idea of the bubbly proportions.

Historically expensive asset markets coupled with heavy public/private debt feed into deflationary pathologies in the event of an exogenous shock (hedge fund default, currency run, higher oil prices, geopolitical crisis, etc.) – or in the simple event that a major market player decides to unwind a large position. A crescendo effect takes hold. This is something I believe many portfolio analytics teams are factoring in as a growing influence on their risk assessment.

Of course I could be proven wrong as the bond market starts to price in inflation, future growth, dollar depreciation, etc. by pushing prices lower and yields higher. But doesn’t this lend to the deflationary theme as well? After all, a high interest burden is murder to an overly-levered economy. After a while, a certain inevitability starts to set in.

--UK

RIDING THE DOLLAR WAVE

The dollar’s relentless decline is fast becoming a one-way ticket to ride. The question is whether this is something the Fed secretly endorses. Chairman Greenspan’s latest warning shot was not a diatribe on the detriments of a falling currency (especially to a debtor nation), but a swift jab directed toward the fiscal authority’s fiscal liberalism. In his mind, if our gaping current account deficit cannot be arrested internally (for instance, due to an irresponsible or non-cooperative fiscal authority), and that a dollar decline in this regard is an inevitable part of the venting process, then why not willfully go along for the ride?

A falling currency indeed carries benefits for a debtor nation, as it erodes the real value of outstanding debt. Either default or inflate it away (the later being by far the easiest to swallow short-term). The enormous debt load is something that has concerned Fed officials for a while, as it is in essence deflationary.

Of course a falling dollar is inflationary. Meaning the Fed will have to keep raising rates longer than they would like – perhaps resulting in more bankruptcies. This is part of the give and take the Fed is forced to participate in. In this regard, 2005 Fed policy would be guided more by secular motivations than by cyclical developments. If the Fed were to follow this script, look for them keep raising rates beyond what the bond market will price in.

On a more technical point, the dollar is approaching critical support at the 80.00 level. Barring any state intervention (which is a long shot), a clear breach of this level would most definitely accelerate the move.

Courtesy of SchaefferResearch:

--UK

CRUDE TKO?

Does crude oil’s recent price decline represent significant deterioration and therefore an intermediate term top or a basic pullback before a resumption of its uptrend? Price data of the four major oil indices support the later.

Throughout crude’s intermediate term run, the price relationship between the CBOE Oil Index (OIX), AMEX Oil Index (XOI), AMEX Oil Service HOLDERS (OIH), Phlx Euro Style Oil Services Index (OSX), and the futures market has been fairly tight – with a sharp move in the indices preceding any significant price move in the futures contract. Today, the XOI pierced its 52-wk high (all-time high) with the remaining indices not far behind. Meanwhile, the Jan 05 contract in the futures market fell $0.44, closing $6.66 off its 52-wk high. This price divergence cannot last indefinitely. A clear break above these current cash levels should help crude futures challenge yearly highs - and as a consequence,  place pressure on equities.

DEFICITS - IT'S ALL IN HOW YOU LOOK AT IT

Brad DeLong quotes Dan Gillmor on the sliding dollar:

"The international financial markets have voted since Bush's re-election, and the verdict is thumbs down. The dollar is weaker than ever, and could start dropping like a stone if America doesn't get its fiscal acts together."

So get your fiscal act together! That makes sense for those that actually view our deficits as a problem – or at least a pressing issue. For some, “deficits don’t matter”, as VP Cheney once intoned. So, is our historically high deficit (on an absolute basis) a pressing issue? It all boils down to how you view the composition of our debt – more specifically, the proportion of borrowing to finance current consumption vs. the proportion to fund future investment. It is simply naïve to believe that the deficit consists fully of one or the other. Opponents view the majority of the deficit as a one-time stimulatory caffeine boost, while proponents view it as an investment with generous future return on investment.

To quote from Michael Boskin in a recent SIEPR Policy Brief:

“For the upcoming 2005 fiscal year, the deficit projected in the President’s budget is roughly $350 billion, 2.8% of GDP. Current inflation estimates and the interest and maturity structure of the $4 trillion of publicly held debt imply a decline by about $75 billion in real value. So the first $75 billion of the deficit is not a real deficit at all. Another $135 billion is President Bush’s real homeland security and military buildups. Other federally financed investment outlays net of depreciation are roughly $70 billion. Thus, netting gets us to a deficit of $75 billion or so, a few tenths of a percent of GDP...Of course, one could argue that the investments, including the military investments, are not worth it, that their dollar value greatly exaggerates the benefits the investment is leaving to future generations along with any debt, but that is the basis on which the argument ought to occur.”

This really is the basis on which the argument should occur. Components such as military buildups and tax cuts cannot be confidently classified as a form of current consumption or investment. Who’s right? Who knows? Although we can look to the collective wisdom of the financial markets for guidance. Unfortunately, there’s no conviction either way. The dollar tanks while the bond market catches a bid. Interesting times to say the least.

--UK

APPLAUDING JOHN SNOW

Treasury Sec. John Snow deserves applause for his defiance during and after a speech given in London. Snow defied continuing pressure by foreign officials urging the U.S to stem the dollar’s recent slide by reiterating our “strong dollar policy” (see my Nov. 12 post) and later, in O’Neil-like prose, restating the belief that capital markets should dictate policy. “The history of efforts to impose non-market valuations on currencies is at best unrewarding and checkered.”

His statements accomplished three things: it carried on the long-standing default response of U.S currency policy (the commitment to a “strong dollar policy”), reemphasized our faith in the efficiency of capital markets, and in case of a future need to tweak current U.S currency policy, set these prospective changes on U.S terms.

Government intervention in financial markets should be used as a tool of last resort. The dollar trading at 104.44 yen is no reason for a call to arms.

The Capital Spectator has excellent coverage on Snow’s remarks.

WALL STREET AND THE BLOGOSPHERE

Trader Mike has in interesting post on the prospect of institutional investors employing RSS and advanced search technology to comb through the blogosphere for relevant data needed to make better investment decisions.

Here's a  Nov. 11th post by Fred Wilson of A VC mentioning the changing role of traditional Wall Street research with the advent of blogs. 

Is it possible that Wall Street is finally appreciating the value in the powerful decentralization of information and ideas inherent in blogs?

On a side note, I'm still pitching RSS (refer to my Nov. 13 post).

-UK

FANNIE FINALLY COMES CLEAN

Fannie Mae warns of a possible $9 billion loss resulting from improper accounting for derivative positions. This doesn’t come much of a surprise. The parabolic growth rate in the mortgage industry over the years has resulted in gargantuan GSE portfolios, whose complexity has rendered them largely unanalyzable. Analyzing Fannie’s derivative positions is largely an act of futility – something which even management has trouble analyzing.

In the past, Fannie has been resolute in its defense of their accounting methods - something Chief Exec. Franklin Raines referred to as "a matter of interpreting complex rules" rather than a question of accounting improprieties. They caved today:

"Fannie Mae also acknowledged that some of its accounting policies do not comply with generally accepted accounting principles, apparently contradicting recent public statements by top executives who have defended the company's accounting.

In its filing Monday, the company said it 'recently determined that its methodology for performing' some calculations for 2001 and 2002 balance sheets 'was not consistent' with generally accepted accounting principles. It said it expects the effect of the discrepancies will be an increase in earnings for 2001 and 2002, and a decrease in 2003 profits, 'with the cumulative effect of these changes across the three periods netting to zero.'"

--UK

FOREIGN CENTRAL BANK ABSENCE

Steve Clemons on whether Chinese/Japanese central bank absence at a Sept. 9 routine Treasury auction portends a global power play:

“...Their mutual absence at the auction may have been a signal to the Treasury Department and George Bush that there will be huge costs to the U.S. economy whether it sides with Japan or, alternatively, with China.

I believe that a missed auction, during these times, is not minor and is probably a signal to the White House that America needs to recognize the subtle leverage that Japanese and Chinese capital holds over the great American empire.

Japan and China wouldn't take this too far because they want Americans to keep buying their myriad products, and to do that, these countries need to keep us addicted to the narcotic of current account deficit financing.”

The motive for their absence was probably less insidious and more a question of sound capital management. The hundreds of billions in holdings of U.S notes and bonds simply looked too risky. To limit large capital losses (which, to a certain extent, they’re willing to put up with in order to put hundreds of millions of people to work), diversification out of dollar assets was/is needed. The prospect that foreign central bank dollar holdings (namely China) become a toolkit for political persuasion rests more on geopolitical rather than economic issues.

Anatole Kaletsky, GaveKal Ad Hoc Comment, Sept 9th: (sorry, no direct link)

"...China will continue to buy dollars and US Treasury bonds rather than accept a revaluation of the Renminbi. The Chinese still see the fixed exchange rate as a source of economic stability and they do not regard the euro or the yen as a serious reserve currency alternative. Deep down, they also consider their US bond holdings as a source of potential leverage in the event of a geopolitical crisis, especially over Taiwan. Potential currency losses on these reserve holdings are simply not an issue.

When we asked a senior Communist Party official who was representing the Chinese government at the Ambrosetti forum how his country benefited from buying US bonds, the initial answer was downright paranoid: ‘It is absolutely not true that we want to use our bonds holdings to pressurize or blackmail the US government. Geopolitical factors play no part in our financial decisions.’ When Anatole pointed out that he had never suggested any such political motives, but simply wanted to know what economic benefits the Chinese people expected from their US bond holdings, the answer was even more instructive:

‘Why don't you ask the Japanese? I think they are buying even more US bonds than we are.’”

--UK

TOO MUCH SUPPORT FOR BUSH?

The viability of President Bush's deficit reduction plan rests on two crucial factors: the strength of the economic backdrop (level of tax revenue), and the level of spending growth. Of the two, the latter is at least controllable. Obviously, a curtailment of spending growth is needed for deficit reduction. With the Republican party controlling both houses of Congress, Bush's proposal to cut federal spending should encounter little to no opposition. Right?

Not so says Robert Reich of Prospect:

"In their heart of hearts, presidents don't like it when their own party controls both houses of Congress. It's the same whether the new President is a Republican or a Democrat. Why? Because when your own party runs Congress, you've got to help them pay off all the IOUs they've accumulated along the campaign trail from all their constituents and patrons and sponsors. You don't have the excuse that you can't help with the payoffs because the other party runs one or both houses of Congress. No, it's entirely your party. You’re stuck with the bill for it."

This reverse logic holds true...

"Why could Clinton hold down spending and special-interest tax loopholes when Bush couldn't? Because for most of the Clinton years, Republicans and Democrats in Congress couldn't agree on much of anything. That meant Clinton could veto or threaten to veto even bills containing pet projects of leading Democrats by blaming Republicans for larding up the bills with too many favors.

...He (President Bush) doesn't stand a chance of reducing it. Every one of those newly-elected Republicans in the House and most in the Senate are carrying around huge IOUs from the election. And all those IOUs require more special tax breaks, more subsidies, more spending. It's enough to make a president downright depressed."

--UK