Brad Setser

Brad Setser: Follow the Money

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Turning on a Paradigm

by Mark Dow

This post is by Mark Dow

Very few things rouse the rabble as much as an ideological debate. And over the past year it has been looking like we are having the beginnings of a nasty one in economics and finance. The current economic and financial crisis has shaken a few trees and made many go back and question first principles. Often, the answer is that the prevailing received economic and financial wisdom has fallen woefully short.

That said, those who are looking for a debate here may be disappointed. A narrow ideological debate is not the can I wanted to open up. Instead, I thought it would be useful to review from an historical perspective how we got here, and then address why this should matter.

For me, making the transition from economist to trader raised a lot of issues about efficient markets and animal spirits. It underscored the shortcomings of formal training and our incomplete understanding of the human element in finance and economics. As a result, the issue of paradigm shift has been simmering on my backburner for quite some time now.

One of the most important lessons I have learned as a trader is not just that emotions play an outsized role in market dynamics—that much became clear quite quickly—but that the emotions regularly swing, as if they were a pendulum, from one local extreme to the opposite. In other words, around any given trend there are oscillations above and below, moments of high bullishness and high bearishness. Time and time again we transition from moments when any positive statement is met with skepticism to moments when no one dares say anything negative. In short, we slowly change directions, see that the new direction starts to work and jump on, take the new direction too far so that it stops working, and then we start the whole process all over again.

These pendular swings in the market can take anywhere from a couple of weeks to numerous months, and they are marked by a distinct, three part psychological process: denial, migration, capitulation. In the first phase, participants deny that a change in market character is truly afoot. Markets rally on bad news (or sell off on good news) and traders look for others to blame for their trading losses (suggestion: when in doubt blame government; no one will ever disagree.) Then, little by little, traders begin to recognize ‘what is working’, start to question their previous beliefs, and then begin migrating from their old camp to the new. In the last phase, capitulation (or give-up phase), the final holdouts switch camps and jump on the new bandwagon—often in climatic fashion. This then completes the pendular swing.

This manifestation of human nature is not confined to intermediate term swings in the market. It also applies to ideological fashions in economics. At the time of the Great Depression the prevailing ideology was the Austrian Business Cycle School, a variant of the classical school of economics. (This school of thought was responsible for the useful term “creative destruction”). As the Depression took hold, the policy response was to allow the system to purge itself of its excesses. In retrospect, the mainstream view is that this policy response—or lack thereof—severely exacerbated the length and depth of the downturn.

Economists of every stripe have their own pet reasons as to what caused the Great Depression and what got us out of it. Leaving this debate aside, it is not controversial to say that Keynesian polices were perceived to have helped lift the US out of the Depression.

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May TIC Data: Still Buying US Assets But Just the Liquid Ones

by rziemba

This is Rachel Ziemba. Brad will I think be back soon but I figured I’d get in one last post going into some excessive details on the Treasury International Capital (TIC) data.

These days, the TIC data released monthly by the US Treasury and detailing the capital flows to and from the U.S. often seems anti-climactic given sharp moves in the fx and treasuries market. Despite the lag, data released yesterday and detailing May purchases tells a few interesting stories.

Most importantly, it illustrates the fact, that in the face of capital inflows to overheating emerging market economies in May, the central banks of these countries kept buying U.S. dollar assets. Q2 has been the first quarter of significant reserve accumulation of the last year. Preliminary estimates we’ve done at RGE Monitor suggest that reserve accumulation was around $180 billion in the quarter (adjusted for valuation), the first significant increase since mid 2008. As in 2008, China accounts for the bulk of the accumulation.

Despite supra-national reserve currency rhetoric given the reluctance for currency appreciation, there was little choice to buy dollars. China added $38 billion in U.S. short and long-term treasuries – a net increase of $26 billion in U.S. short and long-term assets. The discrepancy can be explained by China’s reduction in its USD deposits and continued reduction in agency bonds.

However, they shunned the long-term assets. The major foreign buyers of US assets went back to the short-end of the curve, buying T-bills and adding other short term claims. Total purchases of T-bills by foreign official investors were $53.1 billion.

This move could help explain why long-term treasury yields rose in May. With concerns about the U.S. fiscal position, worries expressed by major U.S. creditors about the dollar’s value, perhaps the move to the short-end of the curve is little surprise. It also suggests that the U.S. government is again becoming more reliant on bills financing as it was towards the end of 2008. This may not be sustainable in the longer-term.

While the decrease in the US current account deficit means that the U.S. may be less reliant on foreign finance in 2009, the U.S. has become even more reliant on China as a share of its foreign finance. China has been the largest reported holder of U.S. treasuries for some months now. But as of May China now accounts for 20% of total outstanding foreign holdings and almost equals the combined holdings of Russia and Japan.

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Nothing brings out buyers like higher prices, and other short stories

by Mark Dow

This post is by Mark Dow

DXY, a dollar index, looks like it has started to break down. At my firm, Pharo, we have been whispering on the trading desk over the last two days that this was looking increasingly likely. The implications are positive for risky assets. Markets play a lot of tricks on investors, and you can’t be too certain of anything in times as unprecedented as these, but, to us, it looks like the short dollar trade is “on”.

DXY, last 12 months

Is there a fundamental reason for this? Not clear. However, I am pretty confident that if the dollar continues to sell off the way it has started to overnight and this morning, and Treasuries continue to weaken the way they have started to, the stories of debasing the currency and Chinese diversification and the like will bob right back up to the surface. So, there will at least be a fundamental ‘story’ behind it.

Personally, I always find it hard to put too much faith in these predominately bearish dollar stories when risky assets are doing well. And, almost inevitably, risky assets do well when the dollar sells off. The correlation between the dollar and risky assets continues to be very high. Here is a correlation matrix of some proxies, using daily observations over the past year.


In the first row and column of the table you’ll see DXY, the dollar index comprising a handful of G10 currencies. The other rows represent various and sundry risky assets—mostly EM currencies, the S&P, and EEM, the ETF for emerging market equities. CCN+ is the 12 month forward for the Chinese Rinminbi, since the forward moves much more in response to market impulses than does the spot rate, which, as all of you know, is tightly managed.

For the dollar to be negatively correlated to risky assets, DXY should be positively correlated the CCN+, negatively related to SPX, AUD (since the Australian dollar is quoted in terms of dollars per Aussie dollar), and EEM. DXY should be positively correlated to TRY (Turkish Lira), BRL (Brazilian Real), and JPY (Japanese Yen).

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Chinese Reserves: Boiling Over Again?

by rziemba

This Rachel Ziemba, filling in for Brad Setser. I’m having technical upload issues so will add charts later but for now some thoughts on reserves

Chinese reserves data released today seem to be one more sign that the Chinese stimulus might be working a bit too well. China’s reserves stood at $2.13 trillion up from $1.95 trillion at the end of March 2009. Although reserve accumulation was likely lower than the headline $178 billion, it implies that hot money is back in China. Adjusting for valuation, Chinese reserve growth was likely about $140 billion, much higher $60-70 billion of China’s trade surplus, FDI and interest income in this period. This accumulation also suggests that China continues to have a hard time diversifying its holdings away from the U.S. dollar.

Adjusting for valuation – the changes in value of the non-dollar holdings in China’s reserves — would imply reserve growth of around $135-140 billion. This accumulation rivals that of Q2 and Q3 2008 for the highest quarterly level.

It is one indicator that suggests that parts of China’s economy may be overheating as China tries all measures to stoke growth. It seems well in line with almost 40% y/y urban fixed investment in May 2009, and loan growth equivalent to 25% of 2008 GDP. However, it just underscores some of the difficulties in both stoking growth and avoiding future distortions.

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Will the Chinese Keep Saving?

by rziemba

This is Rachel Ziemba of RGE Monitor where this post also appears.

In a recent post, Jeffrey Frankel asks will the U.S. Keep Saving? noting that despite the recent increase in the U.S. savings rate, the demographics of the U.S. (as well as those of Japan and Europe) will contribute to a reduction in savings. He argues that despite the fact that wealth losses will boost savings rates, the dis-saving of the retired population will keep the savings rate relatively low, if higher than the pitiful rates of recent years.

The companion question, whether the Chinese will keep saving is equally of importance. Whether the Chinese stimulus is able to boost private consumption ahead will be critical to global and Chinese demand. So far Chinese consumption has held up and even grown slightly from a weak base –as illustrated by retail and auto sales. Yet one reason that the Chinese economic reacceleration is fragile is because it is uncertain where the new production in China’s factories will be consumed. Chinese domestic demand still seems weak and overpowered by some structural incentives to save.

In the near term U.S. savings rates, which reached 6.9% in May, seem destined to keep climbing as U.S. consumers retrench. This could contribute to slower growth in the so-called export-led economies which had grown reliant on exporting demand.

One outcome of the financial crisis has been a narrowing of global economic imbalances, as illustrated by the reduction in the Chinese trade surplus and a reduction in the corresponding deficits of countries like the U.S.. The combination of a sharp fall in consumption across the globe and withdrawal of credit, partly accounted for swift reductions in some countries. I wrote last week about the narrowing of the surplus of oil-exporters. All in all, surpluses and deficits might be smaller given the reduction in credit available even as the increase in government borrowing leads to higher long-term interest rates. This narrowing is likely despite the fact that reserve accumulation seems to have restarted in Q2. Setting aside China which will report reserves data at some point over the next day or so and adjusting for valuation, reserve growth was about $40 billion in the quarter of 2009. While this is much smaller than in the heyday of 2007, it is the first quarter of positive reserve growth since Q3 2008. Yet, there are some signs that we will not return to the earlier pace.

The U.S. current account deficit has been narrowing for some time and has fallen from 6.6% of GDP at the end of 2005 to 3.7% at the end of 2008 and the IMF estimates that it will fall further to 2.8% of GDP over the course of 2009. With U.S. consumers buying less (the savings rate rose to 6.9% in May 2009), Chinese producers need to find new markets.

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Beat Down

by Mark Dow

I have a couple of themes on which I wanted to post, but they will most likely have to wait for later. The market, in the words of the E*Trade commercial, is issuing me a bit of a beat down today, and I have to focus on a little risk management. C’est la vie….

Weekly Federal Reserve balance sheet update

by Mark Dow

This post is by Mark Dow

This just hit my inbox, from the research team at Barclays. Since we’ve talked a fair amount of late about the Fed balance sheet, I thought I’d pass it on.

“Weekly Federal Reserve balance sheet update

Usage of the various Federal Reserve liquidity programs continues to erode as outstanding loan amounts mature and are not replaced with new borrowing. The overall size of the central bank’s balance sheet is now 9% smaller than it was at the start of the year.”

Chinese Handcuffs? No, Chinese trade deficit

by Mark Dow

This is Mark Dow. Brad is away.

China has become the obsession that Japan was back in the 80s. And rightly so. It is a huge place, with a robust secular growth force underlying it (remember the conditional convergence growth hypothesis?). Rumors of China doing this or that have become a daily staple of the market.

Lately, the discussion has focused a lot on their willingness to continue to buy US treasuries. I know Brad does a lot of good work on this issue in this space. Much less attention, it seems to me, has been placed on their need to buy more Treasuries.

It has long been my contention that the large global imbalances were mostly a function of risk appetite and financial innovation leading to an explosion of the money multipliers all over the world—especially in countries with a greater degree of financial sophistication and/or capital account openness (I almost said promiscuity).

Here in the US, we were the leaders. It had less to do with Greenspan, less to do with Congress, Fannie Mae, and Freddie Mac, and more to do with the private sector taking excessive financial risk. After all, it was a global phenomenon. Over the course of history this tends to happen any time there is a period of macroeconomic stability coupled with the observation that others around us are making money. People tend to pile on and take things too far. It is in our very nature. (I would recommend Akerlof and Shiller’s “Animal Spirits”, or Kindleberger’s “Manias, Panics, and Crashes” for anyone interested in these behavioral phenomena).

In this case, it led to a huge trade imbalance with China. Credit allowed us to consume beyond our means, and demand spilled out over our borders into China. The Chinese obliged and became huge holders of Treasuries. While it is true that the Chinese exchange rate regime was an amplifier of this story, I think it was more of a passenger than a driver. The driver was credit.

Today the credit bubble is popping (whence my view on inflation and the money multiplier). At the same time the Chinese are trying to prop up aggregate demand by controlling the only thing they can: domestic demand. This to me means the imbalances are in the process of going away. In fact, I have long said (and have made a few bets with friends) that the Chinese trade balance will likely be in deficit by the end of this year. This means that the need for China to buy our treasuries will have largely gone away. I realize this may be too aggressive a contention over this time frame, but I am convinced the basic story is right. And to my mind’s eye there isn’t an exchange rate regime or Renminbi level that can stop this from happening.

On Monday I posted a chart of the US trade balance, and we saw in it the dramatic swing that took hold as soon as the credit bubble popped. Overnight, the Chinese trade balance figures came out. Have a look at the chart below. Read more »

GCC Sovereigns: A Little Better off

by rziemba

this post is by Rachel Ziemba

Thanks again to Brad for letting me fill in while he’s on vacation. Sorry I’m late catching up with you all but I’ll try to chime in on some of the key releases especially on China in the next week. But let me start out with something from the world of oil wealth.

Timothy Geithner, the U.S. Treasury Secretary, travels to the GCC (Saudi Arabia and the UAE) in a few days to commune with some of the more significant creditors of the U.S. and possibly urge these savings-rich countries to contribute to the IMF, as several emerging market economies have pledged. As a result it seems an apt time to re-estimate how much these governments and their neighbors in Qatar and Kuwait have accumulated.

While the Gulf’s holdings of U.S. assets pale in comparison to China’s, the GCC possesses the largest trove of US stocks among foreign governments. With most of its assets managed by the central bank, Saudi Arabia likely holds the most US treasury bonds. The other GCC countries, most of whom entrusted their oil windfall (and gas in Qatar’s case) to an array of investment funds, tend to have a more diversified portfolio. However, the U.S. dollar still dominates the Gulf’s foreign asset position.

With the rise in the price of oil in Q2, some analysts have again been talking again about the global role of sovereign funds. While some, such as the China Investment Corporation (CIC), for one, seem to have become more active investors again, armed with new advisers, the Gulf funds still seem to be homeward looking for now. The latest –and forthcoming – RGE Monitor Global Outlook suggests that growth in the GCC will be flat in real terms, with a slight contraction possible in 2009. The significant assets of the region have allowed GCC countries to steer their economies to a softer, if still, harsh landing. Much of the region’s output, investment and sentiment remain linked to oil despite various attempts to diversify its economy. Steffen Hertog has a nice new piece on the lessons learned from the 80s by Arab oil producers.

Many GCC sovereign funds have boosted their holdings in domestic banks, domestic equity markets other savings been drawn on to meet fiscal deficits. Meanwhile, some of the few identifiable foreign investments in H1 2009 were made by hybrid funds like the UAE’s Mubadala, which tend to invest in sectors that could help domestic economic development or in sectors they already dominate (such as oil and petrochemicals).

The foreign assets of GCC central banks and sovereign funds are estimated to have fallen to just over $1.1 trillion at the end of June 2009 from about $1.2 trillion at the end of 2008. This estimate draws on a methodology Brad and I created last year, which estimates the inflows to the funds, and assumes similar performance to benchmark indices for each asset class. This estimate though, is somewhat lower than some other prevailing estimates. Recently released analysis by McKinsey Global Institutes suggests that Sovereign investors of the GCC, one of their ‘new power brokers’ managed closer to $2 trillion at the end of 2008.

The national breakdown suggests that Saudi Arabia accounts for over $400 billion of the assets (including the non-reserve assets of the Saudi Arabian monetary Agency and the foreign assets it manages for other parts of the government). The UAE, accounts for the next largest amount, around $350 billion, not including Mubadala and some Dubai funds. Kuwait’s fund managed just under $240 billion and Qatar, over $60 billion. The remainder is managed by the central banks of the region.
The slightly more fiscally-conservative (and richer) countries with more oil reserves per capita, like Abu Dhabi and Kuwait, or gas reserves (Qatar) and their more risk-tolerant funds should have seen the value of their assets reflate along with risky assets. Despite the increase in the oil price, the correction at the end of June 2009, limited the paper gains.image003

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The lunch may be free, but how much is it worth?

by Mark Dow

This is Mark Dow. Brad is still away.

Diversification is the only free lunch in investing. But the way many investment managers sing its praises, one can’t help but wonder if its value is overstated (much the way all portfolio managers are programed to say in interviews that “it’s a stock picker’s market”, no matter what the underlying market conditions). Here’s a graph below that speaks a thousand words.

Brazilian Real vs Turkish Lira, over the past year

This is a chart of the Brazialian Real (BRL, in white) vs. the Turkish Lira (TRY, red), over the last year. They have been nomalized to facilitate comparison. Brazil is well known as a commodity exporter, and Turkey as a commodity importer (oil is a huge component of Turkey’s import bill). Keep in mind that over this same period, the front contract on West Texas crude oil fell from USD 136 per barrel to today’s price of 60, and other commodities–both soft and hard–fell by similar amounts.

You will note the one period of divergence in the performance of these two fundamentally distinct countries came in December of last year. This is due to the unwinding of TARKO (Target Knock-Out) contracts that were sold to Brazilian companies ostensibly as pre-hedging vehicles for future dollar export proceeds. However, once they started “working”, these contracts proliferated and quickly became vehicles for specualtion, often by companies that lacked the necessary sophistication in complex derivatives. And had it not been for the coordination of the hedging of these contracts by the Brazilian Central Bank, the December divergence would have been greater. Once this demand for dollars cleared, however, BRL returned to correlate very closely to TRY.

This notwithstanding, the overall similarity of performance over the period would, I think, come as a surprise to most people–given the fundamental backdrop. I know it took the veteran traders I work with by surprise. And while it is true that all correlations “go to one” when markets are under stress, one would still expect to have seen a greater degree of differentiation over the period shown.

A lot of it has to do with fund flows. Funds flows tend to be trendy, with investors getting into and out of strategies–such as emerging market currencies–roughly at the same time. This makes it tough for investors who do their homework and are counting on markets to be rational and efficient. It also makes risk management at least as important as the investment theses themselves.

Once the fund flows come in, the stories that justify the investment follow. Turkey was a great example. Investors at first expressed reluctance to buy TRY with oil going up through USD 100 per bbl. But the story soon followed that made it okay. Strategists and traders started whispering “with oil at these levels there will be large investment outflows from oil producing states, many of which are Muslim. Muslims will feel more comfortable investing their windfalls in other Muslim states, from which Turkey will be a main beneficiary. This will be good for the country and lead to appreciation of TRY”. And thus it was so. An investment thesis was born. Later, after markets crashed and oil had fallen to $40 per bbl., TRY started appreciating again. The story then reverted to the old one we all know and love: lower oil is good for Turkey and for TRY. The Muslim investment thesis had disappeared. In short, when prices go up, a good story will follow.

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