An interesting graphic from Bespoke Investment Group:

Bespoke G7


*Reference to the ‘Dollar Smile’ theory (explained by Macro Man, coined by Morgan Stanley):

One possible explanation is an emerging school of thought that a US recession/quasi-recession is actually good for the dollar. According to the proponents of this theory, weak/negative US growth is both damaging to the rest of the world and a catalyst to encourage US investors to bring money back home. The upshot is that there is less demand for foreign assets/currencies and more demand for US assets/currency; hence, the dollar rallies.

By gauging the sentiment of news flow in the past week, the answer to the question of continued strength in the Dollar would seem to be no. First, a little history:

The dollar picked up steam back in December once the thesis that the world economy could “decouple” from the woes of the US fell apart — it became clear that the BRIC economies are less equipped to deal with fallout from the credit crisis, and are more likely to default on their own debts. As stated above, this led investors to unwind their investments in emerging markets, and bring them back into US cash (a more liquid asset). Since stocks were tanking, coupled with the Federal Reserve’s  intent to suppress interest rates with its various liquidity programs (TARP, TALF), many investors sought safety and bought US bonds — to at least yield some sort of return while on the sidelines. Since March 9th (the recent bottom in equities), there has been a departure from risk aversion, and more investors have sought the same risk they did last summer in commodities and emerging markets.

here’s a chart of the MSCI Brazil index (a basket of stocks which is representative of Brazil’s economy):


Here’s how the 10-year note has performed in the same time:

10 Note

Yields have gone up (which means people are selling) while emerging markets are simultaneously attracting new capital. The dollar has also weakened – although slightly – which raises the question of a weaker dollar going forward with rising inflation expectations. Tony Crescenzi has stated that the dollar may slowly relinquish the status of being the world’s leading currency, as the dollar is now 63% of the world’s reserve assets (compared to 70% back in 2002). However when considering alternatives (particularly China) he says:

China’s renminbi is ascending but not suitable for parking the world’s reserve assets because there is no bond market there. Moreover, the renminbi is not yet widely used for commerce and in contracts.

Well, Tony may have spoken too soon.

From the Financial Times:

Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil’s central bank and aides to Luiz Inácio Lula da Silva, Brazil’s president.

An official at Brazil’s central bank stressed that talks were at an early stage. He also said that what was under discussion was not a currency swap of the kind China recently agreed with Argentina and which the US had agreed with several countries, including Brazil.

“Currency swaps are not necessarily trade related,” the official said. “The funds can be drawn down for any use. What we are talking about now is Brazil paying for Chinese goods with reals and China paying for Brazilian goods with renminbi.” (Emphasis Added)

FT Brazil Exports China 5-19

The scale of the agreement wouldn’t be enough to dramatically affect the FX markets, but it could if this idea appeals to other foreign countries. Brazil has discussed selling 10 and 30 year bonds in International markets this year, which would add to the currency’s liquidity…which satisfies another trait of a desirable currency.

As many of the world’s economies embrace foreign investment (Malaysia’s FX market is currently closed to outsiders, for example), and as our domestic economy releverages money from this period of zero interest, the dollar may wear a frown sooner than expected.

Naked Short Sales

This chart from the NYT adds credibility to the SEC’s wild-goose chase from last year:

naked-short-sellingIn case you forgot, there were many people who blamed naked short sales – or shorting a stock without borrowing the shares – for the precipitous decline in shares of financial institutions this past fall. As the graph shows, there have been fewer failed trades since the temporary ban on short sales. Here’s why naked shorting is so controversial:

Naked short-selling can save a trader the costs of borrowing shares, or can make it possible to short a stock where borrowing is very difficult because so many others want to sell it short. A large number of fails does not prove naked short-selling, since there are other reasons for trades to fail, but such a number does indicate it is likely.

It looks like the trading arena is on the road to recovery. There’s an ideology developing where the SEC should tax trades to depress volatility — which would probably put a lot of people out of work.

From Portfolio:

Such a tax could make the markets better. Financial markets raise capital for new enterprises. They help people exchange assets and information. But just because there is higher volume doesn’t mean these trades are expressing more views. Instead, all that is happening is that the bandwagon is speeding up. The faster it goes, the more people want to get on. Noise traders drive out the fundamental investors.

The full article brings up some good points.

Tim Geithner’s replacement, William Dudley, offered some interesting remarks on the effectiveness of TALF, the expansion of the FED’s balance sheet, and alternative methods of providing liquidity to banks. Above all, Dudley stresses that while deleveraging is inevitable in a credit crunch, it is imperative to facilitate the volatility which comes with it:

In the current crisis, the deleveraging process at times has been very violent and dangerous, with powerful reinforcing feedback loops intensifying the process. During these episodes, bystanders who did not engage in excess may be trampled and fail. This may exacerbate the tightening in financial conditions, intensifying the constraint on credit availability and the downward pressure on economic activity.

We saw that happen to Lehman Brothers…

I specifically like his analysis of how deleveraging occurs, and why it has been central in reinforcing our tight predicament – although it’s a term tossed around endlessly by the media, the effects of deleveraging are seldom explained:

For example, in March 2008, in the run-up to Bear Stearns’ demise, the deleveraging process intensified. Market volatility increased; this caused lenders to increase the haircuts they assessed against collateral to secure their lending. The higher haircuts, in turn, squeezed highly leveraged investors who were forced to sell assets. This drove down asset prices and increased price volatility further, leading to still-higher haircuts. This intensified the deleveraging process, which led to more mark-to-market losses.

“Haircuts” effect margin requirements and collateral levels, and ultimately have to do with the dealer’s profit margin; if the dealer demands a greater cushion to execute a trade, the burden is passed to the buyer (e.g. a hedge fund).

If interested, here’s the full transcript of NY Fed President Dudley’s speech.

Adding up the Bailout

From CNN Money:


I encourage you to follow the link, since there’s a nice interactive chart. According to CNN’s calculations, we’ve spent $2.6 trillion of the $10.5 trillion we’ve allocated to the bailout. This now dwarfs one of my earlier posts on the cumulative cost of the Iraq War.

Commercial Real Estate

Finally! This issue has been neglected by the media…to think it only took George Soros to speak up about it.

from Bloomberg:

Billionaire investor George Soros said U.S. commercial real estate will probably drop at least 30 percent in value, causing further strains on banks.

“Commercial real estate has not yet fallen in value,” Soros, 78, speaking at a forum in Washington, said. “It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent.”

Soros said the risk of further declines in property prices is reason for the administration of President Barack Obama to move quickly to recapitalize banks. Soros said Obama acted too slowly on a banking overhaul and should have moved immediately upon taking office.

3-Month Market Checkup

I just looked through my archives and discovered that I engage in some sort of market prognostication about every three months…The most recent one from January is a good place to pick up for this edition (if at all curious, here’s September and August).

US Treasury debt is an unreasonably low yielding investment, meaning this is where everyone is hiding from risk – which is a misconception, since the principal investment on a 10-year note is only protected by a 2.10% interest rate, meaning any indication of a sell off could drastically hurt a US debt holder. Should treasuries sell off, certain sectors within equities would be a logical home for this capital – the question is always when.

Well to answer this issue 3 months late, when could be now.

But first, some background on the FED’s role in buying treasuries.

The FED has been overreaching the bounds of their traditional policy tools i.e. setting interest rates through buying short-term government debt (1-3 month T-bills), and has entered the business of buying 5, 10, and even 30 year bonds in an effort to drive down the Mortgage Backed Securities pegged to government debt of longer maturities, which should lower the prices of adjustable rate mortgages and allow people to refinance a fixed mortgage.

Due to this agenda, the Federal Reserve has been a huge buyer at all of the recent treasury auctions (the same ones which finance our $1.5 trillion deficit), and have successfully suppressed bond yields…until today:

From Bloomberg:

Benchmark indexes turned negative at about 2 p.m. after an auction of $34 billion in five-year Treasury notes drew a larger-than-forecast yield of 1.849 percent, spurring concern that government attempts to lower interest rates won’t work.

Treasuries declined for a fifth day following the auction and the failure of a U.K. government debt sale. The last time the U.K. was unable to attract enough investors was in 2002.

This situation is paradoxical; on one hand, as I wrote in January, the disinterest in treasuries could be a indication that investors are beginning to trust equities again – a notion which is supported by the 1,200 point rally in the past 10 days.


On the other, we could have a situation where the free markets counter the aims of the FED by selling off treasuries – when buyers cease to exist, yields will go up, and so will rates on mortgages indirectly pegged to treasuries.

With that, here’s the rest of what I’ve been thinking:

Reasons to be Positive:

  • I think the Dow has temporarily bottomed at 6,500 – for different reasons than Doug Kass – because we will need to see if the effects of the recent government action actually work. More specifically, in order to drop below 6,500 we would need a scenario discernibly worse than a nationalization of our financial system, since that was what a DJIA of 6,500 was pricing in. Besides that, all of the logistics which traders look for are coming into favor: there’s heavier volume to the upside on up days, oil has rebounded (which suggests an antipication of increasing global demand), investor confidence is rising, and home prices/sales are looking more optimistic.

Reasons to be Negative:

  • Citi, BofA, and JP Morgan have all indicated that they were profitable for the first 2 months of 2009, but this was accomplished in a system with free money. What will happen to profitability when Bernanke inevitably raises rates?
  • Do I need to worry about the omnipotence of vacant stores, or is commercial real estate implicitly apart of the same set of issues we’ve been dealing with for the past 2 years?

I never thought I’d run out of negative things to say…I may add in some other points if nothing else interesting happens in the meantime.