Stop Trying To Make BRICS Happen

BRICS was a brilliant bit of sell side marketing, but it has taken a life of its own. One needs to stop projecting fantasies onto the global financial system, and accept that its form follows function.

The extreme dominance of the share of global GDP after World War II by the United States was a historical accident, and so the relative rise of other economic powers was inevitable. Meanwhile, the eagerness of the United States to use sanctions as a foreign policy tool is going to create incentives to develop mechanisms to do an end run around those sanctions. Nevertheless, the geopolitical system is far more stable than is commonly described. (I will enter a geopolitical tangent later in this article to justify that claim.)

Reserve Currency Blues

The “Demise of the Dollar” is a long-running story in hard money circles, and has gotten a recent push by the growth of transactions in the Chinese yuan in international transactions. Although it seems likely that the yuan will grow in importance, this is largely a nothingburger from the perspective of the United States.

Emerging market investor Paul McNamara was recently interviewed by Tracy Alloway and Joe Weisenthal on this topic. His views are better thought out than mine, but I just want to chime in from the perspective of a developed market govvies analyst.

Currencies And Geopolitics

Zoltan Pozsar is back with his stories about “Bretton Woods III” and the petro-yuan. (The original report is presumably for bank clients, but I found this summary by ER Valasco.) Although developing countries trading with China might take these developments seriously, from the perspective of the developed economies, how third parties arrange their affairs has limited domestic impact.

Currency Swap Comments From The BIS

Claudio Borio, Robert McCauley, and Patrick McGuire solved the problem about what I will write about this week by publishing “Dollar debt in FX swaps and forwards: huge, missing and growing” as part of the Bank of International Settlements’ quarterly review (https://www.bis.org/publ/qtrpdf/r_qt2212h.htm). One can interpret the text as a plea for more data, which is reasonable enough. However, the lurid headlines and commentary that the article has attracted elsewhere is somewhat missing the point. I am not attempting to discuss that article in depth, rather offering my interpretation of the underlying issues.

Currency Regime Shift Effects Over-Rated

I have seen a fair amount of chatter about currency regime shifts. Although such an event may be happening, there is no particular reason to get too excited about it from the perspective of the developed countries.

The figure above shows foreign official holdings of Treasuries as a percentage of Federal Government Debt — using the Fed Flow of Funds (Z.15) report. We can see why there was a great deal of excitement about “China buying all the U.S. bonds!” going into the 2008 crisis, but we can also note that this series has moved around a lot over time (mainly the result of mercantilist policies of Asian countries). However, the downdraft in foreign reserve holdings over the past decade certainly did not result in a Treasury bear market.

Is MMT Only Applicable To The U.S.?

One common line of criticism relates to what is termed open economy considerations – can the foreign sector create constraints on fiscal policy that are not apparent in closed economy models? One simplistic variation of this is the argument that “MMT only applies to the United States,” that is, only a global hegemon that issues the reserve currency can afford to ignore the external sector.

(Note: this is an unedited excerpt from my MMT primer manuscript.)

The Currency Market Is A Market. Act Accordingly.

One recurrent line of discussion I have seen over the years are assertions or questions about currency values that follow this format: if some particular economic event happens, then the currency will rise (or fall). This seems to be the result of "all else equal" logic, but it is highly misleading. Foreign exchange markets are markets, and prices (exchange rates) should not be expected to follow simple rules. Otherwise, all foreign exchange traders would end up with above average profits, and we would have discovered a private sector magic money tree.

Why Cross-Currency Bond Yield Spreads Do Not Matter

I have been running into cross-market yield comparisons in the news flow in recent weeks. For example, the raw U.S. Treasury/German bund yield spread often comes up in valuation discussions.The simple rule of thumb is that one should never make such cross-currency yield comparisons; they only matter if the currency value is being pegged. Since I do not have a handy source for euro-denominated bond yields, I will use the Canada-U.S. comparison.

Bitcoin Valuation Part II(b): What Might Work

This article concludes my series on Bitcoin valuation techniques. There appear to be three broad techniques that are not entirely psychological. The first would rely on the use of the crypto currency as an intermediary; it needs to have a large enough market capitalisation for transfers through the currency to work. The second relies on the portfolio allocation decisions of the large holders: at what point does it become irresistible to allocate towards other assets? Finally, there is the slim possibility that it is possible to hire labour or buy commodities at a fixed bitcoin price, allowing purchasing power parity (arbitrage) to work.

Bitcoin Valuation Part II(a): What Might Work

We need to distinguish between a fair value and what price an instrument trades at. Economic and financial theory is almost invariably about the first part, and the second is not viewed as respectable. However, Bitcoin as an instrument is an excellent example how observed prices are actually determined by the actions of human beings, and not mathematical models. If we wanted to have a more formal approach, we need to look at the valuation of Bitcoin on a macro basis, and not arguments about the valuation of one Bitcoin on the margin.

Bitcoin Valuation Part I: The Wrong Answers

The rise of Bitcoin (and other crypto-currencies) appears that it will have a negative net effect for most law-abiding citizens, but it has provided us with a rather wonderful teaching opportunity. It underlines the weaknesses of existing analytical techniques. (I discussed Bitcoin in a previous article, but I used it to take a sideswipe at DSGE models, and I didn't bother giving the correct answer.)

Due to article length, this article will discuss incorrect valuation techniques. Part II will give the correct methodology.... 

Modelling A Gold Standard

Although the topic of the Gold Standard often comes up in economic discussions, their actual operation is less well understood. This article explains how a theoretical model of a Gold Standard works, as implemented by stock-flow consistent (SFC) models. This is a unedited draft of a section of an upcoming book that describes how to use the Python sfc_models framework.

Growth Limits (Again)

The "limits to growth" debate is continuing. Ramanan has written a good article discussing the role of the external constraint in this debate. I agree with what he says, but I am less troubled by the fact that it is not heavily discussed by others.

Monetary Disorder: Some Views From France

One of the entertaining part of economics is the divergence of views on a national basis. Within a country, partisan political views create a spectrum of opinion, but we can usually identify an "establishment view." But those establishment views can be quite distinct across countries. As an example, the French establishment has a fixation upon exchange rate regimes, and an interpretation of the current monetary system which bears little resemblance with mainstream American views on the topic. This was apparent from reading Désordre dans les monnaies [Monetary Disorder]: L'impossible stabilité du système monétaire international?

Canadian Bonds, The Currency, And Cauliflower

Government of Canada bond yields have recently hit (modern) record lows. This is the "pain trade" for most Canadian asset allocators, as this is magnifying their actuarial liabilities, while the consensus underweight of bonds is hurting performance. The outperformance of Canadian bonds also flies in the face of the common wisdom that a collapsing currency is bad for bond markets and somehow limits policy options. Despite the alleged panic of Canadian consumers about the high price of food, the impact of the weaker dollar has been relatively modest (unless you crave cauliflower).

[UPDATE 2016-01-20] The Bank of Canada kept rates on hold today, which apparently surprised some people (the Canadian dollar strengthened on the news). At this point, the BoC has luxury of waiting to see what will happen, and so I do not think they will do anything until there is some decisive hard economic data that justifies further cuts. 

The Effect Of Fed Rate Hikes (Or Lack Thereof) On The Dollar

I am uncertain whether or not the Fed will raise rates any time soon. In my view, I think the monetary policy hawks' analysis is widely missing the mark; inflation is not going to be a problem in the United States any time soon. That said, I see little cost to the Fed raising rates. The most plausible reason to worry about a Fed rate hike is that it will cause the U.S. dollar to become "too strong" and create a severe external drag on U.S. growth. It looks to me that the currency markets have already "priced in" rate hikes, and so I do not see a reason for the U.S. dollar to become appreciably stronger versus other developed currencies.

Introductory Comments On Interest Rates And Currencies

Given the chance that the Fed will possibly hike rates within the next year -- assuming that nothing will cause them to push back "lift off" once again -- the question arises as to what effect this will have on the economy. In my view, a couple of rate hikes will do little to change the conditions in the domestic economy, given that the U.S. housing market is not exactly a major driver of growth. Instead, the effect would likely show up via financial markets, most notably the currency market. (Of course, risk markets may get hysteric about a Fed rate hike; I have no idea why any responsible adult would believe that a marginal rise in short-term funding would have any effect on the fair value of equities.) In this article, I give an overview of how I analyse the relationship between interest rates and the value of the currency; I hope to discuss some historical episodes in later articles.

Primer: Understanding Covered Interest Rate Parity

Covered interest rate parity is the relationship that determines the fair value of forward currency levels. It is easily understood from the perspective of an international bond investor or issuer, and these entities ensure that it holds in practice.

What Are Government Promises Worth - Gold, The SNB, And Sovereign Debt (Part 1)

The shock decision by the Swiss National Bank (SNB) to drop its policy of capping the strength of the Swiss franc came as a shock to most, and proved to be financially painful for some. Certain policies, such as gold or currency pegs, are inherently unsustainable, and the only question is the timing of the end of the policy. But in the case of the SNB's policy, it appeared financially sustainable, as they have unlimited capacity to create francs. This creates an uncomfortable parallel with government bonds - they are typically viewed as default risk-free since the government can create money at no cost.

The 'Widowmaker' And Yen Crash Theories

There has been a recent shift amongst those predicting the collapse of the Japanese economy to switch away from the so-called "widowmaker trade" - short Japanese Government Bonds (JGBs) - towards forecasts of a collapse in the Japanese yen (pictured above). Although this may result from learning a lesson from roughly two decades of failed "JGB collapse" predictions, I suspect that this is the result of learning the wrong things. Being structurally short the yen is hardly the safest trade in the world either.