April 29, 2010

Do Leveraged ETFs still make sense?

As reported by Marketwire earlier this week, Rydex|SGI will close 12 leveraged and inverse Exchange Traded Funds (ETFs). Investors gave a clear thumbs down on some of the more obscure ETFs recently which resulted in lackluster demand.  Below is a closer look at the list - good riddance...

Exchange Traded Fund Ticker Net Assets Exp. Ratio
Rydex 2x Russell 2000© ETF RRY 27.46M 0.70%
Rydex 2x S&P MidCap 400 ETF RMM 20.01M 0.71%
Rydex Inverse 2x Russell 2000© ETF RRZ 13.47M 0.71%
Rydex Inverse 2x S&P MidCap 400 ETF RMS 3.75M 0.71%
Rydex 2x S&P Select Sector Energy ETF REA 11.41M 0.70%
Rydex 2x S&P Select Sector Financial ETF RFL 22.13M 0.71%
Rydex 2x S&P Select Sector Health Care ETF RHM 3.57M 0.71%
Rydex 2x S&P Select Sector Technology ETF RTG 8.12M 0.71%
Rydex Inverse 2x Select Sector Energy ETF REC 1.25M 0.70%
Rydex Inverse 2x Select Sector Financial ETF RFN 8.02M 0.70%
Rydex Inverse 2x Select Sector Health Care ETF RHO 1.52M 0.70%
Rydex Inverse 2x Select Sector Technology ETF RTW 1.72M 0.71%

With regard to leveraged and inverse ETFs, we have been expressing our concerns in numerous articles: here; here; here and here, to list a few. Suffice it to say that the more complex ETFs are to be treated with extreme caution and are not ideally suited for average investors. 

While the demand side of leveraged ETFs may be fading, there may be another reason why ETF sponsors are putting a lid on the supply side.  As a result of increased public pressure and greater investor awareness, the US regulator FINRA has issued new margin requirements for leveraged ETFs which will go into effect on April 30, 2010.  FINRA Notice 09-65 details these new requirements. 

Essentially, a 2x leveraged ETF would require twice the normal margin requirement and also increased maintenance margin requirements.  In practical terms, this counterbalances the increased leverage and makes the rationale for purchasing a leveraged ETF highly questionable.  In this case, investors are much better off trading the non-leveraged ETFs which typically have much lower expense ratios.  While this is bad news for day traders (btw. they should really be trading futures if they like leverage), it’s a step in the right direction in terms of bringing excessive leverage into check.   

On a related note, we refer to an article What happens when an ETF closes.  If you are faced with such an announcement, the best course of action would be to sell your shares as soon as the announcement is made.

To find out more about ETFs that are in danger of being closed, please consider Ron Rowland’s ETF Deathwatch.

The number of exchange-traded products (ETPs) on ETF Deathwatch grew again this month.  For April, the quantity is 108 (76 ETFs and 32 ETNs), up from 104 for March.

It will be interesting to see how many of these ETFs on Deathwatch will survive the coming months after investors begin to realize the effects of the new imposed margin requirements. 

P.S.  Limiting the exposure towards market risk is a good thing, particularly for average investors.  In terms of the securities industry, the relatively high margin requirements for buying stocks, generally set at 50%, has been a well established mechanism to reign in some of the more excessive speculative investor urges.  To put these margin requirements in place or to raise them if and when needed is a relatively simple regulatory process, all things considered. 

Why on earth are there no tougher “margin requirements” for purchasing property?  Buying a house with a 5% down payment is basically like trading futures.  While house prices do not fluctuate as rapidly as commodities and other futures prices, they do fluctuate as we all witnessed in the past few years.  Limiting someone’s leverage is the primary tool for risk management and should be imposed on “novice” investors such as home buyers.  Currently, the margin requirement for buying a gold futures contract is about 5.8%.  The minimum down payment for a home mortgage loan through the FHA program is still only 3.5%. Curious...

April 28, 2010

Why Are Ratings Agencies Still Relevant?

The grilling of Goldman Sachs executives during yesterday’s senate hearings offered a fascinating insight into some of the workings of the world’s most sophisticated investment bank.  At times, it felt like the questioning senators received a lesson in market-making 101.  Trying to be as non-judgmental as possible, I still came to the following realization:  There is a difference between knowledge and wisdom, one that could be characterized by humility or the apparent lack thereof in the case of some financial heavy weights.

Whether those executives were guilty of any wrong-doing and responsible for some of the causes of the financial crisis or not remains questionable. The market seems to have given the thumbs up in favor of Goldman Sachs, whose stock is up over 2% today.

But the hearings also revealed a bit of an insight into the complex nature of the interactions between investment banks and ratings agencies.  At this point, one can only guess how massive the numerous conflicts of interests were and still are, that allowed some of the most obscure financial products to be sold with an official stamp of approval and an “A” rating.  At the basis of this conflict of interest is the simple fact that the ratings agencies are (still) being paid by those institutions who are to be rated, or whose products are to be rated. 

Despite all the negative press, the ongoing investigations and a serious backlash from investors, the markets still seem to follow the recommendations of these agencies.  It is therefore not surprising to see how Greek debt suffered a free fall recently. After a series of rather “timely” downgrades by the ratings agencies, most recently by Standard & Poor’s today, the yields on 2-year Greek government bonds topped 21% today, way above that of the most notorious and riskiest of sovereign debt issues. As the NY Times reports:

The ratings agency Standard & Poor’s lowered the debt rating of Spain on Wednesday, its third downgrade of a European country in two days.  The downgrade came one day after the S.& P. cut the ratings of Greek and Portuguese debt, moves that set off a flight by investors away from global equities and into fixed income securities, particularly those in United States dollars. The news Wednesday set off no such reaction, although an index of Spanish stocks fell about 3 percent. The S.&P. downgraded Spain’s debt one step, to AA, with a negative outlook.

At one point, the Greek 10-year yield reached 12.5% when just 6 months ago it was below 5%.  What has changed in terms of the Greek economy and finances that wasn’t clear to the ratings agencies then?  One should be rather concerned about the apparent inability of ratings agencies to better assess the credit worthiness of their targets.  The US exposure to Greece sovereign debt is relatively small.  However, as the debt crisis is spreading to other countries with the downgrade of Spain today, one must wonder what comparative metrics are used that make the distinction between what is still considered the “risk-free” rate in the US and other sovereign debt yields.

April 24, 2010

Market Insights - 24 April 2010

Here is the latest issue of Market Insights.  Thanks to those of you who completed our reader survey last week;  your feedback is much appreciated!  For those who didn’t have a chance to complete the survey yet, please do so when you have a spare moment.  The survey has only 10 questions and should take less than 10 minutes to complete.  It will remain open until the end of this month. Click here to Start The Survey

Should you have any questions, please email us at: info@fxistrategies.com

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• A Series Of Unfortunate Events For Europe
• Back-Testing ETFs To Improve Your Odds
• What To Make Of This Week’s Data
• Recommended Video
• Last Not Least 

Weekly Snapshot
• New orders for durable goods in March decreased 1.3% from February, to $176.7 billion (ESA)
• US new home sales in March (seasonally adjusted) were up 26.9% from February (ESA)
• Greece formally requests the activation of the €45bn aid package from the EU and the IMF (WSJ)
• Moody’s cut its rating on Greece one notch to A3 (Bloomberg)
• On Thursday, Greek 2-year yields jump over 11% amid ratings cut by Moody's (Business Week)
• Greek 10-year yields rose to a high of 9.13% on Thursday (Bloomberg)
• Portguese bond yields under pressure, with 10 year yields up to 4.77% (EuroIntelligence)
• US Producer Price Index for finished goods rose 0.7% in March, seasonally adjusted (BLS)
• US existing home sales surge 6.8% in March the highest level since December (AP)
• Spain's real estate market bound to deteriorate further, non-performning loans increase (EuroIntelligence)
• Canadian $ dollar at parity vs. US$ - consensus is that rates will go up by June 1 (CBC News)
• The Reserve Bank of India raised its key lending rate by 0.25% to 5.00% (Marketwatch)
• US index of leading economic indicators, up 1.4% in March (Conference Board)

Chart Of The Week
US markets ended the week higher; for the Dow it was the 8th weekly gain.  The broader market index S&P500 is now almost 80% above the current bear market low, the infamous 666.79 from March of last year.  Below is a nice summary of the volatile journey since the peak in October 2007. 

current-bear
Source: http://www.dshort.com/
 

Weekly Barometers

Stock-2010-04-23   FX-2010-04-23
     

A Series Of Unfortunate Events For Europe
Europe has been plagued by a series of unfortunate economic events in recent months and, as luck might have it, mother nature has now chimed in as well.  Last week’s volcano eruption in Iceland and the subsequent flight ban for large parts of Europe caused havoc among travelers and businesses.  It did not help the Euro either which was just about to regain a bit of strength the week before on renewed news that support for Greece from Eurozone member countries would be forthcoming.

When the flight ban was finally lifted on Wednesday, analysts were still debating the economic effects of the volcanic ash cloud and wondered whether the total cost of this calamity would be severe enough to derail the nascent recovery.  No rest for the wicket though and the focus of attention went right back to Greece where the yield on their 10-year government bonds rose above 8% on Wednesday and higher still, above 9% on Thursday.  For the first time, Greek 10-year yields were more than 500 basis points above German Bunds while Greek 2-year Bond yields jumped over 11% amid another ratings cut by Moody's.

Greece's formal request to activate the aid package from the European Union and IMF seems to have calmed investor nerves a bit.  On Friday, the European stock markets recovered, the Euro regained some losses and ended up almost 2 cents above the 12 month low of 1.3205.

To see how Greece got there, please consider the illustration below showing the yields on 10-year Greek Government Bonds as well as the movement of the Euro versus the US Dollar.  April appears to be a pivotal month thus far.  With the formal request by Greece to activate the bailout funds, markets may return to more normal levels now.  But if unfortunate events were to continue and/or the sovereign debt crisis were to proliferate to other Mediterranean Eurozone countries, the blue and red lines below would spread apart even further...

GK_Yield_vs_EUR-4-23

Back-Testing ETFs To Improve Your Odds
The naughties (00’s) are often referred to as the lost decade culminating in the financial tsunami of 2008/09.  Total returns (including all dividends) on the S&P 500 were about –9% (-22% in nominal terms) for the entire decade.  With those numbers, it has become difficult to find a rationale for the “Buy and Hold” strategy that has been indoctrinated to the average investor for decades.

But despite the poor performance of stock markets over the past decade, there is ample evidence suggesting that stock picking and other active investing strategies are bound to run into substantial headwind over a longer period of time.  As Tom Lydon of www.etftrends.com suggests in his post: How to Become a Better ETF Trader:

According to a recent TrimTabs study, ETF investors are so bad at picking the right time to buy or short-sell the equity markets that those doing exactly the opposite of what ETF players did in the past 10 years would have ended up making sevenfold profits, reports Oliver Ludwig for Index Universe. 

The likelihood that a similar scenario would apply to most other active trading strategies in general is high and the rationale for that is quite simple: With more frequent transactions, trading approaches the realm of a zero sum game and the probability of outwitting other investors is by definition 50/50 minus transaction costs.  Unless you are an above average investor (trader), you won’t beat the crowd.  Although this may seem an oversimplification in terms of stock trading, an active investment strategy should on average under-perform the market by the amount of transaction costs incurred. 

So we have established that “Buy and Hold” didn’t work in the past decade and that market timing is also a particularly challenging task.   How can one improve the odds and what is the right strategy?

Tom Lydon suggests a few simple rules:

    • Implement a simple strategy. Studies have shown time and again that there’s a direct correlation between how complicated a strategy is and how often you’ll use it. Keep it simple, silly.
    • Have a stop loss. “It’s easy to buy and hard to sell,” goes the adage. Make selling easier by knowing when you’ll do it. And then do it.
    • A simple strategy we suggest is trend following by using the 200-day moving average to determine when you buy and sell. You’re buying when a trend is there, and only when the trend is there. This allows you to check your emotions at the door.

Of these 3 basic trading tips, the third one is the most concrete example of a relatively simple and verifiable trading strategy. Brokerage firms often provide free access to research and trading analytics.  But these days, there are also free online resources available that let you back-test whether the proposed strategy would have worked for any given ETF. Let’s take this 3rd rule for a test drive then...

As a example, please consider www.etfreplay.com (no affiliation with the author) which has a tool allowing you to back-test a strategy using moving averages:  http://www.etfreplay.com/backtest_ma.aspx

Enter the ticker symbol SPY (the ETF for the US benchmark S&P500), use the suggested 200-day moving average and select “Trade On: Day of Cross”.  Choose your time frame, in this case the past decade, and hit the button to run the Back-test.  Here are the graphical results:

SPY-decade-1

The proposed strategy seemed to have worked quite well with a more than 3:1 ratio favoring the 200 day moving average over the buy and hold period (Note: Returns are calculated from date of first backtest buy).  

Winning vs Losing Trades

Avg Win vs Avg Loss

Return %

SPY-decade-2

There are  a few caveats however, again pointing towards a difficulty with regard to timing and money management.  For starters, the first trade did not occur until January 2002 which means staying on the sidelines for 2 years, had we implemented the strategy in January 2000.   That would have required a lot of patience!  Perhaps more difficult even for seasoned traders is the necessity to stick to a strategy during times when patience and conviction are severely tested.  The first 6 trades of this strategy were all losing money, albeit small percentage losses.  But the fact that the majority of the trades (77%) were losing trades can shatter the guts of the most confident traders.  Sticking to a strategy when the first few trades aren’t working isn’t everyone’s cup of tea.

Avg Days in Trade

Max Consecutive Trades

Max Equity Drawdown %

SPY-decade-3

Perhaps the easiest way to appreciate a simulation like this is to see the actual trading results.  These are detailed in the table below.

SPY-Back-test

In closing, I’d like to note that as with any trading strategy, simulated results from a back-view mirror perspective are always to be taken with a grain of salt.  While the proposed strategy appears to have worked for the benchmark S&P 500 it may or may not work for other indices or other ETFs.  Please also note that this is just one example of an easy to implement trading strategy - there are many others.  In terms of an overall financial plan, a tailored asset allocation may be much more important and prove more successful over time than a serious of specific investments or individual trades, no matter what timing or trading strategy may be adopted.  Usual disclaimers and general investment risk disclosures apply here as well. 

Having said that, there are more and more trading tools available now that allow individual investors to test and verify if a given investment strategy could work, something which was available to only professional traders until recently.  Overall, the easier and often free access to professional trading tools and investment analytics should make for better informed and more educated investors.  But don’t take my word for it, test it yourself. 

What To Make Of This Week’s Data
Consumer spending is up again, realtors had a great month in March with new home sales up 27%, leading economic indicators up 1.4% and US Treasury Secretary Tim Geithner tells us, the economy is getting stronger.  All that is mirrored in the ongoing rise in equities.  And yet, there is this nagging question as to whether these bumper results that drove stock prices up nearly 80% from last year will continue. 

Let’s start with an article from this week’s Financial Times: Foreclosure backlog brings relief for homeowners
A few points to note here:

  • As many as 6m people continue to live in their homes even though they are seriously delinquent or in some stage of foreclosure, according to Moody's Economy.com.
  • Lender Processing Services, which tracks the mortgages on 40m homes, estimates that 1.4m borrowers have not made a single payment in the past year.

In plain English: Several million Americans have been living for free in their home.  Banks cannot clear the backlog in foreclosures fast enough; but even if they could, too many evictions would drive the property prices down further.  And rather than admitting a full loss and writing off the loans completely, a managed delay in processing these foreclosures and keeping the homes “occupied” actually helps the lenders.  But of course, that situation is not sustainable.  Give it 6-12 months and the backlog will slowly shrink, which means several million consumers will no longer have extra cash to buy anything other than the bare necessities.  Watch for a decline in retail sales when the free-loaders have to pay for housing again.

What about home sales?  Home sales definitely benefitted from the $8,000 tax credit for new home buyers as well as the $6,500 for qualified move-up/repeat home buyers.  Vincent Fernando, CFA and Kamelia Angelova of BusinessInsider.com call it “A Government Engineered New Housing Frenzy” (see chart below).

USNewHomeSales

Those government subsidies will end this month and it is questionable whether the increase in home sales and an overall improvement of the US housing market will continue later this year. 

We also believe that the stock market may have run a fair bit ahead of itself.  The Price/Earnings ratio of the S&P 500 currently has a multiple of 22.04, on a cyclically adjusted basis.  That value is about one third above its long-term historic average of 16.36.  Further, through a combination of near zero interest rates and a general sense of “the worst is over”, risk appetite has returned to the markets.  The volatility index, a.k.a. the fear index, has been back at pre-crisis levels for a few weeks now.  Too much complacency?

VIX-2010-0424

We also question whether the US consumer can continue to bear the heavy weight of shouldering the majority of the US economy.  The personal savings rate, which recently improved in historic terms, has begun heading south again in the past few months.  The combination of continued high unemployment and a consumer that may soon be cash-strapped again, if personal savings were to approach zero, does not bode well for a sustainable recovery.  Unless a substantial improvement in jobs is on the horizon, the so far “jobless” recovery will stand on rather shaky ground and current valuations will come under pressure.

fredgraph-perssavings 

Recommended Video
Debatable but certainly entertaining is Paddy Hirsch's video illustration of how the infamous ABACUS/Goldman Sachs deal was put together.  As Paddy put it: “It's a bit like a bookie and gambler teaming up to fix a horse race.” Enjoy!

Last Not Least
In case you’re not upset enough yet here’s a good one.  Amid all the talk of more regulation, tougher rules and yet another federal agency to oversee the financial institutions, here are some examples of how certain federal regulators worked.  Turns out, not everyone at the SEC was asleep at the wheel when the financial markets collapsed; some of them were very busy with other activities...

Good luck and good investing!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.

April 21, 2010

A Series Of Unfortunate Events For Europe

Europe has been plagued by a series of unfortunate events in recent months and as luck might have it, mother nature has now chimed in as well.  Last week’s volcano eruption in Iceland and the subsequent flight ban for large parts of Europe caused havoc among travelers and businesses.  It did not help the Euro either which was just about regaining a bit of strength on renewed news that support for Greece from Eurozone member countries would be forthcoming.

When the flight ban was finally lifted today, analysts were still debating the economic effects of the volcanic ash cloud and wondered whether the total cost of this calamity would be severe enough to derail the nascent recovery.  No rest for the wicket though and the focus of attention went right back to Greece where the yield on their 10-year government bonds rose above 8% on Wednesday. For the first time, Greek 10-year yields were more than 500 basis points above German Bunds.

To see how Greece got there, please consider the illustration below showing the yields on 10-year Greek Government Bonds as well as the movement of the Euro versus the US Dollar.  April appears to be a pivotal month thus far.  If unfortunate events were to continue and/or the sovereign debt crisis were to proliferate to other Mediterranean Eurozone countries, the blue and red lines below would spread apart even further...

GreekYields_vs_EUR

Back-Testing ETFs To Improve Your Odds

The naughties (00’s) are often referred to as the lost decade culminating in the financial tsunami of 2008/09.  Total returns (including all dividends) on the S&P 500 were about –9% (-22% in nominal terms) for the entire decade.  With those numbers, it has become difficult to find a rationale for the “Buy and Hold” strategy that has been indoctrinated to the average investor for decades.

But despite the poor performance of stock markets over the past decade, there is ample evidence suggesting that stock picking and other active investing strategies are bound to run into substantial headwind over a longer period of time.  As Tom Lydon of www.etftrends.com suggests in his post: How to Become a Better ETF Trader:

According to a recent TrimTabs study, ETF investors are so bad at picking the right time to buy or short-sell the equity markets that those doing exactly the opposite of what ETF players did in the past 10 years would have ended up making sevenfold profits, reports Oliver Ludwig for Index Universe. 

The likelihood that a similar scenario would apply to most other active trading strategies in general is high and the rationale for that is quite simple: With more frequent transactions, trading approaches the realm of a zero sum game and the probability of outwitting other investors is by definition 50/50 minus transaction costs.  Unless you are an above average investor (trader), you won’t beat the crowd.  Although this may seem an oversimplification in terms of stock trading, an active investment strategy should on average under-perform the market by the amount of transaction costs incurred. 

So we have established that “Buy and Hold” didn’t work in the past decade and that market timing is also a particularly challenging task.   How can one improve the odds and what is the right strategy?

Tom Lydon suggests a few simple rules:

  • Implement a simple strategy. Studies have shown time and again that there’s a direct correlation between how complicated a strategy is and how often you’ll use it. Keep it simple, silly.
  • Have a stop loss. “It’s easy to buy and hard to sell,” goes the adage. Make selling easier by knowing when you’ll do it. And then do it.
  • A simple strategy we suggest is trend following by using the 200-day moving average to determine when you buy and sell. You’re buying when a trend is there, and only when the trend is there. This allows you to check your emotions at the door.

Of these 3 basic trading tips, the third one is the most concrete example of a relatively simple and verifiable trading strategy. Brokerage firms often provide free access to research and trading analytics.  But these days, there are also free online resources available that let you back-test whether the proposed strategy would have worked for any given ETF. Let’s take this 3rd rule for a test drive then...

As a example, please consider www.etfreplay.com (no affiliation with the author) which has a tool allowing you to back-test a strategy using moving averages:  http://www.etfreplay.com/backtest_ma.aspx

Enter the ticker symbol SPY (the ETF for the US benchmark S&P500), use the suggested 200-day moving average and select “Trade On: Day of Cross”.  Choose your time frame, in this case, the past decade and hit the button to run the Back-test.  Here are the graphical results:

SPY-decade-1

The proposed strategy seemed to have worked quite well with a more than 3:1 ratio favoring the 200 day moving average over the buy and hold period (Note: Returns are calculated from date of first backtest buy). 

 

Winning vs Losing Trades

Avg Win vs Avg Loss

Return %

SPY-decade-2

There are  a few caveats however, again pointing towards a difficulty with regard to timing and money management.  For starters, the first trade did not occur until January 2002 which means staying on the sidelines for 2 years, had we implemented the strategy in January 2000.   That would have required a lot of patience!  Perhaps more difficult even for seasoned traders is the necessity to stick to a strategy during times when patience and conviction are severely tested.  The first 6 trades of this strategy were all losing money, albeit small percentage losses.  But the fact that the majority of the trades (77%) were losing trades can shatter the guts of the most confident traders.  Sticking to a strategy when the first few trades aren’t working isn’t everyone’s cup of tea.

 

Avg Days in Trade

Max Consecutive Trades

Max Equity Drawdown %

SPY-decade-3

In closing, I’d like to note that as with any trading strategy, simulated results from a backview mirror perspective are always to be taken with a grain of salt.  While the proposed strategy appears to have worked for the benchmark S&P 500 it may or may not work for other indices or other ETFs.  Please also note that this is just one example of an easy to implement trading strategy - there are many others.  In terms of an overall financial plan, a tailored asset allocation may be much more important and prove more successful over time than a serious of specific investments or individual trades, no matter what timing or trading strategy may be adopted.  Usual disclaimers and general investment risk disclosures apply here as well. 

Having said that, there are more and more trading tools available now that allow individual investors to test and verify if a given investment strategy could work, something which was available to only professional traders until recently.  Overall, the easier and often free access to professional trading tools and investment analytics should make for better informed and more educated investors.  But don’t take my word for it, test it yourself. 

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.

April 18, 2010

Market Insights - 18 April 2010

Market Insights was on spring break this week and therefore we trimmed down our usual market commentary.  We also request that you complete a short survey at the end of this newsletter.   We would very much appreciate if you could give us some feedback on how we are doing and where we can improve.  Should you have any questions, please email us at: info@fxistrategies.com

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Reader Survey 

Weekly Snapshot
• SEC accuses Goldman Sachs of defrauding investors (AP)
• US industrial production edged up 0.1% in March and increased 7.8% in Q1 annualized (NBER)
• US retail sales in March 2010 increased 1.6% to $363.2 billion from February (ESA)
• Euro area annual inflation up to 1.4%; external trade surplus 2.6 bn euro (Eurostat)
• US CPI +0.1% in March and +2.3% in the past 12 months before seasonal adjustment (BLS)
• China’s GDP surged by 11.9% in the first quarter compared with a year earlier (Economist)
• World Oil demand to hit a record of 1.67 million barrels per day in 2010  (IEA)
• US international trade deficit in February increased 7.4% to $39.7 billion (ESA)
• US Exports increased 0.2% to $143.2 billion, imports increased 1.7% to $182.9 billion (ESA)
• Euro zone countries cobbled together a €30 billion loan package for Greece (Economist)
• Industrial production up by 0.9% in euro area (Eurostat)
• On Monday, the Dow closed above 11,000 for the first time since September '08 (Yahoo Finance)

 

Chart Of The Week
The big news this week came courtesy of the SEC and Goldman Sachs.  The US stock market hit a bumper on Friday when the SEC charged Goldman Sachs with fraud in the structuring and marketing of a debt product tied to subprime mortgages.  European regulators are likely to probe into the investment bank as well.  This of course leaves us with the question: who’s next in line to be indicted?  To see the immediate impact on Goldman Sachs’ stock price please see the chart below.

GS-Daily
Source: http://www.finviz.com/
 

Weekly Barometers

Stock-2010-0416   FX-2010-0416
     

Reader Survey
Our newsletter FXIS Market Insights has been published each week for almost 2 years now. In an effort to continue to improve the content, format and relevance of our newsletter, we would appreciate if you could give us some feedback on how we are doing and where we can improve.

This survey has 10 questions and should take less than 10 minutes to complete.

Please click here to Start The Survey

 

Thanking you in advance for your time.

Clemens Kownatzki
CEO, FX Investment Strategies

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.

April 13, 2010

A Change in China’s currency and the real impact for Americans

While China’s President Hu Jintao is in Washington D.C. to attend President Obama's nuclear summit this week, the discussion on China's currency has been heating up.  The majority of commentators suggest that the Chinese Yuan is undervalued somewhere between 20%-30% and that it is exactly this artificially devalued currency rate which makes Chinese exports cheaper.  

The debate continues and political pressures have been increasing towards pointing a finger at China, finding an easy culprit for the millions of lost US manufacturing jobs.

Within this heated debate, it is a rare to find a level headed opinion.  Mark Dow, a fund manager at Pharo Management, does exactly that.  Please consider this excellent assessment of the possible impact of an appreciation of the Chinese Yuan and what it means in reality for the American consumer.

 

April 10, 2010

Market Insights - 10 April 2010

Here is the latest issue of Market Insights.  As always, please email any questions to: info@fxistrategies.com

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• The Dollar Yuan Hodgepodge
• Euro Upheaval: Is There A Potential Winner?
• More On ETF’s
• Recommended Video

Weekly Snapshot
• China reports $7.24 billion trade deficit in March as imports surge, first in almost 6 years (AP)
• US stocks close at 18-month high, Dow touches 11,000 (Marketwatch)
• US consumer credit fell at an annual rate of 5.6%, to $2.448 trillion in February (CNN Money)
• Rates on 30-year mortgages jump to 5.21% - highest level in 8 months (AP)
• Industrial producer prices up by 0.1% in both euro area and EU27(Eurostat)
• Canadian Dollar touched parity with the US$ for the first time in nearly two years (eSignal)
• Tim Geithner postponed report on whether China manipulates its currency (Economist)
• Greece to target US investors with a multibillion-dollar bond (FT)
• Greece has covered its funding for April, but needs another €10bn in May (Eurointelligence)
• Crude Oil prices touched $87 on Tuesday (Finviz.com)
• Iron ore price hit $160.5 per tonne, Copper at $8010 per tonne (FT)
• Euro area GDP stable and EU27 GDP up by 0.1% in Q4 of 2009 (Eurostat)
• Reserve Bank of Australia raises the cash rate by 25 basis points, to 4.25% (RBA)

Chart Of The Week
In case you were away on Spring Break this week, you may have missed one of those really exciting non-events reflecting how easily markets can still be rattled.   As Reuters reports in Timeline: Greece's debt crisis, it was just 2 weeks ago when “Euro zone leaders agreed to create a joint financial safety net, with the IMF, to help Greece and to try to restore confidence in the Euro.”  But the markets wanted nothing of it earlier this week and Greek Bond spreads reached over 4 basis points on top of German 10-year bonds.  Below is a nice illustration of how the Greek yields have fared thus far. All said however, the Euro recovered again on Friday on renewed news that support from Eurozone member countries would be forthcoming.  Confused?  Stay tuned...

EuroBondSpreads
Source: http://www.calculatedriskblog.com/

Weekly Barometers

Stock-2010-0409   FX-2010-0409

The Dollar Yuan Hodgepodge
Is the Chinese Yuan under-valued?  Is it just right or should it be a freely convertible currency and allowed to float like other major currencies? The number of opinions on all sides of the currency debate feels like a hodgepodge and figuring out what’s really in the soup is potentially an unattainable goal, even for the smartest market observers.  Anyway, let’s try to get a glimpse of what’s in the soup.

The debates about the “right value” for the Chinese currency are now at every level of the media, the government, the investment community and even the general public appears to weigh in on the issue.  Earlier this week, US Treasury Secretary Timothy Geithner announced that he would delay the highly anticipated report determining whether China “manipulates” its exchange rate until after April 15.  This politically motivated move might take some of the heat out of the discussions in anticipation of Chinese President Hu Jintao attending the Nuclear Security Summit in Washington early next week. But below the official line, public unrest is brewing and an increasingly hostile debate with some calls for trade barriers remind us of similar discussions about trade sanctions for Japan during the 1980s.

Before going any further though, let’s look at some historic rates to get a bit of a reference point.

CNY-2010-0406

Undoubtedly, the rise of the US Dollar during the 1980s and more so, the massive devaluation of the CNY in January 1994 from 5.8210 to 8.7219 created a favorable exchange rate environment for exporting goods from China.  To what extent that favorable exchange rate continued to help China’s as a whole is less clear though. For instance, the gradual revaluation of the CNY starting in 2005 does not appear to have made a real impact on the growth in imports from China (see red line in the chart below).  Perhaps the biggest dent in the trend was the global financial crisis of 2008-09 which put a big lid on US consumer demand.

CNY-Imports

Will the US trade balance improve from a stronger Yuan?
Many economists, Paul Krugman at the forefront, have called for China to re-value its currency and for the US to impose trade sanctions if Beijing were not to comply. Other economists feel that trade barriers are ineffective and that a revaluation of the Yuan won’t do much to reduce the US trade deficit.  The latter argue that most goods imported from China are those consumer goods that the US cannot or will not produce domestically anyway. If US consumers don’t buy from China, they will import it from somewhere else. Perhaps the trade with China may suffer but the overall US trade balance won’t improve.

Change is looming upon us however.  From within China, there are now some signs that indicate Beijing might pull the trigger and revalue its currency some time this year.

Grasp
In the financial Blogs, the debate has been ravaging for a long time now and rather outspokenly so.  Opinions have been flying left and right with some increasingly aggressive stances, as if the financial crisis the global economic challenges could be solved by simply adjusting one currency to the upside. The issues are of course extremely complex and the ubiquity of possible implications is probably out of reach for one mind to fully grasp (certainly too complex for mine).

Please consider the following blog post “Why Re-pegging the Yuan and Other Non-Free-Market Solutions to Trade Imbalances With China Will Fail” by Mike “Mish” Shedlock.

This is one of the many articles featured in financial Blogs recently, but it’s a very good example of how complex the issue of the Chinese currency debate has been. Mish, a highly respected blogger who typically employs a healthy dose of common sense when examining financial markets seems to struggle wrapping his head around the issue in a sort of “all over the place” (unusual for him) approach to making sense of the debate.

How confusing the issue can be shows up in the information exchange between Mish and Michael Pettis.  Pettis, a professor at Peking University’s Guanghua School of Management, specializing in Chinese financial markets, first writes:

"...to use a controversial example, if the US were able to force up the value of the dollar by 20% or more against all other currencies, it would become far more profitable to produce cars domestically, it would revive the aluminum and chemical industries, and it might cause a significant divergence of electronics assembly to the US."

He then later replies:

“Mish, sorry, I meant force “down”, not up. The point is that if the dollar were devalued by 20%, the immediate impact would that US manufacturers would become much more profitable and foreign much less so. That would shift US and foreign consumption of cars from foreign producers to US producers, and would of course have a positive impact on US employment.”

Was that a Freudian slip by Dr. Pettis, a simple typo or was it just a reflection of how difficult the issue is in terms of deriving a somewhat simple solution?

Just taking a small bite out of Pettis argument with regard to cars, the answer is not entirely based on exchange rates nor is it simply price-driven.  US car manufacturers might export more cars but it is questionable if they would sell any more domestically.  US consumers have turned their backs against American car manufacturers because they have been building lesser quality cars.  It’s not the price alone that drives consumption, point in case - Apple computers. If the product is of exceptionally high quality, consumers will find the money to buy the product.  Conversely, if a product is “cheap” but not that attractive, why buy it?  The same argument goes for overseas consumers who are actually less price sensitive and given a choice would rather opt for a premium brand.

When and How?
What about a solution then? It’s complicated to say the least and for many analysts, the question is no longer if but when China will drop the currency peg.  That however, has numerous implications, not all of which are positive for the US.

Considering the latest developments, the “When” has become much closer to the near future.  “When” China lifts the currency peg, inflation will also be imported in the US which, at current levels of unemployment, will not bode well for the cash-strapped US consumer.  A fall in the value of the US Dollar and a possible crash in the Bond market may hurt both Chinese as well as US investors - with about $900bn, China is still the largest holder of US Treasuries.  And, the Fed will be required to raise rates to find buyers willing to fund the immense government debt.  None of these measures sound all that appealing. 

At the same time, China is beginning to realize that decades of managed exchange rates have come at a price as well.  Domestic inflation in China is as high if not higher than GDP growth.  As long as the Yuan is relatively cheap, the commodity hungry Chinese manufacturers will struggle maintaining their prices as commodity prices are on the rise again.  This month’s announcement of the first Chinese trade deficit in six years is a clear indication of the pricing challenges these higher priced imports place upon Chinese manufacturers. 

Last not least, China is sitting on upwards of $2 trillion worth of US assets and will not tolerate to have these asset values depreciate drastically.  Any move on the part of China will therefore be highly calculated and timed well, making small gradual adjustments only.

In the long-run, letting the markets determine the “right” exchange rate appears to be the most sensible solution. Because of the complexity and a myriad of unforeseen consequences that a managed exchange rate could bring, the market may have the best shot at finding the “right” exchange rate, even if that rate were to change on a daily basis. Getting there however, will take some time.  Meanwhile, today’s hodgepodge of a currency soup might not be to everyone’s taste.  But as Mish pointed out in his article:

I am certainly in favor of letting the free market solve all of those. Indeed many of them are so intertwined, that only the free market has a chance in hell of solving them.

Euro Upheaval: Is There A Potential Winner?
Just when we thought that Greece had finally taken care of funding its liabilities and convinced the EU and the IMF that their austerity measures would put an end to most of the concerns about a Greek default, it turns out nothing has really changed.  Greece appears to be unable to bolster its finances and to adhere to the austerity measures announced last month.   Instead, Greece has been promoting itself as an emerging market economy and is now targeting U.S. investors in a $5B-10B bond sale to help cover its May borrowing requirement of about €10B.  

Bad news from Greece instantly translated into market reaction.  On Thursday, the yield on 10-year Greek government bonds rose above 7%. The closely watched spread between Greek and German 10-year debt increased to above 4 percentage points.  Combine that with the flat Eurozone GDP numbers for Q4-2009 and the forecast that GDP growth in Europe’s powerhouse Germany is going to be benign at best and you have a recipe for an ongoing Euro crisis.

Not surprisingly, the Euro has been taking a hit this week and fell to the same level of late March before an EU wide support for Greece was announced.  Strangely, the Euro bounced back on Friday throwing the earlier Euro woes into question again.  A retest of the 14 month technical low at the 1.3265 area depends very much on how the Greek debt crisis plays out and whether there are any major fall-outs from the so-called Club-Med countries (Portugal, Spain, Italy) who are rumored to be similar financial shape as Greece.

EUR-2010-0408d

Is there a potential winner from this Euro upheaval? 

Although Friday saw a marked recovery of the Euro on renewed pledge of support by European leaders, the single currency certainly remains under pressure on any hint that Greece or other “Club-Med” countries were to face further financing difficulties.

Much less publicized and yet much more vehement was the decline of the Euro versus other major currencies.  Topping the list is the cross-currency trade Euro versus Australian Dollar.  We previously looked at this currency pair a couple of weeks ago when the Euro hit a new  13-year low of 1.4605 versus the Australian Dollar. Since then, the Euro slid another 300 points to a low of 1.4348, a level not seen since August 1997, and bringing the Euro within a hair of the all-time low of 1.4025.

EURAUD-2010-0408

While the speed and intensity of the decline continues to baffle there are additional factors which paint a slightly rosier picture for Australia’s currency compared to the Euro. After the Australian Reserve Bank announced the 5th quarter percent increase in their cash rate earlier this week, Australia now enjoys a 3.25% spread over European deposit rates making the rationale for a carry trade against the Euro as a funding currency even more plausible than before. 

Intl-Rates

And, as a traditional commodity currency, the Australian Dollar could also enjoy further gains on the back of an increase in commodity prices, particularly the metals and other raw materials which Australia has an abundance of and which seem to be in big demand by many countries in the Far East.

Having said all that, the Australian Dollar has now gained so much against the Euro that one might hesitate to put on a trade that may have already run most of its course – and I realize I am repeating myself here.  There has been no significant technical correction to speak of since this dramatic currency slide began in February 2009, which poses the question as to when the major net sellers of the Euro would cover their short positions. 

With an ongoing Greek debt crisis continues and even a remote likelihood of a possible spill over towards other Southern European member nations, the Aussie Dollar is definitely an appealing alternative to an international investor via the favorable deposit rates.  Much of the Euro-woes may have already been priced in by now, bearing in mind the severity of the decline thus far.  But as long as serious doubts about the continued existence of the Euro remain, one should consider expressing that opinion via the cross currency trade rather than the more commonly known Euro versus US Dollar trade.

More On ETF’s
In our ongoing effort to uncover some myths about Exchange Traded Funds (ETFs) we came across this interesting article published by ProShares, the largest managers of leveraged and inverse funds.  Please consider: Facts and Fallacies About Leveraged Funds.

Proshares also published an FAQ About Leveraged and Inverse Funds. This is quite useful and for easy reference, we took the liberty of quoting from it verbatim:

1. What type of investor is an appropriate candidate for leveraged and inverse funds?
Leveraged and inverse funds are typically most appropriate for knowledgeable investors who are familiar with the risks and benefits of these types of products and have a thorough understanding of investment concepts and practices. Investors in leveraged and inverse funds – or their adviser – should monitor their positions closely and use them as part of a diversified portfolio.

2. What are the investment objectives of leveraged and inverse funds?
A leveraged fund is a mutual fund or ETF that generally seeks to provide a multiple (i.e., 200%, 300%) of the daily return of an index or other benchmark for a single day excluding fees and expenses. An inverse fund generally seeks to provide a multiple (i.e., -100%, -200%, -300%) of the opposite of the return of an index or other benchmark for a single day excluding fees and expenses.

3. Do leveraged and inverse funds seek to achieve their target returns for more than a day?
No. Nevertheless, although no one can predict future performance, Joanne Hill, PhD and George Foster, CFA conducted an historical study that showed a high likelihood of approximating the daily target over short periods. The shorter the period, and the lower the volatility of the underlying index, the more likely returns were to approximate the daily target. Longer and more volatile periods tended to show a greater deviation from the daily target. Using historical data, a model based on 2x the daily return of the S&P 500 index showed a 90% likelihood of producing a return between 1.75x and 2.25x the index return over any 30-day period over the last 50 years. (Models based on an index with higher volatility would have deviated more.)1

4. What causes the performance of these funds over time to be greater or less than the multiple of longer term index performance?
The cause is compounding, a universal mathematical concept that affects the returns of all investments. It is important for investors to understand how compounding affects returns in different market conditions – upward-trending, downward-trending and volatile. For leveraged fund investors, it is particularly important to understand that the effect of compounding on leveraged funds is magnified, and can cause gains and losses to occur much faster and to a greater degree.

5. Does this mean that you shouldn’t hold these funds for longer than a day?
The objective of leveraged funds is to seek a multiple of an index on a daily basis. Leveraged funds can be used for longer periods. An investor’s time horizon may be based on many factors, such as market outlook and risk tolerance.

6. Are there strategies that can increase the chance of approximating the daily target over longer periods?
Yes. Academic research2 supports the idea that a basic rebalancing strategy for leveraged funds can be used to reasonably approximate the daily objectives of leveraged funds over longer periods. This rebalancing strategy involves a calculation that looks to add to or reduce the amount held in a leveraged fund so that the investment exposure held is in line with the targeted return for the period. Rebalancing can be triggered at fixed time periods (e.g., weekly or monthly) or when a specified threshold is reached. A rebalancing strategy may involve transaction costs and generate tax consequences. Rebalancing does not guarantee specific future results and may result in investment losses.

7. Is seeking to approximate the daily target over time the only reason investors invest in leveraged funds over longer periods?
There are other strategies that investors pursue by holding leveraged funds for longer periods other than to seek the daily target over the period. For instance, an investor may choose to hold a long-term position in a leveraged fund based on a view that the index will rise (or fall) in a trending manner in a low-volatility environment. If the investor is correct, this could result in the leveraged fund outperforming the daily target multiple times the period index return; if incorrect, the fund could underperform.

8. What are some common uses for leveraged and inverse funds?
Leveraged funds can be used to help manage risks in other investments. Examples:

a. Use a short fund to hedge portfolio gains.
b. Fine-tune exposure – e.g., use a leveraged fund to overweight a sector
    without using additional cash.
c. Seek to capture returns while eliminating market or sector exposure.

All this sounds very clever and does in fact give a more concise view than the legal jargon of the exhausting prospectus.  However, we cannot stress enough that these instruments are more risky than normal ETFs and are generally not suitable for the average investor.  We have talked about risks of leveraged ETFs on several occasions, for instance at: http://fxinvestmentstrategies.blogspot.com/2009/06/market-insights-6-june-2009.html

I highly recommend doing a few simple investigations prior to considering an investment (a trade rather) in any of these leveraged or inverse ETFs. 

a) Use one of the many free financial portals to find out the expense ratio and other vitals stats for the ETF.
b) Use a charting tool e.g. Yahoo Finance or Stockcharts.com to see comparative performance charts.  I find those to be the fastest way to establish how close an ETF comes to fulfilling what it says from the outset.
c) Establish your time horizon and assess whether the performance towards the ETF versus the underlying is making sense for your time frame.

A few simple examples are below:

Ultra Gold, the double leveraged Gold ETF versus the Spot Gold price.  Turns out this leveraged ETF does an OK job at near double returns.  Over the sample 200 day time period, UGL is up 47.43% when the Gold price was up 24.69%.

Ultra_vs_Gold-2010

If you are extremely bullish on the Japanese Yen, you could consider the 200% leveraged YCL.  Compare that to the underlying FXY Currency Shares Japanese Yen which in itself is again an ETF and the performance doesn’t look that appealing anymore.  In the sample 200 day time frame, FXY was up 2.21% whereas YCL was only up 3.02%.

YCL_vs_FXY-2010

Lastly, consider the Ultra Silver: AGQ compared to Spot Silver, revealing again a distortion of returns even over a shorter time period.  Since the beginning of the year, Spot Silver is up 32.59%.  However, year-to-date returns for the double leveraged ETF is only 50%, clearly falling short of a a value closer to double the returns. 

Ultra_vs_Silver-2010

Possibly more important than chasing after illusive double returns is a good dose of risk management.  Please be aware that leveraged and inverse ETFs can be useful tools at increasing returns (in the short run) they can potentially increase your risk twofold or more as well.  You should carefully consider how a leveraged or inverse ETF increases the overall risk in your portfolio.

Recommended Video 
If all these market gyrations sound confusing, please consider this enlightening interview with Justin Fox as he gives his views on the “irrational market”.  The author of "The Myth of the Rational Market" discusses the implications of maintaining last century's assumptions and concludes: There is no right answer.

Econ
 Click here to view the interview

Good luck and good trading!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.

April 08, 2010

Is there a winner in Europe’s Sovereign Debt Crisis?

Just when we thought that Greece had finally taken care of funding its liabilities and convinced the EU and the IMF that their austerity measures would put an end to most of the concerns about a Greek default, it turns out nothing has really changed.  Greece appears to be unable to bolster its finances and to adhere to the austerity measures announced last month.   Instead, Greece has been promoting itself as an emerging market economy and is now targeting U.S. investors in a $5B-10B bond sale to help cover its May borrowing requirement of about €10B.  

Bad news from Greece instantly translated into market reaction.  Today, the yield on 10-year Greek government bonds rose above 7%. The closely watched spread between Greek and German 10-year debt increased to above 4 percentage points.  Combine that with the flat Eurozone GDP numbers for Q4-2009 and the forecast that GDP growth in Europe’s powerhouse Germany is going to be benign at best and you have a recipe for an ongoing Euro crisis.

Not surprisingly, the Euro has been taking a hit and is now essentially back to square one, around the same level of late March before an EU wide support for Greece was announced.  Whether the 14 month technical low of the Euro versus the US$ at 1.3265 area will hold depends very much on how the Greek debt crisis plays out and whether there are any major fall-outs from the so-called Club-Med countries (Portugal, Spain, Italy) who are rumored to be similar financial shape as Greece.

EUR-2010-0408d

Is there a potential winner from this Euro upheaval? 

The Euro certainly remains under pressure but much less publicized and yet much more vehement was the decline of the Euro versus other major currencies.  Topping the list is the cross-currency trade Euro versus Australian Dollar.  We previously looked at this currency pair a couple of weeks ago when the Euro hit a new  13-year low of 1.4605 versus the Australian Dollar. Since then, the Euro slid another 300 points to a low of 1.4348, a level not seen since August 1997, and bringing the Euro within a hair of the all-time low of 1.4025.

EURAUD-2010-0408

While the speed and intensity of the decline continues to baffle there are additional factors which paint a slightly rosier picture for Australia’s currency compared to the Euro. After the Australian Reserve Bank announced the 5th quarter percent increase in their cash rate earlier this week, Australia now enjoys a 3.25% spread over European deposit rates making the rationale for a carry trade against the Euro as a funding currency even more plausible than before. 

Intl-Rates

And, as a traditional commodity currency, the Australian Dollar could also enjoy further gains on the back of an increase in commodity prices, particularly the metals and other raw materials which Australia has an abundance of and which seem to be in big demand by many countries in the Far East.

Having said all that, the Australian Dollar has now gained so much against the Euro that one might hesitate to put on a trade that may have already run most of its course – and I realize I am repeating myself here.  There has been no significant technical correction to speak of since this dramatic currency slide began in February 2009, which poses the question as to when the major net sellers of the Euro would cover their short positions. 

Yet, as long as the Greek debt crisis continues and while there is even a remote likelihood of a possible spill over towards other Southern European member nations, the Aussie Dollar is definitely an appealing alternative to an international investor via the favorable deposit rates.  Much of the Euro-woes may have already been priced in by now, bearing in mind the severity of the decline thus far.  But as long as serious doubts about the continued existence of the Euro remain, one should consider expressing that opinion via the cross currency trade rather than the more commonly known Euro versus US Dollar trade.

April 06, 2010

The Dollar-Yuan Hodgepodge – What’s Really In The Soup?

Is the Chinese Yuan under-valued?  Is it just right or should it be a freely convertible currency and allowed to float like other major currencies? The number of opinions on all sides of the currency debate feels like a hodgepodge and figuring out what’s really in the soup is potentially an unattainable goal, even for the smartest market observers.  Anyway, let’s try to get a glimpse of what’s in the soup.

The debates about the “right value” for the Chinese currency are now at every level of the media, the government, the investment community and even the general public appears to weigh in on the issue.  Earlier this week, US Treasury Secretary Timothy Geithner announced that he would delay the highly anticipated report determining whether China “manipulates” its exchange rate until after April 15.  This politically motivated move might take some of the heat out of the discussions in anticipation of Chinese President Hu Jintao attending the Nuclear Security Summit in Washington early next week. But below the official line, public unrest is brewing and an increasingly hostile debate with some calls for trade barriers remind us of similar discussions about trade sanctions for Japan during the 1980s.

Before going any further though, let’s look at some historic rates to get a bit of a reference point.

CNY-2010-0406

Undoubtedly, the rise of the US Dollar during the 1980s and more so, the massive devaluation of the CNY in January 1994 from 5.8210 to 8.7219 created a favorable exchange rate environment for exporting goods from China.  To what extent that favorable exchange rate continued to help China’s as a whole is less clear though. For instance, the gradual revaluation of the CNY starting in 2005 does not appear to have made a real impact on the growth in imports from China (see red line in the chart below).  Perhaps the biggest dent in the trend was the global financial crisis of 2008-09 which put a big lid on US consumer demand.

CNY-Imports

Will the US trade balance improve from a stronger Yuan?
Many economists, Paul Krugman at the forefront, have called for China to re-value its currency and for the US to impose trade sanctions if Beijing were not to comply. Other economists feel that trade barriers are ineffective and that a revaluation of the Yuan won’t do much to reduce the US trade deficit.  The latter argue that most goods imported from China are those consumer goods that the US cannot or will not produce domestically anyway. If US consumers don’t buy from China, they will import it from somewhere else. Perhaps the trade with China may suffer but the overall US trade balance won’t improve.

Change is looming upon us however.  From within China, there are now some signs that indicate Beijing might pull the trigger and revalue its currency some time this year.

Grasp
In the financial Blogs, the debate has been ravaging for a long time now and rather outspokenly so.  Opinions have been flying left and right with some increasingly aggressive stances, as if the financial crisis the global economic challenges could be solved by simply adjusting one currency to the upside. The issues are of course extremely complex and the ubiquity of possible implications is probably out of reach for one mind to fully grasp (certainly too complex for mine).

Please consider the following blog post “Why Re-pegging the Yuan and Other Non-Free-Market Solutions to Trade Imbalances With China Will Fail” by Mike “Mish” Shedlock.

This is one of the many articles featured in financial Blogs recently, but it’s a very good example of how complex the issue of the Chinese currency debate has been. Mish, a highly respected blogger who typically employs a healthy dose of common sense when examining financial markets seems to struggle wrapping his head around the issue in a sort of “all over the place” (unusual for him) approach to making sense of the debate.

How confusing the issue can be shows up in the information exchange between Mish and Michael Pettis.  Pettis, a professor at Peking University’s Guanghua School of Management, specializing in Chinese financial markets, first writes:

"...to use a controversial example, if the US were able to force up the value of the dollar by 20% or more against all other currencies, it would become far more profitable to produce cars domestically, it would revive the aluminum and chemical industries, and it might cause a significant divergence of electronics assembly to the US."

He then later replies:

“Mish, sorry, I meant force “down”, not up. The point is that if the dollar were devalued by 20%, the immediate impact would that US manufacturers would become much more profitable and foreign much less so. That would shift US and foreign consumption of cars from foreign producers to US producers, and would of course have a positive impact on US employment.”

Was that a Freudian slip by Dr. Pettis, a simple typo or was it just a reflection of how difficult the issue is in terms of deriving a somewhat simple solution?

Just taking a small bite out of Pettis argument with regard to cars, the answer is not entirely based on exchange rates nor is it simply price-driven.  US car manufacturers might export more cars but it is questionable if they would sell any more domestically.  US consumers have turned their backs against American car manufacturers because they have been building lesser quality cars.  It’s not the price alone that drives consumption, point in case Apple computers: If the product is of exceptionally high quality, consumers will find the money to buy the product.  Conversely, if a product is “cheap” but not that attractive, why buy it?  The same argument goes for overseas consumers who are actually less price sensitive and given a choice would rather opt for a premium brand.

When and How?
What about a solution then? It’s complicated to say the least and for many analysts, the question is no longer if but when China will drop the currency peg.  That however, has numerous implications, not all of which are positive for the US.

“When” China lifts the currency peg, inflation will also be imported in the US which, at current levels of unemployment, will not bode well for the cash-strapped US consumer.  A fall in the value of the US Dollar and a possible crash in the Bond market may hurt both Chinese as well as US investors - with about $900bn, China is still the largest holder of US Treasuries.  And, the Fed will be required to raise rates to find buyers willing to fund the immense government debt.  None of these measures sound all that appealing. 

At the same time, China is beginning to realize that decades of managed exchange rates have come at a price as well.  Domestic inflation in China is as high if not higher than GDP growth.  As long as the Yuan is relatively cheap, the commodity hungry Chinese manufacturers will struggle maintaining their prices as commodity prices are on the rise again.  Last not least, China is sitting on upwards of $2 trillion worth of US assets and will not tolerate to have these asset values depreciate drastically.  Any move on the part of China will therefore be highly calculated and timed well, making small gradual adjustments only.

In the long-run, letting the markets determine the “right” exchange rate appears to be the most sensible solution. Because of the complexity and a myriad of unforeseen consequences that a managed exchange rate could bring, the market may have the best shot at finding the “right” exchange rate, even if that rate were to change on a daily basis. Getting there however, will take some time.  Meanwhile, today’s hodgepodge of a currency soup might not be to everyone’s taste.  But as Mish pointed out in his article:

I am certainly in favor of letting the free market solve all of those. Indeed many of them are so intertwined, that only the free market has a chance in hell of solving them.