The Great Debate

from The Great Debate UK:

Waiting for the other shoe to drop

Laurence Copeland

Aug 25, 2010 15:11 EDT

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own and do not constitute investment advice. -

The unemployed and the terminal insomniacs who have nothing better to do than read my blogs will know that I have long been gloomy about most of the Western economies. How can you fail to be pessimistic when the world economy is still dominated by the U.S. - a basket case, becoming weaker every day, with a political class too blind or too scared to admit in public the obvious fact that the country cannot carry on living beyond its means?

Now house prices are plunging again and, with the dollar still strong, the prospects for an export-led recovery look bleak. In fact, a return to recession is far more likely, and the markets are starting to show signs of that sickening here-we-go-again feeling.

How will it all end?

Anyone who claims to know how this will all play out is on no account to be trusted, but there’s nothing wrong with trying to guess – in fact, that’s exactly what we have to do before we can decide what assets to invest in, or whether to invest at all rather than simply blowing it all on a long bankruptcy binge.

So here goes. I start from the observation that the bond and currency markets, in their infinite lack of wisdom, seem to have divided the whole membership of the United Nations into two classes, high-risk countries and low- (or no-) risk countries.

Flight to “safety” eases China diversification

James Saft

Aug 19, 2010 09:02 EDT

China appears to be taking steps to diversify its holdings away from the U.S. dollar and may just have chosen a pretty good time to do it.

Longer term a meaningful diversification by China, which holds about a third of its $2.45 trillion currency reserves in U.S. Treasuries, is probably both inevitable and highly risky.

Inevitable, because China probably realises that, given the U.S.’s difficult fiscal and economic challenges it is not sensible to have its own fortunes tied so closely to its major client.

Risky, because wholesale sales of U.S. Treasuries by China would drive up U.S. interest rates and could spark panic selling in the dollar. That would undermine the U.S. economy, hitting demand for Chinese goods, fouling U.S./China relations and, not least, torpedoing China’s own accumulated wealth.

However, it seems, people have more important things to be scared of than Chinese portfolio sales, and are running headlong into Treasuries seeking safety from deflation and the threat of a recession. That is overwhelming any impact that China diversification is having on U.S. instruments, at least so far.

China reduced its holdings of Treasuries for the second month running in June, according to data released on Monday by the Treasury Department, sending its exposure down $24 billion to $843.7 billion. Significantly, sales included longer-dated issues, negating the argument that China is simply re-balancing away from the billions in short term U.S. debt it added during the depths of the crisis.

Overall, foreign demand for U.S. securities was about $44 billion in June, or some $5 billion less than the trade deficit, which expanded rapidly in the month. Like so many things in life, that seems to be both ultimately unsustainable but currently sustained.

Dollar favorite in glue factory derby

J Saft

May 6, 2010 08:08 EDT

The dollar may hang by the slender thread of the U.S. recovery, but this is probably enough to make it the major currency of choice.

It is not so much that the dollar is strong, but that the case for its major peers — the euro, pound and yen — is so weak.

The euro zone faces tremendous pressure; Greece may, just, have been rescued, but it, along with Portugal, Spain, Ireland and Italy are unleashing powerful deflationary forces making quantitative easing by the European Central Bank a real possibility. Further contagion within the euro zone is also a  strong possibility, meaning market risk will compound fundamental risk.

Even when the result of Britain’s election is clear, the path to a better fiscal picture is not, and when it comes, it will deal a blow to the economy.

Japan, as for so long, is not really going anywhere and doing so in an erratic fashion, again the implication being that the Bank of Japan will keep rates ultra-low.

The United States, then, is the pick of a bad bunch.

“The dollar is the best-looking horse in the glue derby” said Jan Randolph, director of sovereign risk at IHS Global Insight, speaking at a Euromoney foreign exchange conference on Tuesday.

Be careful what you wish for on currencies

John Kemp

Mar 19, 2010 08:41 EDT

The rancorous argument about global payment imbalances and the yuan’s valuation is exposing a surprising and dangerous economic illiteracy among policymakers and commentators.

Before pressing China to allow a maxi-revaluation of the yuan, western commentators need to think through the consequences carefully. The idea that devaluing the dollar (and by extension euro and yen) will cause payment imbalances to disappear and boost employment in the West with little or no impact on inflation and living standards is a pipe dream.

MAXI-DEVALUATION First some notes about terminology. Proponents generally phrase their argument in terms of an appreciation of the yuan (which keeps the focus on the alleged currency manipulators in China). But it could just as easily be recast as a depreciation of the dollar (which is a much more controversial formulation, highlighting the fact that the exchange rate problem reflects U.S. weakness as much as China’s strength).

Since most observers assume bilateral relationships between the dollar and other major currencies would not alter significantly, China is in fact being pressed to permit a balanced depreciation of the dollar, euro, yen and other major currencies.

Finally, we are not talking about small changes but very large ones. Observers have suggested the dollar might be overvalued as much as 25-50 percent. Devaluing it 5 percent is unlikely to cause a substantial adjustment in China’s trade surpluses with the United States and globally and will not remove the political tensions and the root of the crisis. Only a very large reduction in the dollar’s value over a period of years, in effect a “maxi-devaluation”, could hope to adjust the relative trade performance of the two countries.

ADJUSTMENT WITHOUT INFLATION? Within the United States and euro zone, the main impact would be to raise the price of tradable goods and services relative to their non-tradable counterparts. Exports would become more competitive while imports would become significantly more expensive. Demand would switch from domestic consumption and imports towards exports and import-competing firms.

Normally, such expenditure-switching adjustments would need to be accompanied by expenditure-reducing tax hikes, spending cuts and interest rate increases to shrink non-tradable industries to expand export and free up resources for import-competing sectors, allowing adjustment without triggering inflation. The combination of expenditure switching and reducing policies is the standard prescription at the heart of an IMF structural adjustment programme in developing countries.

Real commodity prices and the U.S. rate cycle

John Kemp

Feb 10, 2010 11:16 EST

– John Kemp is a Reuters columnist. The views expressed are his own. –

Commodity prices exhibit a strong cyclical component — though it can be masked when producers are carrying a lot of excess capacity.

The attached chart shows the real price of various commodity baskets (Jan 1980=100) overlaid by U.S. interest rates (discount rate, later funds target), and the business cycle (NBER Business Cycle Dating Committee).

Prices began rising well ahead of interest rates after three of the last four recessions. Commodity markets anticipated future increases in demand even as policymakers prefered to hold back while recovery became more firmly established.

The current price rebound is unusual only for its strength.

Part of the explanation is the increasing weight of China and other emerging markets in global commodity consumption. As a result, the U.S. business and rate cycles and those of the other advanced economies now affect less than half the consumption of many commodities worldwide.

Prices are geared to the global cycle, which is not captured by measures of industrial output and capacity in the United States and the rest of the OECD.

Welcome to the Teenies, sorry about those returns

James Saft

Dec 29, 2009 10:48 EST

-James Saft is a Reuters columnist. The opinions expressed are his own-

As we say goodbye to a decade so abysmal it never even earned a nickname, it is time to take bets on how the coming 10 years will shape up in economics and financial markets.

Welcome, then, to the Teenies, a word that will describe the decade as well as the small returns in financial markets and the shrinking financial sector it will bring.

So, let’s run through some themes for the 2010s:

Banking – The decade will end with meaningful reform of banking in place, but what is not clear is if this happens soon or only after a new banking crisis brought on by an unwillingness to take tough steps now. The likelihood is that regulation limits leverage and causes the share of the economy captured by financial services to shrink. It will be a lousy decade to be a shareholder, but given the government backing, perhaps not a bad one to be a bondholder.

It will be a great decade in which to have credit skills; even if the ratings agencies escape meaningful reform, everyone is going to want to do their own homework and a shrinking banking sector will open up highly profitable opportunities for alternative avenues of credit.

Investment - Just as the last decade started with dot-comfever and ended with unease, the next one will be all about reconciling oneself to moderate returns and figuring out who is hurt worst by a world of slower growth, less volatility and less debt. My theory is that a balance sheet recession means growth in the developed world for the next few years will be restrained at best. The past few months have been heady, but don’t be fooled, it will be very hard work to make an overall portfolio return even 8 percent. As those expectations slowly deflate, pension fund risk will become much more important in investing. General Motors will not be the last icon partially brought down by its obligation to retirees.

Dollar faces long journey downward

James Saft

Oct 13, 2009 08:49 EDT

- James Saft is a Reuters columnist. The views expressed are his own –

Even putting aside the spectacular but hard-to-measure risks of a financing crisis or the loss of its special status, the dollar faces really serious headwinds from boring old fundamentals.

The dollar has been weak for months and markets have been fretting over a host of big picture worries.

Perhaps the world’s oil exporters will stop using the dollar as the medium for petroleum trade. Or maybe the so-far patient and docile buyers of Treasuries will finally turn jittery. Either could be a disaster for the dollar, but you don’t need conspiracies or crises to be bearish on a currency from a country which on some measures has run the largest-ever deficit between what it imports and what it sells abroad.

One of the most interesting side effects of the first part of the financial crisis was that the dollar actually rose despite being the locus of the credit bubble and despite the U.S. consistently importing far more than it exports. That strength, which has now been reversed in part, was largely because the freezing up of markets set off a scramble for dollars.

The acute phase of the crisis is over and a return to something approaching normalcy is not treating the dollar kindly; from its peak this year the dollar has fallen more than 13 percent against a trade-weighted basket of currencies. The current account deficit — the balance of exports to imports — has also been reduced greatly, from a peak north of 6 percent of GDP to below 3 percent at the end of June, with further narrowing in the months since. That is because a weaker dollar makes U.S. products more competitive, but also because the price of oil, of which the U.S. is a net importer, has dropped, and consumption at home is flagging.

Who lost the dollar?

James Pethokoukis

Oct 12, 2009 14:22 EDT

– James Pethokoukis is a Reuters columnist. The views expressed are his own –

The state of the dollar probably hasn’t been a first-tier political issue in the United States since, say, the presidential election of 1896. Back then, it manifested as whether or not America would stay on the gold standard or switch to a bimetallic one. (The William Jennings Bryan “cross of gold” speech and all that.)

The aftershocks of the global financial crisis may now be propelling the dollar back to the political forefront. The greenback’s continuing slide makes it a handy metric that neatly encapsulates America’s current economic troubles and possible long-term decline. House Republicans for instance, have been using the weaker dollar as a weapon in their attacks on the Bernanke-led Federal Reserve.

For more evidence of the dollar’s return to political salience, look no further than the Facebook page of Sarah Palin. The 2008 GOP vice presidential nominee — and possible 2012 presidential candidate — has shown a knack for identifying hot-button political issues, such as the purported “death panels” she claims to have found in Democratic healthcare reform plans. In a recent Facebook posting, Palin expressed deep concern over the dollar’s “continued viability as an international reserve currency” in light of huge U.S. budget deficits.

She might be onto something here, politically and economically. A recent Rasmussen poll, for instance, found that 88 percent of Americans say the dollar should remain the dominant global currency. Now, the average voter may not fully understand the subtleties of international finance nor appreciate exactly how a dominant dollar has benefited the U.S. economy. But they sure think a weaker dollar is a sign of a weaker America.

And that’s the political problem for the Obama administration. Its benign neglect of the dollar is another example of an economic policy — along with TARP and the $787 billion stimulus — that the White House thinks is helping the economy, but many Americans find wrongheaded.

In his New York Times column today, Paul Krugman makes the usual case for a weaker dollar: It helps U.S. exporters and is a necessary part of a global economic rebalancing. And there is some truth in that, particularly the idea that Rising Asia will result in a less-dominant dollar.

from Rolfe Winkler:

Gold as Armageddon insurance

Rolfe Winkler

Oct 7, 2009 14:47 EDT

Deflation could be the biggest threat to the economy, but gold -- usually an inflation hedge -- is reaching new highs. That's because smart investors aren't playing the inflation trade, they're buying currency crisis insurance.

With the amount being spent by the public sector, with the huge amounts of leverage still in the system, there's a palpable fear that America won't be able to meet its obligations. Relative to GDP, the amount we're borrowing to finance deficits makes us look irresponsible.

When such economies hit a wall, investors make a run on the currency, typically moving their assets to a stronger currency, like the dollar.

But this time the problem is the dollar, along with other leading paper currencies, all of which are threatened by profligate fiscal and monetary policies. So some investors want out of the system entirely. Gold, as my colleague Neil Collins noted earlier, is a way to do that.

The gold market is small enough that a decision by a handful of money managers to increase their asset allocation from, say, zero to 5 percent can move the market. All the gold ever mined would fit aboard an oil tanker; its total weight of 125,000 tons amounts to a few hours' output for the U.S. steel industry.

But economists tell us that inflation isn't a risk now. Are they wrong? No and yes.

The conventional way economists view inflation is to look at things like "output gaps." When the economy falls below a level of output it previously achieved, it is said to have unemployed resources. If you think of inflation as workers demanding and getting higher wages, which leads to higher prices for the goods and services they produce, then inflation isn't a threat.

Global rebalancing to weaken dollar, quietly

Neal Kimberley

Sep 24, 2009 12:10 EDT

– Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own –

Twenty-four years ago, major nations called for depreciation of the dollar to rebalance the global economy. Now, as another effort at rebalancing looms, the dollar will again bear the brunt — though officials will try to ensure its fall is less dramatic this time.

That’s the implication of President Barack Obama’s announcement this week that he will push world leaders for a new global “framework” in which the United States would cut its huge trade and budget deficits.

Agreeing on this framework would be politically difficult, since it would require policy changes by many countries — China, for example, would probably have to rein in its explosive export-led growth.

But as the euro’s climb to a new one-year high versus the dollar this morning shows, markets are starting to think the rebalancing process may start as soon as this week’s Pittsburgh summit of leaders from the Group of 20 nations.

The Plaza Accord of 1985 called for “orderly appreciation of the main non-dollar currencies against the dollar”; it was followed by central banks’ coordinated intervention to ensure that happened.

This time, with the world shakily emerging from a financial crisis, policymakers are likely to try to manage the dollar’s drop in a more low-key fashion.