Dollar index, S&P 500, MSCI Emerging Market Index: Intermarket analysis

Posted on March 28, 2013 by Delta Financials

Like any trader, I tend to spend a lot of time working through little thought experiments. Here’s one that I’ve been looking at, lately. The chart below outlines the relationship between the dollar index (black candles), the MSCI Emerging Market Index (Red line, in US dollar returns) and the S&P 500 index (blue line), going back to 1990.

S&P500 v DXY v MSCI EM

Inter-market relationship between the S&P 500, Dollar Index & the MSCI Emerging Market Index.

The reason I’ve gone back to 1990 with the chart is to display the shift in intermarket relationships. In essence, the early 1990s saw a powerful combination of a rally in US equities, compounded further by a rising dollar (relative to other currencies). While that was great for US stocks, it limited the appeal for Emerging Market equities which didn’t generate any real returns in US dollar terms (in part due to the East Asian currency crisis).

The bursting of the NASDAQ bubble, and 9/11 led to a sea change in US monetary policy. Strong dollar policies were largely abandoned; consumption was encouraged and the ensuing current account deficits went hand in hand with a cheaper dollar. This was a great environment for Emerging markets, which benefited both from rising demand for their goods, and (in many cases) rising currencies (relative to the dollar).

The graph below, which compares the US current account with the dollar index, is by no means a timing tool or indeed a complete explanation. A single factor model of current account surpluses/deficits does not explain currency movements. But, over long periods, the relationship plays out as you would expect.

Over long periods, greater current account deficits tend to drag the dollar down.

Over long periods, greater current account deficits tend to drag the dollar down.

This is the context within which, the dollar is vitally important to any asset allocation choice. Over short periods, intermarket relationships shift significantly (relative strength charts are a good way of studying shorter-term intermarket movements). But, over the long run, market moves and economic trends do interact. You could make the claim that markets (usually) discount data before it arrives, so the dollar index would be expected to lead, rather than lag current account data. But, this is a fluid process, and a historical narrative always sounds more compelling than making assertions about the future.

We can however make a few loose observations. A strong dollar plays a somewhat destructive role for emerging market equities. Till quite recently, the “risk trade” was fairly well defined. A strong dollar was a “risk off” trade – bad for all equities, good for bonds. More recently, the “risk on”, “risk off” paradigm has shown signs of shifting. We’ve seen the S&P rally alongside a stronger dollar, but Emerging Markets have under-performed. This could very well be transitory. There is nothing conclusive to suggest that we’re in a secular dollar bull market.

I’ll leave you with one of the charts that have grabbed my attention. This is simply a zoomed in version of the question mark area of the earlier chart comparing the S&P (in blue), the MSCI EM index (in Red) and the dollar index (candles). The structure of these relationships suggests that any significant signs of dollar weakness could make emerging markets very attractive. Signs of negative divergence on the RSI add a bit of zing to that potential trade. But, remember, divergence isn’t a substitute for price action. The point of analysis such as this, is to build a context to navigate multiple scenarios – not to lock yourself into any one view.

Signs of negative divergence on the dollar index make the MSCI Emerging Market index a temptation. But, depending on your strategy and approach, divergence itself usually isn't a sufficient signal.

Signs of negative divergence on the dollar index make the MSCI Emerging Market index a temptation. But, depending on your strategy and approach, divergence itself usually isn’t a sufficient signal.

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Dijsselbloem, Cyprus and Too Big To Fail

Posted on March 26, 2013 by Delta Financials

A couple of thoughts on this Dijsselbloem interview that’s been causing a lot of controversy. If you haven’t read it yet, here is a full transcript.

The Cyprus problem is at its root a violent depiction of the twin problems of too big to fail and governments with a funding problem. What Europe fails to recognize is the role of a sovereign in a fiat money system. Fiat money can’t survive under deflation. Credit won’t be extended in an environment of falling asset prices and credit is the root of all economic activity under government fiat. So, the role of the sovereign is first and foremost to fight deflationary pulses and then to ensure that the currency system itself maintains its integrity (i.e. a little inflation, but not too much). The fundamental difference between the functional system of credit in the US and the dysfunctional system in Europe is that the American policymakers appear to understand this.

In the European context, the root of the problem lies in an inability to recognize that in order for the sovereign to fulfill its primary responsibility, it must be able to issue currency. If it can’t, the deflationary pulse of a recession fast turns into a depression (a.k.a. Greece).

So, Djisselbloem is quite right in outlining a moral solution for banks. In fact, I couldn’t agree more when he says

If there is a risk in a bank, our first question should be: “Ok, what are you the bank going to do about that? What can you do to recapitalise yourself?” If the bank can’t do it, then we’ll talk to the shareholders and the bondholders. We’ll ask them to contribute in recapitalising the bank. And if necessary the uninsured deposit holders: “What can you do in order to save your own banks?”

In fact, in essence, Djisselbloem is outlining a process of bank resolution without the moral hazard created by sovereign bank bailouts (one of the more problematic aspects of US action over the last 20 years). But, here is where Djisselbloem blows it:

That is an approach that I think we should, now that we’re out of the heat of the crisis, consequently take.

European policymakers need to recognize that they’ve bought time through a series of dubious promises. They have not succeeded at restoring Europe to the status of being currency issuers. Eventually, we will get there – either under the banner of a Euro within a fiscal union, or through a return to individual currencies. But, the current purgatory that Europe insists on keeping itself in is little more than a road to perdition. In this environment, there are no moral solutions. Only sub-optimal choices that leave European policymakers open to criticism and resentment.

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Cyprus bailout: hitting where it hurts

Posted on March 18, 2013 by Delta Financials

A few quick thoughts on what has to be one of the more absurd policy decisions, even by European standards.

Here’s a basic summary of what Europe has done over the last two decades. First, they pooled together incompatible German, Greek, Spanish (and Cypriot) productivity to create a common currency, under the roof of the ECB. This we were told would create “stability”. What ensued was over a decade of southern Europe boosting its consumption and undermining its production under an artificially strong currency. Inflation was contained, there was widespread economic growth and the combination of low rates and an asset price boom fed this false consumption further.

Then came 2008. In the midst of a global banking crisis, the sanctity of deposits were themselves called into question. While it was assumed that European banks would act as one entity under the supervision of the ECB, they instead offered individual deposit guarantee schemes. Since it had now come to light that the banking system wasn’t a single, homogeneous system but instead a collection of widely disparate systems, risk had to be re-priced on a case by case basis.

A few national accounting scandals later, credit spreads essentially re-priced risk in order of productivity. So, nations in Northern Europe continued to enjoy low rates, but nations in the periphery were asked to pay higher rates for their borrowings. This in turn undermined the entire banking system, since bonds were largely treated as “risk-free” assets by financial institutions. Falling bond prices caused a massive crunch on liquidity, and in some cases stretched the boundaries of solvency. Since individual nations couldn’t issue fresh currency, a violent feedback loop between banks and sovereigns was unleashed. As yields rose, bank balance sheets got weaker which in turns increased the potential liability of the sovereign, which led to higher yields and weaker bank balance sheets.

At this stage, the banking system had seized up and Europe faced a fundamental choice between trying to preserve a union which shared neither a single identity, nor a common economic architecture or trying to create an orderly return to individual currencies. The choice was essentially between a transfer union or a return to individual currencies. The fact that individual countries were expected to supervise their banks, but didn’t have the authority to issue fresh currency made the system unviable.

We were told the powers that be had decided to move towards a fiscal union. We were told the ECB would do “whatever it takes” to preserve the Euro. We were told we’d have a single banking supervisor, Europe-wide deposit guarantees and a gradual move towards deeper economic integration. After years of crisis, markets were relieved. There was no need to even test the ECBs resolve, because jawboning had worked. Why would anyone bet against the central bank.

Northern Europe had succeeded. It imposed austerity on the south, in return for the promise of solvency. Then came Cyprus. A little nation with the same banking problem that inflicted Ireland. Suddenly, the rules of the game had changed. We didn’t just get a sovereign bailout with conditionality – we got a whole new method. Savers – large and small were swindled of their savings over a holiday weekend.

The ECB didn’t exactly do “whatever it takes” and the German’s thought primarily about German interests. Nobody seems to have weighed systemic risk. We’re now left with the realization that we have no fiscal union. We don’t have a coherent deposit insurance mechanism if your savings aren’t necessarily safe. We have no reason to believe that Europe is capable of delivering on any of its promises.

Now, the systemic saving grace is this: Cyprus is a small, largely insignificant nation in the broader context. The European banking system depends more on wholesale deposits than retail deposits. So, contagion isn’t guaranteed. But, if people in the South wake up to the sinister reality of how this system works, we do face systemic risk. If you can’t depend on your bank deposit in a fiat money system, faith in the currency system itself is undermined. This is a policy that flirts with deep systemic risk. All in an attempt to fund an additional 6 billion Euros. Whether we see spreads widen, depositors fleeing the south and broader systemic issues or not – this was not smart.

Some might say that in a capitalist system depositors should be at risk for their deposits, that the absence of penalizing nations with excesses would be the creation of moral hazard and so there’s no fundamental problem with the policy Europe is pursuing here. That would make sense if you treated all nations, all bondholders and all institutions at par. Much like that Lehman moment that was followed by saving AIG and others; European policy has revealed its unpredictability and incoherence. The systemic consequences are unlikely to be either as violent or as immediate; but the intellectual edifice of the single currency just took another hit. And so did savers: where it hurts the most.

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NIFTY & FII (Foreign Institutional Investor) Inflows

Posted on March 13, 2013 by Delta Financials

A quick post, before I get into the meat and substance of the nature of flows that most influence the Indian index. The graph below is a depiction of NIFTY levels, compared with cumulative FII (Foreign Institutional Investor) inflows (for equities). The degree to which this is a market structurally dependent on FII inflows is fairly self-evident.

NIFTY v FII Inflows

NIFTY levels v Cumulative FII Inflows

This isn’t a graph that should surprise anyone, but it is a neat depiction of an important reality: the NIFTY has been very dependent on FII money. So when you’re looking to understand market structure, a good place to start is to understand what drives FII money, and what we can say about it with reasonable conviction. An allied question is what we can say about other market participants. More on that, in a future post.

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Buffett: Fed’s unwinding problem

Posted on March 5, 2013 by Delta Financials

Some interesting thoughts from Warren Buffet on the Fed’s unwinding problem. If the data continues to look good, the conversation will eventually start to turn to exactly how the Fed plans to reverse course.

As always, the full interview is filled with Buffett’s inimitable ability to distill complexity. But here’s what was, in some senses, the most important part of it.

all over the world, everybody that manages money is waiting to catch the signal that the fed will reverse course. and, you know, there’s a — I think they’re on a hair trigger. So, i think the fed will try to get little signals here and all of that but in the end, there are an awful lot of people that want to get out of a lot of assets if they think the fed is going to tighten the lot and we’ve never quite had, in my — listen, at least to my knowledge, we’ve never had the degree of disgorgement that might be called for down the line. and who knows how will play out. but it will be noticeable, put it that way.

While the Fed’s unwinding is almost certain to be a lot slower than some might expect, this is a theme worth thinking through. The “what’s the alternative” argument can lead to a lot more P/E expansion than we’ve already seen, particularly if we avoid the weak dollar, strong commodities environment that’s been a hallmark of the market rally since 2009. But, the ultimate unintended consequence of the Fed’s easy money policy is that the longer rates are low, the greater systemic dependency you create on cheap credit.

Sustained economic recovery depends on increased lending in the private sector. Yet, with the expansion of the monetary base, an increase in the multiplier will lead to inflationary pressures. While some have made the argument that a bit of inflation is exactly what we need; that argument usually ignores the impact of rising rates. As Warren puts it

In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farm land, oil reserves, stocks, and every other financial asset. And the effects can be huge on values.

On a day when the Dow has made fresh all-time highs, I’d suggest this is an overall environment best navigated through strategic allocations and trades, rather than secular ones. Unless, you’ve got some of the personal traits of the oracle of Omaha himself.

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Inflation and the fiat money system

Posted on February 10, 2013 by Delta Financials

We live in extraordinary times where a profound misunderstanding of the operational realities of how a fiat money system marked by sovereign currency issuer nations works.

The fiat money system we now operate with was created as an emergency measure with little public discourse. Until 1971, the dollar was redeemable for Gold at the rate of $35 per ounce. When the Vietnam war stretched US government finances, West Germany withdrew from the original Bretton Woods system and other nations started to redeem their dollars for gold. In that backdrop, Nixon temporarily suspended the gold window. That’s how fiat, Latin for “let it be done” currency came into being.

What we have today is a vital and intriguing debate on what the role of government should be, taking place in the backdrop of falsehoods and demagoguery. As I’ve noted before, in an article on Modern Monetary Theory and QE, the government can’t run out of money. It doesn’t operate with the same constraints as a family running its monthly budget.

This lack of traditional constraints is starting to gain acceptance among economists. The very fact that Japan with gross debt levels approaching 250% of GDP, borrows money at less than 1% contradicts the notion that increased “default risk” should lead investors (and bond vigilantes) to demand higher rates of interest. Economists have come around to the notion that since sovereign issuer nations can always issue fresh currency, there’s no good reason to believe that they won’t be able to make interest and principal payments.

Increasingly, the question facing governments and economists is not whether governments can finance themselves through central banks, but whether they should. On the latter question, if governments finance themselves not through a market mechanism, but through a central bank that has no real option but to continue to fund the beast, one of the essential checks on government spending would have ceased to exist. History suggests the the incentive structures surrounding government are ill-suited to economic activity.

There’s a large field of post-Keynesian thought that argues that when faced with a situation where private demand isn’t sufficient – governments need to step in and create enough aggregate demand to prevent depression-like outcomes. Certain schools argue essentially that since central banks can always control short-term rates, we won’t face a spike in interest rates as inflation starts to rise. However, negative real rates would only fuel further inflation. My point here is that to argue that sovereign issuer nations don’t face solvency constraints, isn’t the same as arguing in favor of increased government spending.

An important question that we may get an answer to if Abe’s policies show traction in Japan – is what happens to the long end of the yield curve when you get signs of growth and inflation. If we see a great rotation out of bonds and into riskier assets, surely yields will rise and have a negative effect on Japan’s enormous levels of private and public debt. If the Bank of Japan continues to fund the government by buying long-term bonds, surely that will stoke higher levels of inflation. With a 24 hour news cycle, it’s easy to loose perspective, in a temporal sense. But, we’re still in the early stages of a vast expansion in monetary policy – the demagogues on both sides of the ideological spectrum have got it right then got it wrong, repeatedly. The empirical reality might not be as charged as ideology, but it gives us an important lesson: fear not your government going broke, fear it unleashing inflation down the road.

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