Who is keeping long bond yields low? If it is self-interested Asian central banks, one can imagine the status quo continuing for some time. If it is hedge funds plying the carry trade, the status quo is very, very vulnerable. We noted in this previous post that hedge funds are the fourth largest holder of Treasury debt after Japan, China and the UK. In the article below it is claimed that hedge funds are more likely to be on the long end of the yield curve than foreign central banks.
From Bloomberg today: When one considers that the inflation risks are skewed to the upside, a 10-year note yield near 4 percent is puzzling. Even discounting the surge in oil prices that has boosted the year- over-year increase in the consumer price index to 3.5 percent in November, the core CPI, which excludes food and energy, is accelerating, any which way you look at it. The core CPI rose 2.2 percent in the year ended November, double the increase of a year ago.
...What happened to the higher expected yields that weren't? One frequent answer is massive Asian central bank buying of Treasuries from countries that intervene in the foreign-exchange market to prevent their currencies from rising (Japan) or that acquire dollars from exporters who can't convert them in the open market (China).
While China grabs all the headlines, as of October Japan held $715 billion of U.S. Treasuries, a 40 percent increase from a year earlier. (The Treasury statistics on foreign holdings include both official and privatei nvestors.) China, whose trade surplus with the U.S. ballooned to $131 billion in the first 10 months of the year, increased itsh oldings by 16 percent to $174.6 billion.
...The hole in that argument is that foreign central banks traditionally park their dollars in the short end of the yield curve, according to Jim Bianco, president of Bianco Research in Chicago.
``Don't make the mistake of confusing bonds with GDP futures,'' Bianco says. ``Financing rates are more important to bonds than the inflation rate.''
Easy money since the Sept. 11,2 001, terrorist attacks has encouraged ``a new breed of leveraged investor, with most of the hedge-fund growth coming in fixed-income arbitrage or relative value funds,'' Bianco says, based on data from Hedge Fund Research in Chicago.
The growth in hedge funds is also evident from the explosion of trading in U.S. stocks and bonds from the tax-haven countries of the Caribbean, where total turnover is up 100 percent in the past year, according to Bianco.
If cheap money has been the inducement for hedge funds to load up on 10-year notes, then higher real rates should be the trade's undoing. With core CPI up almost as much as the funds rate this year, there's been no change in the real cost of financing bond purchases so far.
Cheap money has been an incentive for more than leveraged trading. ``It was a big employment incentive, too,'' Bianco says. ``For hedge funds.''
So, if I understand, hedge funds are borrowing short and lending long. Japan, China, India and Brazil are buying America shorter term debt, while hedge funds are buying long term debt. As long as interest rates rise modestly there is no problem, since there is still a profit to be made borrowing short to lend long. But, as in 1994, if rates rise more rapidly and the cost of borrowing cuts away profits from holding long term securities, hedge funds will start selling debt.
ReplyDeleteDo I get this?
Anne
http://www.nytimes.com/2004/12/23/business/worldbusiness/23canada.html?pagewanted=all&position=
ReplyDeleteChina Emerging as U.S. Rival for Canada's Oil
By SIMON ROMERO
CALGARY, Alberta - China's thirst for oil has brought it to the doorstep of the United States.
Chinese energy companies are on the verge of striking ambitious deals in Canada in efforts to win access to some of the most prized oil reserves in North America.
The deals may create unease for the first time since the 1970's in the traditionally smooth energy relationship between the United States and Canada.
Canada, the largest source of imported oil for the United States, has historically sent almost all its exports of oil south by pipeline to help quench America's thirst for energy. But that arrangement may be about to change as China, which has surpassed Japan as the second-largest market for oil, flexes its muscle in attempts to secure oil, even in places like the cold boreal forests of northern Alberta, where the oil has to be sucked out of the sticky, sandy soil.
"The China outlet would change our dynamic," said Murray Smith, a former Alberta energy minister who was appointed this month to be the province's representative in Washington, a new position. Mr. Smith said he estimated that Canada could eventually export as many as one million barrels a day to China out of potential exports of more than three million barrels a day.
"Our main link would still be with the U.S. but this would give us multiple markets and competition for a prized resource," Mr. Smith said. Delegations of senior executives from China's largest oil companies have been making frequent appearances in recent weeks here in Calgary, Canada's bustling energy capital, for talks on ventures that would send oil extracted from the oil sands in the northern reaches of the energy-rich province of Alberta to new ports in western Canada and onward by tanker to China.
Chinese companies are also said to be considering direct investments in the oil sands, by buying into existing producers or acquiring companies with leases to produce oil in the region. In all, there are nearly half a dozen deals in consideration, initially valued at $2 billion and potentially much more, according to senior executives at energy companies here.
http://www.nytimes.com/2004/12/23/business/23truffle.html?pagewanted=all&position=
ReplyDeleteLeave No Truffle Behind?
By EDUARDO PORTER
At Le Bernardin, the four-star Manhattan seafood restaurant, the prix fixe menu these days runs a hefty $92. But Eric Ripert, the owner and chef, winces every time a customer orders the wild salmon on a bed of asparagus.
"If you choose the salmon you kill us," Mr. Ripert said. "We are losing money every time we sell a portion."
Mr. Ripert is not used to worrying about the value of the dollar in foreign currency markets but it is much on his mind lately. That's because one of the prime ingredients in the dish is black winter truffles imported from France's Périgord region.
With the value of the dollar down by roughly 35 percent against the euro since the beginning of 2002, the preserved truffles Mr. Ripert imports to use in his sauce have risen sharply in price lately. Today, a seven-ounce tin costs him about $280, up from $200 a year ago.
The dollar's weakness, Mr. Ripert said, "is a real disaster at the level of the truffles."
Truffle inflation should come as no surprise. The devaluation of the dollar against the euro and some other currencies like the British pound and the Swiss franc forces American importers of goods from Europe to raise prices or accept sharply lower profits because they must spend more, in dollars, to buy products priced in European currencies. On things like truffles and caviar, where few equally good domestic substitutes exist and where aficionados can afford the best, there is little incentive to keep prices from rising in the United States.
But apart from truffles, a variety of other imported foods and a handful of specialized European products, the sinking dollar has so far had a relatively modest impact on the prices paid by American consumers.
Anne,
ReplyDeleteYes, you have described the carry trade. One important ingredient is leverage - you borrow many times more capital than you actually have, at the low short-term rate, and buy long bonds. If the interest differential is, say 2%, but you use 10x leverage, you can make a 20% return on the original capital. But if rates rise and prices of long bonds decline, your losses are also multiplied 10x. There is an old joke on Wall St. about practicing the carry trade until you yourself are carried away on a stretcher.
This means the meltdown on the long end of the yield curve could be quite quick and ugly.
There are even some closed end funds (I think Blackrock, for example) that practice a "light" version of the carry trade - they use more modest leverage, but it's the same thing. These actually had a good year last year - acting like a wimpy academic rather than a trader I avoided them, convinced they would definitely blow up in the rising rate environment.
http://store1.yimg.com/I/palemale-store_1823_2605446
ReplyDeleteLola of New York City...
Markus Brunnermeier and Stefan Nagel have and interesting perspective on Hedge Funds and the Technology Bubble (Journal of Finance (2004) 59(5)
ReplyDeleteThe abstract reads,
"This article documents that hedge funds did not exert a correcting force on stock prices during the technology bubble. Instead, they were heavily invested in technology stocks. This does not seem to be the result of unawareness of the bubble: Hedge funds captured the upturn, but, by reducing their positions in stocks that were about to decline, avoided much of the downturn. Our findings question the efficient markets notion that rational speculators always stabilize prices. They are consistent with models in which rational investors may prefer to ride bubbles because of predictable investor sentiment and limits to arbitrage."
So with much of the world leveraged as never before, including and especially the GSEs: Fannie Mae and Fredie Mac and the banks that hold derivative positions in them -- positions that I don't really understand, but that have many people very nervous in part because the banks, like the American-led financial system at large are in the "too big to fail" category.
Yet just like past history (most recently THE GREAT CRASH (J.K. Galbraith's book is worth rereading)), we seem not to be able to rid our systems of massively corrupting influences this side of crisis. So 2005 or later, but not that much later I suspect, may prove to be interesting in sense of the movie Jumanji. We may all learn more about the complex and wicked connections of geopolitics, and the bit-parts played by economics and finance.
Again, if I understand, stock hedge funds caught as they had to were they to survive the bubble market in technology. But, they were able to leave the technology sector stock by stock as the declines began and preserved gains. Interesting.
ReplyDeleteWhile we might think that hedge funds would bet against a forming bubble, and provide limits to the inflation, there is reason to expect the opposite. Why not bet with the bubble, knowing that bubble it is. After all, your investors expect you at least to keep up in a bull market and not to keep up in a bubble will cost you investors. There might also be a sense that there is no bubble, simply rising asset prices with which you wish to keep up. The problem with simply going along with the rise is forgetting how readily a turn can come. So, we have the hedge fund manager who will contribute to the bubble and continually be looking for reasons to sell.
ReplyDeletehttp://www.princeton.edu/~markus/research/papers/hedgefunds_bubble.htm
ReplyDeleteJust thinking about the essay by Markus K. Brunnermeier and Stefan Nagel. This essay may be worth discussing further. The last post was by Anne.
http://www.nytimes.com/2004/12/23/opinion/23thurs1.html
ReplyDeleteAmerica, the Indifferent
It was with great fanfare that the United States and 188 other countries signed the United Nations Millennium Declaration, a manifesto to eradicate extreme poverty, hunger and disease among the one billion people in the world who subsist on barely anything. The project set a deadline of 2015 to achieve its goals. Chief among them was the goal for developed countries, like America, Britain and France, to work toward giving 0.7 percent of their national incomes for development aid for poor countries.
Almost a third of the way into the program, the latest available figures show that the percentage of United States income going to poor countries remains near rock bottom: 0.14 percent. Britain is at 0.34 percent, and France at 0.41 percent. (Norway and Sweden, to no one's surprise, are already exceeding the goal, at 0.92 percent and 0.79 percent.)
And we learned this week that in the last two months, the Bush administration has reduced its contributions to global food aid programs aimed at helping hungry nations become self-sufficient, and it has told charities like Save the Children and Catholic Relief Services that it won't honor earlier promises.
Anne
Of course of course, such a post does not fit, how could it fit, but darn we should be paying attention, so do not be annoyed, though possibly annoyed at what we are about with agricultural development assistance.
ReplyDeleteAnne
Regarding hedge funds and the tech bubble, the record is clear (see 12/25 post on hedge fund returns, and 12/1 post on bubble dynamics, where I also link to the same Journal of Finance paper).
ReplyDeleteHedge funds lagged the SP500 when the bubble first started - perhaps sophisticated traders were leery of the "new economy" and refused to buy overpriced tech shares. By the end of the bubble, hedge funds were elbowing their way into all the choicest IPOs and front-running everyone else.
There is some very smart money in hedge funds, but due to the fact that they have to have good *annual* returns in order to survive, they cannot be depended on to bet against a bubble. Only exceptional long-term investors like Buffet can be depended on to retain their sanity. Buffet was never in the tech bubble - Berkshire lagged badly, but then caught up post-2001. Also, Buffet has been short the dollar for almost 2 years now!
Slowly, I am reading back through your wonderful posts :)
ReplyDeleteWarren Buffett wrote about buying foreign currency positions in December 2003 in Fortune, by the way. Though you likely knew that. What a pleasure to read your blog. Think of birds for the evening...
ReplyDeleteThe Markus Brunnermeier and Stefan Nagel hedge fund essay is anecdotal. There were, of course, hedge funds that caught the technology boom from 1995 and protected assets from 2000, but there is no sense this was more than selected cleverness of specific managers rather than refelctive of the hedge fund industry. So, what we have learned from the essay is not clear. I am thinking.
ReplyDeleteAnne
http://www.nytimes.com/2004/12/24/business/worldbusiness/24china.html?hp=&pagewanted=all&position=
ReplyDeleteIn Roaring China, Sweaters Are West of Socks City
By DAVID BARBOZA
DATANG, China - You probably have never heard of this factory town in coastal China, and there is no reason why you should have. But it fills your sock drawer.
Datang produces an astounding nine billion pairs of socks each year - more than one set for every person on the planet. People here fondly call it Socks City, and its annual socks festival attracts 100,000 buyers from around the world.
Anne
http://www.nytimes.com/2004/12/24/business/24hedge.html
ReplyDeleteHedge Funds, Once Daring, Trim Their Currency Bets
By RIVA D. ATLAS
The fall in the dollar this year has been severe - the currency reached a low against the euro yesterday - but few of the best-known hedge funds have made a killing off the dollar's decline.
That is a big change from years past, when the largest hedge funds made or lost fortunes by gambling on shifts in currencies. George Soros made $1 billion for his investors by anticipating a decline in the British pound in 1992, and Julian H. Robertson Jr.'s funds lost $2 billion in a single day in 1998 after betting the wrong way on the value of the yen against the dollar.
The apparent absence of any big gains from large-scale speculative plays on the dollar says more about the state of hedge funds than it does about the currency markets. Hedge funds, once the last word in speculation, have become more timid as pension managers and other investors with some aversion to risk increasingly put money into the funds.
http://www.nytimes.com/2004/12/24/business/24hedge.html
ReplyDeleteHedge Funds, Once Daring, Trim Their Currency Bets
By RIVA D. ATLAS
To be sure, some investors have made a fortune by betting against the dollar in 2004, including Warren E. Buffett, the chief executive of Berkshire Hathaway.
"In 2002, we entered the foreign currency market for the first time in my life," Mr. Buffett said in a letter to Berkshire investors in last year's annual report, "and in 2003 we enlarged our position as I became increasingly bearish on the dollar."
Berkshire owned $12 billion in foreign currency contracts at the end of last year; by the end of September, that had increased to $20 billion. It reported a $412 million gain on those contracts in the third quarter, reversing a loss from the quarter before.
Anne
http://www.nytimes.com/2004/12/24/business/worldbusiness/24steel.html
ReplyDeleteSteel Shortage Squeezes Asia's Manufacturers
By TODD ZAUN and WAYNE ARNOLD
TOKYO - It has been a long time since Japan has experienced shortages of any kind. So it came as something of a surprise last month when Nissan Motor was forced to briefly suspend much of its production because it could not get hold of enough steel.
Since then, Suzuki Motor has said a lack of steel would force it, too, to shut down assembly lines for a few days this month, and to reduce production from January to March. Even the giant Toyota Motor said Thursday that it has had to make adjustments in the kind of steel it buys to ensure steady supplies.
The shortfall in steel is unusual in a country that for most of the last decade has been dealing with problems of excess - too many workers, unused plants and more banks than needed - but analysts and executives say it is a problem that could become increasingly common.
Anne
http://www.nytimes.com/2004/12/25/international/asia/25china.html?ex=1104977006&ei=1&en=1545d715c58cab8a
ReplyDeleteChina's Elite Learn to Flaunt It While the New Landless Weep
By JOSEPH KAHN
BEIJING - Chateau Zhang Laffitte is no ordinary imitation. It is the oriental twin of Château Maisons-Laffitte, the French architect François Mansart's 1650 landmark on the Seine. Its symmetrical facade and soaring slate roof were crafted using the historic blueprints, 10,000 photographs and the same white Chantilly stone.
Yet its Chinese proprietor, a Beijing real estate developer named Zhang Yuchen, wanted more. He added a manicured sculpture garden and two wings, copying the palace at Fontainebleau. He even dug a deep, broad moat, though uniformed guards and a spiked fence also defend the castle.
'It cost me $50 million,' Mr. Zhang said. 'But that's because we made so many improvements compared with the original.'
Rising out of the parched winter landscape of suburban Beijing, like a Gallic apparition, the chateau is a quirky extravagance intended to catch the eye of China's new rich. They can rent its rooms and, later, buy homes amid the ponds, equestrian trails and golf course on Mr. Zhang's 1.5-square-mile estate.
It is even more conspicuous to its nearest neighbors, 800 now landless peasants who used to grow wheat on its expansive lawns.
In a generation, China's ascetic, egalitarian society has acquired the trappings and the tensions of America in the age of the robber barons. A rough-and-tumble form of capitalism is eclipsing the remnants of socialism. Those who have made the transition live side by side with those who have not, separated by serrated fences and the Communist Party.
Anne
How the inequities and tensions of development in China are handled will determine whether China's promise can be sustained. The article above is of exceptional importance in the entirety, as is the series.
ReplyDeleteAnne
For a century, we wondered and worried about why developing nations lagged so sorely behind the developed. Now we are evidently finding a catching up by China, India, Brazil, and South Africa. There are other hopeful economies as well, and there is China for them all as a goad and goal. Imagine 2.5 billion people seeing themselves anew in hope. We must weld this revolution in development to economic and sociological models.
ReplyDeleteAnne
http://www.nytimes.com/2004/12/26/international/americas/26argent.html
ReplyDeleteEconomic Rally for Argentines Defies Forecasts
By LARRY ROHTER
BUENOS AIRES - When the Argentine economy collapsed in December 2001, doomsday predictions abounded. Unless it adopted orthodox economic policies and quickly cut a deal with its foreign creditors, hyperinflation would surely follow, the peso would become worthless, investment and foreign reserves would vanish and any prospect of growth would be strangled.
But three years after Argentina declared a record debt default of more than $100 billion, the largest in history, the apocalypse has not arrived. Instead, the economy has grown by 8 percent for two consecutive years, exports have zoomed, the currency is stable, investors are gradually returning and unemployment has eased from record highs - all without a debt settlement or the standard measures required by the International Monetary Fund for its approval.
Argentina's recovery has been undeniable, and it has been achieved at least in part by ignoring and even defying economic and political orthodoxy. Rather than moving to immediately satisfy bondholders, private banks and the I.M.F., as other developing countries have done in less severe crises, the Peronist-led government chose to stimulate internal consumption first and told creditors to get in line with everyone else.
Anne
http://www.nytimes.com/2004/12/26/international/americas/26argent.html
ReplyDeleteEconomic Rally for Argentines Defies Forecasts
By LARRY ROHTER
BUENOS AIRES - When the Argentine economy collapsed in December 2001, doomsday predictions abounded. Unless it adopted orthodox economic policies and quickly cut a deal with its foreign creditors, hyperinflation would surely follow, the peso would become worthless, investment and foreign reserves would vanish and any prospect of growth would be strangled.
But three years after Argentina declared a record debt default of more than $100 billion, the largest in history, the apocalypse has not arrived. Instead, the economy has grown by 8 percent for two consecutive years, exports have zoomed, the currency is stable, investors are gradually returning and unemployment has eased from record highs - all without a debt settlement or the standard measures required by the International Monetary Fund for its approval.
Argentina's recovery has been undeniable, and it has been achieved at least in part by ignoring and even defying economic and political orthodoxy. Rather than moving to immediately satisfy bondholders, private banks and the I.M.F., as other developing countries have done in less severe crises, the Peronist-led government chose to stimulate internal consumption first and told creditors to get in line with everyone else.
I am sympathetic to the sense that we have a political-economic problem, as China looks to become an influence through developing nations on the order of America. But beyond China, beyond India, think of Brazil. Imagine Brazil having become the world's breadbasket. Ah, a new economic reality is being shaped in nations for whom we dictated economics or tho0ught we did. What now?
ReplyDeleteAnne, having forgotten, to say so. I am not anonymous, never have been, resist being so.
ReplyDeleteAnne
Random comments on interesting stuff posted on this thread:
ReplyDelete1) Wealth inequality is potentially a destabilizing force in China. On the one hand peasants have always been at the bottom of a hierarchical system, so perhaps can tolerate more injustice than individualistic westerners might. On the other hand, after 50 years of communist ideology extolling the virtues of the workers and peasants you would think there would be a lot more resistence to the social injustice now rampant in China. (These observations apply to former Soviet states as well.)
I think the biggest challenge China faces is in mid-level governance and resource allocation. The top leaders seem to understand what is going on and are probably managing this as well as they can. At the local level many government officials are very corrupt, and a lot of resources are being squandered because of it. The banking system is also quite rickety, and it was only a few years ago that one of the main reasons the renminbi could not be made fully tradeable was that most Chinese would want to convert their savings into dollars, because of lack of faith in local banks.
2) regarding the rise of "third world" economies (see El Erian's column on emerging markets that I linked to earlier), I think we can look for a number of key benchmarks that might be achieved in the relatively near future, such as: developing world economies become larger than developed economies (true already using PPP, but not at official exchange rates), developing countries start to contribute substantially to developments in science and technology (e.g., Chinese and Indian universities become world class and begin to retain top homegrown talent, significant R&D done in industrial labs in those countries, etc.). These things will occur long before the per capita income catches up with developed nations.