In economic policy there is a difference of view between the US and the rest of the world. As Japan’s largest trading partner the US is especially empathic to the deflation scenario that has plagued Japan since 1990. Therefore, US monetary policy is likely to err on the side of being too loose rather than vigilant on inflation.

Europe has a history of hyperinflation and is therefore likely to tighten sooner than might the US. The current focus on the health of sovereign balance sheets strengthens the case for a retraction of quantitative easing and expansionary fiscal policy.

The flexibility of the CNY is likely to reduce the demand for US treasuries and lead to a de linking between US and China monetary policy. China economic policy will be more hawkish on inflation than before.

All these point to the resumption of de risking that began in May that has led to falling markets and a rise in correlations.

This is all backward looking.

The economy and markets have reacted to the financial crisis of 2008 and the subsequent stimulus policies quite predictably. It rebounded and rallied hard as governments printed money thus debasing their currencies and inflating the value of real assets and future claims on the cash flows expected to be generated by real assets, and quite a little relief and hope.

We have seen in past crises like the one in Asia that post the initial decline, 100% rallies are possible and post those, 50% retracements are also possible. Equity markets are technically weak. They may strengthen over the next few weeks as corporate earnings come in reflecting 2Q financial results, but the trend is down. Earnings, however, are not the driver of markets. Liquidity and policy are.

There are many factors that can drive equity markets over time, but there is usually only one or maybe two factors that drive them at any moment in time. Equity markets are likely to continue to fall until weaker economic numbers prompt policy makers to revise their stance on fiscal rectitude and start printing money again. Who will go first? The US has not tightened policy. Australia, Canada and Norway, for example, have already been running tight monetary policy for some time, since 2009. China has been selectively reigning in leverage in particular sectors of the economy to prevent overheating. The commodity countries and Asia are unlikely to loosen policy again soon. The more likely candidates for reverting to expansionary economic policy are the Europeans on the basis that European economies are likely to be weakest.

Germany is exposed to exports to Asia; a more domestic centric China will impact European exporters. Domestic Europe remains weak and disconsolate. Unemployment remains high, balance sheet repair is slow. Spain is in a depression. Greece is insolvent. The PIIGs face a liquidity crisis. The outlook for Europe is poor. Able or unable, Europe will print money. Interest rates will remain low and if anything head to zero. Fiscal policy is constrained which will put even more pressure on monetary policy.

Europe is likely to be the first to resume printing. And the debasement of currency has as its dual, the inflation of goods and services, and assets.

On Saturday, 19 June, China signalled the end of its currency peg which fixed the CNY at 6.83 to the USD and said it would gradually make the its currency more flexible. The CNY appreciated to 6.80 on Monday.

A stronger CNY it was hoped would:

• Address the trade imbalances between the US and China.
• Address inflationary pressures in China.
• Provide impetus to developing a more balanced Chinese economy away from exports towards domestic consumption.
• Increase outward overseas investment due to increased purchasing power.
• Reduces foreign debt obligations and debt service, China had in 2005 about 180 billion USD of external debt.
• Ease the risk of asset bubbles by delinking Chinese monetary policy from US policy.
• Keep the Washington trade hawks at bay and reduce the risk of a trade war.
• Be a vote of confidence for the global economy in general and the Asian and Chinese economies in particular.

However:

• One wonders how prepared China’s companies are for FX volatility, especially smaller and less sophisticated exporters.
• A stronger CNY can become a much stronger CNY as capital inflows increase in anticipation of further CNY appreciation. Such capital inflows can exacerbate existing asset bubbles such as real estate.
• A stronger CNY will put pressure on the agricultural sector as imports become cheaper. There are some 500 million farmers in China.
• What is the PBOC’s objective, is it a stronger CNY or a freely floating one? There are pros and cons of each route. A freely floating CNY would imply independent monetary policy. On the other hand the PBOC might not want to live with the volatility of a market determined exchange rate.
• A lot depends on the magnitude of the CNY appreciation. Elasticity of exports and imports takes a long time to adjust and usually adjusts to secular trends, of which it is a circular driver, which by implies that the trade balance will adjust more to larger and more established moves in the exchange rate.
• Given the behaviour of CNY when it was allowed to appreciate from 2005 to 2008, it is likely that the PBOC does not intend a floating exchange rate but rather will manage the exchange rate in very tight fashion to achieve a steady and controlled appreciation. This addresses many of the risks of a floating exchange rate that the Chinese economy might otherwise struggle to manage.
• Absent a managed float, market forces are likely to encourage a weaker CNY not a stronger one, as the balance of trade swings towards balance with the US.
• Allowing more flexibility in the CNY exchange rate is likely to translate into a reduction of demand by the PBOC for US treasuries which is a de facto withdrawal of vendor financing for Chinese exports. Demand for trade settlement is likely to strengthen the USD. The natural pressure on CNY is not clear.

Murphy’s Law:

Forecasts and expectations are often confounded as reality has an uncanny tendency to defy all logic and reason.

Hedged.biz has downgraded Fitch, Moody’s and Standard and Poors from AAA directly to junk.

For downgrading (upgrading)  issuers only after price discovery has occurred and being reactive rather than proactive. For downgrading (upgrading) issuers only after bad (good) stuff has happened and been priced in. Downgrading BP over a month after their rig in the Gulf blew up is not very useful.

For operating a conflicted model whereby the issuer pays the credit ratings agency to provide a rating.

For the audacity to rate instruments which they did not fully understand.

For being part of a feedback mechanism of automatic leverage and deleverage.

We are not rewarded to bolster the base of the pyramid but to reach for the stars. Too often intermediate levels are built upon a deck of cards. Where the potential to build highest lies, most effort is directed there, often in disregard of the frailty of the supporting levels below.

The engineer knows that they cannot build to the edge of tolerance, there must be some cushion, for often lives are at stake. What better risk management than that lives are at stake, to shake the engineer’s faith in himself and his tools, in the work of his brethren before him.

Danger lies in faith, in comfort in a higher power, in complacency that error will not be catastrophic, that loss is not loss of life for then the engineer builds to the edge of knowledge.

But how many look at the foundations before they build a tower? The Craft has grown in convolution so much that to do so is an uneconomic endeavour. How many understand the Grand Structure we have built? It has grown without design, evolved beyond our comprehension, that now to break the ramparts, one has but to shake the tower.

The Craft now seeks to mend the Structure, but it will take time, generations perhaps. First is to understand and to understand is to deconstruct. This will not be linear. Charlatan will vie with Sage and Jujuman.

In the meantime, what can the body of the Craft do? Reinvent the wheel. Some of us have done this everyday of our lives. The populist Heretics rail against the reinvention of the wheel, but it is in First Principles that we truly understand, and in Knowledge that we have power, if over no one else then over ourselves in the avoidance of an unceremonious and unnecessary suicide.

With the acceleration of globalization in the last 20 years up until 2008 sector risk has risen relative to country risk. The classic example is in Europe where a stock like RWE starts trading less like a German stock and more like a European utility stock. With the credit crisis of 2008 came a number of factors that reversed this phenomenon. World trade was severely affected by both a fall off in demand as well as a sudden withdrawal of trade finance and other related credit. Also, as countries were forced to bailout their financial systems and their economies, country risk had risen as a proportion of total risk.

Globalization has certainly taken a hit and reversed somewhat, but the underlying current remains intact. Economies continue to become more interconnected and interdependent. With time we are likely to see a resumption of the correlation effects seen in the last 10 years pre 2008.

Based on this premise, I expect correlations between stocks to decline within country indices. The way to capture this is to be short country index volatility and long component stock volatility. This leaves the trade net short covariance. This trade makes money as stocks become less correlated at the country index level.

Also based on this premise, I expect correlations between stocks to increase within sector indices. The way to capture this is to be long sector index volatility and short component volatility. This leaves the trade net long covariance. This trade makes money as stocks become more correlated at the country index level.

One can use strangles and straddles to obtain exposure to volatility in both the index or the components.

Residual delta is hedged with the index futures or component stocks themselves.