1. The US owes China 1 trillion bucks. Is it any surprise that China wants a stronger USD?
2. The US government is broke.
3. China cannot buy CDS protection on the US. It would have to buy it from a strong credit. Which counterparty could write 1 trillion USD worth of protection? Well, China, but that’s stupid. The EU? China probably wants to buy CDS protection on the EU too. The UK? The UK wants to buy CDS protection on the UK. Bid no offer.
4. China has to participate at US treasury auctions. When you borrow a buck, the lender owns you. When you borrow a million bucks, you own the lender. When you borrow a trillion bucks, that’s a cheque that can’t be cashed. And China has to continue to lend to the US too if it is to hope to collect on its existing loans. Non participation at the auction will see 10 year yields instantaneously break 5.50.
5. I can see how a major creditor to the US would want to buy CDS protection on US, EU and UK sovereign risk from the major global banks, hedge their counterparty risk by going short the equity of these banks, do it through options so that its levered and the banks arrange the leverage themselves in the money market. If they were ever able to over-hedge their positions, (no way this will happen), they could then boycott a treasury auction.
6. In the meantime, you want to trickle out your inventory in the open market. But you have to support the auction.

There is an opportunity here to eschew heavy handed regulation.

The public are clearly incensed at the behaviour of the bankers and prop traders. The people are disappointed at the level of diligence and care that their bankers have applied in the conduct of their businesses.

The opportunity exists today for regulators to demand nothing more than disclosure that is fair, clear and not misleading, so that private individuals can decide if they want to deposit money with, invest in the equity of or trade as counterparty with, a financial institution. The public will therefore decide what is too big to fail and provide a market solution for the right size of banks.

The alternative is increased regulation, bureaucracy, inefficiency and ultimately a higher cost to the economy than is optimal.

It is sub-optimal to risk manage to the tails on an ongoing basis. As long as the system consists of a sufficient number of independent decision makers, a concept of self insurance takes force. When the number falls or the independence assumption is breached or weakened, systemic risk rises.

Another condition for a market solution to work is that agents, that’s savers, investors, counterparties, are able to make sense of the information that they are given. This is a stretch. Not many people can understand the full complexity of the modern bank. Not many people understand financial statements of any type of business let alone a bank. Education is the answer. Economic agents need to be educated in prudent household financial management in order to interpret the information and allow them to behave more rationally and predictably. Until they don’t.

In the latter part of 2008, the value of world trade plummeted as availability of trade finance evaporated at the same time that global economic growth slowed drastically. 2008 saw a reversal of globalization as the developed world consumer retrenched after a protracted period of operating too low a savings rate accumulating unsustainable levels of debt. The emergency measures taken by governments to reflate their economies be it in monetary or fiscal policy has sent nominal GDP rebounding with a more moderate impact on real GDP. This caused a recovery in world trade, albeit not to pre crisis levels. The inventory cycle led by lagged destocking and restocking led to a magnified response in industrial production and world trade. The cyclical nature of a lagged transmission mechanism had already manifested in the middle of 2009 where world trade faltered again. November 2009 saw further weakness in world trade. This is further evidence that the developed world economy’s recovery is yet fragile. Aditionally, the situation in trade finance is still difficult. Bank lending remains frozen. Unless banks can find additional capital or capital relief under Basel II, they will not be deploying capital.

And yet, one should not be too quick to lose heart. A lagged transmission system creates oscillations around a recovery path. The current recovery path is interesting. The balance of trade between the US and China is a good proxy, given the volume of trade between these two countries. Since 2001, the trade balance has evolved into a US deficit cyclically correcting but trending well into deficit. The current cycle has seen a sharp correction towards balance as the crisis took hold in 2008. The recovery in 2009 saw a resumption of the US deficit but not to pre crisis magnitudes. The deficit appears to have stopped growing and appears to be in the process of drifting towards balance. As the US trends towards a net exporting position the conclusions for interest rates, the USD and inflation are most interesting.

FX transaction volumes are dominated by speculative and financial activity. Asset-liability share of FX transaction volumes are in the minority, 20% to 25% is an estimate provided by several FX hedge funds. Yet speculative transactions impact on FX tends to add volatility and not drift to the process whereas trade driven transactions tend to introduce drift. The implications are therefore for a strong USD.

There is another factor impacting the USD and that is that as world trade recovers from the doldrums, demand for USD as a trading currency increases. This is especially true from inter emerging market trade which is more likely to settle in USD. Inter developed market trade will sometimes settle in USD but is more likely to settle in the vendor country’s currency.  Countries with closed capital accounts, capital controls, currency risk, and political risk will almost exclusively trade in USD.

Macro conditions are stacked therefore towards USD strength and not weakness. At the time of writing, this is a contrarian view.

Extending this thread, a strong USD worsens the terms of trade for the US potentially countering the drift in the trade balance. If the US is to drift towards a neutral trade balance, and the lack of vendor financing certainly pushes in this direction, internal pricing must adjust where external pricing cannot, suggesting deflation.

I have long argued without success or conviction that interest rates were too low to be efficient, that a low interest rate encouraged over investment as the hurdle rate for putting capital in harm’s way was too low. My argument lacked conviction because with a central bank setting short rates, it was hard to tell what a hypothetical market rate of interest would be…

A naturally strong USD affords the Fed latitude in keeping policy looser for longer. A deflationary environment is likely to keep long term interest rates lower as well.

Where does that lead? Monetary policy that is chronically loose has implications for dollar peg countries. If China does not yet have an asset bubble, it will. But it could take some time. And one can always watch in disbelief and disapproval from the sidelines, for quite a long time.

January 2010 was a bad month for investing. Markets fell from equities to credit to commodities. The USD was strong by default. Fears of a sovereign default by Greece was blamed for the general de-risking.

Markets fluctuate. The almost constant rise of risky assets since March 2008 has muted volatility and confounded the sceptics and perma-bears. Until fundamentals change, or until the perma-bears defect, the upward trend is likely to continue.

That said, the market needs a breather and in the absence of news, would have been equally likely to correct. In a market correction, any credible reason is immediately guilty. Hence Greece.

The opaque and fragile nature of Greek public finances have been known for some time. Greece is too big to fail. Let me correct that. Germany is too big to fail, Greece must be kept in the Euro.

My bet is that it is now a good time to establish a long trading position in liquid risky assets, like equities.