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July 2011

US Debt Ceiling - one sage finishes another begins

July 29, 2011 by CausalCapital   Comments (0)

he US deficit or the growth of it has been a problem that has been kicking around for so long now, that it shouldn't come as a surprise to anyone to hear that the United States of America is bankrupt. None the less at the eleventh hour, the entire world seems preoccurpied watching the US senate debate whether it should raise the debt ceiling or not.  We all know in the end or chances are that the ceiling will go up and everything will go back to normal - yes?


Why then should the world be so concerned and surely this is a US problem?  Alas not as it seems, it is a global problem for several reasons:

The Opacity of Ratings
[1] Firstly the rating agencies are once again in the spot light it seems or at least their credibility is. If the debt to GDP raio of the US is in a similar trajectory to that of other sovereign nations such as Greece, then how can one country be tagged a gold star AAA and the other a CC which is really one notch above default?

We know the answer to that question but few dare talk about it, Randy Neugebauer however is not one of those people:

Reuters reported late last night that a congressional panel has been established to examine whether the Obama administration attempted to unduly influence Standard & Poor's before the credit rater revised its outlook on the debt rating back in April

A review of conversations and emails between the Treasury Department and S&P has prompted Randy Neugebauer, a republican chairman to establish an oversight panel.

|Our concern was if the administration was trying to influence this rating decision, some -- above what would be a normal practice| Neugebauer 

Law maker probing if Treasury meddled in S&P rating | Reuters

This point has been exacerbated by the fact that the US administration itself has been caught tampering with the very fiduciary nature of what it has been trying to make good and, we have to question whether the pain of mandates such as Dodd-Frank Wall Street reform act really stand for very much.  This is ironical in reality and the embellishment of hypocrisy on so many levels. Like it or not that is the truth of the matter but it is always fun to debate what we have to accept that being; the way of life as it stands - the pleasure of a few for the promised sum of many.

My models are broken
So here is another thought, what then is the real rating of a US treasury and, if a US treasury has the potential to default what happens to the concept of risk free?

The rating agencies may keep the US on a tidy AAA rating however the credit market is pricing in 0.8% default in US treasuries over the next twelve months. Interesting this credit curve steepens as time goes out so this ins't all particularly promising.

Back to this risk free concept, our models for bench-marking risk free rates are now themselves formally in question. We know they have been broken for a while but unlike the administration, we can't trick mathematics in the same way we can coerce a rating agency.

Darker clouds on the horizon
There are of course bigger tribulations to face than the fairness of ratings.

One which I have discussed before is that both the International Monetary Fund (IMF) and the Bank of England believe the world should at least entertain a revisit to the Bretton Woods agreement?  Well at least Mervin King and Strauss Kahn think so but as we know Strauss Kahn is no longer part of the IMF's grand plan.

 
Bretton Wood aside, when central banks across the planet hoard gold and the USD collapses, the world will suffer either way.  Let's take any region, say countries in the Gulf for example, many of which import their manufactured goods and will now pay dearly for this pleasure.  It's a feeling of 20% less for the same that vexes people and the UAE, Oman and many others are going to suffer a USD pegged currency curse.

Away from the Gulf, to the world over; the USD is the generally accepted currency for both pricing and settlement.  As the debt ceiling raises in value, we can expect the dollar to collapse equivalently and relative to other global currencies.  This leaves the domain of trade massively exposed to FX risk and we are likely to see more strife as global communities suffer eroded purchasing power.

In effect the world is now paying for America's inability to deleverage cleanly, restructure or accept austerity as a way forward.  Just for one second, lets transport ourselves into the shoes of a poor man trying to feed his family in Africa, imagine the price of rice going up while Americans sit pretty, how do you think he feels, how would you feel?

I leave it there but raising the debt ceiling is not the end of this saga, it might be just the beginning of another.


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Caveat Emptor Basel III Conferences and ERM

July 25, 2011 by CausalCapital   Comments (0)

aveat Emptor : Basel III Conferences and Enterprise Risk, yes the two are being pushed together.

I find it quite disturbing that there are a whole swag of supposed operational risk experts out there from the United States to Australia who are flogging operational risk to death.

Let's be frank or at least a tad earnest, perhaps up front; Basel III has little to do with Operational Risk, period, goodbye, the end, thank you very much.  Yet, I keep seeing brochures on "Basel III and Enterprise Risk" or "How to make your bank Basel III compatible with Operational Risk" popping up like a congenital decease.

Caveat Emptor (buyer-beware) - If you see a brochure on Operational Risk and Basel III, don't entertain it as the heading is misleading and the promoters are trying to ride on the coattails of Basel to sell their wares.

If one is to look at the authentic Basel III document, the label "Operational risk" does not appear.  Not once.  Don't believe me?  Go to the link on the site for the Bank for International Settlements and download the Basel III Global Regulatory Framework adobe file, then search for Operational Risk.

BIS link for Basel III can be found by clicking here

There is nothing on Operational Risk of great importance, two smallish paragraphs with the words "operational performance" within them but that is hardly worthy material alone for a two day conference.

What I am not saying
I am not saying Operational Risk isn't important but when it comes to the financial services sector and Operational Risk, that was all addressed in Basel II - the predecessor to Basel III.  Additionally, I believe a lot of banks across the global didn't really do Basel II properly or in many cases, they are running the Basic Indicator end of the program for fulfilling their Operational Risk requirements. None the less, if you want to learn about Basel III and focus on that goal, then you should leave Operational Risk discussions for another debate.

So why is this happening?
Well, we possibly have a shortage of risk analysts suitable for Basel III on one side of the fence and an oversupply of Basel II operational implementers on the other. In some cases the latter will try and cross the fence but they really should re-skill themselves on Counterparty / Credit risk and Liquidity Risk before leaping into Basel III.  This brings us onto another minor misalignment in Basel common consensus; which is - Basel III is not a replacement of Basel II. To be compliant, banks need to complete Basel II end-to-end including Pillar II and then substitute the capital, Liquidity Risk and Counterparty Risk requisites into their frameworks.


I see this paper from Moody's Analytic's really summarizes the Basel III scope well, you can view that presentation by following this link.

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The USD is dead ...

July 15, 2011 by CausalCapital   Comments (0)

ast week we discussed the state of the USD and the very real potential for a rethink of the world currency for settlement. This week our argument only becomes stronger as the US has been put on review by the rating agencies. It may have taken the agencies a while to come to this conclusion (tongue in cheek) but it didn't take the market long to react. The outcome in the currency markets in particular hasn't been favorable to say the least.

This article is a short review of where we are heading but no secrets, I would say that direction is down the drain one way or another.

Issues for trade
Last week we looked at the move on gold by the central banks and the USD parallax relationship with other currencies in the world - article here.  This week, Singapore exporters who are settling in the USD cross will be settling for less yet again.

USD/SGD CROSS 150711|5:24:17

In effect if you were to trade a product for USD 5000 as a Singaporean exporter that would have netted you around SGD 7100 on a bad day a couple of years back, about the same you would have earned in 1996.  Today however, your take home would be SGD 6050! Nearly a tidy SGD 1000 loss of around 14% of pain (going on quick math in my head).  

No Natural Solution
We are moving into scary times I am afraid, the 1.4 comfort zone has been broken for the Singapore Dollar and it appears that the floor is moving even further away.

"Bernanke offered an optimistic forecast during his testimony to congress but tempered the prediction by saying that measures to encourage a recovery such as purchasing treasury bonds remain on the table if growth falls short of what is expected" | International Business Times

"Optimistic" - my goodness me this guy is walking into a perversely fallacious territory. This can't continue without a drastic effect on world economies who are left with the following options:

[1] Assume a loss when settling in USD - no one does this for very long and stays in business.

[2Move to quote tare-up processes and volatile re-pricing techniques.

[3] Move to pricing on baskets (an article we will give justice to separately and in its own space).

[4] Move off the USD dollar to quote and settle between other more trusted cross currencies.

[5] Buying futures against physical contracts but we might be in for a long tenor of worthless USD and that game comes with huge basis risk, nothing changes there. The damage however is already done, futures won't save you. To be succinct, if you haven't planned for a future contracts approach as of a couple of months back, then you are already starting out of the money. Firms have no choice but to inflate prices when settling in USD.

[6Some customers are looking to quote in ounces of gold! Oh yes the world of Ancient Babylonian trade might be where the future lies for cross boarder transactions. I am not being silly, only today I was valuing a contract with a customer and they said to me - "what would that price be in something other than US dollar, say gold for example".

[7Quoting in mean minor-cross positions has also come back into fashion. It's a simple idea of taking an average value estimate over a twelve month trailing position between two cross currencies spot values such as AUD/SGD and quoting relative to that position. You then settling in the cross.

Is there any hope in sight?
Well the thought of QE3 is that it will only press the US S&P500 equities index higher while main street tanks and when that bubble implodes, the retail investor will be stung again. Then what happens after QE3? We are probably back in this same position and the world will have to entertain a QE4, QE5, QEX for an economy that is bankrupt? Oh we forgot to say, there is a bigger problem for the QE game. That is the US is bankrupt and has now blown its own debt ceiling sitting around the same position as Greece? - Lets be real here.

If the US government misses a payment, it goes to D, Chambers said. That would happen right after August 4th, when the bills mature, because they don't have a grace period. | Chairman of S&P

The question I have is how Bernanke can actually afford this unlimited QE addiction. Either way a default or QE is going to throw the dollar into the toilet, no hang on, the USD is already in the toilet, QE is going to flush it twice. Thinking about the Geithner resignation ploy might allow the US to escape the left hand of madness (article here) but perhaps he can sanely see the writing on the wall.

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EUR/USD Parallax Error

July 9, 2011 by CausalCapital   Comments (0)

 new monetary system has been debated by many an economist or global politician for some time however, now that the big central banks are starting to think about alternatives, we have to question whether we are on the brink of redesigning the world of floating currencies beyond Bretton Woods? 

This article was stimulated by Mervyn King's speech from the Bank of England although momentum has been gathering around the topic of scrapping the US dollar for some time. 

How real could this be?


BOE and IMF
Back in March this year Mervyn King, the Governor of the Bank of England delivered a speech titled "Do we need an international monetary system?" - BIS on New Monetary System speech can be found by clicking here.

His speech opens directly on the topic of trade - If flexible exchange rates were allowed to determine the relative values of different currencies in competitive markets, why should there be any need to change "the rules of the game". Do we need an international currency?  Indeed, why is that so. The UK is not alone with this line of thinking, France has also selected this topic for the theme of the presidency for the G20 discussions this year.

The key motivation for rethinking the world currency for trade is based around the following concept "one country's actions can distort the choices open for others". 

As it stands the US dollar is currently the generally accepted currency for pricing and settlement of trade however, over the last couple of years the world has seen a weak floor-less dollar drive many trade and social disorders.

The fragile state of the US dollar or perhaps its potential collapse is in fact a deeper conundrum than simply the relative value of price differentials for similar goods in different locales:

Annual output in high saving economies has expanded by 10 trillion, 1 trillion more than the growth in domestic demand of the same economies. The rise in output relative to demand in these countries was only possible because there were matching capital flows. In effect, capital flowed uphill from many of the emerging markets to advanced deficit economies and the deficit economies predominately the US, UK and the Euro have been borrowing almost $1 trillion dollars more each year. This has resulted in unsustainable paths for domestic demand, net debt and long term real interest rates | Bank of England

This subversive cross effect spurs on many unwanted economic issues which need to be kept in balance.

[1] Some supposedly first world countries are unable to sustain domestic spending without additional borrowing.

[2] These deficit countries additionally can't raise output enough to allow them to service this increasing debt line.

[3] With a suppressed manufacturing sector, developed countries are seeing a decline in manufacturing and rising unemployment.

[4] As Mervyn rightly points out, the current exchange rate regime makes it difficult for local production firms in developed countries to drop prices relative to overseas production centres.  They can do this of course but it usually results in taking on additional burdens of debt.  

The arguments between the US treasury and the Chinese government over the weakness of the Renminbi or Yuan (whichever label you prefer to use) comparative to the US dollar, is fundamentally based around resolving this deficit issued for the United States.

Mervyn's speech is without any doubt an interesting and extremely well thought through piece of work. The Bank of England doesn't seem to be simply playing with academic ideas here either and it isn't the only central bank with these sentiments. A month before Mervyn's work, the International Monetary Fund also published similar remarks from its leader. Back then of course Dominique Strauss-Kahn's IMF speech was a turning point in thinking and that speech can be found here "Towards a more stable international monetary system"

From an IMF perspective or perhaps the Dominique Strauss-Kahn speech, arguments around the "don't fix it if it isn't broken" are in his sentiment only partly invalid.  In reality the statement that the US dollar served the world during the global financial crisis isn't true because [1] extraordinary international policy cooperation had to be enacted and [2] the recovery that we are seeing today is not the recovery we wanted. We have high unemployment, widening income inequality, global imbalances are back and worse than before the credit crisis, volatile capital flows and exchange rate pressures are present and rapidly growing excess reserves that are sowing seeds for the next crisis.

The similarities or overlap in concepts between Mervyn King and Dominique Strauss are strong enough to indicate that at some point in the future we are likely to endure a rethink of the world currency for pricing and settlement. We may end up in a better place but the transition won't be straight forward.

How real is this?

Central Banks Moving onto Gold
I personally believe the world of fixed income gives us a better long term view on global economic health, none the less; to stay with the currency argument here, it is becoming apparent that there are some very interesting dynamics in play. I take to highlight a few of these indicators below.

Firstly if you didn't know anything about gold twenty four months ago, you'll find most people  do today.  The value of gold on the world index against the US dollar seems to be an endless rocket to the stratosphere. This is driven by both a quantitatively weakened US dollar as well as an incredible appetite for the commodity.

This hoarding frenzy is also not entirely based around the Exchange Traded Funds domain of the retail bubble lovers either. Reserve banks the world over are going long on gold.  

Back in 2009 the Reserve Bank of India made large acquisitions of gold from the International Monetary Funds limited gold sales program. This was an off market transaction for about $1045 an ounce and for India Gold has become a safe store of value compared to the US dollar.

India is not alone and other Asian nations have noticeably been diversifying their stockpiles of foreign currency onto this commodity.  Many analysts two years ago were simply shocked by the move of central banks onto gold at such high prices yet now the value of gold is half as much again. Further, these type of transactions are actually not that common and the India move was the first sale from the IMF in nearly a decade.


So two years on, this theme like the price of the commodity itself is continuing. In May, Mexico also increased its gold reserves with a 4 billion dollar bullion acquisition, well in the premium value space. Russia and Thailand are on the buying path and China alone is now the sixth largest holder of Gold.
There is actually a dual play on gold here: If the world recovery is sharp then gold is a great hedge for inflation. Conversely if the US dollar fails, the reserve banks have already moved onto a physical asset of wealth rather than a fiat currency.  

The US Debt Ceiling and a downgrade
The Euro is no better off. During the early part of the credit crisis the currency strengthened nicely as investors falsely believed that impacts from a collapsing banking system in the US were in some way ring-fenced from other economies. As we know, it soon became apparent that the Euro Zone taking in Greece, Portugal and Spain were also economic basket cases suffering from large debt overhangs. These overhangs are the very kind of disorder that Mervyn King is referring to in his BOE speech.

Comparing the Euro to the US Dollar is akin to comparing two falling rocks although people do it for many reasons. It is probably an inappropriate way of thinking, if you are looking for an indicator on which state of nations or nation of states is going to save the other in terms of a recovery. One is as bad as the other and you profit from shorting which headache you believe is worse and going long something that isn't quite as bad, as bad can be.


This dual falling sensation of the Euro and the US dollar is not so different to Parallax error
 
This becomes even more apparent when you compare the change of the EUR/USD cross value with the delta cross value of another currency pair.  In the diagram above I have done such analysis and it is quite clear that gold is the best thing money can buy and the Aussie dollar is about half way there. This is a bit concerning, may be it's a sign of fresh change on the horizon but either way this trend can't continue. In the end, central banks will eventually move from talking about a new monetary system to planning one and then building it.

This argument is hypothetical and it is just as possible that everything might just slide back to a normal range of trading but there are also serious indicators that we are in for a big change.


  
In respects to the Aussie Dollar, this has broken three major support levels. This is far from normal and far from traditionally where the Aussie Dollar normally trades. Statistically if this continues a regime shift is likely to be established and the resistance ceiling for the Aussie will take on the same shape and colour that gold has with the US Dollar, an outlier in the distance.  I don't believe it quite yet but the signs are there none the less.

In part II of this blog, we are going to look at how importers and exporters can effectively hedge against volatility in currency markets and a collapse of the US dollar, using both traditional and derivative methods.

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The FSA drops the S

July 1, 2011 by CausalCapital   Comments (0)


In a sanctimonious move the 'S' is to come out of the FSA and to be replaced with the 'C'.  Yes it is going to happen. 

What was once the Financial Services Authority of the United Kingdom is to become the Financial Conduct Authority.  Believe it or not there is nothing "prudential" about it, that responsibility lies with the minister.

From serving to conducting, prudentially free the FSA will be is the new motto for London however taking the shine off the spin, one is left kind of feeling that what is supposed to be novel, might just end up convoluted with a good measure from camp bureaucratic.

I must admit up front that I was generally an avid FSA supporter (sorry dear all, but I like them) and I found their past models and approaches on the Basel banking accord quite forward thinking.  Certainly the FSA work was more insightful than the dribble many other regulators conjured up, which for what its worth was pretty much next to nothing in some cases.  This brings me to the first concern:

Where does all the good work go?

The FCA will not have explicit responsibility for financial stability. That will be the responsibility of the Bank of England, the FPC and the PRA | FSA Announcement, June 2011 Link Here ]

The FCA made no direct mention to handing over the design and enforcement of Basel and capital requirements in this release.  Of course it doesn't have to because the May 2011 publication tells us that the FSA and the PRA are working on the real gear together - Link Here.  I suppose on the down side, this joint relationship does give some good headroom for finger pointing opportunities in the future and on the up side; the BOE, the FSA, the FCA, the PRA, the FPC (gosh where are all these beasts coming from) will be one voice, yes?

Perhaps this is an oversight.  The choice to disband the FSA was originally predicated on the fact that the British banking sector failed during the financial crisis.  Let's not forget many other banking communities also collapsed and yet the heart of that debate lies at the centre of the Basel accord and capital effectiveness.

Given this recent publication, we are left feeling that the FSA is to become the FCA and to drop the Basel baton. Yet, the PRA will be picking up and starting from zero. Have we transgressed in this metamorphosis of the FSA to the FCA from grout to naught, from the bond that held it all together to a rethink on how we actually work with a PRA FCP creature?

Let's assume nothing changes on the Basel front and the FCA continues on with the FSA's Basel work and the PRA looks over its shoulder. If that was the case the following statement would stand.

This operational objective will be central to the FCA's supervision of the institutions that provide market infrastructure and the crucial role they play in delivering capital and risk transfer mechanisms and creating confidence in the financial system. 

and  

The FCA will be a risk-based regulator and its risk framework will be the engine room of the business, providing support to the key activities, namely : supervision, policy, enforcement and authorization. FSA Announcement, June 2011  [ Link Here ]

However, the trick then is that the FCA hasn't really addressed what went wrong with the British Banking system in the first place. That job lies with the minister, the PRA - lets not be "Prudential" here.

Either way from the Basel perspective, the British Banking Community isn't provably any better off but we are all more confused.

May be I am missing something, please give me a compass as I did speed read the document.


The naughty child syndrome
Work with me on this next piece, it is a tad painful:

[] The FCA will aim to shift balance towards tackling the root causes of problems, not just the symptoms.

[] The FCA will base its regulatory interventions on a deeper understanding of underlying commercial and behavioural drivers.

[] The FCA will tailor its approach and the use of its regulatory tools, to the particular risks in the sectors, firms and products that it regulates.

[] The FCA will intervene proactively to make markets more efficient and resilient, enhancing integrity and choice.

[] The FCA will ensure that market infrastructure is sound.

[] The FCA will engage more with consumers directly.

[] The FCA will publish more information about its views on the markets.

[] The FCA will recognize that necessary restrictions on disclosure exist in the UK.

[] The FCA will be accountable to government and parliament.

[] The FCA promises that punishment is due if it fails on the list of promises and it puts in lien its testicles for security << Sorry I added that last part.

There is equivalence to a disobedient child here, standing up bent over in assembly with their panties around their ankles facing the world and chanting; I will not be naughty, I will not tell fibs, I will honour the countries commitment to integrity, I will make sure UK banks don't cost the tax payer, please sir can I have another ... What are you guys saying here? What, the FSA was not accountable in the past but the FCA will be in the future?  This is humiliation personified and I can imagine the FSA team pulling this material together and either laughing or crying, I am not sure which is worse.

The New Program
Enough of these antics, what does the framework actually look like?  

Compliments of the FCA, I think its the FCA and not the FSA, anyway; they have given us a road map for not the prudential regulation on conduct authority. We have to be serious this is not, 'not the nine o'clock news'.


Bring on box 6, I like that dotted line.  Are dotted lines contingent responsibilities or more on the optional end of the spectrum?

Back to Risk
The document states that the FSA is currently working on the details for the required risk model.   

In particular, the FSA is examining how to develop a unified methodology which covers different  types of risk - retail conduct, wholesale conduct and prudential, and between firm risk and thematic risk.  This will be covered in future publications.

This I look forwards to reading, sincerely I mean this.  Perhaps the FSA isn't dead after all - take a deep breath. Hang on a second, what was all this FCA business about then and what does the PRA have to say about the FSA instructing the FCA to build more risk models? 

Don't get "prudential" on me now, you promised you wouldn't.

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