Monday, June 30, 2008

Oil Speculation

I like the idea of testing the speculative element in oil futures markets by requiring everyone to go all the way to liquidation, instead of just rolling their futures contracts. I didn't realize that it had ever been implemented, so this story about the silver market is interesting.
In one instance, however, the speculation premium was "successfully" tested - in the silver markets in 1980 when the Hunt brothers attempted to corner the market. As silver approached $50 an ounce in January 1980, the commercial participants asked for relief from the enormous margin calls from ever-rising prices. The CFTC and the Comex (the predecessor to the Nymex) responded effectively by imposing "liquidation-only" trading -- traders were allowed only to close existing positions and not permitted to initiate new positions.

This forced purely speculative positions to be closed rapidly, as they could no longer be "rolled" into future months at expiration. This caused the price of silver to drop by $12 the day after it was imposed, a decrease of over 20%! Over the course of the next three months, as contract months expired, the price dropped over 50%.

While I do not advocate such a move,...I believe that in an election year this will inevitably be suggested and implemented. The effects would be astonishing and immediate. Energy funds would be buried, and commodity-biased portfolios hurt badly...

One thing is for sure: A "liquidation-only" market would settle finally and for all time the argument about speculation premium in the oil markets

BIS Report

After hearing this quote I can't wait to get to the BIS report:
"The current market turmoil is without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point," it said.

"These fears are not groundless. The magnitude of the problems yet to be faced could be much greater than many now perceive," it said. "It is not impossible that the unwinding of the credit bubble could, after a temporary period of higher inflation, culminate in a deflation that might be hard to manage, all the more so given the high debt levels."
This last part is what keeps me up at night. Whip-saw inflation-deflation. I would love to get a better understanding of how that might play out.

Bonus -- there's also this happy thought worth noting:
"Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off.

"To deny this through the use of gimmicks and palliatives will only make things worse in the end," he said.
Fortunately we all know the government is not prone to gimmicks and palliatives.

Saturday, June 28, 2008

Investment Banking

Barron's has a cover story -- Future of the Street -- speculating on what might happen to Wall Street as it recovers from its current meltdown. One particular passage caught my eye, mainly because I think you can already see it happening:

The balance of power is shifting toward the large hedge-fund and private-equity shops and away from the sell side. As hedge-fund boutiques grow into full-fledged institutions, they are sourcing more of their own deals, investing directly in issuers and internalizing trading and processing activities that they used to outsource to the Street.

It shouldn't come as a shock if a hedge-fund complex buys an investment bank. At the same time, Street firms will keep buying up and developing hedge funds of their own, if only to tap top talent and stay in the flow of the smart money.

Throw in the fact that Leucadia just took a big stake in Jefferies, and you can see that it's not just the big hedge funds that are picking at the corpse. The end game is probably three or four big investment banks that specialize in only the largest deals. I don't imagine them losing their competitive edge in this arena, I simply think that they've attached another of very profitable businesses to this core, many of which may end up in the hands of others.

Friday, June 27, 2008


I was wondering the other day why I had never read anything about a secondary market for interests in private equity and venture capital funds. These secondary funds are not quite the same thing as being able to sell your direct LP interest in a fund, but they answer the intermediate liquidity need that the credit crunch represents.

Hot China

Naked Capitalism has a post linking to a bunch of the other stuff I've already read about China, conveniently allowing me to forgoe collecting it all in one place myself (though if the topic really interests you, a stop by Brad Sester's blog is a must).

To summarize: China's FX reserves are growing much faster than their current account surplus, probably as a result of people speculating on the appreciation of the currency. This puts China between a rock and a hard place, because if they continue to let this money come into the country they will inevitably end up with higher inflation, at a time when it is already menacing. However, if they revalue the currency they lose on export competitiveness at precisely the moment that their major buyers' (US, Europe) economies are going into the tank. This would be a serious problem for what continues to be an export-led economy. Finally, the intermediate route, of accepting some inflation, but also partially revaluing, actually makes the problem worse, as now everyone with half a brain will try to make the same bet on their currency gradually appreciating, it being one of the few predictable investments I can think of right now.

Thursday, June 26, 2008


There is an interesting run down of high-level investing strategies from Gavekal in FT Alphaville. Basically, they claim there are broadly four ways to make money investing each of which has some current incarnation:
  1. Momentum -- currently commodities
  2. Reversion to the mean -- currently nothing, which is weirdly true. The article points out that this is perhaps partly for reasons of visibility, but I think the problem is more one of valuation.
  3. Be a bank -- Borrow short and lend long or some other carry trade. This is tough right now, because nobody wants to lend.
  4. Buy insurance -- Run a negative carry trade, or borrow long and wait for the short-term stuff to blow up. This is the CDS strategy.

Tuesday, June 24, 2008

Old news

It's good to point out one of the paradoxes of the current environment as often as possible. America is dedicating enormously productive agricultural land to filling its gas tank, while Saudi Arabia is growing wheat in the desert. When you read stuff like this every day, it gets very frustrating to hear that "the market" is responsible for all our problems.

Friday, June 20, 2008

Lobbying is a business expense

It's Friday evening. The Mighty Sparrow is singing about the Village Ram, and I am about to enter that sweet and oblivious twilight zone of speculation that I so do love.

Dad, what does 'Ram' mean in english? Bloody hell.

Anyhow. Today. Google.

Google really really really needs to start doing some serious lobbying NOW. For a confluence of reasons. First, for all the anti-competitive monopoly of GOOG's competitive position, it ain't the government. I hate google less than I hate the US government. Faint praise, I agree. But second, google has quite obviously staked its competitive well being on the openness of the internet, and that is, equally obviously, under serious attack.

People reading slashdot already know about the end of he world. For the rest of you ... let me fill you in. Pretty much everywhere, the tremendous corruption of what pathetically passes for government -- worldwide -- is closing in on the newest means of communication. Remember when they though that TV was going to be something revolutionary? Me neither. And the internet is going to end up in the same place. Here's how.

First, they're going to pass all these absurd laws on the basis of the ever-predominant logic of the modern nation state -- the Emergency. If we don't spy on everyone all the time, the terrorists will obviously win. Forget about the fact the US is the leading terrorist organization in the world, and in fact is is the only state condemned by the UN for said reason. And forget about the fact that ... you know ... they're are gay people that might hear us. Shhhh. No spying = terrorism.


Pause -- refill -- and so then where was I ... right, then ... the end of the world. Basically, my reflection was simply that the internet is going to turn into something dramatically more pedestrian than what it potentially could be, and than what I think many of us secretly think it might be and want it to be. And this will occur, true to historical form, through government regulation. Precisely the fascist combination of government and business that sponsored the last atrocity when they took the radio and used it to kill millions.

Little matter to to me that the US chose to pursue a career in pornography ... err ... mass destruction. However, this makes it hard for me, Thor-like-plastic-lawn-chair-seated-South -American-hedge-fund-manager to conservatively invest in google. That's right, the US government is fucking with my right, my fucking divine right, to make BIG BIG fucking money. And that's what really busts my chops.

Google has thrown it's lot in with the open-ness of the internet. It's a a clear philosophical principle of the company. And it can just simply be a bad bet, financially, and politically. Remember, for as monopolistic situation as google has built, the providers of the access to its services are also a very small oligopoly, and they have already proven that they know how to use the political system to their benefit. Google is falling behind in the lobbying arms race. They need to prevent the mine-shaft-gap or they simply won't exist, having been replaced by the government/ISP security alliance that takes over the role of spying on he consumer. The question is not whether the consumer wants to be spied on or no (let's face it, the sheep want no privacy) the question is merely who does the spying, and the only important part of the answer is that it not be the same guy that puts people in jail, collects their taxes and drafts them into the army if necessary. What we really need is not more government, but many many more governmentS.

Google is our best hope for the dissonant decoupling of the federal government.

This post is brought to you buy the letter F, for FREEDOM.

Arabian Allocations

The great oil debate of 2008 can get pretty confusing at times. One of the reasons for this is that in their haste to blame the speculators, people forget to define speculation (witness Joe Lieberman and his attempt to draw the line between "speculation and excessive speculation"). If the Saudi royals decide to pump less oil because they don't won't to own the about-to-be-worth-less dollars that would result from selling it -- is it speculation? Oil producers now have huge SWF's and pumping oil has become a portfolio allocation decision:
But as oil producing nations have accumulated vast reserves of financial assets, switching from oil-in-the ground to stocks, bonds, or bank accounts is no longer so sure a bet. ... Central banks and sovereign wealth funds of oil-producing nations already hold hundreds of billions of dollars worth of Western financial assets. They might already have reached or exceeded what they view as an optimal allocation of their national wealth into these securities. Of course, producers are still not well diversified, and it's pretty clear that sovereign wealth funds are looking for alternative assets that might hedge their exposure both to oil and Western paper. But allocating into less liquid, unfamiliar categories of assets is slow work if you want to do it well. Perhaps current oil revenues outstrip oil producers' capacity to find good investment opportunities, and they view oil-in-the-ground as a better second-best asset than dollars in the bank.

Thursday, June 19, 2008


Everybody's opinion needs to be taken with a grain of salt, as you never know what motive they may have up their sleeve. Last year, John Paulson made a fortune in the CDS market betting against subprime, and there's no way to know if he's still riding that trick now. However, one of the things I like about getting opinions from hedge funds is that they actually have the luxury of changing their minds when the facts change. So when I here things like this:
"We're only about a third of the way through the writedowns,'' [John] Paulson, 52, told the GAIM International hedge fund conference in Monaco today. "There are a lot of problems out there and it will continue to be felt through the year. We don't see any signs of stabilizing.''

Paulson said he's preparing to buy distressed securities such as bank loans, call them a "potentially $10 trillion opportunity.'' While it is still "premature'' to invest in many of them, he sees "opportunities this year'' to buy mortgage backed debt, he said.

He hired employees this year to research securities firms such as Citigroup Inc. for long-term investment positions. "We're trying to see the right entrance point,'' he said. "If you invest too early, you lose money.''
It means a lot more to me than when I hear exactly the same thing from Rich Pzena, who you already know is going to say this anyway. For as smart an investor as he is, Pzena has carved out a niche managing a value fund, and mathematically speaking, financials are where the value is right now. So Pzena is not really allowed to have any other opinion or invest in anything else, or even just wait and see how bad all this gets. He may ultimately be right, but he is right the way a stopped watch is. An opinion is only as valuable as the size of the possibility space from which it is chosen, otherwise it contains no information.

Wednesday, June 18, 2008

Modern Finance

NC has some interesting reflection from a former Fed economist on how the Fed has gradually become a more political and less independent agency. This is pretty fundamentally scary to me, because I deeply believe that while markets may not be perfect, they tend to fuck things up much less than if you leave the decisions in the hand of a single monkey. The Fed becoming a political tool of the incumbent party would compromise the US economy deeply, permanently, and nearly invisibly.

Related to this I have another question, which makes me wonder if my observations are essentially irrelevant. Is it even possible for the Fed to function as it should -- ie. regulate the money supply -- with the way the financial system works now? Money is basically electronic at this point. This new technology seems to put the regulated banking system at a disadvantage compared to the shadow banking system. I feel like money can sprout from anywhere these days, and bad credit drives out the good until we arrive at a crisis point. Can anyone really even be in control of this system anymore? And once it's out of control, how do you bring it to heel?

Tuesday, June 17, 2008


The Big Picture points out that some of the big financial companies have actually wiped out all of the profits they made during the debt bubble (one notes though that Goldman has been the least affected of any of these). What makes me both nervous and hopeful is a quick look at the chart in the article. This one is market cap of the financials relative to the overall market, rather than profits relative to overall corporate profits, but the two tell mostly the same story (actually the PE compressed somewhat during the boom, showing you that there were always suspicions in the market about the great new era of financial engineering).

Thinking about a chart like this makes me nervous and hopeful just like it would make me nervous and hopeful if they told me I had a tapeworm. On the one hand, yikes ... you've got a tapeworm. On the other, at least you know why you've been losing weight even though you eat like crazy. That is, I think this chart represents, to a large extent, the growth of an economic parasite.

I'm the first to agree that financial firms have an important role in the overall economy -- matching capital to the real productive uses of capital. I even agree that as an economy matures, and especially the economy of the world's political and economic superpower, you would expect the role of this economic brain, as it were, to expend as a percentage of the overall economy. And finally, I agree that competing to fill the role of capitalist brain financial companies should make a small profit.

But that's not what these charts show. The distribution of capital to the most efficient uses shouldn't be 25% of the market cap and 40% of the profits in an economy. There cannot possibly be that much non-zero sum game in the commodity market for money. This means that at some point the financial sector is benefiting at the expense of the economy, and not along with it. At some point it is a parasite. I don't know exactly what point that is, but I know it was well before yesterday. Buffett had already pointed out this logic in the context of hedge funds many years ago -- it's how the Gotrocks became the Hadrocks.

The big question is of course how the parasite got this big, and I'll just give the answer I always give -- the government. The government's most direct and distorting involvement with the economy has always been with its infrastructure, and above all with its financial infrastructure.

Saturday, June 14, 2008

All you need to know about the supreme court decision

So, the other day, the US supreme court decided that we were going to remain a country marginally committed to the rule of law (or at least a country 5/9ths committed to this). Anyhow, McCain is climbing on the bandwagon of Justice Scalia's dissenting opinion and asserting that giving people in Guantanamo real trials will "cause the death of many more Americans". Here is all you need to know about Justice Scalia's dire warnings:
Justice Scalia’s dissenting opinion, which called the decision “disastrous,” “devastating” and tragic, was reminiscent of the tone of his dissenting opinion almost exactly five years ago, when the court overturned a Texas criminal sodomy law and set out a constitutional foundation for gay rights.

That decision, Lawrence v. Texas, portended a “massive disruption of the current social order,” Justice Scalia wrote then. State laws “against bigamy, same-sex marriage, adult incest, prostitution, masturbation, adultery, fornication, bestiality, and obscenity” were all “called into question by today’s decision,” he warned.

Right ... so ... if we let gay people fuck the terrorists will win. Are we really going to continue to take the opinions of this nut-case seriously?

Friday, June 13, 2008

Hedge banks

The NYT has an article on hedge funds that are moving in to fill the lending role left open by deleveraging banks. The article is interesting on a number of levels.

First, it makes you realized how totally commoditized hedge funds have become. Admittedly, there are plenty of distressed opportunities that are going to be out there in the next couple of years, but once these guys start acting like a bank, they're going to become ... well ... a bank. Expecting 20% or even 15% returns from these guys seems unlikely over the long-term.

Second, it speaks directly to the questions of regulation. The Fed will regulate some investment banks, and change some regulation on regular banks, but these guys simply are not regulated and they never will be. There will always be a shadow banking system, and the government will never keep up with it, because it is the government that actually creates the conditions of its existence.

Third, the cost of capital in corporate America just went up. This may actually be a good thing, if, like me, you think that the Fed shouldn't have let rates get this low to begin with, and especially not primarily to bail out insolvent lender idiots.

Chinese inflation

Stephen Roaach is worried about inflation in China even as another FT article points out that there inflation is down month on month. Reading the whole article (to its credit, even the headline kibbitzs) leaves one a little more skeptical though, for a few reasons:
  1. Umm ... why exactly should we believe these statistics? Nobody believes them in Argentina, and they're right not to. There's even suggestions that the government manipulates this stuff in the US (partially true I think, but somewhat overblown). It was funny to read the Q&A sections the FT published about the individual BRIC economies. Russia was actually the most interesting market -- strong domestic demand growth, low valuations (10 times earnings), a floating currency, and a tremendously educated populace -- and yet all the questions were about whether it was pure Ruskie hyperbole, whether in fact that whole thing was totally corrupt and manipulated. Strangely, people didn't have the same skepticism with China or Brazil.
  2. The article goes on to point out that inflation is partly (maybe mostly) being tackled through price controls. This of course cannot possibly work in the long run, because it simply leads to shortages, which are apparently already occurring.
Chinese petrol and diesel prices, set by the state, have not increased since last November and energy rates are also capped despite rising coal prices. The result has been growing shortages of diesel at petrol stations and serious coal shortages at some power plants.

In the first week of June, Shandong and Shanxi provinces announced new controls on coal prices, to relieve the burden on power producers. Although there is little agreement on timing, the government is expected to raise oil and energy prices at some stage in the year.

There have also been reports of local government limits on prices of some foodstuffs, including milk and cooking oil. Yet even with these controls, separate figures released this week showed factory-gate inflation had edged up last month to 8.2 per cent, a four year-high.

Of course, they go on to point out that maybe this won't have a big impact on consumers because companies will absorb it as a hit to margins. That's fine, but not precisely the cure for inflation that an investor is looking to hear.

Somehow, the official figures don't give me a lot of comfort.


Stephen Roach explains the dynamic that everyone is talking about these days.
But there is a new threat to global inflation that was not present in the 1970s. It is arising from the developing world, especially in Asia, where price pressures are lurching out of control. For developing Asia as a whole, consumer price index inflation hit 7.5 per cent in April 2008, close to a 9½-year high and more than double the 3.6 per cent pace of a year ago. Sure, a good portion of the recent acceleration in pricing is a result of food and energy – critically important components of household budgets in poorer countries and yet items that many analysts mistakenly remove to get a cleaner read on underlying inflation. But even the residual, or “core”, inflation rate in developing Asia surged to 3.8 per cent in April, more than double the 1.8 per cent pace of a year ago.

Given Asia’s new-found role as the world’s producer, such an outbreak of surging inflation in this region is not without serious risks to the global economy. The globalisation of trade flows is a new transmission mechanism of worldwide inflation that was not evident in the 1970s. According to estimates from the International Monetary Fund, overall exports should hit a record 32.5 per cent of world gross domestic product in 2008, more than 50 per cent above the export share of 21 per cent prevailing in 1980, when the “great inflation” was nearing its peak.
He also points out that a lot of these countries don't really have independent central banks, so they can make some pretty irrational decisions from a purely economic point of view.

Financial Globalization

Brad Sester has an interesting post about how many of discussions of the benefits and perils of globalization miss one of the key factors that have driven its dynamic -- massive government intervention in the market. His point is simple but powerful. China, the Gulf, and a lot of other folks have built up huge dollar reserves by keeping their currencies undervalued to one degree or another. They then kept US interest rates low by reinvesting this money in US treasuries, and, increasingly now, US stocks. One market distortion -- China Inc. acting as one solid monolithic entity to hoard dollars -- induces another -- US financial firms benfit from the domestic business (subprime) created by this debt boom, and also make loads of money selling pieces of the US to the holders of all these dollars. The idea is that the big beneficiaries of globalization were banks -- the Chinese central bank, and the US banks and investment banks. This neatly ties together the huge increase in financial profits as percentage of US corporate profits, to the rise of these enormous SWFs, who are now, in a sense, the biggest hedge funds in the world. So the last decade of globalization was primarily a financial globalization, and the very real benefits of it were captured by financial firms.

Am I going to sound like a broken record if I point out that the non-zero sum game of free-trade-benefits-everyone (remember when people actually believed this) was, yet again, fucked up by state intervention in the exact place the state always intervenes to fuck things up -- namely the banking system? Will I sound like any more of a broken record than history itself?

Boiling in oil

I think you've got to have your head in the sand not to recognize that there is some new speculation in the commodities markets. However, the difficulty is in estimating the impact of this speculation, and in trying to figure out what the price of oil would be in lieu of it. I've already said that $75 would be a reasonable estimate, but that's not founded on the firmest of thinking; it's really just a guess based on where the price was at before so much money started pouring in. But let's assume that's correct, and move on to discussing whether that means that at oil at $137 is currently in a bubble. Well, yes and no, seems to be the answer. Yes, in the sense that if this speculative money chose to speculate elsewhere the price would be instantly cut in half. But no, in the sense that it's difficult to see the real price of oil being any lower 20 years from now. There's lots of demand, there's little new supply, and ultimately, there's a fixed amount of this stuff.

This presents the same type of puzzle that you find with the equity premium. You know that stocks consistently outperform bonds over long times periods (a 98% certain conclusion at the 20 year horizon, if I remember correctly). You have 200 years worth of data to this effect -- essentially the entire history of modern capitalism confirms this fact. So, then, knowing this, why doesn't a rational long-term investor bid stocks up to a level now which implies that they will only generate the same return as a bond in the future? This in fact, was the argument behind all those Dow X00,000 books during the internet bubble. Of course, there are good reasons why this doesn't happen, and why it was perfectly fair to call the Nasdaq a bubble back in 2000 -- not everybody invests for 20 years, the appropriate valuation level depends on things that are tough to predict like productivity growth, etc -- but one of the most important reasons this doesn't happen is pointed out here:
Burton Malkiel, a Princeton University economics professor and author of ``A Random Walk Down Wall Street,'' says the rise in oil may be justified because supplies are limited and demand in developing economies is increasing. That distinguishes oil from the market for technology stocks in the 1990s, where supply ``could be expanded infinitely'' and new stock issues helped push down prices, he said.

``The picture is fundamentally different than the Internet picture,'' Malkiel said in an interview from Princeton, New Jersey. ``I'm not saying we're running out of oil, but we're clearly supply-constrained. Five and 10 years from now, the price is going to be higher than $134.''
The idea of Dow X00,000 is a self-defeating prophecy because everybody takes advantage of it to create more supply of stock.

On the other hand, with oil, you have a different wording here of the "peak oil" hypothesis; at some point the limited supply of this stuff starts to be a factor in the price. As an oil producer, if you know the price of oil is going to rise, it behooves you to just leave it in the ground, unless of course you could make more by pulling it out of the ground, selling it, and investing the money in bonds. In equilibrium, you have what is called Hotelling's Rule which predicts that the price of a finite commodity will rise at the rate of interest. So the price increase can't really be called a bubble, if you have a fundamentally rational economic theory that would predict it. The question is whether we've really reached peak oil and this anticipation of scarcity has started to be incorporated into the price. The fundamentals folks insist that the real price of oil is only just now regaining its 1980 highs, so in reality its just making up for lost time, as it were, by spiking now. I think this argument actually has some merit to it, and is a reason not to believe that oil will sink back to the marginal cost of production, but I'm skeptical that it completely justifies the current price level.

Nothing the state does is temporary

Here's NC and Gillian Tett once again reading my mind.
We wondered ever since the Fed established and then repeatedly increased the size of its Term Auction Facility, which now provides $150 billion of support to the US banking system, how the central bank would ever be able to wind down this program. It certainly can't do it when the financial system is fragile, and banks will argue that the withdrawal will hurt their operations even when the economy is in better shape.
On top of this, you may see big political decisions to "save" the housing market, which could contribute to an extended Japan-style malaise.

Thursday, June 12, 2008


Willem Buiter on the new UK police state.
The UK’s gutless House of Commons has just consented to the most serious assault on a free society and on our essential liberties this country has seen for at least a century. It will now be possible for persons suspected of terrorist crimes to be detained without being charged for up to 42 days. This is a major step on the road to a police state in the UK - a horrifying encroachment on human rights. If the government believe there is a war on, let them declare a state of emergency and assume emergency powers. This introduction of state-of-emergency-instruments and powers during ‘normal’ times, is a constitutional outrage.

If you do not have sufficient evidence to charge a person with a crime, you should not detain him or her. That defines the rule of law and a free society. That principle is more precious than life itself, because without it the power of the state becomes unbridled and can roll over any individual. The preservation of the safety and security of the citizens is not the primary duty of the state. The preservation of their essential rights and liberties is. Because the world is an imperfect place, one could perhaps condone this kind of preventive detention for a couple of days. But even that should be subject to strict safeguards.
The 20th century has so twisted our idea of the purpose of government that we now believe that we have a government in order to have economic growth, or public safety, or redistribution, or just about anything except the one true reason to have a government -- to have the FREEDOM to enter into relations of VOLUNTARY mutual benefit. We have governments in order to be free. If you can be told what to eat, smoke, or buy ... if you can be forced to work continually hunched over in a field picking cotton ... if you can be thrown in jail at any time for literally nothing ... You. Are. Not. Free. You need a government. Not ours of course.

US infrastructure

Naked Capitalism has a post today that echoes something I have recently been reading about. The background is that Joe Lieberman now wants to regulate the commodities futures markets so as to exclude pension and index funds (NYT article to this effect). Yadda yadda yadda. This is the typical Washington crap and it's impossible to know what, if anything, might come of it. Note, for the record, that the entire problem has been created by the original regulation that forces people into a sort of black market and creates the opportunity for really serious profits for those who operate that market. But I digress. Anyhow, that regulatory uncertainty alone, coupled with very real questions about whether or not these funds have contributed to a bubble in commodity prices, may make some folks re-think their commitment to a passive commodities index. However, the thinking that led them to investigate that index to begin with -- its purported inflation hedging and diversification properties, the perceived long-term imbalance of supply and demand for the underlying assets -- is still going to be around. Deprived of commodities as an outlet, NC suggests that the same thesis might express itself via infrastructure investments.
Now before the wealth-holding class howls that they've just been done a dirty by being deprived of inflation protection, there is an asset class that, unlike commodities, supports productive investment. and provides inflation protection, namely, infrastructure investments. The cash flow from infrastructure projects (toll roads, airports) goes up over time, as do the payouts, so they have fairly secure cash flow that increases over time. Although there is some debate about how to view them, they seem closest to an inflation-indexed bond (although any investor would need to study the ability of the enterprise to increase charges versus the drivers of operating expenses).
I think this is an interesting possibility, and infrastructure is one of the few places you can imagine being early relatively early to the alternative assets party. There's no doubt that the US is in desperate need of it. There's no doubt about its inflation hedging potential (even better than commodities futures, because you actually own something real). And there's no doubt that the returns shouldn't be terribly correlated with the stock market over the long-term. There is, however, a very real question about the political risk of this type of investment.

Tuesday, June 10, 2008

Expanding the Fed

Here's a good speech by one of the the PIMCO boys about the way the Fed works and what effect the recent changes might have on it. He's pretty sanguine about the whole works, and goes so far as to see a sliver lining in all this:

Post opening the discount window to the investment banks, regulatory arrangements will ineluctably change – it is simply untenable for the Fed to lend to someone that it doesn’t regulate. The Fed knows this and Congress knows it, too. Thus, while the Fed may have less independence over the composition and size of its balance sheet, the Fed will have greater leverage at this watershed moment to demand and get sensible regulatory reform, aimed at counter-cyclical, rather than pro-cyclical, constraints on leverage in the financial system.

And, in fact, I think there actually may be a silver lining in the Fed’s making more loans and holding less U.S. Treasury securities on the asset side of its balance sheet, even if Congress is given to more meddling. More loans will, by definition, give the Fed more power to shape the activities of those to whom it loans, similar to the relationship between Bank of Dad and my 19-year old son.

I am much less certain. Just look at the bit of rhetoric here. The government is the Bank of Dad. Call me a right wing nut-case, but that's exactly what got us into this whole bloody mess! What on earth would make you happy about putting the fox in charge of closing the barn door after all the chickens got out? Sorry, couldn't resist that one.

Anyhow, there is a really easily identifiable pattern in American history. First, you have some crisis. It can be purely financial, more broadly economic, one of security or health and safety and retirement, whatever ... it makes no difference because the crisis is just the MacGuffin, as Hitchcock used to put it. The crisis is always an excuse for the government to come in and take over "for the benefit of everyone". This inevitably seems totally plausible at the time, and sage people will nod their heads in agreement and talk about how it was sadly necessary. Once the government gets its foot in the door it will never leave. Temporary measures needed in the crisis become permanent almost without exception. At first, the new regulation looks great -- after all its wisdom and measure just saved us from the foolishness and greed that precipitated the crisis.

But pretty soon, people start to realize that some of these new regulations have all kinds of undesirable consequences that nobody saw right at first. To begin with, these regulations are overseen by a bunch of bureaucrats whose primary goal in life is not looking to the benefit of "the people" (who, like all other abstract nouns, are after all not to be found anywhere in particular) but to keeping their jobs. So the primary goal of all regulation is more regulation. On top of that, these bureaucrats have to come up with their brilliant regulatory schemes somehow, and they ain't getting any help here from the luminaries in congress, so the natural people to consult are those whose businesses you are regulating, and the natural place to hire people to do this regulating is from the ranks those very businesses. And don't forget that when these people stop regulating, they can always go back to those companies and make many many times more money. So now businesses are back regulating themselves again, except this time not through a free and transparent market, but through a backroom lobbying setup that only the biggest businesses have access to. Unsurprisingly, monopolistic self-regulation is not effective, and sets the stage for another period of stupidity and another crisis, which of course, requires even more regulation to solve.

That little allegory applies equally to finance, defense, the FDA, and just about every other aspect of government I can think of. It doesn't require any conspiracy theory or any terrible plot by the government or by "big business". It's just a simple mechanism that forms a predictable and well defined feedback loop. Government makes more government. Centralization and regulation propagate. When other countries begin to imitate, they reproduce.

I have honestly gotten to the point where I'm almost unable to understand why this is so difficult for people to see. The Bank of Dad is clearly one of the greatest myths of all time.

Monday, June 9, 2008

The anti-dollar

On Friday I was about to comment that the market seems to have become inversely correlated to the price of oil, which does suggest to me the possibility that there is serious speculation going on in the commodities markets. This is still the general impression I have -- that people are scared of the US economy, scared of US inflation, scared that emerging markets might be overvalued and might be coupled to the US ... scared, in short, of just about everything, and looking for something to do with their money. As a result, they move it into the only thing that appears to be doing well, which is why we see these correlations. I stopped because I looked at some charts of oil, the dollar, and the S&P, and didn't see anything that bore out my idea, however, the sentiment is not mine alone, as this WSJ article about oil as an inflation hedge.

Update: The Saudis may have all kinds of reasons to jawbone the price of oil, but at that same time, they are the best positioned to know exactly what the fundamentals of supply and demand are, so we should probably take them seriously when they reiterate what we already suspect, namely, that oil has become a speculative financial commodity at this point.
"The increase in prices isn't justified in terms of market fundamentals,'' the Saudi government said today in a statement distributed by the Saudi Press Agency. Traders covered short positions, bets that prices will fall, because of the dollar's drop and threats of supply disruptions.

Thursday, June 5, 2008

Calling Bullshit

Kenneth Rogoff tells it like it is. You can't complain about China pegging its currency and at the same time claim that it's fine if Saudi Arabia does.

Department of Societal Insanity

First, put 1% of your population in jail, the vast majority of them for smoking a little high-stake. Then, turn it into an enormous big monopoly business opportunity. One would be forgiven for asking which was the chicken, and which the egg in this case.

Hedge Funds on the Farm

The NYT has another article today about something I've been exploring (they actually mention the Ospraie Special Opportunity Fund whose letter I was just reading) -- hedge funds that have commitments both on the financial and physical side of the commodities markets. Naked Capitalism has some skeptical thoughts, as are certainly warranted. It's honestly very difficult to tell whether this is a good place to make money now or not. Clearly, the volatility of the commodities markets and the fact that pension funds keep piling into the long side of the futures market creates an opportunity here. And everybody knows about it, which sounds the contrarian alarm bells (inevitably before it should for me, but one can defend this paranoia as a capital preservation mechanism).

It's hard even to come to a firm conclusion as to what assumptions are necessary to make money here. I don't expect oil or grain prices to stay at the level they are at forever. But simply recognizing that misses the point. Over the long-term the world is going to need more food. And they're going to get it. The question is whether the appropriate medium-term increase is already completely in the pipeline, or whether it's still possible to profitably become the agent of this increased production. What's the time scale on it, and where do food prices need to be to make money over the next 5 years? Another valid question is the exit strategy. If you buy land in the Ukraine to produce wheat, you make make a great profit over the next few years, but then be stuck with a bunch of land for producing wheat at exactly the moment there's too much wheat around. This might make it very difficult to liquidate the fund.

The thing that attracts me to these special opportunities commodity funds that are buying things like grain elevators is that you may be able to hedge out some of these questions, and make a profit regardless.

Wednesday, June 4, 2008

Oil Subsidies

An interesting Morgan Stanley report about oil subsidies in emerging markets has been excerpted here. The basic idea is pretty simple. China, Saudi Arabia, India, etc ... have government subsidies of fuel prices. At the moment, they estimate that 22% of world fuel consumption is subsidized. It's very hard to get people to conserve on something they don't have to pay for, and so no demand is destroyed as prices rise. The result: further prices increases in oil and deteriorating fiscal positions and inflation in these markets. Some of these countries, particularly India, are having trouble maintaining this level of subsidization, and are likely to cut back in the future.

Tuesday, June 3, 2008

RMB Appreciation

Another chapter in the on-going saga called let-your-currency-float. I actually can't think of even a single situation where a currency peg hasn't eventually ended in disaster. It may take a long-time to happen, and the benefits may look fantastic in the meantime, but the dam always seems to break with tremendous destructive force when it does.
China, in other words, is in a nasty fix. Speculative capital is coming in through so many channels that even if the authorities were to impose capital controls, the impact would be limited at best. And the magnitude of the funds flows is eyepopping (note Pettis does go into some detail before reaching his conclusion):
Headline reserve growth for the first four months of this year was a breathtaking $228 billion.....A plausible guess, then, is that hot money inflows are greater than the headline reserve growth, or at least not a whole lot less.

So the net effect is that China has lost control of its monetary policy. It cannot sterilize this volume of inbound funds flows, so it stokes inflation, and inflation is already running at a level that is politically problematic:

Since the PBoC must monetize these inflows – either by issuing currency or by issuing central bank bills – these inflows end up adding to the country’s money base. With the largest part of the inflows probably consisting of speculative money, that is what I mean by saying that Chinese monetary policy is now driven primarily by RMB speculation.

Unfortunately I don’t think we are likely to see much improvement in the next few months, and remember anyway that even if there is a reduction in speculative inflows, it would have to be a massive reduction to mean anything. As money continues to pour into the country, the problems of inflation and overinvestment are going to persist and get worse. As they do, it will become all the more obvious that China is facing serious appreciation pressure, and the talk of a maxi-revaluation will simply increase. Needless to say, this can only increase speculative inflows.
After reading about the commodities futures markets, and these rigged exchange rate markets, and the looming disaster in the CDS and ABS markets, feel like the lesson is obvious: if you want to avoid speculative disruptions, build free, fair, and transparent markets to begin with. Such markets will not be perfect or perfectly efficient. They will be beset by usual behavioral irregularities of the East African Plains Ape. They will still be vastly better than the alternative of giving one ape (systematically bred to be a pathological bullshitter -- ie. politician) the ability to sustain these irregularities until they reach the level of a "system", at which point you are fucked, to put it succinctly. Nobody ever seems to see this line of reasoning though, and when the controls inevitably don't work, everybody asks for better controls. This is like believing an alcoholic when he says that really, this is his very-last-drink-ever.