Tuesday, June 15, 2004

Summer: time for ice-cream

It's tough to sell ice-cream.

Not only is it a highly competitive market, but you are also competing with the toughest competitor of all: Mother Nature.

Ice-cream sellers are at the mercy of the seasons.

The demand for ice-cream waxes and wanes with the months of the year.

So does the price.

To try and get people to eat ice-cream when they otherwise wouldn't, you need to make it cheaper; everyone has a price.

Market forces can overcome the forces of nature. The poor ice-cream seller, however, is at the mercy of both.

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To the casual observer, the price of ice-creams might seem to be very predictable. In the summer, prices will rise. In the winter, prices will fall. Not too complicated.

Now take the entire economy and you get a very complicated picture indeed.

Every market is affected by the seasons. Not all of them to the extent of the ice-cream seller, but the seasons play an important role in explaining why prices rise and fall.

It's important for policymakers to distinguish between factors that are seasonal and those which reflect a more fundamental shift in the economy.

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A lot of emphasis is put on the price of fuel. Anyone who owns a car needs to buy fuel. When more people want to drive in the summer, the price of fuel is going to rise. Like in the case of ice-cream, this is soley due to the fact that temperatures are rising and everyone is hitting the road. Like the demand for ice-cream, this won't last.

When making a decision on interest rates, policymakers need to be able to consider the current strength of the economy compared to any other stage of the business cycle. Seasonal changes should not be allowed to influence this decision.

Like the ice-cream seller in the winter, things can and will improve without the help of anyone else.

The price of ice-cream that doesn't include seasonal variation is the only way to guage the true strength of the market. This applies to the whole economy too.

Wednesday, June 09, 2004

Inflation is our friend

Inflation has gotten a lot of bad press lately.

It's as if we would all be better off if it would just go away. Then we wouldn't have to worry about rising interest rates, right?

Wrong.

Looking at the inflation rate of a country is a good way to guage it's economic health.

Assuming a country isn't engaged in war or some other political turmoil, inflation is one of the best ways to know when the economy is strong and when it's weak.

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Every economy is capable of producing more each year. At the same time, consumers demand more and more. They always want a newer TV, car or house. This is what causes prices to rise.

Looking at a country like Japan, where prices are falling, you might think people there are enjoying lower prices each year. Unfortunately, they're not.

Much like a sick patient, where the temperature is dropping, Japan's economy is also sick.

The best way to cure the disease and is to get people spending and spending more each year. To get people wanting to spend their income on new and improved products, instead of sticking with the old TV and saving their money for a rainy day.

Japan backs off

Japan hasn't weakened the yen in April or May. Why?

They haven't needed to. Why?

The market has weakened the yen all by itself. Why?

The answer depends on who you ask.

An investor might say expectations of rising US interest rates make Japanese assets less attractive.

An analysts might say the yen was overbought, and did not reflect economic fundamentals. After all, Japan's economic growth was always expected to slow over the course of the year.

Of course it's a combination of factors that influence the currency market in the short-term, since currencies move up and down (and up again) all in one minute!

The Japanese government says as little as possible, knowing their every word is being watched by everyone in the market, eagerly waiting to know where to next place their bets.

Still, it's comments by government officials that are responsible for the large part of short-term currency market moves. The market makes money on what the government says. That's how it works.

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Japan's decision to back away from the currency market means fewer purchases of US assets with the money used to intervene in the market. So far this has not created too much cause for concern.

But markets are always looking for ways to make money. It's a sure bet the Japanese government won't allow the yen to strengthen too far against the dollar. Many traders prepare to benefit from short-selling the yen as Japan prepares to get back in the market.

Tuesday, June 08, 2004

Let's talk Japanese

Speaking is the easiest thing to do.

Speaking in a different language can seem the hardest thing in the world.

It really depends on the person; in particular, their application and motivation to learn and use the language.

Some people learn a new language quicker than others. This can come with a stronger motivation to learn the language or a better ability to apply the language to their way of life.

In any case, the more practice the better.

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I've been 'exposed' to the Japanese language for the past 5 years. While I have fallen short in application, my motivation to learn the language has remained strong. It's a fun language to learn. It's more fun to use. It's just harder to use a language than it is to learn.

It never ceases to amaze me how easy it can be to translate a simple sentence from one language to the other but how difficult it can be to do this in a conversation.

When speaking in a different language it's best to listen, think and speak in that language. I often find myself thinking in English, translating this into Japanese and then speaking in Japanese. This makes me look slow and can often disrupt the flow of a conversation. Many kind people have patiently suffered my lacklustre conversations.

Monday, June 07, 2004

Everyone's talking about the Fed

For many months now anyone and everyone has had an opinion on what the US Federal Reserve will do next and when.

We all talk about it but nobody knows exactly what to expect.

It's possibly the most interesting monetary policy in the world right now and that's a problem. Why?

If investors aren't sure what policymakers have planned for us, they can't make well-informed savings and investment decisions.

While the Fed has come a long way in making it's policy decisions more transparent, the heated debate over the past couple of years has highlighted a significant shortcoming in US monetary policy.

Bank of England Governor Mervyn King prides himself on making monetary policy boring (i.e. predictable). This is important if a central bank is going to gain any credibility among investors.

Fed chairman Alan Greenspan still has a long way to go, no matter how eloquent his cryptic remarks may seem.

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The possiblity of further US interest rate cuts virtually disappeared when the inflation rate stopped slowing in 2003.

There seems to be no doubt in people's minds that the Fed's overnight rate will double by the end of 2004. In fact, it is now become the obligation of the Fed to do just that.

If you take a second look at the chart above you'll notice that by historical standards, today's pickup in inflation is very modest to say the least. This is mostly due to (implicit) inflation targeting on the part of the US central bank over the past 10-15 years.

The key question to ask is this: how concerned is the Fed about inflation right now?

If the Fed knew the answer to this question they would have made their next move on interest rates a long time ago.

If the Fed made it's inflation target more explicit, investors would have anticipated this move a long time ago too!

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Since the start of 2003 what we've had is a prolonged situation where both investors and the Fed alike have never been sure when the next move in interest rates would come. Until the Fed makes its policy target clear for all to see, people will not stop talking about it. This only adds to the uncertainty investors face every day. It's the job of policymakers to eliminate uncertainties, not create them.

Jargon-English translation

Here is a line-by-line translation of a recent bond market commentary:

Treasuries have now settled in slightly lower on the day.

Bond market investors have modestly sold bonds today. They have seen something that gives cause for concern that inflation and interest rates might be rising, but nothing to get serious about just yet.

Bonds were higher following the jobs report but are now lower.

Investors had bought bonds in reaction to an earlier economic report, since the data didn't provide any convincing evidence of higher inflation.

It looks like the initial spike was short covering on fears of a blowout number in excess of 300,000 new jobs last month.

In particular, the initial buying was by investors who had earlier sold bonds in anticipation of stronger evidence of inflation.

Prices, particularly in the short and intermediate part of the yield curve are lower and deferred Fed funds futures yields are up 2 to 4 basis points after the data.

Investors have mostly sold bonds with a shorter maturity: 6-months to 3 years. This points to higher interest rates as investors sell those bonds most sensitive to imminent interest rates moves by the central bank.

In the cash market, twos are down 1/8th at 2.68% and tens are off 5 ticks at 4.74%.

The price of 2-year bonds have fallen, pushing the yield slightly higher to 2.69%. The yield on 10-year bonds has risen slightly to 4.74%.

December Fed funds are currently at 2.17%. Futures are off with June bonds down 3 ticks and municipals up 5/32nds.

Investors bet the US central bank will set the overnight rate on bond sales among banks to 2.17% by December.

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Which version makes more sense?

Treasuries have now settled in slightly lower on the day. Bonds were higher following the jobs report but are now lower. It looks like the initial spike was short covering on fears of a blowout number in excess of 300,000 new jobs last month. Prices, particularly in the short and intermediate part of the yield curve are lower and deferred Fed funds futures yields are up 2 to 4 basis points after the data. In the cash market, twos are down 1/8th at 2.68% and tens are off 5 ticks at 4.74%. December Fed funds are currently at 2.17%. Futures are off with June bonds down 3 ticks and municipals up 5/32nds.

or

Bond market investors have modestly sold bonds today. They have seen something that gives cause for concern that inflation and interest rates might be rising, but nothing to get serious about just yet. Investors had bought bonds in reaction to an earlier economic report, since that data didn't provide any convincing evidence of higher inflation. In particular, the initial buying was by investors who had earlier sold bonds in anticipation of stronger evidence of inflation. Investors have mostly sold bonds with a shorter maturity: 6-months to 3 years. This points to higher interest rates as investors sell those bonds most sensitive to imminent interest rates moves by the central bank. Since the demand for bonds fell today, this pushed the price of 2-year bonds lower, pushing the yield slightly higher to 2.69% (to offer a greater incentive to purchase the lower priced assets). The yield on 10-year bonds has risen slightly to 4.74%. Investors bet the US central bank will set the overnight rate on bond sales among banks to 2.17% by December.

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All financial market reports should be written in terms both the professional and layman can understand and appreciate. Anything else just isn't good enough.

The bond market and you

Bonds are complicated.

The mention of the word bonds is enough to send most people to sleep. Why?

Most people hate thinking about matters (especially complex ones) that don't have a direct impact on their everyday lives.

Unfortunately, they do.

If I say the word mortgage you might sit up and take an interest (no pun intended).

Understanding the bond market will make you more aware of the risks facing you as a potential (or present) mortgage-holder.

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The biggest obstacle most people face when trying to figure out the bond market is the concept of price and yield.

Yields and interest rates are very closely related:

Interest rates are the price of loans;
Yields are the returns paid to bondholders.

Banks lend to their customers;
Bondholders buy the debt of an institution.

Interest rates in banks rise and fall;
Yields on bonds rise and fall.

The biggest concern for mortgage holders is the interest they are paying each month;
The biggest concern for bondholders is the return they are receiving each quarter, year etc.

The bond market is a market for debt. This debt carries with it a price.
The mortgage market is a market for debt. This debt also carries with it a price.

As a mortgage holder you are subject to the ups and downs of interest rates. Higher interest rates means a bigger bill at the end of the month. Similarly, for bondholders, a higher yield means a higher return on their investment.

The bond market is the best (and probably only) way to predict the next move in interest rates. Why?

Bondholders want to eliminate risk from their investment. If they are government bondholders (where rerturn on the initial investment is fixed) they are sensitive to just one risk: inflation.

Inflation purges the value of any investment. Bonds are particularly vulnerable to higher inflation because the rate of return on the initial investment is fixed.

So how does the bond market help predict interest rates?

Since bondholders are extremely sensitive to inflation, even the slightest hint of rising prices will send bondholders running for the hills.

When bondholders get nervous and start to sell, bond prices fall. Since the interest rate on bonds are fixed, the investor buying this bond will enjoy a higher yield.

The yield on bonds is so important, not least since it helps set mortgage rates. Why?

The bond market is huge. The US bond market is almost 1.5 times the size of the country's GDP. The global bond market is 95% the size of world GDP! This makes the bond market important and credible. People are seriously putting their money where their mouths are. If investors who are responsible for this much money flag concerns over future inflation, the government is forced to sit up and take notice. Banks take even more notice.

In the past 10-15 years, central banks and governments around the world have made it their sole mandate to target (or at least very closely watch) the inflation rate. Should the inflation rate exceed a certain target level or get out of control, there was a strong probability that interest rates would rise.

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People wise to the bond market will be even wiser to the mortgage market since they will be the first to anticipate higher rates in the future and can take steps to avoid being hurt in the process.

Sunday, June 06, 2004

What you assume is what you get.

Economists need to make assumptions.

This is part of the reason why all economic models are wrong.

This is not the same as saying all models are useless. I was always taught to think of economic modelling in terms of modelling an aeroplane. Each model captures an important aspect of the thing you are modelling. Doing this enables you to isolate possible causes of failure or to think of better ways to improve the final design.

Economists have some favorite assumptions. These include the following:

- complete information;
- perfect foresight;
- no uncertainty;
- prices adjust;
- rational expectations.

These assumptions are clearly unrealistic. So why assume them in the model?

Because it's a model! More importantly, it's a 'baseline' model. The model can be made more complicated but the modeller knows that each time a further complication is added, it takes away from the elegance of the model and, in the end, it's usefulness.

The most complicated model will be that which is closest to the thing you are modelling, which is far from ideal.

The best models balance simplicity and realism.

Economists are playing a delicate balancing act where modelling is concerned. The most precarious part of an economist's job lies in the assumptions being made; this is where art and science combine.

The difference between two perfectly good economic models can simply be the assumptions underlying each.

What determines these assumptions?

The dissatisfying answer is the whim of the economist.

Unfortunately, the economist might not have any choice but to make restrictive assumptions on the grounds that without them the model could not produce any meaningful results.

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Economics is often considered a science; mathematics can explain economic concepts.

The big difference is that in science any idea can be proven or disproven by experimentation.

Economists only have secondary statistics: numbers not generated from any experiment. An economist cannot impose the assumptions of a model onto the real world.

Then why bother?

To help us understand.

Economists seldom provide clear-cut answers; instead they help improve our understanding.

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The strength of an economist's argument lies in their assumptions.

The International Monetary Fund makes an interesting assumption about oil prices in their latest World Economic Outlook:

"... the average price of oil will be $30.00 a barrel in 2004 and $27.00 a barrel in 2005, and remain unchanged in real terms over the medium term." (viii)

You might think this assumption will need to be revised at some point in the future. You'd be right.

All economists need to make assumptions. A perfectly good economic model can be undone by it's assumptions. This is why economists are so notoriously bad at forecasting.

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So, whenever you hear an economist make a forecast don't accept what they are saying without knowing what they are assuming. If you disagree with any of their assumptions, then you shouldn't agree with the forecast they are making.

Tuesday, June 01, 2004

The grass is still greener in England!

Reports of grouchy U.S. drivers having to suffer higher prices at the pumps always irritates me as a Brit. Prices in the U.K. have always been twice as high this side of the pond.

Taxes account for a larger proportion of the final UK retail price of fuel when compared to Asia and the US. This acts to buffer the effect of changing oil prices. Since the British government can decide when and by how much to raise taxes on fuel, the retail prices is less exposed to the volatile market price.

The next time you hear a reporter talk of 'higher oil prices threatening to fuel inflation and derail the U.S. economic recovery' suggest they take a look at the stable inflation rate and strong economy in the UK and see what kind of reaction you get.

Which comes first: rising oil prices or faster inflation?

Rising oil prices contribute to higher inflation. No doubt about it. After all they form part of the inflation rate as measured by the Consumer Price Index.

What is easy to forget is that the inflation rate is determined by a lot more than just oil prices.

More importantly, the inflation rate itself chips away at the value of oil and the earnings of oil producers.

Charting oil prices that are adjusted for the inflation rate next to the rate of inflation might lead you to conclude that oil prices have pretty much determined the U.S. inflation rate since the first oil price shock of the 1970s.

What I see when I look at that chart is the oil industry (essentialy OPEC, a group of oil producers who stabilize the price of oil) attempting to keep track with inflation.

If oil prices were to rise FASTER than the rate of inflation then I would be convinced that it is higher oil prices that cause higher inflation, and that will probably only come with the next REAL oil price shock.

To see why we aren't even close to this type of shock at the moment, read on...

It's *real* easy

In 1950 a mars bar cost 3 cents.

In 2004 a mars bar costs 30 cents.

In NOMINAL terms the price of a mars bar has risen by 10-fold (1000%!!) oh my goodness, what a crazy world we live in.

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In 1950 a mars bar cost 30 cents in 2004 prices.

In 2004 a mars bar cost 30 cents in 2004 prices.

In REAL terms the price of a mars bar is UNCHANGED (0%) oh my goodness, what a... *boring* world we live in!!! BAD TV!!!

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look at the 2 charts on this web-page:

http://www.zealllc.com/2004/goldoil3.htm

on the first chart you will see that NOMINAL crude oil prices are far far higher today than they were in 1975.

on the second chart you will see that REAL crude oil prices are EXACTLY the same as they were in 1975.

In other words,
the nominal price of goods (such as oil and mars bars) has been rising year-on-year. At the same time, the real price of goods (such as oil and mars bars) has remained the same.

In some other words:
the intrinsic value (the scarcity, the quality, the perceived value) of goods (such as oil and mars bars) doesn't change.

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REAL prices matter.
NOMINAL prices don't matter.

People don't understand REAL prices.
People do understand NOMINAL prices.

Why?

If you pay for something you want to know HOW MUCH to pay for it; how much to take from your wallet or bank account or credit card. if the price of something is rising you think you are paying more for it.

Every day the newspapers and tv talk about rising prices. The price of oil is rising, the price of mars bars is going up, the price of a car is going up etc. etc. It is far more complicated for people to calculate the proportion of their annual income they spend on something, especially mars bars and oil. Cars, maybe.

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So as long as NOMINAL prices will matter to people and REAL prices won't, the confusion and concerns over RISING PRICES will persist and all the understanding we have of these concepts will go to waste.

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