Predicting the Fed

The problem with best estimates is two fold.
One, the 'best-ness' criterion is contingent on the information available. So, new information can cause a previous “best” estimate to be a second best or worst estimate. (An extreme example would be, in a non-financial context, American foreign policy on September 10’2001. The next day’s events – led to wildly different prescriptions than most academics/policy wonks had anticipated.) So, the quanta, quality and timing of information is the key.

Second, the estimate itself is a result of some estimating method – an algorithm, a formulae – that econometricians call “estimators”. In essence, it is not just information that is relevant – but the method in which you process the information. It is entirely feasible, and relatively easy to show, that even with the most recent information using a wrong estimator can result in (a) biased estimates (b) unbiased but highly inefficient (c) biased and highly inefficient estimates. By inefficient, one means estimators that contain within itself the possibility of generating widely variant results as the underlying sample increases in size.

As you can imagine, getting oneself tied up in some subtleties is something that many participants on Wall Street have little time for, or worse, just find it plain useless. One of the biggest games is undoubtedly, inspired no doubt by Whack-a-Mole journalism in American media, is watching the Fed’s decisions on rate cuts. (Things are sometimes so absurd that, as Alan Greenspan writes, there are guys dedicated to watching the size of Greenspan’s briefcase!)

One of the well observed predicting markets is the Fed Fund Futures (FFF) market. The FFF is a futures contract written on the “average of the daily effective FF rate”. The FF rate is the rate that the Federal Bank of New York charges to federal fund brokers. The “effective” part in the earlier definition arrives from the fact, for any given day, different brokers who deal with differing transactional sizes, might be charged differently. So, the “effective” is the same as ‘weighted average’. A heuristic reason is that the Fed Funds market participants are likely to take into account all the factors that might affect the path of the interest rates that the fed sets. The rates implied by this market can be thought of as a first-order prediction. There are various issues – as of yesterday, the one month rates are given as below.

7-Oct 95.255
7-Nov 95.495
7-Dec 96.61
8-Jan 95.665
8-Feb 95.785
8-Mar 95.82
8-Apr 95.895
8-May 95.925
8-Jun 95.92

The implied 1-Month rates are given above.

The critical aspect is that the generic expectation is that the Fed will continue to accommodate and allow for a 4% rate over the next six months. i.e., 3/4 of a decrease in rates. Implicit in this expectation is

• Inflation, core or otherwise, will not be a problem. This, despite the clear trends to a 100$ barrel.
  
• The housing conditions will worsen -- i.e., when over 800billion USD worth mortgages are to be reset over the next two months -- expect a lot more defaults.
  
• The weakening dollar is not really something the Fed worries about. (How to reconcile rising import costs with its inflation hawkishness is a tricky question!)

I think, this will be a very difficult time for Bernanke and Co., primarily because with rising inflation (via oil, via imports, via China, via protectionist lobbies) and worsening labor markets -- the short end of the curve will have substantive volatility.

Again, my thoughts are that the demand for non-USD denominated assets will continue.

India -- Some Graphs

Sovereign Wealth Funds -- Behemoths at the DoorStep

With rising US current accounts deficits – resulting in increased demand for foreign denominated assets and foreign currencies, the pressures on the CNY, INR, BRL etc., is well known. Predictably, the sterilization (complete or incomplete) has led to CB intervening in the FX markets – selling their own currencies and buying foreign currencies (typically USD denominated assets). To put this accumulation in perspective, some numbers (in millions) are:

China: 1,334,590

Japan 907,346

Russia 407,495

Taiwan 266,287

Korea 250,667

India 220,223

Central banks (in the emerging markets) control over 5.6 TRILLION dollars of US denominated assets. There are estimates that more than 50% of the US current account deficit was financed by these Emerging Market Treasuries. This financing is slowly declining – because one of the, only (?), benefits of the present credit crises is that the US domestic savings are expected to improve, primarily because they are so far in the hole – there seems to be only one way to go! This financing is also slowly declining because the Central Banks have two primary options – opt for other “major” currencies (Euro, Yen) or opt for more risky ventures (like China investing in BlackStone, Norway’s Global Pension Fund, Dubai in global Ports etc.,) “Sovereign Wealth Funds” are explicitly mandated subsection of foreign Treasury holdings that act on behalf of the domestic Treasuries – and are more likely to invest in non-standard asset classes. i.e., they are likely to be the primary agents that drive the risk premium lower in the coming years across the globe. The size of the numbers being projected is beyond my comprehension (in any meaningful sense). Where are these risky returns like to come from? Potentially innovative financing deals and projects like those done by Macquarie!

In the FX markets, this diversification towards other asset classes and non-USD ‘majors’ is inevitably linked to a decline in the USD value. (one number thrown around is that around 1,200 billion USD is likely to move out of the dollar denominated assets!) I would very seriously look into buying global blue chips – since while still being “risky”, these will fit within the SWFs criterion of being “risky enough”. I would look seriously at global real estate – buy property in semi-industrialized nations.

The secret, I suspect, is to ride the coat-tails of the global central bank investment philosophy changes. The unspoken, unheard of elephant-in-the-room is the United States government. Excessive decline of the dollar, with no perceptible change in consumption/savings in the US, might result in, to use a Lou Dobbs phrase, “selling America to foreigners”.

In essence, I would not be surprised if 5 years from now, a Pulitzer prize winning non-fiction entry is solely geared to explaining the complexities and conspiracies that went behind the spectacular but ultimately unsuccessful management of the Dollar slide.

Carry and Roll-Down: back to the basics

Interest Rate Traders and salespeople talk about carry and roll-down all the time. It is useful to remember what they are talking about.

1. Upfront Carry:
1. For a 10-year receive fixed swap, the 1 year carry is the net present value of a 10-year swap less the net present value of a 9-year swap starting 1 year from now.
2. Upfront roll-down:
1. For a 10-year receive fixed swap, the 1 year roll-down is the net present value of a 10-year swap and less net present value of a 9-year swap today.
2. Typical documentation will have carry and roll-down for various swap lengths: 1M, 2M, 3M and so on. So a 1 year carry can be provided as 0.45 $ per 100 $ of notional or some other dollar convention.
3. Running Carry:
1. the Upfront Carry divided by the PV01 of the forward starting 9-year swap.
4. Running roll-down:
1. the Upfront roll-down divided by the 9-year swap starting today.
5. Actual Vol-adjusted Running Carry & Running Roll-down:
1. 1Y Running Carry divided by the actual volatility of the 1Y rate over the past 1 year.

How to Read the Quotes:

6. Notional Neutral Switch:
1. Typically quoted as where one receives fixed for the shorter rate and pays fixed for the longer rate.
2. If the expected carry and roll-down is 180bps on a 5s/30s – one should read this as follows. For an investor, who receives fixed on a 5 year swap 1mn notional and pays fixed on a 30 year swap 1mn notional -- expected profit is 180,000.
7. Duration Neutral Switch:
1. Typically quoted where one receives a short dated swap, and pays a long dated swap.
2. The notionals can vary here – such that the durations cancel out.
8. Butterfly:
1. Quoted as 2bps on a 3s/4s/15s. Read this as expected roll-down and carry as pay fixed on the 3yr and the 15yr, and receive the 4yr fixed rate.
   

Risk Aversion -- a pseudocode!

There has been much talk about risk aversion indices rising – indicating that investors are willing to hold to low yielding savings, cash or cash-equivalents instead of high yielding investments. In essence, as the Mafia says, investors have been hitting the mattresses.

Standard global indicator of risk aversion is the EURCHF – with the CHF being the currency of choice when currency investors are unsure of their immediate next move. So, any R.A.I must be correlated to EURCHF. The biggest puzzle however has been that volatility of the difference in returns between stocks and bonds is greater than the volatilities of consumption or t-bill yields. So, what could explain this? One conjecture has been that risk-aversion is a time-varying factor. i.e., Investors at different times in the business cycle demand different risk premia. This has been the thrust of research since at least Lucas (1978). So how to capture this number for risk aversion?

The generic modeling structure has been as follows:

1. A fictional investor has a utility function with consumption as a variable and risk aversion and discount factor as constants.
2. This investor has intertemporal budge constraint – where delayed gratification is the theme. i.e., decide to consume today or consume tomorrow by investing in risky asset.
3. Maximize the expected utility subject to this constraint and arrive at equilibrium conditions for consumption, S&P 500 returns, t-bills returns and risk aversion parameters.
4. The equilibrium conditions capture a fictitious state where marginal cost from investing today in risky asset is matched by the marginal benefit of consumption tomorrow.
5. Assume t-bill returns and S&P 500 returns are normally distributed.
6. Using market data for returns, using root-finding algorithms, solve for the discount factors and risk aversion.

For times of the year, solve for the risk aversion numbers. So, ideally as risk aversion numbers rise, one should observe the EUR-CHF to decrease (i.e., Swiss franc appreciates).

Microfinance Bonds! - Liberal Goals through Conservative Means!

Following the mortgage backed securities which ended up as the underlying payment stream against whose stream of payments commercial paper was issued – prior to the credit crunch – there is a generic aversion today to getting deeply involved in that whole rigmarole again. But, innovation and profits are the life-blood and élan-vital of modern finance. So, bonds backed by microfinance lending are here to stay. Famous CLOs backed by loans to microfinance institutions who in turn lend to thousands of really poor individuals. For eg., see BlueOrchard. The exact fate of such CLOs, in wake of the credit crises, is unclear. Nevertheless, I suspect, this is an instrument that is here to stay.

A key issue here is what are the risks involved in such a setup. i.e., when does repayment risk amongst the really poor kick in. By and large, those individuals who qualify for microfinance are those whose income patterns are only marginally affected by business cycle fluctuations, unlike the middle class. In contrast, the real risk comes from weather extremes, failure in governmental subsidy programs etc., So the crash of the NASDAQ or the Sensex barely affects the villagers in Guntur, Andhra Pradesh – but the increase in rationed rice and sugar prices due to governmental policies will affect their income and repayment abilities. So, the bonds/CLOs issued by Wall Street can be a useful market mechanism tool with governmental subsidies to alleviate poverty!

However, one interesting observation is that many of the borrowers borrow from various lenders. i.e., they might borrow from the microfinance initiative offered by ICICI Bank, by World Bank, by Bill & Melinda Gates Foundation etc. Naturally, this raises the issue of what are the likelihood of payments being made out. One my friend from college, Karuna Krishnaswamy, has written a pretty interesting paper on this phenomenon. He argues that those who end up borrowing from various sources – actually end up having a better payment record as opposed to the single source borrowers. The exact reason is conjectural, and I suspect, untraceable to a single factor.

For those who will eventually model these things, the level of complexity has been increased by an order of magnitude. Typical prepayment structures in the Mortgage world grapple with the issue of a single stream being pre-paid. In contrast, in the MFI backed bonds – any single borrower can decide to prepay one stream over the other!

Awesomely technical challenge!

Revaluation of the Yuan...

Given the generic consensus at the G7, US Congress, Rest of the World barring for Sudan and Myanmar that the Yuan is under-valued against all global majors, particularly the USD – it is a question of when, rather than if at all, the Yuan will be revalued. Given the smooth change of guard at the Communist party meeting – it seems fairly certain that the Yuan will be revalued, perhaps not as much as the Treasury officials deem necessary, but in the “right” direction. What does this do to global trade flows?

Some preliminary conclusions/thoughts/conjectures are:

1. The econometric evidence on the contributions exchange rates make on competitiveness, productivity investments and thus, trade surplus in China is too varied to really be of much use in a week-on-week assessment.

2. One estimate is that the Yuan is undervalued anywhere from 0-50%! Assuming it is 50%, and all other costs remain constant, a 50% revaluation (entirely unlike) will affect varying sectors of the economy differently. So, prices observed in the imports will change according to the demand elasticity for given price change. So, in the countries that import low-complexity Chinese commodities -- pencils, mousepads etc., -- there will be a substitution effect in display.

3. Standard trade theory predicts that as Yuan is revalued, the level and growth rate of the Chinese exports should decline. However, it is important to note that most international trade contracts are 6-12 months set in advance. So a container of toothpaste to be delivered at Seattle port set at 1USD, will make the Chinese exporter temporarily better off. In contrast, US exporters of products invoiced in Yuan, will be worse off given the new USD-Yuan rate. The trade deficit numbers will do exactly the opposite as Washington expects in the two-three month period. (The opposite of a J-Curve observed during a devaluation.)

4. What a Yuan revaluation does to non-USD currency majors – is very much contingent on the competition for products in domestic markets and in third-party markets.

5. The supply change management in place for goods to and from China is a well-oiled machine, and changing trade flows will take longer than perhaps one anticipates. There are economies of scale in place and productivity gaining measures in place – that the willingness to abandon China as a primary sourcing place is unlikely to change all that much. Of course, the trade deficit numbers will seem more palatable for political purposes, but whether a substantive quanta of imports declines is unlikely.

6. All of the above assumes the Chinese will continue to produce as always. Then the improvements in the Yuan will provide the results Washington wants. But, all that is unrealistic. If the pricing pressures increase on Chinese products, then it is silly to not expect them to improve their productivity.

7. The most understudied aspect is that when the Chinese exports decline (and thus their income declines) – the effect on goods imported to China. It is easily conceivable that services from India and Europe can replace services and goods offered by the US. The elasticity of Chinese imports to income changes is perhaps the most important, and unclear, aspect of this whole issue.

Now what? When revaluation happens, for a short while the USD will rise, Euro will fall against the USD and the Yen will rise as well (if the USDJPY tracking of 6M USDCNY forwards are to be trusted!).

But, in the intermediate term after the revaluation we will be back here -- singing the same tune.