How the "Masters of the Universe" think about Exchange Rates!

In a recent excellent, if perhaps deliciously short, report issued by the most profitable bank this year entitled "The Foreign Exchange Market" -- one of the sub-reports attempts to forecast the exchange rates for the coming year. What struck me about it is -- other than the predictions they make (I have my issues with that... see below) -- is the elegance of the underlying method. The way do is as follows:

1. Changes in Terms of Trade (= price of exports divided by price of imports) is a function of changing commodity prices (energy, industrial metals, agriculture, live stock).
2. Extract sensitivity estimates (the coefficients in a regression) to predict terms of trade.
3. Changes in Real Exchange Rates ( = price of one unit foreign currency in domestic currency * ratio of foreign and domestic price levels) is a function of two key parameters.
   
• Terms of Trade
• Relative productivity levels -- measured by, say, per-capita output per hour etc.,
  
4. Perform regressions on #3, using #2 to arrive at new estimates for real-exchange rates.
5. Convert real exchange rates into nominal exchange rates.

Amongst key predictions are USD-CAD = 1.10; USD-INR = 50.1. i.e., their model supposedly predicts that the the Canadian dollar is expected to depreciate from the present levels, and so is the USD expected to appreciate against the Indian Rupee. Since, they do not explicitly mention all the concerned control variables in the exchange rate attribution -- it is difficult to really validate their claims, even intuitively.

My own guess is that there are three key parameters that affect the short term exchange rate fluctuations:

1. Global capital flows -- that chase the second-order effects anticipated changes in terms of trade.
2. Changes in US deficits (budgetary and trade) -- this is particularly accentuated by the coming US electoral-cycle.
3. Idiosyncratic events -- particularly emerging market macroeconomic instabilities.
   

So, I suspect their analysis are largely driven by "true" long term economic factors, while the intermediate fluctuations are more complicated beasts -- and therein lies, as Shakespeare writes, the rub.

Lessons from Leamer: Part 2

Continuing from previous post.

1. Housing shows up in the GDP accounting via employment generation. Price appreciation of houses is not part of GDP; and more importantly, increased land prices today if booked as an asset, a liability has to be entered. Where? Liabilities for future buyers. This is transfer of wealth from future generations to present generations!
2. The stickiness of housing prices downwards means, most importantly, price cycles follow sales volume cycle. Also, the volatility of the housing volumes is much higher than the price.
3. Sellers develop their expectations of prices from a backward perspective (“what did I pay for it compared to the offer price?”). Buyers have forward looking price expectations (“what will I get for the house 5 years from now”). So, sales only happen when there is a high bid price by sellers.
4. In a housing boom, the fastest appreciation happens for small houses with low-income zip codes (and smaller square footage = condos and small homes). Predictably, during a bust – they get hit the most.
5. To avoid business cycle fluctuations – one must avoid housing cycle fluctuations and job-losses in consumer durables.
6. Monetary policy that acknowledges the two factors – must face up to the fact that if real interest rates fall temporarily, then for equilibrium level of housing stock will return to “normal”, only if production and sales fall and allow a return to the mean. In contrast, if real interest rates fall permanently, then equilibrium levels of housing stock will rise.
7. Monetary policy that accounts for housing investment is a difficult inter-temporal resource allocation issue.
8. Today, one observes the presence of weak housing starts (new houses being built) and increased inflation – resulting in a conflict for what the “right” policy prescription ought to be.
9. In case of policy choices to be made between housing starts and inflation – there is no real conflict.
10. The best predictor for Fed Funds rate is the 10-year Treasury bond yields.
11. Its the Housing Cycle!
    

Rethinking portfolio allocation at El Paso, Texas.

This is a season of the “immigrant” as a piñata for the sons of the soil.

In an interesting summary of how silly some of the statistics being touted around in the immigration debate is, Christopher Caldwell has furthered my suspicion at publicly bandied about numbers. This following Marc Faber’s report filled with his own suspicions on the meaningfulness of government statistics – I must confess, I am more pessimistic than last week about “key figures” quoted. Watching the US politicians debate for the Presidential primaries convinces me in the sagacity of the old Benjamin Disraeli line, “there are three kinds of lies: lies, damn lies and statistics”.

Although I didn’t agree with Caldwell’s argument that when talking about immigrants, one must concentrate on their contributions to GDP per capita – the underlying message that one ought to debate the utility of immigrants in any society within an economic framework, as opposed to a cultural, is a wise remark. This is so, because other aspects like cultural compatibility, understanding of ‘core-values’ etc., are provably true or false – depending on who is mining the data.

With regards to illegal immigrants, research has been sparse -- although an exceedingly elegant summary of the complexities is here. The key issues that any study must answer vis-à-vis immigrants are:

• The effect of immigrants on wages – the average and the marginal labor.
• The distributional impact – i.e., does the wage distribution tilt asymmetrically.
• The tax contributions the immigrants make.
• The impact of immigrants on resources within a society (hospitals, schools etc.,)
• The relocation centers of immigrants. i.e., do they choose Virginia over Montgomery?

All this said, one could say “show me the money”. i.e., how does all this enable one to think about where to invest? I have great faith in the intrinsic ability of masses to weed out irrelevant information and identify that what matters at the end. Survival! Surviving today for yet another day. Illegal immigrants in the United States are perhaps the starkest example of that. Undereducated, without documentation and limited employment opportunities. Their choices of locations and industries are directly connected to the amount of food they consume, the anticipated monies they expect to earn and the growth potential in monetary terms. Not withstanding the legitimate concerns about security and income dynamics -- I think, one must have the humility to learn from their survival skills. Like migratory patterns of birds can predict the deterioration in quality of their homing grounds, the migratory flow of illegal immigrants can enable investors to learn more about “unsexy” industries like construction, fruits and vegetables, waste disposal amongst others. For those seeking to diversify, and find value in firms in these sectors -- I believe, thinking about illegal immigrant movements might be a useful indicator. Illegal immigrants predict, I believe,

1. The changing contours of growth-patterns in non-tradeable American goods and services industries.
2. The areas of US where economic decline is anticipated. So, for eg., short industries with sales focused in say, Alabama and Georgia, and go long on industries with sales in Washington and Oregon.
3. Given the fact that illegal immigrants ear 2 to 30 time their home wages in the US, an obvious ‘wealth effect’ is to be observed. Thus, invest in industries that cater to their needs: cola, beer, gambling, wire transfers, auto parts manufacturers, super-stores etc., In the coming years, it is fairly clear, that one is likely to see more illegal and legal immigrants in the US – with the tacit consent of various industries – despite the goose-stepping propagandists on the Right and the Left. These industries thus have a growing consumer base with growing needs.

So, perhaps we'll soon see labor economists being hired on Wall Street!