Reykjavík Under Seige?

[you can listen to our broadcast about this here]

It has the world’s highest literacy rate. People live longer in Iceland than any other country. They are supposedly some of the happiest people on earth if you believe a new book out. Here is what is happening to the one of the world’s smallest independent economy and its currency:

1. Inflation is out of control. It’s now at 9%.
2. Central bank interest rate: 15%.
3. Performance of the currency (the krona): -20% against the Euro since the start of 2008.

Who’s to blame? The central bank asserts that it’s the fault of hedge funds and international financier Michael Weist, who operates a currency trading empire out of Malaysia. I am not so sure about the hedge funds, but I would keep an eye on the Weist guy. Sounds shifty.

The central bank really is arguing that international financial players are preying upon a difficult situation in the country and wreaking havoc on the economy. You know, doing wild speculative things that you only see in financial documentaries for people over 18.

But is that really the problem here? Let’s go back and see how the country handled its own finances, and we’ll see if we can trace the line of responsibility for the current problems back to anyone else. In the last 5 years, the three major Icelandic banks issued billions of dollars in cod-bonds.

These are bonds that offered really, really attractive interest payments. Who bought these bonds? International financial players like, oh, say, hedge funds. These hedge funds, as we all know now, sold Japanese Yen and bought high-interest bonds in New Zealand, Brazil, Hungary, and yeah, Iceland. Lots of them in Iceland. Billions of dollars of them. Foreign debt, in the last 4 years, quadrupled. And you know what these banks started to do when they realized they were on the hook for these huge interest payments?

They hedged their bets. Sounds smart, right? That’s what intelligent traders do.

These banks sold their own currency, the krona, in futures contracts. They entered crazy derivatives deals with leverage and bet against the value of their own currency. When the krona started to fall, they made huge amounts of money and everyone was happy.

At the same time the banks were doing this, the hedge funds that were playing the carry trade game were buying and selling – and some of you already guessed it – credit default swaps (CDS) to hedge their own risk, just in case the Icelandic banks weren’t able to pay the debt.

So, let me get this straight:

1. The Bank of Iceland set the base interest rate high.
2. This attracted foreign capital on a massive scale.
3. This launched the economy into a frenzy.
4. Icelandic banks sold their own currency to hedge the bet.
5. Hedge funds did the same.
6. Now the krona is cratering.

Does this seem like an international monetary conspiracy to you? Was the central bank angry when foreign capital came in and boosted the economy? Why would they be upset when foreign capital is leaving and causing problems for the economy? The same country whose banks created “cod-bonds” to specially attract international hedge funds is feeling the effects of having created the entire mess in the first place. You can choose to raise interest rates, or allow your banks to trade on leverage and create risky financial instruments. You can’t choose the consequences of those actions.

It’s not so different from any losing trader. We love the system we’re using when, with outrageous leverage and sweet euphoria we make tons of money. And we become disenchanted with trading for a living when it all goes wrong. We start to say things like, “It’s not actually possible to trade for a living,” and “My dealer stopped me out,” and so forth.

Maybe, I suspect, we shouldn’t have fallen for the oldest trick in the book, which it seems that even countries are not immune from: we tend to increase our bets and greedily want to accumulate as much as possible now, without regard or attention to the longer term consequences of our selfishness.

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Wal-Mart Dollars and the Next Boom

What does it take to have a strong economy since 1990?

1. Capital: the world has to be awash in money. In 1994, Bill Clinton signed into law a regulation that allowed banks to hold less in reserve. The world became awash in cheaper money. Greenspan lowered rates significantly during the latter part of the decade. In 2001, the Fed aggressively cut rates and kept cutting them into the next year, and we saw 1% for over a year.

2. An asset class that attracts the ordinary investor and institutions alike. In the 1990’s, we had stocks and in particular IPOs. It was the decade of equities. It will forever be known as the tech boom, most likely, but in general, the last 5 years of the decade were simply ruled by a white hot stock market and an institutional appetite to invest in startups. Billions of dollars were poured into new companies who developed technologies – many / most of these companies failed, but the result was a huge influx of advanced technology into society.

In the first five years of 2000, housing ruled the American economy. As investors who were burned by tech stocks looked for the next big thing, many of them felt more comfortable buying real estate than investing in the stock market. They were finally listening to their mothers, who said the stock market was risky (a Great Depression era mentality) and put their money into a hard asset like real estate. I have a friend who says that trading and real estate are different, because when something goes wrong with your trade, you can quickly go broke, but when something goes wrong with real estate, you can simply hold on. Well, if you look at a heat map (www.hotpads.com) of foreclosures in the southwest, we’ll all agree that holding on to underwater real estate isn’t what is happening.

Both the stock market and real estate bubble had something not only for the regular investor, but more importantly, had huge appeal to the institutions and funds who needed to park massive amounts of money. It was easy enough to invest in startups, venture firms, office parks, housing developments, and the returns were great during the good years.

So what’s happening now? It seems we’re due for a contraction, which we’re getting right now, before the next bubble comes along. But issue is: what’s the next bubble? Where’s the next driver of the American economy?

We are, as a world, swimming in a sea of capital. There are trillions – yes, trillions – of Wal-Mart- and Petro-dollars in the world today. “Wal-Mart dollars” is my term for the export dollars created when Asian nations ship us cheaply made products and we send them our hard-earned cash. You know what petrodollars are.

So we’ve got the first element: the world’s got money. And piles of it all around us – to the Far East (Wal-Mart dollars), the South (Mexico has its fair share of Nafta-Flavored Wal-Mart dollars), and the Middle East and North (Islamic Petrodollars, and Canuck petrodollars). There are still billions of private equity and venture capital dollars in the states. We’re not hurting for cash as a world right now, and that’s why it’s so easy for WaMu, Wachovia, Citibank, Morgan Stanley – all of them – to raise more capital very quickly. It begs the question of why Bear Stearns couldn’t be helped at the last minute by a big investment rather than a big bailout, but that’s a question for another time.

Do we have an asset class that fits the bill? I think we not only have one, but we have two potential candidates.

The first is health care. Baby boomers were born between 1946 and 1964. There are 82 million of them. The oldest ones are now 62 years old. And for the next 20 years the oldest ones will reach 82 and the youngest 62. That means we’re going to get about 80 million super-users of health care over the next 20 years. Medical equipment, pharmaceuticals, hospitals, disease prevention and curing, and genetic research are just five areas that could use loads of institutional capital to grow. This is probably the next bubble, and it’s going to be huge. This industry is easy for ordinary investors (through stocks) and institutions to invest in.

The second is energy. Energy efficiency is the harder of the two to for me to believe in. The drive to wean ourselves from oil in the states is going to go slower and take more political effort than we might have. If we did muster the courage to do this as a nation and a world, we could launch a huge technological boom. Most of this, however, seems like it would have to come from the government and private sector: there are simply not enough areas for the ordinary investor to participate in – there aren’t enough alternative energy stocks to go around just yet. Maybe that can change.

The point to this enormous post is to say that the conditions are right for another boom. Sure, we need a period of cooling off. We need to shake out the bad people from Wall Street, bail out some rich people, save some banks, contain the cost of food and energy, and finish off the mass foreclosure process around the country. That’s going to take 12-18 more months.

And then, let’s bring on the next boom.

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Let's Not Spend and Have a Recession Instead

If you think that consumer spending is important to the economy, and, like, you probably do if you live on Earth, then this ought to interest you; it's the XRT index -- the S&P Retail Index:

XRT.gif

Consumers in the United States have stopped spending. Consumer spending is 66%+ of total Gross Domestic Product for a country. Recession, anyone?

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The Wisconsin Cheese Index

Do you like “trading the news?” Then the new-news is any news about the bailout. That’s the big news – look for Fed statements, Treasury speeches, and especially a speech by the President which I would assume has to come in the next month. If it doesn’t it will just mean that we’re putting off a statement by the commander in chief of the economy. These statements and speeches will have huge impacts on the RPP’s – the Risk Proxy Pairs:

USD/JPY, EUR/JPY, GBP/JPY , GBP/CHF, USD/CHF

These are pairs that are prone to move a lot when news hits about the state of the world economy. A lot of risk is bundled up in these pairs: the JPY is all about the carry trade (you think that has gone away, but it hasn't quite yet fully played out); the CHF is about Gold, the world's hedge against inflation (which might not actually be a problem, as we'll be exploring on the radio show this week).

It’s mildly interesting to watch what happens to the US dollar after the Non Farm Payroll report. But what you will see after Trichet of the ECB announces the full extent of the European Economic Problem in April or May – that will make a Non Farm Payroll report look like the Wisconsin Cheese Index, which is a fake report I made up to prove my point. Actually Max made it up, and it’s the greatest fake report ever.

cheese.jpg

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The Bailout

For those of you who live in the United States:

Let's suppose that a national referendum were held next week. You could vote for or against the following proposed action by the US Government:

The US Government will take control of 20 of the 50 largest US regional banks which have become insolvent due to overextension of credit to subprime borrowers. All shareholders in these banks will lose 100% of their investment. The government will keep these banks' doors open. All deposits up to $200,000 (twice the current amount) will be guaranteed. All other deposits above $200,000 will be wiped out.

Would you vote for that?

How serious do you believe the current economic crisis to be?

Let's add one line to the law, and now think about your answer:

In addition to rescuing these banks through nationalization, the US Government will honor severance packages to bank executives who lose their jobs as part of the process; this includes honoring and paying out as much as $50 million to CEOs of these banks.

Now what?

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What is Crazy Risk? Why does Leverage Matter?

Martin Wolf, in his excellent column for Financial Times, points out that a 15.4% annual return for a hedge fund would be "handsome." How many of you that read this blog would be willing to show up at a trading expo and brag that you had achieved a total return of 15.4% over the last 12 months of your trading?

He then goes on to talk about how a mediocre hedge fund manager can produce such handsome returns in seemingly easy fashion by allowing himself to go deep into debt (leverage) at risk of blowing up the fund. What is this excessive risk? Here's a quote:

Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised.

I am not making that up. That's what smart financial people believe to be "astonishing" leverage. 31 to 1. Most currency traders trade with 100:1 leverage.

What makes leverage such a big deal? Why does leverage, in and of itself, present such a problem?

First of all, the availability of high leverage encourages a trader to amass a large trading position, even with a small account. Let's take a trader with a $5,000 account. Let's say that his dealer allows 100:1 leverage. This trader puts up $2,000, and in turn is able to command a $200,000 position in the market. Each pip / point that the position moves for him, he makes $20. If the market moves in his favor 50 points, he's made $1,000. That's nearly enough to make a car payment, buy some groceries, perhaps even make a rent payment (at least in West Virginia, where I live -- it could even pay a mortgage).

This all sounds good so far, right? The trader makes a good trading decision, makes a 10% return in one trade, pays some bills, and moves on. Leverage seems to be the friend of the trader. Where else could this person put $5,000 to work so efficiently, so quickly, with such seemingly easy profits? The stock market? Heck no!

In the stock market, this trader would put $2,000 up -- and then be able to command, at most, a position of $4,000 worth of stock (those are the rules -- you can only trade with 2:1 leverage at most in the stock market). If the market moves 50 points, which is unreal in the stock market (can you imagine GE moving 50 dollars in one day?), the trader is likely to make about $50. No wonder so many people are flying out of stock trading and racing into margin currency trading.

This all sounds good so far. The currency market simply allows for a maximization of profits with a small account.

The problems start when this trader begins to have some losses. Instead of making 50 points and $1,000, he loses 50 points and draws his account down to $4,000. If he has a 70/30 trading system that wins on average 7 times for every 3 losses -- he could experience 1, 2, 3, 4 -- or more -- losses in a row and suddenly be looking at a severe reduction in his trading account. Maybe this trader is disciplined in every other way. Maybe the system is tested. Maybe he's a stable person.

But if he loses just 6 times in a row, he's going to have lost $6,000. Um...that's more than he has in the account. He can't even go more than 5 losses in a row.

The problem isn't that leverage exists or that it is available. It's that most of us, when we start trading, don't realize how fast we can run through our entire accounts. We risk more because we can make more and we end up losing more.

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You Have Got to be Kidding Me

For those of you who are unfamiliar with John Meriwether, he's the dude that made a fortune on Wall Street in the 80's in bonds (the securitization of mortgages, as I remember, but I could be wrong) and then went on to co-found and lead Long Term Capital Management. LTCM blew up when the partners, including Nobel-Prize winning economists, failed to appropriately manage their risk and lost $3.6 of their own and investor's money.

It didn't take Meriwether long to start another hedge fund -- in fact, the ink was hardly dry (about a year) on the LTCM rescue deal, when he went out and raised another zillion dollars (ok, it was more like $1 billion) and started running the money again. Keep in mind that if his management fee was 1% of assets, he was pulling in $10 million per year just to open the doors. Where I come from, we have a saying about that much money: holy crap.

Now Meriwether is in trouble again. Bloomberg reports that his fixed-income (bond) fund lost 24% year to date. This is about 10 years after the collapse of LTCM.

I just wanted to mention this, since it might be a good time to bring up the fact that none of us are immune to making the same mistakes twice. None of us learn our lessons so good that we no longer require adult supervision when trading. The same rules of risk apply to you and me, and to John Meriwether, to your forex dealer, to Bear Stearns, and to European Banks (waiting for the other shoe to drop).

When you start thinking that the rules of risk management don't apply to you, that's when risk comes knocking at your door.

NOTE/UPDATE: There are two good books worth reading about all of this and, in particular, John Meriwether. The first is Liar's Poker: Rising Through the Wreckage on Wall Street, Michael Lewis's excellent book about personalities on Wall Street and the City in the 80's, and When Genius Failed, the amazing story of the meteoric rise and stunning fall of one of the world's largest hedge funds. They are worth reading for what they can teach about excessive risk taking and hubris.

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Panic at the Discount Window

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Oil and the Dollar. Yikes!

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Australia Takes a Hike

Brandi sent an intelligent question tonight: If the Australian Reserve Bank hiked rates today, then why would I be selling the pair (which I have been for a few days)? It begs the question: Is a rate hike really good for the AUD? Maybe it is. Maybe it SHOULD be. Perhaps in the beginning stages of a global economic slowdown (meltdown?) the Reserve Bank is worried about stagflation -- a slowing economy but higher prices. Perhaps China's demand for raw materials is enough to keep commodity prices high indefinitely. Perhaps those high prices will continue to filter down into the price of regular stuff in Australia. But what if traders see the hike as the last in the economic up-cycle, and it's all downhill from here? What if they read the statement (click here to read it) and they think, "Holy crap, they emphasized the global economic slowdown?" Then it's bad for the AUD. Just my two cents. Happy Monday evening. If you live in a U.S. Super Tuesday state, then please remember to vote tomorrow.

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What to Do in Times Like These (Revisited)

The challenge: make money when the market is going to Hades in a handbasked. When the GBP/JPY falls apart like a high school relationship, and the US Stock Market turns traitor and rejects the demand that it perform well if interest rates go down (and think about it: if interest rates are headed down because the economy sucks, then no one is going to buy any stocks for the short term).

So, what to do now? I was looking at some order flow / retail positioning information today, and I was shocked to see how many traders are still hanging onto long GBP/JPY positions. The carry trade is exploding all around them, and there is a huge overweighting of traders on the buy side. They are hanging on, hoping that it comes back.

Here are five things that you can do right now in times like this:

1. Stop hoping that the market comes back. Make a realistic assessment of how much further down the market can go before you've lost your entire account. Talk to a friend, a spouse, anyone who you can trust that will hold you accountable to get yourself out of the bad trades that are threatening to destroy your account.

2. Ask yourself: was I ready to benefit from the recent implosion? Was I prepared to make trades that benefit from a market decline? If you are familiar with options, ask, "Was I protecting the downside by buying some options as insurance?" If the answer to this is no, think about how you can do things differently next time.

3. Get in touch with someone who knows more than you about the market -- someone who is making money right now and has been for a long time -- and show them your portfolio.

4. Consider the benefits of having a (substantial) portion of your portfolio invested for the long term rather than the short term.

5. Remember that no one knows where the market is going tomorrow. Anything can happen. Given this truth, what are you going to do about it? How are you protecting yourself from the downside risk?

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Oil Production vs. Prices

We talked about oil prices and production this morning on the radio show.

You can click here to get the full spreadsheet.

And here's the chart that shows price rising and production falling. The point of this all was to highlight that production isn't going to go up very quickly, very soon. And who's going to be the big winner in all of this? The Canadian Dollar. You can click on the chart below to make it bigger.

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The Dow and the EUR/JPY

There has been some talk this year, notably by Boris Schlossberg of DailyFX.com, about how the Dow and the EUR/JPY have some amount of correlation between them -- meaning, that movement in one is somehow correlated to movement in another. Tonight I have been sitting in a hotel room in Vegas and, because I am a currency nerd, I decided to find out for myself if what Boris said is true.

I gathered data from Tradestation and from Yahoo! Finance, and with a bit of help from Ken Fisher, whose new book I am enjoying immensely, I did the analysis. It was quite easy using MS Excel.

Okay, let's get to the conclusion and then I can tell you what I did.

For 2007, it seems that the Dow and the EUR/JPY have a Correlation Coefficient of 83%. That's quite a number. Here's a chart to show the results graphically, and then we'll get even deeper into it (you can click on the image below to make it larger):

Thanks to I. Hills, a student, for the graph.

Here's the spreadsheet. I simply took the data, and cleaned it up a bit to reflect that the Dow and the EUR/JPY did not always trade on the same day (remember fx trades one day extra per week). Then I ran the formulas.

Just because the two are correlated does not mean that there is a causal link -- in other words, that movement in the Dow causes movement in the EUR/JPY. But I do find it interesting that the Dow is correlated to the EUR/JPY. I want to do this for Oil and the CAD, which obviously has already been done but I want to see it for myself.

More on what the numbers mean:

Correlation Coefficient (from Wikipedia): "The conventional dictum that "correlation does not imply causation " means that correlation cannot be validly used to infer a causal relationship between the variables. This dictum should not be taken to mean that correlations cannot indicate causal relations. However, the causes underlying the correlation, if any, may be indirect and unknown. Consequently, establishing a correlation between two variables is not a sufficient condition to establish a causal relationship (in either direction)."

R SQUARED (From Investopedia): "A statistical measure that represents the percentage of a fund or security's movements that can be explained by movements in a benchmark index. For fixed-income securities, the benchmark is the T-bill. For equities, the benchmark is the S&P 500." Ken Fisher sums it up better when he says that this number helps you to be able to say what percent of one variable's movement you can blame on the other variable. That this number is 70% for 2007 on the DOW-EURJPY is quite interesting.

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How to Blow Up a Hedge Fund

It's crazy, but hedge fund managers still blow up their funds. "It's different this time," isn't the only thing that we read. It seems that risk management is still a concept that all of us could learn more about, including fund managers and traders like you and me too. I don't think it's possible to spend too much time learning about risk management. It's all I talk about when I speak publicly (and has been for a couple of years) because I believe that if you can conquer risk management, you can do amazing things as a trader.

Here's an article from BusinessWeek about the blow up of two Bear Stearns hedge funds.

If you take the time to read this article, here are two questions I invite you to think about:

1. What if Cioffi had staged his entry into the CDOs? What if he had not leveraged himself so badly, but rather staged entries as CDOs went down in price, and instead of risking 100% of his funds, he only risked 5% at most? Okay, I get it that he was paid to make spectacular returns. I'm just asking what would be different. Hint: one thing that would be different is that he would still be in business, he would not be getting sued, and he probably would not be heading to jail.

2. What if Cioffi had taken the big positions that he did (forget about #1 above) but, instead of staying in the positions, he had just gotten out?

3. What if Cioffi had admitted that no one is very good at predicting the market, and just bought way, way out of the money options on CDOs that would make money on HUGE breakouts in either direction? That would have cost money in the short term but not as much as what his eventual strategy cost him.

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Understanding the Federal Reserve

A good post is here from the folks at CurrencyTrading.net about interpreting what the Fed says in their statements. If you have ever scratched your head and wondered, "What in the world does that mean?" when you see a statement from the Federal Reserve, this post is for you.

Click here to read the post.

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Chopping off the ARMs?

A friend and trader sent me a table of mortgages set to be reset (interest rate adjusted higher) over the next year or so.

Here's the table. The numbers you see are billions. With a B.

arms.gif

I think part of the bailout that the Fed could orchestrate, could include "encouraging" mortgage firms to refi people out of some of these really bad (read: expensive) loans, even if such people are not really credit worthy of a refi. Maybe the Fed lowers interest rates to make this more attractive. But if all these reset, without any intervention, it is going to get ugly.

And maybe it should get ugly. There is an argument to be made against bailing out everyone. We'll talk about that soon.

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What if the Fed Does ...

1. If the fed raises rates, that will totally shock the market and the dollar will skyrocket.
2. If the fed cuts rates, no one will think it is a big fat hairy deal.
3. If the fed cuts rates and says "we think the economy sucks" in the statement, the EUR/USD is going to 1.4000 in the next week after.
4. If the fed does not cut rates, Larry Kudlow is going to have a heart attack.

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The Real Fed Funds Rate

The U.S. economy lost 4,000 jobs in August, and that sent the US Dollar reeling against most major currencies on Friday, as traders began to believe that a US interest rate cut would be a lock at the Fed's next meeting in a week.

What's even more interesting to me is that, when poking around the Bloomberg terminal, I looked at the effective Federal Funds rate, which is the base rate which the Fed sets for banks to make overnight loans to each other, and which serves as a benchmark rate for the US economy. This is the rate which Bernanke and crew will make a decision about on September 18. This is the rate that everyone talks about when they talk about the Fed "cutting" or "raising" rates. Anyway, the effective rate, the rate which the Fed is already setting for these overnight loans, already reflects a 25 basis point cut in the rate. Meaning, practically speaking, the Fed has already cut rates. Here's a screen shot that shows, in column "EFF", the actual effective US Fed Funds rate. And this only includes up to September 6. You can click on the image to get a larger version: