Ongoing debate: inflation or deflation?

on May 26, 2012 in Economy, Home | 2,120 comments

An important question for all investors is whether low inflation rates will persist or whether the economy is heading toward much higher inflation. Knowing whether the economy is in recovery, recession or depression, is not merely an academic question, but vital to making investment decisions. The answer to that question will indeed dictate asset class allocations, portfolio construction and ultimately the rates of return investors should expect. So, where is the economy heading us? We are currently seeing mixed evidence of both inflation and deflation signals. However there was probably never a time when an economy was purely deflationary or purely inflationary.  But, when I balance the forces of inflation against the forces of deflation, it seems inevitable that we are heading for deflation and an economic repression.  We may see significant inflation, but deflation is definitely around the corner. A lack of job growth, de-leveraging, falling real estate prices…are likely to continue in the coming years and make demand-pull inflation unlikely and thus reinforcing the shrinkage of economic activity. Although commodity prices have become the hot topic in recent months, the most significant input in the cost-push inflation equation is the labor force. The strength in corporate earnings combined with the government response hasn’t been enough to substantially close the structural unemployment gap and consequently fuel an inflation spiral. Japan for instance suffered an extended period of deflation in the 90s. Today, the country’s economy continues to be bottled up in a low inflation, low growth environment that continues to sap its economy. The Fed also said it was extending its commitment to low interest rates through the end of 2014. Its actions reflected forecasts for an extended period of weak growth. This gloomy outlook, along with continued concerns over recessions and debt defaults in Europe, has raised the odds that deflation might be a strong scenario worth...

Is Russia sick with the Dutsch disease?

on May 6, 2012 in Economy, Home | 1,852 comments

Oil prices are currently way above historical averages. From its national icon Gazprom to the privately held Lukoil, shouldn’t economists be in a cheerful mood about Russia’s economy? May be so. Russia is enjoying a period of solid growth, but must tackle several challenges to overcome its dependence on oil exports, improve long-term output, improve the investment climate and curb the worsening of fiscal balances. To guard against the temptation on profligate government spending, Russia wisely created a Stabilization Fund, a nest egg to protect the budget against drops in the price of oil, following the successful example of Norway. But political pressure is growing to use the rapidly accumulating fund, already to boost expenditures. Is Russia simply a victim of the “Dutch disease” like similar resource oriented economies? The term “Dutch disease” originates from a crisis in the Netherlands in the 60s that resulted from discoveries of vast natural gas deposits in the North Sea. The wealth generated caused the Dutch guilder to rise, making exports of all non-oil products less competitive on the international market. Russia exhibits some symptoms of the Dutch disease, due to the real appreciation of the ruble, resulting in the nation’s other exports becoming more expensive, making economic sectors less competitive. The Russian government is trying to diversify away from its dependence on natural resources and is consequently backing start-up entrepreneurs out of the newly created Skolkovo iniative, a mini-Silicon Valley.  It’s got the brain power and the tech talents to build a more innovative economy, but moves to do so are still in their infancy. Still a long way to go I...

The LIBOR OIS spread

on May 4, 2012 in Economy, Fixed Income, Home | 1,960 comments

The LIBOR-OIS spread is an important concept to understand because it plays a vital roll to determine the health of the credit markets that many economists and analysts watch regularly. So let’s take a look at what the LIBOR-OIS is all about. Three-month LIBOR is a floating rate of financing, which fluctuates depending on how risky a lending bank feels about a borrowing bank. The term overnight indexed swap (OIS) rate is the rate on a derivative contract on the overnight rate. The OIS is a swap derived from the overnight rate, which is generally fixed by the local central bank. The OIS allows LIBOR-based banks to borrow at a fixed rate of interest over the same period. There is very little default risk in the OIS market because there is no exchange of principal; funds are exchanged only at the maturity of the contract, when one party pays the net interest obligation to the other.  Furthermore, former Fed Chairman Alan Greenspan stated recently that the “LIBOR-OIS remains a barometer of fears of bank insolvency.” There is no doubt that changes in the LIBOR-OIS spread reflect counterparty credit risk premiums in contrast to liquidity risk premiums.  It appears that the spreads reflect the market’s perception of increased risk endemic to the economy more generally. These measures are telling investors to be very careful. Since September 2009, the TED Spread has typically ranged between 10 and 20 basis points. During economic crisis it gets much higher. It spiked as high as 457 basis points in the fall of 2008, when Lehman and Bear Stearns were collapsing. In short, the LIBOR-OIS spread has been the summary indicator showing the “illiquidity waves” that severely impaired money markets in 2007 and 2008.  ...

The TED spread

on May 3, 2012 in Economy, Fixed Income, Home |

The Ted spread is an indicator of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the Ted spread increases, it is a sign that lenders believe the risk of default on interbank loans is increasing. Interbank lenders, therefore, demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the Ted spread decreases. The size of the spread is usually denominated in basis points (bps). For example, if the T-bill rate is 0.08% and LIBOR trades at 0.47%, the Ted spread is 39 bps. The Ted spread fluctuates over time but generally has remained within the range of 10 and 50 bps except in times of financial crisis. A rising Ted spread often presages a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn. In 2008, the Ted spread peaked at 450 basis points after the collapse of Lehman Brothers. In 2010, the Ted spread has returned slowly to its long-term average of 30 basis points, hitting a low of 11 basis points in March, as confidence returned. But as the Greek debt crisis escalated into widespread fears about the health of the eurozone, the Ted spread started to rise again, moving above 45 basis points by mid-June. This morning it’s at 38 basis points, that’s partly because, in the years since the financial crisis, central banks around the world have made funding much more readily available to banks. When the risks are as high as they are today, you want to see financial conditions getting looser, not tighter. Unfortunately this indicator has climbed steadily since the summer 2011. Central banks actions addressing pressures in global money markets are merely buying...