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Water Cooler Wisdom: Fourth Quarter 2014

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Water Cooler WisdomMajor events at the close of 2014, specifically the fourth quarter of 2014, included: the abnormally low prices of oil; the unique position of the Federal Reserve and the US dollar; US Treasury Rates poised (still) to rise; and American manufacturing ramped up to march on ahead of other world leaders, while an embroiled Europe awaits the coming year.

“Returns and Valuations by Style”

Significantly improved from the previous quarter, overall market growth was strong in the final quarter of 2014; though the annual return was less than half of the growth from 2013’s phenomenal success.

“Energy Price Impacts”

By a landslide, the most compelling story of the closing chapter of 2014 was the low oil prices brought upon by OPEC with ferocious Saudi leadership striving to re-establish control of global oil markets. Oil production outpaced consumption, therefore supply outpaced demand, and led to a build in inventories. The supply is not uniformly distributed, though, and the United States is responsible for the fastest supply growth since 2013; however, consumption in the US did not grow nearly as much, and China continues to contribute to the most global demand growth. Notably, Europe and Japan’s consumption declined.

The population most effected by gasoline prices, of course, is the lowest quintile of the population. If oil production declines, and global demand growth picks up, then oil prices could move higher, but if the demand trends persist, and supply growth remains robust with neither the US nor OPEC yielding any production, then oil prices could move further down. Economists overall are split either way, but most agree that the current low prices are abnormal. The Federal Reserve expects that any resulting deflationary pressure from current low oil market prices will be transitory, rather than permanent, and that the economy will achieve the 2% target inflation over time.

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Water Cooler Wisdom

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Water Cooler Wisdom

September 30, 2014

Nothing is private anymore: celebrity photos are leaked across the Internet, everyone knows that Ben Bernanke was unable to refinance his mortgage and we can even follow professional football players’ misconduct. This technology, which allows us to follow the economy more closely than ever, shows that our economy is growing. Over the last quarter, the economy grew 4.6% and it is poised to continue this growth in the long run.

Here is what we expect: the US economy will continue to grow in the short and long term, interest rates will eventually rise (which is a good thing!), and you will be able to manage your money more effectively in a stable U.S. economy.

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What if the global currency market stops using the dollar?

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For a more extensive response to this question, click here.

Some people fear that the US dollar will stop being so popular, and that will cause an intolerable rise in inflation.  If the US is to experience intolerable inflation, it will likely be as a result of both domestic and international forces; therefore, the international role of the dollar does not tell the whole story.

Inflation is the general increase in prices of goods and services in an economy. The annual percentage change in the general price index (the consumer price index) measures the inflation rate of an economy. As each unit of currency buys less in the market, the economy is experiencing positive inflation because the general price of goods in that economy rises.

The growth of the money supply itself is seen as a tool to cause inflation, though it is not always effective at doing so. When an economy experiences a “liquidity trap”, the increase in the money supply does not yield anticipated inflation. Liquidity traps are believed to be the reason that major money injections sometimes do not result in predictable consumer price index changes (thus, do not result in proportional inflation).[1]

Right now the global demand for the dollar eats up much of the monetary base that would otherwise cause core price inflation in the US. There are no expectations that international institutions will dump their dollar holdings into the market as this action would ruin their own currency value (which is measured against the dollar), and no precedent for a country acting so poorly in their own, and global, interest. If it were to happen, the international community as a whole would intervene to protect the US dollar and thus their currencies before inflation hit. Therefore, academia is reluctant to assign a numerical quantity that determines when the dollar stops being the reserve currency.[2]

 

Do you have questions about the currency, the economy, or other financial matters? If you have a question or topic in mind for our blog, reach out to us directly through our website, or through our LinkedIn page.

Katherine Brown is a Research Associate at Castle Rock Investment Company with a Master’s in Global Finance, Trade and Economic Integration from the University of Denver.


[1] For a sampling of Krugman’s work concerning liquidity traps, see: Krugman (1998) “Japan’s Trap” at https://www.princeton.edu/~pkrugman/japans_trap.pdf; Krugman and Eggertson (2011) “Debt, Deleveraging and the Liquidity Trap: A Fisher-Minsky-Koo Approach” for the Federal Reserve of New York and Princeton University at http://www.frbsf.org/economic-research/files/PKGE_Feb14.pdf;

[2] Institutions funding the research considered include: Princeton, the Department of the Treasury, IMF, National Bureau of Economic Research, the Federal Reserve, and the London School of Economics.

How the World Sees the Dollar

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Let’s talk about dollars. In response to interest by our clients and readers, we will develop an explicative account of the dollar’s role in world trade and exchanges. Our series about the role of the dollar among different parties, such as global investors, traders, and other economic actors, is the beginning of an ongoing pursuit to fully develop dollar discussion with our community.

Today, let’s talk about what makes the dollar appealing to international actors. In this post, we will discuss:

1)    What percentage of world trade is denominated in US dollars

2)    What makes the dollar so appealing to international actors

In order to explain how international trade denominated in the dollar behaves, we first need to step back to see how banks that use various currencies and/or are in different countries settle transactions between one another. The Bank for International Settlements (BIS) provides the best public data on this subject area.

The Bank for International Settlements (BIS) provides services for central banks, monetary authorities, and international financial institutions. Though the BIS is not the only source for foreign exchange, it is a reliable source for research of the international financial system, including foreign exchanges. The BIS assists in the settlement of foreign exchange trades (FX) across countries, so that central banks can settle exchanges from cross-border financial flows. In this way, countries maintain a more stable international financial system.[1]

BIS
Produced by Castle Rock Investment Company

The simple process to transfer dollars to any foreign value is described below, with the BIS as an observational authority. The BIS is responsible for Basel rulings, collecting and publishing research with the cooperation of central banks, and identifying instances of international banking fraud.

What percentage of world trade is denominated in dollars today?

The BIS uses data provided by Central Banks in their Triennial Central Bank Survey (most recently updated in April 2013) to monitor and analyze the foreign exchange market. The US dollar is the dominant currency vehicle in international trade, comprising one side of 87% of foreign exchanges as of April 2013 (according to the Bank for International Settlements’ “Triennial Central Bank Survey”). This means that 87% of settlements between banks on an international level are either to or from US dollars.

Not only is the dollar a popular trading vehicle, it is also very popular to save; dollar holdings abroad are actually larger than the amount used to trade. These values are called “foreign reserves” and are researched globally by the International Monetary Fund (IMF). The US dollar comprises 60.9% of allocated reserves globally, meaning that the dollar denominates the majority of global reserves in government and institutional accounts.

Source: International Monetary Fund, http://www.imf.org/external/np/sta/cofer/eng/
Source: International Monetary Fund, http://www.imf.org/external/np/sta/cofer/eng/

So what makes the dollar universally attractive?

The dollar is popular because it is a hard currency, and more consistent than any other. Due to the framework and history of the international trading system, the dollar has been the dominant currency since the end of WWII and the creation of the Bretton Woods institutions.[2] Currently the dollar does not face strong competition from other currencies, which are either more strictly controlled by their governments through capital controls or do not have the established history of a banking sector capable of providing credit to international institutions and/or governments.[3]

There is no magic number, to the extent of my education and research, to determine when a reserve currency is no longer a reserve currency. Though the current fragmented international monetary system lacks the stability of an idealized model, the exchange system in place is accepted and adopted by all international trading countries. While the reminbi is growing in popularity as a reserve currency for developing countries, it does not significantly compete with the US dollar at this time. The high international demand for dollars, especially in times of crisis, and the current construction of the international trade and banking systems ensure that the US dollar is fundamental to global economic stability.

Do you have questions on or expertise to add to this conversation? What do you hope to hear about? Add to the conversation on LinkedIn or email me directly at Katherine@CastleRockInvesting.com. 

Katherine Brown is a Research Associate at Castle Rock Investment Company.

[1] For a more expansive account of the ways that the BIS contributes to financial stability, see their website www.bis.org.

[2] The most popular recent book about the establishment of the Bretton Woods system is called The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White and the Making of a New World Order by Benn Steil (2013). I highly recommend it for a historic perspective on our institutions.

[3] Many monetary economists hold this theory, but the most popular is Barry Eichengreen of Berkley, California. For further reading on the dollar, the IMF produces regular research papers that take about 30 pages to say a more complicated version of what I just said in two sentences.

When Is a Buck Not a Buck?

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Note:  This is a follow up piece to our August 15th interview with an industry expert regarding the recently adopted SEC reforms.

In the wake of the Lehman Brothers failure in September of 2008, the Reserve Primary Fund, the oldest money fund in the nation, “broke the buck” and fell to 97 cents per share. On September 17, 2008, investors redeemed a record $140 billion from money market funds and the commercial paper market, which banks rely on to fund their day-to-day business, essentially froze. The Treasury stepped in to establish the voluntary Money Market Funds Guarantee Program in order to stop the run on money market funds, but vowed never to do so again.

The Securities and Exchange Commission was obliged to do something. On July 23, 2014, the SEC adopted amendments to the rules that govern prime money market mutual funds. The SEC aims to re-tool institutional money markets behavior by using a combination of floating Net Asset Value (NAV), fees and gates to protect investors and the financial system.

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Water Cooler Wisdom

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By: Katherine Brown, Research Associate, Castle Rock Investment Company

Water Cooler WisdomThe end of the 2nd quarter of 2014 left the global banking sector bracing from the fallout of a weak quarter. In moments of weak growth, we are reminded of the need to diversify our portfolios. Just as it is important to eat a balanced meal, it is important to balance your investment plate.

The US economy grew only 2.9% during the second quarter, which was a result of costly weather conditions, negative global trade relationships, and state and local government spending habits (often due to the extreme weather conditions). An investment portfolio is challenged – but not inherently devastated – by this kind of quarterly strife. For our purposes, more reliable data come from cyclical indicators because they provide more dependable data on economic behavior and trajectory. Capital spending, consumer confidence, orders vs. inventory and PMI indices all indicate good conditions for the economy to pick up. In other words, our markets are doing well, despite the special difficulty in the second quarter.

The Federal Reserve reoriented its goals to respond to the significant gain in jobs this past quarter. Unemployment, which reached 6.1%, is ever-nearing the long-run full employment waterline of 5.4%. While we should expect that economic growth is consistent with unemployment, if we push past full employment at 5.4%, we could face inflation. Instead, the government will work to improve total factor productivity in addition to the labor market’s full employment. This means more capital equipment and greater output per worker.

Since we have already attained 6.1% unemployment, the unemployment goal for 2014, the Fed downgraded the growth forecast for the next year to 2.2% from 3%. The comparison between Inflation and Core Inflation indicates pressures for wage growth and an increase in rental cost that creates a condition where a shift in policy will be necessary. Core inflation is at 1.95%, while bond yields are 0.6%. The economy is tightening and inflation is rising, so long-term rates should go up.

Concerns in the bond market are that Owners of US Treasury Bonds are not as concerned with the pricing of bonds as natural actors would be in an unimpeded market. The Federal Reserve adjusts investments in the bond market monthly through Quantitative Easing (QE2), which is anticipated to end in October 2014. The tapering out of Fed bond purchases means that bond rates will go up. Other distortions in the market will be due to major investors such as the Bank of Japan, which maintains excessive bond holdings that can destabilize the market should it sell off a significant amount. However, these behaviors are unlikely because of the impact it would have on their own economies, not to mention on diplomatic relations.

The bond market is a good place to invest as a defensive structure since a sharp rise in bond yields is unlikely in the future. Quantitative Easing is designed by the Fed to keep bond rates low for the long term, approximately 2% interest rate goals for this coming year. The bond market should be a reliable part of your portfolio this year, but as the economy grows, the equities market will likely exceed bond market growth.

The equities market has the best potential for year-to-year growth, despite holding the greatest risk to investors. The returns and valuations by style indicate the year-to-year earnings remain strong. The fourth quarter has the greatest potential to be the strongest of all this year. Overall recovery from 2009 market lows indicate continued recovery as the expanding data available to research stable market activity show greater returns, but do not indicate bubbles similar to the boom and bust of the last recession.

The rise in interest rates and confidence show that both should rise even further over the next 12 – 18 months, although cyclical sectors are best offset by investment in 10-year treasury bonds as a stabilizing measure to varying performance in equity markets.

Other economies spent the last quarter dealing with their own problems. In a unique twist, the EU’s growth was softened by France’s macroeconomic strife, while the European periphery provided the hopeful signs for growth. China picked up market growth after a rough first quarter, as Japan similarly indicated recovery from the sales tax increase, though neither will likely overcome the first quarter’s poor growth unscathed.

As we approach full employment, traditional investment strategies generally begin to hedge against inflation by including investments in commodities and real estate where GDP growth is perceived to be less influential than in other sectors. Quantitative Easing provides some “carbohydrates” to the US economy, thus allowing bond and equity markets to both grow in the short run. However, this promise is impermanent and may lead to trouble ahead. For a balanced meal, we turn to the foreign bond and equity markets. Thus, we foresee that the most robust investment palette will diversify not only across markets, between American equities and bonds, but across borders to take advantage of equities and bonds abroad.

Katherine Brown completed a Master’s degree in Global Finance, Trade, and Economic Integration from the University of Denver. Her research and writing focus on international monetary economics and central banking. She can be reached at Katherine@castlerockinvesting.com.