Tag Archive | "Nominal Gdp"

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The Fiscal Cliff Draws Near


In the upcoming G-7 meeting, Europe will deflect the angst over its euro zone and European Union debt woes with a unified show of concern about the condition of state of the US economy and the weakness of the USD. There will also be concerns voiced about the status of China’s economy. Indeed, Europe will build its case that the world’s two biggest economies are dragging the global economy down more than the status of the debt-ridden, recessionary euro zone and EU states.

The G-7 was founded in 1975 as the G-6 and consisted of France, West Germany, Italy Japan, the UK and the US. In 1976, Canada was admitted to membership and the entity was re-named the G-7. The G-7 nations once controlled 50.4 percent of global nominal GDP and 39.3 percent of global GDP. The group meets several times a year with the intent of defining the key issues of the day and identifying strategies to correct those issues.

The emphasis of the G-7 debate may shift from the influence and possible solutions of the debt that plagues Europe to the US “fiscal cliff,” a pending crisis in the world’s largest economy that could paralyze global growth.

The fiscal cliff is the direct result of the US Congress’s inability to reach agreement over a tangible plan to trim $1.2 trillion from the national debt. As a result of this impasse, the country’s most ineffective Congress on record, the 112th Congress, agreed to a compromise that would allow the Bush tax cuts to expire, terminate the personal withholding tax reduction and allow a number of billions of dollars of budget cuts to be implemented. The total amount of deficit reduction would be about $1.2 trillion which will take effect on January 1, 2013.

Regarding the expiration of the Bush Tax Cuts, the Tax Policy Center estimates the net affect will be to increase taxes by an average of $3,500 per US household. This tax increase will come into play if Congress does not act. The G-7 is rightfully concerned about the fiscal cliff’s impact on the US economy. Most economists suggest this tax policy will plunge the country into recession in 2013.

In the area of the budget cuts, the biggest loser will be the Department of Defense, which will have to shed about $600 billion is expenditures. This figure will put the nation’s security at risk and could limit our ability to respond to crisis in other areas of the globe.

In any case, the payroll tax holiday appears to be at an end. Both parties have expressed concern over the future of the Social Security system if the cut is extended. Both House and Senate members, including members of the Tea Party appear ready to allow this tax increase to take effect.

On the day of the first debate between the two presidential candidates, Barack Obama and Mitt Romney, it is expected that questions about the fiscal cliff will be asked. The significance of resolving the financial cliff issue must be resolved before December 31st or the budget cuts and tax increases will be enacted.

The Bush Tax Cuts include lowered income taxes, lower capital gains taxes, lower dividend taxes and other tax decreases. These tax cuts were originally proposed and passed in 2001 and were extended in 2003. The income tax cut was proposed by Obama and has resulted in about a $1,000 savings per year for the average American.

Europe is expected to declare that it is working on a number of initiatives to stabilize their debt challenges but that the US appears to have its hands tied and is unwilling to address the fiscal cliff. Failure to solve the fiscal cliff will not only throw the US economy into recession but also will push the global economy into recession.

The theory is that the fiscal cliff will not be addressed before the election and that only an extension of the current programs will be agreed upon until the presidential and congress elections take place. Kicking it down the road is the status quo of the 112th Congress.

On another issue, Japan is expected to call for unified actions to get the cost of oil under control. European members and Japan are expected to push for an increase in global use of oil in order to stabilize prices.

At the current rate, the Federal Reserve is now estimating growth in GDP to rise 2.5 to 3.0 percent next year. If the fiscal cliff takes hold, the country will enter recession in mid-2013. Europe rightfully sees this possible outcome as sealing the fate of troubled European economies.

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Japanese Yen Strength is Illogical, but Does it Matter?


On a correlation-weighted basis, the Japanese Yen has been one of the world’s weakest performing currencies in 2011. Alas, while this information is interesting for theoretical purposes, it is of little concern to traders, who focus instead on individual pairs. Against the dollar (USDJPY), the Japanese yen is still quite strong, having recovered most of the losses inflicted upon it by the coordinated G7 intervention in March. Does the yen deserve such a lofty valuation? No. Will it continue to remain strong as the dollar? Well, that is a different question altogether.

As a fundamental analyst, I am inclined to look at the data before making a determination on whether a particular currency will rise or fall. In this case, the fundamentals underlying the yen are beyond abysmal. The recent release of Q1 GDP showed a 3.7% contraction in GDP. Thanks to an interminable streak of weak growth combined with deflation, Japan’s nominal GDP is incredibly the same as it was in 1996! Based on industrial production, consumption, and other economic indicators – all of which were negatively impacted by the earthquake/tsunami – this trend will undoubtedly continue.

The only force that is keeping Japan’s economy afloat is government spending. While this was a necessary response to anemic growth and natural disaster, it is clearly a double-edged sword. The government’s own (inherently optimistic) forecasts show a budget deficit of 5% in 2015, which doesn’t even include the costs of rebuilding the earthquake region. This will necessitate tax hikes, which will further erode growth, requiring ever more government spending. It seems self-evident that Japan’s national debt will remain the highest in the G7 for the foreseeable future.

From a macro standpoint, there is very little to be gained from investing in Japan. The stock market continues to tank, and bond yields are the lowest in the world. To be fair, years of deflation have made the yen an excellent store of value, but this is hardly of interest to speculator, whose time horizons are usually measured in weeks and months, rather than years and decades.

If not for the yen’s safe haven status, it would and does make an excellent funding currency for the carry trade. Short-term rates are around 0%, and the Bank of Japan (BOJ) has made it clear that this will remain the case at least into 2013. As you can see from the chart above (which mimics a strategy designed to take advantage of interest rate differentials), the carry trade is alive and well. Granted, it has suffered a bit since 2010, due to increased fiscal and financial uncertainty. However, given that the rate gap between high-yielding emerging market currencies and low-yield G7 currencies continues to widen, this strategy should remain viable.

And yet, the Yen continues to rise against the US dollar. It has receded in the last couple weeks, but remains close to the magic level of 80, and it’s not hard to find bullish analysts that expect it to keep rising. They argue that Japanese investors are eschewing risky asset, and that the yen remains an attractive safe haven currency. Not to mention that volatility (aka uncertainty) serves as an effective deterrent to those thinking about shorting it and/or using it as a funding currency for carry trades.

Personally, I’m not so sure that this is the case. If you look at the way the yen has performed against the Swiss Franc, for example, the picture is completely reversed. The Franc has risen 20% against the Yen over the last twelve months, which shows that heads-up, the Yen is hardly the world’s go-to safe haven currency. In addition, you can see from the chart below that on a composite basis, the yen peaked during the height of the financial crisis in 2009, and has since fallen by more than 10%. This shows that its performance in 2011 should be seen as much as dollar weakness as yen strength. Since I’ve spent countless previous posts explaining why I think dollar bearishness is overblown, I won’t revisit that topic here.

In the end, the majority of traders don’t care about this nuance – that the Yen has conformed to fundamental logic and depreciated in the wake of the natural disasters against a basket of currencies – and want to know only whether the yen will rise or fall against the dollar. Even though, I think that shorting the Yen remains an attractive (and as I argued yesterday, comparatively riskless) proposition. Given that the dollar also remains weak, however, traders would be wise to short it against other currencies.

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Icelandic Kronur: Lessons from a Failed Carry Trade


A little more than two years ago, the Icelandic Kronur was one of the hottest currencies in the world. Thanks to a benchmark interest rate of 18%, the Kronur had particular appeal for carry traders, who worried not about the inherent risks of such a strategy. Shortly thereafter, the Kronur (as well as Iceland’s economy and banking sector) came crashing down, and many traders were wiped out. Now that a couple of years have passed, it’s probably worth reflecting on this turn of events.


At its peak, nominal GDP was a relatively modest $20 Billion, sandwiched between Nepal and Turkmenistan in the global GDP rankings. Its population is only 300,000, its current account has been mired in persistent deficit, and its Central Bank boasts a mere $8 Billion in foreign exchange reserves. That being the case, why did investors flock to Iceland and not Turkmenistan?

The short answer to that question is interest rates. As I said, Iceland’s benchmark interest rate exceeded 18% at its peak. There are plenty of countries that offered similarly high interest rates, but Iceland was somehow perceived as being more stable. While it didn’t join the European Union until last year, Iceland has always benefited from its association with Europe in general, and Scandinavia in particular. Thanks to per capita GDP of $38,000 per person, its reputation as a stable, advanced economy was not unwarranted.

On the other hand, Iceland has always struggled with high inflation, which means its interest rates were never very high in real terms. In addition, the deregulation of its financial sector opened the door for its banks to take huge risks with deposits. Basically, depositors – many from outside the country – parked their savings in Icelandic banks, which turned around and invested the money in high-yield / high-risk ventures. When the credit crisis struck, its banks were quickly wiped out, and the government chose not to follow in the footsteps of other governments and bail them out.


Moreover, it doesn’t look like Iceland will regain its luster any time soon. Its economy has shrunk by 40% over the last two years, and one prominent economist has estimated that it will take 7-10 years for it to fully recover. Unemployment and inflation remain high even though interest rates have been cut to 4.25% – a record low. The Kronur has lost 50% of its value against the Dollar and the Euro, the stock market has been decimated, and the recent decision to not remunerate Dutch and British insurance companies that lost money in Iceland’s crash will only serve to further spook foreign investors. In short, while the Kronur will probably recover some of its value over the next few years (aided by the possibility of joining the Euro), it probably won’t find itself on the radar screens of carry traders anytime soon.

In hindsight, Iceland’s economy was an accident waiting to happen, and the global financial crisis only magnified the problem. With Iceland – as well as a dozen other currencies and securities – investors believed they had found the proverbial free lunch. After all, where else could you earn an 18% by putting money in a savings account? Never mind that inflation was just as high; with the Kronur rising, carry traders felt assured that they would make a tidy profit on any funds deposited in Iceland.

The collapse of the Kronur, however, has shown us that the carry trade is anything but risk-free. In fact, 18% is more than what lenders to Greece and Ireland can expect to earn, which means that it is ultimately a very risky investment. In this case, the 18% that was being paid to depositors were generated by making very risky investments. As the negotiations with the insurance companies have revealed, depositors had nothing protecting them from bank failure, which is ultimately what happened.
Now that the carry trade is making a comeback, it’s probably a good time to take a step back and re-assess the risks of such a strategy. Even if Iceland proves to be an extreme case – since most countries won’t let their banks fail – traders must still acknowledge the possibility of massive currency depreciation. In other words, even if the deposits themselves are guaranteed, there is an ever-present risk that converting that deposit back into one’s home currency will result in losses. That’s especially true for a currency that is as illiquid as the Kronur (so illiquid that it took me a while to even find a reliable quote!), and is susceptible to liquidity crunches and short squeezes.

When you enter into a carry trade, understand that a spike in volatility could wipe out all of your profits in one session. The only way to minimize your risk is to hedge your exposure.

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