fx – Behavioral Macro

February 24, 2019February 24, 2019

Argentine Banks, the Sequel

Back in October I posted this about Argentine banks, arguing it was a good risk/reward point of entry on the long side, and that appreciation and/or stabilization of the currency was the likely catalyst.

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Today, the chart patterns suggest we are at a good risk/reward point to add to these positions if you don’t already have a full one, or to put a position on if you missed the last window.

Argentine banks are not for the faint of heart. The stocks are fairly illiquid in any meaningful size, and the macro backdrop there, while improved–and supported by an IMF stabilization program–is still fluid and fraught with risks. Moverover, there are general elections (for the presidency, congress, and the governorships of many provinces) coming up in October, and there will for sure be populist, anti-IMF posing posing in the run up to it.

But using chart patterns to identify good risk/reward points and manage downside risk brings with it courage, and here the asymmetries are good-to-excellent. Argentina poorly managed its monetary policy and currency and had a very hard fall. You can see this very clearly in the long-term chart of the four banks included in the October post (BMA, BFR, GGAL, SUPV).

Historically, Argentina finds a way to crawl back from its blowups. Without getting into the weeds, the pattern has been that the country acts less responsibly when times are flush, and more responsibly when its back’s up against the wall. It could be that this time things turn out differently, but that wouldn’t be the high probability bet.

Technically, the patterns, in the main, show higher highs and higher lows, which also improve the odds on the long side.

So, what about the downside?

For the one year charts below, you can see the banks have had a meaningful downdraft/pullback that hasn’t violated that overall pattern of higher highs and higher lows.

This simple approach here would be to put a stop on any buys here (or perhaps on the entire position–depending on how you need to manage your risk) somewhere at ot below these recent local lows. IMHO, given the illiquidity, stops should be done on a closing basis, and probably based on more than one close below the level chosen. Obviously, the “slower” the closing trigger, the greater the scope for exit slippage, and this needs to be reflected in position sizing.

One final point: the currency. The Argentine peso didn’t have the scope for appreciation in its starting point compared to typical macro blow ups, so don’t be too concerned if it doesn’t strengthen significantly. It does however, at a minimum, need to broadly stable. Even slow depreciation is fine. But a surge in local demand for dollars–above and beyond and seasonal and transitory factors (and seasonal factors are large in Argentina)–means they are losing control of the macro framework. And this would show up quite quickly in the bank stocks.

Good luck.

December 26, 2018April 29, 2019

Misunderstanding Liquidity, Misunderstanding QT

Liquidity. It’s one of the most frequently used words in finance. It gets invoked to explain virtually everything and anything. But it’s often clear that those invoking it are just parroting things they learned somewhere along the way and don’t truly grasp the mechanics of it. Most don’t even make the basic distinctions among its various forms.

Here’s a rough TL;DR of what you need to know.

There are three basic types of liquidity: Systemic, Credit, and Transactional.

Systemic liquidity can be loosely thought of as the unencumbered resources in the banking system that can be used to settle intra-bank payments. Think Fed funds. And if Fed funds breaks down, payroll doesn’t get made and ATMs run dry. This is what we were on the cusp of in 2008.

But, importantly, Fed funds is a closed system. A bank can draw on its reserves to meet payments to other banks in the system, or, when necessary, get physical cash, but it can’t ‘lend them out’ to clients. Nor can it flood the equity or currency markets with them–contrary to the popular trope. They are not fungible in that way. Only the Federal Reserve can add or withdrawal from the system (with that small exception of physical cash). So, while the composition of reserves across banks can change, the aggregate level in the system cannot unless the Fed wants it to. This type of liquidity is exogenous; it’s all about the Fed.

Credit liquidity is the ability of borrowers to access credit–either to increase debt or roll over existing liabilities. Bank loans, bond issuance, trade finance, whatever. Credit availability is a function of risk appetite, not bank reserves.

It is really hard to disabuse people of the belief in the loanable funds model of credit availability we were all taught in school. This will surprise a lot of people, but the level of Fed fund reserves and credit extension are–even over the long run–uncorrelated.

Don’t believe me? Consider this:

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.

Think about what that means. Bank reserves declined over the 25 year span of a generational credit boom of massive proportions. There’s no way this could happen if banks couldn’t, on their own, without regard to reserves, create money ‘out of thin air’.

Skeptical? Go over to FRED and verify these numbers for yourself.

Yes, in theory banks have capitalization ratios that at some point could constrain lending, but, as we’ve seen time and time again, banks find ways to get around regulations when their risk appetite runs hot. Moreover, cap ratios are about sufficient ‘asset coverage’; reserve levels are about sufficient ‘liability coverage’ and have nothing to do with lending.

Think about it this way: If I give my brother an IOU for $100, and he accepts it, we have created credit out of thin air. No cash needed, no reserves liquidated, no assets pledged. He can then sell it to my sister, if he so decides and she trusts my creditworthiness. She then has the claim on me, and we have just created money. If my reputation in her town is sufficiently creditworthy, she could then sell the claim to others, and so forth and so on. No one has to even think about systemic liquidity or the Federal Reserve’s balance sheet, much less be constrained by it. It all comes down to risk appetite, in this case specifically others’ perception of my creditworthiness and their perceived vulnerability should I not make good on it. This is what is called endogenous credit creation.

Transactional, or market-making liquidity is the ease with which market participants can buy and sell financial assets. This is often proxied by bid-ask spreads, volatilities, and market depth. Old hands know how pro-cyclical this type of liquidity is. It is driven by risk appetite, regulatory environment and market structure. This is where things like the Volcker Rule bite. It has virtually nothing to do with the size of the Fed’s balance sheet, either.

The bottom line: Only one of the three fundamental types of liquidity are directly in the hands of the Fed. The other two are pretty much entirely up to our risk appetite.

This is an extremely un-nuanced explainer of the basic types of liquidity and their drivers. Importantly, it abstracts completely from the psychological dimension of what people think the actual drivers are–something that genuinely matters, if only in a transitory way. And it also abstracts from the Fed’s signaling and other indirect effects, which can be significant. But, as a first cut at looking at the mechanistic links between the size of the Fed balance sheet and ‘liquidity’, this should be a good place to start. So, next time when someone comes on TV conflating different types of liquidity, you’ll know what time it is.

P.S. If you want to understand the mechanism through which banks lend, I recommend the Money and Banking chapter of L. Randall Wray’s “Why Minsky Matters“. Some of the concepts are counterintuitive, so keep reading it until it makes sense.

September 4, 2017October 19, 2017

Emerging Market Currencies: Size it Right, Sit Tight

We are probably still in the sweet spot for the emerging market cycle. This doesn’t exempt us from the risk of corrections. It doesn’t eliminate geopolitical flare ups, trade war rhetoric, or the macro scare du jour. And it doesn’t make September/October calendar effects any less scary. But it does mean if you are an investor the wise choice is to stay in, stay the course.

(Pro memoria: the dominant error in professional investing is over-forecasting corrections and then chasing bull markets from a position of weakness.)

I’ve given the reasoning for this view here, here, and here.

And my broader views on central banks and currency markets are laid out here.

Basically, it all boils down to:

At this point in the global risk cycle the US looks mature and investors go abroad
The Fed is closer to its terminal policy rate than expected; other CBs are at the front end of their normalization processes
Investors desperately need yield, and emerging market currencies have it
Country differentiation is less important than asset allocation

And demand is strong. I continue to hear of managers wanting to get into the space and/or increase their allocation, while, as PIMCO points out, local markets deepen.

Technically, the picture is strong. USDTRY and USDCLP have already broken down. It is likely that currency pairs like USDMXN, USDBRL and USDINR are to follow. Here are the charts: