Presidential Race

First, this blog is non-partisan for a variety of reasons.  Second, this is not a partisan post; I just want to bring to light observations on the Presidential race.

One of my favorite “news” sites is Drudge Report mainly because it’s totally headline driven, contains some very good pop culture links, and funny pictures.  I also frequent the NYT.  What appears clear to me is that in national polls Obama and Romney seem tied.

Where it gets interesting is the Intrade betting markets, where Obama is more heavily favored with Romney making ground.  Intrade problems aside, why the disconnect?  The election isn’t decided by the popular vote but by the Electoral College.

Econbrowser did a nice job of laying this out drawing on Real Clear Politics and Intrade numbers.  I again liked to look at the Intrade map, which outlines Electoral College bets on each state.  It’s a nice to play with the math and see the different outcomes.

The one conclusion I came to, and as Econbrowser pointed out, Ohio is really the only state that matters.  I took it one step further and put together a chart of the Obama values (higher = more likely to win) since September 1, when contract volume picked up:

The correlation is almost 1, which advances the theory “as Ohio goes, the election goes”, or whatever it is they say.

Does Iran’s Hyperinflation Mean for Everyone Else?

I have no clear idea, however…

Historically, incidences of hyperinflation result in high levels of social unrest – protesting, rioting, anger, regime change, etc.  This makes total sense; if the masses can’t afford food they get mad and such conditions are ripe for mobs and rioting.

As Walter Kurtz points out, “The only question now is who will be the target of people's rage and desperation this time.”  Will it at be at the regime, the West, or another group?

I want to look at the former (the regime), mainly because the latter two don’t totally change the current dynamic.  In fact, the only two other hyperinflations this century involved Zimbabwe and North Korea.  To my knowledge neither experienced regime change (Note: I think Zimbabwe does have some joint power agreement) and the discourse regarding either country has not really changed.  Still, I should note that both economies are much smaller than Iran.

The whole reason I started on this Iran post (aside from brining attention to it) is to think about the impact of social unrest and possible regime change.  I am not sure what the conventional wisdom is on an Iranian regime change, but even though they are the most destructive actor in the world arena, I think at least in the short-term it would not be a positive geopolitical event:

1. I believe that in most cases those with power, especially in extractive governments, want to stay in power and will do what it takes to do so.  As a result, saber rattling now may turn into action if the regime feels threatened.
• The analogy may be of an angry pit bull that’s cornered and probably has only one move left.
2. Who fills the power vacuum?  See Libya and Egypt.
3. Contagion to the rest of region.  As I look at a map, Saudi Arabia would essentially be surrounded by social unrest.
4. Rising oil prices could tip the world into recession again at a time of high fragility.

Caveat: I am painting this with the broadest of brushes here and shooting from the hip. There could be some important cultural, social, religious, etc. details of which I am unaware, which could derail my hypothesis.

Still the risk is important to consider, especially since we could be at an inflection point.  “Turmoil in the middle east” is always an investment risk.  Seriously, if you find a list of market threats that doesn’t list, or that hasn’t listed that in the past 6 years, please forward it to me. 

So to conclude, while the past couple posts have drifted into world affairs, I believe that what is happening in Iran is at the very least a thought when considering asset allocation going forward, especially given the current state of affairs. 

Iran Economic Collapse

I tend to avoid watching the news and focus the bulk of my reading to aggregators or sources outside traditional media for a variety of reasons.  I am going to presume that many are not that Iran is, or could be, on the brink of an economic collapse as I haven’t really heard it discussed.

Regardless, I have seen an explosion of Iran related articles and blog posts over the past few weeks (I believe it started with The Atlantic) and here are some facts:

• Iran’s monthly inflation is roughly 70%.  This is considered hyperinflation based on a widely accepted definition (> 50% a month).
• This means prices double in 40 days.
• $1 bought you 24,600 Rials (Iran’s currency) on 09/24 in Iran’s Black Market.  On October 2^nd  39,000 Rials is what you got for $1.  The Rial is least valued currency in the world relative to USD.  The official value is 12,260 Rials for a dollar.
• Sanctions began in Summer 2010: since then the Rial has depreciated 70%+ vs. USD and the monthly inflation rate has risen to 70% from 0.70%. 

And why they are having hyperinflation:

1. Iran is heavily dependent on oil exports.  The sanctions are de facto do business with Iran (mid 20s in comparative size) or do business with the US (largest economy in the world).  Thus, production takes a hit while currency in the system stays the same or increases.  Less production + more currency = less demand and greater supply of currency = inflation.
• Simplistically, if an economy produces $100 worth of goods and has currency supply $102 then overnight only has $50 worth of goods there are now $50 less of output to soak up the currency.  As a result, the excess currency goes to purchase the remaining $50 of goods, pushing up prices.
2. As #1 happens, whoever is holding Rials wants to convert those to something with a store of value – USD.  But since the USD is essentially cut off from Iran, the supply of USDs fall rapidly as people begin converting the Rial ASAP.  This reinforces #1.

So what is happening now?

• Hoarding.  Buying goods now instead of later before the price goes up.
• Rioting.  If you can’t buy bread for your family, what else can you do?
• Withholding of goods.  Why sell today when tomorrow’s price will be higher?
• More black markets.  If you want the USD why go to central bank when a guy in alleyway will give you 3x that?
• Outlawing exchange.  Prices rising, currency collapsing, so try and prevent USD demand to prop up Rial.

So now what?  Next post I will touch on this.

OMT. Part III

Outright Monetary Transactions (OMTs) were announced on September 6^th, so what is the plan:

1. ECB buying bonds up to a maturity of 1 to 3 years on the secondary market with new Euros
2. Purchases will only occur in countries who request help from the EFSF/ESFSM (and subsequent ESM) bailout funds, which purchase debt on the primary market)
3. Purchases are conditional on reform programme
4. Purchases stop if country no longer needs help or if don’t comply with the agreed to conditions
5. No exact amount of purchases will be outlined and determined by ECB governing council
6. Purchases will be sterilized fully (e.g. buy Spanish bonds with ECB reserves and then sell German bonds, making reserves in system neutral and lowering inflation risk), TBD
7. No yield caps
8. Not senior to other bond holders

Here is what I think the result will be.  This is what I sent internally relatively verbatim on September 6^th, after the announcement:

The plan goal is to save the Euro - preventing runs on countries that investors feel may leave.  In other words, capital flows out of Spanish banks because as yields on Spanish debt rise, which is a result of banks not bidding on Spain's debt due to default concerns, depositors are nervous they will get a devalued Peseta (i.e. the new Spanish currency). 

As of now, the market is on board as yields in the periphery sank.  In fact, Spain's 10-year was under 6 for the first time since May.  It should be noted though that this happened the last two times the ECB announced a bond buying program only for yields to shoot higher.  However, longer-term is another issue. 

The two keys are "unlimited" and "conditions".  The first would appear to be a bazooka, if investors believe the quantity is unlimited then default is off the table and there would be no reason for capital to flee banks.  I think this would hold true, even if you buy longer dated bonds (5 year bonds eventually have a maturity less than 3 years).  Still, conditionality will ultimately decide this thing. 

For instance, say Spain requests EFSF and subsequently is involved OMT on the condition they keep their deficit at 3% GDP and insist on spending cuts.  Such austerity could actually cause the deficit to rise and/or could be politically unpopular as the economy shrinks further.  At which point, Spain can't keep up the conditions, then what?  Maybe it doesn't matter, as Spain will then have leverage - destroying the Euro and hurting the ECB balance sheet (now full of Spanish bonds).  But if it does and the ECB stops the funding once the conditions aren't met, then it could mean the end of the Euro. 

In short, a Euro breakup is off the table (maybe sans Greece) for now, but it’s much of the same – kicking the can down the road.  At least IMO; however, the plan does seem to have more firepower.

OMT. Part II

In my last post I outlined why I think interest rates were rising, absent from that was a discussion on what monetary policy can do to prevent bank runs, help the economy, and assist in keeping public interest rates low:

1. As defaults happen, central banks can lower interest rates (increasing liquidity, interbank lending, etc), engage in asset purchases (e.g. quantitative easing), act as the lender of last resort, etc.  All of these tools help prevent runs on the bank. 
2. Further, expansionary central bank tools should in theory should encourage banks to lend, stimulating the economy.  It also lowers the value of the currency and creates inflation.  The former helps exports and competitiveness, while the latter helps inflate away debt (as opposed to default).
3. A central bank can create money out of thin air.  It can also require banks to bid on Treasury auctions (as in the US).  As a result the central bank can set interest rates on public debt if need be.

The problem in the EU is that each country is not in control of its own currency, they are subject to the ECB.  Thus, while the US can do all the above, Spain for instance is beholden to the ECB.  This is why I believe their interest rates on public debt were rising…

There was no guarantee the ECB will create the reserves if need be to purchase public debt (e.g. the ECB will purchase or will have banks purchase public debt), as a result the government is revenue constrained to what it can procure in tax revenue and what it can finance in the market.  As tax revenues fall, the likelihood of default increases, which in turn causes the market to push up interest rates, and again increases the likelihood of default, so goes the circle…

Again, the contrast here is that the market realizes the Fed can dare it to sell the Treasury bonds.  The Fed has endless reserves to do so in order to keep interest rates where they want to (see QE3).  The countries in the EU can’t create their own reserves and thus are dependent on the ECB to do so.