Commodities & Currencies From May to August: How Much Has Changed

calendarBack in May, the Financial Stability Oversight Council, a creature of the Dodd-Frank Act, came out with a report on the state of the financial market and regulatory developments in 2015. Now in August, as the end of summer looms, it is instructive to see how much things have changed, just how out-of-date a report from the middle of the second quarter of the year already appears. Two points not only offer that instruction, but shed light of some especial interest for asset managers and alpha seeker. I propose to look at the FSOC’s May-vintage treatment of U.S. state and local bonds on the one hand; and of the global macro pressures on fixed income asset valuations on the other.

State and local bonds

Of course, one debt market that is exciting attention right now is Puerto Rico’s. It skipped an August 1st bond payment and its Governor talks about how the creditors ought to be prepared to make sacrifices. The island/commonwealth has 18 distinct debt issuing entities, which makes this not just a shortfall but a complicated patchwork-driven shortfall. Further, the territory now owes investors $73 billion, most of which is exempt from taxation in The United States, and much of which is in the hands of mutual funds, although hedge funds and distressed debt traders also now have their share.

Thirty-four of the hedge funds involved have commissioned a report of their own, from the Centennial Group. This takes a (relatively) optimistic view of Puerto Rico’s circumstances, stressing that the year to year deficit of the Commonwealth has been shrinking as measured either against the central government’s overall balance or against GNP.

Idiosyncrasy and Containment

But back in May the FSOC’s interest in this situation was apparently limited to the question of spillover, and it seems relieved to report that there has been “little spillover thus far to the broader municipal bond market.” Average municipal bond yields have fallen, indicating that they are generally deemed sound.

That was a pattern for the FSOC: something bad has happened, it acknowledges, but the badness was ‘idiosyncratic’ – that is, unique to that time and place, and this ‘contained.’ It says precisely this about the defaults of the City of Detroit, Jefferson County, Alabama, and “several California municipalities.” How common does something have to become in order not to be so idiosyncratic after all?

The three months since the issuance of this report have not made the issue of state and municipality defaults seem all that satisfactorily ‘contained.’

Fixed Income Assets

On another front, the FSOC observes that a lot of factors have combined to keep up the downward pressure on global long-term interest rates, with all that means for the valuation patterns in fixed income markets. This convergence of factors has in a sense overwhelmed the “strengthening of the U.S. economy and the approaching normalization of domestic monetary policy.”

What a differences a summer makes! Note that wording: in May it was still taken for granted that the “normalization” approached. Since time only moves us in one direction, any possibility, however distant, may be said to be “approaching.” But approaching with any proximity or certitude? The Federal Reserve threw a lot of doubt on this on July 29th, when it issued a statement saying that ”even after employment and inflation are at near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the [FOMC] views as normal in the longer run.”

If the ECB and the Bank of Japan continue to be as accommodative as they have both been lately, then the Federal Reserve will face a lot of pressure to continue delaying “normalization.” Also, the Fed historically has a perhaps-unreasonable fear of deflation. It wants that safe 2% rate of inflation. The continued downward move in the price of oil makes deflation look possible, unless the Fed prevents it. So, again, normalization will be pushed outward much like the closure of Gitmo.

China and Iran

And that was before the latest news from China, or a cabinet Secretary’s speculation about the consequences of a failed Iran deal. Each adds a fascinating twist to this question.

As the western hemisphere slept in the early hours of Tuesday morning, August 11th, the People’s Republic of China responded to a run of bad economic news by devaluing the yuan, setting the official guidance rate at the lowest point in nearly three years. This will make it that much more difficult for the Federal Reserve to “normalize” because that now appears to mean going against the trend of the whole rest of the world, letting interest rates rise while every other nation of importance drives them down.

Later that same day, the U.S. Secretary of State, John Kerry spoke on what might have seemed a very different subject. He spoke of the recent deal, and the warming of relations it intends, between the western powers and Iran, said that if that deal is scuttled, “[T]here will be an increase in this notion that there ought to be a different reserve currency because the United States is misbehaving, and not in fact, you know, living by the agreements that it negotiates itself.”

Much might be said about that statement. But what is remarkable is the near-admission by such a high official that the U.S. dollar is in fact a commodity-supported currency. The commodity is of course not gold. It is petroleum. And the U.S. needs rapprochement with the petro-powers to maintain the reserve status of the U.S. dollar.

This isn’t new since May, but a new openness about the point is.


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