2011 11 CME Market Insights Era of Dissonance

7/31/2019 2011 11 CME Market Insights Era of Dissonance

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nsightsMarket

nroducion

Financial markets have entered an Era o Dissonance that will stand in sharp contrast to the relative harmony and

economic expansion of the last half of the 20th century. The Era of Dissonance will not easily resolve itself into a

more comfortable and predictable environment and may last as long as a decade or more. During this transition

period to a new world order there will be a continual conict between perceptions of reality, widely variant possible

outcomes, and confused future expectations. Financial markets will remain challenged, with bouts of uncertainty

concerning strikingly different potential outcomes. The dissonance will profoundly disturb the dynamic evolution

of market returns, volatilities, correlations, and risk-taking preferences. Our understanding of nancial risk

management is likely to undergo critical changes, because simplied approaches and traditional rules of thumb

will not work during this period.

Foreign exchange markets, as a natural focal point of economic imbalances among countries, will play a criticalrole in transferring sources of volatility into other asset classes, although not necessarily in a direct manner. The

risk-on, risk-off nature of markets is not going away any time soon. One can no longer assume that over time market

outcomes are drawn from distributions of possibilities with similar volatility and correlation structures. Correlation

structures will not be stable and may even swing quite wildly. The ability to manage nancial risks effectively

over any time frame will be much more difcult. Market participants will need to re-assess many of the basic

assumptions that guide their understanding of nancial risks and form the basis for their decision making.

Our hope and challenge in this report is to provide an intellectual framework for understanding how to construct an

effective risk management strategy in this Era of Dissonance as well as to highlight some practical guidelines for

navigating through these difcult times.

Disclaimer. All examples in this report are hypothetical interpretations of situations and are used

for explanation purposes only. This report and the information herein should not be considered

investment advice or the results of actual market experience.
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Our rst step will be to identify the key sources of dissonance and gain an appreciation of their long-term economic

implications. We will examine the role of population dynamics, property rights, and policy constraints. For the most

part, these sources are well known, yet their impact on markets when taken together as a package is not necessarily

well-understood or fully-appreciated.

Populaion dynamics accentuate the economic growth divide between the slower-growing mature industrial

countries and faster-growing emerging market countries. Moreover, the faster-growing countries are less

efcient users of energy and commodities. As emerging market countries grow, they will add to global energy and

commodity demand at an even faster pace. And, as these countries build a larger middle class, their diets will

change and demand for agricultural products and clean water will soar.

Propery ris represent a second critical source of dissonance. We dene property rights broadly to represent

the legal, regulatory, and political environment that determines e conex for consuer and usiness plannin

for e fuure. This denition includes how businesses are regulated, what powers the state has to seize or limit the

use of private property, how people and companies are taxed, as well as the overall stability and predictability of the

political environment. What we see is the gradual erosion of property rights in the mature industrial countries adding

further friction to their economies and making unemployment reduction more difcult. The steady improvement ofcontract law and political stability in the emerging markets is increasing their ability to attract global capital to their

countries, allowing stronger productivity growth that eventually encourages wage growth.

Policy constraints are our third source of dissonance. Constraints on the effectiveness of scal and monetary

policy in the mature countries will severely limit their ability to reduce the mountain of debt they have accumulated

over the years. The relative exibility that emerging market countries have in both scal and monetary policy gives

them some tools to cushion, if only partly, the impact on their economies from the growth recession in the mature

industrial economies.

We might dub these dynamics population, property rights, and policy the Three Ps o Market Dissonance. And

while we start our analysis with these sources of dissonance, what is equally important is to gain an appreciation

that the long-term economic growth implications coming from the sources of dissonance naturally point to

conicting expectations of how nancial markets will resolve different perspectives. Moreover, the sources of

dissonance and their long-term economic implications dramatically increase the tensions within political systems.

This heightened tension is reected in markets, making them much more sensitive to political agendas, not just

the economic trajectory. In short, the Era o Dissonance will be dened by a very large number o perceived

political and economic conficts that will generate a seemingly never-ending series o widely divergent

expectations.

Our second step, then, is to work through a framework for analyzing how markets resolve dissonance. We will do this

by describing how markets deal with expectations of multiple scenarios of low probability but high impact events.

While the statistical and probability theories underlying our analysis are complex, the analytical intuition is

straightforward. Financial markets are designed to be forward-looking discounting mechanisms that resolve

differing perspectives on future scenarios. Markets do not function as smoothly when those competing future

scenarios become more distant from each other. The result is not only more volatility, but times in which volatility

and correlations may shift dramatically only to change again abruptly at some future time.
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The nal step combines our analysis of the sources of dissonance with our appreciation of how markets resolve

dissonance to categorize in a practical manner the challenges all sectors face in managing nancial risks in this

environment. We focus rst on currency markets as a way to illustrate how shocks ow through the asset classes,

changing expected returns, volatilities, correlations, and the risk preferences of market participants in their wake.

We then examine the risk-on, risk-off nature of markets over the past several years. Finally, we draw some practical

conclusions for managing risk in the Era of Dissonance.

. ources of Dissonance and Lon-ter Econoic plicaions

The last half of the 20th century will go down in history as a very exceptional period of global economic expansion.

Following two horrendous World Wars with a Great Depression in between, the formerly protagonist industrial

countries shared common objectives of peaceful nation-building through economic growth and trade. Moreover,

despite large cultural differences, the various industrial nations had similar demographics with young and growing

populations needing to be put to work. A coordinated global monetary system, known as Bretton Woods, was

established to provide a framework for the maintenance of a stable, non-inationary world nancial system. The

industrial countries took broadly similar approaches to the use of scal policy to encourage economic growth andcushion economic cycles, while accommodating well their different preferences for social programs.

Led by the G5 countries US, UK, Germany, France, and Japan economic growth among the industrial countries

of the world was impressive. Certainly, there were some big bumps along the way. The xed exchange rate system

broke down in 1971. Energy prices surged in 1974-1975 and again in 1979. These economic challenges positioned

the decade of the inationary 1970s as a potential turning point toward a world of policy conict. Yet the industrial

nations came together again with the shared objective of taming ination. They coordinated central bank policies,

created conditions for disination, and ushered in another two decades of solid economic growth and expansion of

world trade.

The rst decade of the 21st century, however, served as a wake-up call. For those managing nancial risks, it is

not news that we have already been sailing in uncharted waters for several years. From the time the US subprime

mortgage debacle burst into the publics consciousness in 2007, to the Financial Panic of 2008, the European

Sovereign Debt Crisis of 2010-2011, and disarray in US budget policy in the summer of 2011, among other events,

nancial market participants have been hammered with a sequence of exceptional challenges. Yet, in the rst few

years after the Financial Panic of 2008, there was a general perception that somehow, sooner or later, markets

would settle down into a new order that would be relatively predictable and manageable, even if quite different from

the relative comfort of the latter half of the 20th century.

This resolution to a new order has not happened. Our rst step in understanding why is to review the key sources

of dissonance that markets are facing. It matters not that these trends have been widely recognized for a long time.

What matters is that they are now on center stage, and they are working as a package, not independently.

First, populaion dynaics are spliin e world ino youner and ore aure counries. The younger

countries have brighter futures, higher expectations for future economic growth, more of a focus on job creation,

and more emphasis on the development of their economic infrastructure. By comparison, the more mature

countries are coming to grips with the reality of slower economic growth, a decaying infrastructure, massive over-

indebtedness, and huge challenges in the health care and social safety net arena due to an explosion in the number

of people of retirement age.


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Second, eerin counries are iproin rapidly in ers of poliical sailiy, e enforceen of

conracs, and all e leal anifesaions of e proecion of propery ris that enhance the ability of

consumers and corporations to plan effectively for future investment and growth. By contrast, mature countries are

seeing a steady erosion of the exibility of their economic models due to tax and regulatory uncertainty, limitations

on property rights, and the increasing inability of the political system to reach a consensus and chart a steady

and reasonably predictable course, allowing for the kind of long-run planning by consumers and corporations thatmeasurably enhances economic growth.

Third, oneary and scal policies are ily consrained ools of econoic anaeen in aure

indusrial counries. In many cases, these policy tools have hit their limits of effectiveness in the mature countries,

yet some degree of exibility remains in the policy arena for younger and faster growing countries.

. Populaion Dynaics

There are strikingly different demographic patterns among the major countries of the world. What we have

observed is that while population trends are broadly recognized, the powerful political-economic implications of

demographic patterns are consistently under-estimated by nancial market participants, possibly due to the slow-

moving nature of these trends. Our objective is to emphasize the long-term economic growth implications and thepolitical choices countries have to make that are heavily inuenced by the context of their demographic situation.

1. Differen in Paerns

Here we want to take a brief look at the population pyramids of six major countries. In all of these charts, the

age cohorts represent ve-year brackets, starting with the youth at the base of the pyramid, moving through the

working age population, and capping the chart with the elderly.1 When studying these charts, the issues we are

contemplating are the different political forces that are at work through the dynamics of the demographic patterns.

For example, is the political support for jobs versus health care programs, or for low ination versus export growth,

the same across countries given the different demographic proles shown below?

India and Brazil are striking examples of youthful nations.

1 All of the population pyramids were sourced directly from the website of the US Census Bureau, the International Data Base Section. Available

online at www.census.gov/population/international/data/idb/informationGateway.php

Populations are estimated for 2011, and all brackets are in millions of people with males on the left and females on the right side of the chart.

100+

95 99

90 94

85 89

80 84

75 79

70 74

65 69

60 64

55 59

50 54

45 49

40 44

35 39

30 34

25 29

20 24

15 19

10 14

5 9

0 4

Brazil - 2011

Population (In Millions)

Male

10 8 6 4 2 0

Female

0 2 4 6 8 10

100+

95 99

90 94

85 89

80 84

75 79

70 74

65 69

60 64

55 59

50 54

45 49

40 44

35 39

30 34

25 29

20 2415 19

10 14

5 9

0 4

India - 2011


Male

65 52 39 26 13 0

Female

0 13 26 39 52 65


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In stark contrast, Japan and Germany have the prole of much older populations.

And then, there are countries such as the United States and China which are aging rapidly, but are not yet facing

shrinking populations.

The mature industrial countries, represented by the US, Japan, the UK and Western Europe, are entering a period

when labor force growth is slowing or even shrinking. Their most challenging policy issues, such as health care,

surround the demographic cohort of the rapidly expanding retired population.

By contrast, emerging economies are challenged to put millions of young people to work or to nd urban jobs for

workers migrating from rural areas. In some eerily similar ways, the emerging economies are entering a potentiallydynamic phase of economic growth much like the demographic context that helped propel the industrial countries

into a half century of growth starting back in 1950.

There are some anomalies. For example, China does not t the pattern. While China has been one of the fastest

growing countries over the last 30 years, the countrys population dynamics are that of an older nation. What has

helped to sustain Chinas rapid economic growth is a massive migration from rural areas to urban centers, which

100+

95 99

90 94

85 89

80 84

75 79

70 74

65 69

60 64

55 59

50 54

45 49

40 44

35 39

30 34

25 29

20 24

15 19

10 14

5 9

0 4

Japan - 2011


6 4.8 3.6 2.4 1. 2 0

FemaleMale

0 1.2 2.4 3.6 4.8 6

100+

95 99

90 94

85 89

80 84

75 79

70 74

65 69

60 64

55 59

50 54

45 49

40 44

35 39

30 34

25 29

20 24

15 19

10 14

5 9

0 4

Germany - 2011


4 3.2 2.4 1.6 0.8 0

FemaleMale

0 0.8 1.6 2.4 3.2 4

100+

95 99

90 94

85 89

80 84

75 79

70 74

65 69

60 64

55 59

50 54

45 49

40 44

35 39

30 34

25 29

20 2415 19

10 14

5 9

0 4

United States - 2011


15 12 9 6 3 0

FemaleMale

0 3 6 9 12 15

100+

95 99

90 94

85 89

80 84

75 79

70 74

65 69

60 64

55 59

50 54

45 49

40 44

35 39

30 34

25 29

20 24

15 19

10 14

5 9

0 4

China - 2011


70 56 42 28 14 0 0 14 28 42 56 70

FemaleMale


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has fed the growth of Chinas industrial sector. This rural-to-urban migration was also a feature of Japan in the

1950s and 1960s when the nation regularly posted 10% increases in real GDP per year. The former Soviet Union also

effectively utilized the migration of workers from the farm to the city to power its industrial growth in the 1950s and

1960s, only to slow down dramatically when the supply of labor from the rural sector ran dry.

2. Lon-un Econoic grow Driers

Demographic patterns are important economic drivers because they determine the growth of the industrial and

service sector labor force. When coupled with observations about the potential growth in the productivity of the

labor force, one has a framework for considering the impact on long-term growth prospects related to powerful

population dynamics.

The industrial and service sector labor force can grow for essentially three reasons. (a) There are more young

people entering the working age labor market than there are retirees leaving the market. (b) Working age people are

migrating from rural agricultural pursuits to urban industrial and service sector jobs. And, (c) working age people are

migrating from external locations into the domestic labor force.

Productivity growth also tends to come from three sources. (a) New capital investment can raise the productivityof labor. (b) Urban industrial and service sector jobs tend to have much higher productivity than rural agricultural

employment in developing countries, so a switch from rural to urban employment can raise an emerging nations

labor productivity. And, (c) technological progress can raise labor productivity.

Most of these drivers are present in relatively young, emerging economies, while more mature countries are much

more dependent on technological progress to power economic growth, given the high quality of their existing capital

stock and their lack of labor force growth. Taken together, i is ard o expec annual real gDP row in e

aure indusrial counries o exceed ore an 2.5% per year, and even that may be an over-estimate when

other factors are considered. by conras, annual real gDP can reasonaly aerae 5% or ore per year in e

eerin counries.

Japan

Euro-Zone

UK

US

Brazil

India

China

0% 50% 100% 150% 200%

Cumulative Real GDP Growth from 2001 through 2010

Source: World Bank Annual GDP Data from Bloomberg Professional


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3. ld ersus Youn Poliics

Growth differentials have powerful implications for wage differentials. Labor productivity is very high in the

mature industrial countries, but now grows slowly only as technology progresses. In the emerging countries, labor

productivity is quite low and the potential for productivity growth is huge from investments in infrastructure and

new plant and capital equipment. The interesting challenge in the emerging countries is how the benets from

rapidly growing labor productivity get divided between the wealthy class of owners and the middle class of workers.

Put another way, the middle class will certainly expand, but the income divide between the super rich and the poor

may also expand, leading to internal political tensions if wage growth falls too far behind productivity growth. This is

an important issue today, for example, in China, India, Brazil, and Russia, among other countries.

Energy demand will also be a focal point. The mature industrial countries are relatively efcient users of energy,

such that a 1% gain in real GDP results in something less than a 1% increase in energy demand. For emerging

market countries, it is a different story. They are not very efcient users of energy, and they are in the midst of

infrastructure building which can be energy intensive. For emerging market countries, energy demand is actually

an increasing function of economic growth. As emerging market countries establish a robust middle class, energy

consumption as a percent of real GDP rises.2

Consequently, if global growth is coming more from the emergingcountries, energy demand will rise considerably faster than otherwise.

Other indirect implications will affect both agriculture and water. Agriculture uses a lot of water, but so does

industry, not to mention the publics consumption needs. Rapid growth in the emerging countries is going to

challenge simultaneously food production and clean water supplies around the world, creating political and market

tensions we can only imagine at this stage.

2 See Fueling Growth: What Drives Energy Demand in Developing Countries?, by Arthur van Benthem and Mattia Romani, The Energy Journal,

published by the International Association for Energy Economics, Volume 30, 2009.

Oil Import Bills in Net Importing Less Developed Countries

Notes: 2011 estimated.

Source: Energy for All, page 9, special early excerpt of the World Energy Outlook:

2011 published by the International Energy Agency, 2011.

Billion

dollars(2010) 120

100

80

60

40

20

0

2000 2005 2010 2011


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The point here is that it is hard to underestimate the dissonance that will continually hammer markets from the ebb

and ow of these growth differentials as their direct and indirect implications work their way through the worlds

nancial system. We can make, however, some broad generalizations about the political biases that population and

growth dynamics create.

a. Jos. Youful counries ae a policy iperaie o creae jos and o row waes. With so many young

people entering the labor force, a country needs to creates jobs or political unrest is nearly a given. Consequently,

youthful countries have a clear bias to promote export-led job creation, and these countries fear any substantial rise

in the relative value of their currency that could hurt the job creation process necessary for political stability.

. Weal and heal. By contrast, e poliical issue for an older counry is weal preseraion (a

is, eep wa you ae earned), eal care, pensions, and social safey nes. The bias toward wealth

preservation shows up as a preference for a stable to strong currency to maintain or increase the international

purchasing power of the wealth that has already been created. Creating new jobs is not as important over the long

haul, since the labor force has stopped growing, although putting people back to work after a recession will remain a

cyclical focus.

c. naion tolerance. Similarly, e poliics of ain canes e olerance for inaion. A youthful countryis much more willing to tolerate some ination as a small price to pay for job creation and the pressures that

accompany the establishment of a viable middle class. An older country does not need secular job creation and

wants no part of ination, which depreciates the wealth already accumulated.

b. winin Pendulu of Propery is and eulaory trends

Our inclusion of property rights as a source of dissonance is focused directly on the challenges consumers and

corporations face in planning for the future. As noted in the introduction our denition of property rights is broad,

intended to represent the ability of individuals and corporations to conduct their business on a level playing eld

(i.e., laws, rules, regulations, taxes) with an expectation that the rules and goalposts will shift in an orderly manner

(i.e., political stability, consistency of court rulings and enforcement of contracts, etc.). That is, we are evaluatingthe various elements that allow for effective planning, which we regard as an important determinant of long-term

economic growth.

Wa is ofen underappreciaed are e differen direcions in wic e pendulu of propery ris is

swinin for certain countries or groups of countries. This has powerful implications for relative political condence

and risk among countries in the 21st century as compared to the last half of the 20th century. It is extremely

difcult, if not impossible, to measure quantitatively the comparative degree of property rights among countries,

or the degree to which regulations enhance or degrade economic activity, or even the relative political risks that

emanate from these sources. Our inability to measure something in a credible manner should not, however, become

an excuse to ignore the challenges to the global economy from divergent trends in property rights and economic

regulations, as well as their implications for market condence in political governance systems.

In many of the emerging economies, political stability has been dramatically improved since the 1970s, 1980s, and

1990s. Contracts are more likely to be enforced. The regulatory structure, while sometimes complex and arcane, is

improving in its clarity and predictability. So, if we could measure it in a credible way, we would probably nd that while

the absolute degree of property rights, regulations, and political stability may still favor the mature industrial countries,

the pendulum is swinging backward. Yet in the emerging economy world, the pendulum is swinging forward.


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Property rights trends are likely to lead to an environment in which regulatory competition among countries

becomes more the norm than international coordination. This represents an enormous challenge to multi-national

companies with global growth aspirations, and it also serves as a potentially huge source of market volatility.

Property rights and regulatory changes can come swiftly from both mature and emerging countries, and often the

changes come with very uncertain long-term implications.

For example, the Russian ban on wheat exports in the summer of 2010 was a trade regulation issue that impacted

global markets: rst directly in terms of wheat prices, and then indirectly in terms of related commodities,

currencies of commodity producing countries, and even equities.

Wheat Prices Surge Due to Russian Wheat Export Ban

Russian Export

Ban Commences

SpotWheatPrices,US$perbarrel,

USDA#2So

ftRedWinterWheat@Chicago

Source: Spot Wheat Prices (WEATCHEL) provided by the Bloomberg Professional

Dec-08

Feb-08

Apr-09

Jun-09

Aug-09

Oct-09

Dec-09

Feb-09

Apr-10

Jun-10

Aug-10

Oct-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

9

6

3

0


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The point can be further illustrated by comparing how the corporate planning process in the United States and

China is affected by government decision-making. Chinas modern leaders have an obsession with ve-year plans.

The country is currently in its 12th Five Year Plan. Plans change, and there are course alterations, but China wants

everyone to know the intended path. By contrast, the US Congress over the years has increased its use of stop-gap

legislation. Debt ceilings need to be raised every year or two. Tax legislation has expiration dates requiring new

legislation or a reversion to an old set of taxes. New regulations are enacted into law, but the agencies in charge areunder-manned and cannot meet mandated deadlines to interpret the new law, as with recent nancial and health

care legislation. What is interesting is not that US corporations still have much more control over their own destinies

and freedom to conduct business than Chinese companies at an absolute level. What matters in economics is the

relative direction of trends, and the US system is becoming less friendly to long-run business planning, while the

Chinese system is becoming relatively friendlier.

To extend this illustration with a focus just on the US, observe the time it takes for labor markets to recover after

a recession. Over the last two decades there has been a steady increase in regulations and rules regarding the

relationship between corporations and their employees. The result of this regulation-creep has been a steady

increase in the explicit and hidden costs of labor. One of the manifestations of this shift in the relative cost of capital

and labor is that in a recession corporations have been quicker than ever to reduce costs through cutting back their

workforce. Then, during the recovery period, corporations have been much slower to rehire workers than they once

were given the increase in labor costs, especially related to health care and other benets.

The current recovery period in the US is further challenged by the deleveraging that occurs after a recession caused

by a nancial crisis, by the persistent problems in the housing market, and by the drag from scal policy. Even

taking these factors into account, though, the impressive recovery in corporate prots in 2010 and 2011 has not led

to much hiring by the private sector. The time it takes to regain the previous peak in employment is likely to set a

modern record, and by a very wide margin compared with the four years it took to recover from the 2000 recession,

and the two year recovery time averaged during the recessions occurring between 1948 and 1983.

Dec 2000

Mar 1990

Aug 1981

June 1974

Mar 1970

April 1960

April 1957

July 1953

Sept 1948

PeakofEmployment

US Employment Has Been Taking Longerto Recover after each Recession since 1990

Note: the mini-recession of March 1980 caused by the short-lived restrictions on credit cards is omitted

due to its special circumstances. Source: Federal Reserve Bank of St. Louis FRED Database

Number of Months from Peak to Recovery

0 10 20 30 40 50 60


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. Policy onex and elaie onsrains and/or lexiiliy

The constraints presented by the economic policy context in which countries nd themselves are our third major

source of dissonance for markets. Economic policies can be broadly categorized as (1) scal policy, (2) monetary

policy, and (3) government asset/liability management. What is important to recognize is how much exibility some

countries have in the policy area compared to how constrained others are. This relative matrix of constrained versus

exible policy alternatives will be a large source of potential market dissonance between mature and emerging

market nations and also among the mature nations themselves as they go their own ways in this challenging

decade.

1. iscal Policy

The expansion of government debt as a percentage of GDP in the mature industrial countries over the last two

decades and particularly over the last few years in response to the Financial Panic of 2008 has created a large class

of countries with little or no choice but to restrain scal policy and to focus on getting their debt under control.

To the extent that long-term growth rates of real GDP have decelerated for these over-indebted countries due to

population dynamics and property rights erosion, the problem is even worse.

What really matters is not just the size of the economy relative to the debt load, but the income growth available

to support the interest payments on the debt. Slower economic growth means less income to service a given size

debt load. By contrast, the emerging market world has much lower government debt to GDP ratios, as well as

much higher long-term potential GDP growth rates to service their smaller debt loads. Thus, scal policy is ily

consrained in e aure indusrial world, wile consideraly ore exile in e eerin econoy

world. Moreover, in the mature industrial countries scal restraint is likely to be a major drag on economic growth

for most of the decade to come.

2. moneary Policy

Following the policy efforts to recover from the Financial Panic of 2008, the central banks of many mature industrial

countries found themselves relatively ineffective. Immediately after the crisis, they had pushed short-term rates to

near zero and expanded their balance sheets aggressively. They had reached the limits of their abilities to inuence

economic activity. By contrast, central banks of the emerging economies, with high interest rates and conservative

balance sheets, have some policy exibility to deal with the challenges they face.

A comparison of the US and Brazil is a useful illustration. Over the past decade, the central bank of Brazil has consistently

maintained a steady premium between short-term market interest rates and year-over-year ination a classic central

bank approach to containing ination pressures. As global economic growth slows and ination pressures abate, there is

ample room to cut rates and provide some limited cushion for the economy from global impulses.

By contrast, the US Federal Reserve has not found it possible to operate in nearly as a consistent manner as the

central bank of Brazil (Banco Central do Brasil). As the growth recession in the mature industrial economiescontinues, their central banks, such as the Federal Reserve, are effectively tapped-out in terms of providing

additional economic stimulus, since short-term rates are already at or near zero. This has led to experimentation

with balance sheet expansion, known as quantitative easing or QE.


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Comparison of Debt/GDP Ratios of Selected MatureCountries Compared to Emerging Market Countries

SlowerGrowers

FasterGrowers

0% 50% 100% 150% 200%

Outstanding Government Debt as Percentage of GDP 2010

Japan

Greece

Italy

Germany

France

United Kingdom

United States

Brazil

India

Argentina

Mexico

China

Russia

Source: Based on US CIAs World Fact Book and Eurostat Database.

The use of the central bank balance sheet in a nancial crisis to stabilize the banking system can prevent a recession

from turning into a depression. The evidence is still being collected, but it appears that QE programs have little to no

impact on providing economic stimulus. QE is effectively only a defensive tool to be used to prevent nancial market

disruption from contagion related to weak or insolvent banks.

In addition, when economies are in the midst of a deleveraging phase or when uncertainty about the future is athighly elevated levels, neither consumers nor corporations are making their decisions based primarily, or even

secondarily, on interest rate considerations. In this environment, lower rates are not possible because they are

already at zero. And, the zero-rate policy has only limited effectiveness until the deleveraging ends or the cloud of

uncertainty is lifted. What is critical to watch is both consumer credit and bank lending to corporations. When these

indicators turn upwards and can extend that new trend for three to six months, this will be an indication that interest

rates have again become an important decision factor for consumers and businesses and the zero-rate policy may

start to have a stimulatory impact on the economy.


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Brazils Central Bank Maintains Rates with a Steady Premiumover the Inflation Rate: Expectations of Declining InflationCan Bring Lower Rates

Overnight Interest Rate

Inflation Rate

Source: Brazilian CPI and Rates Data from Bloomberg Professional

30%

25%

20%

15%

10%

5%

0%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Brazils Central BaBrazils Central Baover the Inflationover the InflationCan Bring Lower RCan Bring Lower R

veveve

25%

3. sse/Liailiy manaeen

Asset/liability management at the country level involves two very different tasks. On the liability side, the task is

debt management, which is most challenging for the over-indebted mature industrial countries. On the asset side,

the task is reserve management, which spans both the emerging countries and the mature countries, but does notinclude the US. As the provider of the dominant reserve currency, the US dollar, the US has not had to worry about

asset management, but it may well have to cope with the repercussions of the portfolio decisions other nations

make regarding their international reserves.

Tentative Signs that the US Consumer HasStopped Deleveraging (US Consumer Credit Data)

Source: US Consumer Credit Data Provided Through Bloomberg Professional

USConsumerCreditOutstanding,

TrillionsofDo

llars

3.0

2.5

2.0

1.5

1.0

0.5

0.0

Dec-91

Jan-93

Nov-94

May-95

Nov-97

May-99

Nov-00

May-02

Nov-03

May-05

Nov-06

May-08

Nov-09

May-11

Preliminary Indications that Corporations are

Starting to Increase Borrowing From Banks Again

Source: US Bank Commercial & Industrial Loans and Leases Data Provided Through

Bloomberg Professional

USBAnkCommercial&In

dustrialLoans

andLeases,Trillions

ofDollars

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0

Dec-91

Jan-93

Nov-94

May-95

Nov-97

May-99

Nov-00

May-02

Nov-03

May-05

Nov-06

May-08

Nov-09

May-11


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14 mkEt ght

a. goernen De manaeen. Within the mature industrial countries there are critical distinctions involving

the choices available for debt management. The determining criterion is the relationship between the currency

of denomination of the debt and whether the debtor country controls the central bank that issues the currency.

ounries a issue de in e currency wic eir cenral an conrols effeciely do no ae credi

ris ey ae inaion ris. That is, at some point when the debt load is perceived as too crushing to manage

through scal policy, the central bank can issue liabilities (i.e., print money, depreciate the currency) and inate thevalue of the debt away. By contrast, wen a counry issues is de in a currency i does no conrol, e inaion

alernaie is no aailale, and e de us e ealuaed y world ares in ers of is credi ris.

In the 1960s and 1970s, it was typical of emerging market countries to issue debt in their own currency. But as

they over-extended themselves, they abused scal and then monetary policy, leading to currency depreciation and

ination. One solution was to force debt issuance by certain emerging countries, particularly in Latin America, into

US dollars, a currency they did not control, making explicit the credit risk challenge. As emerging market countries

have been able to demonstrate policy credibility over time, they have been able to pay off their US dollar debts and

again issue debt in their own currencies.

The countries in the 21st century that nd themselves in the credit risk market segment are the countries of theEuro-Zone. While they may issue their debt in euros, the common currency of the region, no one country controls

the European Central Bank (ECB). As the sovereign debt crisis of Europe demonstrates, this is a crisis of credit risk,

which has evolved into a parallel crisis for the banks of Europe that took on excessive credit risk in the form of the

sovereign debt of weaker Euro-Zone countries.

What emerging market countries already knew from their own experience in previous decades, and what they are

learning again from watching the Euro-Zone struggle with its sovereign debt crisis is that they should avoid issuing

debt in another countrys currency, such as the US dollar, and issue their debt in their own currency. This has very

large implications for the currency management and currency convertibility policies of emerging countries that have

sought to restrict how their currency is used internationally. Currency restrictions and limited currency convertibility

are not compatible with a globally viable market in their currencys debt.

We note that certain Western European countries chose not to join the Euro-Zone. For example, Sweden has had

a National Debt Ofce since the 1700s to manage the countrys liabilities, and for liability management and many

other reasons did not want to adopt the euro. The UK also places a high value on being able to manage its own

independent currency, which was among a variety of reasons this country also did not adopt the euro.


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Country

US/UK/Japan

Euro-Zone Countries Before the Euro

Euro-Zone Countries After the Euro

Emerging Markets Then

Emerging Markets Then

Country Issues

Debt in its Own

Currency With

Control of

Central Bank

Country Issues

Debt in its

Own Currency

Without Control

of Central Bank

EUR

USD

YES

YES

NO

NO

YES

. nernaional esere manaeen. Between the years 1998 through 2011, countries of all stripes from

emerging countries, such as Brazil, India, and China, to mature countries, such as Japan accumulated

international reserves on the asset side of their central bank balance sheets and in the coffers of their sovereign

wealth funds. A majority of the international reserves are denominated in US dollars, which creates a potentially

large zone of tension specically with the United States and a major source of policy dissonance for global markets.

Should the owners of these massive stockpiles of US dollar denominated assets choose a policy of currency

diversication, the implications for US interest rates and the US dollar will cause policy challenges not only for the

US, but for the whole world nancial system.3

If, or perhaps we should say, when the owners of the US dollar denominated international reserves shift from

exchange rate stabilization policy goals to wealth preservation policy objectives, currency diversication will be an

obvious step to take. The catalyst for this asset allocation shift may come from the economics of the US, or it may

come from the global political arena. One of the political features of the Era of Dissonance is that it represents a

transition period from a world order dominated by one super power, the US, to a world order in which there are at

least two powerful countries at the world level the US and China and a number of important regional powers

with global ambitions Brazil, India, and Russia. And, because of the disruptions of the sovereign debt crisis, it is

not at all clear where Europe ts into this power matrix.

3 The study of the role of economic growth, money supply, exchange rates, and the accumulation of international reserves has a long history,

pioneered by Professor Harry Johnson, Nobel Prize winner Professor Robert Mundell, and the always-controversial Professor Arthur Laffer

when they were together at the University of Chicago in the late 1960s and early 1970s. The author of this research report has also contributed

to this scholarly literature, starting with Money, Income, and Causality in the United States and the United Kingdom, co-authored with Profes-

sor D. Sykes Wilford and published in the American Economic Review, Volume 68, in 1978, and including more recently Chinese Exchange

Rates and Reserves from a Basic Monetary Approach Perspective, co-authored with Professors Stephen Jay Silver and D. Sykes Wilford,

published in the Journal of Financial Transformation, Volume 31, in 2011, as well as several books and other articles on the subject published

over the years.


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Brazil

Mi

llioinsofUSDollarsofInternational

ReservesNotIncludingGold

350,000

300,000

250,000

200,000

150,000

100,000

50,000

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2008

Source: IMF IFS Data Base from the Bloomberg Professional

What is clear, however, is that the role of the US dollar as the primary reserve currency for the world is a legacy from

the previous era and almost certainly will be challenged, if only by the requirements of portfolio diversication. That

is, i is wron o analyze e U dollars resere currency role sarin fro e assupion a e U

dollar can only e replaced y a iale callener, and seein no iale callener, jup o e conclusion

a e role of e U dollar will coninue ore or less as i as een. There need be no viable challenger for

the US dollars role to erode as a reserve currency, just a strong desire by the nations of the world to manage theirreserves more like a diversied portfolio.

There are several things to watch regarding the behavior of central banks and sovereign funds in terms of how they

manage the currency diversication of their assets. First, central banks tend to focus on maintaining liquidity and

so they are the primary holders of US Treasury and Agency marketable securities. For the better part, they use the

Federal Reserve as their custodian, and the Federal Reserve issues a weekly report as to the quantity of marketable

securities it holds in custody for central banks and international agencies. If central banks are diversifying their

currency portfolios away from US dollars, this data series will at-line or turn downwards.

India


Milli

oinsofUSDollarsofInternational


350,000

300,000

250,000

200,000

150,000

100,000

50,000

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2008

Japan


Millioinso

fUSDollarsofInternational

Rese

rvesNotIncludingGold

1.200,000

1,000,000

800,000

600,000

400,000

200,000

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

China


MillioinsofUSDollarsofInternational


3,500,000

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009


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Data on US Treasury and Agency Marketable Securities Held in Custody bythe Federal Reserve for Central Banks and International Agencies Can beUsed to Monitor the Attractiveness of the US Dollar as a Reserve Currency

Source: US Federal Reserve H4.1 Report as provided by the Bloomberg Professional

Tr

illionsofUSDollarsHeldby

C

entralBanksandAgencies

4.0

3.5

2.5

2.0

1.5

1.0

0.5

0.0

Jan-97

Nov-97

Sep-98

Jul-99

May-00

Mar-01

Jan-02

Nov-02

Sep-03

Jul-04

May-05

Mar-06

Jan-07

Nov-07

Sep-08

Jul-09

May-10

Mar-11

Second, sovereign wealth funds are typically viewed as managers of less liquid investments, including equity,

joint ventures, private equity, real estate, etc. These funds are almost always well-diversied in terms of the

currency of denomination of their assets. To the extent that sovereign wealth funds are growing faster than central

bank international reserves, this is a sign of an increased preference for portfolio diversication. Indeed someresearchers put current sovereign wealth fund assets in the range of $2 trillion to $3 trillion or even higher. This

amount is projected to grow to as much as $13 trillion in the next ten years, an amount even larger than the current

stock of foreign reserves of about $7 trillion at year-end 2009.4

4 See the research paper, Asset Class Diversication and Delegation of Responsibilities between Central Banks and Sovereign Wealth Funds,

by Joshua Aizenmann (University of California, Santa Cruz) and Reuven Glick (Federal Reserve Bank of San Francisco, published as Working

Paper #2010-20 by the Federal Reserve Bank of San Francisco.


18/35


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. mare Dynaics and Ways Dissonance is esoled (or no)

Recognizing that the 21st century has a markedly different fundamental context one governed by sources of

dissonance rather than the shared objectives and similar political and economic fundamentals of the latter half

of the 20th century makes a powerful case that global nancial markets are not going to settle back into older

patterns. Indeed, because the sources of dissonance are so powerful and so slow moving5

, it is hard to avoid theconclusion that nancial ris anaeen us e uc ore proacie and forward-looin o andle

effeciely e callenes posed for world ares y e Era of Dissonance.

To get at the heart of understanding market dynamics that are governed by sources of dissonance rather than by

shared objectives and common fundamentals, we need to delve into the nature of nancial market expectations.

Financial markets are designed to resolve conicting expectations among market participants. This sounds basic.

Yet underlying this straightforward function of nancial markets is a more complex process that is quite challenging

to analyze. We are expecting a long series of conicts, with market participants holding widely varying expectations

of how the conicts will be resolved. Contributing to the challenge is that many market participants will stubbornly

hold onto expectations based on past experience that now are highly unlikely in this new era. And, in many cases,

the political process will be deciding between widely divergent monetary and scal policy prescriptions.

To gain an intuitive understanding of the complexity of the expectations and market adjudication process, we will

start with the theory behind a relatively simple comparison of two different categorizations of market expectations,

namely expectations governed by shared fundamentals and expectations governed by sources of dissonance.

Please bear with us as we work through these theoretical cases. Our analytical framework will provide us with the

tools to cope with a series of market conicts surrounding expectations in which multiple and potentially highly

divergent scenarios are possible. In studying how the sources of dissonance are likely to be resolved by markets, we

will rst examine some basic theory, and then draw our practical conclusions.

. Undersandin two ases of Expecaions, volailiy, and orrelaions

We believe that there is a fundamental difference in the volatility and correlation behavior of markets depending

on (a) whether expectations are governed by shared fundamentals or (b) expectations are governed by sources

of dissonance. The shared fundamentals category generally produces a probability distribution of expectations

around a single most likely outcome (mode) and maintains a relatively consistent volatility (variance). By contrast,

expectations constructed in the sources of dissonance category are much more complex and may have more than

one quite different competing scenario. Even more disturbing for markets, estimated volatilities are not conned to

a reasonable range, but can shift, sometimes abruptly and dramatically. The practical implications for how market

conicts are resolved relate in no small way on which categorization is in the ascendant.

5 One can think about the slow moving plate tectonics that eventually cause highly disruptive earthquakes. It is easy to forget about plate tec-

tonics because it is such a slow moving natural phenomenon, but it is still not a good idea to build a big hydro-electric power dam or a nuclear

power plant near a fault line, even an inactive one.


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1. Expecaions goerned y ared undaenals

The typical underlying assumption about the expectations of market returns is that they are centered around a

single mode and with dened variance (volatility). For most market models the assumption is even more specic

expectations of returns are drawn from a normal distribution or can be described by a normal distribution without

doing damage to the basic conclusions, even if the distribution is non-normal. In our case, the normal distribution

assumption is not the important part. What is critical is that there is a single mode, even if the distribution has a

fat tail (skewness) or a tall or short central section (kurtosis). These types of distributions of expected returns are

relatively easy for markets to handle even though there are some difcult risk management challenges.

If market participants broadly share a similar vision of the fundamentals guiding economic behavior, then when

market participants receive new information, such as new economic data or a policy announcement, the expected

mean of future returns shifts, but the expected volatility remains more or less the same. Broadening the case into

a multi-exposure environment, market participants would also share a similar view of the correlation structure

of expected returns, which is assumed to remain stable even as market return expectations change with new

information.

Take for example what happens when new information comes to market participants, say in the form of the US

employment data that is released for the previous month on the rst Friday of every month. When this data release

surprises the market in terms of the outcome being different than the consensus expectation, market participants

quickly revise their perspective on US Treasury yields, equities, and other securities. For example, a negative

surprise generally means lower US Treasury bond yields and lower stock prices, while a positive surprise is often

accompanied by higher US Treasury bond yields and higher stock prices. This means that the expected mean of the

probability distribution for both US Treasuries and stock prices has shifted. But the degree of condence with which

market participants hold their newly-revised views does not change much it stays in a reasonably well-dened

range, or condence interval, for both bond yields and stock prices. That is, what we have is a new probability

distribution with a new mean but more or less the same variance (i.e., volatility or condence).6

6 Financial practitioners refer to volatility, while academic economists will refer to the variance which is equal to the standard deviation

squared. Condence and volatility are tightly linked in terms of expected returns. Ones condence in a forecast of expected returns is in-

versely related to the expected volatility (variance) of those returns. That is, high volatility is associated with low condence in a given forecast.


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New Information Causes the Expected Mean to Shift,But the Standard Deviation and Probability Curve

Shapes are not Changed

US 10-Year Treasury Yield. Source: Calculation by CME Economics Research

Pr

obabilityDistribution

Scenario A

(sluggish growth):

10-Year Treasury=

2% Yield expectation

Scenario B

(new payroll

data suggests

possibility of

stronger growth):

10-Year Treasury

Yield=2.5% Yield

25%

20%

15%

10%

5%

0%

0 1 2 3 4 5

2. Expecaions goerned y ources of Dissonance

The distribution of expectations of future market returns can take on a very different shape when there are two

potential outcomes that are very far apart from each other. The challenge is that the market is trying to combineexpectations of market participants that cannot be reasonably described by a distribution with a single mode.

Lets take an example from the world of mergers and acquisitions. Suppose company A has made a bid for

company B at a price of $120 representing a 20% premium over the previous market price of $100 that is, the

bid represents a substantial premium to gain full control of the target company. Now, suppose that the regulatory

authorities decide to review the potential merger and that there is a reasonable probability that the merger

might be rejected. Lets say that after the merger is announced but before the regulatory authorities make their

decision, there is a 50/50 probability of approval or the merger. How does the market resolve these conicting

expectations?

Effectively, there is a one set of expectations for the stock price of company B if the merger is approved and that is$120, with a very small variance, since an adjustment to the bid in this case is not assumed to be very likely. And if

the merger is rejected by the authorities, then the stock price of company B would likely fall back to its pre-merger

announcement price of $100, give or take, and there would be considerable uncertainty as to the future of company

B (high variance) since a new suitor might appear or the company might be perceived as damaged goods and the

stock price spiral downward.


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Scenario A: Merger Approved (Mean = 120, STD=2)

Source: Calculation by CME Economics

25%

20%

15%

10%

5%

0%

70 80 90 100 110 120 130 140

Probability

Distribution

Scenario B: Merger Approved (Mean = 100, STD=6)


25%

20%

15%

10%

5%

0%

70 80 90 100 110 120 130 140

Probability

Distribution

Combination of Scenarios A & B at 50% Each (Mean=110, STD=4)


25%

20%

15%

10%

5%

0%

70 80 90 100 110 120 130 140

ProbabilityDistribution

Normal Distribution (Mean=110, Standard Deviation=4)

Stock Price Source: Calculation by CME Economics

25%

20%

15%

10%

5%

0%

70 80 90 100 110 120 130 140

ProbabilityDistribution

The expected value (mean) of the combined distributions depends on the probability of scenario A (merger

approved) or scenario B (merger rejected). At 50/50 probabilities, the expected mean for the combined probability

distribution is $110 and the standard deviation is 4.

In the gure shown on the left above, the probability distribution on the left combines a 50% chance of Scenario A

with a 50% chance of Scenario B to produce a distribution that is clearly not a bell-shaped curve and also has two

modes. The gure on the right has the same mean ($110) and the same standard deviation (4), and is the familiar

bell-shaped curve or normal distribution.7 A very high percentage of quantitative models assume that the gure on

the right (single-mode, bell-shaped curve) represents reality, and in most nancial environments over the last half of

the previous century this was not a bad assumption to make. f e realiy is ore lie e i-odal disriuion

on e lef, en jus nowin e ean (expeced reurn) and e sandard deiaion (esiaed fuure

olailiy) is no reoely enou o anae ones ris properly.

7 Note, a bi-modal distribution would have two humps like a Bactrian camel from Mongolia. In fact, one will not see a bimodal shape when com-

bining two normal (bell-shaped) distributions unless the difference between the two means is quite large. This is just another way of saying

that unless the two scenarios are far apart one will not get the kind of probability distribution that will cause markets lots of problems.


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Probability

Scenario A:

Merger

Approved

Mean of

Combined

Distribution

Standard

Devaition of

Combined

Distribution

100

102

104

106

108

110

112

114

116

118

120

6.0

5.6

5.2

4.8

4.4

4.0

3.6

3.2

2.8

2.4

2.0

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Indeed, the likely market volatility actually depends importantly on the probability of Scenario A (merger approved)

versus Scenario B (merger rejected), assuming each scenario remains unchanged. That is, the expected volatility

the market is pricing (e.g., in options for example) moves with the perceived likelihood of each scenario, rather than

the scenarios changing. As the likelihood of Scenario A (merger approved) gains favor, the mean (stock price) rises

toward the acquisition bid price, and the estimated volatility declines. Thus in our example, the expected volatility

goes from 6.0 to 2.0 as the probability of the merger being approved (Scenario A) goes from 0% to 100%.

Lets explore this more. Now, some new information arrives. Maybe it is a rumor that the regulatory authorities are

leaning against merger approval. If the odds against merger approval go down, the expected mean of the combined

probability distribution declines and the estimated standard deviation (volatility) rises.

Another form of new information would be the possibility of a white knight with a higher bid. A new suitor enteringthe fray would shift the expected mean higher and might decrease the standard deviation.

Note that both the expected mean and the estimated standard deviation (volatility) shift in these cases where a bi-

modal distribution of two far apart scenarios with different probabilities govern the combined distribution that sets

market prices. Put another way, wa is nearly cerain is a e are price will no say were i is once

e reulaory auoriies ae eir decision. te saus quo is decidedly unsale.

b. Pracical plicaions or mare volailiy and orrelaions

Sources of dissonance that create these kind of bi-polar outcomes tend to focus considerable attention on revising

estimates of volatility, not just expected outcomes. In turn, this makes risk management practitioners much more

focused on options8, which price volatility, in addition to futures and physical securities which price direction.

Moreover, isorical easures of olailiy are of lile o no use a all in ese i-polar cases, especially

as e wo poenial scenarios e farer and farer apar. That is, the implied volatility embedded in an

option price on company Bs stock will depend on the probabilities associated with regulatory decisions and not the

previous history of the stock prices volatility.

8 The simplest option pricing models, such as the famous Black-Sholes model, require ve inputs into the valuation formula, of which four are

known and one has to be estimated. The strike price, current price of the underlying security, market borrowing rate, and the time to option

expiration are all known inputs. The unknown input is the estimated volatility of the expected returns of the underlying security.


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Our merger example was constructed to focus on why expected volatility shifts around as a function of the

probabilities changing for the two potential scenarios. If we move more into the real world, the actual case studies

take us quickly into cross asset class situations, and we see that not only are volatilities not stable, but correlations

will move abruptly, too, as probabilities about far apart scenarios change.

As shown in the chart above, the annualized volatility of the S&P 500 Index looks much less stable when viewed

through the lens of only 60 business days of historical data compared to 260 business days (one year). Moreover,

one can easily see, and as the nancial regulators always insist that asset managers tell their clients, the past is not

necessarily indicative of future performance, which clearly applies to volatility analysis. Or put another way, in e

Era of Dissonance one sould no drie a car looin only rou e rear iew irror e aware ere are

oin o e soe airpin urns up aead a you will no wan o iss.

Historical Volatility Looks Very Different

Depending on Your Time Perspective

Source: Volatility Calculations by CME Research based on S&P 500 Index (SPX)

data provided through Bloomberg Professional.

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11AnnualizedStandardD

eviationoftheS&P500

Index

basedonDailyPercentChange

80%

70%

60%

50%

40%

30%

20%

10%

0%

60-DayAnnualizedVolatility

260-Day(1-year)AnnualizedVolatility


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Correlations shift in powerful ways, as well, especially in ight-to-quality liquidity events as shown in the chart above.

The chart above illustrates the correlation between US Treasury 10-Year Note price percent changes and S&P 500

Index daily percent changes. The correlations goes strongly into negative territory (inverse relationship) when

markets shift from greed into fear.

Take the sovereign debt crisis in Europe that started in 2009 and 2010 and then in the summer of 2011 spread fromGreece to worries about Italian bonds, to a downgrading of the euro against the Swiss franc, to concerns about

the capital adequacy of French and other European banks, to a correction in global equity markets. As market

participants questioned the capital adequacy of certain European banks, this led to fears that the global payments

system would breakdown. Thus, the focus shifted simultaneously (a) to the European Central Bank (ECB) to see

whether it would or would not serve as lender of last resort and provide essentially unlimited overnight funding (as

long as necessary) to prevent a disruption of the banking system and (b) to the stronger European governments

to see if they could craft a meaningful bail-out plan. Differing views by market participants as to the potential

actions by the ECB and European governments meant there was a low probability expectation that a Lehman-style

banking system failure was possible set against a more typical suite of expectations about how the situation could

be resolved less disruptively. The least likely scenario in this bi-modal distribution was the then-current set ofmarket prices, because the dissonance would be resolved either by a dramatic breakdown or by some form of policy

compromise to muddle through the crisis, but the status quo was clearly not sustainable.


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R

olling3-monthCorrelationBetweentheItalian

minusGermanBondSpreadandtheS&P500

Index

DailyPercentChange

Average Daily Trading Volume (in contracts) in CME Nearby EUR/$ FuturesContract over Previous 60 Days

The European sovereign debt and banking capital adequacy crisis also has interesting implications for relative

counterparty risk. Take the FX market. Participants can acquire currency exposures through exchange-traded

futures contracts or through bank-sponsored forward contracts. While there are a number of possible differences in

these methods of implementing currency exposures, one of the more subtle differences is the relative counterparty

risk being taken on by the ultimate investor. After the nancial panic of 2008 and as the European sovereign debt

crisis morphed into concerns about European banks, and while other factors were also at work, FX futures, with their

risk associated with a central counterparty clearing house (CCP), saw an increase in trading volume.


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Another example makes the same point. In July and August of 2011, the US hit its legislated debt ceiling, and

without an Act of Congress to raise the debt ceiling, the government would have defaulted on its outstanding debt.

The low probability expectation of a Congressional deadlock leading to even a temporary suspension of interest

payments on US Treasury securities was accompanied by predictions of rather dire consequences for the US and

global economy. Another set of expectations ruled out the default scenario and was centered on expectations of a

compromise for future scal policy. What was clear was that the status quo could not be maintained and that therewere two possible resolutions to the conict with outcomes that would be strikingly different and each scenario

came with its own inherent volatility and correlation structure.

But it is not just about the US and Europe. China is continually evaluating its renminbi (RMB) policy. In 2005, it

started to allow incremental appreciation of its currency. Then, in response to the Financial Crisis of 2008, the

appreciation policy was abruptly halted, only to resume again a few years later. When China is xing the value of

the RMB, there is essentially no volatility until the government decides not to x the currency to the US dollar and

then a degree of volatility re-enters the market. As China approaches the time in which it will want to normalize its

currency in terms of its role in world nancial markets, volatility will increase, and the lack of historical volatility will

have little or nothing to say about future volatility of the RMB. Yet again, risk managers must be forward-looking.

In the Era of Dissonance, what we are likely to see are a lot more examples of conicts leading to two, or even more,

distinctly different and widely divergent potential scenarios. We will still have plenty of cases of expectations

shifting modestly around reasonably consistent condence or volatility estimates, as in the case of shared

fundamentals, but the number of dissonant scenario cases is likely to be much, much higher than in the half century

that just ended.

1. volailiy and orrelaions as moin tares

When there are multiple, very powerful sources of dissonance, the nancial environment is highly conducive to

market participants holding the view that the status quo is not sustainable. The perspective of a status quo that is

not sustainable is often associated with alternative scenarios differing quite widely; that is, a low probability disaster

scenario couched against a more likely alternative. Unfortunately, markets do not cope well with bi-modal or multi-

modal expectation distributions. Both modes effectively represent very different new environments with different

implied volatility and correlation structures.

In this type of nancial environment, market participants are nearly certain that the present price structure will not

last, even if they cannot agree on the eventual outcome. One or the other scenario (or more) will take control of both

reality and expectations. Until that happens, however, markets are prone to large price swings, and because the new

information tilts expectations toward one or the other scenario (mode), there is a big swing in expected volatility

and expected correlations as well. That is, in widely divergent expectation cases, the market has to combine not

only expectations of future returns, but the options market must also put a price on the different scenarios involving

widely different expected volatilities and correlations. This creates and sustains what has become known as the

risk-on, risk off environment, when the market swings wildly from risk-seeking to risk-aversion, as the probabilities

of different scenarios shift with new information.

2. Looin o e uure: Policy onfusion or oordinaion?

In practice, the dynamic evaluation of the potential outcomes is critical. ne oucoe is for e sources of

dissonance o pus counries apar, lead o copeiie dealuaions of currencies, rade resricions, and


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a eneral unwillinness o see sared soluions o loal proles that cross national boundaries, such as

water rights among many other challenges. This every man for himself scenario is a prescription for sluggish

global growth with signicant volatility and possibly a global recession. second oucoe could inole a ore

cooperaie world in wic seeral loal or reional powers, fro ina, o brazil, o ndia, o ussia

copee aressiely ye wi clear ojecies o furer rade aon eseles and wi e aure

indusrial counries. In this scenario, the slower growing industrial countries recognize their limits and also avoidprotectionist tendencies. This scenario could lead to strong world economic growth, as multi-national corporations

in the mature countries maximize the benets from the robust growth of the emerging market countries, and

interestingly, even with higher economic growth, nancial market volatility might be reduced.

Assigning probabilities to these two very different scenarios for the coming decade is not easy. Countries have

many incentives to work together. Yet, there are multiple political hurdles at the domestic level that push countries

away from cooperative efforts. As new information comes into the market about economic trends and political

opinions, whatever our initial probabilities were between the two scenarios, they will be adjusted, dynamically, to the

new information. As one scenario becomes more likely than the other, the expected mean and expected variance of

the combined distribution can change quickly and quite dramatically.9

If we expand this perspective to a variety of nancial exposures, we can also appreciate that the correlation

structure that might be stable within each scenario could be quite different between the two scenarios. And, as

the probabilities shift between the two scenarios, the correlation structure from the combined distribution would

appear as unstable. In short, until one or the other scenario becomes the consensus view, nancial markets are

very likely to encounter periods in which new information triggers rapid shifts in expectations of outcomes, volatility,

and correlation structures, not to mention risk-taking preferences.

We entered this environment in 2008 with the nancial panic. And, instead of seeing a resolution into a consensus

scenario, market participants have been hit by a series of events that involved choices among scenarios that were

strikingly different. There was the Russian ban on exporting wheat in the summer of 2010. There is the stop/start

incremental appreciation policy of the RMB managed by China. The US debt ceiling debacle in the summer of 2011was a choice between a low probability of default and a high probability of compromise. The European sovereign

debt crisis has swayed between a muddle-through scenario and a break-up of the euro and break-down of the

European banking system. The future of the US dollar depends very much on whether central banks and sovereign

wealth funds move aggressively to diversify their portfolios or whether they are content to maintain a majority of

their assets denominated in US dollars. econizin a e sources of dissonance, aen as a pacae, are

creain a sor of dieren coices for are paricipans is a ajor sep oward an appreciaion of e

difculies we face in anain nancial exposures in e Era of Dissonance.

9 The alert reader will perceive that the market expectations process espoused by the author is following the rules of Bayesian inference.

Bayesian methods that adapt to new information are likely to be among those approaches that work better in the Era of Dissonance than more

traditional frequentist statistical approaches, because they learn from their mistakes and can also accept expert information, so are lessdependent on historical data. See New Bayesian Statistical Approaches to Estimating and Evaluating Models of Exchange Rates Determina-

tion, by Bluford H. Putnam and Jose M. Quintana, American Statistical Association, 1994 Proceedings of the Section on Bayesian Statistical

Science, and Multivariate Dynamic Models for Financial Time Series: Is the Whole Greater than the Sum of the Parts, by Jose M. Quintana,

Eric Norland, Bluford H. Putnam, and Janine Shagoury, American Statistical Association, 1997 Proceedings of the Section on Bayesian Statisti-

cal Science, among other articles that illustrate the use of Bayesian learning methods in nancial management.


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. is manaeen allenes

The market implications and risk management challenges from the Era of Dissonance are enormous. Policies are

inherently in conict as opposed to being drawn into coordination as they were in the latter half of the 20th century.

The interaction of nancial exposures within asset classes will be inuenced simultaneously with the different

impacts regarding how asset classes interact among themselves. To gain an understanding of the risk managementchallenges we look to foreign exchange markets as the pivot point for how the different sources of dissonance are

simultaneously reected in a variety of asset classes. We will then focus on the risk-on, risk-off phenomenon, which

is a direct reection of the markets difculties in adjudicating bi-modal distributions of expectations. Finally, we

want to draw some general conclusions concerning the implications for practical risk management in the Era of

Dissonance.

. X mares as e ulcru

The interplay of economic and policy dissonance places currency markets in the forefront as arbiters of market

consequences regarding the different directions in which countries are headed. While the process is simultaneous,

and one could choose any starting point, the analysis of currency markets shows how the effects of economic

and policy dissonance spread outward into other asset classes, from rates, to equities, to energy, metals, and

agriculture.

While other things are never equal, it is useful to run down a selection of how certain economic factors typically

impact currency markets. Then, we can introduce some caveats to show how quickly the analysis becomes

complex.

1. Econoic grow and urrency mares

Lets take long-run growth differentials as an example. Countries with more robust long-run economic growth

potential, ceteris paribus (i.e., everything else being equal), would be expected to be relatively powerful attractorsof capital, to have relatively strong equity markets, and to see their currencies appreciate relative to slower growing

countries. In the cases where the country is dependent on export growth, however, an appreciating currency might

not be considered a positive development by domestic policy makers. They might worry about the rising relative

value of their currency increasing their export prices and slowing down their engine of growth. Countries facing

this quandary might choose to have their central bank intervene in the currency markets to keep the exchange rate

stable. The currency intervention means buying the reserve currency, namely US dollars, and potentially acquiring

a large pile of US dollar assets, usually held in the form of US Treasury bills, notes, and bonds. To quite different

degrees, both China and Brazil have taken this course of action.

China has had faster economic growth than Brazil over the last decade, but has resisted the implied pressure on

its exchange rate, keeping it xed for a long period before allowing small incremental steps in the appreciationprocess.10 The result has been that China has accumulated an enormous quantity of international reserves, about

$3 trillion by IMF estimates.11

10 While the pace of RMB appreciation over the last few years has frustrated US policy makers, the cumulative appreciation of the RMB is now

about 30%, which is a decidedly non-trivial adjustment.11 In their IFS Data Base, the International Monetary Fund tracks countrys international reserves less gold, measured in US dollars. All interna-tional reserve data cited in this report was obtained from this source.


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Brazil has used a mixed policy approach over the last decade. There has been no attempt to x the value of the

Brazilian real to the US dollar, but the central bank has undertaken considerable intervention and accumulated

$300 billion of international reserves (not including gold). Brazil has also introduced rules and regulations

effectively to tax certain types of currency transactions in an effort to contain the appreciation of the Brazilian

real. The use of exchange rate taxes and controls should be considered a step backwards in terms of planning and

property rights.

The accumulation of large hoards of international reserves comes with its own policy quandaries. As the wealth

stored in the international reserves gets larger and larger, there is greater political pressure to manage that wealth

to an investment performance benchmark which typically means diversifying its assets and currency exposures.

This is problematic, however, in that the policy objective of exchange rate stabilization (or leaning against the wind

of currency appreciation) is what results in the accumulation of international reserves, and a policy of diversifying

the currency exposures will undo the currency stabilization efforts. The point at which currency stabilization

policies may become less attractive depends in part on (a) the growth of domestic demand making export growth

less important to the economy and (b) the relative value of the international reserves to the size of the country. For

example, Singapore, a small country with a large accumulation of international reserves, long ago opted for more

currency diversication and chose to manage its currency relative to a basket instead of just the US dollar. China

remains more focused on exports, currently maintaining currency stability against the US dollar, and with a target

currency basket a possible next policy move. Brazil is highly sensitive to the fact that China has surpassed the US

as its largest trading partner, and China links the RMB to the US dollar, doubling down Brazils exposure to the US

dollar.

2. neres aes and urrency mares

Lets take another example, relating exchange rates to interest rates. Exchange rate markets often appear to have

a love/hate relationship with interest rates. In expansionary economic times, market participants are drawn to

owning (being long) the higher interest rate currencies and borrowing (being short) the low interest rate currencies.

At various times in the past decade this showed up as long Australian dollar, short Japanese yen, or long Brazilianreal, short US dollars, and the like. The protability of this carry trade making enough to justify its inherent risks

depends on the assumption that the high interest rate currency will not depreciate against the low interest rate

currency. The viability and robustness of this assumption hinges on many things, not the leas

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2011 11 CME Market Insights Era of Dissonance

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