Category: Economics

The Governor of the Bank of Canada, Mark Carney, made a speech today. Although the media is reporting otherwise, Carney is still keeping his options open:

Since the spring, the Bank has unwound the last of our exceptional liquidity measures, removed the conditional commitment, and raised the overnight rate to 1 per cent. Following these actions, financial conditions in Canada have tightened modestly but remain exceptionally stimulative. This is consistent with achieving the 2 per cent inflation target in an environment of still significant excess supply in Canada and the demand headwinds described earlier. While Canada’s circumstances and the discipline of the inflation target dictate a different policy stance than in the United States, there are limits to this divergence.

At this time of transition in the global recovery, with risks of a renewed U.S. slowdown, with constraints beginning to bind growth in emerging economies, and with domestic considerations that will slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered. The unusual uncertainty surrounding the outlook warrants caution.

Historically low policy rates, even if appropriate to achieve the inflation target, create their own risks. Aside from monetary policy, Canadian authorities will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing in an environment of still low interest rates and relative price stability.

If you read the context of the rest of the speech, essentially he is saying the economy cannot be solved with monetary policy alone, which is correct.

Also, 3-month banker’s acceptance futures (the proxy for the overnight rate projection) are not moving as a reaction to this speech.

The bond market is pricing in an upcoming deflation. Canadian 10-year benchmark yields are at around 2.8%, which is quite close to the all-time low of 2.55% reached during the pits of the economic crisis in early 2009. Although I stated previously that the next economic cycle will be inflationary, it will only be after certain conditions have been achieved – mainly the willingness of companies and consumers to spend money. Until then (which could be years away), we will not see inflation.

If this is true, then cash is likely to be a good performing asset class, if not the best asset class.

Cash is also the least “sexiest” of asset classes. It is boring. Just imagine trying to tell your colleagues that your investment portfolio is packed full of Canadian dollars. It provides a very low return (about 2%), and no possibility of appreciation. It is ironic that it might be a good asset class by virtue of other asset classes having negative returns.

Investors of government bonds will also be profiting in a deflationary environment because the government will be guaranteeing the payment of the principal – longer durations will result in larger capital gains as yields go down.

Corporate debt and other fixed income securities will fare less well simply because in deflationary environments it becomes more difficult for companies to generate cash. Debt-issuing companies will have to repay debt in nominal dollars that will have higher real value – hence, credit risk becomes a more predominant concern of the pricing of the corporate debt. For companies that have good solvency ratios (e.g. debt-to-equity and/or debt-to-free cash flows are very good), then this becomes less of a concern and corporate debt will then appreciate. But junk debt issues or corporations that are inflation-sensitive (i.e. can’t charge as much to your customers) will not be a safe haven in such an environment.

Deflation really messes with economic intuition and if market participants cannot adapt to it, there will be inefficient pricing in the markets to take advantage of if it does materialize. It would be a virtual guarantee that the Canadian real estate market would get hit badly in an economic deflation, as the prospect of paying off higher-valued debt in the future would crush prices and trump even the low interest rates that would be offered to credit-worthy customers.

I notice that Larry MacDonald has had some issues with the Akismet spam filter, which has been over-zealous in filtering his comments on other people’s websites.

I notice that on this site, he had three comments which I had to fetch out of the spam filter.

Spam is really all about economics – you can produce enough of it for such a low cost that even with a microscopic payback rate, it still is profitable. It does cause a lot of pollution on the internet, but with some Bayesian filtering you can weed out most of it and have an acceptable false positive rate.

Spam is also about game theory – a cat-and-mouse type game. The new game is that spammers are trying to increase their “credibility scores” by making innocent-sounding comments and posts in the hopes that human operators will “approve” them and then they will be able to deliver their payloads more effectively elsewhere.

Akismet has been good at picking up comments like “Like your site, keep up the good work” and other such spam comments that were socially engineered to let site owners keep them on their site. Filtering techniques are quite effective at weeding out these types of comments, such as using the IP address of the comment origin, and the submitted name and/or email address included with the comment.

However, if filtering gets too hyper-aggressive such that it begins to block out legitimate comments (called false-positives), it undermines the entire system.

Imagine a cellular phone network taking 5% of your incoming phone calls and/or text messages and not relaying them to you. You would consider this unacceptable. In the comment world, the acceptable false positive rate is likely higher, but for emails, it has to be one in a thousand in order for the system to be effective.

If spammers are able to increase the false positive rate, it will also be a victory for them since it undermines confidence in the spam detection system.

Unfortunately for Larry, it is likely that Akismet has somehow flagged his online signature as spam. Not sure how that happened, but at least on this site, I have taken three of his comments out of the spam bucket.

The second quarter of 2010 ended today. I noticed there was a lot of trading going on, especially in less-than-liquid issues that tended to trade down. I am guessing there were some liquidations that were part of some window dressing and/or automatic buying/selling for indexing purposes.

In terms of the broader markets, the S&P 500 was down 12.2% for the quarter. The TSX composite was down 6.2%. Spot oil was down 10.0%.

Perhaps the most important broad market financial measure was the 10-year US treasury bond, down from 3.85% at the beginning of the quarter to 2.95% – the market has made a significant deflationary bet over the past three months. The Canadian 10-year bond was down from 3.56% to 3.09% (June 29th data). This decrease in long term interest rates has very interesting implications – banks are parking cash in bonds rather than lending it out.