How Markets Interact, Part 2: Commodities

Commodities are probably the easiest markets to understand. They are comprised of products and materials which are so basic that they generally are bought and sold at one standard price set by the open market. Some examples of commodities are oil, natural gas, gold, silver, corn, wheat, rice and live cattle.

Futures contracts, the means by which commodities are bought and sold, allow buyers and sellers, called hedgers, to lock in future prices. They also allow speculators to attempt to profit from fluctuations in prices. In any event, the prices of commodities are set by this trading in the futures markets.

As I said, commodities are fairly easy to understand. If prices of commodities overall are rising, that is indicative of inflation. Falling commodity prices are indicative of disinflation, or even deflation. Said another way, commodities signal expectation of economic expansion or contraction. If commodity prices are rising, that shows an expectation among investors that demand, hence prices, will be higher in the future. If they are falling, investors are voting that economic contraction is coming. What’s interesting is that this tends to be self-fulfilling. Rises and falls in market prices both signal and help bring about rises and falls in economic activity.

When currencies rise in value, commodities prices tend to fall. This makes sense, because if currencies increase in buying power then the amount of currency needed to buy things, and hence the price of those things, decreases.

In the case of the U.S. dollar, this relationship between currency value and commodity price is often more pronounced. This is most dramatically seen with oil. Since the price of oil is measured internationally in U.S. dollars, when the dollar falls the increase of the price of oil is immediate, and vice versa. As I write this the price of oil is at a multi-month low and the dollar is at a multi-month high. This is no coincidence. When oil prices are rising, most likely the dollar is falling.

Some currencies are called commodity currencies. This means they come from countries whose economy is directly tied to particular commodities, because they major in the production of those commodities. Canada (oil) and Australia (gold) are both examples of commodity currencies. In the case of commodity currency countries, the relationship between the value of the currency and the price of the commodity is direct instead of inverse. Generally speaking, when the prices of their respective commodities rise, so does the value of their respective currencies. This is because instead of buying these commodities, they sell them. So buyers, in order to buy the commodities, must convert their currencies into the exporting country's currency, that is buy the currency. So they buy the currency first, then use it to buy the commodity. This drives the price of both up. Another way to look at it is that the flow of money into the exporting country enriches the country, and so adds value to its currency.

Next up: Bonds.

How Markets Interact, Part 1: Currencies

Have you ever noticed that when the stock market goes up, the dollar goes down? Or when bonds go up, the stock market goes down? Maybe you've noticed that when oil goes up, the dollar goes down.

What’s going on here? Just how do the markets influence each other? In today’s financial markets, just about everything is interconnected.


There are four main markets which trade globally on an almost daily basis. These are stocks, bonds, commodities and currencies.

• Stocks represent part-ownership in companies, like Apple or Google.
• Bonds are IOUs for money loaned to companies, nations or cities.
• Commodities are basic goods with a standard price, like oil, gold or grains.
• Currencies are the money used for exchange in countries or regions, like the U.S. dollar, the European euro or the Swiss franc. 

You may have heard of other markets, like futures or real estate. Futures includes commodities as well as derivatives of the other three markets. Real estate is an important market and does have influence, but it is not an easily tradable, or liquid, market like the main four. For this discussion we'll focus on these main four globally liquid markets.

Currencies

Since finance starts with money, let's start with currencies. Almost all currencies today are "fiat" currencies, which means they have value based solely upon the relative strength of the economy which issues them. Relative is an important word. All currencies values "float" based on their value as compared to other currencies. If you have U.S. dollars and want to buy something from Europe, you must convert your dollars to euros. How many euros you get for your dollars depends on how the two compare in strength at the moment. So a "strong" dollar compared to the euro is good for our imports, because it makes European goods cheaper for us. Then again, a "weak" dollar is good for exports, because it makes it easier for Europeans to buy our goods.

Since currencies are themselves kind of commodity, they are bought and sold on the open market. When the dollar is in demand, its value goes up. Again this makes sense, because the dollar wouldn't be in demand unless people thought it had value; and if it does have value, then that must mean there is some strength in our economy. If there is strength, it makes sense that foreign products should be affordable for us, since that is one thing a strong currency tends to ensure--low inflation.

Why would a certain currency be in demand? Well, if a lot of people want to buy products from a particular country, they need to use its currency. This is how strong exports strengthen the currency of the exporting country. But in the case of the U.S. dollar, there is an added feature. Our dollar is the world's "reserve currency." This means that it is the standard currency for much international trade. For example, oil prices are tracked in U.S dollars. This reserve currency status gives the dollar added demand and strength. This can be good and bad. It can be good because it adds resilience to our economy. It can be bad because it masks real underlying problems in our economy which might have been exposed earlier. This is exactly what is going on now.

Currencies are directly affected by inflation, and they themselves affect inflation. When the dollar goes down, that means inflation is up, because the dollar has lost buying power. So a strong dollar tends to keep prices down, while a weak one tends to do the opposite. When you see the prices of commodities rising, that means the dollar is losing value.

Another way to view inflation is that it is directly influenced by the amount of currency in the market place. If the U.S. Treasury suddenly doubles the amount of dollars in circulation, that will weaken the dollar and increase inflation. This is why the actions of the Fed in increasing the money supply can have a major affect on the future buying power of Americans.

I'll talk more about currencies and inflation in the coming segments.

Next up: Commodities.

It's All About Debt, Part 2

You've probably heard about America's debt problem. (If you read "It's All About Debt, Part 1," you learned a bit about it from me.) But if you are like most people you probably don't know exactly the extent or cause of the problem, what its consequences will be, or what to do about it.

The extent is bad. So bad that we will never repay our debt. We will either attempt to inflate it away or we will default on it. Either option will cause great financial hardship to Americans, but that's the reality of the situation. It's as much a fantasy to believe we will grow ourselves out of this debt as it is to believe it can be endlessly ignored. We don't have the will to cut spending, let alone pay anything back, let alone pay anything back approaching the amount we owe.

Before I say more, it's important to face that our debt problem is not a Democrat or Republican problem. Republicans blaming big-spending Democrats and Democrats blaming tax-cutting Republicans are like two little siblings bickering over who broke their mother's lamp. It misses the point, and may even be designed to miss the point. Both parties have indulged in our national vice of living beyond our means for decades, and we citizens have enjoyed the benefits. But the chickens are coming home to roost, and blaming tax cuts or entitlements in the same old politics-as-usual way is just childish finger-pointing and won't solve anything.

Although balanced budgets are worthy goals, our problems go deeper than that. The United States became the world's biggest debtor nation because almost all our leaders have embraced an economic philosophy that addresses almost all economic problems by deficit spending. In Washington, where politicians never look past the next election, there is now never a good reason not to deficit spend.

Truly, we've reached the point of being like drug addicts. The drug is killing the the addict, but it's the only thing that makes him feel good. Debt has become our drug. Debt has become the only way to forestall the inevitable crash that debt itself is causing. We are trapped in it. They don't call it a vice for nothing.

Another factor is that we have gone from being a productive nation to being a consumptive nation--from having net exports to having net imports; or, said another way, from having a trade surplus to having a trade deficit. When a country imports more than it exports, it must make up the difference by exporting money. When it doesn't have the money it must borrow it. That's exactly what we do.

Borrowing money is not all bad when you borrow to invest to become more productive. But we don't do that. We borrow to consume. Consumption is not bad; in fact, it's the ultimate point of production. But if you consume more than you produce you are digging yourself into a hole. That's exactly what we are doing. Politicians like consumption, though, because it gives the appearance of economic vitality, that is until the bottom falls out. 

So who are we borrowing from? More and more it's not from American investors, but from foreigners--first and foremost China. Basically China is buying us. They loan us money by buying our bonds, we blow the money on non-productive consumption, keeping our "standard of living" high. We are like a family that eats out every night, charges the bill to our credits cards, with no intention of ever paying the balance. 

So what should we do? The way to begin answering that is to say we will get a major economic recession one way or the other. We can put it off with more borrowing, but that will just make the inevitable crash and hangover worse. So what we must do is severely restrict our borrowing. This will force us to stop spending so much, and will likely force us to restructure, or default on, most of our debt. The status and living standards of America will be significantly reduced, but at least we will give future generations a chance to climb out of a shallower hole.

AIG, Bear Stearns Pay Off Government Loans with Interest

Remember AIG, the insurance company which became the credit crisis' poster child for "Too Big to Fail?" Well, apparently they have paid off all their government loans, with interest.

Bear Stearns, another big casualty of the credit meltdown of 2008, also repaid all its loans.

This is good news for taxpayers, though I don't know all the details.

"The repayment of loans by AIG represents a turnaround for an insurance company that many had given up for dead during and even after the financial crisis. The insurance company has slimmed down its operations, closed down many of its loss-making divisions and has been profitable for two years."

It’s All About Debt, Part 1

What in the world is going on with the world’s economies? After a twenty-year stock market boom, we had the tech bubble and crash in 2000. Then there was the housing bubble and crash in 2008, followed by the credit crisis. Now Europe seems to be going down the tubes. Markets rally, then crash. The days of steadily rising 401ks seem to be over. What’s going on?

In short, debt is what’s going on--not only personal debt, but even more importantly government debt. This is not just a typical economic slump. Nations all over the world are drowning in debt and this has created a situation which cannot be solved in the typical way--because the typical way governments address economic problems is by taking on more debt. It's not hard to understand that you can't solve a debt problem by borrowing more.

So how did we arrive at this place?

A Very Short History of Economics

Economics refers to how societies distribute limited resources. This distribution is largely done by trade, and people have developed sophisticated ways to do this. Money was invented to make trading more convenient. In a sense, money is now the problem, because although money was once measured and distributed as things that had real value (e.g., salt, silver, gold), or that at least were backed by something else that had real value (e.g., gold certificates), now money is simply created out of thin air and is “backed” only by the belief that others will honor it. This is called fiat money, and it is the way of the world now.

Fiat money is created by central banks. Almost all nations now have some kind of central banking system. The United States central bank is called the Federal Reserve, or just the Fed. The Federal Reserve has the power to literally create money out of thin air. You may have heard of the “quantitative easing.” That is simply the Fed creating money and distributing it to banks with the hopes of stimulating the economy.

Years ago, an economist named John Maynard Keynes came up with the theory that government borrowing and spending and creating money out of thin air was actually good for a nation's economy, because it could help smooth out economic rough patches. Most leaders over time have assumed this attitude, mostly because it makes their short-term goals of getting re-elected easier. People have come to think it's primarily the government's responsibility to ensure prosperity. Politicians don't mind this because it allows them to take credit for good times and blame their opponents for bad times. Voters mostly just tend to back whomever's ideas seem to be working at the moment. Everything has become about the short term.

That, as Yoda said, leads to the dark side. Once a central banking system and fiat money are in place, the restraints on leaders to make wise long-term economic choices are greatly reduced, and the incentives to make convenient short-term choices are greatly increased. If you were a political leader and all you had to do to stimulate the economy right before an election was to borrow and spend money, what would motivate you--the long-term effects of debt or the election? This, in a nutshell, is the world’s problem.

So the world has gotten itself into a situation where it’s just too easy for governments to borrow money they don’t have (and which often really doesn’t even exist!). Some pundits are screaming that we need to borrow and create even more money. People in general wonder if this process is really so bad, since it seems to have worked for so long.

The answer is as long as investors are willing to buy debt with hope of future profit the day of reckoning will be pushed into the future. Although we will see signs of it approaching; that’s what all these bubbles and crashes have been. But if we continue on the path we are on, investors will at some point refuse to buy our debt, and the real day of reckoning will arrive. And when it does, the medicine we will have to take then will taste a lot worse than the medicine we could take now.

More in Part 2...

It's All About Risk

Why is investing so hard?  Why is it so difficult to know how any investment will perform?

The answer is simple: Investors and traders are paid, if they are paid at all, for assuming risk, and risk precisely means that you don't know what is going to happen. Investors and traders perform a service to society by providing money for potentially productive projects and thereby absorbing financial risk. For their services they are offered only the potential for profits. Their risk is the possibility of not getting paid, or of even losing money.

Risk by definition means you don't know what is going to happen. If you knew what an investment was going to do, then there would be no risk, so there would be no reason to expect payment. Riskier investments offer to pay more precisely because their outcomes are more uncertain. The dumbest investment is one that is very risky but doesn't pay much, like going on Wipeout for $500.

But if you don't know what is going to happen, why make an investment? The answer is because you have determined that the probabilities are in your favor. Note: Probabilities, not certainties. So that means the key to investing and trading is learning how to handle risk, not pretending you know for sure what the outcome of the investment will be. The former is doable, the latter is impossible.

To handle risk you must define risk. That is you must consider the probabilities and decide how much you are willing risk to find out if a certain idea works out. Most investors and traders don't do this. They just throw their hat full of money in the ring and hope for the best, with no plan for what to do if the investment doesn't work out. This usually means they lose more money than they vaguely planned to lose, precisely because their plans were vague.

You can't know for sure what any investment idea is going to do. But you can plan for what you will do when it does whatever it does. You should always have a plan for what you will do when it works and when it doesn't.

All success in life is based on taking some kind of risk. Nowhere is this more true than in the financial markets. Never forget that there you are being paid to assume risk, which means risk will always be a factor. The key then is to research the probabilities, define beforehand what you are willing to risk, design an action plan for all outcomes, and, only then, take on the risk.

Four-Minute Finance Debut

You may have heard that most people put more thought into buying a $1000 refrigerator that into investing their $100,000 retirement account. This may be true. But if it is, I don't think it's because people are reckless. I think it's just that the subject of finance overwhelms them.

Of all the subjects that directly affect our lives, finance, investing, markets and economics are probably the most confusing. We hear that the trade deficit is up, or the dollar is down, but we don't know if those are good or bad. Is it time to buy a house, or time to sell one?  Should I invest my retirement account in stocks or bonds, or get into cash? Why do stocks and bonds go up together, and why do they sometimes go in opposite directions? No wonder most people just throw up their hands and hope for the best.

To make matters worse, even though finance offers a hope of wealth, it is, to most people, boring. Economics has been called "the dismal science." But I don't think these subjects are so much boring as they are just hard to understand. People simply don't know where to begin. In addition, some of the seemingly best financial analysis can just turn out to be flat wrong. And there is so much disagreement. It's easier to predict the weather than the future conditions of economies and markets.

In fairness, prediction is hard. As I'll explain in my next post, the best you can do is go with probabilities. But before you can do that, you have to have some sense of how things actually work. 

Finally, people just don't have a lot of time to devote to learning this subject. They'd rather spend time on things they have some hope of predicting or understanding, like the NBA playoffs or American Idol. So I came up with the idea of writing short blog posts which explain some things about our economic world in quick, readable, and hopefully interesting ways. In doing so, I'll learn more, have some fun writing, and maybe help a few people along the way.