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What is Goodhart's law

When everyone is looking at something, it changes In quantum physics, the observer effect is the theory that simply  observing a situation or phenomenon necessarily changes that phenomenon. Economics has something similar, called Goodhart's law. It's named after British economist Charles Goodhart who observed that when a measure becomes a target, it ceases to be a good measure. The issue is that once everyone is watching a measure or a target and knows what it means, then the observers anticipate the effects and adjust for the outcome, thus changing the effect. The idea is prescient because of the market's intense focus on the yield curve inversion. When longer-dated yields fall below shorter-dated yields, it's a classic recessionary signal. Intuitively it makes sense because it signals a situation where people would rather have long-term safety than earn more yield in the near-term. Its effectiveness as a predictor of recessions is undoubtedly excellent but whether the curve is inverted is always a matter of interpretation. Surely 10-year yields falling below 3-month bill yields is an inversion but is 5-year yields falling below 2-year yields as strong of a signal? More importantly, does Goodhart's law apply? If all market participants believe it's a sure sign of a recession, then they will surely behave differently than they would otherwise. Similarly, central bankers are also watching the yield curve more closely than ever and as the curve approaches inversion, they may react. Taken to a further extreme, you may have central banker who actively target the entire yield curve in the belief that so long as the curve is steep, a recession can't occur. The idea of Goodhart's law is that any statistical relationship will break down when used for policy purposes. This is frequently seen in regulation and even in the workplace. Whenever targets are set, people find ways to game and abuse them, and so do broad markets and the economy. ForexLive

Here's what a recession really looks like

It's not that bad I posted a part of this chart earlier but here's a longer version. It shows Canadian GDP for the past 50 years. It's similar in most of the world. It's beautiful chart going from the lower left to the upper right with some tiny dips. I feel like the perception of growth is something far different. I don't know if it's the scars of the crisis or the experience of a few outliers like Italy and Spain but the reality is that recessions are bumps in the road. Yes, for some people who lose jobs/careers it's heartbreaking but as investors we see recessions as these mythical dragons to be feared but they're more mosquito than monster.     As investors and traders, recessions are incredible opportunities to find mis-priced markets and if you have a longer view and a steady hand then your path -- like this chart -- will be higher.

How the Bank of England got its nickname

The Old Lady of Threadneedle Street The Bank of England has been at the same location in the hear of the City of London since 1734. The stone complex fills an entire block with its entrance on Threadneedle St. It's nickname came from this 1797 James Gillray cartoon that shows the Prime Minister -- William Pitt the Younger -- trying to get the central bank's gold as part of the protest against paper money. The BOE is not the world's oldest central bank, that title is held by Sweden's Riksbank, which was established in 1668. The Bank of England also holds the world's second-largest gold vault after the New York Fed holding about 400,000 bars worth more than GBP100 billion. The UK central bank has a rich history and Mark Carney is the 121st governor as part of one of the great banking legacies. However, despite the nickname, no woman has ever led the Old Lady. Bloomberg has more on the history and if you're ever in London -- like for the 2018 Finance Magnates London Summit --  the BOE has a free museum that's worth a quick trip.    

China's foreign minister has no idea how the yuan exchange rate is set. Do you?

Yesterday a China foreign ministry spokesman said "The exchange rate of China's RMB is determined by the market. There are ups and downs. It's a two-way float" Wrong. Each day the People's Bank of China set a 'reference rate' and allows the market to trade the rate plus or minus two percent from that rate. So, no, not a free float at all. The end.  - There is a 'pirate' currency that can trade at whatever rate you like, the offshore yuan, CNH.  So there is that. Stay tuned for today's RMB onshore mid rate setting, it hits just after 0115GMT and ForexLive reports it each day. Oh, while we're on the foreign ministry comments, the spokesman also said China is not engaged in a currency war,  China is not trying to boost exports through competitive devaluationChina's economic fundamentals are sound I'll leave it up to you to decide if that is more b/s or not. 

The 'second demographic transition' might be the greatest long-term threat to markets

Where have all the children gone? In the long-term, the answer to every question is demographics. Changing ages and populations determine an enormous portion of which companies and countries will be successful. At the same time, they're one of those things that moves so slowly that we rarely stop to consider them. So the new buzzword/thing that people who talk about demographics are talking about is the 'second demographic transition', which immediately begs the question: What was the first demographic transition? It is the shift from high birth rates to low birth rates as mortality rates fall. It's consistent globally and is marked by the shift away from very large families. It came with a lag in places where mortality rates fall, usually due to improvements in medicine. The first demographic transition was initially thought to be the only demographic transition. The belief was that birth rates would level off around replacement at 2.1 per woman. That hasn't happened. Instead, in most of the richest countries -- particularly the more-secular ones -- rates have fallen below that and in some cases, far below. The United States and UK are at 1.8, Canada is at 1.6. Italy is at 1.4, Denmark at 1.7, Germany at 1.4, Japan at 1.4, South Korea at 1.2 and China at 1.6 as of 2016. The inclination is to believe that lesser-developed countries are still growing rapidly but that's not the case. Brazil is at 1.9 and all of Latam at 2.1, the Middle East and North Africa at 2.8 with the only truly high birth rate in sub-Saharan Africa at 4.8, which is about where the US was in the 1950s. The world is at 2.4 and falling. The average woman is having half as many children as their mother. This is the second demographic transition. You might be tempted to think this is a good thing because since Malthus more than 200 years ago, humanity has been fretting about overpopulation. Like all things in markets: When everyone piles into one side of the trade, it's the other one that wins out. Why is it a problem for markets? I would conservatively estimate that half of corporate profits over the past 50 years have been due to a growing population and the rise of the middle class in emerging markets. All companies ultimately make things for people and if there are fewer people, there will be fewer profits. Debt is a bit more complicated. In theory, the remaining people should be richer per capita than their parents and the excess savings will allow them to be creditors, which would make for a strong market for increasingly indebted countries, especially in an environment of falling stock prices due to lower profits. However, higher per capital wealth isn't a given. Take housing. Even in an environment with a small surplus of housing, prices quickly fall. A house with no one to live in it isn't even worthless -- it's a ongoing cost due to property taxes. So if you bring housing values down to construction costs, that is a massive drag on per capita wealth. What most countries have been relying on is immigration. It's the easiest way to supplement a declining population but I expect the glory days of immigration to the developed world are behind us. Rising wealth and living standards are helping to keep people at home, net migration in India and Brazil in 2017 was flat.  That likely means a future where countries compete for more aggressively immigrants or they lower standards, which could backfire into more pressure to close borders. Even the staunchest pro-immigration policymaker will admit that a doctor from India is more likely to make a positive contribution than someone who can't read.  Another option, and this is already underway, are government incentives to have children. France might be the best example of this. It has a strong social safety net and recognized the problems of a declining birth rate early on and is Europe's most-fertile country. Benefits include long maternity leaves, cash allowances and subsidized daycare and spending in the EU ranges from 2-4% of GDP. These policies have helped but even countries with the most-generous programs aren't particularly close to 2.1. France in 2018 fell to 1.88 in 2017 in a steady slide from 2.0 in 2014. Even more frightening is the cultural change in views about having children -- the way we think about the purpose and meaning of children. Historically, they were critical to replenishing the tribe. They were labour, a way to honour God, and perpetuate the family name -- a necessity. Now they're a lifestyle choice increasingly seen as a sacrifice and a commitment that's growth from 13 years to 18 years to 25 years and beyond.  As for what the future holds , your guess is as good as mine.

The output gap is like a lot of things in economics: It works in theory

Don't mind the gap The Bank of Canada was talking about the output gap way before it was popular. It's been the central bank's guiding light for years. A report the BOC released Friday shows they might be having second thoughts. The output gap is a simple concept. An economy has a speed limit -- an amount it can grow before sparking inflation. The gap is how much below the speed limit the economy is operating. If there is a big gap, like there was after the crisis, then you can stimulate an economy for years before it gathers enough speed to test the limit. It all makes perfect sense. The problem, as the BOC outlines, is that the output "is unobservable and highly uncertain". Essentially, you don't know what the speed limit is. And if productivity improves, the speed limit moves higher. There are all kinds of ways to estimate the output gap but the new study from the BOC suggests they're not very at forecasting when inflation will appear. "We find that most output gap estimates do not appear to add much information to simple models with lags of inflation in forecasting total CPI inflation and CPI-median," the study says. More importantly, they found that using real-time data did little to understand the output gap and what it meant for inflation. Ultimately, this report should once again humble central bankers. In a globalized world it's even more difficult to predict or observe when an economy is running at full capacity. It all begs a different question: Instead of having an inflation target, maybe central banks should have a wage inflation target?

If unconventional tools are used as a substitute for rate hikes, how does FX respond?

How unconventional tightening works Its via HSBC, titled 'FX and yield curve', and the broad 'rules of thumb' are summarised below: The market is increasingly fixated on the prospect of unconventional tightening. In the US the focus is on a reduction of the Fed balance sheet and in Europe there is an expectation of a tapered rate of bond buying by the ECB. In a normal tightening cycle, hikes in policy rates would lead to an increase in short-term interest rates and this has typically led to a stronger currency. The FX market understands this process well. However, if unconventional tools are used as a substitute for rate hikes, how do we deal with this in the FX market? Unconventional policy measures may change the shape of the yield curve as much as they change the level of rates. So to answer this question we need to measure how changes in both the level and shape of the curve influence exchange rates. Rules of thumb We have modelled the relationship between changes in swap rates and FX returns. We note the following rules of thumb: Not surprisingly, higher rates are associated with a stronger currency.Once we have accounted for the change in the overall level of rates, a steepening curve is associated with a weaker currency.When both the level and the slope of the curve change, the change in the overall level of rates is the most important variable. These rules of thumb can help you to translate your views about interest rates into the FX space. Model behaviour In addition to the broad rules of thumb above, two other notable results will be helpful to those of you building formal models: It is not just the interest rate differential which matters. In the FX market it is common simply to compare the FX return to changes in an interest rate differential. However, we find that this approach can miss important information and suggest that it is better to consider rates from both currencies as separate variables, rather than simply the differential.The model parameters change over time. The sensitivity of FX to rates changes over time. This means that model parameters must be frequently updated to prevent them becoming stale. - Some food for weekend thought there

Why FX intervention is far more rare than rumors about intervention

Why central banks rarely intervene in FX From time-to-time I see questions/comments on why central banks don't intervene to push currencies where they want them, instead of just talking about valuations etc. A lesson to draw from Chinese FX reserves is that intervention costs money ... for example, in order to support the yuan (i.e. they are slowing its fall, that's pretty much all) the People's Bank of China is buying CNY and selling USD (or other currencies as the case may be).  As you can see by the level of China's foreign currency reserves, its not as if the PBOC is short of a bit of FX cash to splash if they wish, but that's not the point, intervention does have a price. China can afford it. Not all countries are in the same flush position. Central banks from other countries don't have quite the level of reserves to play with. As an example, the Reserve Bank of New Zealand do intervene from time-to-time, but they have much smaller reserves to play with. The RBNZ has a 'traffic light' system guiding the timing, trying to be effective and get the most bang from their (foreign) buck. I've posted on it before, here (and there are other links at that post to more if you are interested). While this guide is specific to the RBNZ its not too much of a stretch to say other reserve-challenged central banks have a similar approach.

Five economic terms to learn for the new era

If you want to walk the walk, gotta talk the talk Bloomberg's Noah Smith is out with a great little list of five economic terms to learn this year: Endogeneity, Marginal versus average, Present value and discounting, Conditional versus unconditional and Aggregate. We try not to nerd out too much here but Smith's explanations are clear and accessible. "Another good example is debt. Individually, borrowing and spending money reduces your wealth. But in aggregate, debt doesn't reduce the value of the whole world's wealth, since one person's debt is another person's asset. When we consider our own lives, it makes sense to think from an individual perspective, but when we discuss government policy, it's important to think in the aggregate." Read it here


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