CFA Economics, Trading with the World, Foreign Exchange & GDP

This is a short summary on some of the Economics readings in CFA Level 2.

Study Session 4

Chapters: 17, 18 & 20 (2010 curriculum)

BOP

Balance of Payment Equation (holds in real world)

Current Account + Capital Account + Official Reserve Account = 0

Capital Account includes principal investment where as Current Account includes income from those investments, goods and services and unilateral transfers (gifts, remittance by immigrants, pension payments, foreign aid, etc)

The official reserve account is to offset

Foreign Exchange Quotations & Notations

Direct Quote = X units of Domestic Currency per unit of Foreign Currency

· e.g. – if you are in Canada, then a direct quote for EUR would be 1.37 CAD/EUR or 1.37 EUR:CAD

Indirect Quote = X units of Foreign Currency per unit of Domestic Currency

· e.g. – if you are in Canada, then an indirect quote for EUR would be 0.73 EUR/CAD or 0.73 CAD:EUR

Base Currency is the currency with one unit

· Direct quote: Foreign currency is the Base Currency (EUR)

· Indirect quote: Domestic currency is the Base Currency (CAD)

FX Notation, Key takeaways

· EUR:CAD = CAD/EUR

For triangular arbitrage using cross rates:

· go Up the Bid and Down the Ask (in CAD/EUR notation)

GDP & GNI

GDP measures goods and services produced within the geographical boundaries of a country (widely used)

GNI measures goods and services produced by citizens of a country

Expenditure based GDP at market prices includes indirect taxes and subsidies whereas GDP at factor prices does not.

GDP Deflator

· is used to adjust nominal GDP for inflation

· can be used a measure of inflation trends

Technical action in Gold does not look good

Gold has declined $100 or 7% at pixel time from its recent all-time high… even when the US Dollar is declining (correlation trade broken?)! I think it is primarily due to rising growth forecast for the global economy (read US economy).

Technically, the charts speaks for itself:

· Medium term trend seems intact on the 1-Year chart

· We are near strong support area at $1325

The 3-year chart, however is more interesting… gold is hanging to dear life with these support points:

· Green long-term trend line

· Green support line

· 100 day moving average

If the long-term trend line is successfully breached, then I think we will test 61.8% Fibonacci retracement of the rise from $700-1425 at about $1150

Economics 101 aside, commodities as a store of value will only go higher in the long-term (> 5yrs) because the only solution to massive public and private sector debts is inflation.

GTA housing market largely followed its seasonal pattern in 2010

Here is the final update for 2010

Monthly Prices followed the seasonal pattern rather religiously!

Source: Toronto Real-Estate Board

Sales was not different, although the overall level of sales (~86k) was less than 2009 & 2007.

Source: Toronto Real-Estate Board

I will admit that through 2010, my housing related posts had an inherent negative bias… I will end the 2010 housing post on a more positive note at least by one measure.

Look at the long-term chart of house price trends in GTA… the 5-year compound average growth rate (CAGR) in GTA house prices is 5.22%… in the long term, this rate should equal the growth rate in the GTA economy, personal income and all other products and services.

Source: Toronto Real-Estate Board

Now I don’t have hard data for GTA economic indicators and I doubt the GTA economy grew by >5% annually in the last 5 years…. BUT consider this: Canada’s economy grew 3.55% annually from 2005-2009 and for the same period, GTA house prices rose 4.16% annually…

Do I still think GTA house prices are over the top, perhaps not so much given that GTA’s economy most likely outpaces the rest of Canada (likely due to increasing immigrants)… yes, there are other factors that affect house prices but in the long run… all growth rates should converge!

Let’s hope 2011 is slower so I can buy a house !

Possible Black Holes to Canadian Outlook

Housing related highlights from BMO’s North American outlook. BMO expects Bank of Canada  to increase rates starting in spring and end the year at 2% from the current 1%

The Good

Canada’s housing market has stabilized.

After slowing from record highs to more normal levels in the summer, existing home sales picked up in the fall, and prices have reclaimed their peaks. Low mortgage rates and rising personal incomes have kept housing reasonably affordable (at least at current rates) for the typical buyer. As long as prices do not outrun incomes in coming years, housing should remain within reach of buyers, reducing the risk of a correction when rates normalize. Still, higher interest rates and possibly stricter mortgage rules in the federal budget should restrain home sales in 2011.

Not so good

Canadian house prices rise sharply.

Witnessing the bust in other housing markets, Canadians should understand that house prices can’t outrun incomes forever. Thus, it would be irrational for buyers to bid prices sharply higher in coming years, especially since prices have already climbed twice as fast as personal income in the past decade.  But irrational doesn’t mean impossible.

Definitely not impossible primarily because:

1. Mortgage rates are still affordable
2. Realtors continue talking up the housing market (Less than 10% of agents I have met think housing will soften)

Canadian household debt mounts.

Canada’s household debt-to-income ratio, though above the current U.S. ratio, is still meaningfully below the peak U.S. ratio in 2007. Still, Canadians could hit a similar debt wall if they can’t resist the lure of cheap money.

Source

Housing Update

I have been meaning to post an update on the Toronto housing market but waiting for TREB to release the December numbers (and annual by extension)… which I think should be out any day now.

2011 curriculum changes from 2010

This post highlights the 2011 curriculum changes (from 2010) and the significance of each change… Kudos to FinQuiz for detailing the CFA Level 2 changes between 2010 and 2011 curriculum.

I have marked the changes as one of the following:

· None – Change is insignificant and you can refer to the 2010 books/notes.

· Low – Change is of low significance and you can may need to refer to the new book

· High – LOS has changed substantially and you need to refer to the new book

· New – New LOS in 2011 curriculum

For the original list of changes from FinQuiz, go here.

For spreadsheet with a significance ‘rating’ of each change, go here:

Inflation… still no chance

Couple months ago I posted a chart on inflation in Canada… even though interest rates have risen since the QE2 announcement, this hasn’t changed inflation expectations dramatically…

Here is the updated long-term chart of inflation expectations as implied by Real-Return bonds…

And here is the above data since the formal QE2 announcement (3-Nov-2010)… the green line is flat implying inflation expectations haven’t changed in Canada…

…although your daily bills (grocery, gas, insurance, etc) have only gone up! How does that add up? Paul Krugman does an excellent job of explaining core inflation (excluding food & energy) vs total inflation.

Update [7-Jan-2010]: Paul Amery at SeekingAlpha talks about (non-existent) inflation expectations globally