Redacted Version of the December 2014 FOMC Statement

Photo Credit: International Monetary Fund

Photo Credit: International Monetary Fund

October 2014December 2014Comments
Information received since the Federal Open Market Committee met in September suggests that economic activity is expanding at a moderate pace.Information received since the Federal Open Market Committee met in October suggests that economic activity is expanding at a moderate pace.No change. This is another overestimate by the FOMC.
Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing.Labor market conditions improved further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.Shades their view of labor use up a little.  More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.No change.

 

Inflation has continued to run below the Committee’s longer-run objective. Market-based measures of inflation compensation have declined somewhat; survey-based measures of longer-term inflation expectations have remained stable.Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices. Market-based measures of inflation compensation have declined somewhat further; survey-based measures of longer-term inflation expectations have remained stable.Shades their forward view of inflation down.  TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.07%, down 0.28% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators moving toward levels the Committee judges consistent with its dual mandate.They are no longer certain that inflation will rise to the levels that they want.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.CPI is at 1.3% now, yoy.  They shade up their view down on inflation’s amount and persistence.
The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program.Sentence removed.
Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month.Sentence removed.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.Moves this sentence lower in the document.
This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.Moves this sentence lower in the document.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.Highly accommodative monetary policy is gone – but a super-low Fed funds rate remains.  Policy normalizes, sort of, but no real change.
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.In other words, we’re on hold until something goes “Boo!”
The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No real change.
However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.Tells us what we already knew.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.Sentences moved from higher in the document.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.

 

Voting against the action wasVoting against the action were Richard W. Fisher, who believed that, while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate;Fisher thinks the economy is healthy enough to take some rate hikes.
Narayana Kocherlakota, who believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to keeping the current target range for the federal funds rate at least until the one-to-two-year ahead inflation outlook has returned to 2 percent and should continue the asset purchase program at its current level.Narayana Kocherlakota, who believed that the Committee’s decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target;

 

 

Kocherlakota wants to create another bubble, along with the rest of the doves.
and Charles I. Plosser, who believed that the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements.Plosser wants to say that a shift has happened, when no shift really has happened in policy.  He also thinks they should avoid the idea that the Fed is waiting to do something, suggesting that tightening could come sooner.

 

Comments

  • Pretty much a nothing-burger. Few significant changes, if any.  The only interesting thing is that they have given up on inflation getting anywhere near 2% for now.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Equities flat and long bonds rise. Commodity prices are flat.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC chops some “dead wood” out of its statement. Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

On Financial Risk Statements, Part 1

Photo Credit: Chris Piascik

Photo Credit: Chris Piascik

Most formal statements on financial risk are useless to their users. Why?

  • They are written in a language that average people and many regulators don’t speak.
  • They often don’t define what they are trying to avoid in any significant way.
  • They don’t give the time horizon(s) associated with their assessments.
  • They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
  • They don’t consider whether history might be a poor guide for their estimates.
  • They don’t consider the conflicting interests and incentives of the parties that direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
  • They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
  • Occasionally, approximations are used where better calculations could be used.  It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
  • Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
  • Where complex math is used, there is no simple language to explain the economic sense of it.
  • They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story.  I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did.  The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into.  It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them.  The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual.  You can’t believe how many people came to us saying, “I get it.”  Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known.  Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not.  It combined the best of both rules and principles, going well beyond the minimum of what was required.  Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

  • Investment prospectuses and reports, and all investment and insurance marketing literature
  • Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
  • Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
  • The reports that sell-side analysts write
  • The analyses that those that provide asset allocation advice put out
  • Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
  • Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Have Your Cake, Eat It Too, And End Up With Only Crumbs

Photo Credit: brett jordan

Photo Credit: brett jordan

Beware when the geniuses show up in finance. “I can make your money work harder!” some may say, and the simple-minded say, “Make the money sweat, man!  We have retirements to fund, and precious little time to do it!”

Those that have read me for a while will know that I am an advocate for simplicity, and against debt.  Why?  The two are related because some of us tend toward overconfidence.  We often overestimate the good the complexity will bring, while underestimating the illiquidity that it will impose on finances.  We overestimate the value of the goods or assets that we buy, particularly if funded by debt that has no obligation to make any payments in the short run, but a vague possibility of immediate repayment.

The topic of the evening is margin loans, and is prompted by Josh Brown’s article here.  Margin loans are a means of borrowing against securities in a brokerage account.  Margin debt can either be for the purpose of buying more securities, or “non-purpose lending,” where the proceeds of the loan are used to buy assets outside of brokerage accounts, or goods, or services.  Josh’s article was about non-purpose lending; this article is applicable to all margin borrowing.

Margin loans seem less burdensome than other types of borrowing because:

  • Interest rates are sometimes low.
  • They are easy to get, if you have liquid securities.
  • They are a quick way of getting cash.
  • There is almost never any scheduled principal repayment or maturity date for the loan.
  • Interest either quietly accrues, or is paid periodically.
  • You don’t have to liquidate securities to get the cash you think you need.
  • There is no taxable event, at least not immediately.
  • Better than second-lien or unsecured debt in most ways.

But, what does a margin loan say about the borrower?

  • He needs money now
  • He doesn’t want to liquidate assets
  • He wants lending terms that are easy in the short run
  • He doesn’t have a lot of liquidity at present.

So what’s the risk? If the ratio of the value of assets in the portfolio versus accrued loan value falls enough, the broker will ask the borrower to either:

  • Pay back some of the loan, or
  • Liquidate some of the assets in the portfolio.

And, if the borrower can’t do that, the broker will liquidate portfolio assets for them to restore the safety of the account for the broker who made the loan.

Now, it’s one thing when there isn’t much margin debt, because the margin debt won’t influence the likelihood or severity of a crisis.  But when there is a lot of margin debt, that’s a problem.  As I like to say, markets abhor free riders.  When there is a lot of liquid/short-dated liabilities financing long-dated assets, it is an unstable situation, inviting, nay, daring the crisis to come.  And come it will, like a heat seeking missile.

Before the margin desks must act, some account holders will manage their own risk, bite the bullet, and sell into a falling market, exacerbating the action.  But when the margin desks act, because asset values have fallen enough, they will mercilessly sell out positions, and force the prices of the assets that they sell lower, lower, lower.

A surfeit of margin debt can turn a low severity crisis into a high severity crisis, both individually and corporately, the same way too much debt applied to housing created the crisis in the housing markets.

I would again encourage you to read Josh’s excellent piece, which includes gems like:

Skeptics from the independent side of the wealth management industry would ask, rhetorically, whether or not most of these loans would be made with such frequency if the advisors themselves were not sharing in the fees. The answer is that, no, of course they wouldn’t.

He is correct that the incentives are perverse for the advisors who receive compensation for encouraging their clients to borrow and take huge risks in the process.  It’s another reason not to take out those loans.

Remember, Wall Street wants easy profits from margin lending.  They don’t care if they encourage you to take too much risk, just as they didn’t care if you borrowed too much to buy housing.

The Free Advice that Embraces Humility

Just say no to margin debt.  Live smaller; enjoy the security of the unlevered life, and be ready for the day when the mass liquidation of margin accounts will offer up the bargains of a lifetime.

If you have margin loans out now, start planning to reduce them (before you have to).  You’ve had a nice bull market, don’t spoil it by staying levered until the bear market comes to make you return your assets to their rightful owners.

Wisdom is almost always on the side of humility, so simplify your life and finances while conditions favor doing so.  If you must borrow, do it in a way where you won’t run much risk of losing control of your finances.

And after all that… enjoy your sleep, even amid crises.

Should Jim Cramer Sell TheStreet or Quit CNBC?

Photo Credit: Penn State

Photo Credit: Penn State

Like my friend Josh Brown does, I often don’t know where I will end when I start writing… I know I have something to say, given my own time writing for RealMoney.com, and now having publicly written on financial matters for over eleven years, with thanks to Jim Cramer, who gave me my start.

Recently, a 9% holder of TheStreet sent a letter to Jim, asking him to either sell off TheStreet in an auction or leave CNBC and rebuild the value of TheStreet.  The Stock rose roughly 7% on the news.  Personally, I don’t think it should have budged.  Here’s why:

1) What is a perpetual money-loser worth?  TheStreet hasn’t earned significant money since 2007.

2) What is TheStreet worth in an auction?  The complainant says:

Despite these improvements TST trades at an enterprise value to 2015 estimated revenues of 1.3. This compares to BC Partners Limited’s acquisition of Mergermarket Group at three times revenue. Morningstar Inc. (“MORN” – $65.97) trades at 3.4 times 2015 consensus revenue estimate. Allegedly, BoardEx competitor Relationship Science recently raised capital at a $300 million valuation compared with its purported $5 million revenue for 2013.

TheStreet is not comparable to these in my opinion.  I’ll use Morningstar as my example: it is a comprehensive site offering a wide amount of data about investments, and relatively light on opinions.  Where it speaks, it is authoritative, and it has a relatively sticky following, making their revenues more valuable than that of TheStreet.  Let’s be real… would you buy TheStreet at the same enterprise value to sales ratio as Morningstar?

3) Selling investment opinions is a very competitive business, with low barriers to entry.  If a party is any good at marketing it, and wants to sell a newsletter, there are a lot of people who will buy, as noted later by the complainant:

We estimate that 41,500 customers pay roughly $350 per annum ($14.5 million in totum) for your newsletters. This is nothing to scoff at but a fraction of the 400,000 to 500,000 subscribers enjoyed, by (we believe) The Motley Fool Stock Advisor and Stansberry & Associates Investment Research – two wildly more profitable competitors which charge similar prices. (We estimate that each of these competitors yield $25 to $45 million of pre-tax earnings for their private owners.) Given the strength of your brand, it both amazes and frustrates that subscriptions to your products are so paltry. Were you to de-couple from CNBC (where you are understandably prohibited from promoting PLUS) I would hope, nay expect, that subscriptions of PLUS would treble.

I don’t like market newsletters generally, but I know there are a lot of people who would rather pay for opinions than money management services.  I often get requests to start a newsletter, but I don’t respect the concept.  My detailed ideas are for my clients; that’s the business that I am in.

Jim’s newsletter has been out for a long time.  Of those that buy newsletters, most would be familiar with Cramer, and know that the newsletter exists.  Even if Cramer came back to TheStreet full-time, I doubt it would get that much more in subscriptions.

4) Also, auctioning off a Cramer-less TheStreet would likely flop.  There would be few if any buyers for a such a company that had lost its main writer.

5) Then there is the complainant’s appeal to Cramer as to his legacy:

You are 59. When you lie upon your deathbed, how will you reflect upon on your legacy? Once a $70 stock, TST is now $2.20. You have done well, but how has the common shareholder done?

I have a little insight here.  A little less than twelve years ago, I was invited by my Merrill coverage to come to an institutional investor conference where Cramer would be the unscripted keynote speaker.  It was a great talk, and at the end of it, as Cramer left, I figured out where I likely needed to be if I wanted a word with him.  Sure enough, he came my way, and I identified myself to him as the guy who had been writing to him on bonds for the past four years.  He remembered me and greeted me warmly.  I told him that I was going to work at a hedge fund.  He congratulated me, and said that it was where all the smart guys were going.  And then he said something to the effect of:

I wish I were still running a hedge fund.  I really loved that.

And at that point, the crowd caught up, and that was the end of my time with him.  But when I got home that night, I sent him an e-mail telling him that life is too short, do what you love.  Go back to the hedge fund and write more occasionally for the rest of us.  His reply was brief as usual, and if my memory is any good it was something like:

Can’t do that.  Gotta get the price of theStreet.com over the IPO price.

Even at the time, that made me blink.  Make the stock rise by more than a factor of 10?  That would be Herculean at minimum.

But, that gives you an insight into Cramer’s mind at one point.  He’s already thought along those lines.  He’s no dummy.  He knows how difficult it would be — and he has pursued that effort for a number of years.  My sense is that he has given up, or maybe something close to that.  The price of TheStreet has been remarkably stable for the past five years, despite all efforts made…

6) But does Cramer have no legacy from TheStreet?  I would argue he does.  He enriched the investment writing world in two ways: he created a bunch of young savvy journalists that occupy many places in the broader investment journalism world, and he encouraged a lot of clever investors to write for him.

We are all better off as a result of both of these, even if the benefits never went to shareholders.  It’s a tough business, and even the best enterprises have a hard time making money at it.

7) Perhaps the complainant needs to be reminded of one of Marty Whitman’s principles on value investing: “Something off the top.”  Control of a company is a valuable thing, and one of the reasons is that a closely-held company does not merely pay the controlling owner dividends, they often receive something off the top.  That is true of Cramer here, with a salary of $3.5 million/year.  Why should he relinquish that?  In his mind, he may think that he has tried to turn it around for years to no avail.  If the company is not likely to ever get back to a significantly higher price, why should he knock himself out on a hopeless mission that he has already tried?

8 ) So, with that, let the complainant contact his fellow shareholders and ask for help.  I’m not sure they will agree with the prescription, though they might like to see some actions taken.  Personally, I can’t get excited about it; I would be inclined to pass, and quietly sell my shares into the current strength generated by the complainant.

Full disclosure: no positions in any companies mentioned here, and as they used to say at TheStreet, I am writing about a microcap stock, so they would typically not allow articles on it without a big warning, if at all.  To make it plain: don’t buy any TST shares as a result of what I wrote here.  Thanks.

Two Notes: Crude Oil & Bonds

Photo Credit: S@Z

Photo Credit: S@Z

I’ve been busier than ever of late — not much time to blog. Thus, a few notes:

1) Often the rate of change in a price can tell you something, particularly if the good in question is widely traded/held by a wide number of parties with different interests.  In this case, I am talking about crude oil prices, and the related set of prices that are cousins.

Overall demand for crude hasn’t shifted, and neither has supply.  Yes, there has been some buildup of inventories, and some key global players refuse to cut production in response to lower prices.  But the sharpness of the price move feels more like some large player(s) who were relying on a higher oil price finally hit their “stop loss” point, and their risk control desk is closing out the trade.

I could be wrong here, but paper barrels of oil trade more rapidly than physical shifts in net demand, and risk control and margin desks will force moves that are non-economic.  Wait.  Surviving is economic, even at the cost of forgoing potential profits.

We’ll see how this shakes out over the next few months.  There’s a lot of pain for pure play producers, and those that aid them.  I particularly wonder at governments that rely on crude exports to support their budgets… they may not cut, but what will they do, if they don’t have reserves?  Cuts will have to come from economic players initially.  It make take a revolt to affect non-economic governmental entities.

All that said, sharp price moves tend to mean-revert, slow moves tend to persist, so be wary of too much bearishness here.

2) An article in yesterday’s Wall Street Journal was entitled Bond Funds Load Up on Cash.  This qualifies for the “Dog Bites Man” award, as it puts forth the conventional wisdom that interest rates must rise soon.

That drum has been banged so frequently that it is wearing out.  We’re not seeing the pickup in lending necessary to convince us that the economy needs higher real interest rates so that more savings would be available to be lent out.

Also, some managers may be running a barbell, holding more cash and long debt, and not so many intermediate securities.  This would be logical, because a barbelled portfolio does better in volatile markets — it’s ready for inflation and deflation, while giving up yield should times remain stable.

All for now.  Maybe when my busy time is done, I’ll write about it.

Lagging Long Yields

yield curve shifts_22703_image001I’m a very intellectually curious person — I could spend most of my time researching investing questions if I had the resources to do that and that alone.  This post at the blog will be a little more wonky than most.  If you don’t like reading about bonds, Fed Policy, etc., you can skip down to the conclusion and read that.

This post stems from an investigation of mine, and two recent articles that made me say, “Okay, time to publish the investigation.”  The investigation in question was over whether yield curves move in parallel shifts or not, thus justifying traditional duration [bond price interest-rate sensitivity] statistics or not.  That answer is complicated, and will be explained below.  Before I go there, here are the two articles that made me decide to publish:

The first article goes over the very basic idea that using ordinary tools like the Fed funds rate, you can’t affect the long end of the yield curve much.  Here’s a quote from Alan Greenspan:

“We wanted to control the federal funds rate, but ran into trouble because long-term rates did not, as they always had previously, respond to the rise in short-term rates,” Greenspan said in an interview last week. He called this a “conundrum” during congressional testimony in 2005.

This is partially true, and belies the type intelligence that a sorcerer’s apprentice has.  The full truth is that long rates have a forecast of short rates baked into them, and reductions in short term interest rates usually cause long-term interest rates to fall, but far less than short rates.  There are practical limits on the shape of the yield curve:

1) Interest rates can’t be negative, at least not very negative, and if they are negative, only with the shortest highest quality debts.

2) It is very difficult to get Treasury yield curves to have a positive slope of more than 4% (30Yr – 1Yr) or 2.5% (10Yr – 2Yr).

3) It is very difficult to get Treasury yield curves to have a negative slope of more than -1.5% (30Yr – 1Yr) or -1% (10Yr – 2Yr) in absolute terms (i.e., it’s hard to get more negative than that).

On points 2 and 3, when the yield curve is at extremes, the real economy and fixed income speculators react, putting pressure on the curve to normalize.

Aside from that, on average how much do longer Treasury yields move when the One-year Treasury yield moves?

MaturitySensitivity
3-year T94.64%
5-year T89.31%
7-year T85.17%
10-year T81.14%
20-year T75.41%
30-year T72.89%

The answer is that the effect gets weaker the longer the bond is, bottoming out at 73% on 30-year Treasuries. But give Greenspan a little credit — in 2005 the 30-year Treasury yield was barely budging as short rates rose 4%.  Then take some of the credit away — markets hate being manipulated, so as the Fed uses the Fed funds rate over a long period of time, it gets less powerful.  In that sense, the Fed and the bond market integrated, as the market began looking past the tightening to the long-term future of US borrowing rates, what happened to short interest rates became less powerful on long yields.  This is particularly true in an era where China was aggressively buying in US debt, and interest rate derivatives allowed some financial institutions to escape the interest rate boundaries to which they were previously subject.

Also note my graph above.  I took the Treasury yield curves since 1953, and used an optimization model to estimate 10 representative curves for monthly changes in the yield curve, and the probability of each one occurring.  If yield curves moving in a parallel direction means the monthly changes at different points in the curve never vary by more than 0.15%, it means that monthly changes in yield curves are parallel roughly 70% of the time.

When do the non-parallel shifts occur?  When monetary policy moves aggressively, long rates lag, leading the yield curve to flatten or invert on tightening, and get very steep with loosening.

Later, the article hems and haws over whether rising long rates would be a good or a bad thing, ending with the idea that the Fed could sell its long Treasury bonds to raise long yields if needed.  That brings me to the second article, which says that long interest rates are at record lows, as measured by average Treasury yields on bonds with 10 years or more to mature.

The graph in the second article shows that it takes a long time for inflation to come back after the economy has been in a strongly deflationary mode, where bad debts have to be eliminated one way or another.  Given the way that monetary policy encouraged the buildup of the bad debts from 1984-2007, it should be little surprise that long rates are still low.

Conclusion

So what should the Fed do?  If they weren’t willing to try a more radical solution, I would tell them to experiment with selling long Treasuries outright, and not telling the market that it was doing so.  The reason for this is that it would allow the Fed to separate out the actual effect of more Treasury supply on yields, versus how much the market might panic when it learns that the long Treasuries might be available for sale.  The second effect would be like Ben Bernanke mentioning the word “taper” without thinking what the effect would be on the forward curve of interest rates.  It would be an expensive experiment, but I think it would show that selling the bonds in small amounts would have little impact, while the fear of a flood would have a big but temporary impact.

If the Fed doesn’t want to raise long rates, it could try moving Fed funds up more quickly.  Historically, long rates would lag more than with a slow rise. (Note: 2004-2007 experience does not validate that idea.)

What do I think the Fed will do?  I think that eventually they will let all long Treasuries and MBS mature on their own, and replace them with short Treasuries, should they decide not to shrink the balance sheet of the financial sector as a whole.  That’s similar to what they did after the 1951 Accord, which restored the Fed’s independence after monetizing some of the debt incurred in WWII.  Maybe this is the way they eliminate the debt monetization now, if they ever do it.

I think the present Fed will delay taking any significant actions until they feel forced to do so.  They have no incentive to take any risk of derailing any recovery, and will live with more inflation should it arrive.

PS — that long rates move more slowly than short rates may mean that duration calculations for longer bonds are overstated relative to shorter bonds.  It might mean that 30-year notes would be 2-3 years shorter relative to one year notes than a parallel shift would indicate.

It’s Their Money

Photo Credit: Richard.Asia

Photo Credit: Richard.Asia

Recently, I had a client leave me.  I’m not sure why he did — I didn’t ask, because that’s his business.  It *is* his money, after all, not mine.  After deducting the accrued fee, I thanked him for his business, and wished him well.

I try to be low pressure in my work.  I also try to discourage the idea that if someone uses my services, they will do better than the average, much less phenomenally.  I remind potential clients of what happened to stocks in the Great Depression (down almost 90% during a period in 1929-1932).  I ask potential clients to stick with me through a full cycle of the market, but I don’t require it because:

It’s their money.

One thing I do promise them is that my money is on the line in the exact same proportion as their money.  Over 90% of my liquid wealth is invested in my stock portfolio.  I don’t make any decisions for clients that I would not make for myself, mostly for ethical reasons.  But I make sure of it, because I am still my largest client, and I am always on the same side of the table as my clients, aside from my one and only source of revenue, my fee.

It’s their money, but, when it is under my care, it gets the close treatment that my own money receives — no more and no less.

Many wealth/asset managers want as much of a client’s assets as possible.  Me?  I get uncomfortable when more than 50% of their assets are riding on me, but if that’s what the client wants, I will do it if they ask, because:

It’s their money.

Jesus, inverting Hillel, said “Do unto others, as you would have them do unto you.”  That guides my marketing, because I know that many people feel pestered by those who market to them, including those who once they have their foot in the door, now want the whole relationship.  Thus I avoid as much pressure as possible in marketing, and leave it to the good judgment of my clients as to how much they want to entrust to my care, and for how long.

It’s their money.

I don’t pretend to have all of the answers, or even all of the questions.  If one of my clients asks me an unrelated question, and I have the time and expertise to aid them as a friend (i.e., you can’t sue me), I will take some time to help.  They may ask me about what other managers are doing for them, asset allocation, insurance policies, and other things also.  I will give them friendly advice, without any other expectation. I thank them that they are a client of mine — I try to end all of my client letters with that.  In the end, I want them to be happy that they chose me to aid them, and to be happy when they leave as well.

That’s the way I would like to be treated as well — low pressure, transparency of services and fees, and alignment of interests with an ethical adviser who is a fiduciary.

Back to the beginning, aside from the client leaving me, the other reason I write this is all of the pitches I have been getting via e-mail, web, radio, etc., where I say to myself “How can they promise that?” “Doesn’t that break the ‘No Testimonials’ rule?” “Great to be selling advice and seminars — why not start an investment business and prove your theories?”

The investment business has more than its share of those who don’t deliver value, and I labor to be on the positive side of that ledger, as do many others.  Choose those who will treat you as you deserve to be treated, and enjoy the benefits, because:

It’s your money.

The No-Lose Line

The No-Lose Line_14068_image001How long can you hold a Treasury Note or Bond, and not suffer a loss in total return terms, if yields rise from where they are today?  Maybe the answer will surprise you, and maybe not — it depends on how fixed-income literate you are.

Okay, here’s the scenario: I start off with the current yield curve for 2-, 5-, 10-, and 30-year Treasuries (0.51%, 1.61%, 2.32% and 3.04%).  I make the following assumptions:

  • Annual Coupon Payment at the end of the year (at the current bond equivalent yield)
  • The bonds are priced at par, so they are current coupon bonds.
  • They are new bonds with the full maturity to go.
  • Each year, the coupon payment is reinvested in bonds of the same type.
  • Each scenario is run until there is one year left to go.  The rate in the last year is the total return earned in the scenario if the notes/bonds pay off.
  • I’m not considering inflation, so these will be real losses if inflation is positive on average.
  • Those that hold don’t need to earn any income, unlike insurers, banks, pension plans and endowments.  We could do the same analysis for them, but the lines would look flatter, because they can’t afford to lose as much.

So, what higher yield rate on the bonds will make the total return zero as the years elapse?  That’s what the above graph shows… so what can we learn from that?

For 5-,10- and 30-year Treasuries, a yield rate near 3.03% will hold the package to roughly a zero total return after 2 years.  After 3 years, that same figure is around 3.74%.

As time elapses, scenarios above the lines would represent losses on a total return basis, and below the line would be gains.  The path itself would matter a little, but the latest position more.  The graph can be used in another way also… if you have an idea of how high you think interest rates will go, you will have a have an idea of how long it would take to break even.  Remember, if the Treasury is “money good,” you get it all back at the maturity of the note/bond.

Or, if you are holding bonds for a little while, if you think the stock market is too high, this can give you an idea on how long to buy the bonds if you don’t want to take losses if you decide to reinvest in stocks.  (Yes, I know… in a hard down market, you will likely be grateful that you held the Treasury notes/bonds.  That is, unless the US Dollar is no longer viewed as a reliable international store of value… and then we will have bigger fish to fry.)

The main lesson: choose your maturity preference with care for slack balances that you don’t want to invest in risk assets… you get more yield as you go longer, but the longer bonds lose money more rapidly for a given rise in interest rates.

Final notes: the lines are a little cockamamie at the end — they aren’t wrong, but the economic scenario producing such a path of interest rates would imply very high inflation or capital scarcity — the latter would tank the stock market as well, at least in the short run, and the former might tank the dollar, or lead to a run in commodities.

Those scenarios are also unusual because they highlight how bond investors investing to a fixed term earn more reinvesting coupon payments in a rising interest rate environment.  At least that is true nominally prior to taxes and inflation, but those are separate issues.

All for now.  Thanks for reading.

Is This Legit?

Photo Credit: .SilentMode || Doubts that the deal is legitimate?

Photo Credit: .SilentMode || Doubts that the deal is legitimate?

I’ve written a lot about financial fraud at Aleph Blog.  I try to encourage people to be skeptical, because it is genuinely rare when a deal is exceptionally good for an average person.  Most of the time in life, you are doing pretty well if you are getting a fair deal, particularly when it comes to financial matters.  Most people selling financial products know more about the product than the prospective buyer.

Thus, Aleph Blog has written about a wide number of deals that are bad, and those that are outright fraudulent.  (At the end of this article, there will be a sample of articles that I have written.)  Not that anyone appointed me, but I regard this as one of my sub-missions, in writing this blog.  Cleaning up the investment world should be a goal of many legitimate investors, because the cleaner things are, the better the culture of trust will be for legitimate financial products.

Now, Aleph Blog does this service on two bases: free and paid.  Free is for the simple stuff.  If you write an e-mail to me asking “Is this legit?” and it is simple enough for me to give a quick answer through a blog post, I will likely (but not certainly) write a post on it, or point you to one I have written.  I may even answer the companion question, “Is it a smart thing to do?”  Most of what I do here will fall into the free category.

The complex stuff is another matter.  I have done analyses like these for prior employers, and on a freelance basis for wealthy individuals and corporations.  Examples have included:

  • Analyzing whether the Permanent Portfolio idea works or not (and other investing theory questions).
  • Analyzing a complex tax avoidance deal that involved insurance, securitization, and other factors.
  • Analyzing whether a private business deal looks legitimate.
  • Analyzing whether a securitization deal looks legitimate.
  • Analyzing complex bonds or other securities for value.
  • Giving a second opinion on an investment question.
  • Giving a second opinion on a new investment product.
  • Giving a second opinion on a financial plan.

I like an occasional complex project because it keeps my skills sharp.  I am a good financial modeler, and though I did not go to the finals the last two years in the Modeloff competition, I placed well in the first round the last two years, and in the second round in 2013 was in the top half, and though I qualified, this year I could not compete in the second round due to a schedule conflict (presbytery meeting).

If a project does not fit my expertise, I will turn it down.  Why waste your time and mine?  If I don’t have slack time, I will turn it down — my investment clients come first.  But if you have an interesting project that you think might fit me, email me, and let’s talk.  I am willing to sign confidentiality agreements, and not publish the results if need be.

Beyond that, let’s make the financial world better, and eliminate as many scams as we can.

Articles

Hey, thanks for reading… ;) and play it safe, please.

 

Book Review: Bad Paper

Bad-Paper-Chasing-Debt-from-Wall-Street-to-the-Underworld-Book-Online

This book has two significant types of insights: on people and on market failure.  It does well with both of them, but spends most of its time on the former, because it is more interesting.  That said, the second set is more important, and is buried in a few places in the second half of the book.

With people, this book answers the following questions:

  • Why does this book largely take place in Buffalo, NY? Because entrepreneurs got started there, and found it easy to acquire talent there.
  • Why does the industry employ a lot of ex-convicts? There are some crossover benefits to having been through the rough-and-tumble of street life that gives an edge in dealing with desperate people who have bad debts.
  • Is there an ethical code for debt collectors? Well, yes, sort of.  Kind of like “the code” from the movie Repo Man – don’t tell debtors they are in legal trouble, don’t threaten, treat them with kindness, don’t buy debt where you don’t have a clear chain of title, don’t sell lists of debts to collect where the debtors have already been verbally flogged.
  • Do all debt collectors follow the code? Well, no, and that is one place where the book gets interesting, as various debt collectors look for edges so that they can make money off of debts that creditors have given up on.  There *is* honor among thieves, and be careful if you cross anyone powerful or desperate enough.
  • Can’t you use the legal system to try to recover money on the debts? Well, only at the end, and even then it is difficult, because if the debtor asks for evidence on the debt that is being collected, the debt collector usually doesn’t have it, and the case will be dismissed.  It is best for collectors to come to settlements out of court.

The book follows around debt collectors and those associated with them, a colorful bunch, who see their see their opportunities flow and ebb as the financial crisis first produces a lot of bad debts to work on, and they mine that ore until the yields get poor.  Some of these people you will gain sympathy for, as they are trying to make a buck ethically.  Others will turn you off with their conduct.

As for market failure issues, you might wonder why the credit card companies and other creditors don’t pursue the debtors themselves.  Why do they sell the right to collect on unsecured debts at such deep discounts to the face value of the debts? [Pennies on the dollar, or less…]

The creditors don’t want to make the effort to dig up the necessary data to make the case in court a slam-dunk.  It would not pay for them to do so in most cases given the large number of cases to pursue, and the relatively small amounts that would be recovered.  That’s why the debts are sold at a discount.

Some debts don’t get removed from databases when payments are made to close them out, and as such some debt collectors try to collect on debts that were once in default, but paid off in a compromise.  This could be remedied if there were a comprehensive database of all debts, but the costs of creating and updating such a database would likely be prohibitive.

Finally, you might ask where the regulators are in all of this.  Between the States and the Feds, they try to clip the worst aspects of debt collection, but they are stretched thin.  This means that for many people, the optimal strategy is not to pay on defaulted unsecured debts, and challenge them if they take you to court.

Quibbles

Lots of foul language, but you’re dealing with the lowest rungs of society, so what do you expect?

Summary / Who Would Benefit from this Book

This is a good book if you want to understand the unsecured debt collection business.  If you have friends who are troubled by debt collectors, it might be worth a purchase, and lend the book to them.  If you still want to buy it, you can buy it here: Bad Paper: Chasing Debt from Wall Street to the Underworld.

Full disclosure: I received a copy from the author’s PR flack.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.