I’m going to try to put in two posts this evening — this one on recent activity, and one on the Fed, to try to address the commentary that my last post generated.
Central Banking in the Forefront
Let’s start with the state of monetary policy. Is it easy or tight? It’s in-between. The monetary base is growing at maybe a 3% rate yoy. The Fed has not done a permanent injection of liquidity in over 3 months. MZM and M2 are around 5%, and my M3 proxy is around 8%. But FOMC policy is compromised by the willingness of foreigners to finance the US Current account deficit, and cheaply too. The increase in foreign holdings of US debt is roughly equal to the increase in M2. That provides a lot of additional stimulus that the Fed can’t undo.
So what have the Central Banks done lately? Barry does a good job of summarizing the actions, all of which are temporary injections of liquidity, together with statements of support for the markets. So why did short-term lending rates to banks spike? My guess is that there were a few institutions that felt the need to shore up their balance sheets by getting some short-term liquidity. I’m a little skeptical of the breadth of this crisis, but if anything begins to make me more concerned, it is that some banks in the Federal Reserve System needed liquidity fast. Also, some banks needed quick liquidity from the unregulated eurodollar markets. But who? Inquiring minds want to know… 😉
So, over at FT Alphaville they wonder, but in a different way. What do central bankers know that we don’t? My usual answer is not much, but I am wondering too. Panicked calls from investment bank CEOs? Timothy Geithner worrying about systemic risk? Maybe, but not showing up in swap spreads, yet. Calls from commercial bankers asking for a little help? Maybe. I don’t know. I wonder whether we’ve really felt enough pain in order to deserve a FOMC cut. We haven’t even had a 10% correction in the market yet. Obviously, But some think we’ve had enough pain. But inflation is higher than the statistics would indicate, and is slowly getting driven higher by higher inflation abroad, some of which is getting transmitted here. Not a fun time to be a central banker, but hey, that’s why they pay them the big money, right? 🙂
Speculation Gone Awry, Models Gone Awry
We can start with a related topic: money market funds. Some hold paper backed by subprime mortgages. With asset backed commercial paper, some conduits are extending the dates that they will repay their obligations. Not good, though ABCP is only a small part of the money markets. Ordinary CP should be okay, even with the current market upset, though I wonder about the hedge funds that were doing leveraged non-prime CP.
In an environment like this, there will be rumors. And more rumors. But many admit to losing a lot of money. Tykhe. Renaissance Technologies. The DWS ABS fund. There are some common threads here. I believe that most hedged strategies (market-neutral) embed both a short volatility bet, and a short liquidity bet, which add up to a short credit spreads bet. In a situation like this, deal arbitrage underperforms. The Merger Fund has lost most of its gains for the year. Part of the reason for losses is deals blowing up, and the rest is a loss of confidence. Could other deals blow up, like ABN Amro? If you want to step up now, spreads are wider than at any point in the last four years, and you can put money to work in size.
More notable, perhaps, are the extreme swings in stock prices. Many market-neutral strategies are underperforming here. (Stock market-neutral does not mean credit market-neutral.) Statistical arbitrage strategies were crowded trades. Truth is, to a first approximation, even though almost all of the quant models were proprietary, they were all pretty similar. Academic research on anomalies is almost freely available to all. Two good quants can bioth start fresh, but they will end up in about the same place.
Last week, I commented how my own stocks were bouncing all over the place. Some up a lot, and some down a lot on no news. Many blame an unwind in statistical arbitrage. Was this a once in every 10,000 years event? I think not. The tails in investing are fat, and when a trade gets crowded, weird things happen. It is possible to over-arbitrage, even as it is possible to overpay for risky debt. As the trade depopulates, prices tend to over-adjust. Are we near the end of the adjustment? I don’t think so, but I can’t prove it. There is too much implicit leverage, and it can’t be unwound in two weeks.
Odds and Ends
Two banking notes: S&P has some concerns about risk in the banking sector, despite risk transfer methods. A problem yes, but limited in size. Second, ARM resets are going to peak over the next year. The pain will get worse in the real estate markets, regardless of what the Fed does.
Insider buying is growing in financial stocks, after the market declines. I like it. My next major investment direction is likely overweighting high quality financials, but the timing and direction are uncertain.
Finally, from the Epicurean Dealmaker (neat blog. cool name too.), how do catastrophic changes occur? I love nonlinear dynamics, i.e., “chaos theory.” I predicted much of what has been happening two years ago at RealMoney, but I stated the the timing was uncertain. It could be next month, it could be a decade at most. The thing is, you can’t tell which straw will break the camel’s back. I like being sharp rather than fuzzy, but I hate making sharp predictions if I know that the probability of my being wrong is high. In those cases, I would rather give a weak signal, than one that could likely be wrong.