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Archive for December, 2009

Nine Notes and Comments

Thursday, December 31st, 2009

As I roll through the day, i often make comments on the blogs and websites of others.  I suppose I could gang them up, and post them here only.  I don’t do that.  Other sites deserve good comments.  Today, though, I reprint them here, with a little more commentary.

1) First, I want to thank a commenter at my own blog, Ryan, who brought this article to my attention.  I’ve written about all of the issues he has, but he has integrated them better.  It is a long read at 74 pages, but in my opinion, if you have 90 minutes to burn, worth it.  I will be commenting on the ideas of this article in the future.

2) My commentary on Dr. Shiller’s idea on Trills drew positive attention, but the best part was being quoted at The Economist’s blog.

3) Tom Petruno at the LA Times Money & Company blog is underappreciated.  He writes well.  But when he wrote Fannie and Freddie shares soar, but for no good reason.  I wrote the following:

From my comments to my report on financials yesterday —Federal Home Loan Mortgage Corp [FRE] and Federal National Mortgage Assn [FNM] Rise as U.S. Removes Caps on Assistance — this gives the GSE stocks more time, and hence optionality. I still think they will be zeroes in the end, but there will be a lot of kicking and screaming to get there. The government is engaged in a failing strategy to reflate the housing bubble, and they aren’t dead yet.

I write a daily piece on financials for my company’s clients.  The stock of the GSEs rose because the odds of them digging out of the hole increased.  You can’t dig out of the hole if you are dead, so when you are near that boundary, even small changes in the distance from death can affect sensitive variables lke the stock price.  Plus, the odds rise that the US will do something really dumb, like convert theor preferred shares to common.

4) Kid Dynamite put up a good post on CDOs, I commented:

KD, maybe we should play chess sometime. Spotting a queen and rook is huge. I have beaten Experts, though not Masters on occasion (except in multiple exhibitions), and I can’t imagine losing to anyone who has spotted me a rook and queen.

All that said, I never gamble, and as an actuary, I know the odds of most games that I play.

Now, all of that said, I never cease to be amazed at all of the dross I receive in terms of ideas that look good initially, but are lousy after one digs deep.

Good post. Makes me wonder how I would have done in the same interview. Quants need to have a greater consideration of qualitative data. When I was younger, I didn’t get that.

5) Then again, Yves Smith comments on a similar issue at her blog.  My comment:

I’m sorry, but I think jck is right. The risk factors were clearly disclosed. Buyers should have known that they were taking the opposite side of the trade from Goldman.

As I sometimes say to my kids, “You can win often if you get to choose your competition,” and, “Winning in investing comes from avoiding mistakes, not making amazing wins.”

As a bond manager, I was offered all manner of amazing derivative instruments. I turned most of them down. Most people/managers don’t read the prospectus, but only the term sheet. Not reading the prospectus is not doing due diligence.

Since we are on the topic of Goldman Sachs, in 1994, an actuary from Goldman came to meet me at the mutual life insurer where I worked. I wanted to write floating rate GICs which were in hot demand, and all of my methods for doing it were too risky for me and the firm.

Goldman offered a derivative instrument that would allow me to not take too risky of an investment strategy, and credit an acceptable rate on the GIC. So, as I read through the terms at our meeting, a thought occurred to me, and so I asked, “What happens to this if the yield curve inverts?”

He answered forthrightly, “It blows up. That’s the worst environment for these instruments.” Now, if you read the docs, it was there, and when asked, he told the truth. The information was not up front and volunteered orally.

But that’s true of almost all financial disclosures. You have to read the fine print.

As for the derivative instruments, in early 2005, many large financial institutions took billion dollar writedowns. All of my potential competitors in the floating rate GIC market left the market. I went back to buyers, and offered the idea that I could sell them the GICs at a lower spread, which would give them a decent return, but with adequate safety for my firm. All refused. They basically said that they would wait for the day when the willingness to take risk would return.

And it did, until the next blowup in 1998 around LTCM.

My lesson: the craze for yield drives many derivative trades. What cannot be achieved with normal leverage and credit risk gets attempted, and blows up during hard times.

Structure risks are significant; the give up in liquidity is significant. The big guys who play in these waters traded away liquidity too cheaply, and now they are paying for it.

=-=-=-=-=–=-==-=-Whoops, where I said 2005, I meant 1995. That loss I avoided for the firm was one of my best moves there, but we don’t get rewarded for avoiding losses.


6) Then we have CFO.com.  The editor there said they want to publish my comment in their next magazine.  Nice!  Here is the article.  Here is my comment:


Time Horizon is Critical
Yes, Wheeler did a good job, as did MetLife, including their bright Chief Investment Officer.

What I would like to add is the the insurance industry generally did a good job regarding the financial crisis, excluding AIG, the financial guarantors, and the mortgage insurers.

Why did the insurance industry do well? 1) They avoided complex investments with embedded credit leverage. They did not trust the concept that a securitized or guaranteed AAA was the same as a native AAA. Even a native AAA like GE Capital many insurers knew to avoid, because the materially higher spread indicated high risk.

2) They focused on the long term. The housing bubble was easy to see with long-term perception — where one does stress tests, and looks at the long term likelihood of loss, rather than risk measures that derive from short-term price changes. Actuarial risk analysis beats financial risk analysis in the long run.

3) The state insurance regulators did a better job than the Federal banking regulators — the state regulators did not get captured by those that they regulated, and were more natively risk averse, which is the way regulators should be.

4) Having long term funding, rather than short term funding is critical to surviving crises. The banks were only prepared to maximize ROE during fair weather.

I know of some banks that prepared for the crisis, but they were an extreme minority, and regarded by their peers as curmudgeonly. I write this to give credit to the insurance industry that I used to for, and still analyze. By and large, you all did a good job maneuvering through the crisis so far. Keep it up.

7) Then we have Evan Newmark, who is a real piece of work, and I mean that mostly positively.  His article:  My comment:

Good job, Evan. I don’t do predictions, except at extremes, but what you have written seems likely to happen — at least it fits with the recent past.

But S&P 1300? 15% up? Wow, hope it is not all due to inflation. ;)

8 ) Felix Salmon.  Bright guy.  Prolific.  His article on residential mortgage servicers.  My response:

Hi Felix, here’s my two cents:

I think the servicers are incompetent, not evil, though some of the actions of their employees are evil. Why?

RMBS servicing was designed to fail in an environment like this. They were paid a low percentage on the assets, adequate to service payments, but not payments and defaults above a 0.10% threshold.

Contrast CMBS servicing, in which the servicer kicks dud loans over to the special servicer who gets a much higher charge (over 1%/yr) on the loans that he works out. He can be directed by the junior certificateholder (usually one of the originators) on whether to modify or foreclose, but generally, these parties are expert at workouts, and tend to conserve value. The higher cost of this arrangement comes out of the interest paid to the junior certificateholder. Pretty equitable.

Here’s my easy solution to the RMBS problem, then. Mimic the CMBS structure for special servicing. An RMBS special servicer would have to be paid a higher percentage on assets than a CMBS special servicer, because he would deal with a lot of small loans. The pain of an arrangement like this would get delivered where it deserves to go: to those who took too much risk, and bought the riskiest currently surviving portions of the RMBS deal.

The underfunded RMBS servicers may be doing the best they can. They certainly aren’t making a bundle off this. As a former mortgage bond manager, I always found the RMBS structures to be weaker than the CMBS structures, and wondered what would happen if a crisis ever hit. Now we know.

9) But then Felix again through the back door of Bronte Capital.  My comments:

I don’t short. Short selling is socially productive though. Here is how:

1) Sniffs out bad management teams.

2) Sniffs out bad accounting.

3) Adds liquidity.

4) Defrays the costs of the margin account for retail investors. Institutional longs get a rebate. Securities lending programs provide real money to long term investors, with additional fun because when you want to sell, you can move the securities to the cash account if the borrow is tight, have a short squeeze, and sell even higher.

5) Provides useful data for longs who don’t short. (High short interest ratio is a yellow flag in the long run, leaving aside short squeeze games.)

6) Allows for paired trades.

7) Useful in deal arbitrage for those who want to take and eliminate risk.

8) Other market neutral trading is enabled.

9) Lowers implied volatility on put options. (and call options)

10) And more, see:

http://alephblog.com/2008/09/19/governme nt-policy-created-too-hastily/Short selling is a good thing, and useful to society, as long as a hard locate is enforced.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

That is what my commentary elsewhere is like.  I haven’t published it here in the past, and am not likely to do it in the future, but I write a lot.  Amid the chaos and economic destruction of the present, the actions are certainly amazing, but consistent with the greed that is ordinary to man.

One Dozen or so Books on Economics

Wednesday, December 30th, 2009

One reader asked me:  David do you have a Top 10 book list on Economic Theory for beginners? Just finished “The Myth of the Rational Market” and loved it. But I don’t know what to read next. Or let me ask the question another way, should I start with reading books on Austrian economics? Hayek? Misses? Fisher?

I do want to give a list of economics books that I have read that I have found useful.  I am an odd duck here, because I have been schooled in the neoclassical theories, and I have largely rejected them.  Men, and the institutions of men are more complex than that.

Here’s my dirty secret.  Yes, read the Austrian economists, but I have not read any of them.  I have come to their conclusions on my own, but my views have also been influenced by Minsky and the Santa Fe Institute.  I view economics as ecology.

All that said, here is a list of economics books that I think are valuable, that I have read:

1) Manias, Panics and Crashes, by Kindleberger. Kindleberger explains how crises come into existence in a systematic way.

2) Devil Take the Hindmost, by Chancellor.  Chancellor describes the history of crises, and gives significant background data regarding economic crises.

3) The Alchemy of Finance, by Soros.  Explains why men are not rational as the neoclassical economists think.  Explains nonlinear dynamics — reflexivity, as he calls it.

4) A History of Interest Rates, by Homer.   Detailed studies of how interest has played a role in our world again and again, even as idealists attempt to limit or eliminate it.

5) The Volatility Machine, by Pettis.  Explains how smaller nations get whipped around by the economics of larger nations.  The author is an important read in my opinion at his blog.

6) The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, by de Soto.  Puts forth the idea that laws protecting property rights help create wealth.

7) Against the Dead Hand: The Uncertain Struggle for Global Capitalism, by Lindsey. Promotes global trade as a means of increasing wealth.  On the same topic, How Nations Grow Rich: The Case for Free Trade, by Krauss.

8 ) The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor — Puts forth why culture matters.  Some cultures by nature will be poor and others rich.

9) The House of Rothschild: Volume 1: Money’s Prophets: 1798-1848 and The House of Rothschild: Volume 2: The World’s Banker: 1849-1999, by Ferguson.  Records tumultous years, and how some of the most clever capitalists ever known survived it.  Also notes that they never expanded to America when it would have counted.

10) The Birth of Plenty : How the Prosperity of the Modern World was Created, by Bernstein. Explains how the Western world grew into the present lack of scarcity that it now has.

11) The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics, by Easterly. Development economics is at its best when there are few subsidies — economics in the developing world is the same as it is here, only more so.

12) The Nature of Economies, by Jacobs.  In story form, she explains the nonlinearities of economics.

My view is that governments should provide a few basic simple rules regarding the economy, and let the courts fill in the details.  Economies grow best when they are free, and where the culture concludes that growth is valuable.  That is not true everywhere.

Full disclosure: all of the books that I mention here I own, and I bought with my own money.  If you enter Amazon through my site and buy anything, I get a small commission, but your prices are he same regardless.

Update: These are books on macroeconomics.  I may have a similar post on microeconomics coming.  Also, I forgot one book that I recently reviewed: This Time is Different, by Reinhart and Rogoff.  They cover why crises happen, but unlike Manias, Panics, and Crashes or Devil Take the Hindmost, they quantify it.

Rope Limit

Tuesday, December 29th, 2009

I remember the debates from the late 70s or early 80s about government borrowing out private borrowing.  At that time, I thought it was likely, but it was seemingly proven false.  If nothing else, the long time of survival after that is proof enough.

Now with the US government borrowing more and more, and guaranteeing more and more debts of Fannie and Freddie, it really looks like the US Government is running up against its rope limit, i.e., that amount that it can borrow without raising its interest rate significantly.

Think of all that they are implicitly guaranteeing, and $500B+ deficits going out as far as the eye can see.  All of the programs the US government proposes relies on the idea that larger deficits will be readily absorbed by the rest of the world, as well as some US investors.

Think of the Fed buying $1 trillion of MBS, and the US Treasury buying $220 billion of MBS.  Why should our government borrow to own mortgage loans?  (For these purposes, I count the Fed as a part of the government.)

The government is trying to support residential real estate prices, rather than letting the system clear by letting prices fall further, and letting the financial system absorb large losses.  Many financial firms would fail, and have to go through bankruptcy, but after the crisis was past, the US economy would grow rapidly, unencumbered by bad debts, as it grew rapidly after 1941.

Government actions tend to prolong large crises rather than resolve them.  Small crises are another thing — the government seem to help, but merely builds up the problem of bad debt for a larger crisis.

As the US government has stretched to bail out the residential mortgage market over the last three months, is has faced a situation where additional support for the residential mortgage market did not matter.  Additional borrowing by the US government did not matter, because the US Government is increasingly a bank or a hedge fund, borrowing to buy residential mortgages.  The borrowing is becoming so great that government debt investors are looking at the residential mortgages to understand what value truly lies behind the promises of a US Treasury security.

This is just my gut felling but as the US government has acted over the last month, borrowing and offering guarantees with abandon, amid economic weakness and a wide yield curve, I have been surprised by the continued widening of the yield curve.

It is as if the US Government has finally reached its “rope limit,” the line in the grass where the dog can go no further.  If true, we are near an inflection point in the markets, though with little idea of where we go, because central banks could act in favor of inflation or deflation.

I wish I could say more here, but a barbell of long Treasuries and money markets could offer some protection of purchasing power.  The inflation argument is the easy one, but I can’t say that will happen with certainty.

Not so Cheap Trills

Sunday, December 27th, 2009

What would you pay for a bond that offered to pay you $1/year, but would increase its payment by 3.4% each year?  Assume that bonds that offer no increase in payment, but offer $1/year currently yield 4.4%, for a price of $22.73.  Assuming there is no doubt about the creditworthiness of the issuer, one should be willing to pay $94.48 for the bond increasing its payment at 3.4% per year, accepting an initial current yield of 1.06%.

That is part of the idea behind bonds that Dr. Schiller is proposing.  These bonds called trills would:

  • Pay one trillionth of GDP as interest each year.
  • Would be full faith and credit bonds of the US Government.
  • Would be consols — perpetual bonds that never pay the principal back.

The key here is how fast GDP grows in nominal terms.  TIPS increase at the rate of the CPI-U.  If there is growth over the inflation rate, a trill would  be more valuable than TIPS, and at equivalent interest rates, people would pay more for trills.

My interest rate models indicate that if the US were to issue a consol, a perpetual bond, it would have a yield near 4.4%.  Here’s the question: what do you think nominal GDP growth will be on average  forever?  If it is above 4.4%, one should be willing to pay an infinite amount to buy it.  At lower rates of nominal GDP growth, the security will have a finite value that declines rapidly with lower nominal GDP growth.

Trills would be volatile securities.  The prices would fall hard during periods where long term interest rates are rising, but where GDP is not expected to be growing as rapidly.  Conversely, they would rise rapidly when long term interest rates are falling, but where GDP is not expected to be shrinking as rapidly.

I would not want the US Government to issue trills.  Why?  They suck a lot of money in, and do not consider what it will do to the government in future years.  I can say with confidence that a large issuance of trills would lead to the demise of the US Government.  There is no way that the government could keep up with the payments, because most finance today relies on the idea that the economy can grow out of the debt burden.  With trills, that is not possible.

Trills sound like a nifty idea, an to indebted governments, they offer very cheap finance in the short run, but the eventual end is the insolvency of the government that cant keep up with the increase in interest payments.

Governments want to keep the option of inflating away their debts if they can.  Don’t tell governments in the EU about this though.  They sold that option too cheaply.

In summary, trills are a bad idea.  They are just another way for the government to suck in a lot of money in the short run, while paying out far more forever.

Five Notes on the Current Market Situation

Saturday, December 26th, 2009

1)  It seems that the US Government is determined to dilute its creditworthiness, and extend a large amount of credit to Fannie and Freddie.  My view is that it will not lower yields for Fannie and Freddie as much as raise yields for Treasuries.  The debt level of the US Government is rising — they haven’t absorbed the debts of Fannie and Freddie yet, but they might.  Articles:

2) The Health bill… Senate bribery is rarely so blatant.  This bodes ill for our republic.   One consolation is that the reconciliation process will be tough, and will possibly result in a bill that one chamber or the other cannot pass.

3) When I was a corporate bond manager, the bulge-bracket firms would approach me with novel investments.  I would buy a modest number of them.  Why not more?  Wall Street is always looking for patsies to lay off risk to.  When you are dealing with the big guys, the way to win is to avoid losing.  They aren’t your friends.  Avoid complexity and novelty, particularly when spreads are tight.

But I have little sympathy for those who were chasing yield and now say that they were cheated.  Pigs.  Yield is never free in tight spread environments.  As Buffett has said, “Be greedy when others are fearful, and fearful when others are greedy.”

4) The Treasury curve continues to widen.  We are in “interesting times.”  How much debt can the US Government issue before the debt markets choke?  I don’t know but keep putting more straw on the back of that camel.

5) So the 2000s were a rough decade, the worst that we can remember.  Many think that means the next decade must be good.  But as I commented at Abnormal Returns: Too many people think we couldn’t have another negative decade in the 2010s. I don’t think it is likely, but opinion is too universal there. After all, consider Japan — it has had two lost decades in a row, and we are following something close to their monetary and fiscal policies, minus the fact that Japan at present self-funds their debt and we don’t.

That’s all for now.  We are in an ugly situation where most investors do not grasp the gravity of the troubles we are in.

Where Can I Learn the Investment Math? The Bond Math?

Friday, December 25th, 2009

I was recently asked where to look for how to understand quantitative investing, fixed income, etc.  Let me try to explain.

I have reviewed in the past Investing by the Numbers (Frank J. Fabozzi Series).  This is a good book that covers a wide number of areas in quantitative investing without getting too technical.  I learned a lot from it, and I don’t think the lessons there are out of date.

As for Fixed Income, the main book is Handbook of Fixed Income Securities 7th Edition, edited by Frank Fabozzi.  Fabozzi gets practical experts to write for him and he edits the book so that it reads well.  The result is a readable book that gives all of the qualitative information about the market, but does not deliver the math.  That’s a good thing.  Most people don’t want the math.

But… what if you are a misfit like me who does want the math.  Where do you go? Buy the Theory of Interest.  And, don’t buy it new.  Buy it used, or get it through interlibrary loan.  Same for Fabozzi’s book.  Don’t overpay.  And, if you can understand it well, maybe you would like to become an actuary.  The actuarial profession has done many good things for me; maybe it will do so for you also.

I have learned a lot from all three of these books.  You can too.

On Contrarianism

Wednesday, December 23rd, 2009

With markets, it doesn’t matter what people say.  What matters is what they rely upon.

Face it, people have opinions, and when asked only the most cautious or prudent won’t give an answer.  Talk is cheap.

But money talks.  What will people or institutions risk some of their financial well-being in order to make money?

Turning points are exceptionally difficult to call with time precision.  Anyone can say that a trend is going to break for a long while before it breaks; the trick is to be able to make the change within a short distance of the inflection point.  I’ve done it a few times, but I have little confidence in whether I can do it regularly.

Examples:

Now part of this is that if you predict enough things, you will have some right ones to point to.  I am obviously picking and choosing here, but when I made these predictions, there was a method to my madness.  I am not like Cramer, who makes predictions every day.  I wait for points where markets are out of kilter, and then I act, and sometimes predict.

Calling turning points is very difficult.  I want to offer two bits of advice to those to try to do so.

1) Look for situations where the yield is unsustainable on the high side or on the low side.

Examples:

  • Earnings yield too low during the tech bubble.  Also workers were relying on stock to rise, because they were getting much of their pay through options.
  • Net yield on much residential investment real estate negative in 2005-7, without even factoring in maintenance costs.  When someone is relying on price appreciation in order to break even something is wrong.
  • Toward the end of the commercial real estate bubble, the same was true.  Equity investors began to rely on price appreciation in order to break even.
  • When spreads on high yield blew out, at its worst the market was assuming that half of all high yield issues would die, with low recoveries.  Even the Great Depression wasn’t that bad.  The same was true in a faint echo for BBB Corporates.
  • During the recent bottom in March 2009, high quality companies could be bought for less than their net worth and at earnings yields unseen since 1973-74.

2) Look for a qualitative change when you think we might be near a turning point.

  • Chatter changes at/near turning points.  Certainty gives way to uncertainty.  Uncertainty gives way to worry.  Worry gives way to panic.  In October 2005, Googlebots that I created tipped me off to the change in the residential real estate markets way ahead of most parties.
  • Inflection points tend to be times of stasis as far as economic variables go, but confusion in terms of chatter.  During the tech bubble in early 2000, the chatter became decidedly less certain.

Inflection points are times of change, and chatter should reflect that.

Coming back to contrarianism, ask yourself, “What are people relying on to be true, that may not be true?”  That is what it means to be a contrarian.  Mere disagreement means little.  Where have men placed their bets?  Betting against the consensus is what a contrarian does.

My TIPS, Treasuries, and Inflation Model

Wednesday, December 23rd, 2009

I finished the first phase of a project today.  But first let me tell you a story.  It was 1990, and the Society of Actuaries Investment Section was holding a conference.  It was a great conference; I still have the binder from it.  There are few meetings from twenty years ago that still have relevance for me.

One of the presentations was by Stanley Diller, a managing director of Bear Stearns, who insulted all of the actuaries at the conference by telling them the the insurance industry was dead wrong for talking about yields and spreads.  Everything was duration and convexity, and those that did not understand that would lose.

He ended his presentation suddenly, did not take questions, and stormed out of the room.  I’m not sure why, but I had a seat in the back, and intercepted him.  I said, “You can’t just say this and not give any justification for your views, how do you back it up?”  He thrust a business card into my hand and said, “Call my secretary, she will send you the info.”  He stormed away.

The next day I called the secretary, and she told me she would send the information.  Two days later, I had it, and a few days later, I had replicated it in my own model.

Since then, I have used the model profitably many times.  Today I use it to describe the yields in Treasury Notes and TIPS.  I have used it to produce an estimate of future inflation expectations.

Using closing prices, here is my estimate of the coupon-paying yield curve:

And here is the spot curve (estimating where zero coupon bonds would price):

And finally, the forward curve, which estimates the expectations of future short-term rates, inflation, and real rates:

Pretty neat, huh?  Let me tell you a little about the model:

  • Values are as of the close 12/22/2009, but the model can be run in real time.
  • It is estimated from the full coupon-paying Treasury Note and Bond markets — over 200 bonds in the model.
  • The model estimates a nominal spot curve, fitting prices with 4 parameters, over 99% R-Squared.
  • The model estimates a forward inflation curve, fitting TIPS prices with 4 parameters, over 99% R-Squared.
  • The two models are estimated jointly, through nonlinear optimization.
  • The model has one constraint — nominal spot yields must be positive after 4 months.
  • Every other curve is derived from those two curves.

What are the useful things that we learn from the model?

  • There are mispricings in the Treasury and TIPS curves, but they are typically small, and would be hard to make money off of.  That’s  demonstrated by the high R-Squareds.
  • The Fed has achieved its goal of making real rates negative in the short term.
  • And, has made made nominal rates negative for some very short instruments inside 6 months of maturity.
  • Inflation expectations start low, and peak around 2022, then tail off.
  • Long term inflation expectations are still under 3.5% — ignore the portion of the inflation and real curves after 23 years, they are extrapolations.
  • Implied short-term real yields go positive in 2011, peak in 2024 and tail off thereafter.
  • The nominal forward curve is steep as a mountain on both sides.  Though there is a lot of fear over what will happen over the next 12-14 years, those fears have not been built into the prices of longer-dated Treasury securities.
  • The nominal spot curve peaks after 22 years — in my experience, that is normal, and is a reason why longer nominal note yields decline.  US Treasury — take note.
  • Inspecting the differences between coupon-paying yields on Treasuries and TIPS makes inflation expectations look more tame than they really are.  Federal Reserve — take note.
  • 30-year TIPS would likely fund cheaper than 20-year TIPS — US Treasury, take note.  The scarcity value would help as well.

This is just the beginning.  I’m not planning on writing about this every day, but I should be able give you some updates every now and then.  Hopefully the firm I work for should be able to benefit through research that this enables me to create for institutional clients.

Full disclosure: I own shares in Vanguard’s TIPS fund.  And truth, we all own Treasuries somewhere if we look deep enough. ;)

Uncharted Waters

Tuesday, December 22nd, 2009

It does not matter how you measure it, the US Treasury yield curve is at its steepest level ever.  Away from that, the value for expected five-year inflation, five years from now is at its highest level ever, excluding the noise that we had as our markets crashed in the fourth quarter of 2008.

This concerns me.  Anytime we hit new extremes on critical financial variables, it makes me think, “What next?”  Treasury yield curve slope and inflation expectations are fundamental.  Reaching unprecedented levels is a big thing.

Could the US Government ever face the possibility that it could not meet its obligations?  I think so, and a record wide yield curve is one of the things that I would see prior to such troubles.

Last week, I had dinner with my friend Cody Willard.  His favorite idea was shorting long bonds.  I indicated that I had some leaning that way but could not go  all the way on that idea, as the Federal Reserve had the option of inflating during the Great Depression, and did not do so.  Cody said something to the effect of “but we have so much less flexibility today.”  Can’t argue with that, though I wonder whether politicians and bureaucrats favor foreign claims over domestic claims.  Would they bankrupt Americans to pay off foreign claimants?  Yes, they might do that.  It has happened before.

Cody might be on the right track, but the steepness of the yield curve may fight him.  It is very, very hard to get a yield super-steep without something breaking — inflation running rampant, etc.

The greater worry from my angle is the US pursuing Japanese solutions that have failed miserably over the past 20 years.  Japan continues to follow failed Keynesian ideas, fostering a low return on asset culture, with all of the failed projects financed by very low interest rates.  Now we do the same.  The Fed runs a low interest rate policy via Fed Funds and buying mortgage bonds.

All that does is reinforce mediocrity by enabling assets with low returns to be financed and survive.  Better that many of those should die, and the capital be released to more profitable uses.

All of this is the price for not allowing recessions to be deep — now we have to clear away bad loans bigtime.  But who has the courage to do that?  Certainly not our government.  They avoid all short-term pain, leading to long-term problems.

That’s where we are now, in uncharted economic waters.

On the Effects of Chinese Inflation

Sunday, December 20th, 2009

I have often thought that international macroeconomics boils down to looking at all of the big nations that have some degree of economic flexibility, and are willing to make non-economic decisions for political purposes.  They drive the excesses in the global economy through their actions.

It is not as if their actions have no cost, but that the cost is realized later.  They get to impose their will for a time, but eventually their non-economic actions catch up with them, impoverishing them, and set the stage for the next set of actors to abuse their power.

Tonight, I want to talk about China.  Bloomberg has a great piece up about Andy Xie, former Morgan Stanley economist who posits that China will head into inflation because of their monetary and fiscal policies.  If true, it is my opinion that a bursting of a China Bubble will decrease demand across the world.  The world depends on a China with increasing demands for all kinds of raw goods.

My view is that China is stretching itself too far economically.  The powers that be chose too fast of a growth path, and inflationary consequences will come, and spread to assets in China, as well as Western nations.

In the long run, there is no free lunch.  No country can permanently force the rest of the world to do their bidding, whether that is buying up debt, or buying goods or services.  Eventually the terms of trade change, and either value is delivered, or trade collapses after a default.

Be aware.  The global economy could shift down dramatically if China has to slow down its economy because if inflation.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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