Ten More Notes on the Current Market Scene

11) I was surprised to read that there is not a perfect market in interest rate swaps.  They are so vanilla, but counterparty risk interferes.

12) There is always a skunk at the party, and who better than Baruch to dis bonds?  I half agree with him.  Half, because the momentum can’t be ignored entirely.  Half, because profit margins are wide.  But rates are low, and unless we are heading into the second great depression, stocks look cheap.  That’s the risk though.  Is this the second Great Depression? (Or the Not-so-great Depression that I have called it earlier.)

13) Housing is a mess.  The US government has been engaged in a delaying action on defaults, while calling it a rescue effort.  The sag in housing prices may lead to a recession.  The FHA is raising the costs of mortgages because their past loans have had too many losses.

14) Commercial Real Estate continues to do badly while some CMBS performs — no surprise that what is more secured does well.

15) The Fed gets whacked on its lack of transparency.  This could be a trend for the future.

16) In the current difficulties in the Eurozone, the ECB is beginning to suck in more bonds, presumably from peripheral Eurozone countries that are seeing their financing rates rise.  As central banks get creative, a simple question for currency holders becomes what backs the money?  It would seem to be governments, which will absorb losses if central banks generate them, and cover it with additional taxes or borrowing (some of which could eventually be monetized).  What a mess.

17) Bruce Krasting is almost always worth a read, and he digs up something that I had forgotten about how interest is credited on the Social Security Trust Funds.  It’s calculated this way:

The average market yield on marketable interest-bearing securities of the Federal government that are not due or callable until after 4 years from the last business day of the prior month (the day when the rate is determined). The average yield must then be rounded to the nearest eighth of 1 percent.

Krasting thinks that’s too high.  I think that is too low, given the true tradeoff that is going on here.  Think about it: when the government borrows from the SSTFs in a given year, a slice of the benefits incurred over that year don’t get “funded.”  The debt claim to back that should match the maturity profile of those future claims.  Medicare would have some short claims, Disability and Supplemental Security slightly longer, but Old Age Security develops most of the assets, and is a long claim.  Say the average person paying in is 40, and they will retire on average at 65.  That is a 25-year deferred claim that will last for maybe 20 years on average, with inflation adjustment.  The US offers no debt that is that long to back such a liability, so I would argue that the proper rate to use would be that of the longest noncallable debt offered by the Treasury.

But here would have been my second twist on this: they should have absorbed the longest marketable securities from the debt markets, and bought and held them.  That would have looked really ugly as the rates looked piddling against current interest costs.  But today, it would reflect the true costs of the borrowing from the SSTFs, and that cost would likely be greater than what was paid to the trust funds.  My guess is that the interest rate paid on the trust funds today would be higher than 5%, maybe higher than 6%, if a fair method had been used.

If there is enough interest, I could try to run the numbers, but the point is academic.  It would not change the total claims against the government plus SSTFs as a whole, but it might have changed the behavior of the government if it had tried to borrow on a long duration basis, competing for funds with private industry.  It would have revealed the true tradeoff earlier, and shown what a trouble we were heading for.

18) On retained asset accounts, this Bloomberg piece makes me say, “Yes, this is a big enough issue to deal with.”  For MetLife particularly, which has its own bank, it would be simple enough to set up a genuine bank account with all of the statutory protections involved.  If there are risks from forgery, that is big.  Even the risks of not being covered by the state guaranty funds is big enough.

My view is this: full cash payment should be the default, and a genuine bank account an option.  If you have one of these checkbooks now, and you want to minimize your risks, do this: write one check for the balance so that it is deposited in your bank account.  Simple enough.  You can protect yourself with ease here, even without legal change.

19) The yen will continue to rally until the Japanese economy screams.  Currency moves tend to last longer than we anticipate, and secular moves force needed economic changes on countries.

20) Consider what I wrote last week on long Treasuries:

I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.  And some think that I am only a fundamentalist value investor.  With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.  Better to miss the first 10% of a move, than miss it altogether.

Now, I never expect to be right so fast, but with rates gapping lower on economic weakness — the 10-year below 2.5%, and the 30-year below 3.6%, I would simply say this: don’t fight it.  Let the momentum run.  Wait until you see a significant pullback in prices, and then short.  Don’t be a macho fool fighting forces much larger than yourself.  The markets can remain crazy for longer than you remain solvent.


  • David, if I may… and where do you see the money flowing into? You said, “wait and then short”. Money will surely rush out the door at some point. Is it going to go stocks? Gold? Real Estate? Hard assets in general? Commodities? Mattresses? I ask because there really aren’t any catalysts at the moment. Although if you ask me, stocks appear cheap as an asset class. I wrote this paragraph at econbrowser site:

    “In 1998, national GDP was around 8.6 trillions. Today, it hovers the 14+ mark. On March 1998 -12+ years ago- the SP500 was trading at 1121, a ~4.8% premium to today’s prices!! Can someone honestly say nothing has changed in the last 12 years which would be like saying that there has been no internet, Google never existed and that we are still speaking on mobile phones that are the type of relics like the one Michael Douglas was using in the movie “Wall Street”?”

    I am curious to know what you see as the catalyst for the end of this run.

  • matt says:

    Having some nice gains on the 10-year, I am beginning to think about an exit point, but the polemic is this: why can’t the 10-year t-note go the way of the 10-year JGB?

    The big factors are (I think):
    1. unemployment (how long and how severe)
    2. inflation
    3. better investment alternatives (I have been told that some PE funds have returned capital because of lack of viable investments; there seems to be more unsolicited M&A bids, which might indicate a lack of profitable investments with all of that “cash on the sidelines” that corporations refuse to return to shareholders)

  • jdmckay says:

    13) Housing is a mess. The US government has been engaged in a delaying action on defaults, while calling it a rescue effort. The sag in housing prices may lead to a recession.
    (end quote)

    I think that summation needs more detail, going back to cause of “financial crisis”, through what Fed/gov did in response, w/in context of what was actually going on in US economy over that time.

    AFAIC, the “sag in housing prices” is/was utterly predictable. The “rescue” was credit charge against future tax revenues to re-fi the bloaks who engineered the “crisis”. And these were the folks who directed lions share of US investment for short term gains at expense of maintaining/growing meaningful, purposeful economic activity.

    As I’ve said before David, w/all due respect, as I see things your context(s) are too narrow. You and many others track/predict investment flows… bonds, money markets, treasuries, commodities etc. Just over last 6 weeks or so, these pictures, w/in context that omitts entirely what the hell we’re doing here… these things are all over the map.

    They are all over the map because (in particular) the US has avoided it’s day of reckoning. Our government has not had the where with all to identify fraud, to identify needs that our economy must produce… none of it.

    Housing prices are hitting the skids (again) because the underlying economy which doesn’t get discussed is not producing value sufficient to provide America’s workforce w/$$ to meet levels prior to the crisis.

    AFAIC, any narrower view misses the forest for the trees.

    (quote)The FHA is raising the costs of mortgages because their past loans have had too many losses.
    (end quote)

    FHA did not fuel the housing boom.

    Mis-appropriation of mortgage bonds, which excluded function of larger economy… that’s what did that. Ignoring reality, more or less.

    FHA was a cog in the machinery, and a 2ndary one at that.

    Seems to me we’re in a cannibalistic process economically, where bigger fish are feeding on available food chain which is no longer dynamic, rather static. And this process gets it’s various parts analyzed as though they were unrelated, simply various “market forces” doing their thing.

    What seems to me is being ignored is that, absent “fuel” to drive economic activity addressing what’s needed on our shores, those finite resources are going to go where honest capitalism has always said: where the $$ is.

    Given $USD manipulation shenanigans we’ve been sold as “recovery” and “rescue” funds are beginning to metastasize into a coherent picture whereby the currency value is meeting hard realities previously papered over…

    I hope our public wakes up and gets real before this quagmire turns into a sea of quicksand.

  • RedSt8r says:

    #17 “The US offers no debt that is that long to back such a liability, so I would argue that the proper rate to use would be that of the longest noncallable debt offered by the Treasury.”


    “But today, it would reflect the true costs of the borrowing from the SSTFs, and that cost would likely be greater than what was paid to the trust funds”

    Both quite correct – for a non-governmental organization that should balance liabilities with assets. However, the government(s) objective is always and everywhere to maximize current spending and assume it will balance out the liabilites with future tax increases.