1) It is a wonderful thing to be the world’s reserve currency; we can milk the rest of the world until things change.  There is some push from emerging markets to have a change, but the effectiveness of that push is questionable.  Someone has to give the US an ultimatum, and no one is there yet.

2) With the decline in fixed income volatility, mortgage yields are falling.  Good for mortgages, but the real question is what happens when the Treasury starts borrowing like a maniac.

3) Many hedge funds have raised the gates.  Capital cannot easily exit.  GIven the weak balance sheets that hedge funds have, this is normal for a bear market.  The only surprise is that investors did not anticipate the troubles.

4) Perhaps the money to banks from the government is going only to relatively sound institutions.  That is consistent with the idea of making some institutions sound, and letting them buy up marginal banks.  Upshot: don’t expect an early increase in lending.

5) Analyze those that are on the other side of the table.  If they have a reputation for being smart, be extra careful.  Many municipalities and other entities lost money dealing with investment banks.  No surprise.

6) Many do not understand mark-to-market accounting.  First, GAAP is the least of the problems — collateral agreements require MTM.  Regulators can ignore MTM as they please. Second, MTM is misapplied by auditors; it does not mean “last trade,” but an estimate of where a liquid market would trade.

7) Shut the barn door after the cow has escaped.  Yes, loan underwriting standards have tightened, in the middle of a credit bust.

8 ) There is less cash flow to service; the financial sector should shrink.

9) S&P 500 at 600?  Not impossible, and not likely, but if profit margins crush down, possible.

10) where could longs make money in October 2008? Nowhere.  Real bear markets crush almost everyone.

In closing, I am not concerned about the victory of Obama.  The new president will have little freedom, and will face significant unsolvable problems.

It’s election day, and I may as well try to fuse economics and politics for a moment.  Personally on an economic basis, I don’t think this election means that much.  Consider this post at RealMoney from earlier this year:

		David Merkel
		Cultures are Bigger than Economies, Which are Bigger than Governments
		1/7/2008 1:19 PM EST

To start this off, I don’t fit neatly on the political spectrum. I am an economic libertarian, socially a conservative, but utterly against the recent wars that we have pursued. I also think that we need to find a way to dismantle the two party system, but that will never happen. So now you have enough to disregard me if you like.

I don’t think the primaries make any difference at all. The three leading Democrats are all very alike. It doesn’t matter which one wins the primary. The Democrats would have their best chance with Obama, because general elections tend to be won on (sadly) which candidate is more likeable.

As for the Republicans, there are differences, but not to any great degree on likely economic policy. I say “likely economic policy” because none of their differential policies are likely to survive if one of them wins the general election. Any Republican win is unlikely to have that much of a mandate.

There are differences between the Republicans and Democrats on economic policy, but this is where my headline comes into play: “Cultures are Bigger than Economies, Which are Bigger than Governments.” Given the mismanagement of our government, particularly with respect to entitlement programs, though also costly wars, future governments will have less wiggle room. Raise spending, cut taxes? Go ahead and try. No surprise that the US Dollar continues to fall. Outsiders will eventually tire of funding US deficits in US currency.

The Republicans will leave the micro-economy more free than the Democrats, but aside from that, I don’t think the election matters much, at least as far as economics goes. There may be other reasons to vote for one side or the other, but pocketbook issues rank low for me, and in this election, the payoff from the differences will not be big.

Now, cultural change, in the unlikely event that it would occur, is another matter. But American history has been replete with big shifts before, and the economy and politics get dragged along. Perhaps the question to ask is what will be the next big shift in American culture? I don’t have any read on that now, but then, when it happens, it is often fast.

Position: none

Our biggest bubble, which is still inflating, are the debts of the US Government, both explicit and those not accrued for.  We are going to have a difficult time borrowing in the present for all of these new bailout/stimulus/pork programs.  Our debts are getting deeper, not shallower.

Consider this graph from this article at Clusterstock:

We may have a slight breather from the increase in total debt recently (2006-7), but it is going up in the near term.  My view is that we need delevering, and that will be a big theme in coming years once the government tires of the new policy of shifting private debts onto the public balance sheet.

Now, I’m still dubious that the bailout policy will work.  Reasons:

• We’re still unclear on what bailout money is for.  Consider the banks.  Is it so they can lend, buy marginal banks, or so they don’t go insolvent?  (No, Barney, there is no direct way to force them to lend…)
• With some banks, it may be the latter, as commercial real estate goes into its slump.
• It encourages banks to take more uncalculable risks.
• We’re just creating a new set of problems, which may give us a different type of depression.
• Where the government is intervening in the markets, it seems to be replacing the markets, and not encouraging risk-taking on the part of private investors.
• Areas where the government isn’t intervening are still under stress.  When Verizon has to offer nearly 5% over Treasuries to get $3.25 billion of financing, that is stress.
• CDS is now pricing in significant US Treasury default risk.

When a foreign holder of Treasuries is willing to give up 40 basis points of yield on a 10-year T-note yielding 3.80%, so that they can get paid off in Euros if there is a repudiation of US Treasury obligations, there is significant uncertainty over the creditworthiness of the US Government.  (That’s just an example, there are other reasons to enter into such a CDS.)

Now, the debt-to-GDP graph above doesn’t take into account pension and entitlement underfunding/non-funding.  From another comment at RealMoney:

		David Merkel
		Digging a Hole to China (So We Can Borrow Some More)
		10/28/03 08:26 AM ET
With a gracious assist from one of our readers at Economy.com, here is the link I promised yesterday. The report does not break out one final number — one has to look at the “balance sheet” on page 58, and the “Statements of Social Insurance” on page 65, which they count as an off balance sheet liability, and add them up. It looks like this (in USD): Net Liability: $6.8 trillion Soc Sec, Pen & Dis: $4.6 trillion Medicare, part A: $5.1 trillion Medicare, part B: $8.1 trillion Total: $24.6 trillion This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government. np

That $24.6 trillion figure was from September 2002. As of September 2007, it would now be around $50 trillion. ( Here’s the link to the 2007 figures.  New figures out in two months.)  By the way, thanks Mr. Bush, for being such a reformer of Social Security and Medicare. You added on another $10 trillion of unfunded liabilities that future generations will have to fight over bear in your prescription drug program.  You have been the most damaging president on economics since Nixon.  (Sorry, I lost my cool. )

That $50 trillion does not count in state and corporate underfunding of pensions and benefits.  Oh, and with the fall in the markets, they want a bailout also.

Who doesn’t want a bailout?  The US Government can just borrow some more to aid us on our way to prosperity.  Those debts and unfunded promises will have to be paid someday, either through taxes, inflation, or repudiation (total or external).  The economic mess at that point will be far worse than it is today for all those who rely on the US Dollar.

Our problems in the US are larger than our politics.  It goes down to our very culture, borrowing from the future to take care of the present.  It is true for our Government, and many corporations and individuals.  The pain will come, the only question now is what form it will take.

Until I read the last sentence of this Wall Street Journal article on AIG’s risk models, I felt somewhat sympathetic for the guy who developed the models.  Having developed many models in my life, I have seen them misused by executives wanting a more optimistic result, and putting pressure on the quantitative analyst to bend the assumptions.  Here’s the last paragaph:

On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: “There doesn’t seem to be a fundamental reason why.”

When I read that, I concluded that the poor guy was in over his head for years, and did not have the necessary expertise for what he was doing at AIG.  All good credit models contain something for boom and bust.  Creditworthiness of borrowing entities is highly correlated, especially during the bust phase of the credit cycle.  That said, to get deals done on CDO-like structures, the modeler can’t assume that correlations are as high as they are in real life, or the deals can’t get done.

But to my puzzled professor, there are fundamental reasons why.

• Overlevered systems are inherently unstable.  Small changes in creditworthiness can have big impacts.
• Rating agencies undersized subordination levels in order to win business.
• Regulators allow regulated financials to own this stuff with low capital requirements, partially thanks to Basel II.
• Much of the debt was related to Financials, Housing, and Real Estate, and all of those sectors are under pressure.
• When financials ain’t healthy, ain’t no one healthy.

Now, for another look at the problem from a different angle, consider this New York Times article on Wisconsin public schools buying CDOs for teach pension plans.  As a kid, I played against a number of the schools mentioned in sports, etc., so many of these names bring back old memories for me.

Again, what is clear is that the guy advising the school one of the school districts barely understood the ABCs of what he was doing, and the district trusted him.  I’ll say it again, if you don’t understand it, or you don’t have a trusted friend on your side of the table who does understand it, don’t buy it. Also, relatively high yields on seemingly safe investments typically don’t exist.  Beware the salesman that offers high yields with safety; there is usually one of four things involved:

• Financial leverage
• Options sold short
• Low credit quality of the underlying debt instruments
• Foreign currency risks

These deals fall far short of the “prudent man rule” in my opinion.  Not only is the salesman culpable in this case, so are the board members that did not do proper due diligence.  For something this complex, not reading the prospectus is amazing, even though it might not have helped, given the complexity of the beast.  At least, though, a board member should read the “risks and disclosures” section of the prospectus.  There is usually honesty there, because that is what the investment bank is relying on to protect themselves legally if things go bad.

The districts should have accepted a lower rate of return on their investments, and asked the taxpayers for contributions to the pension plans, etc., to make up any deficits.

We will probably see many more stories like this over the next year.  Politicians and bureaucrats are often short-sighted, and look for “that one little thing” that will magically close a gap in the budget.  It’s that little bit of fear of the taxpayers and other stakeholders that caused “that one little thing” to become so tempting.  But now they have to live with the bad results; heads will roll.

1) Where are we?  Is the equity market cheap or dear?  Personally, I think it is cheap, and though it might rally in the short run, it could get cheaper.  When the financials are compromised, all bets are off.  Here are some article indicating that things are cheap:

• Steve Leuthold (what a guy!)
• Wall Street Journal

And, not cheap, consider the arguments of this humble student of the markets.  He considers survivorship bias and war as factors that investors should consider.  I agree, and I would urge all to consider that wars often occur as a result of economic crises.

2) The trouble is, quantitative finance is tough.  We don’t have enough data.  Our models are poor, and until recently, often reflected two major bull cycles, and only one bear cycle.  My view is that the equity premium is more like 3% over the long run, and not the 6% bandied about by careless consultants.

3) During the “great moderation,” I argued over at RealMoney that volatility and credit spreads were too low, and would eventually snap back.  Okay, we are there now.  Volatility is high, and so are credit spreads.  The brain-dead VAR models used by Wall Street have been falsified again.  Quantitative investors have gotten savaged again; it only works when implied volatility is flat/declining — it is an implicit credit bet.

4) This is a global crisis.  Where is it appearing?

• The Gulf States (notable since they have had huge trade surpluses)
• Emerging markets, especially Ukraine
• Japan (and again)
• More emerging markets

5) As I have mentioned before , the IMF, previously seeming irrelevant, has a new lease on life.  But how much firepower do they have, and will countries in crisis send them money to aid foreigners?

Consider their new plans for a short term lending facility, and the exogenous shocks facility.  They will have a lot to fund in this environment.

6) Might government programs to guarantee bank deposits have caused a shift from stocks to bank deposits?  Possible, though for every seller, there is a buyer.

7) How do we pay back what we borrow?  Who will borrow more from us?  Those are  the great unanswered questions as we attempt to bail out many troubled entities.  I’m a pessimist here, and think that we will have higher long rates as a result, and that “Bernanke” will become a cuss word.  (Among the cognoscenti, only “Greenspan” will do as a proper insult.)  On the despondent side, will the US default in 2009?  Doom-and-gloomers are always early, and ignore the flexibility in the financial system prior to failure.  I see default as more of a 2017-2020 issue.

8 ) Uh, let Lawrence Meyer pontificate.  There is nothing good about a zero Fed funds rate.  Let him wax grandiloquent about Japan over the past two decades.  Consider how low interest rates destroy money markets funds.  Consider as well how much low rates destroy saving, sometyhing that we have had too little of.

9) In an environment like this, every M&A deal is open to question.  M&A is credit sensitive, and higher volatility impairs the flow of credit.

10) I don’t think that GAAP mark-to-market accounting has had a material impact on this crisis.  True, many accounting firms have interpreted mark-to-market as mark-to-last-trade, but that is not what SFAS 157 specifies, and firms can ignore their auditors (with some risk).  The truth is that the firms that have failed choked on bad balance sheets and inadequate cash flow.  It doesn’t matter what the accounting rules are when a company is running out of cash.  Cash is impervious to accounting rules.

11) Want a closer view of the Fed and politics.  Read this piece at The Institutional Risk Analyst.  While at RealMoney I espoused a view that the Fed was more political than economic.  This article confirms it.

12) How do I view Greenspan’s apology?

13) At a prior employer, we often commented that credit risk in credit cards appears late in the credit cycle.  Well, we are there now.  It is seemingly the last form of credit to default on.  In this environment, one can lose their home, but losing financial flexibility can be bigger.

14) The FDIC can modify many mortgages, at a cost to taxpayers.  It could cost a lot, and many people who made dumb decsions could be bailed out by the prudent.

15) If John Henry were alive, he would be smiling.  Let humans make markets, and not machines.

1) Greenspan — what a waste.  A bright, engaging man becomes a slave to the Washington political establishment.  Now he gives us a lame apology, when he should be apologizing for his conduct of monetary policy, which encouraged parties to take on debt because of the Greenspan Put.  Now the debts are too big to be rescued by the Bernanke/Paulson Put, where the Government finances dodgy debts.

On a related note, Gretchen Morgenstern is right when she calls the apologies hypocritical.  I would only add that Congress also needs to apologize; they did not do oversight of the Administration properly.  Many members of the oversight committees are not economically literate enough to do their jobs; they can only score political points.

2) I found this post highly gratifying, because it points out the disconnect between macroeconomics and finance, which I have been writing about for years.  When I was an economics grad student, I felt economics had gone astray by trying to apply statistics/mathematics to areas that could not be precisely measured.  In this case, if your models of macroeconomics can’t accommodate the boom/bust cycle, you don’t deserve to be an economist.

3) You want accounting reform?  Start with accounting that disallows gains-on-sale in a financial context.  WIth modern life insurance products, gain from sale is not allowed under SFAS 97, and I would modify SFAS 60 to be the same way.  No profits at sale.  Profits are earned in a level way over the life of the business as risk decreases.  Let other financial firms use something akin to SFAS 97, and many business problems would be solved.

4) What freaks me out about this article is that Taiwan is refusing the full faith and credit of the US Government, which stands behind GNMA securities.  Don’t bite the hand that feeds you; who knows but that you might be traded for the elimination of Kim Jong Il.

5) It figures that the moment the PBGC buys the specious arguments of a pension consultant that the equity markets crash.  Whaat makes it worse is that the PBGC tended to buy long Treasury debt which has been one of the few securities rallying  recently.

Given all the furor over investing in long duration bonds for pensions versus equities, it is funny that the PBGC rejected the growing conventional wisdom that DB plans should invest in safe long bonds.  Once they reject their current pose, the equity market could rally.

6) Is the economy weak?  Well, look at the states.  If their tax receipts are going down, so is the economy.  We are in a recession, and maybe a depression, given the lack of strength in the banks.

7) Do we need a new system for managing the global economy?  The Chinese certainly think so.  They finance the US and don’t get much in return.  Perhaps China could host the new global reserve currency?  I don’t think so.  Their banking system isn’t real yet, and they still want to subsidize their exports.  The global reserve currency role will flow to the largest economy allowing free flow of capital.  Now, who is that?  Japan?  Too small, but the world now recognizes that their banks may be in better shape than many other countries.  Plus, they have been through this sort of crisis for a while, and may be closer to the end of it than the rest of us.  The alternative is that Japanese policymakers still don’t have the vaguest idea of what to do, much like the rest of the world now.

Thing is, we don’t have a logical alternative to the US Dollar as the global reserve currency.  The Euro is a creation of an alliance of nations untested by economic crisis.  Perhaps the rest of the world should consider the possibility of no global reserve currency, or keep the US Dollar, or, move to a commodity standard like gold or oil.

For now, though currencies will follow the path of panic, as carry trades unwind, as countries that had too much borrowing see loans repaid (Japan, Switzerland), and countries with high interest rates see a demand for liquidity, which perversely will push rates higher.  (Isn’t everything perverse in the bust phase, just as everything is virtuous in the boom phase?)

8 ) On the bright side, some boats are rising.  After seeming irrelevant, the IMF has found a reason to exist again with loans to Iceland, Hungary, and Ukraine, with more to come.  The small/emerging markets once again learn that they were at the end of the line in this economic game of “crack the whip.”  That said, the developed market banks financing them will get whipped too.  This is truly a global crisis.

And given that it is a global crisis, I wonder how willing the developed nations will be to add more funds into the IMF when they have crises at home to deal with?  I’m skeptical, as usual.  Perhaps the Treasury can send them a raft of T-bills.  The IMF can ask the Fed for contact info.

(more to come)

Originally, I was not a fan of Bernanke, but the more I read about him, the more I liked him.  Still, my main fear that I wrote about at RealMoney at the time of his nomination has largely been realized in my mind.

		David Merkel
		Why I Don’t Like Bernanke as Fed Chairman
		10/24/2005 12:09 PM EDT

From my post on April 4th:

“I’m not crazy about Ben Bernanke being selected chairman of the Bush administration’s Council of Economic Advisers. This is not because I think he’ll do a bad job there; odds are, he’ll do fine. It’s kind of a nothing job, anyway. I just suspect that this is a stepping stone to becoming the next Fed chairman. Bernanke is too much of a dove on inflation for me, and too seemingly certain of his own opinions. If we have very placid economic conditions, he could do fine as Fed chairman. If we have crisis conditions, the last thing I want is a dovish idealist as Fed chairman.”

Greenspan was more of a political operative than an academic, and as such, fairly pragmatic as he threw liquidity at every crisis, creating a climate of moral hazard. Investors lose fear of loss, because monetary policy will bail them out in a crisis.

Academics think they understand how monetary policy affects the economy, and in my opinion, have a higher degree of confidence in their views than say, a banker in a similar position would. When models of the world are imperfect, a false certainty can do a lot of damage. Bernanke is a bright guy, but bright doesn’t mean right.

Position: None

Bernanke spent a lot of time studying the Great Depression as a grad student, and I did not.  As an academic, there is the bias that says, “Yes, but we have learned from the past, and know what to do next time.  We have the game plan to fight Depression II set.”

I think the wrong lessons were learned by Dr. Bernanke, and many academic macroeconomists.  They look at the ineffective remedies at the time: negative monetary growth, Smoot-Hawley, and lack of stimulus, and they conclude that if they can stimulate a lot more, they can avoid Depression II.

Depressions occur because market actors take on too much debt, including financial institutions, and at the tipping point, cash flow proves insufficient to service the debt, starting a self-reinforcing bust cycle going the opposite direction of the prior self-reinforcing boom.  Once the self-reinforcing bust starts, I’m sorry, but there is little that can be done.  Liquidation of bad debts must happen to clear the system.  In the absence of that, we can have a Japan-style scenario where rates go to zero, and we stay in a funk, or we could inflate the mess away, harming savers and pensioners.

The boom-bust cycle is normal to Capitalism and should be enjoyed, rather than avoided by policymakers.  A lot of smaller busts are better than one big bust when national debt to GDP levels are at record levels.

At this point, stimulus merely slows down the inevitable.  We aren’t liquidating debts as much as transferring them to the government.

I am waiting for the first Treasury auction failure.  They won’t call it a failure, and they may reschedule it.  When that happens, we will have a statement that shifting private debts to the US Government is not appreciated by the creditors of the government.

We also could have semi-failures, where the market clearing rate at the auction is well above the average bid.  A few of those, and the yield curve could be at record wide levels.

I view the Federal Reserve and Treasury as being a bunch of amateurs here.  That’s not an insult.  Take me, James Grant, or any number of bright critics of the Fed and Treasury, and if they were in charge now, they would be amateurs also.  There is nothing in their training that prepares them for dealing with the credit equivalent of nuclear winter.  Nor should there be.  These abnormal periods happen every 40-80 years whether we like it or not, once we forget the lessons of building up too much leverage under a fiat money system.

Should they be blamed for not bailing out Lehman?  That was the inflection point for this crisis as it is manifesting now.  Yes and no.  Yes, since they took it upon themselves to be the guardians of the whole financial system.  Yes, since they bailed out Bear and AIG, two institutions that they had no business bailing out.  Both were bailed out for reasons relating to systemic risk, and both were politically unpopular.  But though Lehman may have posed less systemic risk than AIG, it certainly posed more risk than Bear.  Yes, because they jolted expectations.  No, because they couldn’t have known the full chain of events that allowing Lehman to fail would touch off.

A hidden cost here is that activism begets more activism, or, at least, a demand for more activism.  If the Federal Government and the Fed are now the lenders of first resort, it is no surprise that many will come-a-beggin’.  Once you are willing to lend to support one critical area of the economy, my but many areas will deem themselves critical as well.  Where does it stop?  At this point, I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity.  This extinguishes debt claims, and accelerates the healing of the economy.  This would be true reform.

Looking Forward

Now, suppose for a moment that the monetary and fiscal stimulus programs work in the short-run, and bring down rates.  What happens when the Fed tries to exit?  My guess is that they can’t exit.  In paying interest on reserves, the Fed is slowly replacing the Fed funds market with its own lending.  If the Fed leaves, the crisis reappears.  But even apart from that, the government ends up with more debt, and that has to be serviced in some way.

In providing guarantees to money market funds, buying top-rated CP, and helping financial firms finance paper of varying quality, the Fed replaces markets that ceased to function for a time.  The Fed sets yields and prices for credit, but with little to guide their decisionmaking.  Set the price too high, and there are few takers.  Too low, and there are many takers.  Beyond that, with so many programs, what is a bureaucrat to do to figure out which programs are offering the most relief?  I’ll tell you, it is not possible to figure that out.  The money going out is certain, but the benefits are not.

Now, as Greenspan mumbles, wondering about how this crisis could have come about, those of us that are more aware (or intellectually honest), look at the increase in total debt levels and say, “It’s pretty amazing that the system held together for so long.”  It’s an ugly situation, but it is worth asking whether the current actions of our government might harm the future well-being of our nation.

It’s almost never a good idea to sacrifice freedom for security.  But the Federal Reserve has done that.  They are now tied to the Treasury Department, and any policy independence they had is gone.  Book-smart Bernanke has been co-opted by the street-smart Paulson.  Bernanke is a bright guy, but he was not “Born and bred in the briar patch,” as was Paulson, who learned the ropes on Wall Street.  (Do I have to say that Wall Street produces harder characters than academia?  No?  Good.)

In this case though, we are beyond normal, even for seasoned veterans of Wall Street.  There are no comparables any more.  This is more severe per unit time than 1973-4 or 2000-2.  Only the Great Depression remains as a benchmark, and that era grins at us as we think we can beat the process of delevering through government action, of which they had much.

I’m not grinning here.  We are looking at tough times.  May the Lord help us.

After not feeling well for a few days, I am back to writing.  Let me start with a blast from the past from RealMoney, during happier times:

		David Merkel
		Swap Curve Inverts a Teensy Bit, for a Moment
		2/17/2006 12:29 PM EST

Nothing big here, but the swap curve briefly inverted twos to tens a few minutes ago. There is no reason to panic here; I’m just pointing out something that is highly unusual in the bond market. Having successfully traded bonds 2001-2003, I can say that strangeness tends to beget more strangeness. If this inversion gets larger and persists, I will have a post on the topic, but for now, this is just a curiosity.

Position: none, but the swap market affects us all in a wide number of quiet ways…

		David Merkel
		The Deepening Inversion
		2/22/2006 11:06 AM EST

I did not expect the inversion in the Treasury curve to get so deep so quickly. At present, the Treasury curve is inverted 15 basis points from twos to tens. Does this mean the market is falling apart? No, only the economics of spread-based lenders.

Whoever taught me (way back when) that the swap curve can’t invert deserves a few whips with a wet noodle. It’s small, but swaps are inverted two basis points twos to tens. What will I see next? Inverted corporate curves for BBB bonds? I can’t imagine what that would imply for the economy. It would deepen my feeling that we are in uncharted waters in a low nominal world.

On the CPI, it is an advantage for TIPS buyers that the bond market focuses on the core CPI, when TIPS buyers get paid off of the unadjusted CPI. It allows us to get more yield off of our TIPS.

Inflation is higher than the core CPI indicates for a wide number of reasons, but the simplest one is that they exclude food and energy, whose prices have risen at faster than everything else for the past 10-20 years.

Eventually the long end of the Treasury curve will react badly when market players revise their long run inflation expectations, which in my opinion are too low. But for now, international flows dominate because US yields are higher than those in most other countries, and pension fund flows dominate because of a need to fund long liabilities. Until those factors quit, we will continue to live in a weird bond market, with uncertain implications for GDP and the equity markets as a whole.

This doesn’t make me change any of my strategies yet, but it does leave me uneasy.

Position: long long-dated TIPS, bank floating rate loan funds

Back then the yield craze was upon us, and credit risk forgotten.  The swap curve was theoretically never supposed to invert on a yield basis.  That was then, this is now.  A new yield craze is upon us, where credit risk is omnipresent, even in securities of the highest quality.  It reads, “I don’t care about the yield, just give me guarantees for a long time, and keep me safe.

That is manifesting in (at least) three ways right now:

• Failure to deliver in repurchase markets. (Alea, Jesse’s Cafe Americain)
• Swap spreads going negative on the long end of the curve. (Across the Curve, FT)
• What bond deals are getting done for investment grade names are getting done at amazing spread levels.  (Baker Hughes, Pepsi — in 2002, spread levels for single-A names never got this wide, though some cyclical BBBs got that wide.)

The grab for safety is relentless, and the efforts of our Government are small relative to the size of the economy.  The yields of the investment grade bond market are a truer measure of the troubles, because no one is fiddling with it yet.  Even so, the fiddling may not turn even the manipulated markets around.

PS — As a final note, a kind word for the CDS market — their netting procedures work admirably, as pointed out by Alea (numerous times), and Derivative Dribble (a valiant start for a new blog).  Here’s a wild thought: we need the same thing on a broader and more complex scale, allocating the embedded losses in our financial system to their rightful recipients, wiping out common, preferred equity, and subordinated debt as needed, and forcing the conversion of debt claims to equity, delevering the system in a colossal way.

CDS netting does that in a flash for synthetic debt exposures, but how do you do it for a wide number of assets at once?  I’m not sure it can be done.  My question is this: do the present actions of policymakers genuinely help, as they shift debts from private to public hands, or do they merely delay the inevitable?  I hope the former, but I think it is the latter.

Full disclosure: long PEP

In his usual brief style, jck at Alea displays the collapse of carry trades through the appreciation of the yen.

• Carry Trade: EUR/JPY
• Carry Trade: AUD/JPY

Put on your peril-sensitive sunglasses before viewing.  When I was at RealMoney, I wrote a lot about carry trades, and how the end would be ugly.  We are experiencing that now.

		David Merkel
		The Craving for Yield, Part 2
		2/6/2007 2:55 PM EST

If you hang around bond investing long enough, you run into the phrase “carry trade.” It’s a simple concept where one borrows at a lower rate, and lends at a higher rate, just like any bank would do.

Free money, right? Yes and no. People make money in these trades often enough to make them popular, but there are often points where they blow up. The simplest example is when the Treasury yield curve is very steep, like it was in late 1993, or mid-2003 right after Alan Greenspan finished his last contest of “How much liquidity can I provide?” At that point, it seemingly paid to borrow short and buy longer dated Treasuries, clipping the interest spread. That works well when interest rates are falling, or when the FOMC is on hold at the bottom of the cycle, but once the hint that the first tightening might occur, it doesn’t work well until the first loosening is hinted.

Carry trades can involve other factors as well. Some creditworthy entity can borrow cheaply, and invest in less creditworthy or more illiquid paper, capturing a spread. That trade also goes in cycles; good to do it when everyone is scared to death, as in late 2002. Bad to do it in late 1999-2000, as the negative side of the credit cycle kicks in.

Carry trades can involve different currencies. Borrow in the low interest rate currency (Yen, Swiss Francs, Offshore Yuan), and invest in the high interest rate currency (US dollars, NZ dollars, Australian dollars, Korean Won, Indian Rupee, etc.) Again, it all depends where you are in the cycle, as to whether this is a good trade or not. The weak tendency will be for low interest rate currencies to appreciate versus high interest rate currencies, but in the short run, currency movements are somewhat random.

What fascinates me in the current environment is the size and variety of all the carry trades being put on at present. CDOs of all sorts. Borrowing in developed markets and investing in emerging markets currencies. Levering up nonprime commercial paper. Borrowing offshore in Yuan. Borrowing short to finance paper with short embedded call options. Corporate, RMBS, CMBS and ABS spreads are tight.

When I think of all of the different risks that can be taken in bonds (duration, convexity, credit/equity, illiquidity, currency, etc.) they are all being taken now, and at relatively high levels. There is an exception. Duration risk is not being taken because of invested yield curves. (But who is borrowing long to lend short? Not many I hope.)

The danger here is not immediate. As with most topping processes, it is just that, a process. Bubbles pop when cash flow proves insufficient to finance them. Cash flow is still sufficient now. Banks are still growing their balance sheets faster than their central banks. Petrodollars and Asian surpluses are still being recycled. Wealthy investors are still for the most part bullish. We’re not to the point of no return yet; the sun is shining amid large cumulus clouds. But as those clouds cumulate, we should prepare for rain. Okay, snow.

Position: none

Alas, but the boom has given way to a bust, and “All the king’s horses and all the king’s men, Couldn’t put Humpty together again.” Sad times these, but they had to come. There was too much leverage in the the system, and now leverage is collapsing, and the value of assets whose prices were artificially high due to the temporary additional purchasing power that leverage afforded.

Have a wonderful day amid the chaos, and be grateful if you have food, shelter, clothing, family, friends, and peace with God.

When I wrote for RealMoney, one of my continuing themes was that the Federal Reserve was less relevant because neomercantilistic nations like China (and perhaps OPEC nations) had reasons for promoting exports to the US that were less than economic.  As such they would buy US fixed income in order to facilitate their exports.  What could be sweeter?  You send goods; we send promises, denominated in our own currency.

With that, I want to point to a short post from Marginal Revolution.  Like me, he takes the “modified Austrian” view that the bubble was caused not only by the Fed, but also by the neomercantilists, both of which I fingered in my “Blame Game” series.  Buying longer dollar-denominated debt stimulated mortgage rates more than the Fed could, because under normal conditions the Fed can only affect the short end of the yield curve.

PS — What a long day, to NYC and back.  I appeared on Fox Business News show “Happy Hour.”  They said I did very well.  If I get video I will post it here.  As I have said before, time on live television goes fast.  The four minutes seemed like the blink of an eye.  At the end, Liz asked me for a third stock, and I blanked out, so I said Assurant, a company that I love, but don’t currently own.  I will own it in the future.  I meant to say Pepsico, but it just didn’t come to mind.

I also had dinner with my friend Cody Willard after the show.  Though our rhetoric is different, we basically agree that the actions of the government in the bailout offer much possibility/potential for favoritism.  Also, that it is easy to start a bailout, and hard to end one.

Let the government chew on this: Pepsico issued $3.3 billion of corporate debt yesterday.  For a company with recession-proof products and a Aa2/A+/AA- balance sheet, for them to pay 4%+ over Treasuries is astounding.  Liquidity?  What liquidity?  If financing needs are outside the A-1/P-1/F1 CP box, there is no help.  Not that there should be help, but the corporate bond market is a truer indicator of our stress than the money markets, which still aren’t in great shape.

Full disclosure: long NUE PRE PEP

There was a great hoo-hah made in the ’90s and early 2000s over the grand importance of having an independent central bank, one that the politicians could not mold to their own ends.  This was largely during the Greenspan era, where the party line was independence, but Greenspan did what the administration wanted, no matter who was president.  Volcker was a better example of what an independent central banker was like, and as such, he was shown the door by Reagan.  Much as I liked Reagan, we would have been better off with Volcker, and better off with someone other than Greenspan.  (Ron Paul for Fed Chairman, baby. )

I could talk about the social or political aspects of the Fed that makes it less independent of the Government:

• They have worked together in other roles.
• They are grateful for their cushy sinecures.
• The Fed has a too-large employment base that they don’t want to draw attention to.
• There is an aspect of mutual back-scratching.
• No one wants to take abuse from Congress or the Treasury.  Best to go with the flow.
• News coverage always favors loose monetary/credit policy in the short run.

But I’m going to take another approach tonight, one that is more data-driven.  Here’s chart number one of the asset side of the Fed’s balance sheet:

My, but look at how Treasuries owned by the Fed and not sold to them by the Treasury have disappeared.  The most common asset (maroon) has disappeared, and has actually gone negative.  Here’s a simpler version of the graph:

Without the Treasury selling the Fed Treasury securities, the Fed would have run out of Treasuries with which to support its market intervention programs.  They are economically dependent on the Treasury.  That may have impact on their future decisions, not that the Treasury would want to ruin the Central Bank, after all they take care of the extra-constitutional stuff that the Treasury can’t.  Besides, it allows the Treasury to finance the government cheaply by issuing the Treasuries to the Fed.  The relationship is symbiotic.  What could be happier?

I’ve made the comment before that we are heading down the path of Japan with a few differences.  The differences are summarized in my pieces Liquidity for the Government and no Liquidity for Anyone Else, and Inflation for Goods Prices, Attempted Inflation for Housing-Related Assets, but Sorry, No Inflation for Wages.

Where we vary from Japan’s path of quantitative easing is that the money created from government credit in Japan was pumped into the banking system as a whole. In the US, it is pumped into the Fed’s plans to fix various lending markets. This article from The Economist has a good discussion of the similarities and differences.  Whether that will result in fixing those markets, or result in the Government/Fed becoming the one sole counterparty for those “markets” (with a difficult disentanglement) remains to be seen.

In a financial crisis, there are no good solutions.  The good solutions existed 7-20 years ago when orthodox central banking was replaced with tinkering, through oversupply of liquidity in minor problems that should not be called crises, which allowed investors to build up the level of leverage, because the Fed always came to the rescue.  Also, many Fed Chairmen of the past (in the 50s, 60s, and Volcker) stood up to the Adminstration and Congress, and did not enable their policies.  The economy was healthier as a result in the intermediate-term.

I’ve also said that Fed policy works through stimulating healthy parts of the economy, and that pulls the sick parts of the economy out eventually.  Well, because of the overleverage of the past, there are no healthy parts of the economy to work with.  I wish I could be more optimistic here, but given the path that the government is taking, I see the explicit debt of the US Government going to 100%+ of GDP before the system stabilizes, just in time to leave us overleveraged for our entitlements crisis.  At least the debt is denominated in US dollars. :(  How long will our lenders continue to honor that?

We face painful choices over the next 20 years partly as a result of the policies of the last 20 years.  20 years of pain… hmm… that sounds like Japan as well.  Let’s pray for a better outcome.