After the recent piece Waters Uncharted, I received this comment:

Why do you have a large portion of your fixed income portfolio allocated to foreign bonds?

Are you afraid of a large devaluation in the U.S. dollar?

It seems like American corporate balance sheets are very healthy (especially relative to sovereigns and personal balance sheets).

I have a rule.  I look at the spreads offered for various classes of domestic bond risk.  I buy bonds in the areas where I believe the incremental risks are more than adequately rewarded in the spreads.  If few or no areas offer adequate compensation for risk, I invest in foreign debts, because it is a statement that the US Dollar itself is overvalued.

Think of it this way: if I were a Swiss investor looking in at the US, and concluded that the opportunities weren’t great, would I buy anyway?  No, I would look elsewhere in the world for opportunities.

At present, my bond portfolios are invested:

• 40% in Foreign Bonds
• 30% in long US Treasuries
• 20% in preferred stocks, and
• 10% in US Dollar-denominated emerging markets bonds

There are several forces at play here.  The actions of the US Government and the Fed tend to weaken the US Dollar — it’s the additional debt, and low fed funds rates, as well as the residual effects of QE.  So I invest in foreign bonds; it’s not ideal, but it is the best of a bunch of opportunities.

The US is still a safe haven currency.  With the difficulties in the Eurozone, some are giving up yield to gain safety, or at least predictability for now. That’s why the position in Long  Treasuries, and my, hasn’t it run of late.

The preferred stocks reflect a part of the credit market that hasn’t gotten whacked too bad, offering a decent yield for the junior debt on healthy companies risk.

I used to hold more emerging markets debt, but I have been trading out of it as the momentum has been weakening.  Economic troubles are rising in the emerging markets, and the eventual result might be ugly.

Back to the original question, yes, corporate balance sheets are in good shape, aside from the banks. But spreads reflect that or better, and so I don’t want to play there now.

Will any decrease in the valuation of the dollar be large? No, I expect it to be moderate, but yes, a decline.

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I have a saying, “Fast moves mean-revert, slow moves persist.”  It makes me a little edgy with the long Treasuries, because the move has been so fast.  I may sell some in the near term if prices rocket higher.  If they edge higher, I might not sell.  Flat or slight selloff, do nothing.  Big selloff, sell into it.

Bonds are a funny mix of momentum and mean reversion.  Good bond managers get a sense of when momentum is overdone, and act against it, but follow when the momentum is gentle.

It’s difficult balance.  I remember buying long Treasury bonds in 2006 when the timing was just right.  Hard negative momentum had just broken.  I remember the trader coming back to me weeks later and saying, “How do you do it?” and I said, “I don’t,”  then saying that nothing is certain when you enter into such a trade.  Market sentiment was horrible, so we legged into the trade, nibbling as prices fell, entering the full position as prices began to rise, once the cascade of forced selling abated.  A few months later, we legged out of the position for a good-sized profit in bond terms.

It’s my opinion that bonds trend more than equities, and that it is easier to calculate the downside risk of most positions.  There are cycles:

• Credit
• Currency
• Hedging of interest-rate-sensitivity (otherwise known as duration)
• Liquidity

These are not totally independent of each other, but neither are they totally dependent, which makes the game complex.  At present, credit conditions are declining, the US Dollar is not attractive, except compared to the Euro.  There seems to be a grab for the long end of the yield curve, agents buying bit of the far future, perhaps to fund or immunize long liabilities.  Finally, liquidity seems to be slipping — too many markets with abnormalities in the short end of the yield curve.  That will eventually affect the prices of bonds where the value proposition is less than clear, unless the Central bankers decide to do another round of ill advised “stimulus.”

Enough for now, we’re still in uncharted waters, but maybe we have a few guides to aid us in managing fixed income in an era where monetary policy does not work, and governments borrow madly.

We can’t rely on US Treasuries?  If so, what can you do to preserve purchasing power?  I will ignore a variety of exotic strategies/derivatives and focus on things that can be executed by individuals and small institutions.

The first idea that comes to mind is gold, silver and commodities.  Commodities don’t lie, they just sit there.  But the prices don’t just sit there.  They go up and down with demand and supply.  I’m not an expert there, so I would say keep positions small, enough for diversification relative to volatility.

Idea two is foreign debt of unquestionable solvency.  Well, that takes much of the world off the table, leading to investment in the developed fringe currencies — Canada, Australia, New Zealand, Norway, Sweden, and the Swiss Franc.  Toss in the Yen, though it isn’t fringe.  Not a very large group, and their currencies have run like mad.  Could they fall?  Imagine a US default, where aggregate demand drops across the world because the Treasuries in the banks of other nations are only worth 70% of face value.  Deflation would drive commodities and fringe currencies lower.

Idea three is an echo of two — buy the debts of emerging markets with more orthodox economics than the US, Eurozone, and China.  Nice, but their currencies are high as well.  Same problem as two.

Idea four is buy high quality equities that pay dividends.  There’s a plus and a minus here.  Minus: Equities are highly sensitive to confidence / trends in aggregate demand.  Plus: equities, if conservatively financed have positive optionality, subject to the same problem you have: what is a good store of purchasing power?

Even buying needed resources ahead might not work because demand conditions might be lower going forward.

Idea five is buying high quality non-Treasury domestic debt.  Along with ideas 2, 3 and 4, this seems to be Pimco’s strategy.  But our payments system is interconnected.  Any non-payment, or serious threat of non-payment will disrupt the ability and willingness of others to pay.

Idea six is stay in US Treasury debt — where else can you go?  You’ll get paid back eventually, with interest, most likely…  Hey, TIPS could work in an inflationary scenario.

Idea seven is hold physical US cash.  That should retain value of a sort until the debt ceiling situation is settled.

My main point is that there is nowhere to hide with certainty.  There are places to diversify into, and maybe you should consider some of them as part of a broader asset management strategy.  But avoid changes motivated by panic.  They almost never work.

In a debt-driven world, with fiat currencies, everything is confusing because there is no obvious store of value offering some small (but not near-zero) yield.  A small positive inflation adjusted return is healthy for savers, and good for the economy.  Let the Fed adjust its policy, and then the hiding place would be simple — CDs.

Today, Charles Rotblut, CFA who is the AAII Journal Editor wrote:

Federal Reserve Chairman Ben Bernanke continues to be the enemy of savers. Yesterday, the Boston Red Sox fan reiterated his belief that interest rates should be kept at rock-bottom levels for an extended period of time. He views this as necessary in order to keep the economy growing.

When you run an investment group that is largely composed of retirees and near-retirees, it is reasonable to call Bernanke the enemy of savers, because he is the enemy of savers.  When one can’t earn anything over one year without risk, something is wrong.  Better that the economy grow more slowly, than that savers not get their due for not consuming.

Saving deserves a return.  Let the Fed raise the Fed funds rate by 1%, and they will see that there is no harm to the banks, and little harm to the economy.  Once you have 1% slope between twos and tens you have more than enough oomph to make the economy move.  What, does the AARP have to bring a age discrimination lawsuit against the Federal Reserve to make this happen?  The Fed is discriminating against the elderly.

But now consider another issue — money market funds.  I consider them to be superior to banks because their asset-liability mismatch is so small, and they have generated small losses relative to banks and other depositary institutions.

Prime money market funds in the US have been investing 50% of their assets in the Commercial Paper [CP] of Core Eurozone Banks.  Well guess what?  If the Greeks and other fringe members of the Eurozone default, and the core governments don’t bail the situation out, those holding  CP of core Eurozone banks may take a loss.  And this is at a time where French and German Banks are facing liquidity issues.  Take time to review your money market funds.

The problems of the US and China are significant, but the problems of the Eurozone are pressing.   The endgame there will arrive more rapidly because the underlying structure is unstable.  One currency can’t serve multiple cultures.  Also, there should have been an Eurozone exit plan designed in from the beginning.  It was hubris to think it would never need that level of adjustment.

It seems like the ECB is becoming a repository of euro-fringe debt, and perhaps the IMF as well.  After all, it doesn’t cost the ECB anything to absorb those debts, but it indirectly spreads the risk to the euro-core nations if there is ever a default or unfavorable restructuring.  A central bank can’t go broke, but it can impose problems on those that use the currency if defending the central bank exacerbates other problems in the economy.  (E.g., printing money to cover over bad debts absorbed by the bank, while inflation rolls on.)

On a slightly different level, I’m not sure that the banking regulators in the US or Europe really got the main lesson from the crisis.  Risk management is liquidity management.  I still think that banks rely too much on short liabilities to finance illiquid, longer assets.  One advantage of mark-to-market accounting is that it can reveal those mismatches to investors, or perhaps, to regulators.   Extra capital can help, but it is usually not enough when there is a run on short-term liquidity, particularly because capital is the excess of assets over liabilities.  If there are not enough liquid assets to meet the redemption of liquid liabilities, the result is insolvency.

“But that’s a liquidity problem, not a solvency problem — just give it time and the market will normalize, the assets are worth more than the liabilities anyway.”  But at such a time, no one wants to buy the longer, less liquid, lower quality assets.  If the bank could raise liquidity, it would.  It can’t, so it is not only illiquid, but insolvent.  It’s always cheaper to issue liquid liabilities, because those are attractive to savers and investors, but they a poison in a crisis.

My fear here is that there may be another call on liquidity that forces the Fed or the ECB to backstop banks.  Not sure what would cause it; it’s always hard to pick which straw will break the camel’s back.

Thus I say be cautious at present; have some safe assets available in case we have a panic that emanates out of Europe, and has second-order effects on the US.

In Chess, it is good etiquette to topple your king when the position is hopeless.  Why prolong the agony?

Now, I am only a casual player of chess.  I play maybe  one to three games per year since I turned 25.  I’ll tell you two quick stories.  I played chess on Yahoo! six years ago, and was unrated.  After engaging a game with a “Class C” player, he found himself in a bad position after 20 moves, and said,”You may be unrated, but you are clearly not a beginner.”  I won shortly after that, with him resigning before checkmate.

Then when I was 22, my suitemate at the grad dorm invited me to his father’s 50th birthday party. (Being 50 now, it makes me think.)  A fellow asked me if I would like to play chess.  I said yes, and in a long, closed, ugly game, he crushed me.  I toppled my king, so as not to prolong the agony.  He grinned at me and said, “Good game.  I’m a rated chess Expert.  Want to play again?”

The grin got me, so I said yes though I knew I could not beat an Expert.  I was a Class C player at best.  I was White this time.  I played an aggressive open game and somehow forced a checkmate on move seventeen with his king in the center of the board.  The look on his face was precious to say the least.  Then the surprise came.  An old guy watching behind me said, “You have talent with combinations in open games.  Do not play closed games.  I am a Chess Master.”  He then proceeded to play the Expert, and trounced him solidly.  I did not dare play him, though there was no opportunity.

My personal history in Chess is only here to describe when one should give up.  My view is that the EU should give up on the Euro, and plan now for its demise, going back to individual currencies for each nation.  The experiment has failed.  Topple the King.

If all Eurozone nations collectively give up on the Euro, and it ceases to exist, after a period where national currencies float against the Euro to determine breakup value, that would be a good thing.  We all have known that it is impossible for monetary union to exist without political union, unless a small nation be a slave to a larger one (US-Panama).

Is Greece having a liquidity problem or a solvency problem?  I think it is the latter.  Extensions and additional loans to a country that has structural solvency problems will not solve the problem, but merely extend the problems.

If you are in Germany, France, or the Netherlands, rather than bailing out Greece, take the cheaper route — bail out your banks for losses on Greek debt, and be prepared to do it for other weak Eurozone nations.  Prepare for the dissolution of the Eurozone; it is coming.  Topple the King.

Or , be more aggressive, end the Eurozone entirely because it is flawed in entire, and let national currencies re-emerge.  It will be better for all nations involved.  Germans won’t  have to subsidize others, and Greeks will be able do devalue and survive, as in the past.

To the Eurozone, I say, “Topple the King.”  You should have done it long ago for the good of all.  Free trade is a good thing, but a common monetary policy is not.  Give up before you are checkmated by the global bond markets.  It may come slowly or quickly, but it will come.

PS — to this day, I don’t play closed Chess games.  My winning percentage has gone up.

When currencies do not serve as a long-term store of value, economic actors search for ways to preserve future purchasing power, which often mean purchasing commodities. But most commodities are not cheaply storable over long periods, so actors get forced into the few that do: gold, silver, etc. There is a problem here, stemming from dumb money. When dumb money shows up for purchase of generic “commodities” distortions follow: backwardation, large storage demand, and warped market incentives.

Eventually overproduction catches up, but the volatility when it breaks can be huge and self-reinforcing, with c0unterparties raising margin to protect themselves.  Extreme volatility causes exchanges to raise margin requirements substantially, which reveals which side of the trade is inadequately financed, which typically is the side that was winning, which leads to a reversal in price action.  The dumb money is revealed.

Now after a washout, the dumb money often assumes that powerful entrenched interests colluded against them to deny them their long-deserved free ride to prosperity through speculation.  The exchanges are in cahoots with the other side.  Well, no, the exchanges have two interests, which are solvency and transaction volume, which drives their profits.  Solvency is a more primary goal for an exchange, because the second goal can’t exist without it, and exchanges are not thickly capitalized.

Many different types of financial systems are subject to these risks.  Think of AIG: they were rendered insolvent by rising margin requirements as their creditworthiness was downgraded, largely because the rating agencies concluded they were going to lose a lot of money off of their many bets on subprime residential credit.  Think of all of the mortgage REITs that got killed as repo haircuts rose on all manner of mortgage-backed securities at the time that values for the securities were depressed.  Alternatively, think of Buffett, who entered into derivative trades where he received money and bore the risk, but his agreements limited the margin that he would have to post.

Commodity-linked exchange traded products serve four functions:

1. Allow sponsoring financial institutions to get cheap financing through exchange traded notes.
2. Allow sponsoring financial institutions to inexpensively hedge their commodity risks.
3. Allow commodity producers to have cheap financing of their inventories via backwardation.  (And indirectly allow more clever speculators to earn extra profits from gaming the rolling of futures contracts.)
4. Allow retail speculators who cannot access the futures market to make or lose money.  Scratch  that, that should probably read “lose money in aggregate.”

Wall Street does not exist to do small investors/speculators a favor.  It exists to make money off of the issuance of securities, and their trading in secondary markets.

As Buffett put it, “What the wise man does in the beginning, the fool does in the end.”  Yes, there is monetary debasement going on.  We should expect gold, crude oil, and other commodity prices to rise to reflect that.  But rises can overshoot, particularly in smaller markets like gasoline and silver.

So in answer to the question, “Which came first – the margin call or the commodities mayhem?” my answer is simple: The cause of the bust is found in the boom, not in the bust.  The boom happened because of loose monetary policy, which led many people to adjust their risk posture up, whether in commodity speculation, or in high yield debts.  (Oh wait, there are ETFs for that now too.)  Eventually self-reinforcing booms have self-reinforcing busts.  The elites think they can tame this, but they can’t, because you can’t change human nature, which means you can’t change the boom-bust cycle.

James Grant, at a recent meeting of the Baltimore CFA Society said that we had exchanged a “gold standard” for “Ph. D. economist standard.”  And indeed, the value of our currency is manipulated by that intellectual monoculture at the Fed, who pass Einstein’s test of insanity: doing the same thing over and over again and expecting different results.  I say that because the Fed thinks that it can produce prosperity by reducing interest rates.  All that their policy does is produce an asset bubble, or price inflation in goods and services.

The Fed drove us into this liquidity trap through increasing application of an easy money policy.  It will take different ideas and different people, and a lot of pain to get us out, because the Fed is blinded by their bankrupt theories.

This is the third part of an irregular series on solvency and liquidity.  This time, though, I am not focusing on corporations, or accounting rules, but on countries and municipalities.

With the crisis in the Eurozone, there are times of calm, and then times of panic, with seemingly little warning for transitions.  Let me try to explain why this happens, even though it won’t explain why it happens on a particular day.

A country with a profligate fiscal policy builds up debt beyond its ability to repay if bad times were to come, but times are good, the country is growing rapidly, and most think that there will be more than adequate ability to repay given the growth of GDP.

Or, the financial sector grows of a nation far more rapidly than GDP, abut again, in boom times, the profits of the banks are roaring ahead, and only cowards or bears would question the prosperity of a boom.

But the truth is, during a credit-driven boom (whether governmental, financial, or other), much of the supposed prosperity is a mirage.  The additional leverage pushes up asset prices until the cost of financing the assets exceeds the yield the assets throw off by a small margin.  Economic agents have to rely on capital gains to make money, and that is where bubbles pop, and go into reverse, with a vengeance.

With nations, an overleveraged situation is revealed during a bear market.  Asset prices shrink.  Incomes shrink.  Demand for welfare payments rise.  Governments that relied on expanding asset prices are revealed to be the spendthrifts that they are.

Now, when a government is overleveraged, but interest rates are low, the situation is potentially unstable.  A rise in rates could tip the scales.  Market actors would conclude that they can’t survive at rates high than a certain threshold, so sell the debt now, in case rates would get so high.  That action forces rates higher, leading to a self-reinforcing panic.

Sometimes this happens in advance of a debt refinancing, leading some politicians and bureaucrats to say the forever bogus phrase, “This is not a solvency crisis, this is a liquidity crisis.”  Sorry, if you play near the cliff, don’t complain if you happen to fall off.

Liquidity crises do not happen to governments with low debt levels.  Liquidity crises are solvency crises during the panic phase, before they are revealed to be solvency crises alone.

It is difficult to change government behavior, because the politics of reducing spending, or raising taxes is tough.  Once a crisis hits, there are protests.  People point at shadowy interests that are denying them the illusionary prosperity of the boom; conspiracy theories thrive.

With the Eurozone, there are contagion effects; panics in one nation prompt investors to look at other nations, and leave weak situations.  Crises separate good and bad credits.  That may push bad credits over the edge.  Again, never play near the cliff; always ask, “Could we survive easily in bad times?”

The difficulty for the strong nations of the Eurozone is that their banks lent a lot to the fringe nations that are failing.  Thus the strong are likely to bail out the fringe, though a more prudent course would be to bail out their own banks after a promise limiting lending abroad.  The real political question is what is the price that Germany will charge to bail out the Euro?  What sovereignty will the fringe have to give up?  And what will the German and Fringe electorates tolerate?  Perhaps the intersection set is null.  No agreement.  At that point the Eurozone shrinks or ends.

The proper solution for the Eurozone fringe, and other deadbeats in this crisis, is to negotiate writedowns of debt, and cut them off from borrowing at the rate they were accustomed to receive.  Recognize losses, and wean them off credit.  If not, let them fail, and bail out your own banks, which is cheaper than bailing out the fringe.

Pressures are building.  If the Eurozone survives in its present form, it will be because Germany bailed it out, at some political price that they will specify.  Investors should look at cash financing schedules and balance sheets to evaluate the future solvency of Eurozone nations.

And, lest the US smirk, the same exercise will come here, reserve currency or not.

This is an odd book.  It runs through the year highlighting the US economy data releases week-by-week in 2011.  It describes ways in which the data releases affect the behavior of markets on average.

There are many interesting articles in the book, but there is little in the way of an overarching theme, or anything that might say, “And here is how it could work for you,” even though quants typically only trot out only their formulas that have weakened, while keeping their potent ideas private.

I found it disappointing.  Hey, but maybe someone else will love it.

Quibbles

This book is useless to the average investor, who does not trade futures.  Personally, I have experienced that trading around data releases is usually a zero-sum game.  Part of that is due to the inaccuracy in the data.

Who would benefit from this book:

If you run a quantitative hedge fund, and aren’t aware of the government data news flow each week, or how it can be used for profit, then this is the book for you.

If you want to learn about some obscure quantitative strategies just for fun, this could be a good book for you.

If you want to, you can buy it here: The Quant Investor’s Almanac 2011: A Roadmap to Investing.

Full disclosure: I was mailed a copy of the book without asking for it.

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

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

I like my son Peter.  He works hard, but is occasionally overconfident.  (Where does he get that from? )  A typical example:

Peter: No, Dad, I am right on this Precalculus problem.  The book is wrong.

Me: Peter, don’t sell me an antigravity machine.  I had one once, but it floated away.  The book is right, and I will show you.

After which, I would write out the answer longhand, and show him that the book was right.  And at the end of the year, when he took the final, I scored his test, and found a wrong answer, so I wrote out the right answer to show it to him, but I got his answer, not the book’s answer.  So I did it another way. Same answer.  I solved it numerically, not analytically — same answer.  The book was wrong. But I never told him, because I did not want to reinforce the overconfidence.

But often, people trust in antigravity machines in the economic arena: ideas that sound good, but have no basis in fact.

1) Start with Japan intervening on the yen.  This is but stage three on the five stages of grieving.  Why does Japan think that it can successfully intervene by itself in the currency markets?  The history of such actions supports the idea that Japan will lose the battle without help.  Also, they were working against momentum, and without economic news that would support a stronger yen.  The intervention should not work, and what will the BoJ do with all the new Dollar bonds that they bought?

2) Or think of Cisco Systems.  They are going to pay a dividend.  Hooray, maturity has come!  Okay, it has come 10+ years too late.  The question is not whether Cisco has excess cash, but whether its management is good at allocating capital, and the answer is no.  Cisco has spent years buying up marginal firms and buying back stock, with no sense for what their company is really worth.  I might have interest at a price near $15.

What most investors don’t get is that earnings matter, but what firms do with retained earnings / free cash is even more important, because that directs the path of future profits.

3) Then there is Social Security Disability — what a foolish program.  If you can’t control the benefits, don’t start the program.  Yet here are three articles:

• Jobless are straining Social Security’s disability benefits program
• America’s Hidden Welfare Program
• Obstacle to Deficit Cutting: A Nation on Entitlements

I’ve seen able bodied people on SS disability.  I’m not saying that all of it is a scam, but some of it is, and the government should make many requalify for aid.

4) One casualty of quantitative easing is DB plans.  The value of their liabilities rises as high quality interest rates fall.  And that drives investment in alternative assets, because it is that much tougher to earn the needed returns in a low nominal rate environment.

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This environment is particularly fertile for financial “antigravity,” because many hope against hope in a time of scarcity, and believe that they will do well, even if they have done nothing truly defensive in their investing.

Hope is not a solution.  You may as well believe in antigravity.

In my last post on this topic, I went over the orthodox and unorthodox monetary policy responses to the crisis in the US.  Here were the orthodox options:

• Lower the Fed funds rate into lower positive territory.
• Offer language that says that the Fed Funds rate will be low for a long time.
• Buy more long-dated Treasury bonds.

And the unorthodox options:

• Lend directly to classes of private borrowers.
• Create negative interest rates for Fed funds.
• Debase the currency by expiration dates, lotteries, etc.

On orthodox policy: I’m not sure there is that much difference between Fed funds at 0.25% and 0.10%, except that money market funds will find themselves in further trouble, as yields are too low to credit anything. That the Fed will be on hold for a long time seems to be the default view of the market already, so an explicit declaration would likely prove superfluous.  On buying long-dated Treasury bonds, that will benefit the US Government by pseudo-monetizing the debt, but won’t help the real economy much.

Yes, some high-quality corporate and mortgage bond rates will be pulled down with it, but so will discount rates for liabilities.  The same applies to spending rules for endowments, and how much retirees can get if they go to buy an annuity.  The effects of QE are mixed at best, and on balance, might be depressing, not stimulating.  But what practical proof, if any, do we have that QE has ever worked?

We need policymakers to understand the bankruptcy of the theories they are working with.  So many macroeconomic models work with one interest rate.  But in the real world there are many rates, and duration and quality of lending make a huge difference in what rate is charged.  I would urge that every person who would be on the FOMC work at a buyside firm managing bonds and money market instruments.  Let them see how the markets really work, and it might disabuse them of their false neoclassical views of how the lending markets work.  Better still, if their P&L is less than the cost of capital, revoke their appointment.  It’s time to kick out the academics, with their failed ideologies, and let those who have worked in the markets successfully manage the economy.

Direct Lending

But then there are the unorthodox methods.  When Social Security came into existence, they argued over where the money would be invested.  It was decided that the only fair investment was in government bonds, because it was neutral.  Investing in other assets, like the S&P 500 would be unfair, because they would be favoring a sector of the economy.

The same argument applies to direct lending by the Fed, because it would smack of favoritism.   Going back to my last article, favoritism undermines confidence in the system, and makes people less willing to invest unless the government gives them an edge — cash for clunkers, $8,000 tax credit, etc.  We are Americans, after all.  Why buy from the retailer now, when you know that there will be another sale coming soon?  Economic policymakers should not rely on people to behave “as usual” when policy becomes unpredictable and unfair to the average person.

So I don’t see direct lending by the Fed, or buying high yield bonds, or offering protection on baskets of bonds as wise moves.  It may temporarily goose an area for a time, and make an area of the economy QE-dependent, or stimulus-dependent, but at best it is helping a few, while discouraging the rest.

Negative Fed Funds

I’ve been thinking about negative rates for Fed funds, and I think that they will have the following effects:

• Banks will drop their excess reserves at the Fed to zero, and vault cash (or its short-term debt equivalents) will increase.
• Banks will try to borrow from the Fed at negative interest rates, if they allow it, and just sit on the cash, park it in T-bills, Top-top CP — it’s free money, after all.  Of course, some point free money may be construed as valueless money, but that is another thing.

Required reserves are not a large percentage of liabilities.  Unless Fed funds goes deeply negative, it’s not going to affect bank profitability that much.  Banks may just view it as a cost of doing business, and pass it on to customers.

Destructive Creative Currency Debasement

With apologies to Schumpeter, who popularized the concept of creative destruction, I’ll try to define a new concept that is the opposite — destructive creativity.  Destructive creativity is when bureaucrats or regulators get too clever, and in an attempt to solve a lesser problem, end up creating a bigger problem.

I’ve heard proposals for further debasement of the currency via placing expiration dates on currency, or randomly canceling currency through lotteries based on the serial numbers on the bills.  The idea is that people will change their behavior: save less and spend more.

I can’t say that I can see every unintended consequence with these proposals, but according to Keynes, Lenin said, “The best way to destroy the capitalist system is to debauch the currency.”  These creative means of debasing the currency might do it.

Who gets to be the one holding the Old Maid card as expiry draws near.  How much time would be wasted scanning currency at registers as money is handed over and change is handed out?  Is the money cancelled or expired?  Close to expiration?  Quick, put it into the pile to give as change to the next customer.  There may be legal tender laws, but I can tell you that there would be fights over things like this.  Would all of the dollar bills used as a shadow currency overseas come trotting home?

If the Fed wanted to write its own death warrant, it should implement schemes like these.  The Fed is already viewed with enough skepticism by average people, that it wouldn’t take much to tip the scale from “Audit the Fed,” to “End the Fed,” where it gets replaced with the currency board tied to a commodity standard.

This leaves aside ideas like expiring/canceling a certain amount of monies in savings or checking accounts.  After all, why stop with the paper money?  Move onto the blips that we transfer day after day, silently, quietly choking the economic well-being of people, making them feel less safe, less secure, more paranoid.  Would we set up checking/savings accounts in other currencies to avoid this trouble?  Would that even work, such that we would have to set them up in foreign countries, and access funds that way?  What’s that you say?  Exchange controls?  Destructive creation indeed.  To “solve” a smaller problem, a dud economy, create a much larger problem…

Want to kill the economy/country?  Taxation is one thing, confiscation is another.  There are more than enough people who have question marks in their heads over what the government is doing with monetary policy and stimulus.  Aggressive actions to debase the currency can turn those question marks in to exclamation points.

This has gone longer than I thought.  Time to hit publish, and I will finish this tonight.

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.