With apologies to Mr. Krugman, I must correct some of what I wrote in my piece, “Pushing on a String? Credit Marches to its Own Drummer.“? When one does statistical analyses, one needs to understand the limitations/features of the tools that one uses.? Bloomberg’s regression function had a funny default that led me to make an error.? Had I done it right, the R-squared over the full sample period would have been 64.8% (correlation 80.5%), with a beta of 0.614.? Lagging the Fed funds target by one year, roughly the time it takes Fed policy to work boosted the R-squared to 77.2% (correlation 87.9%), with a beta of 67.1%.
But, here ‘s what is unusual.? If one is looking at the last five years, the relationship has broken down.? During that period, with no lag, the R-squared was 11.2% (correlation 33.5%), with a beta of negative 13.0%.? Even with the lag, the R-squared was 3.8% (correlation 19.4%), with a beta of negative 3.7%.
My conclusion: given the unusual credit conditions in the 2000s, where we have had extremes of default and monetary policy, I would not rush to say that the Fed is pushing on a string, yet.? That said, the debts of financial companies are a larger part of the index than they were five of ten years ago, and they are the ones in trouble at present, unlike the prior difficulties in industrials and utilities in 2001-2003.? Because of that, the Baa index of Moody’s may lag longer than ordinary versus Fed funds… but Fed policy has been called impotent before, and usually just before it shows its bite, as in the tech bubble of 2000, or the liquidity rally of spring 2003.
To my readers: if you see something that might be amiss in my writings, post a comment.? I owe it to all of you that I post corrections when I make mistakes.? Thanks for bearing with me on this one.? In the original piece, I sounded more certain than I should have, to my detriment…
Thanks to Naked Capitalism for pointing out this post by Paul Krugman. Here was my response:
Mr. Krugman, do your homework.Extend the graph out to five years, and you will see that yields on Baa bonds fluctuated between 7.1% and 5.7% over that time period.The correlation between Fed funds and Moody’s Baa series was pretty small during that time period, whether the fed funds rate was rising or falling.I just calculated the R-squared on the regression — 0.1%, for a 3.2% correlation.
Maybe it’s just a bad time period, so I ran it back to 1971, which was as far as my Bloomberg terminal would let me go.(Maybe I’ll go to FRED and download longer series, and use Excel, but I don’t think the result will be much different — the R-squared was 6.5%, for a correlation coefficient of 25.5%.Not a close relationship in my book for two time series relationships that are both interest rates.
Practical economists like me are aware that credit-sensitive investments often have little practical relationship to Fed funds.We work in the trenches of the bond market, not the isolation of academic economics, where you don’t contaminate your theories with data.
The Fed may or may not be pushing on a string, but you have certainly not proven your case.
-=-=-=-=-
Here’s the graph for the Fed funds rate and Moody’s Baa yield series since 1971. (When I ran my calculations, I used monthly, but could only get the graph back to 1971 if I went to quarterly.
(graph: Bloomberg)
As I said, not much of a correlation, but why so low?? This is related to a topic on which Bill Rempel has asked me for an article.? (To do that article, I have to drag a lot of yield data off of Bloomberg for analysis; I will be getting my full subscription soon, and once that happens, I can start.)
As an investment actuary, I’ve had to develop models of the full? maturity/credit yield curve — maturities from 3 months to 30 years (usually about 10 points) and credit from Treasuries, Agencies and Swaps to Corporates, AAA to Single-B.? A Treasury yield curve at any point in time can be fairly expressed by a four factor model, and the R-squared is usually around 99%.? (I learned this in 1991, and there is a funny story around how I learned this, involving a younger David and a Bear Stearns managing director.)
The short end of the Treasury yield curve is usually far more volatile than the long end in yield terms (but not in price terms!).? All short high-quality rates are tightly correlated, and that includes Fed funds, Agency discount notes, T-bills, LIBOR (well, usually), A-1/P-1 commercial paper, etc.? As one goes further down the yield curve in maturity, the correlations weaken, but still remain pretty tight among bonds rated single-A or better.? (As a further note, Fed funds and 30-year Treasury yields also don’t correlate well.)
Credit is its own factor, which varies with expectations of the economy’s future prospects.? A single-B, or CCC borrower can only repay with ease if the economy does well.? If prospects are looking worse, no matter what the Fed does to short high-quality rates, junk grade securities will tend to rise in yield.? Marginal investment grade securities (BBB/Baa) will tread water, and short high-quality bond yields will correlate well with Fed funds.
When I say “credit is its own factor,” what I am saying is that outside of Treasury securities, every credit instrument participates to varying degrees in exposure to the future prospects of the economy.? (Credit in its purest form behaves like equity returns.)? For conservatively capitalized enterprises with high quality balance sheets, their credit spreads don’t change much as prospects change for the economy.? For entities with low quality balance sheets, their spreads change a lot as prospects change for the economy.
So, for two reasons, Mr. Krugman should not have expected the Fed funds target rate and the Moody’s Baa yield to correlate well:
Fed funds is a short rate, and Moody’s Baa is relatively long (bonds go over the full maturity spectrum).
Fed funds correlates well with the highest quality yields, and Baa is only marginally investment grade.? Recessions should hurt Baa spreads, leaving yields relatively constant.
There are many things that are unusual about the current Treasury yield curve. I’ve built a moderately-sized model to analyze the shape of the curve, and what it might tell us about the state of the economy, and perhaps, future movements of the yield curve. My model uses the smoothed data from the Federal Reserve H15 series, which dates as far back as 1962, though some series, like the 30-year, date back to 1977, and have an interruption from 2002-2005, after the 30-year ceased to be issued for a time.
So, what’s unusual about the current yield curve?
The slope of six months to three months (19 bp) is very inverted — a first percentile phenomenon.
The slope of two years to three months (38 bp) is very inverted — a third percentile phenomenon.
The slope of seven years to ten years is steep (57 bp – 5 bp away from the record wide) — a 100th percentile phenomenon.
The slope of five years to thirty years is steep (186 bp – 30 bp away from the record wide) — a 100th percentile phenomenon.
The slope of two years to thirty years is steep (274 bp – 97 bp away from the record wide) — a 97th percentile phenomenon.
The slope of ten years to thirty years is steep (82 bp – 29 bp away from the record wide) — a 98th percentile phenomenon.
The butterfly of three months to two years to thirty years is at the record wide (312 bp). (Sum of #5 and #2. Buy 3 months and 30-years, and double sell 2-years? Lots of positive carry, but the 30-year yield could steepen further versus the rest of the curve, and its price volatility is much higher than the shorter bonds.)
What prior yield curves is the current yield curve shaped like?
9/7/1993 — after the end of the 1990-1992 easing cycle to rescue the banks from their commercial real estate loans.
2/15/1996 — after the end of a minor easing cycle, recovering from the 1994 “annus horribilis” for bonds.
9/14/2001 — 60% through the massive easing cycle where Greenspan overshot Fed policy in an effort to reliquefy the economy, particularly industrial companies that were in trouble. Also days after 9/11, when the Fed promised whatever liquidity the market might need to stave off the crisis.
Okay, I’ve set the stage. What conclusions might we draw from the current shape of the yield curve?
The curve is forecasting a 2% Fed funds rate in 2008.
Fed policy is adequate at present to reliquefy the economy; the Fed doesn’t need to ease more, but it will anyway. Political pressure will make that inevitable. (If we really want an independent central bank, let’s eliminate the pressure oversight that Congress has over the Fed. Better, let’s go back to a gold standard; a truly private monetary policy. Oh, wait. I’m behind the times. We don’t want an independent central bank. Dos that mean we can now blame Congress for monetary policy errors?)
We could see a record slope for the yield curve (in the post Bretton Woods era) if the Fed persists in its easing policies.
One can sell sevens and buy tens, dollar-duration-weighted and have positive carry. Assuming one can hold onto the position, it would be hard to lose at these levels, if the last thirty years of history is an adequate guide to the full range of possibilities.
The Fed is planting the seeds of its next tightening cycle now. Every cut from here will make the tightening cycle that much more intense.
The curve can get steeper from here, but it is getting close to the boundaries where strange things begin to happen. The Fed is not omnipotent, and the steepening curve is evidence of that.
As I have said before, recently, the US Dollar is no longer a “sell” for now. The anticipation of Fed funds cuts is already factored in, and even if we get down to 2%, I suspect that we can’t go much lower because of negative real interest rates and rising inflation.
That’s where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable. Continue reading “What Might the Shape of the Treasury Yield Curve Tell Us?”
I’m just trying to clean up old topics, so bear with me:
1) This blog is not ending because of my new job. Finacorp wants me to keep it going, and they may use the posts in PDF form for clients. Also, unlike my prior employer, Finacorp wants me to have a high degree of exposure, because it aids them. You may see me in more venues, which could include TV and radio.
2) In one sense, I had an unusually productive Saturday. I built two models — one for a critique of the PEG ratio, and one for a model of the Treasury yield curve. You will see articles on both of these, and I am really jazzed on both of them. It is not often that I get one impressive result in a day. Today I got two. I’ll give you one practical upshot for now, if you are an institutional bond investor: go long 10-year Treasuries and short 7-year. We are very near the historical wides. If you are like me, and can live with negative carry, dollar duration-weight the trade, so that you are immune to parallel yield curve shifts.
3) I didn’t read Barron’s, Forbes, or The Economist today, but I did read the Financial Analysts Journal. In it there were three articles that are worth a comment. There was an interesting article on fundamental indexation that comes close to my view on the topic. Fundamental indexation, when properly done, is nothing more than enhanced indexing with a value tilt. Will it make you more money than an ordinary index fund? Yes, it will, over a long enough period of time. Will it work every year? No. Is there one optimal way to fundamentally index? No. There is no one cofactor, or set of cofactors that optimally define value, if for no other reason than the accounting rules keep changing.
4) The second article went over the value of immediate annuities as risk reducers to retirees, something I commented on recently. The tweak here is buying annuities that start paying later in retirement, for example at 80 or 85, with the risk that if you die before then, you get nothing. Longevity insurance; a very good concept, but the execution is tough.
5) The third article was on Risk Management for Event-Driven Funds. Here’s my take: risk arb is like being a high yield bond manager. Anytime a deal is announced, you have to do a credit risk analysis:
How likely is it that this deal will go through?
How badly could I be hurt if it does not go through?
Am I getting paid more than a junk bond with equivalent risk?
But the portfolio manager must ask some more questions:
Are there any common factors in my risk arb book that could bite me? Sectors? Need for debt finance?
What if deal financing terms go awry all at the same time? How will that affect the worst risks in my book?
Am I getting paid more than a junk bond with equivalent risk? (Okay, it’s a repeat, but it deserves it.)
Risk arbs have been burned lately, with all of the deals that have been busted because financing is not available on easy terms. It’s tough but this happens. Most easy arbs tend to get overplayed before blowups happen. The lure of easy money brings out the worst in people, even institutional investors.
I took some criticism at RealMoney.com for writing things like this about GM, though the author here was a much better writer.
The thing is, there are enough levers here that GM can keep the debt ball in the air for some time, as can many of the financial guarantors, so long as they can make their interest payments.
The “Big 3” lose vitality vs. Toyota and Honda each year — in the long run GM and Ford don’t make it. Perhaps after they go through bankruptcy, and shed liabilities to the PBGC, and issue new equity to the current unsecured bondholders, they can exist as smaller companies that have focus. Maybe Ford could be a division of Magna, and GM a division of Johnson Controls. At least then there would be competent management.
7) Barry Ritholtz had a good post called, 5 Historical Economic Crises and the U.S. The paper he cited went into five recent crises in the developed world, and how the current US situation stacks up against that.? Here was my comment on one of the areas where the US situation did not seem so dire, that of the run-up in government debt:
On the last point about the increase in the debt, what is missed is that a lot of the government debt increase is hidden by the non-marketable Treasury bonds held by the entitlement programs. Add that in, and consider the unfunded promises made at the Federal, State, and municipal levels, and the debt increase on an accrual basis is staggering.
We do face real risks here.? The rest of the world will not finance us in our own currency forever.? Oh, one critical difference between the US and the 5 crises — we are the worlds reserve currency, for now.
8 )? I like Egan-Jones on corporate debt.? They have quantitative models that follow contingent claims theory, and use market based factors to estimate likelihood and severity of default.? They are now trying to do models for asset backed securities.? Very different from what they are currently doing, and their corporate models will be no help.? They will also find difficulties in getting the data, and few market-based signals that inform their corporate models.? I wish them well, but they are entering a new line of business for which they have no existing tools to help them.
9) This article from Naked Capitalism pokes at the rating agencies, and the proposed reforms from the SEC.? My view is this: the financial regulators need a model on credit risk.? They need a common platform for all credit risks.? They need one set of ratings that allow them to set capital levels for the institutions that they regulate, or they need to bar investments that cannot be rated adequately.? The problem is not the rating agencies but the regulators.? How do they properly set capital levels.? They either have to use the rating agencies, or build internal ratings themselves.? Given my experiences with the NAIC SVO, it is much better to use the rating agencies.? They are more competent.
I’ve wanted to post on a bunch of little things for a while, and while it won’t make for organized reading, maybe we can have some fun with it?? Here goes.
1) If Prudential drops much further, I am buying some.? With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company.? I am also hoping that Assurant drops below $53, where I will buy more. ? The industry fundamentals are generally favorable.? Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife…? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry.? Going into the energy wave in 2002, I was quadruple-weight energy.? Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so.? This is a defensive group, with reasonable upside.? I’ll keep you apprised as I make moves here.
2) Reader Steve brought this to my attention: Mark Gilbert at Bloomberg brought attention to a monetary policy game at the San Francisco Fed’s website.? So did the estimable Marketbeat blog at the WSJ.? The game used to be found at this link.? Alas, no more.? Maybe all of the attention crashed the site, after all, the SF Fed can’t afford a heavy-duty website like mine.? Okay, sorry, they get 10x the traffic that I do, more like The Kirk Report.
Perhaps the game was removed over the embarrassment from Gilbert playing the game and applying the current Fed strategy to the game, and finding inflation going through the roof.? Now, for those that want to play a monetary policy game, my current favorite is this one from the Bank of Finland.? In a true American version of the game, we would replace the manic announcer with clips of who else, Jim Cramer.? Nobody does it better.? Oh and for true junkies looking for monetary policy games, here is a list of some of them.
3) Dig the falling long bond.? Worst day since 2004.? Echoing what I said yesterday, there’s a lot of fear in that part of the market, and a lot of foreign interest.? Well, at the 30-year auction, foreign interest was light at the lowest yield since regular auctions began in 1977.? A few strong economic numbers can make fear temporarily dissipate.
When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade). Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)
Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.
Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Position: none
Now after the close, MBIA offered stock at a 14% haircut to the closing price. ? Let’s see where the price closes tomorrow… it almost boils down to the number of buyers saying, “At a 14% haircut, there’s no way that it will close below that level.? We can buy and flip for an easy profit.”? In this case, though, there are 60%+ more shares after this issuance.? That’s some level of dilution.? MBIA may keep its AAA, but that says little for the value of holding company common stock.
5) One reader wrote me, “mr. merkel — would you care at all to expound on point 2? it’s been the assertion of some that what makes the monoline threat a non-issue is specifically that there IS a harmony of interests in seeing ambac, mbia et al at least get to a point where they can run off their obligations. however, i must admit, i’ve not seen the case made with specificity — that is, what are the interests of the interested parties, and how do they conflict or coincide?”
Point 2 was the idea that a bailout would be tough to achieve, because of differing interests on the part of those being sought to bail out the guarantors. ? Here’s my rationale: different investment banks have differing levels and types of exposure to the credit risks covered by the guarantors.? Coming up with an equitable allocation of concessions would be tough, but not impossible.? Beyond that, you have all of the ways that the guarantors reinsured each other, which further tangles the web of promises.? A bailout could be done, given enough time, and enough angelic third-party experts to divide the pie perfectly.? Time is short here, and I suspect the rating agencies will lose patience, given their need to protect their franchises.
6) At present, the yield curve indicates a 2% Fed funds rate by mid-to-late 2008.? Uh, that’s not what I would do, but it seems pretty likely for now.? What kind of price inflation would get the attention of the Fed here?? Beats me; the slope of the yield curve today is adequate to allow banks to make money; if the Fed waits at these levels, the economy should recover over the next two years.
8) From another reader, Bamboo: I have not seen much discussion of the statutory capital requirements of the financial guaranty insurers.? It seems that Article 69 of the New York Insurance Law is the critical statute.
Although the rating agencies do not consider mark to market losses in their evaulations of capital adequacy, do they affect statutory capital?
Is there a possibility that the financial guarantors will have to take a premium deficiency reserve for their structured finance business?
I would like to get a copy of article 69, but I can’t find one.? In general statutory regulations are less market-oriented than rating agencies and GAAP.? The problems usually show up faster on GAAP than Stat, leaving aside high growth situations.
9) Another reader, Bill Luby of VIX and More, writes: Hi David,
Once again, kudos for keeping up a consistently high quality of posting here.? Your thinking often sets my brain in motion — in a very good way.
If you don’t mind, I’d be interested to get your take on the current status of the bond insurer problem and how you think it might play out.? In addition to what happens to MBI and ABK, I am also interested in whether you think others with a stronger financial position (AGO?) might make significant gains in this space.
Cheers,
-Bill
Yes, AGO, Dexia (FSA), and Berky all do well from the turmoil.? Strong balance sheets benefit from increased volatility, even as weak balance sheets are harmed.
10) Finally, from Reader Scott, regarding Medicare and entitlements, “David, wondering your thoughts on how the situation gets addressed.? There is no question at all that the equation doesn’t solve, presently.? My current thoughts are that (1) taxes go higher – not even up for serious discussion; and (2) so do trade barriers.? we trade some protectionism, a la Europe, and reduced overall welfare, for a feel-good “leveling” of some of society’s current inequties.? our nation’s most influential demographic, old folks, who vote, are appeased. add to that, perhaps, some guest worker immigration policies.? second class citizens earning second-tier wages.? on balance, we begin looking a lot more like Europe, reversing the cherished myth of American exceptionalism, and staving off acceptance of the twenty-first being the China Century.? Care to comment?”
Americans are exceptional, and that is not always a good thing.? We have fewer presuppositions than most of the world, and that leads to innovative solutions, a certain amount of unnecessary chaos, and occasional hubris.? We are probably heading for an era of leveling, but that is not certain.? Historically, it is likely.? Trade may be another matter; we may be getting close to a point where the rest of the world sees the value of freer trade, even if the US goes the other way.? Organized efforts against free trade are weak compared to protectionist eras.
As for old folks that vote, yes, that’s what makes this problem tough.? I’m not into doom and gloom, but I can see a negative self-reinforcing cycle coming.? If Bush, Jr., got smacked over his all-too-cautious attempt at Social Security reform (it would have done almost nothing, but listen to the squeals), can you imagine what true reform of a much bigger problem might entail?? We would need a full blown panic in the debt markets to get focus there, and as for now, foreigners are still very willing to roll over US debt denominated in US dollars.
Every now and then, valuation metrics in a market will get changed by the entrance of an aggressive new buyer or seller with a different agenda than existing buyers or sellers in the marketplace.? Or conversely, the exit of an aggressive buyer or seller.
Think of the residential mortgage marketplace over the last several years.? With an “originate and securitize” model where no one enforced credit standards at all, credit spreads got really aggressive, and volumes ballooned. Many marginal mortgage lenders entered the market, because it was strictly a volume business.? Now with falling housing prices, there are high levels of delinquency and default, and mortgage volumes have shrunk, leading to the failures/closures of many of those marginal lenders.? Underwriting standards rise, as capacity drops out.? Even prime borrowers face tougher standards.? In two short years, fire has given way to ice.
If you’ll indulge another story of mine, I worked for an insurer who had a well-run commercial mortgage arm.? Very conservative.? They did small-ish loans on what I would call “economically necessary real estate.”? See that ugly strip mall with the grocery anchor?? Everyone in the area shops there; that’s a good property.
Well, in 1992, the head of the Commercial Mortgage area had a problem.? The company had only three lines of business, and two lines representing 60% and 20% of the assets of the firm were full up on mortgages.? What was worse, was they didn’t want to even replace maturing loans, because the ratings agencies had told the company that commercial mortgage loans were a negative rating factor.? Never mind the fact that the default loss rate was 40% of the industry average.
He stared down the possibility that he would have to close down his division.? He had one last chance.? He called the actuary that ran the division that I was in (my boss), and pitched him on doing some commercial mortgages.? The conversation went something like this:
Mortgage Guy: I know you haven’t liked commercial mortgages in the past, but my back is against the wall, and if you don’t take my originations, I’ll have to shut down.? You’ve heard that the other two divisions won’t take any more mortgages at all.?
Boss: Yeah, I heard.? But the reason we never took commercial mortgages was that we didn’t like the credit spread compared to the risks involved.? 150 basis points over Treasuries just doesn’t make it for us.
M: Well, because many companies have reduced originations, the spreads are 300 basis points now.
B: 300?! But what about the quality of the loans?
M: Only the best quality loans are getting done now.? I can insist on additional equity, in some cases recourse, and faster amortization.? My loan-to-values are the lowest I’ve seen in years.? Coverage ratios are similarly good.
B: Well, well.? Perhaps I’ve been right in the past, but I’m not pigheaded.? Look, we could take our percentage of assets in mortgages from 0% to 20%, but no more.? At your current origination rate, that would allow you to survive for two years.? We will take them all, subject to you keeping high credit quality standards.? Okay?
M: Thank you.? We’ll do our best for you.
And they did.? For the next two years, our line of business and the mortgage division had a symbiotic relationship, after which, spreads tightened significantly as confidence came back to the market.? We had 20% of our assets in mortgages, and the other two lines of business now felt comfortable enough with commercial mortgages to begin taking them again — at much lower spreads (and quality) than we received.
It’s important to try to look through the windshield, and not the rear-view mirror in investing.? Analyze the motives of current participants, new entrants, and their likely staying power to understand the competitive dynamics.? I’ll give one more example: the life insurance industry was a lousy place to invest for years.? Why?? A bunch of fat, dumb, and happy mutual companies were willing to write life insurance business earning a minimal return on capital.? As another boss of mine once said, “It doesn’t take mere incompetence to kill a mutual life insurer; it takes malice.”? Well, malice, or at least its cousin, killed a number of insurers, and crippled others in the late 80s to mid 90s.? Investment policies that relied on a rising commercial real estate market failed.
But that was the point to begin investing in life insurers.? They began pricing capital economically, and the industry began insisting on higher returns as a group.? Many mutuals demutualized, and the remaining large mutuals behaved indistinguishably from their stock company cousins.? The default cycle of 2001-2003 reinforced that; it is one of the reasons that the life insurance industry has had only modest exposure to the current difficulties afflicting most financials.? After years of being outperformed by the banks, the life insurers look pretty good in comparison today.
I could go on, and talk about the CDO and CLO markets, and how they changed the high yield bond and loan markets, or how credit default swaps have changed fixed income.? Instead, I want to close with an observation about a very different market.? Who likes Treasury bonds at these low yields?
Well, I don’t.? At these yield levels the odds are pretty good that you will lose purchasing power over a 2-3 year period.? Then again, I’m a bit of a fuddy-duddy.? So who does like Treasury yields at these levels?
Players who are scared.
Players who have no choice.
There is a “fear factor” in Treasury yields now.? Beyond that, there is the recycling of the current account deficit, which is still large relative to the issuance of Treasuries.? The current account deficit is large, but shrinking, since the US dollar at these low levels is boosting net exports.? As the current account deficit shrinks, Treasury yields should rise, because foreign demand has been a large part of the buyers of Treasuries.? The Fed can hold the short end of the curve where it wants to, but the long end will rise as the current account deficit shrinks.
I think the current account deficit does shrink from here, because the cost of buying US debts, and not buying US goods is getting prohibitive.? Also, fewer retail buyers will take negative real yields.
That’s my thought for the evening.? Analyze the motives of other players in your markets, and don’t assume that the current state of the market is an equilibrium.? Equilibria in economics are phantoms.? They exist in theory, but not reality.? Better to ask where new entrants or exits will come from.
It was pretty tough to dislodge William Poole, but if anyone could win the coveted “FOMC Loose Cannon” award in a single day, it would be Richard Fisher, after suggesting that the FOMC was “clearly in the eighth inning of a tightening cycle, we’ve been doing 25 basis points per inning, it’s been very transparent, and very well projected by the Federal Open Market Committee under the leadership of Chairman Greenspan,” and, “We’re in the eighth inning. We have the ninth inning coming up at the end of June.” [quoted from the CNBC Web site] Why don’t they have media classes for rookie Fed governors and Treasury secretaries? Even if he’s got the FOMC position correct, typically the Fed governors come out with a consistent message, and then, they cloak and hedge opinions, in order not to jolt the markets.
Okay, so Fisher dissented.? So he hasn’t had a predictable tone since becoming a Fed Governor.? Big deal.? The Fed needs more disagreement, and more original thought generally, even if it is wrong original thought, just to challenge the prevailing orthodoxy, and force them to think through what are complex decisions that might have unpredictable second order effects.
2) I hate the phrase “ahead of (behind) the curve,” because there is nothing all that clear about where the curve is.
3) Watch the yield curve, and note the widening today.? That is a trend that should persist, regardless of FOMC policy.
4) Rate cutting begets more cutting, for now.? The current cuts will not solve systemic risk problems embedded in residential real estate, and CDOs, anytime soon.? They will help inflate China (via their crawling dollar peg), and healthy areas of the US economy.
5) Where is the logical bottom here?? How much below CPI inflation is the Fed willing to reduce rates before they have to stop, much less raise rates to reduce inflation?? My guess: they will err on lowering rates too far, and then will be dragged kicking and screaming to a rate rise, as inflation runs away from them.? The oversupply in residential housing will cause housing prices to lag behind the price rises in the remainder of the economy.
6) Eventually the FOMC will resist Fed funds futures, but for now, the Fed continues to obey the futures market.
7) The stock market loves FOMC cuts in the short run, but has not honored them in the intermediate-term.
When I began my career as an actuarial trainee in 1986, I didn’t know much. When I began working in fixed income as an actuary back in 1992, I didn’t know much. When I entered my first investment department and bought my first bond (institutionally CMAT 1999-1 A4) in 1998-99, I didn’t know much. When I was made a corporate bond manager in 2001, I didn’t know much. When I went to work for a hedge fund in 2003, I didn’t know much. It is probably still true today, because “the markets always find a new way to make a fool out of you.” I’ve made my share of mistakes, and then some. But for the most part, I have been a fast learner.
So, what I write in this post is a little speculative. I don’t know as much as I would like to. About seven years ago, I had a conversation with a more experienced colleague about Fed funds futures. It went something like this:
David: Fed funds futures do a really good job predicting Fed moves.
Colleague: Yes, they do.
D: What if Fed is using Fed funds futures to set policy?
C: Huh? You mean let the view of market participants set policy? They would never do that.
D: They certainly could never let it be known that they do that, if they did. There would be too much money chasing the Fed funds futures markets in order to influence policy.
C: The Fed would never do that. Why would they give up their discretion?
D: Perhaps Greenspan might do it in a misguided free-market attempt to let the markets dictate monetary policy, rather than removing the punchbowl, as was said in the ’60s.
C: I think you are wrong here. The Fed is a complex institution and can’t be boiled down to a simple futures market. They take a lot of different things into account before making their decisions. The Fed funds futures market is just very good at sensing the various forces that affect the Fed, and the collective wisdom of the market is very good at predicting the Fed. After all, there is a lot of money on the line.
D: Okay, you’re probably right. One last thing. How much would it be worth if you knew that the Fed followed the Fed funds futures markets, and no one else did?
C: If you had enough money to manipulate the Fed funds futures market, that would be worth a lot. But the Fed sets its own policy, and does not want to be manipulated, so that’s not happening.
D: Thanks. I think I get it.
C: You’re welcome.
I’ve talked before about the Fed outsourcing monetary policy before to the markets. I consider it a possibility that the FOMC uses Fed funds futures to set policy. After all, even with the TAF, the Fed uses Fed funds futures to set a reservation yield for the auction. Even if it is not true that the Fed uses Fed funds futures to set policy, the futures work really well when one tries to predict what the Fed will do.
Now, perhaps this is a bad argument for a different reason: the Fed funds futures market trades alongside all of the short-term debt markets — eurodollars, CP, T-bills, etc. In order to truly move Fed funds, you would have to move much more, and it is unlikely that any single player could do that. The market as a whole could do it, though, because it is bigger than the Fed. But if that were true, no one would be manipulating. The FOMC would simply follow the judgment of the marginal short-term fixed income investor, which wouldn’t make the policy correct, because markets a a whole make forecasting errors.
Back to the Present
I will say it now, the FOMC will cut 50 basis points today, the stock market will rally, and the yield curve will steepen. The explanatory language will make the requisite bows to both sets of risks, but will say that current weakness justifies the cuts. Now, I don’t like this forecast for a few reasons:
The yield curve has enough slope already. 138 basis points between 2-year and 10-year Treasuries should be enough to allow the banks to make money over the intermediate-term.
The NY Fed has left Fed funds on average 6 basis points higher than the target since the emergency cut. Why the incremental tightness?
Total bank liabilities and MZM have been growing at 10%+ rates over the last year. That level of credit growth should be adequate for our level ofnominal GDP growth.
The Fed hasn’t done a permanent injection of liquidity since 5/3/07, and was sparing with them early in 2007. The behavior there is unusual to say the least. Why not be be more conventional if you are loosening monetary policy?
Economic weakness is noticeable, but isn’t severe once one gets outside housing and related industries.
At some point, the Fed has to break with the futures market, and deliver a surprise to the markets as a whole, whether positive or negative. Even breaking out of the 1/4% steps would break some of the models used to analyze the FOMC. How about a 3.1% Fed funds rate? This is a digital era where stocks trade in penny increments. The FOMC can move into that digital world as well.
I was taught in economics class (way back when) that policy moves that were anticipated had no effect. Well, eventually the Fed either needs to take back its mandate that it delegated to the markets, or inform the markets that their best estimate of their policy is wrong, and deliver a surprise. A little confusion, a little lack of transparency would benefit the markets over the long haul, and help to reinstate a sense of risk that has been lost among many market participants.
Eventually this will happen, and it might happen tomorrow, but the money on the line says “Cut 50 bps,” and so I don’t argue.? Compared to the market, I don’t know much.
Two more news bits. I don’t buy for takeovers, but today Bronco Drilling got bought out by Allis-Chalmers Energy. (Now I have three open slots in the portfolio.) I also don’t buy to bet on earnings. But I will ignore earnings if I feel it is time to buy a cheap stock. With yesterday’s purchase of RGA, I did not even know that earnings were coming today. What I did know was that they are the best at life reinsurance, and that it is a constricted field with one big (in coverage written) damaged competitor, Scottish Re. So, today’s good earnings are a surprise, but the quality of RGA is not.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Scottish Re to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Position: long RGA BRNC
2)? There’s a lot of commentary going around on the Financial Guarantors and bailouts, whether to profit-seeking individuals like Wilbur Ross, or a consortium of investment banks who will not do so well without them.? For a good summary of what will make a consortium bailout of the industry as a whole tough, read this piece at Naked Capitalism.? I will say that Sean Egan’s estimate of $200 billion is too high (maybe he is talking his book).? Just on a back of the envelope basis, the whole FG industry earned about $2 billion per year.? If they needed $200 billion more capital to be solvent, their pricing would have to expand about 5-10 times to allow them to earn an acceptable ROE.? No one would pay that.? So, if the $200 billion is right, it is just another way of saying that the FG industry should not exist.? (Well, the Bible warns us of the dangers of being a third-party guarantor…)
Then again, there are many risks that Wall Street takes on where the probability of ruin is high enough to happen at least once in a lifetime, but adequate capital is not held because protecting against the meltdown scenario would make the return on equity unacceptable.? The risk managers bow to pressure so that the businesses can make money, and hope that the markets will stay stable.
3) There’s been even more musing about the Fed 75 basis point cut, with a hint of more to come.? No surprise that I agree with Caroline Baum that the Greenspan Put is alive and well, or with Tony Crescenzi that we could call it the Bernanke Pacifier.? But Bill Gross leaves me cold here.? He and Paul McCulley consistently argued against raising rates during the recent up cycle, and in the prior down cycle cheered the lowering of the Fed funds rate down to 1%.? These policies, which overstimulated housing, helped lead to the situation that Mr. Gross now laments.
I also think that David Wessel and many others let the Fed off too easily on their misforecasting. ? Who has more Ph.D. economists than they do?? I’m not saying that the Fed should read my writings, but there is a significant body of opinion in the financial blogosphere that saw this coming.? Also, they basked in their aura of invincibility when it suited them, particularly in the Greenspan era.
One last note on the Fed: Eddy Elfenbein points out the basic mandate of the Fed.? I’m not sure why he cites this, but it is not a full statement of the Fed mandate, unless one interprets it to mean that the Fed has to promote the continuing growth of the credit markets (I hate that thought).? Since the Fed is a regulator of banking solvency, and must be, because money and credit are similar, the Fed also has a mandate to preserve the banking system under its purview.? That’s difficult to do without overseeing the capital markets, post Glass-Steagall.? Unfortunately, that is what creates at least the appearance of the “Greenspan Put.”? And now the market relies on its existence.
4)? But maybe the Fed overreacted to equity markets getting slammed by SocGen exiting a bunch of rogue trades.? Perhaps it’s not all that much different than 2002, when the European banks and insurers put in the bottom of the US equity markets but being forced to sell by their regulators. If so, maybe the current lift in the markets will persist.
As for SocGen, leaving aside their chaotic conference call, I would simply point out that it is a pretty colossal failure of risk control to allow anyone that much power inside their firm.? Risk control begins with personnel control, starting with separating the profit and accounting functions.? Second, the larger the amounts of money in play, the greater the scrutiny should be from internal audit, external audit, and management.? I have experienced these audits in my life, and it is a normal part of good business.
Because of that, I fault SocGen management most of all.? For something that large, if they didn’t put the controls in place, then the CEO, CFO, division head, etc. should resign.? There is no excuse for not having proper controls in place for an error that large.
That’s all for the evening.? I am way behind on my e-mail, so if you are waiting on me, I have not given up on responding to you.
Don’t we wipe the slate clean after two generations or so?? Or, as my old boss used to say, and he is looking smarter by the day, “We don’t repeat the mistakes of our parents; we repeat the mistakes of our grandparents.”? Our monetary policy is being guided by fear of repeating the Great Depression.? We may avoid that, and end? up with two lost decades, like Japan.? (it would fit the demographic trends…)? Or, maybe, the FOMC will ignore (or suppress the knowledge of) inflation, and bring us back to an era reminiscent of the 1970s.? Either way, we may face stagnation, but defaults are fewer in a 1970s scenario, though those on fixed incomes get hurt worse.
Don’t get me wrong.? I’m not blaming Bernanke and the current FOMC much; the blame really rests with Greenspan, and the political culture that can’t take recessions, so monetary policy must bail us out.? Consistently followed, it eventually leads us into a liquidity trap, or an inflationary era, or both.
Recessions are good for the economy; they clear away past imbalances.? We should have been accepting them to a greater degree over the past 25 years.? But now things are tougher, and most policy actions will lead to suboptimal results.? Personally, if the FOMC could resist the political pressure, leaving Fed funds on hold at 3.0-3.5% would produce an adequate result 2 years out, with some increase in inflation, but allowing the banks to reconcile their bad loans.
The fear is that the FOMC will drop rates to Japan-like levels in order to avoid a Great Depression-style scenario, and create the Japan scenario as a result.? My guess is that we would get more inflation than Japan, and not be able to do that.? We are a debtor nation, versus Japan as a creditor nation; that makes a difference.
Patience is a virtue, individually and corporately.? We are better off waiting and allowing monetary policy to work, rather than overdoing it, and setting up our next crisis.
As For A Financial Guarantor Bailout
The last time financial guarantors went broke in a major way was during the Great Depression.? The financial guarantor stocks have rallied massively in the last few days, and I think those rallies are mistaken.? There is much hope for a bailout of the insurers.
The insurers may indeed get bailed out, if the NY Commissioner can convince those that would get hurt to pony up equity, much as many of them are already hurting at present, but that equity would significantly dilute existing shareholders of the holding companies of the guarantors.? I would not be a buyer of the guarantors here; I would sell.
