Macroeconomics – Page 112

Seven Brief FOMC Notes

Posted on 31 January 2008 by David Merkel

1) From an old post at RealMoney:

		David Merkel
		Nominate Fisher for the ‘FOMC Loose Cannon’ Award
		6/1/05 4:05 PM?ET

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.

Time to Begin Increasing Credit Risk Exposure

Posted on 31 January 2008 by David Merkel

Ugh, today was a busy day.? My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut.? The bond market direction I got right.

Look at this post from Bespoke.? Ignore the percentage increase, and just look at the raw spread levels.? Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield.? When you get to 10% yields, the odds tip in your favor on high yield.? That said, today’s crop of high yield corporate debt is lower rated than in the past.? Don’t go hog wild here, but begin to take a little more risk.? I was pretty minimal in terms of credit risk exposure for the last three years, owning only a? few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

For which of the following risks am I being adequately rewarded?? Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
What are my client’s tax needs?
How much volatility is my client willing to tolerate?
How unconventional can I be without losing him as a client?
What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions.? That is where I have been for the past three years, and now it is time to adjust that position.? With respect to the list of risks:

Illiquidity: indeterminate, depends on the situation
Credit/Equity: begin adding, but keep some powder dry
Negative Convexity: attractive to add to prime RMBS positions at present.
Duration: Avoid.? Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
Sovereign Risks: Avoid.? You’re not getting paid for it here.
Complexity/Taint:? Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
FX: Neutral.? Maintain core positions in the Swiss Franc and the Yen for now.? Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now.? The biggest changes are on credit risk and FX.? That’s a big shift for me.? If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views.? Also, for those that have read me here and at RealMoney.com, you will know that I don’t change my views often.? I’m not trying to catch small moves.? Instead, I want to average into troughs before they hit bottom.? If you wait for the bottom, there will not be enough liquidity to implement the change in view.

My Best Relative Value Week in a Long Time

Posted on 26 January 2008 by David Merkel

I’ve worked for years to take the emotions out of my investment processes, with some success.? Where it gets tough is when I am in an absolute and relative drawdown, as I was for most of the second half of 2007.? Nonetheless, I stuck with my disciplines.? This week, a lot of things went right:

Retail
Insurance
Trucking
Energy
Small cap value was the best style

Will this persist?? Who can tell…? I was ahead of the Russell 2000 Value index this week, even though my portfolio is more midcap value in nature.? I’m still wrestling with where to deploy incremental funds.? I’m 2-3 positions light at present, and I know I am already insurance-heavy, with many of my best candidates being insurers, and the rest Irish Banks.? I don’t want to get too heavy in financials… I’m overweight there now.? Ideas are welcome.? Oh, at the end of the day I did make a small purchase:

		David Merkel
		Rebalancing Buy
		1/25/2008 4:02 PM EST

Bought some Gruma, SA into the close. Tortillas and other Mexican foods are not going out of style, even if the Mexican stock markets are having difficulty of late. I’ve had a good week. Hope you did too.

Position: long GMK

The market always has a new way to make a fool out of you, so I am not relying on a change in the financial weather here.? I just keep doing what I do best.

Full disclosure: long GMK

Miscellaneous Musings on Our Manic Markets

Posted on 25 January 2008 by David Merkel

1) I had another good day today, but my body is telling me otherwise.? As I wrote at RealMoney:

		David Merkel
		Two Positive Surprises; Two Things I Don’t Do
		1/24/2008 3:11 PM EST

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.

As I commented last night, Bernanke is a bright guy who will not let his name go down in the history books as the guy who allowed Great Depression #2 to emerge.? So as? the bubble bursts, the Fed eases aggressively.? Even Paul Krugman points to the writings of Bernanke on the topic.

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.

Full disclosure: long RGA BRNC

Living in the Shadow of the Great Depression

Posted on 24 January 2008 by David Merkel

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.

Three Notes on Housing

Posted on 23 January 2008 by David Merkel

1) One part of the story that does not get much play is the demographic story on real estate.? (Note graph on the left.)? Baby boomers will try to cash out of homes to fund their retirement.? Now, that effect will vary by region, because oldsters will want to live in warmer or drier climates.? Perhaps apartments in Florida, the South and the West will benefit, as homes in the Midwest and Northeast languish.? Then again, at least in the Midwest, it would be cheap to live there, as well as less popular areas in the South.? Perhaps we should turn New Orleans into a haven for retirees. 😉

2) Housing prices down by another 25-30%? Sounds too severe to me, but markets do overshoot, particularly illiquid markets.

3) Even when recourse is available, lenders often find it not worth their while to pursue those who “mail in the keys.” There are many who are giving up on their homes, and rationally so, because they know that the home is beyond their means.? They may have known it from the time they took out the loan, realizing that they got a lot more house than they ever dreamed of.? Well, we wake up from dreams and face reality.? Given the slipshod nature of the lending, many banks will not pursue for recourse.? You can’t squeeze blood from a stone.

PS — I should have a post tomorrow on the portfolio reshaping.

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A Bonus from MoneySense Magazine

Posted on 23 January 200820 June 2017 by David Merkel

For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.? In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.? Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.? Fortunately, the piece I wrote was generic, and can benefit investors anywhere.

Notes on Stocks and the Fed

On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.? It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.? This wasn’t just true of the US, but of most global equity markets.

So, if we are going down further, the market will have to rest a while.? That said, valuations are more compelling than they were, especially compared to Treasuries.? Compared to BBB corporate yields, they are still attractive.? I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.

One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.

Deflation or Inflation? Why Choose?

Posted on 22 January 2008 by David Merkel

Some of the commentary regarding inflation and deflation misses the point.? We are presently faced with both rising consumer price inflation and asset deflation.? Not a fun combination, to say the least.? It puts the FOMC into a real box.? To borrow an analogy from the Bible, Greenspan ate sour grapes, and Bernanke’s teeth are set on edge.

So what does the FOMC do in such a situation?? We don’t have that much history to work with, but during the ’70s, the FOMC generally loosened.? Fixed income portfolios should tilt toward shorter duration, even though you are losing income, and away from the dollar.? It is probably still too early to begin taking a lot of additional credit risk, but the bet is getting more attractive by the day.

Now, there are a number of commentators that can’t wait one week, and say the FOMC should act now.? The economy is not like someone that you have to take to the emergency ward; one week makes little difference, and the FOMC will do better work if they are meeting each other face-to-face under normal meeting conditions, than over a conference call.

Given the present equity market distress, should we assume that the FOMC will do more than 50 basis points in January? Had you asked me last week, I would have said “no.”? The political pressure is a lot higher now, so I would say yes, they will do more.? It won’t help the areas under credit stress, but it will make it look like they are serious about “fixing the economy.”

We could see a move of either 75 or 100 basis points.? I debate internally how good Fed funds futures are in abnormal environments like this.? Under Greenspan, I sometimes felt that monetary policy had been privatized, and whatever the futures market said, the FOMC would do that.? I don’t know if Bernanke has the same faith that futures traders know what the right monetary policy is.? If I were a Fed Governor, I certainly would not have that confidence.? Once the yield curve gets to a certain slope, the recovery will come in time.? Making the curve steeper won’t make it any faster.

People are impatient, and their complaining causes the FOMC to overshoot on policy decisions.? The lag that monetary policy has is significant, and the FOMC in recent years has made it even slower through their policies of incrementalism.

There are several possibilities here for the FOMC action:

They hold firm, and don’t lower much (50 bp), because price inflation is a concern.
They take the judgment of the futures traders, and move a full 100 bp.? Or, they conclude that asset deflation is a bigger risk, and decide to make a bold statement.? After all, isn’t Bernanke the guy who never wants to see the Great Depression recur, and loose monetary policy can prevent that?? (I don’t think that’s right, but…)
They split the difference, make bows to both camps in their language, and do a 75 bp cut.

The last of those seems most likely to me.? I have said in the past that the FOMC is:

Being politically forced to loosen more than they would like, and
Dragging their heels in the process.

That’s why I think we end up on the low end of where Fed funds futures will likely point tomorrow.? 75 basis points does not trip off the tongue, but will be a compromise position in the minds of Federal Reserve Governors who are puzzled at the present situation.? Because of political pressure, they know that they have to move big, but consumer price inflation will make them less aggressive.

Bond Bubble?

Posted on 19 January 200820 January 2008 by David Merkel

Eddy Elfenbein at Crossing Wall Street has put forth the concept of a “bond bubble” over at his blog.? I support the concept in part, but I need to modify it.? Let’s call it a Treasury Bond Bubble, because other classes of intermediate term debt have significant yield spreads over Treasuries because of the current economic volatility.

Should 2-year Treasury notes yield less than CPI inflation? No, and CPI inflation is not going down.? Scarcity of food and fuel are normal conditions in our growing world.? We can only extract so much out of the planet in the short run.? Why lend to the government at a loss?? Better to invest in a money market fund, or perhaps, the stock of a business that is inflation-sensitive, or TIPS.

Can 2-year yields go lower?? You bet they can.? The Fed is flooding the short end of the yield curve with liquidity for now, until inflaton pressures become intolerable.? In the present political environment, the Fed is incented to loosen, even in the face of rising inflation.? Remember my “pain model” for the Fed.? They move in the direction that avoids the most political pain.? People are screaming over a weak economy now, and no one complains about inflation.? Thus they loosen.? How much at the end of January?? Uh, that is up for grabs.? My view of the Fed is that they want to drag their feet, because they see inflation rising, so even if Fed funds futures indicate a 75 basis point cut, my current view indicates 50 as more likely, again, with language in the statement that indicates even-handed risks.

One final note: the concept of a bond bubble sounds a little like the Austrian school of economics.? The central bank pushes interest rates below the natural rate of interest (i.e., the one that would exist in an free market equilibrium), in order to stimulate the economy.? Bonds would be worth more than their long-term intrinsic value in such a scenario.? That’s true today, with one modification, because of the credit stress, only the highest quality borrowers get those rates.

Meet Some of my Friends

Posted on 19 January 200822 June 2017 by David Merkel

In the center of the picture to the left are my friends Bill and Margie Wright. They have been dear friends of our family for eight years. Their kids have played with ours; they have ten, we have eight.

They’re special people. Margie has homeschooled all of their children (so far), and Bill has built a thriving enterprise, Wright Manufacturing, which makes the best commercial lawn mowers in the world. (Full disclosure: I own a little less than one percent of his private firm.)

Wright Manufacturing is unusual because it is a very innovative firm. They manage the business well with a series of principles borrowed from some of the best Japanese manufacturers, but then marry that to the exceptional innovative engineering talent of Bill Wright and his staff. Many of his competitors license his patented technologies.

Oh, the person on the far right of the picture is, yes, President Bush. He came to visit Bill’s factory today, and gave a brief talk on the economy, and the proposed stimulus package. Here’s what he said:

1:55 P.M. EST

THE PRESIDENT: Let me tell you why I’m here. This man started his own business. He’s a manufacturer, he employs over a hundred people, and he represents the backbone of the American economy. And today I talked about our economy, and the fundamentals are strong, but there’s uncertainty. And there’s an opportunity to work with Congress to pass a pro-growth package that will deal with the uncertainty.

Any package has got to remember that jobs are created by small businesses. A good package will have incentives for investment. The package we passed early in my administration helped him. He bought some equipment and made his firm more productive, kept him in business. And that’s the same spirit that needs to be in this next growth package.

The other thing is, is that we got to make sure that we benefit consumers. We want our consumers out there spending, and the best way to do that is broad-based tax relief. Now, this plan ought to be broad-based, it ought to be simple, and it ought to be temporary.

I had a conversation, Congressman, with the leadership on both sides of the aisle yesterday, and I was encouraged by what I heard. And I believe we can come together on a growth package very quickly. We need to. We need to get this deal done and get it out and get money in the hands of our consumers and our small business owners to help this economy.

I’m optimistic, I truly am. One reason I’m optimistic is because I understand we got all kinds of Americans just like this man here, working hard to provide a living for folks and to make a product people want.

And so, while there’s some uncertainty right now, if we act quickly and in a smart way that helps growth, we’re going to be just fine.

Anyway, thanks for letting me come by. I’m proud to be — I love the entrepreneurial class in — I love people who have a dream and work hard to achieve the dream.

And so — a fine-looking machine you got here.

MR. WRIGHT: Thank you. It’s a team effort. We thank you, thank you for all your work, too.

THE PRESIDENT: Do you wonder where they got the name “Wright?” That’s his name. And his wife is the co-founder of the company. And this is — it’s really great to be with you.

And, Congressman [DM — Roscoe Bartlett, another good guy with a big family], thank you for being here. I’m proud to be with your workers. You’ve got some fine workers.

MR. WRIGHT: We’ve got a great team here, don’t we?

THE PRESIDENT: Yes, you do. And if they get a little more money in their pocket as a result of the growth package, it will help make sure this economy continues to grow.

Anyway, thank you all very much.

END 1:59 P.M. EST

Bill, for all of his accomplishments, is a humble guy. He and Margie went through many lean times during the early years, and they bore with it well. The business began as a lawn mowing business, and then broadened out to software for managing lawn mowing businesses, together with grass catching attachments. That started the manufacturing. Bill developed a wide number of innovations, from zero-turning radius mowers, to sulkies, and more.

In my opinion, President Bush could not have picked a better place to visit. It is an example of American manufacturing at its best, and Bill Wright is a great example of American entrepreneurship. I am proud to be a part owner of the firm, and to have been able to help Bill at times on financial issues.

Now, for further coverage of the visit of President Bush:

Bush Wants Fast Tax Aid to Boost Economy

Frederick Residents Voice Concerns About Economy

Frederick Officials Hope They Are Recession-Proof (Video)

As far as I am concerned, the stimulus package is hooey; what stimulus occurs now will be funded by debt and a cheaper dollar later. There is nothing wonderful there. There is something wonderful about the Wrights though, and I am happy to be a small part of that.