Category: Public Policy

The Effect of Democratic Delegate Allocation Rules

Posted on by David Merkel

Photo Credit: Gage Skidmore || Unless things change, Democratic Party Elites should get comfortable with Sanders being their nominee for President

This is a rare post on politics at Aleph Blog. I am not taking a position on any candidate here, nor their effect on the economy. As an applied mathematician, I want to point out the implications of three factors:

  • Bernie Sanders is getting roughly 30% of votes in the primaries/caucuses, and the next five split the rest in an uneven way.
  • These Democratic contests typically award delegates based on the vote in each area as defined by a state, and the state as a whole. The delegates get split pro-rata to a candidate’s share of the vote in each area if the candidate gets over 15%. It’s a little more complex than that if no one gets more than 15% of the vote, but that’s not likely to happen in 2020.
  • If Sanders gets over 35% of all the pledged delegates, it will get increasingly ugly to not give him the nomination the nearer his delegate total gets to 50% of pledged delegates. No one wants a convention where over 1/3 of the delegates feel cheated. If you need examples where there wasn’t cheating, but there were sure a lot of hard feelings, you can think of Ford/Reagan in 1976, Carter/Kennedy in 1980, and Clinton/Sanders last election.

Add in one more bit of data — in an internet age, it is easy to keep a campaign on life support. Candidates with low funds can nominally hold on for a long time subsisting off of what free media and a skeleton staff can give them.

I ran a few simple simulations yesterday. With six main candidates altogether, if Sanders gets 30% of the vote on average, and the other five split the rest in a lopsided way, on average Sanders will end up with roughly 45% of all of the delegates. But suppose one of Sanders’ opponents drops out, and the other assumptions remain similar — Sanders would get 36% of the delegates. If one more opponent drops out, the effect is a lot smaller — Sanders would get 33% of the delegates.

The most unlikely assumption not to change is that Sanders doesn’t pick up support from voters when opponents of his drop out, particularly if the ones dropping out would be Warren or Buttigieg. I would expect that Sanders might pick up more support if one of them dropped out, as opposed to Biden, Bloomberg or Klobuchar.

But the main effect going on here is with so many opponents to Sanders splitting the remaining votes, few of them get above the 15% threshold, and Sanders gets a decidedly higher allocation of delegates than what he got in the popular vote — not as big of a difference as in the GOP’s winner-take-all primaries, but this is still a considerable advantage unless one of his challengers breaks out of the pack.

Thus, when I read an article like No,?You?Drop Out: Why Bernie?s Rivals Are All Stubbornly Staying in the Race I realize that most of Sanders’ opponents would like others to drop out of the race, but no one sees a decent reason to do so. Everybody thinks it’s nice to get more cars off the crowded highway, as long as it is not them.

Thinking back to 2012 when I wrote Searching for the Not-Romney, I noted how virtually every GOP candidate had had a surge and fall versus Romney. After each surge, there wasn’t a second surge. Voters had given them a limited window of time when they reviewed them — they weighed them in the balance, and found them wanting. No second chances.

I don’t think that’s a perfect paradigm. Second chances ARE possible for the opponents of Sanders, but I think they are unlikely. The candidate would have to give voters a reason to think, “Huh, I guess I didn’t understand him right the first time.” Getting a lot of people to change their minds is difficult after a first impression is made. Thus in the present state of matters, I assume that Sanders will be the nominee of the Democrats.

And, since I can’t resist making at least one comment regarding the economic implications of that, yesterday the market went down hard because of the coronavirus, something that I think is transitory, and should have little effect. Perhaps the drop was due to Sanders’ convincing win in Nevada. That would certainly have more effect on the economy, particularly profits, for a longer period of time.

It might be wise to check your risk position, and ask yourself whether you feel comfortable given an increased likelihood of Sanders being the next President of the USA.

All for now.

Greenspan’s Pathology

Posted on by David Merkel

Photo Credit: The Aspen Institute || His shadow still affects central banking today…

At Aleph Blog, I will argue for things that are against my short term interests. After all, the higher stock and bond prices go, the higher my income goes in the short-run. In the long-run, that’s not sustainable.

I am here this evening to criticize the philosophy of Alan Greenspan that had the FOMC doing the bidding of the stock, bond, and futures markets.

  • Don’t disappoint the markets.
  • Give the markets what they want, and everything will work out well.
  • Flag the markets to tell what your intentions are.

None of those are the province of the Fed. The Fed is supposed to care for:

  • Low inflation
  • Low labor unemployment
  • Moderate long-term interest rates
  • (and indirectly) A healthy banking system, because the levers of Fed policy depend on it.

All of these things are going well at present, AND the yield curve has normalized. So why loosen again? Well, Fed funds futures indicate a igh probability of a cut… so give the market what it wants, right?

Ah, bring back Volcker and Martin, who would follow their statutory mandate, and not just mention it to excuse policy errors.

I write this partly after reading this article at Marketwatch. The article is a mix of different opinions, but the ones that get me are the ones that say that the Fed has to listen to the markets.

Well, that’s what Greenspan, Bernanke, and Yellen did, and it led us into a low interest rate morass because they never let recessions do their work and eliminate entities with low marginal efficiencies of capital.

Recessions are not always bad, and lower interest rates are not always good. Just as fires are good for forests in the long run, so are recessions that clear away marginal economic ideas.

It may not come this week. It may not come in the next few years, but eventually the Fed will be willing to offend the markets again. When it does, the jolts will be considerable, but it may lead to a better economy in the long-term.

Improving Liquidity for Small Cap Stocks

Posted on by David Merkel

Picture Credit: OTA Photos || This is easier said than done!

The SEC is seeking ideas on how to make small cap stocks more tradable. Let me quote the closing of an article from the Wall Street Journal:

In soliciting the proposals, the SEC laid out a number of possible approaches, without endorsing any of them.


One such approach would limit trading in low-volume stocks to the exchange where they are listed. Nasdaq Inc. has promoted a similar plan, arguing that it would create deeper markets for small-cap stocks by concentrating the trading of their shares on one venue. But critics, including some rival exchanges,?have attacked Nasdaq?s plan?as anticompetitive, saying it would benefit big exchanges like Nasdaq.

In another approach floated by the SEC, trading in low-volume stocks would take place in periodic auctions, separated by discrete time intervals, instead of continuously throughout the trading day.

SEC Seeks Ideas For Improving Trading in Small-Cap Stocks

I’m not sure that any of these proposals will work. Longtime readers know that I think that liquidity is hard to permanently increase, or decrease for that matter.

By nature, small cap stocks have smaller floats. There’s less information about them Many accounts and managers have mandates that don’t allow them to purchase small cap stocks. Bid-ask sizes and spreads tend to be smaller and larger respectively than those of large caps. That’s largely a function of floating market cap and the underlying riskiness of the company in question. Market structure plays less of a role.

The composition of investors does matter. It typically doesn’t change that much; it is cyclical. Horizons shorten as volatility rises, and vice-versa.

The more buy-and-hold investors there are, the more liquidity decreases. The more traders with short time horizons there are, the more liquidity increases. Commissions declining will possibly make time horizons a little shorter for day-traders, but I can’t imagine that the effect will be that big.

As a smaller investor, I do like the concept of a central order book that would have a monopoly on trading a stock, because it would remove an informational edge that high-frequency traders [HFT] have. I don’t think it would increase liquidity much though. It would change where the trades happen, and perhaps who makes the trades. I think that some less technologically inclined investment advisors would be willing to put up larger bids and asks in such a context, but they would mostly replace lost volume from HFT.

I also think that having more auctions during the day would be a good idea, say like one every half hour. I don’t think it would increase liquidity, though. Trading would become more sparse away from the auctions.

I own four illiquid stocks for my stock strategy clients, and one less liquid closed-end fund for my bond clients. I can trade them if I need to. I just have to be more patient with those securities, and break trades up into bite-size pieces.

For me, trading is a way of implementing changes to the portfolio. If any of the proposed changes happened, my trading would not change much at all. I suspect that would be true for all but the investors with the shortest time horizons, but I think that could go either way. We have lower commissions on one hand, and disadvantages for HFT on the other. Could be a wash.

Enough rambling. I don’t see a lot of likely change here, and liquidity should not be the highest priority at the SEC. Rather than facilitating more secondary trading, it would be nice to see more private firms going public. SEC efforts on that would get my attention.

Post 3000 — I’m glad to be back!

Posted on by David Merkel

Photo Credit: Stephan Caspar || In Roman numerals 3000 is MMM… and thus the yummy picture that will make some people go “mmm….” As for me Mmm… I’m glad to be back.

Every 100 posts (except that I did not do it at the 2900 milestone), I take a moment to reflect. I started blogging back in February of 2007. I was 46 years old then; I am 58 now.

I resisted starting a blog for some time. When my editor at RealMoney asked me (she was asking all the contributors) “Are you going to start a blog?” I answered, “RealMoney, particularly the Columnist Conversation is my blog.”

I loved writing for RealMoney, but in some ways I was not the best fit for RM. I wrote more about theory, and less about actionable ideas. My main reason for that was that beyond holding a CFA charter, and at the time, a dues-paying life actuary, I have a code of ethics in addition to those from CFAI and the SOA. Aside from that, feedback is lopsided, like on Yelp. You get disproportionate feedback when you make a mistake, but little praise when you get something right.

But the reason I decamped from RealMoney was that I wanted more editorial freedom. It is the same reason that I tried writing for The Balance, and gave it up because I needed more freedom to write what I was thinking. (Also, writing for The Balance involved rewriting old articles, many of which were average for the web, but way below my standards. Rewriting those took a lot of time, and did not satisfy the other requirement of writing new articles on topics the the editors wanted, most of which were decidedly niche.)

How Aleph Blog Changed Over Time

When I began, I was writing two small articles per night. I morphed into writing articles that were relatively long, and one per night. I had a goal: to express all of the main ideas that I had come to regarding finance, economics and investment. A major part of that was The Rules posts, which mostly stemmed from insights I had between 1999 and 2003. There were a few that came after that, but not many. When I finished the last of the original Rules posts, I breathed a sigh of relief, because one of the major goals of the blog was complete. I had written an article on all of the “Rules.”

Now, one other thing that changed was the financial crisis. During the crisis, I resolved to write about all of the issues that I thought my distinct view could help explain. But I did not want to be a “crisis blogger.” There are some bloggers that are locked into writing about disaster, which is problematic when we have been in a very long though shallow recovery. Some commenters criticized me for not being like Zero Hedge back in 2009 or so. I ignored it because I want to be an “All Weather” blogger. I will write when the sun shines. I will write when it rains.

I do want to make one comment from the crisis era, when I was one of the bloggers invited to the first US Treasury / Blogger summit. In my 7-part coverage of the event, I never mentioned what I said during the main portion of the event. I was not the most outspoken at that event. Those that were “crisis bloggers” dominated the conversation.

There were only two things I got to say during the meeting. The first was my telling them that they could learn something from the way Canada regulates their banks, and also that the US state-regulated insurance companies were regulated better than the depository institutions in the US, especially for solvency.

The second thing that I said was that the US should lengthen maturities for Treasury issuance, and issue fifties, centuries, and consols. Also, they should issue floating rate debt. I told them that the US government would face a crisis when there is too much debt to roll over, so stagger the maturities, and pay up to borrow longer.

Back to the Present

I wrote a lot of book reviews in the past. I am unlikely to write a lot more of them, though there will be some. Part of that is Amazon favoring reviewers that bought their books at Amazon. I got most of mine from the publishers.

I have maybe 40 article ideas to work on now. Many of them will require significant work. Many of my best articles required that level of work, but it will mean that my output will slow down. If you have something you would like me to write about, send me an email. My address is on the Contact Me page. I don’t guarantee that I will write about it, but reader letters have led to more articles at my blog than most others.

Thanks to my Readers

There is one post that is especially dear to me, the one entitled Learning Leadership. It describes a time when I effected a huge change in the business that I worked for, and got little to no reward for doing so.

I thank all of my readers for reading me, wherever you are. One-third of my readers are outside of the US. I try to write for a global audience, but living in the US, I know that it will be somewhat US-centric. All the same, I invite those outside the US to write me and ask me questions.

And with that, I close this piece. Not that I will answer every question, but I will read everything that is written to me. My readers help make my blog better. Keep writing to me and helping me; I appreciate it.

Issue Longer Treasury Debt

Posted on by David Merkel

Picture credit: DonkeyHotey || Should bonds get longer?

When I visited the US Treasury during the first Treasury/Blogger summit I encouraged the US Treasury to issue debts longer than 30 years, and also floating rate debt. I said the insurance companies, pension funds and endowments would be willing buyers, and that it would be cheaper than issuing 30-year bonds. I thought that the yields on (say) 50-year bonds would be lower than 30-year bonds, because the yield curve for most of my life (at that point) had the yield curve peaking out at around 22 years or so. 30-year bonds usually yielded less than 20-year bonds.

The case for issuing longer debt was easy when 30-year bonds yielded less than 20-year bonds. That is no longer true, and has not been true since the financial crisis. In a low interest rate environment, 30-year bonds yield more than 20–year bonds. In a higher interest rate environment, the relationship flips.

So, should the US treasury issue 50-year, 100-year, or perpetual bonds? I still think the answer is yes, and for three reasons.

1) It’s an experiment. The market doesn’t always know what it wants until you offer an option to it. No degree of discussion with the advisory committee can beat an actual offering to the market. There used to be callable T-notes, and even a Treasury note denominated in Swiss Francs. Experiments are worth trying on a small level just to see what happens. Knowledge is a valuable thing — theory is worth less than tangible data.

2) Rates are low. Why not lock in the low rates? Even if 50-year bonds have a premium yield to 30-year bonds, those yields are likely lower than what you might get when interest rates are high.

3) It would be genuinely useful for life insurance companies and pension funds to have a benchmark for 50-year bonds, which would encourage the corporate market to issue debt as well. Those who make long promises need others who will make similarly long fixed commitments.

Then there are the speculators, who I don’t care much about. They would appreciate longer debt as well, as it would give them a greater place to speculate.

My advice to the US Treasury is this: issue longer debt as an experiment. If there is additional cost in the short-run, see if it is cheaper in the long run. There is a market for longer debt, even if your advisory committee thinks differently.

Always Late

Posted on by David Merkel

Photo Credit: Brendan Ross || When policy is late it becomes procyclical. Better to do nothing.

Start with four premises.

1) One of the things everyone acknowledges about monetary policy is that it works with long and variable lags. It’s kind of like dealing with an unmanned space vehicle a long way away. You have to make choices taking into account the lag for the signal to get there, and the lag for the craft to send back data on what is happening. Fortunately with this the length of the lags are known.

2) Another thing that most economists acknowledge is that employment is a trailing indicator of the economy as a whole. Thus employment can misrepresent the strength of the economy. The economy can be strengthening rapidly, and employment has barely budged, or like now, the economy can be weakening and employment can seem really strong.

3) Then there is the Fed’s dual mandate, which means the Fed must try to aim for low consumer price inflation and low labor unemployment.

4) Further confusing matters here is the Phillips Curve, which posits negative correlation between consumer price inflation and labor unemployment. The key assumption of the Phillips Curve is that there is a fixed relationship between wage increases and price inflation. It is dubious that this theory ever worked. If it ever worked, it was during an era when closed economy macroeconomics was a reasonable approximation for how the US economy worked. This might have been true in the 20 years following WWII.

In an open macroeconomy like today, as the US economy strengthens, labor can be sought in many other countries than the US. The key assumption of the Phillips curve is wrong. Whatever modest effects exist are likely accidental and not structural.

I’m no fan of stimulating the economy. If you regulate the banks tightly to keep them solvent, the economy will largely self-correct. Booms and busts will still be there, but not as big.

But that’s not the way our culture views things. They want the government to manage the macroeconomy, even if that management won’t work so well. They want to believe in Oz. (Which, given that Oz was about the so-called failure of the gold standard, this has come full circle.)

Here’s how Oz can function better. The Fed can focus on GDP rather than employment, arguing that by focusing on GDP employment will follow for the most part — and that where it doesn’t follow so well, tell the truth that the Fed doesn’t have much influence over employment.

The opposite of this argument is like this article in the Wall Street Journal, where it says:

Referring to the latest Fed two meetings, Ms. George said, ?with moderate growth, record-low unemployment and a benign inflation outlook, maintaining an unchanged setting for policy would have been appropriate, in my view.?

Fed?s George: U.S. Economy Is in ?Good Place?

George is driving through the rearview mirror. GDP looks a little further forward, and the yield curve looks more forward still. The yield curve is a discounting mechanism, and predicts future movements in lending, GDP and employment, in that order.

So long as the controlling members of the Fed say things like “We couldn’t need to loosen, the economy or employment is strong,” amid an inverted yield curve, or ” “We couldn’t need to tighten, the economy or employment is weak,” amid a steep yield curve, it will always be late, and exacerbate booms and busts.

The Fed likes to trumpet its independence, but more than fearing Trump or Congress, they fear public opinion, and don’t want to take right moves that have bad optics. They would rather get there late, and pretend that the heroes have arrived on time. Going back to Oz, the Fed is a mishmash of the scarecrow and the lion.

Summary

My solution is that the Fed should look at forward-looking indicators, and educate the press and public about what they are doing. If they do that, policy will work better until the forward looking indicators lose their value. Oh well… search for new ones.

Postlude

I know some people tire of my musings on Central Banking. Personally, I hope this is my last post on it for a long time.

Easy In, Hard Out (IV)

Posted on by David Merkel

Photo Credit: Fabricio Olivetti || Beware situations where some governmental entity thinks that they have unlimited power…

This is the fourth in a series of posts regarding the Fed’s balance sheet, and quantitative easing. Unlike the first three, I’m not going to do the graphs of the composition of the Fed’s balance sheet that I did before, because I’m not sure it’s relevant to the present argument.

I want to quote a few passages from prior articles, because it has been so long. From the conclusion of article 3:

My main point is this: even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can?t control.

Easy In, Hard Out (III)

The main thing that I got wrong in the prior parts of this series was assuming longer interest rates would rise, leading to a tightening of short-term interest rates. I expected my scenario 2 ( Growth strengthens and inflation rises), and we got scenario 3 ( Growth weakens and inflation remains low). Regarding scenario 3, I said:

3) Growth weakens and inflation remains low.? This would be the main scenario for QE4, QE5, etc.? We don?t care much about the Fed?s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

Easy In, Hard Out (Updated)

I also thought that the Fed would have a hard time taking back the policy accommodation:

But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the ?policy accommodation.?? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

Easy in, Hard out

Back to the Present

The hullabaloo over raising the fed funds rate over 3% has passed. A debt-laden economy slowed down faster than expected, leading long rates to fall, and the yield curve inverted. The Fed has been loosening amid an economy that is middling-to-weak, grudgingly, because unlike most other loosening cycles, nothing has blown up yet.

(An aside: The Fed could have fought back via a balance sheet-neutral swap of all their bonds longer than 10 years for an equal amount of T-bills,and short T-notes. That would have steepened the yield curve.)

But we are in an environment where the Fed is trying to deal with everything, like an overworked superhero. Repo markets having trouble? Flood the short-term lending markets with liquidity, and reverse the shrinkage of the Fed’s balance sheet.

By removing risk from the repo markets, it incents players there to get more aggressive, because they know the Fed has their backs. Better to let the players know that the repo market is subject to considerable volatility. They need to consider liquidity conditions like any other prudent investor, realizing that losses are indeed possible.

Summary

The Fed needs to return to the days of Volcker and Martin, where they let risk markets go their own way, and focus on the real economy only. They won’t do that, because past Fed easy accomodation has led to a lot of debts, both public and private.

Monetary policy accommodation is “easy going in, but hard going out.” The financial markets now think of low rates and ample liquidity as a birthright, not a temporary accomodation, partially because servicing the debt in a low interest rate environment is a lot easier. It is also partially because rates were so low for so long that expectations have adjusted.

I don’t see how the Fed gets out of this situation. Sitting and waiting, swapping away the long Treasuries would not be the worst idea in the world. But when there is a lot of debt, it tends not to get paid down in a orderly way during a recession. Defaults will come cheaper by the dozen.

I don’t think avoiding financial fragility at this time is the best long-term option. The banks are in decent shape, despite the repo market. Corporate bonds and loans and low-end consumer loans will bear most of the losses in the next recession. Best to take the hit, and let everyone know that the Fed does not exist to facilitate speculation, but to restrain inflation, and promote labor employment.

Then maybe, post recession, we can get a growing economy, a normal-shaped yield curve, and a less-indebted economy… excluding the indebted US and municipal governments, which truly are hopeless.

What Caused the Financial Crisis?

What Caused the Financial Crisis?

Posted on by David Merkel

Photo Credit: Alane Golden || Sad but true — the crisis was all about bad monetary policy, a housing bubble, and poor bank risk management======================

There are a lot of opinions being trotted around ten years after the financial crisis.? A lot of them are self-serving, to deflect blame from areas that they want to protect.? What you are going to read here are my opinions.? You can fault me for this: I will defend my opinions here, which haven?t changed much since the financial crisis.? That said, I will simplify my opinions down to a few categories to make it simpler to remember, because there were a LOT of causes for the crisis.

Thus, here are the causes:

1) The Federal Reserve and the People?s Bank of China

For different reasons, these two central banks kept interest rates too low, touching off a boom in risk assets in the USA.? The Fed kept interest rates too low for too long 2001-2004. The Fed explicitly wanted to juice the economy via the housing sector after the dot-com bust, and the withdrawal of liquidity post-Y2K.? Also, the slow, predictable way that they tightened rates did little to end speculation, because long rates did not rise, and in some cases even fell.

The Chinese Central Bank had a different agenda.? It wanted to keep the Yuan cheap to continue growing via exporting to the US.? In order to do that, it needed to buy US assets, typically US Treasuries, which balanced the books ? trading US bonds for Chinese goods ? and kept longer US interest rates lower.

Both of these supported the:

2) Housing Bubble

This is the place where there are many culprits.? You needed lower mortgage underwriting standards. This happened through many routes:

  • US policy pushing home ownership at all costs, including tax-deductibility of mortgage interest.
  • GSEs guaranteeing increasingly marginal loans, and buying lower-rated tranches of subprime RMBS. They ran on such a thin capital base that it was astounding.? Don?t forget the FHLBs as well.
  • Politicians and regulators refused to rein in banks when they had the power and tools to do so.
  • Securitization of private loans separated origination from risk-bearing, allowing underwriting standards to deteriorate. Volume was rewarded, not quality.
  • Mortgage insurers and home equity loans allow people to borrow a far greater percentage of the value of the home than before, for conforming loans.
  • Appraisers went along with the game, as did regulators, which could have stopped the banks from lowering credit standards. Part of the fault for the regulatory mess was due to the Bush Administration downplaying financial regulation.
  • The Rating Agencies gave far too favorable ratings to untried asset classes, like ABS and private RMBS securitizations. This is for two reasons: financial regulators required that the companies they oversaw must use ratings for assessing capital needed to cover credit risk, and did not rule out asset classes that were unproven, as prior regulators had done.? Second, CDOs and similar structures needed the assets they bought to have ratings for the same reason.
  • There was a bid for yieldy assets on the part of US Hedge funds and foreign financial firms. Without the yield hogs who bid for CDO paper, and other yieldy assets, the bubble would not have grown so big.
  • Financial guarantors insured mortgage paper without having good models to understand the real risk.
  • People were stupid enough to borrow too much, assuming that somehow they would be able to handle it.? As with most bubbles, there were stupid writers pushing the idea that investing in housing was “free money.”

3) Bank Asset-liability management [ALM] for large commercial and investment banks was deeply flawed. ?It resulted in liquid liabilities funding illiquid assets.? The difference in liquidity was twofold: duration and credit.? As for duration, the assets purchased were longer than the bank?s funding structures.? Some of that was hidden in repo transactions, where long assets were financed overnight, and it was counted as a short-term asset, rather than a short-term loan collateralized by a long-term asset.

Also, portfolio margining was another weak spot, because as derivative positions moved against the banks, some banks did not have enough free assets to cover the demands for security on the loans extended.

As for credit, many of the assets were not easily saleable, because of the degree of research needed to understand them.? They may have possessed investment grade credit ratings, but that was not enough; it was impossible to tell if they were ?money good.?? Would the principal and interest eventually be paid in full?

The regulatory standards let the banks take too much credit risk, and ignored the possibility that short-term lending, like repos and portfolio margining could lead to a ?run on the bank.?

4) Accounting standards were not adequate to show the risks of repo lending, securitizations, or derivatives.? Auditors signed off on statements that they did not understand.

===============

That?s all, I wanted to keep this simple.? I do want to say that Money Market Funds were not a major cause of the crisis.? The reaction to the failure of Reserve Primary was overdone.? Because of how short the loans in money market funds are, the losses from money market funds as a whole would have been less than two cents on the dollar, and probably a lot smaller.

Also, bailing out the banks sent the wrong message, which will lead to more risk later.? No bailouts were needed.? Deposits were protected, and there is no reason to protect bank stock or bondholders.? As it was, the bailouts were the worst possible, protecting the assets of the rich, while not protecting the poor, who still needed to pay on their loans.? Better that the bailouts should have gone to reduce the principal of loans of those less-well-off, rather than protect the rich.? It is no surprise that we have the politics? we have today as a result.? Fairness is more important than aggregate prosperity.

PS — the worst of all worlds is where the government regulates and gives you the illusion of protecting you when it does not protect you much at all.? That tricks people into taking risks that they should not take, and leaves individuals to hold the bag when bad economic and regulatory policies fail.

 

Why I Watch the Thirty

Why I Watch the Thirty

Posted on by David Merkel

Photo Credit: andy carter

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I like long bonds.? I am not saying that I like them as an investment.? I like them because they tell me about the economy.

Though I argued to the Obama Administration that they should issue Fifties, Centuries and Perpetuals, the Thirty-year bond remains the longest bond issued.? I think its yield tells us a lot about the economy.

How fast is nominal growth?? Look at the Thirty; it is highly correlated with that.

What should the Fed use for its monetary policy?? Look at the Thirty, and don’t let the Five-year note get a higher yield than it.? Also, don’t let the spread of the Two-year versus the Thirty get higher than 1.5%.? When things are bad, stimulus is fine, but it is better to wait at a high spread than goose the spread higher. Excesses in loose policy tend to beget excesses in tight policy.? Better to avoid the extremes, and genuinely mute the boom-bust cycle, rather than trying to prove that you are a genius/maestro when you are not.? Extreme monetary policy does not get rewarded.? Don’t let the yield curve get too steep; don’t invert.

Finally, the Thirty is a proxy for the cost of capital.? It’s long enough that it is a leap of faith that you will be paid back.? Better still for the cost of capital is the Moody’s Baa average, which tracks the bold bet of lending to low investment grade corporations for 20-30 years.

That said, the Thirty with its cousin, the long Treasury Inflation Protected Security [TIPS] gives you an idea of how long term inflation expectations and real rates are doing.? The thing that kills stocks is higher long term real interest rates, not inflation expectations.? The main reason for this is that when inflation rises, usually earnings do also, at least at cyclical companies.? But there is no reason why earnings should rise when real rates rise.

This is why I pay more attention to the Thirty rather than the more commonly followed Ten.? I know that more debt gets issued at a maturity of ten years.? Granted.? But the Thirty tells me more about the economy as a whole, and about its corporations.? That’s why I carefully watch the Thirty.

Notes on the Fed Announcements

Notes on the Fed Announcements

Posted on by David Merkel

Photo Credit: City of Boston Archives

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Listening to the Fed Chair’s press conference, there was one thing where I disagreed with what Powell was saying.? He said a few times that they only made one decision at the FOMC meeting, that of raising the Fed Funds rate and the reverse repo rate by 0.25%.? They made another decision as well.?The decided to raise the rate of quantitative tightening [QT] by increasing the rate of Treasury, MBS and agency bonds rolloff by $10B/month starting in April. They did that by increasing the rate of reduction of MBS and agency bonds from $8B to $12B/month, and Treasuries from $12B to $18B/month. The total rate of QT goes from $20B to $30B/month.? This may raise rates on the longer end, because the Fed will no longer buy so much debt.

There was also a little concern over people overinterpreting the opinions of the Fed Governors, especially over the “dot plot,” which shows their opinions over real GDP growth, the unemployment rate, PCE inflation, and the Fed funds rate.? My point of view is simple.? If you don’t want people to misinterpret something, you need to defend it or remove it.

Personally, I think the FOMC invites trouble by doing the forecasts.? First, the Fed isn’t that good at forecasting — both the staff economists and the Fed Governors themselves.? Truly, few are good at it — people tend to either follow trends, or call for turns too soon.? Rare is the person that can pick the turning point.

Let me give you the charts for their predictions, starting with GDP:

The Fed Governors have raised their GDP estimates; they raised the estimates the most for 2018, then 2019, then 2020, but they did not raise them for the longer run.? I seems that they think that the existing stimulus, fiscal and monetary, will wear off, and then growth will return to 1.8%/year.? Note that even they don’t think that GDP will exceed 3%/year, and generally the Fed Governors are paid to be optimists.? Wonder if Trump notices this?

Then there is the unemployment rate.? This graph is the least controversial.? The short take is that?unemployment rate estimates by the Fed governors keep coming down, bottoming in 2019, and rising after that.

Then there is PCE Inflation.? Estimates by the Fed Governors are rising, and in 2019 and 2020 they exceed 2%.? In the long run the view of the Fed Governors is that they can achieve 2% PCE inflation.? Flying in the face of that is that they haven’t been able to do that for the duration of this experiment, so should we believe in their power to do so?

Finally, there is the Fed Funds forecast of the Fed Governors — the only variable they can actually control. Estimates rose a touch for 2018, more for 2019, more for 2020, and FELL for the long run. Are they thinking of overshooting on Fed Funds to reduce future inflation?

Monetary policy works with long and variable lags, as it is commonly said.? That is why I said, “Just Don?t Invert the Yield Curve.”? Powell was asked about inverting the yield curve at his press conference, and he hemmed and hawed over it, saying the evidence isn’t clear.? I will tell you now that if the Fed Funds rate follows that path, the Fed will blow something up, and then start to loosen again.? If they stop and wait when 10-year Treasury Note yields exceed 2-year yields by 0.25%, they might be able to do something amazing, where monetary policy hits the balancing point.? Then, just move Fed funds to keep the yield curve slope near that 0.25% slope.

There would be enough slope to allow prudent lending to go on, but not enough to go nuts.? Much better than the present policy that amplifies the booms and busts.? The banks would hate it initially, and regulators would have to watch for imprudent lending, because there would be no more easy money to be made.? Eventually the economy and banks would adjust to it, and monetary policy would become boring, but predictably good.

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