Category: Bonds

The Boom-Bust Cycle, Applied to Many Markets

The Boom-Bust Cycle, Applied to Many Markets

Posted on by David Merkel

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.

An Economist at Last — Life Changes for David

An Economist at Last — Life Changes for David

Posted on by David Merkel

I started my business career as an actuary.? For an actuary, though, I had an unusual background — I wasn’t a math or a statistics major, I was an economics major, though admittedly, one with a lot of math.? You can’t get through the Ph.D. courses in econometrics without a lot of math.? In my business career, I’ve put my economics background to use, and added to it through studying finance.? Now, I studied much of the finance and economics of risk literature back in grad school, and developed a healthy dislike for MPT, the CAPM, and suchlike.

I grew up in a home where my self-taught mother used her head and picked stocks.? She did it quite well, too, and continues to do so today.? I figured that I could do it too, and over the past fifteen years, have done so.? Perhaps my major theme would be “hunt for value, and don’t be afraid to have a portfolio that looks weird.”? My studies of finance in my post-academic days were practical in nature, analyzing ways of beating the market, or reducing risk, realizing that any strategy can become overused, and useless.

After leaving my former employer, I’ve done a bunch of things — writing, consulting, etc.? Now it is time to focus.? I have taken a job as Chief Economist and Director of Research for Finacorp Securities, based in Irvine, California.? Their main focus is serving the investment needs of municipalities.? I have three main tasks:

  • Publish research that encourages clients to trade with us.
  • Provide research for internal staff and clients, enabling staff to serve clients better.
  • Build an asset management franchise for our clients around my value investing, and bond investing.

Beyond that, aid in the management of the firm where possible.? Now, I’m not changing locations; I am still based near Baltimore.? What I do can be done from anywhere, so long as I can connect to the Internet.
I have already produced a draft version of a newsletter for our institutional clients.? I am making preparations to?offer equity asset management services to clients.? What form that will take is still open.

That said, it is interesting at this point in my life to finally have the word “Economist” in my job title, as well as “Chief.”? In one sense, this dovetails well into my interests, as those who read my blog will know.? I write about the intersection of macroeconomics and investing.? That’s what I do.? It allows me to keep my interests broad, while solving a wide array of practical problems.? I have sometimes said that I am an investment omnivore.? That’s not quite true, but I like to wander across the investment wilderness, and gather disparate data, gaining good conclusions about the total investment landscape.

Anyway, that is what I am up to now.? To the extent that our newsletter or investment services might be open to individuals, I will let you all know.? I thank you all deeply for your support of me.

PS — I may be on FOX Business Wednesday between 12 and 2PM Eastern.? This is uncertain at present.? We will see.

All or Nothing at All

All or Nothing at All

Posted on by David Merkel

I had some “down time” today (taking my third child to junior college), when I could sit and think about some of the issues in the markets, when all of a sudden, a weird correlation hit me.? Similarities between:

  • The near bankruptcy of the Equitable back in the early 90s.
  • Neomercantilism
  • The relationship of Moody’s and S&P to MBIA and Ambac.

Now, I write as I think, so at the end of this, I hope to have a theory that links all of these.? For now, let me tell a story.

When I was younger, I worked for AIG in their domestic life companies.? While I was there 1989-92, the life insurance industry was undergoing a lot of troubles from overinvestment in mortgages and real estate.? Many companies were under stress.? A few went bankrupt.? One big one was probably insolvent, and teetered in the balance — the Equitable.? I was the juniormost member of AIG’s team.? I have a lot of stories about what happened, and why AIG lost and AXA won.? If readers want to read about that, I’ll write about it.? For now though let me mention what I did:

  • Produced an estimate of value of the annuity lines in four days.
  • Estimated the “hole” in reserving for the Guaranteed Investment Contract line of business (accurate within 10%, according to the writedown they took later)
  • Wrote an analysis of AXA that indicated that we should take them seriously (probably ignored).
  • Analyzed the Statutory statement, the Cash Flow testing, and Guaranteed Separate Account filing (Reg 128), and came to the conclusion that the latter two were in error.? (Those filings, I later learned, forced the NY department to
    tell Equitable that it had to find a buyer, because they could not believe the rosy scenarios.)
  • Analyzed the investment strategies that the Equitable employed in the late 80s.? (They doubled down.)

Two years after that, I was at the Society of Actuaries annual meeting, where I met a well-known actuary who had worked inside the corporate actuarial area of the Equitable during the critical years.? I.e., he watched and analyzed the assets and the liabilities as they arose.? The conversation went something like this:

David: What was it like working inside the Equitable during that period of fast growth?

Corporate Actuary: It was amazing.? It took everything we could do to stay on top of it, and still we fell behind.

D: Didn’t you think that perhaps you were offering guaranteed rates that were too attractive?

C: We wondered about it, but with money coming in, everyone felt great about the growth.? We simply had to find ways to productively deploy all of the cash flow.

D: But wait.? Didn’t the investment department have a difficult time investing all of the proceeds?? With that much money coming in, the likelihood of making severe errors would be high.

C: Were you a bug on the wall at our meetings?? Yes, that is exactly what happened.? The money came in faster than we could invest it prudently.

D: Wow.? I thought that was what happened, but it amazes me to hear it confirmed.

They offered free options, and surprise, investors took them up on them.? They couldn’t make enough to fund the promises, and undertook a risky strategy in the late 80s that I called “double or nothing.”? The strategy failed, and they almost went broke, except that AXA bought them, pumped in a little capital, and then the real estate market turned.

What’s my point here?? Twofold: one, rapid growth in financial institutions is rarely a good thing; it usually means that an error has been made.? Two, there is a barrier in many financial decisions, where responsible parties are loath to cry foul until it is way past obvious, because the cost of being wrong is high.

So what of my other two cases?? With the neomercantilists, which I have written about more at RealMoney, they entered into the following trade: sell goods to the US and primarily take back bonds.? This suppressed inflation in the US, and lowered interest rates, because their bond buying reduced the excess supply of bonds.? In one sense, through export promotion, the neomercantilistic countries sold their goods too cheaply, and then had little current use for the US Dollars, since they did not want their people buying US goods.? So, they took the money and bought US bonds, probably too dearly.? Certainly so, after taking the falling US Dollar into account.

With the major rating agencies and the major financial guarantors, they are locked in a co-dependent relationship, one that I highlighted in a RealMoney article three years ago.? The financial guarantors are next to a cliff, and the rating agencies have a choice:

  • The guarantors are clearly in trouble, but how bad is it?? Do we push them over the edge to save our franchise, at a cost of a lot of forgone revenue in the short run?
  • Or do we sit, wait, and hope that things are not as bad as the equity markets are telling us?? This could preserve our ability to make money, and the government is giving us pressure to go this way, for systemic risk reasons.? Besides, someone could bail them out, right?

Ugh, I went through this back in 2001-2002, when the rating agencies changed their methodology to become more short-term in nature.? Funny how they always do that in bear markets for credit.

So, what’s the common element here?? Each situation has a major financial entity at the core.? Underpriced goods or promises were made in an effort to attract revenue.? When the revenues came too quickly, errors were made in deploying the revenues, whether into goods or bonds.? The faster and the larger the acquisition of the revenues, the larger the problem in deployment.

In each of these situations, then, there is a cliff:

  • Do the rating agencies push the guarantors over?
  • Does the NY department of insurance force Equitable to find a buyer?
  • Do neomercantilistic nations keep sucking down dollar claims in exchange for goods, importing inflation, or do they finally give up, and purchase US goods, and slow down their own economies, and the inflation thereof?

This is what makes practical economics tough.? Cycles that are self-reinforcing eventually break, and when they break the results can be ugly.? Why else are credit cycles long and benign in the bull phase, and short and sharp in the bear phase?

Seven Brief FOMC Notes

Seven Brief FOMC Notes

Posted on 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

Time to Begin Increasing Credit Risk Exposure

Posted on 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.

Could Investors Manipulate the Fed?

Could Investors Manipulate the Fed?

Posted on by David Merkel

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.

Living in the Shadow of the Great Depression

Living in the Shadow of the Great Depression

Posted on 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.

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A Bonus from MoneySense Magazine

Posted on 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?

Deflation or Inflation? Why Choose?

Posted on 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:

  1. They hold firm, and don’t lower much (50 bp), because price inflation is a concern.
  2. 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…)
  3. 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?

Bond Bubble?

Posted on 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.

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