Fed Policy – The Aleph Blog

Notes and Comments

Posted on 25 April 20206 June 2020 by David Merkel

1) I still can�t post images at my blog. If you can believe it, WordPress is trying to fix it. The one cost involved is that the last three posts will be wiped out, and all comments since 4/8.

2) I�ve spent the time since my last post improving my models. I played around with a seven-parameter model, but found that it took ~10,000x as much time to converge to a solution, and there were multiple solutions with very different results that fit close to equally well. My conclusion was that they were different ways to amplify noise.

Instead, I created a second model based on the idea that the rate of growth of total cases was exponentially decaying at a rate slower than that of the first model. The new case figures have been coming at rates far closer to the second model.

I�m sensitive to when models keep having errors in the same direction� 2-3 weeks ago, errors were close to even � as many up as down. But since then more new cases have persistently come in than the first model would have predicted.

Austria, Switzerland and Germany are fine, but most of nations I have modeled have a long way to go, if model 2 is closer to the truth. Add five weeks onto getting to the 99% point.

As such, don�t put me in the camp of optimists any more. I recognize my initial predictions were wrong. Some of it stems from increasing testing as time has gone on. Indeed, what will happen if that study in New York is correct (seems to be too small of a sample, and perhaps biased), and maybe 10-15% of the NY population caught COVID-19 with almost no symptoms? That is mostly a good thing, and might even be a testimony to how little reported cases moved up in the face of that � social distancing restrains the spread of COVID-19, particularly with those who would be most harmed distancing via self-quarantine.

3) I think the history books will end up calling this the voluntary recession, where governments chose ham-fisted solutions out of fear, and did not consider the long-run implications of draconian solutions like general quarantine. What are the effects on:

Unemployment
Division of labor
Pensions, both public and private
health care for those that don�t have COVID-19
Small businesses that run out of resources

Death rates rise from sudden recessions. Might it be more than the lives saved via general quarantine. What Sweden is doing makes more sense. Yes, their death rates are a little higher, but they didn�t close many things at all � their populace has covered up, and kept working. They integrated social distancing into their total lives, including work.

4) But, after the crisis is over, there will be some things that we realize we did not need. Will a video teleconference do as well as a trip to a remote office? How much additional productivity do we get or lose from having staff in a single location? Hay, I can cook for myself! I don�t have to go to restaurants! We don�t need low-end malls! And more� we just don�t know what all will change. That said, never underestimate the ability of Americans to forget.

5) There are charities that help some businesses finance their inventories. They are called commodity ETFs. Long ago, I wrote about the folly of buying ETFs that follow complex strategies. USO always underperformed. This past week was the worst of it.

Negative prices for oil futures are like negative interest rates. If you can safely store paper currency, you will never have a negative interest rate. If you can safely store oil, then a day will come when you can use or sell it.

6) One of my clients asked me what I thought about what the Fed is doing now. My answer is this: they aren�t doing much. The market took their bluff and ran with it. How is this?

All of the risk flows back to the US Treasury explicitly or implicitly, via loss of seigniorage.
They are mostly financing assets, not buying them.
When they are buying assets, they aren�t taking much risk, either in duration or credit.
The QE that they are doing is just a closed loop with the banks � it doesn�t get into the general economy.

The Fed makes me think of a nerdy kid who thinks he is being cool, but all the cool kids know he is a nerd. That said, in this case a good bluff can be quite effective if the cash keeps flowing.

Personally, I like the fact that the Fed is taking little risk. That�s the way a central bank should be. But that�s not the way the markets are interpreting the matter � they think the Fed will always rescue them.

7) But at least at present, I don�t think we are using MMT yet, unless you mean that the Fed buys government debt.

To me, the big question is when do foreign entities get sick of owning US Dollar claims? When do foreign governments finally say that they won�t subsidize exporters anymore, and will stop investing in US Dollar claims?

Of the major governments, the US is the �cleanest dirty shirt,� but when will the free ride of cheap capital end? Nature abhors free lunches, and this one has gone on for a long time� pity that the competition is so poor.

8 ) When will we learn that savings doesn�t inhibit growth? Stable households and businesses survive better, and ultimately spend more.

9) 60/40 stocks/bonds as an asset allocation has been maligned, but not for any good reason. Yes, high-quality interest rates are low. The real value of bonds is that they don�t fall as much as stocks. In a stock market where valuations are still high, though not relative to bond yields, stocks should play a larger role, but not so much as to eliminate the value of having assets that protect the portfolio against hard falls.

That�s all for now.

Too Much Debt

Posted on 24 March 2020 by David Merkel

Photo Credit: Steve Rotman || As Simon and Garfunkel sang, “The words of the prophets are written on the subway walls…”

Debt-based economies are unstable. Economies with a lot of short-term debt are more unstable. The Fed is like Johnny One-Note, or Fat Freddie with a hammer. They only know one tool, and it will solve all problems.

Are there problems from too much debt? More debt will solve the problem. Shift debts from the private to the public sector. Don’t let the private market solve this on its own.

Though the bed debt is not in the same place as the last crisis, we are once again trying to play favorites through the Federal Reserve and rescue entities that took too much risk.

My view is let them fail. The whole system is not at risk, and the COVID-19 crisis will pass in two weeks. The great risk is not from the disease, but from the ham-handed response from policymakers who are short-sighted, and highly risk averse to the point of not wanting to cross the street for fear of dying.

Have we become like the Chinese, who bail out their banks and non-banks regularly? Who can’t bear to see any significant institution fail?

(Yes, I know they are getting more willing to see entities fail in China, but why are we getting less that way in the US? Let market discipline teach companies to not have so much debt.)

Here are three things to consider:

Bond ETFs Flash Warning Signs of Growing Mismatch — The Fed now think its purview extends to managing the discounts of bond ETFs? Let the system work, and let profit seeking institutions and individuals benefit from artificially high yields. Let insurance companies do what I did: purchase a cheap package of bonds in an ETF, and convert it into the constituent bonds, and sell those that you don’t want for a profit. (Losses from ETFs premiums and discounts are normal, and it is why the dollar weighted returns are lower than the time-weighted returns.)
The same applies to repo markets. As I have said before, the accounting rules need to be changed. Repo transactions should not be treated as a short-term asset, but as a long asset with a short-term liability, because that is what it is. With Residential Mortgage-Backed SecurIties in trouble, the market should be allowed to fail, to teach those who take too much risk to not do that. This failure will not cascade.
The same applies to the crony of Donald Trump — Tom Barrack. He pleads his own interest, seeking for the Fed or the Treasury to bail him out, and those who are like him. Let him fail, and those who are like him.

Market participants need to know that they are responsible for their own actions, particularly in a small and short-lived crisis as this one. COVID-19 as a systemic crisis will be gone within weeks.

My statement to all of those listening is “When will we set up a more rational system that discourages debt?” We could made dividends tax-exempt, and deny interest deductions for non-financial corporations, including financial subsidiaries of non-financial corporations. Of course we would grandfather prior obligations.

Are we going to wait for the grand crisis, where the Fed will continue to extend credit amid roaring inflation, or where extend no credit amid a tanking economy? This is what eventually faces us — there is no free lunch. The Fed can’t create prosperity via loose monetary policy, and Congress cannot create prosperity via loose fiscal policy.

The bills eventually come due. The USA might get the bill last after the failure of China, Japan, and the EU, but it will eventually get the bill.

As such, consider what you will do as governments can’t deal with the economic and political costs of financing the losses of the financial system.

The Worst Policies are Made During Crises

Posted on 21 March 202022 March 2020 by David Merkel

Photo Credit: Mike Licht || As a culture, we are very much “live for the moment.” But what happens when buyers of Treasuries decide that it’s not worth it anymore?

I am not a fan of the Democrats or of Big Government Republicans like Bush Jr. and Trump. In general, I think we need to shrink our government, decentralize, and de-lever our economy such that we make debt a smaller component of how we finance our lives. The Democrats talk about inequality, but they don’t really mean it. Increasing marginal tax rates is good show, but the real game is how income is calculated, and they won’t touch that, because their richest donors find ways to hide their income — the same as donors to the Republicans.

That’s why I call the governing elite in DC “The Purple Party.” A blend of red and blue, with just enough difference to get politically motivated donors to give, but practically doing the same thing, serving wealthy elites.

I’m going to make a post on COVID-19 next week, but my last post on the topic was too optimistic. That said, the politicians, particularly governors, are being scaremongers. They are vastly overestimating the size of the crisis.

What really bugs me are the foolish ideas being propounded by the Fed and politicians. Let me talk about a few of them.

1) Don’t close the stock or bond markets. Closing the markets does not eliminate volatility. It only hides it. Practically, it makes the price of securities to be zero for those who want to sell them. And, for those who left some cash on the side, it denies them the opportunity to profit from their wisdom.

2) The Fed should only hold short government debt. That is a neutral asset. Anything else makes the Fed play favorites in what they buy, whether it is mortgage-backed securities, municipal bonds, or corporates. Don’t let the Fed become a political institution, creating ad hoc policy by whose debt they do and don’t buy.

3) Don’t close businesses. Let all businesses set their own policies. They don’t want their workers to infect others. Let them operate.

The idea that there are “necessary businesses” is foolish. The “necessary businesses” rely on other businesses to be their suppliers.

What would be better would be to have extensive testing for COVID-19, and to quarantine those who are infected, and those who are not tested who had contact with those who are infected. Leave the rest of society free. Don’t close firms down, and then give some lame amount of government assistance to them. We do best when we are working. People staying at home lack the healthy stress that working provides.

4) Now, if you have to give assistance, giving it to people directly is the best way. I advocated for that in the last financial crisis. But you should give it to all Americans equally, to avoid favoritism. Now, there is the issue of those who buy US Treasury debt objecting to the concept, and I can respect that. Why else do you think that the yield on 30-year Treasury Bonds has risen 0.8% over the last ten days?

There is no such thing as a free lunch, and with all those advocating excessive deficit spending, I would say “Yes, the past efforts have not disrupted the markets, but if you read economic history closely, no one can tell what will make the paradigm shift. Are you feeling lucky?”

Summary

From my reading of the data, I don’t see how this crisis lasts past the end of April. Yet there are governors of states foolishly shutting down businesses, and thinking that they are doing something good. “Shelter in place” is a recipe for turning all Americans into lawbreakers in the same manner as is with highway speed limits. Do you really want to ruin our culture via overly strict laws?

What of the poor people running out of money? What of the small businesses that go broke? Governments should focus on testing for the virus, and quarantining those who have it and those who have had contact and are untested.

In closing, I would encourage all readers to vote all incumbents out of office. They are not serving the interests of average Americans well. They are cowards who listen to scaremongers, and that includes Trump.

PS — some people might suggest that I am not kind to those that are hurting. It’s not true. I give over 10% of my income to charity each year. Beyond that, I would challenge people to consider Venezuela. Many small to medium-sized actions by Chavez and Maduro slowly robbed the country of economic vitality. The wealthiest nation in South America became the poorest.

The same could happen here. Economic disasters often spring from something small — remember Ben Bernanke saying that the risk from subprime mortgages was “well contained?” Yes, subprime mortgages were small, but they represented the marginal buyers of residential real estate, so when they failed, so did property prices. Like dominoes, they fell.

Thus I am saying to urge the government to not engage in policies that increase its deficits. You can’t tell when the last bit of debt will be the straw that breaks the back of the camel.

Greenspan’s Pathology

Posted on 29 October 2019 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.

Always Late

Posted on 8 October 2019 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 1 October 2019 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?

Posted on 15 September 201816 September 2018 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.

The Pips are Squeaking

Posted on 15 May 2018 by David Merkel

Photo Credit: sid=================

This should be a short post.? I just want to note the degree of stress that many emerging market countries are under.? The Fed raises rates, and something blows up.? That is often the class of debt that has grown the most in the bull phase of the cycle, or, the one that has financed with short-term debt.? This is the “volatility machine” that Michael Pettis wrote so well about.

The Brazilian stocks I own have been falling.? A little lower, and I will make them double-weight positions.? Five times earnings for utilities that cannot be done without?? Wave the shares in.

Look at Argentina, Indonesia, and Turkey.? Fundamentally misfinanced.? Maybe own assets there that have enduring demand.? I own IRSA [IRS].

Russia is fundamentally sound.? I own shares in RSXJ, which is not so connected to the energy sector.

Buy the emerging markets generally, avoiding those markets are fundamentally misfinanced.? Or wait, and buy later.? Emerging market selloffs are often sharp and significant.? I’m not sure what is the right way to do it, so you could buy half now, and wait.? If it rallies, be glad you got some cheap.? If it sells off more, buy the full position.

There are some good values now; they could get better later.? Buy a little and wait like my “do half” strategy says.? Don’t get greedy, look for decent gains over 3-5 years.

And now for something completely different:

https://www.youtube.com/watch?v=gLyoBCIBCW8?t=1343

I appeared on RT Boom/Bust two weeks ago, and offered my thoughts on Wells Fargo at the end of the show.? I think they still have more problems to be revealed.? That said, things aren’t getting worse, so this might be a good time to buy the shares of Wells Fargo.

Full disclosure: My clients and I own shares of IRS, SBS, ELP, BRF, and RSXJ

Why I Watch the Thirty

Posted on 19 April 2018 by David Merkel

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

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

Posted on 22 March 2018 by David Merkel

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

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.