Fed Policy – Page 10 – The Aleph Blog

AIG Was Broke

Posted on 30 September 201430 September 2014 by David Merkel

138524447_df928490da_o — Photo Credit: Ron

There’s a significant problem when you are a supremely?big and connected financial institution: your failure will have an impact on the financial system as a whole. ?Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve. ?You are Too Big To Fail [TBTF].

Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities. ?They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.

In such a time, it does no good to say, “Just give us time. ?This is a liquidity problem; this is not a solvency problem.” ?Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly. ?The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.

That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG. ?If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed. ?Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis. ?Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well. ?This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.

Buffett was asked to bail out AIG, and he wouldn’t touch it. ?Running a large insurer, he knew the complexity of AIG. ?Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products. ?He also likely knew that AIG’s P&C reserves were understated.

For more on this, look at my book review of?The AIG Story, the?book that tells Greenberg’s side of the story.

To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent AIG as if it were a simple thing for them to be solvent through the crisis. ?It was no simple thing, because only the government could have provided the credit, amid a cascade of failures. ?(That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)

Two Questions on Fixed Income from the Mailbag

Posted on 20 September 201421 September 2014 by David Merkel

From my readers:

What are your thoughts on Pimco’s new strategy for its flagship fund?

This concerns me because its one of the few “safe” funds in my company’s 401k plan.

I haven’t heard anyone critique this and thought you’d be the best that I know of.

It seems to me that its a disproportional risk. And that due to its size could potentially cause problems.

?http://blogs.barrons.com/focusonfunds/2014/09/17/deriving-returns-at-pimco-total-return/

This is not a new problem with Pimco. ?You can review these two articles here:

Pimco has always used a lot of derivatives, though for marketing reasons some of their funds have fewer derivatives, even as Pimco tries to follow the same strategies. ?You can view this three ways:

It hasn’t had horrible effects in the past, so why worry now?
We haven’t had the market event that would test the limits of this strategy yet, but can it really get that bad?
Now that the bond market is more crowded, Pimco’s quantitative bond strategies have less punch. ?They don’t have the same room to maneuver. ?Like the London Whale, have they become the market?

I lean toward the last of these views. ?When you manage so much money, it becomes difficult to wrench alpha out of the market because mispricings are limited, and it is difficult to keep your trades from moving the market.

You might want to split your “safe monies” in your 401(k) plan if you have other credible investments. ?That said, the likelihood of a large disaster harming Pimco is small — but you could try to cover that risk by setting a relative?stop loss where you would exit Pimco versus a similar maturity fund run by Vanguard.

Another letter:

I’m a fledgling portfolio manager and blog reader.? Would you care to comment on the bounce we’ve seen in Treasury rates this month? (28 bp on the 10-year month to date).? I just don’t get it.? I see global growth continuing to underwhelm, more monetary opiates out of Asia, persistent dovishness from the Fed and the arrival (?) of the Godot that has been ECB stimulus.? These circumstances plus ongoing geopolitical issues make me wonder why Treasury yields have not gone further down or at least held the line.? I know it might be mean reversion or a supply/demand phenomenon but do not feel qualified to say and would enjoy reading your perspective.

Separately, are you aware of any Readers’ Digest Condensed summaries of monetary policy in Europe since 2007?? My career is not so old and each time I read about their approach to sorcery I encounter yet another acronym of which I am ignorant.

Best and thank you!

Back when I was a corporate bond manager, and things were moving against me, I would do a few things:

Seek out contrary opinion, and see if there was something I was missing.
Go out to lunch for Chinese food, dragging my trading notebook, and a sheaf of research with me, and schmooze over the data while there was no Bloomberg terminal in front of me.

Now, my own current views are conflicted, because I view the global economy like you do. ?There is no great growth anywhere. ?Geopolitical events should lead to a Treasury rally, and sanctions should weaken growth prospects. ?I’m still long a moderate amount of the?iShares 20+ Year Treasury Bond (TLT), for myself and clients — it is difficult to see too much of a bear market with monetary velocity so weak.

That said, my recent 2-part series on the shape of the yield curve suggested that the curve shape was the sort where we often get negative surprises. ?Despite the Fed’s confident mutterings that amount to little more than “Trust us!” the Fed has never been in a situation like this one and does not have the vaguest idea as to what it is doing. ?They are proceeding largely off of untested theories that so far haven’t done much good or bad, aside from allowing the US Government to finance its deficits cheaply, thus cheating savers who deserve a better return on their money.

This is my thought: the slightest hint of tightening coming sooner moves the forward yield curve up, particularly in the 3-5 year region of the curve, but extending to 2- and 10-year notes as well. ?But the questions remain how well growth holds up, how sensitive will the economy be to higher interest rates, and whether banks start genuinely lending against their expanded liabilities.

Personally, I expect rates to go lower after further growth disappointments, but I could be wrong, very wrong, so don’t be too bold here — scale into positions as you see opportunity.

Full disclosure: long TLT

Redacted Version of the September 2014 FOMC Statement

Posted on 17 September 2014 by David Merkel

Comments

Pretty much a nothing-burger. Few significant changes, if any.
Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Small $10 B/month taper. Equities rise and long bonds fall.? Commodity prices are flat.? The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
The FOMC needs to chop the ?dead wood? out of its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

The Problem with the Phillips Curve

Posted on 16 August 2014 by David Merkel

I remember sitting in my intermediate macroeconomics class at Johns Hopkins, when the Professor was trying to develop the concept of the Phillips Curve, which posits a trade-off between labor unemployment and price inflation, at least in the short run. ?The time was the Fall of 1980, and macroeconomics was trying to catch up with what happened with stagflation, because that was not something that expected would come from their policy recommendations that offered the politicians a free lunch.

This trade-off underlies the concept of the dual mandate of the Federal Reserve, where they are not only to try to restrain price inflation, but also aim for full labor employment. ?I don’t think it is realistic to do this for two reasons.

1) For the theory of the Phillips Curve to work, the central assumption is that price inflation funnels directly into wage inflation. ?This is a questionable assumption, as I will explain below.

2) The FOMC has a hard enough time using monetary policy to restrain or accelerate price inflation.

Why might price inflation vary from wage inflation? ?There are two main reasons in the present: technological improvements that require less labor to produce the same or better output, and an increase in overseas laborers available to produce good or services?outside the US for sale inside the US. ?Notice I am not mentioning immigration, though that might have a small impact on the wages of the lowest-skilled jobs in the short run.

I see both of these factors acting at present, which until our economy adjusts to create more jobs, initially at lower pay than most will want, will restrain the growth in wages, particularly adjusted for inflation.

Now, give Janet Yellen some credit, because she recognizes the weakness of looking at the headline unemployment number as a guide to policy and has broadened out her labor market indicators to reflect that a low U-3 unemployment rate doesn’t mean the labor market is great. ?She looks at the rates of layoffs/firings, job openings, voluntary quitting, hiring, and labor force partipation, among others.
This is similar to what I suggested in a recent post on labor underemployment. ?Payments to labor are a smaller fraction of the economy, and real wages have flatlined.
That said, I don’t think the Fed can succeed here, because the relationship between monetary policy and real wages is nonexistent as far as I can see. ?The Fed is better at inflating assets in an era where the better-off save, than it is in inflating prices, which it more direct effect on than wages.
There is slow but steady pressure for wage rates to equalize globally, slowly but surely. ?Being born in the West is not in itself a ticket to above average wages.

I don’t blame the Fed for the poor labor market conditions; it’s not in their power. ?Maybe we can blame Congress and the Executive Branch for making laws that inhibit hiring and firing, both at the national and state levels. ?We might blame the schools for not taking a more balanced approach to education,?stressing vocational education alongside a strong liberal arts education that includes real science and math. ?Parents, if the school systems don’t do this, if your children will listen to you, get them thinking along these lines.

You are your own best defender with respect to your own employment, so put some thought into alternative work, should you find yourself unemployed. ?Analyze how you can meet the most needs/demands of others and fill those needs/demands, and you will never lack work.

I wish you the best in a tough labor market.

The Shadows of the Bond Market?s Past, Part II

Posted on 13 August 2014 by David Merkel

This is the continuation of?The Shadows of the Bond Market?s Past, Part I. ?If you haven’t read part I, you will need to read it. ?Before I start, there is one more thing I want to add regarding 1994-5:?the FOMC used signals from the bond markets to give themselves estimates of expected inflation. ?Because of that, the FOMC overdid policy, because the dominant seller of Treasuries was not focusing on the economy, but on hedging mortgage bonds. ?Had the FOMC paid more attention to what the real economy was doing, they would not have tightened so much or so fast. ?Financial markets are only weakly?representative of what the real economy is doing; there’s too much noise.

All that said, in 1991 the Fed also overshot policy on the other side in order to let bank balance sheets heal, so let it not be said that the Fed only responds to signals in the real economy. ?(No one should wonder who went through the financial crisis that the Fed has an expansive view of its mandate in practice.)

October 2001

2001 changed America. ?September 11th led to a greater loosening of credit by the FOMC in order to counteract spreading unease in the credit markets. ?Credit spreads were widening quickly as many lenders were unwilling to take risk at a time where times were so unsettled. ?The group that I led?took more risk, and the story is told here. ?The stock market?had been falling most of 2001 when 9/11 came. ?When the markets reopened, it fell hard, and rallied into early 2002, before falling harder amid all of the scandals and weak economy, finally bottoming in October 2002.

The rapid move down in the Fed funds rate was not accompanied by a move down in long bond yields, creating a very steep curve. ?There were conversations among analysts that the banks were healthy, though many industrial firms, like automobiles were not. ?Perhaps the Fed was trying to use housing to pull the economy out of the ditch. ?Industries that were already over-levered could not absorb more credit from the Fed. ?Unemployment was rising, and inflation was falling.

There was no bad result to this time of loosening — another surprise would lurk until mid-2004, when finally the loosening would go away. ?By that time, the stock market would be much higher, about as high as it was in October 2001, and credit spreads tighter.

July 2004

At the end of June 2004, the FOMC did its first hike of what would be 17 1/4% rises in the Fed funds rate which would be monotony interspersed with hyper-interpretation of FOMC statement language adjustments, mixed with the wonder of a little kid in the back seat, saying, “Daddy, when will we get there?” ?The FOMC had good reason to act. ?Inflation was rising, unemployment was falling, and they had just left the policy rate down at 1% for 12 straight months. ?In the midst of that in June-August 2003, there was a another small panic in the mortgage bond market, but this time, the FOMC stuck to its guns and did not?raise rates, as they did for something larger in 1994.

With the rise in the Fed funds rate to 1 1/4%, the rate was as high as it was when the recession bottomed in November 2002. ?That’s quite a long period of low rates. ?During that period, the stock market rallied vigorously, credit spreads tightened, and housing prices rallied. ?Long bonds stayed largely flat across the whole period, but still volatile.

There were several surprises in store for the FOMC and investors as ?the tightening cycle went on:

The stock market continued to rally.
So did housing.
So did long bonds, at least for a time.
Every now and then there were little panics, like the credit convexity panic in May 2005, from a funky long-short CDO bet.
Credit complexity multiplied. ?All manner of arbitrage schemes flourished. ?Novel structures for making money off of credit, like CPDOs emerge. ?(The wisdom of finance bloggers as skeptics grows.)
By the end, the yield curve invests the hard way, with long bonds falling a touch through the cycle.
Private leverage continued to build, and aggressively, particularly in financials.
Lending standards deteriorated.

We know how this one ended, but at the end of the tightening cycle, it seemed like another success. ?Only a few nut jobs were dissatisfied, thinking that the banks and homeowners were over-levered. ?In hindsight, FOMC policy should have moved faster and stopped at a lower level, maybe then we would have had less leverage to work through.

June 2010

15 months after the bottom of the crisis, the stock market has rallied dramatically, with a recent small fall, but housing continues to fall in value. ?There’s more leverage behind houses, so when the prices do finally fall, it gains momentum as people throw in the towel, knowing they have lost it all, and in some cases, more. ?For the past year, long bond yields have gone up and down, making a round-trip, but a lot higher than during late 2008. ?Credit spreads are still high, but not as high as during late 2008.

Inflation is low and volatile, unemployment is off the peak of a few months earlier, but is still high. ?Real GDP is growing at a decent clip, but fitfully, and it is still not up to pre-crisis levels. ?Aside from the PPACA [Obamacare], congress hasn’t done much of anything, and the Fed tries to fill the void by expanding its balance sheet through QE1, which ended in June 2010. Things feel pretty punk altogether.

The FOMC can’t cut the Fed funds?rate anymore, so it relies on language in its FOMC Statement to tell economic actors that Fed funds will be “exceptionally low” for an “extended period.” ?Four months from then, the QE2 would sail, making the balance sheet of the Fed bigger, but probably doing little good for the economy.

The results of this period aren’t fully known yet because we still living in the same essential macro environment, with a few exceptions, which I will take up in the final section.

August 2014

Inflation remains low, but may finally be rising. ?Unemployment has fallen, much of it due to discouraged workers, but there is much underemployment. ?Housing has finally gotten traction in the last two years, but there are many cross-currents. ?The financial crisis eliminated move-up buyers by destroying their equity. ?Stocks have continued on a tear, and corporate credit spreads are very tight, tighter than any of the other periods where the yield curve was shaped as it is now. ?The long bond has had a few scares, but has confounded market participants by hanging around in a range of 2.5%- 4.0% over the last two years.

There are rumblings from the FOMC that the Fed funds rate may rise sometime in 2015, after 72+ months hanging out at 0%. ?QE may end in?a few more months, leaving the balance sheet of the Fed at 5 times its pre-crisis size. ?Change may be upon us.

This yield curve shape tends to happen over my survey period at a time when change is about to happen (4 of 7 times — 1971, 1977, 1993 and 2004), and one where the?FOMC will raise rates aggressively (3 of 7 times — 1977, 1993 and 2004) after fed funds have been left too low for too long. ?2 out of 7 times, this yield curve shape appears near the end of a loosening cycle (1991 and 2001). ?1 out of 7 times it appears before a deep recession, as in 1971. 1 out of 7 times it appears in the midst of an uncertain recovery — 2010. 3?out 7 times, inflation will rise significantly, such as in 1971, 1977 and 2004.

My tentative conclusion is this… the fed funds rate has been too low for too long, and we will see a rapid rise in rates, unless the weak economy chokes it off because it can’t tolerate any significant rate increases. ?One final note before I close: when the tightening starts, watch the long end of the yield curve. ?I did this 2004-7, and it helped me understand what would happen better than most observers. ?If the yield of the long bond moves down, or even stays even, the FOMC probably won’t persist in raising rates much, as the economy is too weak. ?If the long bond runs higher, it might be a doozy of a tightening cycle.

And , for those that speculate, look for places that can’t tolerate or would ?love higher short rates. ?Same for moves in the long bond either way, or wider credit spreads — they can’t get that much tighter.

This is an unusual environment, and as I like to say, “Unusual typically begets unusual, it does not beget normal.” ?What I don’t know is how unusual and where. ?Those getting those answers right will do better than most. ?But if you can’t figure it out, don’t take much risk.

The Shadows of the Bond Market’s Past, Part I

Posted on 12 August 2014 by David Merkel

Source: FRED

Above is the chart, and here is the data for tonight’s piece:

Date	T1	T3	T5	T7	T10	T20	T30	AAA	BAA	Spd	Note
3/1/71	3.69	4.50	5.00	5.42	5.70	5.94	6.01*	7.21	8.46	1.25	High
4/1/77	5.44	6.31	6.79	7.11	7.37	7.67	7.73	8.04	9.07	1.03	Med
12/1/91	4.38	5.39	6.19	6.69	7.09	7.66	7.70	8.31	9.26	0.95	Med
8/1/93	3.44	4.36	5.03	5.35	5.68	6.27	6.32	6.85	7.60	0.75	Med
10/1/01	2.33	3.14	3.91	4.31	4.57	5.34	5.32	7.03	7.91	0.88	Med
7/1/04	2.10	3.05	3.69	4.11	4.50	5.24	5.23	5.82	6.62	0.80	Med
6/1/10	0.32	1.17	2.00	2.66	3.20	3.95	4.13	4.88	6.23	1.35	High
8/1/14	0.13	0.94	1.67	2.16	2.52	3.03	3.29	4.18	4.75	0.57	Low

Source: FRED ? ||| ? ? * = Simulated data value ?||| ?Note: T1 means the yield on a one-year Treasury Note, T30, 30-year Treasury Bond, etc.

Above you see the seven yield curves most like the current yield curve, since 1953. ?The table also shows yields for Aaa and Baa bonds (25-30 years in length), and the spread between them.

Tonight’s exercise is to describe the historical environments for these time periods, throw in some color from other markets,?describe what happened afterward, and see if there might be any lessons for us today. ?Let’s go!

March 1971

Fed funds hits a local low point as the FOMC loosens policy under Burns to boost the economy, to fight rising unemployment, so that Richard Nixon could be reassured re-election. ?The S&P 500 was near an all-time high. ?Corporate yield spreads ?were high; maybe the corporate bond market was skeptical.

1971?was a tough year, with the Vietnam War being unpopular.?Inflation was rising, Nixon severed the final link that the US Dollar had to Gold, an Imposed wage and price controls. ?There were two moon landings in 1971 — the US Government was in some ways trying to do too much with too little.

Monetary policy remained loose for most of 1972, tightening late in the years, with the result coming in 1973-4: a severe recession accompanied by high inflation, and a severe bear market. ?I remember the economic news of that era, even though I was a teenager watching Louis Rukeyser on Friday nights with my Mom.

April 1977

Once again, Fed funds is very near its local low point for that cycle, and inflation is rising. ?After the 1975-6 recovery, the stock market is muddling along. ?The post-election period is the only period of time in the Carter presidency where the economy feels decent. ?The corporate bond market is getting close to finishing its spread narrowing after the 1973-4?recession.

The “energy crisis” and the Cold War were in full swing in April 1977. ?Economically, there was no malaise at the time, but in 3 short years, the Fed funds rate would rise from 4.73% to 17.61% in April 1980, as Paul Volcker slammed on the brakes in an effort to contain rising inflation. ?A lotta things weren’t secured and flew through the metaphorical windshield, including the bond market, real GDP,?unemployment, and Carter’s re-election chances. ?Oddly, the stock market did not fall but muddled, with a lot of short-term volatility.

December 1991

This yield curve is the second most like today’s yield curve. ?It comes very near the end of the loosening that the FOMC was doing in order to rescue the banks from all of the bad commercial real estate lending they had done in the late 1980s. ?A wide yield curve would give surviving banks the ability to make profits and heal themselves (sound familiar?). ?Supposedly at the beginning of that process in late 1990, Alan Greenspan said something to the effect of “We’re going to give the banks a lay-up!” ?Thus Fed funds went from 7.3% to 4.4%?in the 12 months prior to December 1991, before settling out at 3% 12 months later. ?Inflation and unemployment were relatively flat.

1991 was a triumphant year in the US, with the Soviet Union falling, Gulf War I ending in a victory (though with an uncertain future), 30-year bond yields hitting new lows, and the stock market hitting new all time highs. ?Corporate bonds were doing well also, with tightening spreads.

What would the future bring? ?The next section will tell you.

August 1993

This yield curve is the most like today’s yield curve. ?Fed funds are in the 13th month out of 19 where they have been held there amid a strengthening economy. ?The housing market is?doing well, and mortgage refinancing has been high for the last three years, creating a situation where those investing in mortgages securities have a limited set of coupon rates that they can buy if they want to put money to work in size.

An aside before I go on — 1989 through 1993 was the era of clever mortgage bond managers, as CMOs sliced and diced bundles of mortgage payments so that managers could make exotic bets on moves in interest and prepayment rates. ?Prior to 1994, it seemed the more risk you took, the better returns were. ?The models that most used were crude, but they thought they had sophisticated models. ?The 1990s were an era where prepayment occurred at lower and lower thresholds of interest rate savings.

As short rates stayed low, long bonds rallied for two reasons: mortgage bond managers would hedge their portfolios by buying Treasuries as prepayments occurred. ?They did that to try to maintain a constant degree of interest rate sensitivity to overall moves in interest rates. ?Second, when you hold down short rates long enough, and you give the impression that they will stay there (extended period language was used — though no FOMC Statements were made prior to 1994), bond managers start to speculate by buying longer securities in an effort to clip extra income. ?(This is the era that this story (number 2 in this article) took place in, which is part of how the era affected me.)

At the time, nothing felt too unusual. ?The economy was growing, inflation was tame, unemployment was flat. ?But six months later came the comeuppance in the bond market, which had some knock-on effects to the economy, but primarily was just a bond market issue. ? The FOMC hiked the Fed funds rate in February 1994 by one?quarter percent, together with a novel statement issued by Chairman Greenspan. ?The bond market was caught by surprise, and as rates rose, prepayments fell. ?To maintain a neutral market posture, mortgage bond managers sold long Treasury and mortgage bonds, forcing long rates still higher. ?In the midst of this the FOMC began raising the fed funds rate higher and higher as they feared economic growth would lead to inflation, with rising long rates a possible sign of higher expected inflation. ?The FOMC raises Fed fund by 1/2%.

In April, thinking they see continued rises in inflation expectation, they do an inter-meeting surprise 1/4% raise of Fed funds, followed by another 1/2% in May. ?It is at this pint that Vice Chairman McDonough tentatively realizes?[page 27] that the mortgage market has?now tightly coupled the response of the long end of the bond market to the short end the bond market, and thus, Fed policy. ?This was never mentioned again in the FOMC Transcripts, though it was the dominant factor moving the bond markets. ?The Fed was so focused on the real economy, that they did not realize their actions were mostly affecting the financial economy.

FOMC policy continued: Nothing in July, 1/2% rise in August, nothing in September, 3/4% rise in November, nothing in December, and 1/2% rise in February 1995, ending the tightening. In late December 1994 and January of 1995, the US Treasury and the Fed participated in a rescue of the Mexican peso, which was mostly caused by bad Mexican economic policy, but higher rates in the US diminished demand for the cetes, short-term US Dollar-denominated Mexican government?notes.

The stock market muddled during this period, and the real economy kept growing, inflation in check, and unemployment unaffected. ?Corporate spreads tightened; I remember that it was difficult to get good yields for my Guaranteed Investment Contract [GIC] business back then.

But the bond markets left their own impacts: many seemingly clever mortgage bond managers blew up, as did the finances of Orange County, whose Treasurer was a mortgage bond speculator. ?Certain interest rate derivatives blew up, such as the ones at Procter & Gamble. ?Several life insurers lost a bundle in the floating rate GIC market; the company I served was not one of them. ?We even made extra money that year.

The main point of August 1993 is this: holding short rates low for an extended period builds up imbalances in some part of the financial sector — in this case, it was residential mortgages. ?There are costs to providing too much liquidity, but the FOMC is not an institution with foresight, and I don’t think they learn, either.

This has already gotten too long, so I will close up here, and do part II tomorrow. ?Thanks for reading.

Regarding Underemployment

Posted on 2 August 20142 August 2014 by David Merkel

This is just meant to be a few thoughts. ?I haven’t worked everything out, but I want to talk about how the labor markets are weak.

Yes, the headline statistics are strong. ?The U-3 unemployment figure is low at 6.2%. ?But look at a few other statistics:

My, but wages as a share of GDP has been falling.

And real wages have flatlined. ?No surprise that many feel pinched in the present environment. ?Even the Federal Reserve Chairwoman Janet Yellen expresses her doubts about the labor markets, which was expressed through the most recent FOMC Statement.

The problem is this: the relationship between labor employment and monetary policy is weak. ?It is weaker than pushing on a string. ?There are two major factors retarding the US labor market, and they are globalization and increased productivity from technology.

The value of knowledge is rising relative to less-skilled labor. ?As such, we are seeing increased income inequality in the US, but lower income inequality globally. ?Bright people in foreign lands who can transmit their skills over the internet can do better for themselves, even as more expensive counterparts in the US lose business.

Call this the revenge of the nerds. ?The internet enables bright people to profit from their differential knowledge, as it can be applied to wider opportunities.

Think of India for a moment. ?Many bright people with advanced degrees, but education amounts to little unless you can use it for your own benefit.

Here’s my main point. ?The FOMC con’t do much about the labor markets; their power is weak. ?The bigger factors of globalization and technology can’t be fought. ?They are too big.

Thus, you are on your own. ?The US Government does not have the power to re-create the unique middle class prosperity of the ’50s and ’60s. ?If you work for others, you are not your own master. ?Aim to make yourself the master of your situation, by making yourself invaluable to your clients.

Redacted Version of the July 2014 FOMC Statement

Posted on 30 July 2014 by David Merkel

Comments

The two main points of this FOMC statement are: 1) ?The Fed recognizes that inflation has risen, and is likely to persist. 2) ? Despite lower unemployment levels, labor market conditions are still pretty punk.? Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Markets don’t move much on the news. ?Really, not a lot here.
Small $10 B/month taper.? Equities and long bonds both rise.? Commodity prices rise.? The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
The FOMC needs to chop the ?dead wood? out of its statement.? Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do?? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

A Few Notes on Bonds

Posted on 25 June 2014 by David Merkel

My comments this evening stem from a Bloomberg.com article entitled?Bond Market Has $900 Billion Mom-and-Pop Problem When Rates Rise. ?A few excerpts with my comments:

It?s never been easier for individuals to enter some of the most esoteric debt markets. Wall Street?s biggest firms are worried that it?ll be just as simple for them to leave.

Investors have piled more than $900 billion into taxable?bond?funds since the 2008 financial crisis, buying stock-like shares of mutual and exchange-traded funds to gain access to infrequently-traded markets. This flood of cash has helped cause prices to surge and yields to plunge.

Once bonds are issued, they are issued. ?What changes is the perception of market players as they evaluate where they will get the best returns relative expected future yields, defaults, etc.

Regarding ETFs, yes, ETFs grow in bull markets because it pays to create new units. ?They will shrink in bear markets, because it will pay to dissolve units. ?That said when ETF units are dissolved, the bonds formerly in the ETF don’t disappear — someone else holds them.

But in a crisis, there is no desire to exchange existing cash for new bonds that have not been issued yet. ?Issuance plummets as yields rise and prices fall for risky debt. ?The opposite often happens with the safest debt. ?New money seeks safety amid the panic.

Last week, Fed Chair Janet Yellen said she didn?t see more than a moderate level of risk to financial stability from leverage or the ballooning volumes of debt. Even though it may be concerning that?Bank of America?Merrill Lynch index data shows yields on?junk bonds?have plunged to 5.6 percent, the lowest ever and 3.4 percentage points below the decade-long average, the outlook for defaults does look pretty good.

Moody?s Investors Service predicts the global speculative-grade default rate will decline to 2.1 percent at year-end from 2.3 percent in May. Both are less than half the rate?s historical average of 4.7 percent.

Janet Yellen would not know financial risk even if Satan himself showed up on her doorstep offering to sell private subprime asset-backed securities for a yield of Treasuries plus 2%. ?I exaggerate, but yields on high-yield bonds are at an all-time low:

Could spreads grind tighter???Maybe, we are at 3.35% now. ?The record on the BofA ML HY Master II is 2.41% back in mid-2007, when interest rates were much higher, and the credit frenzy was astounding.

But when overall rates are higher, investors are willing to take spread lower. ?There is an intrinsic unwillingness for both rates and spreads to be at their lowest at the same time. ?That has not happened historically, though admittedly, the data is sparse. ?Spread data began in the ’90s, and yield data in a detailed way in the ’80s. ?The Moody’s investment grade series go further back, but those are very special series of long bonds, and may not represent reality for modern markets.

Also, with default rates, it is not wise to think of them in terms of averages. ?Defaults are either cascading or absent, the rating agencies, most economists and analysts do not call the turning points well. ?The transition from “no risk at all” in mid-2007 to mega-risk 15 months later was very quick. ?A few bears called it, but few bears called it shifting their view in 2007?– most?had been calling it for a few years.

The tough thing is knowing when too much debt has built up versus ability to service it, and have all short-term ways to issue yet a little more debt been exhausted? ?Consider the warning signs ignored from mid-2007 to the failure of Lehman Brothers:

Shanghai market takes a whack (okay, early 2007)
[Structured Investment Vehicles] SIVs fall apart.
Quant hedge funds have a mini meltdown
Subprime MBS begins its meltdown
Bear Stearns is bought out by JP Morgan under stress
Auction-rate preferred securities market fails.
And there was more, but it eludes me now…

Do we have the same amount of tomfoolery in the credit markets today? ?That’s a hard question to answer. ?Outstanding derivatives usage is high, but I haven’t seen egregious behavior. ?The Fed is the leader in tomfoolery, engaging in QE, and creating lots of bank reserves, no telling what they will do if the economy finally heats up and banks want to lend to private parties with abandon.

That concern is also revealed in BlackRock Inc.?s pitch in a paper published last month that regulators should consider redemption restrictions for some bond mutual funds, including extra fees for large redeemers.

A year ago, bond funds suffered record withdrawals amid hysteria about a sudden increase in benchmark yields. A 0.8 percentage point rise in the 10-year Treasury yield in May and June last year spurred a sell-off that caused $248 billion of market value losses on the Bank of America Merrill Lynch U.S. Corporate and High Yield Index.

Of course, yields on 10-year?Treasuries (USGG10YR)?have since fallen to 2.6 percent from 3 percent at the end of December and company bonds have resumed their rally. Analysts are worrying about what happens when the gift of easy money goes away for good.

With demand for credit still weak, it is more likely that rates go lower for now. ?That makes a statement for the next few months, not the next year. ?The ending of QE and future rising fed funds rate is already reflected in current yields. ?Bloomberg.com must be breaking in new writers, because the end of Fed easing is already expected by the market as a whole. ?Deviations from that will affect the market. ?But if the economy remains weak, and lending to businesses stays punk, then rates can go lower for some time, until private lending starts in earnest.

Summary

Is too much credit risk being taken? ?Probably. ?Spreads are low, and yields are record low.
Is a credit crisis near? ?Wait a year, then ask again.
Typically, most people are surprised when credit turns negative, so if you have questions, be cautious.
Does the end of QE mean higher long rates?? Not necessarily,?but watch bank lending and inflation. ?More of either of those could drive rates higher.

To the Fed: A Picture is Worth 1000 Words

Posted on 19 June 2014 by David Merkel

The FOMC statements are much longer than they used to be, and as such, are less clear, giving faulty signals to the markets. ?If language is not likely to change much ?for a while, why not drop the language ?entirely, especially in cases where it affirms ideas that are obvious.

We may?all know people in our lives who will say more and more if you don’t agree with them, because if you don’t agree with them, you don’t understand. ?More words will bring clarity to you, and you will understand. ?But what if they are nuts, and you are a sane person? ?This is how I think about the FOMC — they are bad forecasters, and they don’t understand how weak monetary policy is in a period where there is too much debt.

So let’s try some pictures to replace the words of the FOMC:

As I have said before, the FOMC is composed of overly optimistic neoclassical economists, who don’t know that their theories don’t work when and economy is too indebted. ?They think: Real growth is our birthright, and price inflation promotes growth. ?Neither are true.

Note that they have been consistently pessimistic on the unemployment rate, flawed measure that it is. ?Thus they think they need to keep monetary loose.

Their views of PCE inflation reflect a view that monetary policy can easily achieve a 2% rate of inflation in the long run. ?Pray tell, when have actions of the FOMC ever led to an equilibrium result?

Aside from that, the PCE index does not fairly represent inflation for the average person in the economy. ?Maybe it reflects what the rich experience.

This is a study in contrasts. ?They were once more optimistic that Fed Funds rates would rise sooner, and that has not happened. ?That said, they are now more certain that the Fed Funds rate will rise significantly in 2016. ?As for the long run they are getting more pessimistic about?economic growth, at least in their Fed Funds forecasts.

This is another example of where the FOMC should take a step back, and not try to interpret every short-term wiggle. ?As a group, they whipsawed in their view of when tightening would happen over the last three datapoints, when I would not have changed much.

To the Fed I say, “Say less, and provide more graphs.” ?I understand that you don’t want to discredit yourselves because you are bad forecasters, but maybe you could get your points across in a more potent way by not diluting your message by many needless words.