Public Policy – Page 14 – The Aleph Blog

The Butterfly Machine

Posted on 23 October 2014 by David Merkel

Photo Credit: whologwhy || Danger: Butterfly at work!

There’s a phenomenon called the Butterfly Effect. ?One common quotation is “It has been said that something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world.”

Today I am here to tell you that for that to be true, the entire world would have to be engineered to allow the butterfly to do that. ?The original insight regarding how small changes to complex systems occurred as a result of changing a parameter by a little less than one ten-thousandth. ?Well, the force of a butterfly and that of a large storm are different by a much larger margin, and the distances around the world contain many effects that dampen any action — even if the wind travels predominantly one direction for a time, there are often moments where it reverses. ?For the butterfly flapping its wings to accomplish so much, the system/machine would have to be perfectly designed to amplify the force and transmit it across very long distances without interruption.

I have three analogies for this: the first one is arrays of dominoes. ?Many of us have seen large arrays of dominoes set up for a show, and it only takes a tiny effort of knocking down the first one to knock down the rest. ?There is a big effect from a small initial?action. ?The only way that can happen, though, is if people spend a lot of time setting up an unstable system to amplify the initial action. ?For anyone that has ever set up arrays of dominoes, you know that you have to leave out dominoes regularly while you are building, because accidents will happen, and you don’t want the whole system to fall as a result. ?At the end, you come back and fill in the missing pieces before showtime.

The second example is a forest fire. ?Dry conditions and the buildup of lower level brush allow for a large fire to take place after some small action like a badly tended campfire, a cigarette, or a lightning strike starts the blaze. ?In this case, it can be human inaction (not creating firebreaks), or action (fighting fires allows the dry brush to build up) that helps encourage the accidentally started fire to be a huge one, not merely a big one.

My last example is markets. ?We have infrequently?seen volatile markets where the destruction?is huge. ?A person?with a modest knowledge of statistics will say something like, “We have just witnessed a 15-standard deviation event!” ?Trouble is, the economic world is more volatile than a normal distribution because of one complicating factor: people. ?Every now and then, we engineer crises that are astounding, where the beginning of the?disaster seems disproportionate to the end.

There are many actors that take there places on stage for the biggest economic disasters. ?Here is a partial list:

People need to pursue speculation-based and/or debt-based prosperity, and do it as a group. ?Collectively, they need to take action such that the prices of the assets that they pursue rise significantly above the equilibrium levels that ordinary cash flow could prudently finance.
Lenders have to be willing to make loans on inflated values, and ignore older limits on borrowing versus likely income.
Regulators have to turn a blind eye to the weakened lending processes, which isn’t hard to do, because who dares oppose a boom?? Politicians will?play a role, and label prudent regulations as “business killers.”
Central bankers have to act like hyperactive forest rangers, providing liquidity for the most trivial of financial crises, thus allowing the dry tinder of bad debts to build up as bankers use cheap funding to make loans they never dreamed that they could.
It helps if you have parties interested in perpetuating the situation, suggesting that the momentum is unstoppable, and that many people are fools to be passing up the “free money.” ?Don’t you know that “Everybody ought to be rich?” [DM: then who will deliver the pizza? ?Are you really rich if you can’t get a pizza delivered?] ?These parties can be salesmen, journalists, authors, etc. whipping up a frenzy of speculation. ?They also help marginalize as?”cranks” the wise critics who point out that the folly eventually will have to end.

Promises, promises. ?And all too good to be true, but it all looks reasonable in the short run, so the game continues. ?The speculation can take many forms: houses, speculative companies like dot-coms or railroads, even stocks themselves on sufficient margin debt. ?And, dare I say it, it can even apply to old age security schemes, but we haven’t seen the endgame for that one yet.

At the end, the disaster appears out of nowhere. ?The weak link in the chain breaks — vendor financing, repo financing, a run on bank deposits, margin loans, subprime loans — that which was relied on for financing becomes recognized as a short-term?obligation that must be met, and financing terms change dramatically, leading the entire system to recognize that many assets are overpriced, and many borrowers are inverted.

Congratulations, folks, we created a black swan. ?A very different event appears than what many were counting on, and a bad?self-reinforcing cycle ensues. ?And, the proximate cause is unclear, though the causes were many in society pursuing an asset boom, and borrowing and speculating as if there is no tomorrow. ?Every individual action might be justifiable, but the actions as a group lead to a crisis.

In closing, though I see some bad lending reappearing, and a variety of assets at modestly speculative prices, there is no obvious crisis facing us in the short-run, unless it stems from a foreign problem like Chinese banks. ?That said, the pension promises made to those older in most developed countries are not sustainable. ?That one will approach slowly, but it will eventually bite, and when it does, many will say, “No one could have predicted this disaster!”

When Will the FOMC Tighten the Fed Funds Rate?

Posted on 10 October 2014 by David Merkel

Photo Credit: Moon Lee || When is this train going to arrive?

There are several ways to gauge the Federal Open Market Committee wrong. I am often guilty of a few of those, though I hope I am getting better. ?Don’t assume?the FOMC:

Shares your view of how economies work.
Cares about the politics of the situation.
Knows what it really wants, aside from magic.
Won’t change its view by the time an event arrives that was previously deemed important for monetary policy.
Cares about the reasoning of dissenters on the committee.
Understands what is actually happening in the economy, much less what its policy tools will really do.

But you can assume the FOMC:

Cares about the health of the banks, at least under extreme conditions
Wants to do something good, even if their minds are poisoned by neoclassical economics
Will err on the side of saying too much, rather than too little, when it feels that its policies are not having the impact?desired on the markets and economy.
Will act in the manner that most protects its continued existence and privileges.

So if we want to guess when the FOMC will tighten, we can do three things:

Look at market opinion
Look at the FOMC’s own opinions, or
Something else 😉

Let’s start with market opinion. ?At present, Fed funds futures have the Fed funds rate rising to 0.25% in the third quarter of 2015, and 0.50% in the fourth quarter. ?Now, market opinion has tended to be ahead of the actual actions of the FOMC on tightening policy, so maybe that will be true in the future as well. ?So far, those betting for tightening in the Fed funds futures market have been losing over the last few years along with those shorting the long Treasury bond, because rates have to go up.

Okay, so what does the FOMC think? ?Starting back in January of 2012, they started providing forecasts to us, and here is a quick summary of their efforts:

In general, they have been overly optimistic about growth in the US economy. ?They probably still are too optimistic.

They have been better at forecasting the unemployment rate, even as it has become less useful as an indicator of how strong labor conditions are because of discouraged workers and more lower wage jobs.

In general, they have expected inflation to perk up in response to their policies a lot faster than it has happened.

And as a result, like the market, they have expected to tighten in the past a lot sooner than they are presently projecting, which is not all that much different than the view of the market. ?Also like the market, you can’t simply take an average of their views as representative of where Fed Fund will be. ?Since the FOMC relies on voting, the median view would be more representative than the average Fed funds rate forecast, and that has remained at a relatively consistent “tightening will happen sometime in 2015” since September 2012. ?The median estimate of where Fed funds would be at the end of 2015 has also been 0.75-1.00% over that same period, which is higher than the current market estimate of 0.60%, but lower than the FOMC’s own estimate of 1.1%.

So, where does this leave us, but with a view that the FOMC will tighten policy next year. ?But what if the monetary doves on the FOMC remain dominant? ?After all, those that are permanent voting members are more dovish than the average participant tossing out an estimate. ?That leaves me with this, which reflects the influence of the doves better:

This graph is based on the average forecast, which includes a decent number of outlier views from some of the doves, which at present suggests tightening in January of 2016, but if you take into account the time drift of views since September 2012, it augurs for tightening in August of 2016.

The drift has happened because the economy has not strengthened the way the FOMC expected it would. ?If we muddle along at the average rate of growth over the last two years, the FOMC may very well sit on its hands and not tighten as quickly as presently expected. ?After all, labor conditions are soft, and inflation as they measure it is not roaring ahead. ?(Please ignore the asset price inflation that aids the non-existent wealth effect.)

As it is, statements from the FOMC have been noncommittal, only saying that they are ending QE. ?They are still waiting for their grand sign to act on Fed funds, and it has not come yet.

Summary

Current expectations from the market and the FOMC suggest that the Fed funds rate will rise in 2015. ?Prior expectations of FOMC action have signaled much earlier action than what has actually happened. ?From my vantage point, it is more likely that the FOMC moves later than the third quarter of 2015 versus?earlier than then. ?The FOMC has been slow to remove policy accommodation; it is more likely that they will remain slow given present economic conditions.

Inevitable Ineffective Banking Regulation

Posted on 1 October 20141 October 2014 by David Merkel

I am mystified at why people might be outraged or surprised that the Federal Reserve does a poor job of overseeing banks. ?The Fed is an overstaffed bureaucracy. ?Overstaffed bureaucracies always tend toward consensus and non-confrontation.

I know this from my days of working as an actuary inside an overstaffed life insurance company, and applying for work in other such companies. ?I did not fit the paradigm, because I had strong views of right and wrong, and strong views on how to run a business well, which was more aggressive than the company that I worked for was generally willing to do. ?Note that only one such company was willing to hire me, and I nearly got fired a couple of times for proposing ideas that were non-consensus.

This shouldn’t be too surprising, given the past behavior of the Fed. ?In 2006, the Fed made a few theoretical noises about residential real estate loan quality, but took no action that would make the lesser regulators do anything. ?It’s not as if they didn’t have the power to do it. ?One of the great canards of financial reform is that regulators did not have enough power to stop the bad lending. ?They most certainly did have enough power; they just didn’t use it because it is political suicide to oppose a boom. ?(Slide deck here.)

As a result, I would not have enacted Dodd-Frank, because I like my laws simple. ?Instead, I would have fired enough?of the regulators to make a point that they did not do their jobs. ?How many financial regulators were fired in 2008-2009? ?Do you hear the crickets? ?This is the #1 reason why you should assume that it is business as usual in banking regulation.

You won’t get assiduous regulation unless regulators are dismissed for undue leniency. ?I have heard many say in this recent episode with Goldman Sachs, the New York Fed, and?Carmen Segarra that those working for the Fed are bright and hard-working. ?I’ll give them the benefit of the doubt; my own dealings with those that work for the Fed is that most of them, aside from bosses,?are quiet, so you can’t tell.

Being quiet, and favoring the powerful, whether it is bosses, politicians, or big companies that you regulate is the optimal strategy for advancement at the Fed over the last 30 years. ?It doesn’t matter much how bright you are, or how hard you work, if it doesn’t have much impact on the organization’s actions.

I try to be an optimistic kind of guy, but I don’t see how this situation can be changed without firing a lot of people, including most of the most powerful people at the Fed, lesser banking regulators, and US Treasury.

And if we did change things, would we like it? ?Credit would be less available. ?I think that would be an exceptionally good thing, but most of our politicians are wedded to the idea that increasing the availability of credit is an unmitigated good. ?They think that because they don’t get tagged for the errors. ?They take credit for the bull market in credit, and blame everyone except themselves and voters for the inevitable bear market.

Also, if we did fire so many people, where would we find our next crop of regulators? ?Personally, I would hand banking regulation back to the states, and end interstate branching, breaking up the banks in the process.

Remember, the insurance industry, regulated by the states, is much better regulated than the banking industry. ?State regulators are much less willing to be innovative, and far more willing to say no. ?State regulation is simple/dumb regulation, which is typically good regulation.

But whether you agree with my policy prescription or not, you should be aware that things are unlikely to change in banking regulation, because it is not a failure of laws and regulations, but a failure of will, and we have the same sorts of people in place as were there prior to the financial crisis.

Postscript

I would commend the articles cited by Matt Levine of Bloomberg regarding this whole brouhaha:

A bit more on Carmen Segarra.

Apparently the place to discuss regulatory capture is on Medium. Here is Dan Davies:

Regulated institutions generally have better contacts and relationships with the top central bankers than their supervisors do. And for whatever reason, top central bankers never developed the necessary knee-jerk aggressive response to any attempts to make use of these relationships to affect the behaviour of supervisors.
So banks never need to listen to their line-level regulators because they can always get those regulators’ bosses’ bosses’ bosses to overrule them. Here is Felix Salmon, mostly agreeing. And here is Alexis Goldstein with a litany of Fed enabling of banks. Elsewhere, Martien Lubberink explains the transaction that got so much attention in the Fed tapes, in which Goldman agreed to hang on to some Santander Brasil stock for a year before delivering it to Qatar. He thinks it was pretty vanilla. And Adam Ozimek has a good point:

This American Life ep should lower avg est corruption belief. Goldman and NY Fed secretly taped & all u get is in non-confrontational nerds?

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.)

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 FSOC is Full of Hot Air

Posted on 6 September 2014 by David Merkel

I’ve written about this before, but if the FSOC wants to prove that they don’t know what they are doing, they should define a large life insurer to be a systemic threat.

It is rich, really rich, to look at the rantings of a bunch of bureaucrats and banking regulators who could not properly regulate banks for solvency from 2003-2008, and have them suggest solvency regulation for a class of businesses that they understand even less.

And, this is regarding an industry that posed little?systemic threat during the financial crisis. ?Yes, there were the life subsidiaries of AIG that were rescued by the Fed, and a few medium-large life insurers like Hartford and Lincoln National that took TARP money that they didn’t need. ?Even if all of these companies failed, it would have had little impact on the industry as a whole, much less the financial sector of the US.

Life insurance companies have much longer liability structures than banks. ?They don’t have to refresh their financing frequently to stay solvent. ?It is difficult to have a “run on the company” during a time of financial weakness. ?Existing solvency regulation done by actuaries and filed with the state regulators considers risks that the banks often do not do in their asset-liability analyses.

Systemic risk comes from short-dated financing of long-dated assets, which is often done by banks, but rarely by life insurers. ?I’ve written about this many times, and here are two of the better ones:

MetLife and other insurers should not have to live with the folly of “Big == Systemic Risk.” ?Rather, let the FSOC focus on all lending financials that borrow short and lend long, particularly those that use the repurchase markets, or fund their asset inventories via short-term lending agreements. ?That is the threat — let them regulate banks and pseudo-banks right before they dare to regulate something they clearly do not understand.

One Less Mentioned Reason for Stock Buybacks

Posted on 6 September 2014 by David Merkel

1357046602_c11590eace_z — Photo Credit: Bill Selak

Buybacks are not my favorite way to redeploy excess capital, in general. ?But let me describe to you when they are useful and when they are not [taken from this article]:

Buybacks are preferred on a taxation basis to dividends.
But buybacks are especially good when the stock is trading below its franchise value, and especially bad the further above franchise value the stock is trading.
Using slack capital to improve operations, or do little tuck-in acquisitions is probably best of all.? Organic growth is usually the best growth, and small acquisitions can facilitate that.? Small acquisitions are usually not expensive.? Be wary of acquisitions to increase scale, they don?t work so well.
Paying a dividend makes management teams more cognizant of the cost of equity capital, which makes them more effective.
In the reinsurance business in Bermuda, companies with slack capital tend to buy back shares below 1.3x book value, and issue special dividends if they are above that level.

The whole article is worth a read, but there is one more factor that drives buybacks, especially illogical buybacks where they pay more than the per share intrinsic value of the company: they don’t want to get taken over by another company. ?After all, the current management team may never have such nice jobs ever again.

Buying back stock at uneconomic prices temporarily keeps the stock price high, and removes cash from the balance sheet that an acquirer could use to help purchase the company. ?We haven’t seen it in a while, but some companies under threat of a takeover would do a semi-LBO and borrow a lot of money to buy back stock, making a purchase of the company?less attractive.

Thus, I’m not sure we could ever get rid of buybacks, even when they don’t make sense, except perhaps in the long run by selling the shares of companies that are too aggressive in the buybacks.

Closing Note

I rarely disagree with Josh Brown, but I did not find the?HBR article he cited?criticizing buybacks to be compelling. ?I would find it really difficult to believe that management teams avoid projects offering organic growth at rates exceeding the implied yield from buying back stock. ?Also, there are many different ways to run businesses in our country, and if public companies suffer from a buyback bias, then private companies might be able to think longer-term, and invest in profitable?organic ventures.

Thus I would not blame buybacks for other problems in society; I might blame too much investment in residential housing and financial institutions, but even then, I would not be certain. ?What we invest in as a society does affect future growth, but it is difficult to see where the end-investments take place. ?Money from a stock buyback might get redeployed into a business startup. ?It may be that public businesses are light on organic investing, and take less risk in investing via buybacks.?But that is why we have startups, private equity, etc., much of successful of which go public or get acquired by public companies.

Anyway, just a few thoughts…

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.