Image Credit: Aleph Blog with help from FRED || Believe it or not, I used FRED before it was a web resource — it was a standalone “bulletin board” that I woul dial into on my computer modem

I’ve talked about this here:

• Estimating Future Stock Returns, December 2021 Update
• Time for Another Convexity Crisis?
• The First Priority of Risk Control (2009, this tells the story of what I did during the 1994 crisis.)

And recently I have tweeted about it.

Mortgage rates are surging faster than expected, prompting economists to lower their home sales forecasts https://t.co/IiX2gPlAnI 1994 scenario re-occurring. Falling prepayments makes MBS lengthen, leading indexed bond managers to sell low-coupon MBS forcing rates still higher

— David Merkel (@AlephBlog) March 22, 2022

We may be in the 1994 scenario where mortgage durations are extending, dragging the long end of the yield, as those that hedge duration are forced to sell, setting up a self-reinforcing move up in yields.

— David Merkel (@AlephBlog) March 22, 2022

The MBS coupon stack is a lot flatter in 2022 than in 1994. There is more than 4X the mortgage debt now than in 1994. Lots of pent-up negative convexity. I lived through that in 1994, and made money off it.

— David Merkel (@AlephBlog) March 22, 2022

Then from the piece Classic: Avoid the Dangers of Data-Mining, Part 2

“In 1992-1993, there were a number of bright investors who had “picked the lock” of the residential mortgage-backed securities market. Many of them had estimated complex multifactor relationships that allowed them to estimate the likely amount of mortgage prepayment within mortgage pools.

Armed with that knowledge, they bought some of the riskiest securities backed by portions of the cash flows from the pools. They probably estimated the past relationships properly, but the models failed when no-cost prepayment became common, and failed again when the Federal Reserve raised rates aggressively in 1994. The failures were astounding: David Askin’s hedge funds, Orange County, the funds at Piper Jaffray that Worth Bruntjen managed, some small life insurers, etc. If that wasn’t enough, there were many major financial institutions that dropped billions on this trade without failing.

What’s the lesson? Models that worked well in the past might not work so well in the future, particularly at high degrees of leverage. Small deviations from what made the relationship work in the past can be amplified by leverage into huge disasters.“

Finally from the piece What Brings Maturity to a Market:

Negative Convexity: Through late 1993, structurers of residential mortgage securities were very creative, making tranches in mortgage securitizations that bore a disproportionate amount of risk, particularly compared to the yield received. In 1994 to early 1995, that illusion was destroyed as the bond market was dragged to higher yields by the Fed plus mortgage bond managers who tried to limit their interest rate risks individually, leading to a more general crisis. That created the worst bond market since 1926.

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I am not saying it is certain, but I think it is likely that we are experiencing a panic in the mortgage bond market now. Like 1994, we have had a complacent Fed that left policy rates too low for too long. Both were foolish times, where policy should have been tighter. This led to massive refinancing of mortgages, and many new mortgages at low rates.

But when that happens with most mortgages being low rate, if the Fed hints at or starts raising rates, prepayments will fall and Mortgage-Backed Securities [MBS] will lengthen duration while falling in price. Bond managers, most of whom are indexed and want a fixed duration, will start selling long bonds and MBS, leading long rates to rise, and the cycle temporarily becomes self-perpetuating.

This is likely the situation that we are in now, and it very well may make the Fed overreact as they did in 1994. All good economists know the monetary policy acts with long and variable lags. But the FOMC for PR reasons acts as if their actions are immediate. Thus they become macho, and raise their rates too far, leading to a crash. (Can we eliminate the Fed? Gold was better, if we regulated the banks properly. Or, limit the slope of the yield curve.)

I’m planning on making money on the opposite side of this trade if I am right. I will buy long Treasuries after the peak. I am watching this regularly, and will act when it is clear to me, but not the market as a whole, which in late 1994 to early 1995 did not know which end was up.

Anyway, that’s all. The only good part of this environment is that my bond portfolios are losing less than the general market.

Image credit: All images belong to Aleph Blog

This should be a brief post. At the end of 2021, the S&P 500 was poised to nominally return -1.53%/year over the next 10 years. As of the close yesterday, that figure was 0.73%/year.

The only period compares with this valuation-wise is the dot-com bubble. We are near dot-com level valuations, in the 98th percentile. And if you view the 10-year returns from the worst time of the dot-com bubble to now, you can see that the results they obtained are worse than what I forecast here.

Of course, a lot of what will happen in nominal terms will rely on the actions of the Fed. Will the Fed:

• Allow a real recession to clear away dud assets that are on life support from low rates? (Collapsing the current stock/junk bubble.. they would never do this unless their hands were tied.)
• Risk the 1994 scenario where the compressed coupon stack in the Residential Mortgage Backed Securities [RMBS] market begins a self-reinforcing interest rate rise cycle on the long end as mortgage rates rise, prepayments drop, mortgage durations extend, leading to bond managers selling RMBS and long bonds with abandon to bring their duration risk down. The Fed chases the yield curve up, and the stock and housing markets both fall. The Fed chokes on their policy, and gives up tightening to save both markets.
• Or, if not the 1994 scenario, does the Fed dare to stop tightening before the yield curve inverts, and just wait for a flat curve to do its work? (Nah, that would be smart. The Fed always inverts the curve to prove their manliness, and blows some part of the market up in the process.)
• Or do they just accept financial repression, and punish savers to benefit wage earners (Will it really work? Dubious.), as the Fed keeps their policy rate low.

I posed those scenarios to Tom Barkin, President of the Richmond Fed when he came to speak to the CFA Institute at Baltimore last week. He gave answers that were either evasive, or he didn’t get it.

Anyway, this is an awkward market situation, but the one thing that is clear to me is that investors should be at the lower end of risk for their asset allocation.

PS — As for me, I am living with value stocks, small stocks, and international stocks. Very little in the S&P 500 here.

Photo Credit: atramos || Inflation isn’t the most organized phenomenon, and investors often all want to be on the same side of the boat…

I have a very irregular series called, “Problems with Constant Compound Interest.” Part of the idea of that series is that it is difficult to assure growth in capital in any sort of constant way. The simple models of the CFPs, and even actuaries that assume constant or near constant growth are ultimately doomed to fail if they try to exceed growth in nominal GDP by more than 2%/year.

Because of the oddities in the current market environment, current interest rates and inflation have decoupled. They are separate processes. We all want to build value in real (inflation-adjusted) terms, but how do you do that in an environment where price to free cash flow multiples are sky high, nominal interest rates are low, and the prices of most commodities are high as well (leaving aside gold as an oddity). Mindless stock bulls talk of TINA [There Is No Alternative (to buying stocks)], as if there is no limit to how high stock prices can go when interest rates are low. I want to tell you about TIN. There Is Nothing (worth buying). This is the nature of financial repression.

If you invest in short bonds, you get gouged by current inflation. If you buy long bonds, you run the risk that the Fed might start monetizing Treasury debt directly, and inflation really runs. With stocks you run the risk of any hiccup in the global economy (when is the omega variant coming so that we can move on to Hebrew letters?) can derail the market, particularly if it leads to higher interest rates.

The Fed has gotten its wish and is forcing an asset bubble on the US to aid growth, however fitfully. All of the relationships of the present to the future are out of whack, because interest rates are too low. But if intermediate interest rates rose to the level of nominal GDP growth, we would see deficits grow even more rapidly as the US government would refinance at higher rates. The Fed is stuck in a doom loop of its own design ever since Alan Greenspan got the great idea to cut short recessions too soon. That has led us into a liquidity trap designed by the Fed.

As I said to one of my clients this week (a bright man), “If you are not bewildered, you are not thinking.” About the only idea I can think of for investing at present is the intersection of high quality and low-ish valuations. As it says in Ecclesiastes 11:2 “Give a serving to seven, and also to eight, For you do not know what evil will be on the earth.” Diversify among safe-ish investments, with a few cyclicals that will do well if things run hot, and stable businesses, if things do not.

That’s all.

Image credit: All images belong to Aleph Blog

This should be a brief post. At the end of the third quarter, the S&P 500 was poised to nominally return -0.64%/year over the next 10 years. As of the close today, that figure was -1.83%/year, slightly more than the -1.84%/year at the record high last Friday.

The only period compares with this valuation-wise is the dot-com bubble. We are above dot-com level valuations. And if you view the 10-year returns from the worst time of the dot-com bubble to now, you can see that the results they obtained are milder than what I forecast here.

Of course, a lot of what will happen in nominal terms will rely on the actions of the Fed. Will the Fed:

• Allow a real recession to clear away dud assets that are on life support from low rates? (Collapsing the current asset bubble)
• Change the terms of monetary policy, and start directly monetizing US Treasury debt? (Risking high inflation)
• Continue to dither with financial repression, leaving rates low, not caring about moderate inflation, with real growth zero-like. (Zombie economy — this is the most likely outcome for now)

In some ways the markets are playing around with something I call “the last arbitrage.” Bonds versus Stocks. The concept of TINA (There is no alternative [to stocks]) relies on the idea that the Fed will be the lapdog of the equity markets. If stocks are high, the Fed is happy. Phrased another way, if the Fed maximizes wealth inequality, it is happy.

And the Fed will be happy. They live to employ thousands of macroeconomists who would have a hard time finding real employment. These economists live to corrupt our understanding f the macroeconomy, justifying the actions of the Fed. The Fed just wants to scrape enough seigniorage to pay the staff, and keep Congress and the Administration mollified. All taken out of the hides of those who save.

So with the last arbitrage… interest rates have to stay low to keep the stock market high, even if it means slow growth, and moderate and growing inflation. The likely change promulgated by the Fed today, raising the short rate by 0.75% in 2022 will likely flatten the yield curve, leading to a crisis of some sort, and push them back into QE and near-zero short rates. The stock market will have a pullback and a rally, but what of inflation? How will people act when there is no way to save for the short-run, without inflation eating away value?

Brave new world. The Fed is stuck, and we are stuck with them. Gold does nothing, and would be a kinder mistress than the Fed. Better to live within strict limits, than the folly of an elastic currency. But as is true with all things in America, we are going to have to learn this the hard way.

PS — As for me, I am living with value stocks, small stocks, and international stocks. Very little in the S&P 500 here.

Photo Credit: duncan c || I know it is graffiti, but face it, most arguments regarding COVID-19 or politics are little better than graffiti

There’s a popular argument going around about the VAERS [Vaccine Adverse Event Reporting System] database that the COVID-19 [C19] vaccines are killing a lot of people. I am here tonight to tell you that is likely false, but at minimum, that you can’t prove that through the VAERS database.

First a digression: Out of group of one million picked at random in the US, how many people will die on a given day?? Using 2019 US crude mortality data, roughly 20.?

So, out of 470 million vaccine doses administered, how many should have died for any reason within one day of receiving the dose of vaccine? Roughly 9,400.? Within two days? 18,800. How many deaths are in VAERS after one day? 1,921. Two days? 2,415. Expected deaths for any reason versus VAERS data after five days? 47,000 vs 3,244. Fourteen days? 131,600 vs 4,458. 30 days? 282,000 vs 5,629. There are 4,799 additional deaths 31 days and after, and those where no date was specified in the VAERS data. So, 10,428 deaths from COVID in the VAERS database.

So, the VAERS data does not support the idea that the vaccine is killing people.? Now the VAERS database has inconsistent and uncontrolled reporting ? it is a voluntary database, and anyone can post to it, makes any study design pretty useless, which is part of their disclaimers. Many allege underreporting but ask yourself “Could there be more than 25 deaths from the vaccines for every one reported?” Really, I doubt it. A big blip in the death rate from vaccination would get noticed ? you couldn?t suppress it. The news outlets would be all over the story.

We have never had a vaccination campaign of this size in the US before.? We should expect people dying post-vaccination at an ordinary rate.? Where VAERS could be useful would be looking at cause of death codes for a given vaccine, and seeing if there are any death causes that are unusual in proportion.? And that?s what the researchers mostly use the VAERS database for.

From other statistical work I have done I can tell you that the vaccines are generally effective, and that if you don’t have a medical reason to not get vaccinated, you should get vaccinated. The vaccines reduce the likelihood of infection, severity of infection, and the likelihood of death from C19.

And for my Christian friends who object because fetal tissue from abortions long ago were used in the process of creating the vaccines, I will ask you this: many drugs get tested or developed using the aborted fetal tissue, including aspirin, Tylenol, Ibuprofen, Lidocaine, Mucinex, Pepto Bismol, MMR Vaccine, Remdesivir, Tums, Maalox, Preparation H, Claritin, Robitussin, Lipitor, Zoloft, Aleve, Ex-Lax, Benadryl, Suphedrine, and Sudafed, among many others. Are you willing to make the moral claim and do without almost all drugs, not just the C19 vaccines?

Those children are dead, and nothing can be done about it. The cells that comprised their bodies are long since gone. The cells existing today are many generations removed from the babies who were killed through the abortions. Not that they should have been killed (let’s end Roe v Wade), but they have indirectly done more good for mankind than most people (including me) will ever do.

Public health is a proper province of government, unlike most matters that governments concern themselves with today, because it involves matters in health that can be made better via collective action. The Mosaic Law supports this idea. And so I say to my Christian friends, get vaccinated, and stop listening to the right wing media that milks you to make money via advertising.

Photo Credit: eflon || All in all, you’re just another brick in the wall…

In some ways, the Federal Reserve is the whipping boy of Congress. Congress can’t decide on anything significant, so the Fed fills in the blanks, and keeps things moving, even if it creates humongous asset bubbles in the process.

That is what we are facing today. Overvalued stocks, housing, corporate bonds, private equity, and more. Inflation in goods and services may be transitory, but asset inflation is a constant. Whether by QE or rate policy, the Fed tries to end the possibility of recessions by making financing cheap, and blowing asset bubbles in the process.

What of the future? The Fed will be dragged kicking and screaming to tightening. It will follow the stupid Alan Greenspan highway of 25 basis points per meeting. It will be all too predictable, which has little to no impact until it is too late, creating pro-cyclical economic policy, something the Fed specializes in.

The Fed will be surprised (again) to see that the long end of the yield curve does not respond to their efforts. Are they stupid? Yes. the yield curve hasn’t worked in the classical way for over 20 years. In an overindebted economy, long rates are sluggish. Can the Fed abandon the dead orthodoxy of neoclassical economics to embrace the reality of overindebted economics?

I doubt it. I asked two Fed governors three years ago when the Fed would abandon the failed Neoclassical economics. They looked like dead sheep for a moment, before they gave some lame defenses of the theory that can’t account for financial markets or marketing.

What I expect is that the Fed will tighten the Fed funds rate to 1.5% or so, the long end sinking, and then something blows up, and they return to the prior policy of 0% rates, and QE… failed policies that inflate asset bubbles and increase inequality.

We’re in a “doom loop” where there is no way to purge this system of its errors. We would be better off under a gold standard, with stricter regulation of banks. Would we have a recession? Yes, but eventually the economy would grow again organically, without the pollution of stimulus.

That said, the Federal Reserve is not the main problem. The main problem is American culture that will not tolerate severe recessions. We need recessions to liquidate bad debts that hinder the economy from growing rapidly in the future.

We need to accept the boom-bust cycle, and not look to the government or central bank to moderate matters. Bank regulation is another matter, as loose regulation of banks led to extreme booms and busts, particularly between 1870-1913, and 2004-2008.

Conclusion

The Fed will tighten and fail, returning us to the same morass that we are in now. Financial repression via the Fed will continue to create inequality with no smoking gun. Stupid people will finger other causes, when the real cause is the Federal Reserve. We need to eliminate the Federal Reserve, and cause Congress and the Executive Branch to take responsibility for their failed policies.

PS — there could be a currency panic, but I doubt it. Too many countries want to export to the US.

Photo Credit: Chris Blakeley || Always optimistic when things are growing, and in the dumps when it falls apart

Over the years, I have suggested that two firms should break up on a number of occasions: AIG & GE. Both are now in the process of completing their breakups.

The news on GE dropped today, and I was surprised that the media did not pick up on one significant question on the GE breakup. Who gets the insurance liabilities that have been a real pain to GE even after selling off Genworth. As I tweeted:

General Electric to Split Into Three Public Companies – WSJ https://t.co/BR8uXhhDVJ Notably missing from all the $GE press coverage is who has to pay off the insurance liabilities: Aviation, probably the weakest of the three. Could gore those relying on the guarantee… pic.twitter.com/qhT0y4gfXL

— David Merkel (@AlephBlog) November 9, 2021

I think I first suggested that GE should break up in a comment in RealMoney’s Columnist Conversation sometime back in 2005, but that is lost in the pre-2008 RealMoney file system, and exists no more. In terms of what I can show I will quote from this old post from 2008:

5) File this under Sick Sigma, or Six Stigma ��GE is finally getting closer to breaking up the enterprise.? It has always been my opinion that conglomerates don�t work because of diseconomies of scale.? As I wrote at RealMoney:

David Merkel

GE � Geriatric Elephant

4/27/2007 1:16 PM EDT

First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don�t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.

Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn�t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO�ed it rather than spinning it off to shareholders�

But here�s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)

Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.

Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.

Position:�none, and I have never understood the attraction to GE as a stock

Over the years, I continued to write about GE and Genworth (I grew bearish over LTC after analyzing Penn Treaty. I was always bearish on mortgage insurance). I never thought either would do well, but I never expected them to do as badly as they did. Optimistic accounting ploys from the Welch years bit into profits of Immelt, as he was forced to reset accruals higher again and again. Overly aggressive financial and insurance underwriting similarly had to be reversed, and losses realized.

After today, all but the successor firm for GE (Aviation) has a chance to do something significant, freed from the distractions of being in a conglomerate. They can focus, and maybe win. As for GE Aviation, because of the insurance liabilities they will probably receive a valuation discount. Maybe they will sacrifice and pay up, selling the liabilities to Buffett with significant overcollateralization.

American International Group

I first suggested that AIG break up back in 2008. Only M. R. Greenberg had the capability of managing the behemoth, and once he was gone, lower level managers began making decisions that Greenberg would have quashed, which led to short-term gains, and larger long-term losses. After AIG was taken over by the Fed, bit-by-bit they began selling off the pieces — Hartford Steam Boiler, ILFC, AIA, Alico (to MetLife), and more. They were left with a portion of the international P&C business, and the domestic life and P&C businesses.

They are now planning on spinning off the domestic life companies, which will leave AIG as a P&C insurer with relatively clean liabilities (They reinsured Asbestos and Environmental with Berkshire Hathaway).

Where do we go from here?

Is there a lesson here? Avoid complexity. Avoid mixing mixing industrial and financial. Avoid mixing life and P&C. (Allstate is finally splitting that.)

That said, there may be another lesson for the future. What of the extremely large companies that are monopolies? Some of them aren’t complex; they just dominate a large area of the economy as monopolies. Governments want to do one of two things with monopolies. They either want to break them up, or turn them into regulated utilities. Why?

The government doesn’t like entities that get almost as powerful as them, so they limit their size, scope, and subject them to regulation. So be aware if you hold some of the largest companies in the US or the world, because governments have their eyes on them, and want them to be subject to the government(s).

Full disclosure: long MET

Photo Credit: Paul Kagame || Hail Emperor Xi, the greatest since Qin Shi Huang!

Ready for a cold winter? Much of the world is not. Many places have discouraged using hydrocarbons to produce power, ostensibly for environmental goals, whether those are valid or not. Whether by the fiat of the Chinese Communist Party, or because some Eurocrats push a green agenda, many people are facing a winter where power/heat may be limited. And even if there may not be absolute shortages everywhere, higher prices for all forms of energy, will pinch the budgets of many in the lower middle class and below this winter in the Northern Hemisphere.

Part of this stems from central planning. China is the easiest example. Xi Jinping has arrogated to himself more and more power over time, changing the dynamics of the Communist Party, which once at least had some factions, to a unitary party that has only one leader, Emperor President Xi. Some of it came about by eliminating corrupt rivals, but the rest from instilling fear within the Party.

Almost every evening, my wife and I read the Bible together. Recently we have been going through the post-exilic portions of the Old Testament where the Jews live under the rule of the Babylonian and Medo-Persian Empires. Those rulers were typically absolute monarchs: do what I say or die! In going through Esther, my wife commented that it was stupid to have laws that cannot be altered. (The same thing is stated in the Book of Daniel.) My comment back to her was if you were an absolute monarch in that era, you were God walking on earth, and could never be wrong. Thus no decree of an Emperor could be wrong.

And so it is for President Xi: everything he says is right. He may be an atheist, but to the Chinese in Red China, he is “God walking on Earth” in at least the Hegelian sense. As such, he makes a decree, and those serving him are scared to do anything more or less than he wants. But with vague directives, what does he want?

Unilateral authority is particularly vulnerable to making mistakes. In the intermediate-term, China is likely to get weaker because of the increasing concentration of power of President Xi. That’s not to say that capitalist democracies can’t run off the rails, but typically with enough dissenting voices, the worst outcomes don’t usually take place. There are exceptions though.

The first exception is regulators with too much discretionary authority. By pursuing one limited goal in the short-run, such as long-term environmental objectives, they may harm the interests of ordinary people in developed markets by making it hard to get food, fuel/energy, and other necessities. And applying the same rules in foreign policy, they may well condemn the developing world to permanent poverty. The developing world thinks the developed world doesn’t care. They are right, and they will ignore what their current leaders have promised in order to curry temporary favor with the developed world.

Now where there is the ability to self-correct, eventually societies will remove regulators, politicians, etc. That said, some things are more entrenched than others. I speak of the cult of stimulus.

What is more untouchable than the central banks? It’s hard to think of anything more unaccountable. They may technically be beholden to the local parliament, but practically, no one ever messes with them aside from despots pursuing hyperinflation (Venezuela, Turkey, Lebanon, etc.).

What gores me is that the unaccountable central banks never ‘fess up to errors. Listen to this:

�Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall,� the Fed said in its twice-yearly Financial Stability Report released Monday.

Fed Warns of Peril in Run-Up of Risky Asset Prices, Stablecoins

That serial blower of bubbles, the Fed, warns us about the height of risky asset prices. Fed policy works via encouraging economic actors to borrow less or more. They have been running a more aggressive monetary policy than they ever needed to, and in the process have inflated housing prices, stocks, bonds of all sorts, private equity, etc. This is not just true of the Fed in the US, but in most developed country central banks.

This was an unforced error. Monetary policy could have been tightened in mid-2020, and I mean raising the Fed funds rate, not just stopping QE. When the equity markets race to new highs so rapidly, why should any stimulus exist at all?

We don’t need stimulus from Congress either. When demand is so strong that supply chains creak, buckle, and seize up, it is not time to stimulate more, rather, it is time to balance the budget.

I would like to think that supply-chain troubles, inflation, and growth are all transitory. But if in an effort to force growth higher than it should be in the short-run, the growth will still be transitory, but the supply-chain troubles and inflation will persist.

Beware the experts that say they run things for your good; they likely don’t know what they are doing.

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Ending note: one more thing, beware the inflation numbers, particularly on items in short supply. If the economists reduce the weights on those things in short supply, it will artificially understate inflation.

Photo Credit: miketransreal || Truly when the small seems big, and the big seems small, reality may intrude and reverse matters

Today I tweeted:

Fed's Preferred Libor Replacement: SOFR Rate Drop Fuels Jitters Over Transfer https://t.co/oqHADuh2YZ As SOFR gets bigger it could screw up short-term lending markets.

— David Merkel (@AlephBlog) October 21, 2021

What I am about to say is speculative. For the last nine years, I have thought that the move away from LIBOR could be a case of “The cure is worse than the disease.” If you are going to have an index for short-term lending it can be created in a few ways:

• Off of surveys, like LIBOR.
• Off of transactions, like SOFR [Secured Overnight Financing Rate], or the on-the-run Treasury yield
• Off of a liability yield, like a cost of funds index

One of the virtues of a non-transactional benchmark is that you won’t have to deal with the problem where the market generating the index is smaller than the market using the index. When that is the case, you can have those in the market using the index attempting to hedge in the smaller market generating the index, leading to distortions, volatility, etc. Though the small market was created to control the large market, when hedging starts, the large market will dominate the small one, and maybe games will get played in the small market to influence the large market.

As I wrote nine years ago in The Rules, Part XXXII:

Dynamic hedging only has the potential of working on deep markets.

Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against. The process cannot work in reverse, except by accident.

The SOFR market is a lot smaller than all the floating rate financing that goes on, which is transitioning from LIBOR to SOFR. My fear is that as the conversion from LIBOR to SOFR grows, and SOFR-based new issuance expands, that hedging by taking the opposite side of a SOFR trade will come to dominate that market, leading to volatility, and the taint that comes from the appearance of playing games.

Again, I am not certain here, but I think we may regret the transition from LIBOR to SOFR.

Picture Credit: WyldKyss || The greatest mistake of economics is thinking we can influence the economy to make it do more over the long haul than it otherwise would do.

I am not a liberal; I am not a conservative. I wish the Balanced Budget Amendment had been passed in the1970s, such that we would not be making such grandiose as a result of legislative/bureaucratic tinkering. I think the government should not try to solve economic issues, and should focus on Issues of justice. The US government has never done well managing the economy. Set some basic boundaries to define fraud, and then let the economy run.

But in the present environment, i like anything that hinders the US Government from borrowing more. Most government spending reduces real GDP. You want infrastructure? Build it locally. Tax the area needing it, and see if they really want to pay the price. Don’t do it at the Federal level, where no one understands what is in any omnibus spending bill. It is all a waste, where those in Congress engage in a form of fraud telling their constituents what they got for them. If they really needed it, their state, county, or city should have done it. Projects should be done at the lowest level of government possible.

Think of the situation regarding ports. We have spent 10x+ more money on ports on the east of the US rather than the west, and far more freight comes to the west. If these decisions were not federalized, we would not make such stupid choices.

Bring back the sequester. Bring back anything that restrains the idiocy of the Congress and the last four Presidents. The high level of debt makes the economy unstable. You want more and more crises? Keep adding to the debt. The US and the World grew faster in real terms when the rule was balanced budgets and restrictive monetary policy. As such, I appreciate any measure that restrains the ability of the US government to borrow more.