The SEC's money market rules: Buridan's Ass redux

Updated on Thursday, July 24, 2014 at 12:48PM by hb

Updated on Thursday, July 24, 2014 at 03:24PM by hb

Updated on Thursday, July 24, 2014 at 03:27PM by hb

Updated on Friday, July 25, 2014 at 12:36PM by hb

Updated on Wednesday, July 30, 2014 at 12:00PM by hb

Updated on Thursday, July 31, 2014 at 08:36AM by hb

The SEC finally passed it’s final regulations on money market “reform”.  The short story is that institutional money market funds will now mark to market & trade at Net Asset Value, such as it can be priced from the market. Retail funds sold to individual investors will continue the mythology of trading at $1 per share. All money market funds will have the ability to temporarily block redemptions and impose a 2% redemption fee at their discretion.

Our conclusion: while the NAV mechanic presents an improvement on the margin, the basic problems remain the much same, unchanged from the days of crisis. The SEC’s proposals

• are in and of themselves ineffective in significantly reducing systemic risk or altering the mechanic of transmitting it. The interconnections of the participants are unchanged while the concentration of the markets are greater than they were in the days of crisis

• will not improve underlying credit quality or provide incentives to funds to improve risk management

• rely on the NAV mechanic for liquidity. This is untested in distressed markets. How this works when price discovery itself is opaque is open to question.

• require no directly paid in capital to support the risk implicit in all money market funds

Click to read more ...

The effect was never there... it was just a random pattern

This caught our attention and we thought it worth sharing: Pseudo-Mathematics and Financial Charlatanism: The Effects of Backtest Overfitting on Out-of-Sample Performance wherein we learn, should we have ever doubted, that Phineas Taylor Barnum is alive and well in the form of excessive back testing. Excessive backtesting is easy to do given the computational power currently available to most researchers and when combined with an absence of disclosure of relevant backtesting parameters, it creates an in inability to distinguish valid from invalid results and often with the consequence of adverse investment performance. The abstract is excerpted in whole below the quotations, also from the paper.

...

"with four parameters I can fit an elephant, and with five I can make him wiggle his trunk"

 John Von Neumann

"another thing I must point out is that you cannot prove a vague theory wrong. [...] Also, if the process of computing the consequences is indefinite, then with a little skill any experimental result can be made to look like the expected consequences." 

 Richard Feynman [1964]

“the effect was never there; instead it was just a random pattern that gave rise to an overfitted trading rule”

the authors

Click to read more ...

Volatility: the inverse bubble

Updated on Wednesday, June 18, 2014 at 01:34PM by hb

We were dismayed to see today’s WSJ article Fed Officials Growing Wary of Market Complacency only because we were working on the final draft of this posting yesterday. No matter.  We recommend the better and earlier article of May 20th,  Tranquil markets are enjoying too much of a good thing by Ms. Trett of the FT about the continuing decline of volatility in nearly every market. It is worrisome, and we’re not sure anyone understands why it is happening. Nor is it limited to equity markets: oil, fixed income, currencies... pick a card.

Click to read more ...

Another public body blow to active management

The anomalies of language can often be instructive. What Americans properly call “pensions”, British call “schemes”.

The Brits claim to speak English, and we Americans find their accents quaint and, if you consider the rampant overuse of British accents in US media any evidence, vested with a soupçon of sophistication. So it was with interest that we read in the Financial Times, Britain needs local authority pension revolution. Americans particularly like revolutions that involve the British.

It seems the Department for Communities and Local Government had the good sense to retain the consulting firm of Hymans Robertson to review the pension operations & results of funds managed by Local Government Pension Scheme, which is one of the largest public sector pensions in the UK, managing some 99 pension funds for more than 4.6 million members comprising some £178 billion. It’s a pretty big deal.

Click to read more ...

Lowering your state tax burden: you will be surprised at the size of the benefits

Updated on Tuesday, July 22, 2014 at 03:09PM by hb

Since we've all just finished our taxes, well, we couldn't resist...

Taxes make a huge difference in your personal financial picture, and it's worth taking a look at the burden that the 72,000 page federal & state tax codes place on you, your retirement, and your estate. State taxes add to considerable burdens, which we don't need to tell those in CT, NY, NJ, CA, etc. They never stop, even when you die.

Those thinking about retirement or relocation should pay attention. There are material & significant benefits to be had by arbitraging state taxes... yes, moving. 

We present some informational resources that caught our attention. Art Laffer in this video, Laffer: Save Taxes By Moving outlines some simple examples where the savings on state income taxes alone can add $500,000 to $1,000,000 to your retirement funds over time. You can visit his state tax calculator to explore particular options.

Click to read more ...

Uncertain & sideways: our QI 2014 take on the markets and economy

Let’s start with fixed income and look at some pictures.

One year look back at 5, 10 & 30 year Treasury yields:  5 (blue), 10 (red), and 30 (green) years all indexed to inception date:

 5’s and 10’s had significant moves over the last year while the 30 year has been remarkably stable. The middle of the curve, 5 years, took a fairly dramatic move upwards. No one who owned duration was particularly happy. We suspect a slow and modest grind upwards, notwithstanding and ever mindful of Ms. Yellen.

Changing the perspective to the last 3 months as pictured below gives a dramatically different picture, one that reflects convergence of three sources of uncertainty  

1. the start of Yellen’s tenure

2. the macro regulatory & policy uncertainty that seems to continually cloud the economic outlook. Is the economy picking up? Do we have naturally increasing demand for money that derives from an expanding economy? Or do we have a whiff of no growth or even deflation?

3. lastly, the geopolitical instability in Crimea that came to a head, don’t you know, in February (see below).

We see this three month period as more interesting than iconic or dispositive, but we see none of these broader factors mitigating in the near to intermediate term. Note the same relative volatility focused on 5 year Treasury yields which led the way down and up. A three month lookback with the same color scheme as above.

We can’t do any better at defining fog, so we’ll quote Ms. Yellen’s first FMOC statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. ... asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.

In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.

With the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward guidance.

Our take: the FMOC will not say what it really means which we translate as “we will do whatever we feel like.” No rules based policies here, so don’t look for any, and while that may seem helpful to the current administration, it is not helpful to the productive direction of global capital flows.

Now that we have that sorted out, ladies and gentlemen, place your bets.  And that’s where we are. We will defer until later the implications for fixed income strategy, but Putin seems more predictable than our domestic monetary policy.

Equity markets: let’s take a longer term look at the broad domestic US (VTI in blue) and foreign equity markets (VEU in red) first. These are big numbers. Those who sold at the bottom out of fear suffered huge & permanent impairment.

We are five years in to a significant bull run built on the weakest recovery since the Great Depression. How long do these things run? Not forever.

Certainly equities are not cheap and by some metrics fully priced as the time series below of the S&P index priced to real GDP suggests. Or maybe not if the shale and fracking boom, not to mention genomics, are finally incorporated into a sane North American centric political and geostrategy that redirects petro$ capital flows & investment back here?

S&P 500 Index/real GDP

If you are sobered by the chart above, there is another perspective. Consider that on March 24, 2000, the S&P was at 1,527. As of this writing it stands at 1,889. Have we only added 362 points or ~23% of value in almost a decade and a half?

We do consider the hypotheses that uncertainty has slowed the rates of economic reaction, that

• policy and regulatory uncertainty has slowed the recovery materially and may have the consequence of extending the tenor of recovery beyond normal timeframes?

• monetary velocity is already starting to heat up, that transactional demand and excess liquidity of the banks can quickly cause a run up in money supply?

• if so, will the Fed in turn get spooked or more likely be forced by the rational market bond vigilantes to increase interest rates in a hasty and defensive move?

Note the last data point above is Q4 2013. You can’t get much lower in terms of money velocity and still keep breathing, nor, as you can see below, can you get much more gunpowder stuffed into the cannon of excess bank reserves.

GDP checks in at a 3.36% continuously compounded rate as of last and endlessly adjusted data available on 3/27/2014. This suggests some slow but residual tectonic strength in the economy.

Our loyal readers know that we have wondered though how you get a sustainable economic recovery with weak employment, hence weak consumer demand, hence weak capital expenditures to fulfill it. A known unknown as Mr. Rumsfeld would say.

And we are unwilling to exercise fiscal discipline: we are over levered and this problem will continue to compound until it is solved.

Conclusion

There are significant cross currents that make it difficult if not impossible to suss out reliable themes: we have none, at least with conviction. These wheels grind slowly.

We retain our focus on risk, so we again emphasize the importance of the asset allocation and diversification. We acknowledge the bull run of the equity market is getting long in the tooth but suspect there is more to go.

Given the likelihood of ongoing domestic political paralysis the major risk to the equity markets comes from the fixed income market where the equilibrium is delicate. If money velocity kicks up the Fed may be forced to respond quickly and a chaotic repricing may ensue. On the other hand, if the Fed  stays wedded for too long to the QE mechanic & manipulation of rates or is perceived to back off from the unwind, a shoving match may break out again between the Fed and the rational market players as happened on Bernanke's first foray into the taper scenario. The lack of clarity from the Fed is not helpful to avoiding the volatility of either outcome. We leave you to speculate on the odds of a perfect landing....

So the question for equities is how do you price a seasoned, though continuing, weak domestic recovery marked by weak employment and lower levels of capital expenditure and low growth. Can the Fed juice equities more in the short term? Probably. They’ve done it for a while. Can we have a robust and prosperous economy in the long term on our current trajectory? Probably not. We know what that economy looks like:

source: Zero Hedge

The costs of Obamacare will dramatically increase and that may not be fully priced into equities yet. Europe and the emerging markets seem to be synchronized in their indigestion. Europe shows no sign of significant reform. Asia has asset quality problems, but perhaps more political elasticity to solve them. We still think domestic US growth for 2014 will end up around  2-3%. We may be low. We hope so.

Lastly, we draw your attention to two important articles: New, Revolutionary Way To Measure The Economy Is Coming -- Believe Me, This Is A Big Deal. It involves a new metric, an alternative to GDP and perhaps more accurate view of the economy:

The statistic is called Gross Output and will be issued by the Bureau of Economic Analysis (housed within the Commerce Department) .... Why is GO such a big deal? Because it measures the economy in a far more comprehensive and accurate manner. GDP represents the value of all final products and services. It ignores all the steps that go into the making of these things. It’s sort of like looking at a carton of milk and paying no heed to everything that goes into creating that milk and getting the carton onto the store shelf.

GDP thus gives a distorted picture of the economy. How many times do we read that consumption represents 70% of the economy and therefore it’s important to “stimulate demand” by increasing government spending?

In figuring GDP, government spending is said to represent 20% of the economy, investment a measly 13%. (Incredibly, imports are counted as a negative for the economy and subtract 3% from GDP. Protectionists love this absurdity.)

GO counts all the intermediate steps in the making of products and services. The results are stunning: Consumption is 40% of the economy, not 70%; government outlays are down to 9%; and business spending soars to 50%.

It begs a reevaluation of cause & effect. Does healthy consumer spending create a robust economy or vice versa?  Does cancer cause smoking or vice versa? GO presents, potentially, a re-ordering of the major components, perhaps the priorities that might be appropriate from a policy perspective, of the economy. Keep an eye on this. What if we were delivering all that wonderful stimulus to the wrong place and in the wrong way?

And just for current events, if you want to get schooled on the high frequency trading stuff we recommend Cochrane’s posting  Budish, Cramton and Shim on High Frequency Trading which will prep you for an in depth paper he cites,  The High-Frequency Trading Arms Race. Good luck.

hb

Outlook for 2014: the dawn of reality or infinite QE?

Positives

• A reduction of long term energy costs driven by natural gas is underway and will bring significant long term benefits. Fracking, entirely driven by private sector initiative, is now starting to transform the United States, despite federal policy, into an exporter of energy. This will partially re-route global petro$ capital flows... well, to us... and have an impact on related geostrategic matters. Imagine that. Take a look at Exxon’s annual Energy Outlook here.

• The bankruptcies of Detroit, Stockton, and others yet to come, are starting to induce a greater awareness of financial & economic reality. We also see as a signal event the recent vote of the International Association of Machinists & Aerospace Workers District 751 (IAM) to accept Boeing’s contract. A key part of the deal was a transformation from defined pension benefit plans to defined contributions styled akin to a 401K. A different outcome of the vote would have seen Boeing move to South Carolina and precipitated a crisis for Seattle, the state and the IAM. We see more reality creeping into contractual behavior & the assumption of risk. Sight of the gallows sharpens the mind: this is necessary, will spread, and is a long term positive trend.

• While domestic economic growth is still too low, it is positive, increasing, and seemingly sustainable. We look for ~ 2% real GDP in 2014 and hope we turn out to have been a bit pessimistic.

• Political paralysis may stop some of the bleeding induced by bad policy. We sense a growing perception that government is too big and doesn’t do things well. We also sense that the electorate and particularly young people, are learning the hard way about legislated generational theft. More political failures, and we do expect more, will create a growing awareness that results actually count, that there is a growing need to assess cost, effectiveness, and quality of all our important national initiatives: fiscal, monetary, tax, regulatory, defense, and educational policy issues, and, last but not least, quality of leadership.

Negatives

• The US has a crisis of ineffective & unethical leadership. Abroad we see an erosion of our credibility, strength & leadership, while at home we face bitter divisions of seemingly all descriptions, inflamed by our leaders for political purpose. A divided citizenry watches the paralysis and quietly growing Constitutional and cultural crises. The failure of education, corruption of leadership, and the advent of the welfare/dependency state as a preferred permanent political outcome by our leadership has put the heart of America, the American Creed at risk. If not turned around, this trend will define the end of the country... think of a different kind of Supreme Court, one with Romulus Augustus and Maximilien de Robespierre deliberating while the mob chants “You didn’t build that!” The mob could win.

• We anticipate continuing softness in the labor market. Low labor force participation will make consumers and corporations cautious. The measured unemployment rate may improve but the labor market participation will only marginally improve.This is bigger than the usual short term cyclical issue. A whole generation of young Americans are at risk of being left behind in the job market... courtesy of misguided policy... and that loss is an age based demographic and permanent. It is not: “Take a ticket and move to the back, please.” It’s: “Get off the bus.”

• State, municipal, and federal finances are in the main unsustainable and demonstrably so. Kyle Bass presents the dark side here. Our national perspective on debt discussions must be changed to always include funded & unfunded liabilities. The topic must be constantly brought to public attention. The politicians will fight tooth and nail to prevent it: that’s their vig.  They know if you can’t see the problem, you can’t solve it. Improved disclosure & enforcement is absolutely necessary.

• Regulatory & tax uncertainty will continue to depress employment, corporate capital expenditures, investment & innovation. It is lowering our standard of living.

Neutral

• A slow & steady increase in interest rates will be benign or beneficial for the equity markets.

• Inflation will be neutralized by the significant slack in the economy, but the fuse which ignites inflation, unprecedented excess reserves on deposit at the Fed, has gotten much shorter. If the knots all hold it should be benign for the balance of 2014... bear in mind, that means low, not high economic growth. We anticipate the Fed is going to increase its scale of manipulation... uhh, we mean intervention... beyond the interest rate curve to include the (global?) repo market to directly manage excess banking reserves and money supply. We are unclear what makes them think the repo market will be stable absent the all-in-check book of the American taxpayer? Merely putting the pea under a different shell. John Cochrane has suggested that maybe the old rules don’t work in this economic, structural, and regulatory construct: the Fed should listen.

• Valuations: we’re agnostic on equity valuations. Yes, they’re getting high, but not prohibitively so. We’ve been selling into to bull market to rebalance back to target for most of this year, and anticipate doing so when appropriate this year. It’s a matter of risk management.

Implications for 2014: short and simple

In 2013 we were primarily in short duration and selling equities into the bull market to rebalance back to target. We anticipate the same trend this year, although we expect much smaller absolute gains for equities in 2014, perhaps in the 4-6% range (but we don’t know, and we know we don’t know). We could be forgoing some upside, but our sense is that we’re due for a correction, and 2014 could deliver one. This kind of equity run doesn’t go forever.

Again, we focus on risk. We got the returns accorded by our allocations. Our strategy for 2014 will again be to rebalance back to target periodically, and we will be prepared to buy to target if a correction comes.

Below are the equities markets over the last 2 years (price only,  US equities/VTI in blue,  and non-US equities/VEU in red):

If you expand the timeframe the run in equities gets even more impressive. Again, the issue of risk management looms large in our thinking.

Interest rates will hopefully rise in a measured and steady manner if an improving economy increases demand for money, and if so, it will be beneficial for equity markets. This was the case for 2013 where as you can see below. The 10 year rates had a pretty dramatic move with no adverse impact on equities. If you were holding duration, well, our sympathies. Fortunately, neither we nor our clients were, nor will we for a while. We suspect there is more to go here, but we stipulate we don’t forecast interest rates.

There are just too many moving parts. Again, our focus is on risk management, and we are prepared to pay the opportunity cost of not buying mid to long duration until we have better clarity. We might reconsider if or when the 10 year hits ~4%. Frailty, thy name is Fed, currency wars, and leverage.

10 year Treasury yields over the past year:

We continue to like short duration and investment grade credit spreads which have narrowed but remain attractive.

Overall there are some powerful long term forces at work. On balance we tend to think the Positives will carry the day, or rather the year. We do expect some kind of correction, but it seems for now we have a semi-stable equilibrium. The question is how long it will last. Our concern is that we have a lot of pressures deriving from monetary and fiscal issues that without sensible & timely resolution will stress markets and social structures.  

So, for 2014 we keep our expectations modest, but positively so, and our risk budgets tight.  

Richmond Fed interviews Cochrane: a must read

Consider this interview of John Cochrane by the Federal Reserve Bank of Richmond as an exploration of the cutting edge of the major issues facing finance & economics, of both application and theory, as well as a great example of effective communication... simplicity, concision & clarity with little to no jargon. 

It is the best piece we've read in some time. We can only hope the administration is listening and that his influence grows.

Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound

Our readers know that we have been sharply critical of the Fed's policies. Here's one reason why.

Wu and Xia of University of Chicago Booth School of Business and University of California, respectively, have some interesting conclusions in their paper, Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound. We quote their abstract: 

This paper employs an approximation that makes a nonlinear term structure model extremely tractable for analysis of an economy operating near the zero lower bound for interest rates. We show that such a model offers an excellent description of the data and can be used to summarize the macroeconomic effects of unconventional monetary policy at the zero lower bound. Our estimates imply that the efforts by the Federal Reserve to stimulate the economy since 2009 succeeded in making the unemployment rate in May 2013 0.23% lower than it otherwise would have been.

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Now think about that for a minute in terms of the risk, magnitude, cost, and global impact of the Fed's actions. Their conclusion calls into question the entire and ethereal basis of Fed policy. And we do recall the plaintive, aspiration qua argument "Think of how bad it would have been if we had done nothing!" 

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Turns out nothing is looking like a much better deal for all except those who borrowed to hold assets that were subsequently inflated by the Fed and, don't you know, funded by the wealth transfer from savers to borrowers implicit in the Zero Interest Rate Policy itself.

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If you like your zero interest rates, you can keep 'em?

US Treasury to offer floating rate notes in January

This is a welcome and needed addition to Treasury offerings. Most investors don't have adaquate access to the capital markets to manage interest rate (e.g. swaps) and those that do may not want the incremental counterparty risk of banks or clearing exchanges ("value adding" intermediaries?).

This from the press release:

Floating Rate Notes (FRNs)

Treasury intends to announce the details of the initial Floating Rate Note (FRN) auction on Thursday, January 23, 2014, with the first auction occurring on Wednesday, January 29, 2014. Settlement of the security will occur on Friday, January 31, 2014.  

The FRN is the first new product that Treasury has brought to market in 17 years.  The FRN will have a maturity of two years and Treasury anticipates that the size of the first auction will be between $10 and $15 billion.   

Specific terms and conditions of each FRN issue, including the auction date, issue date, and public offering amount, will be announced prior to each auction.  For more details about the new Treasury FRN product, including a term sheet, FRN auction rules, and Frequently Asked Question, please see:

http://www.treasurydirect.gov/instit/statreg/auctreg/auctreg.htm

In addition, a tentative auction calendar that includes Treasury FRNs can be found at:

http://www.treasury.gov/resource-center/data-chart-center/quarterly-refunding/Pages/default.aspx

This will be a useful tool for investors looking to manage interest rate and inflation risk.

Update on Thursday, November 7, 2013 at 01:27PM by hb

It's not often that we scoop the WSJ and the FT.

US floating rate debt: take note from the FT: "It is a dream come true: US Treasury debt without the interest rate risk. That’s an investment you can really cram your mattress with."

US to sell $15bn of floating rate debt from the FT: "the arrival of a new Treasury security stands to create a new benchmark for this area of fixed income and, over time, encourage a move away from using the London interbank offered rate as a floating reference rate...“The bulk of corporate floaters uses Libor as the reference rate, and with a Treasury benchmark we may see future corporate floaters change to using the Treasury bill rate,” said Mr Jersey."

U.S. Treasury to Introduce Floating-Rate Notes from the WSJ: "We're looking forward to the issuance," said David Glocke, head of taxable money markets and the Treasury bond trading groups at Vanguard Group Inc., which has nearly $2.4 trillion in U.S. mutual-fund assets under management... "Demand at the beginning will come from Treasury funds. This is a way to diversify and enhance yield at the margin," he said.... We're looking forward to the issuance," said David Glocke, head of taxable money markets and the Treasury bond trading groups at Vanguard Group Inc., which has nearly $2.4 trillion in U.S. mutual-fund assets under management... "Demand at the beginning will come from Treasury funds. This is a way to diversify and enhance yield at the margin," he said."

Our take - WWB suspects the advent of floaters may impact demand for money market funds and bank deposits particularly after the floaters season and people begin to understand more fully that money funds and even bank deposits no longer pass muster when examined for complexity and risk ...operational, liquidity, regulatory and credit risks. And, oh yes, we anticipate the entire interest rate swap market will eventually migrate to the floaters as the reference rate.

Buyer beware: where is the SEC?

Read this to understand the dynamic of how large scale firms represent, or mis-represent as the case may be, their practices: Brokerages Pull Back on Fee Label  (excerpted below):

The two largest U.S. retail brokerage firms as measured by client assets have told their financial advisers who hold the certified financial planner designation to not promote their businesses as "fee only."

The directives followed reports that hundreds of brokers were inaccurately describing themselves as fee-only on an industry standards group's website.

Under rules that the Certified Financial Planner Board of Standards Inc. recently clarified, advisers who have the CFP designation and work for brokerages whose business includes commissions cannot call themselves fee only. 

 Last week, Financial Planning magazine and The Wall Street Journal reported that hundreds of them, from firms including Morgan Stanley, MS +0.89% Wells Fargo & Co WFC +0.44%, Bank of America Corp. BAC +0.72% and UBS AG,UBS +1.54% among others, were doing just that on the board's website...

The classifications as "fee only" occurred on the website of the Certified Financial Planner Board, and the Certified Financial Planner Board of Standards are such that "fee only" is appropriately used only when all the advisor's compensation including that of any related parties come from client fees. The standards are very clear.

The website is regularly used by consumers who are looking for "fee only" advisors as opposed to those who take receive sales commissions or other emoluments from providers or distributors of investment products.

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So it appears we have major firms constructively and widely misrepresenting their compensation practices in public advertizing. Is this what people used to call fraud? 

Update on Monday, October 7, 2013 at 08:59AM by hb

The business model called to mind a seperate, but related story earlier in September. Wells Fargo Hires $1B Morgan Stanley Broker Team - "They previously managed more than $1 billion in client assets and their annual production in fees and commission was roughly $5.8 million, according to Wells Fargo." We invite the reader to comptemplate what impact fees and commissions of $5.8mm might have on specific product recommendations. 

Read Cochrane's New Keynesian Liquidity Trap

This is a big deal and just in. The emperor's new clothes revealed. Will Yellen read it?

"Technical regress, wasted government spending, and deliberate capital destruction do not work. Growth is good, not bad. That outcome is bad news for those who found magical policies an intoxicating possibility, but good news for a realistic and sober macroeconomics." - John Cochrane

The New-Keynesian Liquidity Trap

The taper of Q3: actual results may vary

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Now you see me, now you don't. Now you see me, soon you won't!

The country seems to be facing a crisis of confidence that now surpasses that of Jimmy Carter’s “malaise”. There is a loss of confidence in leaders and institutions that now encompasses civil, cultural, educational, economic, and Constitutional dimensions. Americans are a practical people: they expect things and people to work, including their leadership.

Consider the non-stop headlines, some small, some large, all cumulatively indicia of a mechanic of dysfunction of large magnitude. It has financial implications.

Let’s start with the Fed, and we’ll quote our last posting which reflects our continuing view:

“We believe the Fed is in fact looking for an unwind strategy but can't find one.  A financial Burdian's Ass? Does any bale of hay contain an acceptable unwind? We've gotten a whiff of the revolt of the rational market investors squaring off on the 10 year rates at any sign of tapering which was not pretty.

Our take is that the Fed will do nothing intemperate, take an agonizingly slow incremental approach ... at least while all the knots hold. By this we mean near stasis. We suspect the probabilities are growing for a much longer & slower unwind than many contemplate. We are, however, unwilling to bet much of the ranch on it. The stasis scenario provides 'flexibility' for a strategy that is pinned to the hope of economic growth that may or may not materialize. One is tempted to suggest decades and for the intermediate period a near permanent increase in the money supply. Just a thought. Watch money velocity.” - THE FED, COLLATERAL AND REPO: MORE SYSTEMIC RISK?

The Fed, in pursuit of “transparency”, led the market to anticipate a “tapering” this week, or so some 67% of economists thought. After months of preparation & indications that “we will taper”, they did not. Hmmm.

“Federal Reserve officials created new uncertainty about how much farther they will push their easy-money policies—and new questions about how effective they are at communicating their thinking—with the decision to stand pat on the pace of their bond purchases for now.” Fed's Guidance Questioned As Market Misreads Signals

Paradoxically, the Fed is adding uncertainty as to the predictability of its short term actions but more certainty as to the ultimate outcome of its strategy. QE and the balance sheet of the Fed, which is now the largest undercapitalized hedge fund in the world, will have to be downsized, unwound at some point. The inflated asset prices it has created are not sustainable nor is the continual expansion of the money supply nor is the balance sheet of the Fed without market constraint. OK, but some problems arise. We don’t know the timing, magnitude, consistency, or forms of the ultimate unwind or market response. We do know that large complex things take time to process and adjust (or as the dinosaurs, die). We do not know the form of market response as it will be influenced by mode & timing of implementation.  Intuitively, we see two polar options: a potentially chaotic repricing of some magnitude or a gradual decline of our standard of living induced by inflation and/or lower productive economic output over time. Likely, it will be a more moderate combination of both. It is a huge Markov Chain. Look for rising risk premia.

One thing is certain: no jobs means no recovery, no growth. U6 is the green line. We basically have 15% of the country out of work. Equally disturbing is the youth unemployment: we are loosing a generation of workers which has huge long term cultural & economic implications. These wheels grind slowly but finely, and the fate of the black nuclear family comes to mind.  The Civilian Unemployment rate is simply misleading & does not count those who have left the labor pool over time for want of employment.

As to the inevitability of outcome consider this and ask if the trajectory is sustainable. Recall it omits unfunded liabilities:

 

Equities: But the juice works in the short term. Set aside for a moment that steady decline in real median family income and take a look at the ride in equities: Obama and Bernanke have delivered for the 1% like nobody's business.

US and non-US equities have put up great numbers. It seems extended low growth with expectations for the grind to continue in the US has been sufficient to buy Euroland and Asia some time to put their houses in semi-order. We remain skeptical of expectations for higher growth in the US. Evidently, so does Mr. Ben.

Large, mid and small caps all up: beta wins.  These are outsized gains clustered within a relatively small time frame. 

Growth or value pretty much didn't matter.

 

Fixed income: we know too well the implications for continued manipulation of zero to negative real interest rates. It is a coersed wealth transfer from savers & risk constrained investors to borrowers. You get no or negative real return on your fixed income investments, and the borrowers (including the US government) get the interest you do not. It’s pretty simple. In a macro perspective every fixed income investor (from Grandma to Bill Gross) become poorer. Real rates have increased substantially in proportional terms, and we suspect more to come... when is the question.

Meanwhile fixed income investors have learned a harsh lesson: maybe Grandma shouldn't hang out in long bonds. More learning to come?

 

We note again there are only three ways to get yield in fixed income: duration, credit risk, or liquidity risk. As the Fed starves the market of real interest rates, it drives investors out the risk curve along any of those parameters. So, if you buy the thesis that the current game is not sustainable, do you load up on duration, credit or liquidity risk when you know the markets are distorted by the Fed at the precise time when the Fed has demonstrated you cannot rely on its indications of policy? We think not, unless you have impeccable market timing which, by the way, neither you nor we have.

We maintain our bias to short duration investment grade product. A diversified portfolio with a duration of 2.7 pays a spread of .97% over the interpolated Treasury rate. Consider that the 3 year Treasury currently pays .87%.  The credit spread is more than the underlying Treasury, not a bad value.  We caution against chasing yield: it never ends well. You just can’t get 8% in a 2.75% market.  Remember that next time PT Barnum starts pitching you.

Our outlook: We anticipate low growth and increasing risk premia induced by the Fed, ill conceived regulations or geostrategic blundering. We look for sluggish employment and weak capital expenditures. Every dimension of fiscal, monetary, social, energy & tax policy is directionally wrong from an economic perspective. Paralysis may be the best hope as a least-worst outcome. We anticipate Ms. Yellen will be the nominee to head up the Fed and do not anticipate that she will raise rates in face of a congressional election year and certainly not in a presidential cycle, but as they say, the opera isn't over until the fat lady sings.

Stocks and bonds will respond favorably as will all risk assets. Everyone may well join the drunken pig pile, and all the animals of the forest will be happy, at least for a while. Systemic risk & moral hazard will grow and long tailed risk will increase. We see near term risk of inflation as offset to some extent by slack capacity in the economy. 

For equities the good news is that globally corporate balance sheets continue to be in great shape (excluding financials) and well positioned for marginally decent earnings in a slow growth environment. There is much less opportunity for cost cutting & greater efficiency. Earnings growth will start to converge with nominal GDP growth.

It is no trivial matter for the asset class as a whole that corporate compensation models are much better aligned toward wealth creation. There is no such scheme with fixed income assets, save the anti-model of governments that are driven by grafted re-distributionism, so to speak, and incentives to inflate. Equities historically have been a source of high sustainable real returns, and we don't anticipate that will change. We do anticipate greater uncertainty which may manifest itself in greater volatility from here to there and stretch the time frames required for those expected returns to eventuate as business models adjust.

We'll close with two last comments. We see two major risks to long term investors. One takes the form of undisciplined investment programs that devolve to decisions driven by emotion which in turn subverts the asset allocation and risk management. The fog of uncertainty holds implications, again, for the importance of asset allocation and diversification. The other risk is inflation. If you think you can go to cash and sit this out, consider the picture below (reproduced from  PRE Q3: IT'S NOT AN EMPTY CHAIR, IT'S AN EMPTY WALLET).  Here's a hint: if the graph starts to get darker blue, you've probably lost 70% of your real value.

The Fed, collateral and repo: more systemic risk?

Updated on Saturday, July 20, 2013 at 05:13PM by hb

Updated on Monday, July 22, 2013 at 09:44PM by hb

Updated on Monday, July 22, 2013 at 10:11PM by hb

We’ve had the FT article of April 23, 2013, The Misuse of Collateral Can Help Create Systemic Risk by Satyajit Das, on our desk for several months. It is highlighted and underlined, and we borrow from it liberally here (in fair use we trust). His article was prescient.

The thesis is simple enough: in the main collateral is now the basis of our primary financial institutions, most capital markets transactions, and source of liquidity, which is to say, our entire financial system. One might infer that collateral is what you use when you have no capital. He highlights, excerpted below, some consequences, intended or not, of the increasing dependency on collateral. Translation: “you can run, but you can’t hide.”

First, it shifts the emphasis from the borrower or counterparty’s creditworthiness to the collateral. Parties normally ineligible to borrow or transact in the first place are able to enter into transactions. Rapid growth in debt levels, derivative contract volumes and the shadow banking system (hedge funds or structured investment vehicles) are dependent on the use and availability of collateral.

Click to read more ...

What happened to the red line? The blue line?

The red line is total government expenditures as a % of GDP (which excludes accurals for unfunded liabilities). The blue line is velocity of M2 which Jim Paulsen, who is very good, advises is "the rate at which the money supply is converted into nominal GDP". Think of it as the turnover of the money supply, that is, like inventory turnover. Faster means a lot of activity & demand for product, in this case money. Slower means you're not selling what you have on the shelf.

Do we see a pattern?

A little more perspective

Updated on Tuesday, July 2, 2013 at 11:11AM by hb

Updated on Tuesday, July 2, 2013 at 11:25AM by hb

Updated on Tuesday, July 2, 2013 at 03:39PM by hb

Our last posting, A Bit of Perspective regrettably promised further thoughts on recent market events, so here we go. First time readers may want to take a quick look at the graph in the original posting. It is our starting point.

We are not unduly troubled by the recent volatility in the market. You have to place it in a longer term context of a huge bull run in equities & the perils of the Fed artificially fixing prices for a long time and then changing its mind. So, we wash out some levered players, and some folks start to get a clue as to the perils of duration. We don’t mean to be dismissive because we do watch this closely, but it’s not the short term noise that gets our attention, it’s the underlying tectonics.

The key issues are quite large, and no one in government is asking, or we might hypothesize has the capacity or inclination to understand, let alone fix.

We start a simple question, “What caused the damage to the fundamental fabric of the real economy?”

Click to read more ...

A little perspective

We provide the following price charts from March 1, 2009 to June 20, 2013 for context. The blue is the Vanguard Total Stock Market Index (VTI) which represents roughly the entire tradable US market. The other colored line is Vanguard Total Bond Market Index (BND) which tracks a broad index of the US bond market and currently has a duration of about 5.5.

 

We have commented endlessly about the adverse impact of Fed policy and the irresponsibility of fiscal policy, and we see recently the perils of the Fed artificially fixing prices and then changing its mind. It manufactures uncertainty & volatility. 

We may well get some more jetwash... at which point we might be interested in equities, but for now, keep proper perspective: a significant run up is having a bit of the air let out.

We watch & assess. We do not necessarily believe rising interest rates are incompatible with rising equity markets.  What everyone fears, however, is that this symptomatic of something systemic and global: could this be the snowflake that causes the avalanche?  We don't think so. This was probable, if not predictable, in direction, but not in timing.

Much depends on the Fed and the wisdom of this Administration & Congress, which is never comforting. We intend to follow this with more substantive commentary shortly, but wanted to respond to some inquiries.

 

 

A review of the administration's fiscal year 2014 tax proposal

We found this review of the Administration's 2014 tax proposal a helpful yet sobering summary of tax and estate issues. It is clear that the Administration will pursue virtually all options to increase revenues by higher taxation of capital and income... anything to feed the Leviathan.

You may find the article here:  Administration's Fiscal Year 2014 Revenue Proposal.

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We do not provide tax or legal advice, but suggest you consider these issues in consultation with your tax adviser. 

Gary Shilling on deleveraging

Steve Forbes interviews Gary Shilling, and it warrants a listening. 

You find some familiar themes put differently:

• an expectation sustained low growth induced by deleveraging
• risk on trade & asset quality
• concern about  the dis-connection between monetary policies and real economies that creates a growing risk of chaotic re-adjustments 
• concern with and an explanation for the decline in money velocity 

Agree or not with the particulars, and we make no endorsement in that regard, we're in for a long ride... so we have some time to think about loading up on 30 yr zeros.

Update on Saturday, March 16, 2013 at 08:18AM by hb

Forward P/E Ratio for S&P 500 was also below long-term averages on October 9, 2007

"The estimated earnings growth rate for Q1 2013 is -0.6% this week, unchanged from last week’s growth rate. On December 31, the Q1 earnings growth rate for the index was 2.2%. Nine of the ten sectors have witnessed a decline in earnings growth rates since that date, led by the Materials, Consumer Discretionary, and Information Technology sectors. The Financials sector is the only sector that has not recorded a decrease in expected earnings growth since the start of the quarter.

Part of the reason for the drop in expected earnings growth for the index is the high percentage of negative guidance issued by S&P 500 companies for Q1. Overall, 83 companies have issued negative EPS guidance for Q1 2013, while 25 companies have issued positive EPS guidance. Thus, 77% of the companies in the index that have issued EPS guidance have issued negative guidance. This percentage is well above the 5-year average of 61%."

The failure of governance and the uncertainty curve

Updated on Thursday, February 7, 2013 at 06:56AM by hb

Updated on Friday, February 8, 2013 at 05:09PM by hb

Updated on Monday, February 11, 2013 at 08:42AM by hb

Updated on Friday, March 15, 2013 at 10:02AM by hb

Phineas Taylor Barnum constructed and marketed his fraudulent Figii Mermaid to the crowds, and his spirit lives on.  

"I am a showman by profession...and all the gilding shall make nothing else of me,"^[1] .  

At least Barnum, setting aside for a minute the notion of authoring two autobiographies, remained sober in his perception of reality.

For stark contrast we would highlight for the attention of our national policy makers that certain corporate issuers of investment grade debt have periodically traded at negative spreads to their US Treasury benchmark, that is at lower rates than the comparable Treasury note.  A capital markets redux of The Emperor's New Clothes? 

Click to read more ...