2015 Q4 Review and Outlook: What Every Flying Machine Man Thinks

Updated on Monday, January 4, 2016 at 02:11PM by hb

Updated on Monday, January 4, 2016 at 02:13PM by hb

Updated on Wednesday, January 13, 2016 at 07:33AM by hb

Updated on Thursday, February 4, 2016 at 08:33AM by hb

Updated on Thursday, February 4, 2016 at 08:33AM by hb

“Monetary policy made itself ineffective with low interest rates, which were seen as a cure rather than a transitory painkiller.” - Nassim Taleb

Our economic view remains from last quarter’s. We anticipate a recession in the US with about a ~60-70% probability starting sometime in the next 6 to 24 months, assuming that we are not unknowingly in the front end of one now. Given the timing of the national elections, we do not anticipate any material reform of our wayward domestic policies. Political paralysis with essentially a sideways and weak GDP, say ~2%, seems our best case.

To the downside we see an increasing likelihood of a disruptive environment

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James Grant on the Fed's hike

Simple, clear, easy to understand, and hugely important. Watch:

http://video.cnbc.com/gallery/?video=3000466793

Q2 2015 Commentary: the pruning knife vs two issues

Updated on Saturday, July 18, 2015 at 11:27AM by hb

Updated on Monday, July 20, 2015 at 02:53PM by hb

Our market outlook is simple. Nothing will happen between now and November 8, 2016, that is, nothing particularly good. Anticipate no reform of policy or regulations...  tax, fiscal, monetary, environmental, energy, labor, or educational matters. We may see futile, symbolic, political gestures, and we will most certainly see Obama launch a last wave of initiatives, mostly by Presidential fiat, and some will likely be materially destructive. A cynic might argue Republicans have incentive to let them roll, to sit and watch the rubble in advance of the elections. But who among us would be a cynic?

Meanwhile the big economic picture remains the same. Our national problems remain unsolved, and so they compound, become more deeply embedded, more complex & costly to remedy.

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Q4 Review & Outlook for 2015

Updated on Thursday, January 15, 2015 at 08:37AM by hb

Updated on Thursday, January 15, 2015 at 08:42AM by hb

Our intermediate term outlook is shaped by the sense that ill conceived macro policies - fiscal, monetary, tax, regulatory & social - have done large scale damage to essential components of the US economy and that recovery of the wealth creation process will be slow & increasingly risky.

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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?

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

What's wrong with the Fed

John Cochrane of University of Chicago provides the best explanation of why & how the Fed is off track in his recent article The Federal Reserve: From Central Bank to Central Planner. 

Jim Rickards on the latest Federal Reserve Rate Decision and Operation Twist 2.0

For a lucid view of the recent Fed action in global context watch this:

Jim Rickards on the latest Federal Reserve Rate Decision and Operation Twist 2.0

It's a bit long, but worthwhile. Of particular interest at the back end are his comments on structural rent seeking and the costs it creates for our economy. Rent seeking translates into the political form of your risk, my return.   Moral hazard, the kudzu of our current regulatory framework, is the fountain of rent seeking, and it's everywhere ... 

• Too Big To Fail whereby the entire loan & swap books of the TBTF institutions are underwritten by the US taxpayer
• the failure to reform money market funds and the repo market and  the consequent expectation of federal support for funds which have no independent capital or collateral to support trillions of dollars of credit,  counter party & clearing risks
• Fannie & Freddie which were essentially untouched by Dodd Frank and comprise about 95% of the entire US mortgage market and
• pick a sector: health carer, automotive, education, pensions, energy etc.

We missed a lot, but you get the picture. We continue to manufacture boatloads of systemic risk by moral hazard. It is not a cost or risk free proposition.  And our politicians monetize for their own benefit their ability to allocate the privilege. No one seems to address the loss of freedom which accompanies the growth of moral hazard, but it is very real.

Lastly, an excerpt from an article on the SEC & money markets in today's WSJ:

Money market mutual funds have been rescued from financial trouble by their parent companies more than 300 times since the 1970s, about 100 more than previously reported, according to a new Securities and Exchange Commission study.

The study, which isn't being released to the public, appears to bolster SEC Chairman Mary Schapiro's contention that the $2.6 trillion industry needs stronger regulation

Wait a minute: "The study... isn't being released to the public"? One might reasonably ask, why not?  How are citizens to make informed decisions about what might be one of the most important regulatory & structural issues of the decade when key information is withheld? 

And if you're considering your freedom you might want to ponder the answer implicitly proffered: you don't need to know... if we wanted your opinion, we would ask.

Choosing the Road to Prosperity: Why We Must End Too Big to Fail –Now

If you haven't seen this you should: Choosing the Road to Prosperity: Why We Must End Too Big to Fail –Now . We commend the Dallas Fed for putting it together.

If we don't fix the issue of moral hazard (Too Big To Fail) we can't have a market oriented economy. It's that simple. Read this in connection with our very own Reforming Money Market Funds: A Response to the Squam Lake Group.

It must change.

Update on Monday, June 11, 2012 at 12:31PM by hb

No More Welfare for Banks by Thomas Hoenig, Director of the FDIC.

That which is seen and that which is unseen by the Fed

Updated on Monday, February 6, 2012 at 09:01AM by hb

Updated on Tuesday, February 7, 2012 at 08:22AM by hb

Updated on Monday, February 13, 2012 at 08:05AM by hb

The testimony of Ben Bernanke yesterday (2/2/2012) to the Committee on the Budget of the U.S. House of Representatives was marked by an assertion as to the health of the US capital markets, that in response to a question that cited an opinion piece in the WSJ by Kevin Warsh excerpted below:

 "Private investors are crowded out of the market when the Fed shows up as a large and powerful bidder. As a result, the administration and Congress make tax and spending decisions—with huge implications for our standard of living—with heightened risks around future funding costs."

The transcript of the testimony has not yet been published as of this writing, so we quote, sort of, Bernanke's response:

 “The capital markets are all okey dokey. Never better. Next question.”  

We return to that issue because we disagree. We think the narrow context of his response is facially misleading. First, we stipulate

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Caedite eos! Novit enim Dominus qui sunt eius

Updated on Wednesday, January 4, 2012 at 09:48AM by hb

Updated on Thursday, January 5, 2012 at 08:20AM by hb

Updated on Friday, May 4, 2012 at 08:55AM by hb

We probably should talk about investments, although what I want to do is rant about our domestic policies which are destroying so much of our economy, so much of our national value. We'll get to both, and pictures are a good place to start.

This year's markets were uninspiring at best, frightening at worst. US equites struggled to hold near even while foreign markets, both developed and emerging, suffered. As always we select broad indices for illustrative purposes and note these are graphs of prices, not total returns.

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Kurtosis and systemic risk: policy makers need to get a clue

When we see phenomena we think we intuitively understand, and it's important, we try to kick the tires a bit. Intuition is good, confirmation by fact is better. Here we take the S&P 500 for a broad proxy of the US equity market and further take VFINX, Vanguard's 500 Index Fund, as our guinea pig. We downloaded 10 years of daily data and found some of the pictures of interest, some entertaining, one vitally important. Here we go:

Here is the time series of daily price data from Jan. 3 to Sept 27, 2011 downloaded from Vanguard. You know its ugly, but take a look anyway.

Here is the same data sorted by % size of daily gain or loss. Less ugly, but only due to style of presentation. If we hadn't put the drop down line in, it might have passed for semi normal. But it seems a little longer on the left side, yes? Of the 185 data points, 100 are negative.

Same data displayed differently, or as a matter of conceptual art perhaps a "splatter chart" of someone's viceral reaction hitting the floor.

So how does this volatility stack up to a decade of price behavior?  Below we chart the minimum and maximum one day % changes of the past decade (specifically from 9/21/2001 to 9/27/2011). Well, so far it seems there are only three worse years:

Interestingly, so far this year's standard deviation in and of itself is about average, but the dispersion seems to be increasing.

We took at look at the kurtosis over the last decade. You can see the definition in the picture (bolding courtesy of editor). The trend since mid to late 2007 is not encouraging. Others have found similar results, that is increasing excess kurtosis, in the yields of 90 day T-bills. This is systemic risk.

 

This bears particular import for the operation of global capital markets, and in particular for alternative assets as a class. Most of the literature we've seen indicates that adding alternative assets to portfolios of traditional asset classes can increase kurtosis of the overall portfolio (think pensions & endowments) if unartfully done. We also suspect that the notion of kurtosis induced by alternative assets isn't even examined in by most small institutional & retail investors. And certainly most alternative assets are soldpresented on the basis of mean variance risk/return space which is the quintessential apples to oranges.

Policy implications

At some point the Fed, regulators, and policy makers have to get a clue. They are manufacturing systemic risk and mere repackaging doesn't help. Granted some of this is spillover form Europe, but at the end of the day in the financial sector we still have large scale asymmetry in the treatment of the too big to fail financial sector, that in the form of socialized risk and privatized return. We are still left with increasing aggregates of black box counter-party risk. 

We have utter chaos in the regulation of the non-financial sector, and we have a chaotic tax code that incents the mis-allocation of productive capital. And they continue taking economic water out of one side of the bucket to put in the other side without regard to leakage or fundamental damage to the bucket....We note that free trade bills have languished without action for the last 3 1/2 years; the Senate undertakes consideration of Currency Exchange Rate Oversight Reform Act, our very own modern version of Smoot Hawley; an energy policy designed to throttle exploration & production; and a Rube Goldberg tax code.

But the good news is that the market and the United States has the ability to suffer through the current toxcity of policy and leadership.  No doubt the outcome of the election will impact valuations. Intrade now prices the probability of BHO's re-election at 47%.  Even with a sensible regime change, we're in for a long slog, but we're is not ready to piss on the fire and call in the dogs1. 

In the context of a seven to ten year time frame equities are not unattractive at these levels, but the meaning of the kurtosis graph is that you better buckle up. The investment premise is simple: you'd better not be investing for near term value. Getting from here to there will be the trick, and adaquate liquidity will be important.  If we get some sensible policies in place and some new leadership, then the values offered today may very well look compelling 7-10 years forward. But as our President is known to say, "let me be very clear": it's going to be a bumpy ride from now to then.

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1  Colliquial expression of cultures in the Appalachian & southwestern regions of the United States.

The ECB thing

The inquiry:

This is what I've gotten so far... let me know if this makes sense. 

The gist is that the central banks of the world, implored no doubt by the ECB, intend to create programs to allow banks cheaper access to short term USD funding.  The ECB already does this but will now extend the duration of their loans.  One of the concerns the ECB is juggling has been the pending liquidity crunch in Eurobanks holding a ton of bad Sov. paper.  These banks haven't been able to access repo funding markets at rates that weren't damaging their already fragile capital levels (leverage was so 2007... right?... right?... oh...) so the central banks of the developed world have essentially colluded to provide funding at rates and durations at which the free capital markets would not provide.  I am not clear on the time frames here...

WWB response:

The ECB does not have enough liquidity or capital to replace the US$ liquidity lost by the euro banks… that to include the Euro and US repo markets; the ECD markets; the ECP markets; and the USCP markets (probably not available for euro banks now I suspect (hit CP GO for a look) or if it is it won’t be next week). One questions whether the ECB + Germany + France + Othereuro + [limited?] US support is adequate.

So, the US Treasury, Fed and few remaining semi- solvent euro sovereigns are probably funding for now the Euro Central Bank via some non-visible means like private gold loans or swap lines of various types or other undisclosed transactions, this a bridge to the unstated & unknown Uber plan… a mega GLOBAL TARP, a liquidity facility underwritten by undercapitalized sovereigns to prop up the Euro banks with no capital and a boatload of bad sovereign debt.   

The reason you can’t conceive of how it works or makes sense is that it doesn’t. It cannot work unless Germany, France and all the others including the US all play for size (recall the word “overwhelming” by Timmy G, you know the fellow who said there was "no risk" of a downgrade for the US?). You are thinking, "no way US taxpayers would support committing of huge amounts of scarce US (read that taxpayer) capital to such a venture!"

Consider that Timmy G, Fed, and Treasury are not concerned with that quaint notion. It is likely we're already in for size, such and duration to be expanded and defined later. Since it's election time, and Congressional inactivity is always a good thing, how about a Congressional hearing? A little transparency on swap or currency line usage or risk limits? 

Back to the ECB thing. This is the final rounds of injecting CTBPApynm (Capital To Be Pissed Away, perferably yours, not mine) before the euro thing likely grinds to a halt. 

They may have bought some time … a few weeks, possibly days, or months (who knows since there is no disclosure of the means, magnitude, or duration of the temporary support)… to raise capital for the banks which, if successful, will also be CTBPA. 

So,

1. inject temporary capital
2. threaten negotiate with Euroland
3. hope you can get out
4. discover you can’t
5. repeat 

Repeat, that is, until the a) viable sovereigns (France & Germany & some US) go all-in or b) until you hear “BLAMMO” which will be the sound of serial Euro bank failures working their way up the collateral base, which will be insufficient. In the latter case, the losses will be realized by commercial entities and specific sovereigns to the fullest extent possible. Those sovereigns will then default or restructure because they’re broke and also have no access.  In the former case, the standards of living will decrease by a significant multiple of the unrealized losses. Think of that as a reverse, large scale negative Keynesian multiplier less further large scale costs for friction, agency, and corruption.

Update on Saturday, October 1, 2011 at 05:48AM by hb

The WSJ explains the ESFS. What is the sound of one hand clapping? Of one flipper flopping?

More than half of the Fed's Term Auction Facility went to foreign banks

The Financial Times reports today that more than half of the TAF went to foreign banks. It was an outright transfer of wealth from US tax payers to foreign banks (excerpted below):

Ed Clark, TD chief executive, said that using Taf was logical even though his bank never had a liquidity problem. “That wasn’t how we made a lot of money. But you make a dollar here, you make a dollar there. What’s the spread you make on a billion dollars?” he said.

In the summer of 2008, TD was borrowing $1bn from TAF at rates of between 2 and 2.5 per cent. For that borrowing it used the lowest quality – and hence highest yielding – collateral acceptable to the Fed.

More than 80 per cent of its collateral had a triple B credit rating at a time when such bonds yielded about 7 per cent. TD could therefore have made a notional gross spread of about $4m a month during 2008.

Mr Clark said the authorities were encouraging healthy banks to use schemes such as the Taf so as not to stigmatise their weaker counterparts. In January 2008, Ben Bernanke, the Fed chairman, said the Taf appeared to be succeeding because “there appears to have been little if any stigma”.

“You go through the whole crisis and there were lots of things we did that weren’t necessarily economic but were the right thing to do for the system,” said Mr Clark. “So I’m not embarrassed by this at all.”

One presumes not, given that Mr. Clark played by the Fed's rules, but the Fed has no such cover. It ought to be embarrassed.  The US taxpayer lent at 7% to non-US AAA rated banks (or banks including RABO) based on putatively BBB quality collateral.  And presumably the collateral were paying cash. This wasn't however a loan: it was the provision of contingent equity capital to foreign banks (Canadian, European and Asian) for no consideration, all courtesy of the US taxpayers.

WWB understands bank liquidity, solvency, and systemic risk. All should know that the melding of sovereign and trans national bank risk leads to reckless underwriting (QED), more risk, and then to a vitiation of contract & property rights and ultimately to democracy itself. Managing systemic risk is not hard, but you have to forgo some of the social agenda that has been attached to it. If you want to reduce systemic risk, break it down into its components and start taking them off the table, piece by moral hazard piece.

The alternative is to manage systemic risk as the Fed has done, and apparently will continue to do, by aggregating it into larger and larger amalgamations of undefined, hence unmanageable, risk structured as an uber asymetrical option in favor of rent seeking financial institutions and underwritten by the taxpayer. And all US taxpayers know what that means: "Heads, I win. Tails, you lose."

Lastly, if gas hits $5/gallon in 2012 as the former President of Shell Oil today predicts, will the energy sector be declared to pose a systemic risk under Dodd-Frank? Well, are volatility and duration the primary drivers of option value?

The Fed and the May 6th crash: more monkeys & darts?

Mark Spitznagel in today's WSJ piece, excerpted below, has got it exactly right.  We encourage all to read it in full and also in conjunction with our posting, No Better than Monkeys Throwing Darts, in which Larry Swedroe recounts William Sheridan's research on 'expert' economic forecasting.

Whenever markets are manipulated by regulatory fiat there are unanticipated consequences, systemic or otherwise. The wealth transfer, perhaps one of the largest of all time, from investors to borrowers effected by the artificial manipulation of low to negative real rates is having untoward consequences on market function and risk allocations.  One suspects there are many more unanticipated consequences yet to come.

"The profitability of an investment is simply its return on capital beyond the cost of that capital. It is against this spread that investors must assess risk. So when the Fed distorted the cost of capital following the 2008 collapse by lowering it for many by roughly 2% (to about 0% for banks), it had the same effect as the 2% higher aggregate dividend yield for stocks or higher credit spreads for investment grade bonds. Suddenly what was toxic looked cheap.

The Fed lured everyone to buy everything and anything that was risky—and did so itself with outright purchases of risky assets like mortgage-backed bonds. Anyone eager for easy profits fell right in line, bidding up dangerous assets like clockwork. Sensing safety in numbers, the herd quickly followed, and in no time the market had consumed the Fed's gifted 2% profit spread and then some.

The Fed has managed to align every little market fault right with each other such that they all succumb to the very same stresses at the very same time. Meanwhile—no surprise—the world remains a very seismically active place. What's extraordinary is that the Fed continues this intentional deception about the real cost of credit, even as we've repeatedly witnessed the consequences of this policy.

Left alone, the market works naturally, with waves of buy-order ruptures and waves of sell-order ruptures. Sometimes mini-ruptures coincide to form much larger ones, such as on May 6. But searching for a discrete trigger for such events is futile. To find the real source of the system's excessive fragility, the regulators will need to look much closer to home."

Do we want thin markets or thick markets? It's not a tough call.

Nouriel Roubini on the US$ carry trade

Nouriel Roubini has an article in today’s Financial Times that is a must read: Mother of all carry trades faces an inevitable bust , excerpted below. 

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

He's got the broad structural issues right, although perhaps stated with a flair for the dramatic. Timing & rates of reaction are critical for these kinds of things: will we have a moderate point of inflection or a herd stampeding over a cliff?

A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

I'm not sure any analyst, including the Roubini or the Fed, has a clue, or at least a valid one.  My experience in the global markets has led me to believe that >80% of any liquidity (sovereign or otherwise) is determined by no more than 15 players, 3 of whom are seated next to the door, proximity to which is in order of cognitive ability. The other 12 investors are watching them. This is the stuff of which catalytic events are made.  The rates of reaction can be a little slower here given the scale involved and limited options for alternative reserve currencies. But an observer of grizzly bears knows that big things may look slow but can actually move quickly, particularly when faced with threats or a prospective meal.  Big things can also can grind quite finely.

Some have argued that Fed policy distorts a variety of macroeconomic factors including inflation measures, that nominal Treasury bonds less TIPS spreads are artificially low (I'm less sure on that one but am unwilling to rule it out). Roubini below argues Fed policy has induced an artificially low global volatility (although equities recently seem to contraindicate) with a tsunami of liquidity and artificially low interest rates.

The structural aspects do seem to follow a certain logic of unintended consequences that derive from the Fed's strategy of trying to manage excessively large and stupid concentrations of risk (i.e. "too-big-to-fail") by further aggregating and centralizing even greater concentrations of stupid risk.

Now, the question is, if you're the Fed,

"You're thinking...now to tell you the truth I forgot myself in all this excitement. But being this is a .44 Magnum, the most powerful handgun in the world and will blow your head clean off, you've gotta ask yourself a question: "Do I feel lucky?" - Dirty Harry

Well, do we?

The unwind could get a bit bumpy, but the point here is not to scare people but to help.

From from a practical perspective, what does this mean for investors? Our framework of bounded asset allocations, efficient diversification, and prudent risk management in many ways accomodates many of the concerns implicit here. Appropriate asset allocation is the touchstone. It is not only a measure of expected returns, but a matter of risk management. And if you find yourself inclined to changing it or second guessing things in response to market activity or headlines, stop right there. It doesn't fit or you're mis-using it. 

Rebalancing is critical. In broad concept if you've had a run up of some 80-92% in equities over the last 12 months (for example China, Turkey, or Brazil) rebalancing as a mechanic would lead you naturally to sell some of the rockets and perhaps lead you to consider some that have fared less well (US regional banks were off some 27% over the same period). Similarly, foreign small caps are up nearly 50% over the same time period while US large cap value stocks weigh in at 2-4%. The same goes for fixed income: emerging markets debt and domestic high yield bonds have racked up 12 month returns in the low 40%'s, while US short bonds have gone sideways. A rebalancing in front of the US$ unwind may not be a bad thing. Rebalancing will naturally remove the excesses from the portfolio, a systematic sell high/buy low (for many of us a novel experience).  Generally, this takes the portfolio in the direction you are intuitively inclined to go, but in a bounded and disciplined way.

It is very clear that now is not the time to stretch prudence in reaching for yield. Take the market rates and live within prudent risk budgets. Now is also not the time to run short on liquidity.

Stay the course with diversification. The corelations are in the words of a trader 'all kinds of screwed up' by virtue of the artifice of the Fed. It is not clear to us that anyone has an elegant solution to model and correlation risk (just ask the rating agencies), but common sense can go a long way.

Lastly, as an enterprise and portfolio matter, take a look at counterparty credit risk profiles and potentially embedded performance risks. Like it or not you've got 'em. For example, make sure you understand the operational risks of your book... like hypothecation risk in your custody agreements. On credit/counterparty performance risk I remain suspicious of whatever is highly regulated, complex, and opaque...insurance comes to mind....and for that matter Congress as well.