Accrued Interest

Ben Bernanke: Smooth Criminal

2009-06-26T10:16:00.003-05:00

I know this isn't a universally held opinion, but to me there is a simple reality. Between September and December we were facing a significant chance of another Great Depression. Beyond that, we were potentially looking at a financial disaster from which the United States would never recover.

Today, it looks like we are merely facing a very bad recession.

Who deserves credit? Certainly not Hank Paulson and the Bush administration. They choose philosophy over pragmatism every chance they got. They gave in to the moronic "moral hazard" bullshit argument. They stuck to their right-wing "fuck off and die" mentality toward the banking system. That worked out great didn't it? Then when they had the chance to use the TARP right, they failed miserably. Again, they gave into the moral hazard wing of the Republican party and instead of buying up bad securities, they initiated the Capital Assistance Program. No moral hazard there!

Can't credit Obama either. I'll admit that the Stress Test was a much better idea than anything Bush ever came up with, but I'd argue that by December we had already turned a corner. Obama just managed to keep the momentum going. Besides, his $800 billion stimulus program is, at best, a waste of time, and at worse, contributing to rising Treasury yields and thus retarding the recovery.

I have to give most of the credit to Ben Bernanke. He understood that while liquidity wasn't the whole problem, illiquidity could have made (and was making) the problem much much worse. He understood what really made the Great Depression a 15 year affair rather than a 2 year recession. He understood what created Japan's lost decade (and counting). He saw how dangerous debt deflation could be, and he attacked it with both guns blazing.

Some people derided the Fed's efforts as ineffective. That's because they were looking at how the stock market or housing market was reacting to Fed rate cuts. But the cuts were never meant to "solve" anything. Housing prices had to fall to more affordable levels. Nothing could (nor should have) been done to stop that. Stocks had to fall in reaction to the oncoming recession as well as the reality of a weak recovery. For that matter, unemployment was bound to rise as workers are moved from leverage-oriented jobs to someplace else. The Fed wasn't trying to solve any of these problems.

Compare this with Alan Greenspan's constant manipulation of the stock market. In today's FT, Greenspan says as much in an opinion piece. "In my experience, such episodes [rising or falling stock prices] are often not mere forecasts of future business activity, but major causes of it." (My emphasis). That sums up Greenspan's tenure at the Fed doesn't it? He's basically saying that by creating bubbles, he was able to spurn real economic activity. Look, a lot of us fell for it for a long time. He was called the Maestro for the Force's sake. But now, in hindsight, we can certainly see the folly in this philosophy.

Now the morons in congress are coming for Ben Bernanke for how he handled the Bank of America/Merrill Lynch merger. Seriously? Now, let there be no doubt. Ken Lewis was pressured by the Fed in a way that should leave a bad taste in the mouth of any free citizen. But we were in the middle of an economic war. Sometimes some bad shit happens on the battlefield and sometimes its OK if we look the other way.

If the Republicans push this, though, Obama will be left with little choice but to not reappoint him. Then we'll get Larry Summers. Great. Even if you forget all the virtues I've just bestowed on Bernanke, remember this. The key to an effective Central Bank is independence. Otherwise we have Arthur Burns. It was Burns, not oil, which caused the Great Inflation of the 1970's.

How can we seriously assume Summers will be independent of Rohm Emanuel? If Summers winds up running the Fed, mark my word, inflation will follow.

FOMC: Keep your concentration on the here and now where it belongs

2009-06-25T07:38:00.002-05:00

So the FOMC follows Qui-Gon Jinn's advice and not Obiwan's instincts. Yesterday's FOMC release was a slightly hawkish shade of April's release, which I (and the bond market) found disappointing.

Just before the announcement, I suggested an alternate FOMC statement that emphasized both downside inflation risks (which the Fed dropped in their statement) as well as the need for an eventual exit strategy. I think my version walked the line between acknowledging the continued downside risks in the economy, the very tenuous and limited nature of the nascent recovery, as well as an admission that non-traditional monetary policy carries a risk of inflation. I've written time and time again that inflation is a low probability risk, but the severe steepness of the yield curve says otherwise.

The Fed would love to flatten the curve. That would bring down mortgage and other borrowing rates, and actually aide the recovery. The way to do that is to calm the inflation fears. No matter how much I might deride the hyperinflation story, it isn't going to magically go away. So if you are the Fed, why not assure the market that you are cognizant of this risks of quantitative easing? You don't have to give a time frame to the removal of accommodation, but you do have to convince us that it will eventually be removed.

FOMC: Be mindful of the future

2009-06-24T11:48:00.002-05:00

Alright I'm trying something new here... I'm going to call the actual Fed statement. In about an hour you can make fun of how wrong I was.

---

Incoming data indicates to the Federal Open Market Committee that the economy continues to contract, though the pace of contraction appears to have further slowed since April. Household spending has shown signs of stabilization, but remains constrained by ongoing job losses and lower housing wealth. Credit conditions for both consumers and businesses have moderated, yet the Committee observes that credit is generally only available to the best borrowers in both markets. There are signs that the business inventory liquidation which occurred toward the end of 2008 and first few months of 2009 has ended, and some rebuilding of inventories may be underway.

Therefore while the Committee acknowledges the progress made thus far, it also judges that economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

In light of continued economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term. In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve currently plans to purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve currently expects to buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. In addition, should economic conditions warrant, the Committee may choose to curtail these security purchase programs before the full amount has been purchased.

The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee believes these programs are temporary in nature and at some point in the future will need to be wound down. While it does not judge that the need will arise in the near term, the Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.

---

The key changes:

Indicate some improvement in the economic outlook, especially the credit markets, which have improved a good deal since April.
Suggest that QE (outside of the TALF) will not be expanded. They won't come out and say so at this point, but given the improvement in the outlook, some curtailment of QE is appropriate.
Acknowledge the need for an exit strategy. Conditions are too fluid to outline such a strategy right now, but its enough for the moment to discuss it conceptually.
Finally, expect the FOMC members to start giving some specific ideas about an exit strategy in their upcoming speeches.

All this should calm the bond market, creating a bull flattener, and improve the dollar.

California Munis: What is it? Some kind of local trouble?

2009-06-23T08:54:00.004-05:00

Lots of people have asked my take on California. Speaking strictly from a bond holder perspective, there are two issues. First, what are the possibilities for missed or delayed payments? Second, apart from actual missed payments, what could cause spreads to tighten or widen?

In terms of California bond holders actually missing a payment, those odds are remote. S&P points out in their report coinciding with putting CA on negative watch:

An austere analysis of the state's ultimate capacity, from a budgetary perspective, to service its debt suggests to us that at $35.97 billion, constitutionally required spending on education (Proposition 98 expenditures) for 2010 leaves $53.15 billion in resources available for debt service (estimated at $5.74 billion) on general obligation and lease revenue bonds.

So if it came down the state actually running out of cash, first certain education spending would be met, then bond holders. On that basis, there is plenty of coverage. I think this leaves the likelihood of a payment completely missed as extremely low.

Now a payment delayed is a different matter. If the legislature were to not pass a budget by June 30, the state wouldn't be able to sell short-term notes to restock their checking account. At that point, I really don't know what the protocol would be. If, in theory, the state literally ran out of money, they obviously couldn't forward coupon payments on to bond holders. This would be a form of default. But of course, bond holders would eventually get their payments, most likely when the next quarterly payments were made by tax payers.

We have to imagine what such a world would look like. You think Californians are pissed off now? Imagine the state is literally unable to make payroll. The political backlash would be severe. The fact that bond holders get cash first would put tremendous pressure on legislators, not the least of which would come from powerful public employees unions. So I imagine the most likely scenario is that some kind of budget is passed in the next few days.

Unfortunately, the odds also seem high that the budget will include some one-time revenue measures to help close the gap. As S&P noted, that's a problem, since it will likely mean the state will be in the same budget situation next year. Revenue items like sales tax might improve next year, but even in an optimistic economic scenario, unemployment will still be very high and property tax revenues will likely fall again. Its very hard to imagine how California's revenue would experience organic growth in 2010 or 2011.

If the budget is passed with significant stop-gap measures both the ratings agencies and bond holders will react negatively. I'd wager that right now players in CA GOs are unusually tilted toward speculators, hoping for a pop. A budget which doesn't address long-term problems will fail to create a pop, and most likely cause speculative players to sell.

What the legislature should do is create some mechanism for funding a reserve fund, even if the reserve won't be funded this year. For example, some kind of provision by which revenue flows into the reserve if revenue grows naturally by some percentage.

Ideally, there would also be work done on reforming CA's budget process. The combination of referendum-based spending with no attached revenue source is just silly. The corresponding need for super majorities to pass tax increases is similarly dumb. Its an obvious recipe for runaway spending without any reasonable means of funding the expenditures. A start would be to require all spending referendums to either have an explicit revenue tied to them, or to result in an automatic increase in sales tax. That would make voters think twice about voting an increase in stem cell research funding.

There is substantially more risk in local California credits, especially smaller school districts. One of the one-time measures the legislature is likely to use is borrowing/curtailing local aid. Combined with the fact that school districts take most of their funding from (gulp) property taxes... I think we're in trouble.

Black Swan: Fallen from the pure faith

2009-06-16T20:07:00.002-05:00

This story in today's Wall Street Journey has me scratching my head. (I know, it was reported a couple weeks ago as well, I'm a busy blogger). I read Black Swan. I thought it was absolutely brilliant. Nassim Nicholas Taleb has truly come up with one of the most useful and original ideas about markets that I've read in my entire career.

All that being said, what I'm reading about Universa betting on inflation is total incongruous with what I thought was Taleb's philosophy: basically that the big events in life, history, and markets are almost totally unpredictable. Given this, the best way to invest is to bet on change. Not to bother with long-term predictions based on fundamentals as we see them today, because by the time the long term comes around, fundamentals will be wildly different.

Now I'll admit. I'm not convinced Taleb's method of investing (doing nothing but buying out of the money options) is a good trading strategy. But I am convinced that his general way of thinking is a critical addition to any trader's mindset. Don't assume that the world as we know it today will exist tomorrow. Don't assume that just because you can't think of a reason why the world will radically change, doesn't mean it won't. Just because you make an accurate prediction about a certain event, doesn't mean you'll be able to accurately predict the myriad of consequential events. Just because something seems impossible given what we currently know, doesn't mean its actually impossible.

Taleb and his colleagues have never been more vindicated than now, when what seemed like a backwater portion of the mortgage market (sub-prime) touched off a series of events that almost crashed the whole capitalist system. Even among those that saw sub-prime as a problem, few imagined how this crisis would play out. And that's was Taleb's whole point. Its nearly impossible to see the Black Swan coming.

So now... Mark Spitznagel, who runs Universa, the hedge fund Taleb advises, is betting on inflation? I'm not going to rehash my own view on inflation, that's not the point. The point is that Taleb is known specifically for not betting on markets and economic events. Any market/economic outcome that you can see ahead of time, even as a lesser possibility, it isn't a Black Swan at all. Many people see inflation accelerating. Almost every client meeting I attend, I get a question asking about the consequences of hyperinflation. I don't know that even an extreme version of a commonly held view can be called a Black Swan.

Second of all, Taleb and Spitznagel aren't economists. They are mathematicians and traders. I don't know that they are especially equipped to make an inflationary call.

So it makes you wonder. Is Spitznagel doing this because its his view of markets or his view of what's marketable? I have a feeling its more of the later than the former. He's brought in all kinds of new assets based on Universa's huge returns in 2008. Now he wants to continue the trend. He knows that hyperinflation is a common fear, and his fund is known for thriving during a period of disaster. Its an easy fit.

It just doesn't fit his purported philosophy. I remember an interview Taleb gave on CNBC during the winter when he derided the money bank executives had made, specifically arguing that they managed their banks to enrich themselves, not their shareholders... Mmmm...

Our methods are not as different as you pretend. I am but a shadowy reflection of you.

Fed: Deflation? Over my dead body.

2009-06-15T12:17:00.003-05:00

Many Accrued Interest readers will gafaw at the memory of John Ryding, economist at Bear Stearns from 1991 until the bitter end in 2008. Intelligent man, I'm sure, but also something of the Nouriel Roubini of the bond market. I think he was bearish on interest rates basically my entire career, which is ironic, since for most of my career, interest rates have been falling.

Anyway, the one really good piece of advice I heard from Ryding over the years was if you have a view on inflation, don't change your inflation outlook, change your Fed outlook. In other words, if you think forces are aligning toward higher inflation, bet on Fed hikes, not on inflation itself. I think this is a smart way to approach the bond market, because the Fed may actually short-circuit inflation itself (making a bet on, say, TIPs a loser).

Today St. Louis Fed President James Bullard declared that the Fed had averted a deflationary outcome, and is now considering an exit strategy. As readers know, I've been touting deflation as the Fed's primary concern for some time now. But in talking about deflation as the primary risk, I'm still thinking of Ryding's advice. I'm not necessarily betting on deflation per se, but on a Fed ready and very willing to fight it. That's why I've been willing to bet on massive rate cuts, unorthodox liquidity programs, etc.

But will we see CPI print below zero? Only if the Fed fails. In other words, sustained deflation remains a remote possibility. But sustained Fed interference in the markets in attempt to avert deflation is a strong probability.

So the bet should be not on deflation outright, but on the fallout from attempts to fight it. Weaker dollar. Higher commodities. Low short-term rates (including buying 2-year bonds as opposed to holding cash). Flat yield curve. Lower mortgage rates (at least from here).

That's is how I'm playing my deflation view.

James Grant: Depends greatly on our own point of view

2009-06-12T06:43:00.004-05:00

James Grant (of Grant's Interest Rate Observer) have a great interview on CNBC Wednesday, you can see it for yourself here. I'd say this interview represents the intelligent, pure monetarist argument for higher inflation. The type of thing that would have been perfect to pick apart on SMACKDOWN week!

For what its worth, I think Grant is a great writer and always an interesting read, though in recent years I think he's become more and more of a lawyer. That doesn't invalidate his argument, but it does tend to mean he seems less willing to consider possibilities away from his base view. I think its fair to say that Grant is generally against central bank intervention, particularly when it comes to stimulus. He comes from the school that thinks its necessary to keep money tight always and everywhere.

Here are a couple thoughts. First, Grant's off-handed comment that the Fed's balance sheet is as bad as Citigroup's is just dumb, and he's too smart to make that kind of comment. 54% of the Fed's balance sheet is in Treasuries and GSE debt. Another 14% is in straight currency and/or gold. 37% are short-term repo/discount window type transactions, which are all overcollateralized, mostly with extremely high quality collateral. 5% is in Bear Stearns/AIG bailout-related assets. That's the only realistic place where the Fed stands to lose money. Obviously Citigroup doesn't have such a high-quality list of assets. I said a few weeks ago that leverage alone isn't the sole determinant of risk. Is Grant trying to argue otherwise? Asset quality doesn't matter at all? Or is he just trying to throw a good sound byte out there?

He also comments that M2 is up 9% year-over-year, and that didn't happen back in the Depression. I can just imagine Ben Bernanke sitting at home throwing up his hands yelling at his TV. "EXACTLY!!" The idea is to prevent the Great Depression right?

He goes on to say that he expects higher CPI prints, but admits that its possible that the Fed's extra cash flows someplace besides consumer goods. That kind of thinking would be entirely consistent with my argument that consumer spending won't rise, and yet still suggest that the Fed's actions are problematic. In fact, I'd go so far as to agree that the cash must flow someplace. It is accurate to say that excess liquidity can and does lead to bubbles.

However, based on the data, I'd argue that the cash has all flowed into bank excess reserves. M2 is up $691 billion year-over-year. Excess reserves are up $836 billion. Is there a bubble in excess reserves?

I'd go on to say that once the cash starts to flow to consumers, they seem likely to save it. The savings rate is currently 5.7%. Household net debt has declined two quarters in a row now. If consumers see more money I'd think it would continue to flow this way. I don't think that printed money turning into balance sheet repair should worry us all that much. In fact, I think its a pretty favorable outcome, allowing consumers to improve their debt position without causing economy-wide deflation.

The risk, as similar to what I outlined last week, is that consumers become satisfied with a level of balance sheet repair, and funds start flowing elsewhere. In order to avoid this, the Fed is going to have to pull back on their extraordinary programs quickly, and frankly, soon. We'll see on June 24!

US Dollar: He's no Jedi

2009-06-10T15:59:00.002-05:00

Some quick thoughts on the dollar. After the inflation SMACKDOWN from last week, especially my comments that I didn't see a dollar crisis and that foreign investors had few near-term choices but to accept Federation control er-- U.S. Treasuries for the time being, a lot of people are asking me about the dollar.

First a preface that I am not a currency trader, nor do I play one on the interweb. So its possible that the story I'm about to tell is baked in already, or that the dollar is already oversold and could actually rebound from here. But overall, it seems like the balance of factors lean toward a weaker dollar.

I'm a guy who appreciates the classics. Like early 80's sci fi, as you may or may not have heard. Anyway, I see currencies as a matter of relative investment return and relative inflation.

In terms of the big 4 currencies (dollar, yen, euro, pound), the BoJ is already stuck at maximum firepower in terms of monetary policy and the ECB is deluded about economic growth prospects. The U.S. has been much more aggressive in terms of easy money. The BoE is closer to the U.S. model, but still, less aggressive. So of the big 4, the U.S. has pursued the most inflationary path. Now as I've emphasized, I don't expect much in the way of actual inflation, but relative to the other currencies, we should have more inflation. That's dollar negative.

In terms of emerging currencies, I think the relative investment opportunities are greater abroad than here. While I expect the U.S. to keep its head above water, our economy needs to radically change. We haven't even gotten through the deleveraging process yet much less come up with new engines of growth! U.S. growth is going to be anemic for several years. Again, dollar negative.

I can't say what precise level of USD/EUR is right given this view, because like I said, I'm not a currency trader, and besides, I think my view is pretty mainstream. I don't see a crisis, but I also don't see a ton of upside for the dollar.

10-year Auction: This place can get a little rough

2009-06-10T12:11:00.002-05:00

The 10-year auction was horrible. Non-fixed income people don't realize how big a miss 3bps is on a 10-year auction.

The ancillary stats indicate no foreign flee. Indirect bids were the second highest this year. So people will buy bonds, they just want more yield to do it.

Meanwhile, this story on Russia is worth watching. Can they really increase their IMF holdings, and if they do, does it matter? Here are two links to read.

http://www.imf.org/external/np/exr/facts/finfac.htm
http://www.imf.org/external/np/exr/facts/gabnab.htm

Russia currently holds about $140 billion in U.S. debt. I understand none of that is in Agency holdings so I assume that's overwhelmingly Treasuries. China holds $768 billion.

Its counter-intuitive to me that the DXY is solidly higher while Treasuries sell off. I really think this sell-off has reached silly levels.

Jefferson County: How many languages do you speak?

2009-06-09T08:28:00.002-05:00

Apparently SMACKDOWN week was popular, as we haven't got a single vote against doing it again. We got a few Ooteedee votes, but those are either readers who are voting to continue with the constant obscure Star Wars references, or else those readers who speak exclusively Jawa. I wonder if anyone got the GONK reference on the previous poll... Anyway, e-mail me topic ideas, and I'll eventually post a list of the best ones for the readers to vote.

Meanwhile, I'm working on a piece on Jefferson County and I'd like to solicit some help from the readers. If you are a muni guy, especially a bond attorney, who knows the legal rationale as to why the County itself has taken responsibility for the sewer debt, please e-mail me. accruedint AT gmail.com.

Thanks, and thanks for reading.

SMACKDOWN WEEK: Epiloge: At that speed are you sure we'll be able to pull out in time?

2009-06-08T06:39:00.003-05:00

So Accrued Interest has settled it once and for all. Inflation risk is low. The Poll proves it! I posted a new poll asking if readers like the SMACKDOWN format, where I spend several posts on the same subject in greater depth. If you liked it, vote. If you hated it, vote.

As a final point on the inflation subject, I wanted to look forward, to the future, the horizon. Obviously the dire consumer situation isn't going to last forever. Even though much of the wealth destruction I mentioned last week isn't going to recover in a V-shape, we will reach some sort of equilibrium in housing eventually. Even given a L-shaped recovery in housing, consumers eventually get back on their feet. Maybe they can't spend their home equity but they'll still spend their earnings. We will also reach some sort of equilibrium in personal savings, which I think will wind up in some relatively low, but still elevated level.

So inflation isn't dead. Not yet. And thus the Fed will eventually have to pull way back on its current policy accommodation. How and when will this happen, and what are the risks.

The biggest risk is Fed independence. You want to know what really worries me for the long-term? Fed independence.

I believe firmly that the men and women who are responsible for normal Fed policy actually learned the lessons of the 1970's. That inflation is an insidious problem, and once it takes hold, its is painful to wrench out of the system. I realize many readers will disagree, given the aggressive policy of the last 12 months, but spend a day going back and reading Ben Bernanke's old speeches, and I think you'll agree. Policy of the last 12-18 months has been all about eliminating a Great Depression style debt deflation. Once that battle is won, I believe the Fed's policy makers will want to wind down their non-traditional policy maneuvers.

There are those who say they can't remove these policies in a timely manner. I don't get this argument, as it seems to be merely based on the sheer size of the programs. Remember that inflation is a rate of change, therefore stock measures aren't terribly relevant. Its all about marginal changes.

To see what I mean, consider the Fed's MBS purchase program. As of June 3, the Fed had $428 billion in MBS on their books. To simplify, let's call that $428 billion in incremental demand in period 1. If they Fed just held their position, no new buys or sells, what's the inflationary impact in period 2? None right? No marginal demand for MBS from the Fed, no money printed. So execution of the exit is relatively easy.

To me its all about timing and will. The timing is a bit of a guessing game. I think we have seen some legitimate green shoots since January of this year. Consumer spending is way down, but no longer seems to be collapsing. Thus there should be some commensurate slowdown in the pace of the Fed's policy actions. Its also clear that the Treasury buying program has been a major failure, in that it spooked foreign investors. I expect the Fed to let the Treasury program die a quiet death, and let that be their first removal of some accommodation.

But do they have the will? There are those that say the Treasury has made the Fed its padawon. The Fed is creating inflation to help solve the Treasury's debt problem. I don't think this is the case, but its a scary thought. It would represent a return to Nixon-era central banking, where the Fed was highly political and thus unwilling to tackle inflation with the steady hand necessary.

Consider this. Will a Fed with an expanded mandate, as the primary regulator of banking and possibly other elements of the financial system, becomes more political? Probably. Will Congress get more oversight of the Fed-as-regulator? Certainly. Will that translate into less independence on the monetary policy side? Its a very big risk.

SMACKDOWN WEEK: Now consumers are all but extinct

2009-06-04T08:29:00.002-05:00

Today on SMACKDOWN we'll look at just how inflationary the Fed's programs have been to date.

My premise remains that consumer inflation occurs because consumer spend more nominal dollars. I won't go over the rationale for this viewpoint right now, you can read it here or here. Given this, any program will only be seen as inflationary if it puts cash into consumer pockets, or at the very least, results in goods being purchased.

The headline grabbers are stories like this one at the New York Times. They throw out numbers like $12 trillion and we all cry out inflation! But a large percentage of these figures are asset guarantees, such as the money market insurance program. These programs are clearly not inflationary as they never even involved any exchange of cash.

In order to see how much money may actually go into the economy, let's take a real look at the Fed's balance sheet. We know it has exploded in size:

We also know that most of the Fed's outlays have been funded by crediting bank reserves. That is, the Bernanke's old "electronic printing press." If printing money makes you shudder, you aren't alone.

But remember, even printing money doesn't cause inflation unless that money reaches consumers. I've said before: if the Fed mints a quadrillion new Sacagaweas and just sticks them in a vault at Ft. Knox, there is no inflationary impact.

Alright so what's in the Fed's balance sheet? What have they buying with all that printed money? (All figures represent an increase).

I've color coded this based on inflationary impact. The various shades of blue are non-inflationary. Starting at the top and moving to the left, the first is the Maiden Lane transactions. These are all related to Bear Stearns and AIG bailouts (note I added some AIG-related loans that technically aren't part of Maiden Lane LLC into this figure). Can't see how these impact inflation in any meaningful way. The next is related to dollar swaps with foreign central banks. Again, while I think this helps provide meaningful liquidity to the worldwide financial system, the impact on consumer inflation is minimal, even if the Fed is "crediting reserves" to help provide the cash. Finally we have "other" Fed activity, which involves stuff like the Fed's gold stock. Not an issue.

Term Auction Debt and the CP/money market programs are a little more nebulous. These plus the actual discount window is in green. The Term debt is mostly the TAF and the TSLF, both of which were meant as quasi-discount window loans to banks and primary dealers. Neither is as heavily used as it was in late 2008. I'd argue that the these term loans are merely replacing other types of borrowing that would otherwise have occurred in the capital markets. So while it is interfering in markets, it isn't inflationary. The commercial paper program is similar. If it just replaces private sector borrowing, it isn't inflationary.

Now wait a minute, you say, the market is over-leveraged. This kind of short-term debt is what helped get us into this mess! The private sector should be winding down! The Fed shouldn't be encouraging short-term borrowing of this nature. That's besides the point when you are thinking about inflationary impact. Inflation (or deflation) is caused by the change in effective money supply from one period to the next. If all the debt was suddenly drained from the system, it would surely be severely deflationary. So to the extent the Fed is substituting its own balance sheet for private lending, that's a neutral event in terms of inflation. Indeed, according to the Fed, financial debt grew at a 6% pace last year, down from 12% in 2007 and the slowest pace since 1991.

The other programs (in yellow) do have some inflationary impact. Securities held directly are, most notably, the Fed's mortgage, agency, and Treasury buying programs. (I've subtracted the decline in repo from this figure, since these new programs really replace the Fed's old repo-based programs.) When the Fed buys bonds, they are buying them from someone, and that cash eventually makes it into the system. I've argued that in fact, securities purchases are just a convenient means of pumping dollars into the economy. So it seems that an inflationary result is the goal.

Same with the TALF. The idea behind the TALF is to restart the ABS markets, which would provide cash directly for credit-based consumption. This is practically printing money and giving it to consumers. However, for better or worse, the TALF has been little used. It was supposed to be up to $1 trillion. It would be just as well to let him go, he's too far out of range.

Now let's add up the "inflationary" increase in the Fed's balance sheet. $528 billion.

Now let's compare that with some other key indicators of consumer behavior. The chart below compares the increase in the Fed's programs with the decrease in the other indicators. The decreasing elements have been inversed to illustrate the relative size.

The amount of inflationary Fed programs is slightly larger (in the scheme of the overall economy) than the decline in nominal GDP, consumer debt, and consumer spending. Now none of these figures are directly comparable, i.e., you can't say the inflationary impact is simply x - y. But comparing the relative size of each of these gives some sense of context.

Now if we add the decline in household assets...

Suddenly the Fed's activity seems like a drop in the bucket. And that figure is only through 12/31/08. We don't yet have the Fed's Flow of Funds report through 1Q. We know that household assets are continuing to decline, as evidenced by the continued drop in home prices.

Now we know that eventually consumers will regain their footing and start to spend (and borrow) again. So even if you agree that the Fed's actions aren't inflationary for now, they may become inflationary once the economy starts recovering. So its all about the exit strategy. That will be next time, on SMACKDOWN!

SMACKDOWN WEEK: China: If you leave now...

2009-06-02T14:47:00.003-05:00

Thanks to the readers for all the e-mails so far. Most have concentrated on the problem of foreign ownership of U.S. debt, and the potential impact on the dollar should foreigners stop funding our profligate spending.

First, let's make a distinction between debt monetization and what the Fed is currently doing with their Treasury buying program. A classic debt monetization is a solution to overwhelming domestic debt. Its printing money to actually pay off the debt because the government has no other solutions. If you want to claim that the Treasury might someday get to this point, have at it. But its clear that in the here and now, the Fed's buying program isn't meant to solve the problem of deficit spending. The Fed wants to buy Treasury bonds in an attempt to put more money into the U.S. economy in the name of fighting deflation. It might also be an attempt to force interest rates lower, although I'm increasingly doubtful that is their intention. Either way, Treasuries are just serving as the helicopter out of which the Fed is throwing money. In other words, Treasuries are a means to an end. In a monetization, buying Treasuries is an end of itself.

That being said, its legitimate for foreign investors to fear the possibility of a monetization. I can't say its out of the realm of possibility, and if your China, it would be such a disaster, they have to be watching it.

Right now, I think the U.S. and China are living in a state of mutually assured destruction. China has too much invested in U.S. dollars, and thus can't afford to have it tank. Meanwhile the U.S. has borrowed too much from China. We can't afford to have the Chinese exit.

Therefore thinking about Chinese exit is a bit like thinking about a nuclear attack during the cold war. Can't deny the possibility, but it wouldn't be in anyone's interest to allow it to happen.

How worried are foreign investors? So far they are mostly just talking. Here is the bid/cover ratio on recent 2yr, 5yr, and 10yr auctions. If the Treasury is auctioning $20 billion and the bid/cover is 2, that means they they got $40 billion in total bids.

No obvious pattern here. Plenty of buyers for Treasuries. For me, I don't take much from any given bid/cover, because a bid at any price counts. I.e., if you bid 4% for the new 10-year, that counts as a bid, even if that's actually 40bps away from where the 10-year is. But as long as the bid/cover is solidly above 1, we aren't in danger of a failed auction.

Another worthwhile auction stat to watch is indirect bidders, where foreign central banks normally hide out.

No real pattern here either.

TIC data measures foreign buying directly, but its always a little dated. Anyway, here is net purchases (buys minus sales) of Treasuries. The red line is a 12-month rolling average.

Again, no obvious pattern of selling. Now if you want to see what foreign panic looks like, check out the chart on Agencies.

The Jutland Wastes are not to traveled lightly! I've heard the Russians blew out all their Agency positions entirely, but I've also heard Chinese insurers say they'd be a natural buyer of GSE debt if it were indeed full faith and credit. Part of this too reflects an overall decline in Agency issuance, but let there be no doubt, foreigners panicked after FN/FRE conservatorship.

The overall TIC does show some pattern of decline...

But it appears to reflect a change in risk tolerance. Since overall TIC is declining while Treasury purchases are about flat, it means that foreign portfolios are more heavily Treasury weighted than in the past.

I've said before that the dollar won't have the same dominance as a reserve currency in 25 years. But I be surprised if the impact is felt in any given year. The big foreign bond buyers have come face to face with a dollar disaster. Just because it didn't happen doesn't mean it won't result in changes. But they will be long-term changes. The kind that are hard to trade on.

To those who really fear a China sell-off, my challenge is to show me hard evidence that its happening.

SMACKDOWN WEEK: Prequel

2009-06-02T09:17:00.003-05:00

Later today I'll post my first extended rebuttal to the inflation argument, specifically on the concept of debt monetization and foreign participation in the U.S. Treasury market. There's still time to write me your thoughts (accruedint AT gmail.com)!

Meanwhile, I've posted a poll on where you come out on the inflation/deflation case. See the right hand side of the main page.

Also, as a bit of a prequel, I thought I'd post a link to my primary deflation argument from a few weeks ago. Feel free to post your own rebuttals here, or if you make a rebuttal on another blog, post a link in the comments.

Treasury Market: Gonk!

2009-06-01T09:42:00.004-05:00

John Maynard Keynes once famously said "The market can remain irrational longer than you can remain solvent."

Now, I believe in a generally efficient market, but not the one you read about in college. The textbook theory of efficient markets describes a world were security prices constantly move toward "real" value. Where information is instantly disseminated, asset, and priced into security valuation.

In real life, the "correct" assessment of information isn't so black and white. Especially since in real life, economic data is often pointing in multiple directions at the same time. Market participants must then weight various bits of data to make a valuation determination. Some will put more weight on certain pieces of data, while others will overweight other items.

This is starkly evident in the U.S. Treasury market right now. I've argued that inflation is of little concern here, despite some improvement in the economy. I point to data like today's release of Personal Income and Spending. It shows that consumers have more income to spend for the first time in 7 months. But they aren't actually spending that income: Expenditures declined by 0.1%. I've said it before and I'll say it again, there is no consumer inflation without consumers spending more money in nominal terms. Deflation is the bigger worry when consumer spending is declining.

Others take the other side, arguing that massive government deficits and the ever-running Fed printing presses will cause inflation. The dollar and foreign willingness to own U.S. Treasuries also plays into the bearish Treasury view.

The difference of opinion is especially wide now. The inflation camp suggests 10-year Treasurys rise to 6-7% or even higher. The deflation crowd currently sees a 10-year Treasury yield which is currently above typical real yield. The median real 10-year yield (just taking 10yrs minus CPI) is about 2.9% since 1989. If I assume inflation will print at or near zero in the coming months, then Treasuries seem like a deal at 3.70%. Obviously if you foresee inflation accelerating to anything above average, even something as benign as 4%, Treasury yields are far too low.

No near-term event is really going to resolve the debate either way. The economy has improved substantially since last fall, when I was writing most about deflation. Despite this, I still see a consumer preoccupied with balance sheet repair than buying new dishwashers. The inflation crowd is the same way. When the dollar was stronger earlier in the year, I didn't see the inflation crowd backing off, and why should they? Their basic thesis was still in tact.

The perception of the debate is colored day by day based on where the market is going. Friday the Treasury market was up substantially and I got a few e-mails congratulating me on my recent buy. I responded (and I blogged) that I thought it was just a month-end extension, not a validation of my view. Lo and behold, the rates market gets crushed today.

In fact, I argue that an argument always sounds smarter when its backed up by recent market moves. I can't tell you how often investment managers and traders come on CNBC and make an "argument" for a certain position that doesn't contain any argument at all. For example, if one went on CNBC and said "I think the long bond is going to 8% because inflation will spike, the Asians will dump Treasuries, and the deficit will get out of control." That's not really an argument is it? Its just a statement of cause and effect. We know Treasuries will get crushed if those things happen. The question is why might those things happen. Right? That argument is like a detective pronouncing a case closed after determining that the victim was shot. Who shot the victim is the real question.

Anyway, if you make the Treasury bear case on a day when Treasuries are getting crushed, the human mind instinctively find your argument more compelling. This guy says the Treasury market is going to get crushed, and look at it! Its already happening! If you watch, you'll notice that on any given day, CNBC tends to have more interviews with people who agree with that day's market action than not. Can't be a coincidence. It makes the casual observer feel like CNBC has on smart people!

What makes this all tough for the serious analyst is that you have to balance holding firm to your viewpoint while admitting you could be wrong. Its another way of saying that the toughest thing in investing is a sell discipline. I'm long Treasuries now (only avoided a real shellacking based on some good technical analysis). I believe in my deflation thesis, but I know I could be wrong. The inflation camp isn't stupid. There is a valid argument for much higher interest rates. The smart trader puts his ego aside and admits when he's wrong.

Many have e-mailed me asking for signposts that I'm wrong. I know what my signposts are, but I'd rather put it back on the readers. E-mail me (accruedint AT gmail.com) with the best arguments you have (could be your own, another blogger, a research report, etc.) for a significant Treasury sell-off. I read a lot of arguments myself, of course, but I won't pretend that I read everything. Send me the best stuff you have. Over the course of this week, I'll respond point by point to some of the best pieces I get. While I'm making my points, I'll also try to show the indicators I'm watching that would tell me that I'm wrong and the opposing writer is right. We'll call it Deflation vs. Inflation week! Its a smackdown!

Treasuries: Have you ever heard the tragedy of Darth Plagueis the Wise?

2009-05-29T16:15:00.002-05:00

I remain a believer in lower interest rates. I remain of the mind that deflation is a much bigger risk than either inflation or the dollar (which is a correlated risk anyway). Still, today's move had a lot to do with month-end rebalancing. The duration of the Barclay's Aggregate has risen from 3.73 on 3/31, to 3.96 on 4/30 and now to 4.33, all on MBS extension. The MBS portion of the Agg has moved in duration from 1.54 on 3/31 to 2.22 on 4/30 to 3.16 now.

So unless rates follow through on Monday, its debatable whether this rally is real. Again, I think the thesis is in tact, but I don't know whether the market believes it or not.

Month-end buying was also highly evident in the corporate market. I came in to do some buying myself and found offerings were like pulling teeth. Since I'm not married to month-end reporting like a lot of people, I decided to roll the dice and see what the market felt like on Monday.

And the stock market? I've seen some month-end window-dressing rallies, but today took the cake.

Yeah but this time I've got the money!

2009-05-27T21:03:00.000-05:00

It was shades of 2002, only in reverse today. Mortgage servicers sold intermediate/long rates, which drove rates higher, which brought out more mortgage hedge sellers. Now we are set with some very basic problems.

The Fed can't keep mortgage rates at or below 5% with the Treasury market where it is. Can't happen. This chart is the Fannie Mae 30-year mortgage "current coupon" which is basically what the prevailing coupon would be on a theoretical par-priced mortgage. Or perhaps more importantly for those who don't trade MBS, this rate plus 50bps would be the prevailing borrowing rate based on how MBS are trading.

Not good. Fundamentals in the housing market are weak enough without having affordability take a turn for the worse.

Taking a longer-term look at the mortgage current coupon, we see its still a good bit below the pre-conservatorship levels. Still, worrisome.

Interestingly, the Fannie Mae 4% MBS fell two points today, about the same price action as the long bond! There are no natural buyers of 4% and 4.5% coupons. They are a trap, as I've discussed before, all downside and no upside. Someday I expect this bond will trade at $91. And your upside is... collecting a 4% coupon? For probably 10 years? Where do I sign up!?!?!

Where does this leave us? With a bunch of problems I'm afraid. The massive decrease in money velocity has left us with a Alderaan-sized hole in the money supply. The Fed has already lowered the funds target to zero, so the only way to get more money into the system is to print it. Plain and simple.

The most efficient means to get printed money out into the world is to buy Treasury bonds. Not only does this put cash into the economy, but it also should lower borrowing yields and thus increase velocity.

When the Treasury buying program was announced, it was assumed that the Fed had some ceiling on Treasury yields in mind. This was a logical conclusion, since classically the Fed operates with a target, and buys or sells Fed Funds to meet that target. Why not do the same with the Treasury market? Target the 10-year at 3%?

But 3% came and went. 3.25% came and went. 3.5% came and went. The market kept waiting for the Fed to increase its purchases, but their purchase amounts have been remarkably consistent. Almost as though their only goal was to get money into the system, and they didn't really care about where Treasury bonds actually traded.

Helicopter Ben is trying to do just that. Print money and pass it out. He's just using the Treasury market as his helicopter. He's not actually trying to push yields lower.

And what about Asia? What about the U.S.'s AAA credit rating? Is the dollar about to plummet and foreign investors run away like Han Solo from Stormtroopers? I can't say there is zero risk of this, but think about it. Doesn't the negative outlook on the U.K.'s credit rating strengthen the position of the U.S. in terms of foreign buyers? If China cares about credit ratings (which traders I've talked to say they do), then doesn't S&P's actions take away one of China's main alternatives to the dollar?

I think foreign diversification of reserves is a reality. The dollar's dominant role in international commerce is fading, but it will be a slow fade. Many are expecting a Death Star like explosion of the dollar. Think of it more like Palpatine's rise. Slow and insidious over the course of many years.

Complicating all this is a very real risk that further Fed purchases of Treasuries will look like a monetization of our debt. I don't think that's the goal, but I can see how Asian buyers, especially outside of China, would come to that conclusion. Richard Fisher of the Dallas Fed has expressed exactly these concerns.

So I don't know what the Fed's next move is, but if interest rates stay where they are, those green shoots are going to turn to yellow. They need more water to start growing.

Bill Gross: Do you trust him?

2009-05-21T14:28:00.005-05:00

No... but he's got no love for the Empire, I can tell you that.

This morning, S&P put the AAA rating of the United Kingdom on negative outlook. Generally when S&P puts a negative outlook, it merely means they leaning toward a downgrade without any particular urgency. In this case, S&P says they need to see some progress made by an incoming British government on their burgeoning debt.

Since the U.K. is generally seen as the third most stable (U.S., Germany) of the big western economies, its not a big leap to say that the U.S. could be next. Its a perfectly legitimate concern. S&P mentions their concern that British debt could rise to 83% of GDP by 2013. In the U.S., its already 80%!

What would happen if the U.S. lost its AAA? Very hard to say. Foreign investors would still have the problem of finding someplace to put their money. I'd be surprised if the U.S. would lose its AAA rating, but say, France and Germany hold on to their ratings. Japan is already AA. It might result in a revision of how foreigners view ratings in general.

In other news, how is General Electric AA+ and stable if the U.K. needs to be downgraded? How is Assured Guaranty still AAA and stable?

Enter Bill Gross, always eager to talk his position. He stokes the fire by saying that the Treasury market is selling off due to ratings fears. Maybe. Indeed, I've heard that Asia is selling today. But always remember, when Bill Gross talks, he is always always always talking from position. So I'm assuming Gross is short Treasuries and today is adding.

I don't think really think the whole ratings thing makes sense to explain the Treasury sell-off. Here is the intra-day on Treasuries. S&P comes out with their report on the U.K. at 4:20 AM.

Treasuries are actually higher all during the Asian and European sessions, and its only once the U.S. session really gets going that the bond market sells off.

A better explanation is the continued belief that the Fed is defending some level on Treasuries. Admittedly, I thought they would, but the evidence is clear that they aren't. Here are the Fed's Treasury purchases since the program began:

Traders keep hoping the Fed will increase their POMO buys, whereas this chart clearly shows they keeping to the $7-8 billion range in the belly and about $3 billion on the long end. Their reluctance to increase purchases shows they either have no particular target or their target is much higher than where we are.

No sense in getting in the way of the Treasury negative momentum here. I'm probably not a buyer until 3.60%.

Treasuries and Stocks: If he could be turned...

2009-05-21T10:23:00.004-05:00

Interesting to watch the Treasury market turn weaker today even as losses in stocks accelerate. I've been feeling for a while that the classic negative correlation between Treasury and stock prices will break down, at least on a day-by-day basis.

1) Any significant rise in Treasury prices will force consumer borrowing rates higher. There isn't much room for further spread tightening, especially in mortgages. So higher Treasuries probably means lower stocks.

2) Foreign buying is critical if Treasury yields are to remain low. Foreigners are more likely to buy when the dollar looks stable. The dollar is more likely to be stable if the economic picture is decent, and thus stocks advancing.

3) The stock market would probably welcome additional quantitative easing from the Fed. Based on yesterday's minutes, I expect any additional QE to be aimed squarely at the Treasury market. So Treasuries and stocks would both rally.

For what its worth, yesterday's minutes also indicated that the Fed doesn't have any particular 10-year yield in mind to defend. Or at least, if they do, that number is much higher than where we are. If the Fed cared about 3% or even 3.25%, the talk of expanding QE would have been more urgent.

Could you argue that allowing the 10-year to move from 2.50% to 3.25% is a de facto tightening of monetary policy? Maybe not, because most non-Treasury borrowing rates are lower today than 2 months ago, and thus you can't claim that credit availability has declined. However, I certainly think if they allow the 10-year to move much past 3.25%, they you will start seeing yields away from Treasuries back up as well. That will indicate tighter policy, which would be bearish for the economy.

Municipals and Chrysler: What happens to one will affect the other

2009-05-15T14:12:00.006-05:00

I've been notably absent in expressing my outrage over how the Obama Administration treated Chrysler's secured debt holders. Let it be known I'm sufficiently outraged on the inside, but resigned on the outside. We should all take it as a lesson: you simply never know what the government might do. The more they tighten their grip, the less I want to invest in any company which has taken government money. Especially in the investment-grade bond market, where, generally speaking, the potential for appreciation is limited.

This brings us to the municipal bond market. In Berkshire Hathaway's 2008 letter to shareholders, Warren Buffett had this to say about the municipal insurance business (the section starts on page 13 if you want the total context). Hat tip to downwithcapitalism who, despite his evil galatic moniker inspired this post.

"A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.

To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial."

At the time the letter was made public, back in February, I thought it was mostly just Buffett's way of 1) Making sure he could keep charging exorbitant sums for muni reinsurance, and 2) Temporing shareholder's expectations for the muni insurance sector. After all, there is no record of insured bonds defaulting at a higher rate than uninsured bonds, controlling for all other factors. And the type of behavior Buffett warned of hasn't been evident with Jefferson County, where the overwhelming majority of outstanding bonds are insured. In fact, I'd bet that the insurers have better lawyers and other workout specialists at their disposal compared to what any ad-hoc group of bond holders could put together.

In addition, notice Buffett says "imagine all the city's bonds had been insured... by Berkshire." This isn't the case in reality. Any large issuer is going to have a mixture of insured bonds with various monolines. Given the state of XLCA, CIFG, FGIC, and Ambac, I'd say that de facto, most issuers have a fair number of bonds that are now uninsured. Certainly its fair to say that the local investors, who Buffett argues prevented politicians from ravaging bondholder rights, would suffer a large market value decline if any issuer fell into default, even if the bonds were insured, since all insurers are seen as weak.

Still, we've seen the precedent set by Chrysler. I've argued many times before that state and local governments can't choose to pay teachers and not bond holders. But can we universally assume this will remain the case? As readers undoubtedly have read numerous times, Chrysler's "secured" bondholders suddenly found themselves unsecured by Fiat (pun intended). Why? Because it was politically expedient.

Couldn't the same thing happen in a municipal bankruptcy? Especially if the Federal government gets involved? Absolutely it could.

I don't see this happening with some local school district someplace. Take Vallejo or Jefferson County, both of which are going on right now. So far it looks like the courts are playing a lesser role in both cases, with politicians and debt/swap holders negotiating directly. These are the kinds of bankruptcies I expect out of munis in the next few years.

But what if a really large issuer, like the city of Detroit, were to enter Chapter 9. Then what if the Federal government stepped in to provide some sort of bridge financing. Then suddenly the Treasury gets to dictate terms, and Obama has shown he's not going to make the unions bear the same burden as bond holders. I'd argue that the public employees unions are more powerful than the UAW!

If that happened, then immediately local governments would see bankruptcy as an expedient solution, solving structural deficits by punishing bondholders.

Ultimately, this would be an incredibly foolish course of action. Consider the consequences: the municipal bond market would shut down, with only the strongest issuers able to come to market, and maybe not even those issuers. Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.

So I sure hope this isn't the direction we head. The long-term consequences would be devastating. You'd like to think the Administration has the sense to consider the long-term impact of their decisions, and wouldn't kill municipal bond holders. But then that's what I said about letting Lehman go bankrupt...

Corporates: All craft retreat!

2009-05-14T14:27:00.002-05:00

Corporate spreads weak again today. Heard that J.P. Morgan's new 5-year was 20bps wider than issue, American Express 10ish weaker on the break, InBev weaker again. The new Simon Property is 25 weaker today.

On the positive side, it sounds like the new Wal*Mart bonds did OK, came at 130, now 10ish tighter.

Worth noting, from a macro perspective, new issue buyers are a fickle bunch. If they have bad experiences with one sector or name, the tend to stay away in the future. So its important that these new financial issues perform well or it may become difficult for future issuers. So far, even though AXP and JPM didn't do that great, a lot of the other issues are still mildly tighter (BAC, GECC), but its worth watching.

Weakness in the credit market makes you scratch your head at how well stocks are doing today. Smells like options expiry BS to me. I covered part of my S&P 500 short yesterday, added a short of JNK. Might add back to my S&P short if we rise any more. I like 875 as a target.

Leveraged ETF Math: This may smell bad, kid

2009-05-12T11:15:00.003-05:00

The other day I was asked why I'm short SSO as opposed to just long SDS. The answer is that there is natural drag on leveraged ETF prices. Part of this is due to the decay factor in futures pricing. But the bigger factor is just the math of multiplication and time linked returns.

Bear in mind these are my personal investments, not anything I'm doing professionally.

OK, let's use a product like SSO, which is the 2x leveraged S&P 500. The way its supposed to work is that every day, you get 2x whatever percentage return is on the S&P 500. On Monday, SSO closed at $25.73. If the S&P 500 were to finish up 1% today, SSO should be up 2%, or $0.51 to $26.24. If its then down 1% the next day, SSO should be down 2%, or -$0.52 to $25.72.

Over time, the math of total return (in percentage) looks like this (just in general, not of these ETF's specifically):

(1 + X0) * (1 + X1) * (1 + X2) ... (1 + Xn) -1

Where X is day n's return.

Now you'll notice that if we get the exact same percentage return, but in opposite directions, on two separate days, it doesn't mean your total return will be zero. For example, say you lose 1% on day 1, but gain 1% on day 2.

(1 - 0.01) * (1+ 0.01) - 1 = -0.0001, or -1bps.

The more severe the return, the more severe the result. Say its -10% and +10%. The result would be ...

(1 - 0.1) * (1 + 0.1) - 1 = -0.01, or -1%.

It doesn't matter what order these occur in, because multiplication is commutative.

(1 + 0.1) * (1 - 0.1) - 1 = -0.01, or -1%.

It would therefore seem like there is a natural negative drift in security prices. But in the normal world, we assume security prices aren't dependent on previous percentage gains, but on some fundamental valuation. For example, if I buy a bond at $100 but it subsequently has some credit problem that results in it falling to $90, I will have lost 10%. But if the credit problem is resolved and it gets back to par, I realize a 11% gain. I'm not limited to getting back the opposite of what I lost.

But the multiplication factor of ETFs sort of mess with this. Let's say the S&P 500 drops by 2% on day 1, then rises by 2.0408% on day 2 (which puts you back to where you started), and repeats this pattern for 6 days.

Now let's say you own the double long ETF, and we'll assume the ETF works as its supposed to. On day 1, you'd lose 4% (-2% * 2) and on day 2 you'd make 4.0816% (2.0408% * 2). But do the math...

(1 - 0.04) * (1 + 0.040816) * (1 - 0.04) * (1 + 0.040816) * (1 - 0.04) * (1 + 0.040816) - 1 = -0.24%

Why? Think about the pay back formula, i.e., percentage return you need in period 2 to go back to zero given a loss in period 1. Its ...

1 / (1+x) - 1

Now if the S&P return was x, then the ETF return is going to be 2x. But notice that...

2 [1 / (1+x) -1] <> [1 / (1+2x) -1]

See? In fact, the left equation is always going to be larger than the right equation if x is negative, and always smaller than if x is positive.

Now I can't say there is a real arbitrage here, because if the market moves higher or lower decisively, that will dominate all these pretty equations. But if you are short-term trading, it seems to me you're better off shorting the opposite ETF than going long. So I'm making a bearish play by going short SSO as opposed to owning SDS.

Corporates: I'll never turn to the wide side!

2009-05-11T12:50:00.002-05:00

Corporate spreads are weaker this morning, finally. I've been feeling like a pull back is long over-due in corps. Beyond the general feeling, two interesting notes on today's movement.

1) Recent new issue Dow Chemical is getting trounced. Dow's 10-year (8.55 5/15/19) was priced on 5/7 at a spread of 525bps over the 10-year. Now the bid is +600. Most recent new deals have moved quickly tighter, anywhere from 15-50bps almost immediately.

2) Other new issues producing mediocre results. Bank of New York, BB&T, Morgan Stanley, all basically at new issue levels. Again, most new issues have moved substantially tighter on the break. For what its worth, GE and Bank of America's deals are doing a little better, maybe 20ish tighter.

3) Today's InBev deal isn't going gang-busters either. Initially the price talk was "Low 300's" and "Mid 300's" for a 5-year and 10-year tranche. Recently when you've heard "Low 300's." that meant it would actually be +290. When you heard "Mid 300's" that would actually be +325.

The deal actually will come at +337.5 and +375 respectively. So they actually had to widen this thing to get it sold. I don't think its some kind of teetotaller conspiracy. I think the rally in corporate bonds is exhausted and its time to set up for a pull back.

Remember that when every one heads for the exits in corporate bonds, the Street won't be taking on massive inventory to take customers out of their positions. So the pull back could be more violent than the economic outlook would indicate.

Among other new issuers today was Microsoft, who sold bonds with a Micro spread of 105bps. Agencies were wider than that less than 6-months ago! Also Simon Property with their second offering this year, the other on 3/20. Worth noting that their March deal was sold at $97.5, now over $110. Coupon is going to be in the "high 7's" as opposed to the 11% yield on the previous issue.

For those who care, I've recently put on a decent short on the S&P (shorted SSO mostly) expecting a pull back there. It makes me a little nervous that this seems like such a popular view, though.

Inflation: Not this ship, sister

2009-05-05T09:30:00.001-05:00

Alright so the Fed isn't going to defend the 10yr at 3%, and in fact appears to be targeting the belly of the yeild curve. That doesn't change the fundamental problem of deflation. Near term, based entirely on technicals, I've made a small short play in Treasuries. But I'm really just looking for a new entry on the long-side.

Almost exactly 2-years ago, I made my now famous (in my own mind) analogy of inflation to a Monopoly game. Basically my point was inflation wasn't about the price of any given property (or good) but the price of all the properties. Allowing any given good (at the time it was energy) to rise isn't, in and of itself, inflation.

Now there is fear that the Fed and Treasury's activities, especially the Fed's recent panache for "crediting bank reserves" (which means printing money). Here is the chart for M1 and M2 up 14% and 9% respectively in the last year.

Back to my Monopoly analogy. We might think of the M's as the actual multi-colored cash that each player has. As I demonstrated two years ago, an increase in cash available should cause the price level to rise, but only if you hold the savings rate constant.

Speaking more technically, you could say that an increase monetary base would have some multiplied impact on transactable money. In your textbook from college, this only involved banks and their willingness to lend. Actually, most often text books assume banks want to lend as much as they are legally allowed, which isn't the case right now. But I digress.

The securitization market makes this all much more complicated. The supply of loanable funds isn't just a function of cash in the banking system, but also cash invested in the shadow banking system. Right now net new issuance in ABS (meaning new issuance less principal being returned in old issues) is negative, meaning supply of funds from the shadow banking system is contracting.

This contraction of funds doesn't show up anywhere in the Ms, at least not directly, but obviously it matters in terms of consumers ability to buy goods. And it isn't just about availability of credit, which had everything to do with liquidity. Its about demand for credit also. Consumers want to save, they don't want to borrow right now. The following chart of household liabilities shows consumers actually decreased their total liabilities in 2008, the first year-over-year outright decline since the Federal Reserve began keeping the data in 1952.

Consumers are like a Monopoly player who has mortgaged all his properties. Passing GO doesn't cause him to buy more houses, it causes him to unmortgage his properties! That isn't inflation!

Getting back to consumers, it isn't clear to me that consumers are actually running out of money. Check this chart of the Household Financial Obligation Ratio, basically a debt service coverage ratio for consumers.

So consumers might not have to repay debt all at once, which is nice. It means a second-half recovery of sorts remains in play. But the large losses in assets coupled with out-sized debt ratios are going to cause consumers to keep saving at an elevated level. Check out liabilities as a percentage of disposable income.

This isn't a perfect ratio, since liabilities is a stock and income is a flow. But with declining asset values (both homes and financial assets), means that consumers are actually going to have to rely on incomes to pay debt service. Or for that matter to qualify for loans. So I'd think this ratio moves back toward 100%. That implies $3.6 trillion. TRILLION. It will be repaid over time to be sure, but it will remain a continual drag on consumer spending levels.

So keep this in mind when you think about the size of Fed/Treasury programs. $3.6 trillion. Are we worried about $800 billion for the "Stimulus Package" or the $1 trillion revised TALF? Not in terms of inflation.

I'm looking forward to the day when I'm worried about inflation. It isn't today.

Fed to Treasury Market: It is you who are mistaken

2009-04-30T10:31:00.004-05:00

Its flying a little under the radar this morning, but the Fed just disavowed the market of the notion that they would defend the 10-year at 3%. Today's Permanent Open Market action was to buy a paltry $3 billion in 10-year and longer notes.

Here are the last several POMOs of Treasury bonds (excluding TIPs)

I color coded it by the portion of the yield curve which the Fed was buying at each action. Notice that its very clear that the Fed isn't doesn't have a soft target of 3% on the 10-year. Moreover, the Fed isn't focused on the 10-year portion of the curve at all. Most of the buyer has occurred in the 4-7 year area, which I'm assuming the Fed thinks will be most influential on consumer borrowing rates.

This leaves me tactically short the 10 and longer part of the curve, looking to re-enter (I'm still a deflation believer) at a higher yield level. Technically, I don't see any stop points between 3.07% and 3.80%, so I'll probably we waiting a bit before re-entering the long-term Treasury market.