Friday, December 10, 2010

Unstable Equilibrium

Woodblock print by Utagawa Hiroshige

Freeze and Thaw

An increasing number of analysts are forecasting better time ahead for the economy and the stock market. Elaine Garzarelli daid on CNBC that there will be better economic growth and stock market performance next year as a result of the money put into action by QE II.  PIMCO's Mohammed El-Erian also raised his US growth forecast for 2011, to between 3.0 and 3.5 percent from an earlier estimate of 2.0 to 2.5 percent, based on the prospect that Bush-era tax cuts will be extended for another two years. However, he added that further stimulus would be needed to sustain growth.

To be sure, not all of the optimism is US-centered or long-term. Byron Wien just came out with a warning that investors need to be invested in emerging markets, and he recommended a portfolio allocation that emphasizes emerging markets, high yield bonds, and hedge funds.  Bill Gross just advised fixed-income investors to look to emerging markets like Brazil where they can earn an attractive real interest rate, rather than the pittance offered in the US.

Also, many structural factors are against the US in the longer term. Gross added: “The U.S. is being out-trained, out-educated and out- maneuvered in the global competition for employment.”  About his forecast of higher US economic growth, El-Erian wrote: "Maintaining such a growth rate beyond 2011 requires additional measures to enhance competitiveness and achieve medium-term fiscal consolidation."

Risk Probabilities Remain Tilted Toward Recession and Deflation

Despite recent talk in the press about signs of an improving economy, a look at a broader range of evidence shows persistent and underlying economic weakness. Combined with underlying conditions, including high levels of debt in both the private and public sectors, the economic and financial evidence suggests that the way out of this country's troubles will be a long slog and fraught with risks.

Fed Chairman Bernanke said last Sunday that the economy is barely expanding at a sustainable pace and that it’s possible the Fed may expand bond purchases beyond the $600 billion announced last month to spur growth. “We’re not very far from the level where the economy is not self-sustaining,” Bernanke said in an interview broadcast yesterday by CBS Corp.’s “60 Minutes” program. “It’s very close to the border. It takes about 2.5 percent growth just to keep unemployment stable and that’s about what we’re getting.”

Indeed, this country is not alone in its troubles. Around the developed world, financial systems burdened by high levels of debt and stagnant economies are highly dependent on government policies for their maintenance. Certainly, the economies and financial systems of the US, EU, and Japan are supported only by extraordinary monetary policy, and errors in these countries' policies could have negative repercussions that would reverberate around the world. As Hugh Hendry says in his December 2010 Eclectica Fund commentary, "This is an environment rich in policy error contingencies."

Hendry also made the very practical point that serious dislocations can also present serious investment opportunities. In the spirit that our wealth is only as safe as our ability to prepare for an uncertain future, I'd like to review recent commentaries about these risks and uncertainties.

Is Santa Coming to Your House?

In case anyone thinks that the economy and financial system actually are making progress, he or she need look no farther than recent news headlines. As an example, consider the headlines from the news stories reprinted in The Automatic Earth blog, last Saturday, December 4, 2010:

Senate Republicans Defeat Reauthorization Of Jobless Aid, Tax Cuts

4 Million Americans Set To Lose Unemployment Benefits Even If Congress Passes Extension

Here Are The The AWFUL Details Behind Today's Big Jobs Report Miss

Value Sinking Fastest on Homes Priced Low to Start

Homes Prices are Plunging: Let's Talk About the Deficit

Distressed Homes in U.S. Sell at Biggest Discount in Five Years

The con of the century – Federal Reserve made $9 trillion in short-term loans to only 18 financial institutions. Since 2000 the US dollar has fallen by 33 percent. The hidden cost of the bailouts.

ECB bows to German veto on mass bond purchases

Angela Merkel warned that Germany could abandon the euro

The details within these stories are no better than the headlines. For example, consider the imbalance between good and bad news in this list of employment facts from the above-mentioned jobs report article:

1. First, the headline: Nonfarm payrolls barely move upward.
2. And the unemployment rate is now creeping up again.
3. Those unemployed for more than 15 weeks is now near 2010 highs.

4. And those unemployed for more than 27 weeks is moving higher.

5. The civilian employment ratio is back at the post recession low.

6. Civilian employment numbers have given up the past few months' gains.

7. The civilian participation rate is now at a new low.

8. Weekly hours have slipped as well.

9. Now, a look at the industries hardest hit: Manufacturing employment in non durable goods now below 2010 lows.

10. And durable goods manufacturing jobs don't look too much better.

11. Government jobs have dipped again, although only slightly.

12. Construction jobs remain low, and flat.

13. BRIGHT SIGN: Total private industry jobs are still moving higher.

He's Making a List

Maybe we can muddle through with a weak economy, or maybe not. For my part, I'm worried about all the risks we fact before (if ever) we get out of the woods. Pragmatic Capitalism made this point forcefully: "I still believe we are mired in a balance sheet recession that will result in below trend growth, deflationary risks and leaves us extremely vulnerable to exogenous risks that could exacerbate the current malaise."

If the current stagnant situation is being propped up only with extraordinary monetary policy, then surely the situation is actually quite fragile. A world delicately balanced between debt disaster and policy overreach must surely be fraught with numerous, serious risks. Niels Jensen, Managing Partner of Absolute Return Partners LLP listed 12 risk factors for the attention of readers of his latest Absolute Return Letter.  Here are the risk factors, each accompanied by my own short exegesis:

High yield priced for perfection? Are spreads getting so tight that one could even talk of a bubble, and could that bubble burst, should the US (and/or European) economy fall back into recession?

The risk of double dipping. Just consider the economic news that I listed earlier.

The sinking ship of Japan. This refers to the high and growing level of government debt, the funding of which is endangered by an old and aging population.

Beggar thy neighbor mentality. Just consider administration talk of devaluing the dollar to increase exports (as if anyone needed our products), complaints from various emerging countries about manipulated interest rates in the US, and China's policy with the Renminbi.

Capital flows too hot to handle. We read every day about the risks of overheating in China and other emerging economies. Capital controls would damage both overseas investors and internal growth. Not imposing controls would risk high inflation and runaway bubbles in commodities and other assets.

Chinese inflation out of control? Although the leadership has said that it is considering price controls on food, lax monetary policy is pushing up prices of a variety of goods and assets.

Food inflation induced civil unrest. Based on the last food price peak in 2008, it may not be too much to expect civil unrest across Asia if food prices continue to climb.

Is India an accident waiting to happen? Although India is financing its external deficit with ease at present, due to the positive capital flows into emerging markets, tighter overseas monetary policies or a change in investor risk perceptions could endanger those flows.

European contagion and solvency risk. Current efforts to avert a crisis are just kicking the can down the road. Banks are in trouble, and the underlying solvency problems are not being solved by adjustments in liquidity.

Massive refinancing program. "This programme poses the biggest risk to my benign outlook for bond yields ...", because of the huge financing needs that are approaching, according to Jensen. Zero Hedge ventured that the problem is even bigger: "Simply put, it's not just fiscally-challenged nations in the eurozone that are suddenly being forced to address the threat posed by too much borrowing. Over the next 12 months, countries across the world, including the United States, will be looking to roll over approximately $10 trillion worth of debt."

Premature withdrawal of monetary support. Not only are the indebted peripheral nations of Europe dependent on continuous support, but the US economy is in danger if Congress follows through on Republican promises to rein in the Federal budget, seemingly without any consideration of the consequences.

Israel launching a pre-emptive strike on Iran’s nuclear facilities. The world is full of political-military risks, and this is just one risk that happens to be a current focus of attention.

I don't know if these are exactly the risks that I would focus on, but they serve to convey the general notion that the present unstable equilibrium could easily be disturbed and send the system sliding off into a new trough of worse conditions.

He's Checking It Twice

Naturally, David Rosenberg has taken his turn listing risks to economic recovery, and out of his list, I think that these two pose particular domestic threats next year:

Massive tightening in U.S. fiscal policy coming via spending cuts and tax hikes. This is the part of the macro forecast that is not given enough attention.

Many goodies will expire at the end of the year and question marks linger over whether they will be extended. These range from the Build America Bond program that subsidized municipal issuance, the Bush-era tax cuts, the extended/emergency jobless benefits, and the little-known Obama tax benefit called the Making Work Pay Credit.

Pragmatic Capitalism reviewed Rosenberg's list and added another domestic risk : "The one major risk that Rosenberg and the market is largely overlooking at this juncture is the housing double dip. This has the potential to be THE most important story of 2011. As I've previously explained, declining asset values are highly destructive during a balance sheet recession."

Tighter fiscal policy will do no good for the economy, and it also brings into question how much money the states might receive from the Federal government should states continue down their present road to budgetary crisis. In "Mounting Debts by States Stoke Fears of Crisis" The New York Times noted just a few examples of how bad the situation has become:

"The State of Illinois is still paying off billions in bills that it got from schools and social service providers last year. Arizona recently stopped paying for certain organ transplants for people in its Medicaid program. States are releasing prisoners early, more to cut expenses than to reward good behavior. And in Newark, the city laid off 13 percent of its police officers last week."

Given continued problems with the national economy, many states could be overwhelmed by debt in a few years, if they are not already at the brink of the precipice. Worries about Federal willingness to aid the states may not be mere fear mongering. The Times added: "Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country."

Felix Rohatyn, the financier who helped save New York City from budget problems in the 1980s warned that while municipal bankruptcies were rare, they appeared increasingly possible. Mr. Rohatyn added that the imbalances are so large in some places that the federal government will probably have to step in at some point, even if that seems unlikely in the current political climate.

In noting the likelihood of legislative deadlock in 2011, David Rosenberg wrote:

Folks, we are on life support. We have been since 2008. Nothing will change in 2011. QE has been extended, the tax cuts will be extended, BABs and the Agency loan limits are being extended. The IV is full and inserted into the arm. The juice that is keeping us alive is still flowing. But make no mistake about this. Without the IV the lights will go out very quickly. 2011 is the last year for these extensions. When we wake up to the fact that we are alive only as a result of medicine we take on a daily basis there is going to be another “event”.

In the current political climate, we have to wonder what kind of price the Republicans might try to exact in exchange for eventual bailouts of the states. Breaking public employee unions would surely please the Republicans, but they might have to provoke a state bankruptcy crisis in order to get their way. Financial systems don't like crises, unfortunately.

In Wednesday’s NYT, David Leonhardt commented: “Mr. Obama effectively traded tax cuts for the affluent, which Republicans were demanding, for a second stimulus bill that seemed improbable a few weeks ago.” It seems likely that any resulting stimulus will be too little to make a difference.

It is to be hoped that the recent extension of tax breaks for the wealthy will prompt those who are often referred to as the "job creators" to get with it and start hiring. Given that the demand for goods from the masses is lacking, there is little reason for more hiring, but we can all hope. At least there are some modest increases in prospective hiring surveys for the first quarter of next year.

The Neighbors Have Been Naughty Too

David Rosenberg has a good way with words, so I'll let him express the nature of the risks with Europe: 

"All these “rescue” packages in euroland really do is provide bridge financing — they do not resolve the underlying structural problems in these countries or the deflating asset values in bank balance sheets."

"The massive selloff in government bond markets, even in countries like Belgium and Italy (let alone Portugal and Spain), is a clear sign that the bond vigilantes are now targeting the supposedly stronger governments in the eurozone. These bond vigilantes are also speculating that the national purse will be needed to keep their banks afloat and the relentless widening in CDS spreads is an added suggestion from the markets that these governments may not have the resources to fully repay their creditors once they have moved to support their banking systems."

The Washington Post commented last Tuesday that bond markets are not the only worry with Europe:  "A greater danger is that a full-blown debt crisis in Europe could put new pressure on the region's banks, tightening credit and potentially slowing growth in one of the world's largest economic engines. It could also send the euro plunging against the dollar, making the greenback stronger on world markets and undermining the efforts of the Obama administration to boost U.S. exports overseas."

In a guest editorial in Naked Capitalism, the author of Washington's Blog wrote: "...... by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default."

Nouriel Roubini put it this way, “So at some point you need restructuring. At some point you need the creditors of the banks to take a hit —otherwise you put all this debt on the balance sheet of government. And then you break the back of government—and then government is insolvent.” There remains the question of what kind of restructurings will take place, but Europe seems to be kicking the can down the road at present. The transfer of risks onto government balance sheets is already being reflected in the widening of sovereign credit default swaps.

Should there be a systemic breakdown in Europe, it could bring a banking crisis of the same kind that we saw in 2008. Banks in the US, Europe, and elsewhere could face sudden lack of liquidity if European banks take a hit.  Investors on the whole are probably not prepared for such an event.

The Bond Vigilantes May Beat Santa to Town

CNBC reported Wednesday that Nouriel Roubini voiced concern over the compromise on extending tax cuts between President Obama and Republican Congressional leaders. Roubini said that the agreement could expose the US to bond vigilantes who will drive up bond yields. The Fed has kept short-term rates as rock-bottom levels to support the fragile economy, and an increase in bond yields could damage any chance of a recovery

Roubini said on Twitter: “Obama-GOP tax deal costs $900 billion over two years. US kicking the can further down the road. Are bond vigilantes starting to wake up?”  Bond prices have fallen from the highs of a few weeks ago when speculators were anticipating the Fed's purchases under QE II, and renewed worries about US government debt levels could send Treasury prices even lower.

Worries about the debt positions of other advanced economies, which seem to be in even worse condition, might be a mitigating condition preventing any abrupt break in US bond prices. Nevertheless, given the seeming intractability of the debt problem, it would not be surprising to see recurring periods of worry about US debt levels over the next few years, accompanied by occasional declines in bond prices.

Progress on reducing the national debt will require both steady tax revenues and reduced budget expenditures. The weak economy will make progress on both fronts very difficult, since it will increase demands for fiscal and monetary intervention. As Jesse's Crossroads Cafe put it, "For a nation that is a net debtor, deflation is tantamount to suicide."

Despite criticisms of its monetary policies, the Fed seems unlikely to allow deflationary suicide anytime soon.  In his CBS interview, Federal Reserve Chairman Ben Bernanke did not rule out buying more than $600 billion of bonds in further quantitative easing. Once the idea of an imminent QE III gets into the consciousness of Wall Street, we should not be surprised to see even more money piling into commodities, emerging markets, and other "risk" assets. Perhaps this time the weakness of Europe will help to support the dollar ... perhaps.  A weaker dollar would help exporting industries in the US, if the Fed could engineer it.

According to the New York Times, financial markets have interpreted the tax cut deal, which was announced this week between the administration and Congress, as contributing to economic growth over the next couple of years but also increasing the federal deficit and raising borrowing costs. Higher borrowing costs would not help in funding extant debts, and the elephantine issue of reducing the federal debt is being pushed off to the future.  Whatever happens on the fiscal side, the monetary side of policy seems likely to keep levitating financial asset prices. When that levitation will end it hard to tell, but at some point the bond vigilantes will likely have their say.

An increasing number of analysts is saying that it makes no sense for the Fed to keep monetary conditions so loose when the economy is enjoying growth in excess of 2 percent.  They may have a point, because the bond market has responded to better growth prospects, and bond prices have declined recently.  Given all of the risks that we have enumerated in this article, we have to wonder if that growth spurt will be short-lived.


Pundits who make point predictions about the economy and the markets are absolutely foolish, because any alert observer will admit that the future is a swirling sea of variables.  No one knows what is going to happen.  On the other hand, we all need to protect our assets and prepare for the future.  To do that, we need to consider a range of alternative futures and form judgments about their relative plausibilities.   You can tell in which direction I think the probabilities are pointing.

Friday, October 29, 2010

The Beginning of the End

The End of a Bull Market in Bonds

PIMCO's Bill Gross shook me up the other day with his October commentary. Bond investors do not like it when a bond guru writes that the Fed's announcement of renewed quantitative easing next Wednesday "will likely signify the end of a great 30-year bull market in bonds."

Whoa! I've been raking in easy if modest returns with a portfolio tilted toward high credit quality bonds. That's what you do in a debt deflation, isn't it?

"Safe Spreads"

Always prone to hyperbole, Gross softened the message toward the bottom of his commentary, when he said that PIMCO had no intention of suffering a bear market in bonds, and that they could maneuver around this little problem of no more bond bull. Specifically, he intends to invest in what he calls "safe spread" securities that offer higher yield "without taking a lot of risk" of inflation.

One example is emerging market debt with higher yields and non-dollar denominations, and another is high quality global corporate bonds. Gross added: "Even U.S. Agency mortgages yielding 200 basis points more than those 1% Treasuries, qualify as 'safe spreads'.”

You know, I wouldn't call a bond portfolio exactly safe it includes a lot of securities sensitive to highly correlated risks like currencies and emerging market economies. So, how does this square with the "end of a great 30-year bull market in bonds?" Well, with Gross we know that he likes to engage in a hyperbole and that he doesn't tell the whole story.

Bonds Are Not "Over the Cliff"

Gross appeared on Bloomberg Surveillance Thursday and was more nuanced in his explanations. By an end to the bond bull he means "not over the cliff" for the entire market but a recognition that "certain maturities can't go much lower." Two-year maturity Treasuries, for example, are yielding near the overnight rate. Not much opportunity for return there. He explained that Fed purchases make it mathematically impossible for bonds to do much better.

He also explained that "safe spreads" refer to securities that offer yield without being vulnerable to inflation expectations. This concern with inflation sensitivity seems an important point.

Gross added that he hasn't shortened the maturity of his Total Return portfolio, which is still in the vicinity of four to four and a half years. This is in contrast to Dan Fuss, who said on Bloomberg Surveillance the day before that he had reduced the average maturity of his Loomis Sayles portfolios.

Rather than reducing PIMCO's bond maturity, Gross has gone "to a space not vulnerable to inflationary expectations."  A lot of securities are much less sensitive to inflation than are Treasuries, and he is focusing on the "safe space.".

It is interesting that Gross is concerned with vulnerability to inflation. Inflation is what the Fed is trying to achieve with QE, and with the suggested 2.5% inflation target. If PIMCO takes it seriously, perhaps there is a risk that they will succeed, or at least that investors will be spooked by the expectation.

Higher Rates in Three to Five Years

Another reason that Gross hasn't changed his portfolio's average maturity yet is that "the Fed isn't changing its target rate." So, he isn't expecting inflation soon, but apparently he thinks that it is a possibility sometime in his planning horizon. He believes that the Fed will tighten eventually.

The timing of inflation is influencing the maturities in his portfolio. Gross said that he is avoiding the 10-year Treasury because policy rates may go higher. The "safe maturities are five years and in, not five years and out." So apparently five years is approximately the horizon at which the Fed is expected to tighten. (I have no idea how anyone can predict if and when the Fed will tighten, but there it is.)

Gross reinforced this estimate of a five-year "safe" period when he said that CD investors could go out in maturity to three or four years. Five-year CDs might appeal a risk taker. Just to make it clear that he is willing to make a prediction, he added: "The Fed won't raise for three years, maybe four or five."

Stagflation Coming?

Given that the Fed is unlikely to restart the economy with monetary policy, it is natural to wonder why the Fed might raise rates within three to five years. The answer may be stagflation. If the Fed creates inflation through dollar devaluation or speculative bubbles, it would probably result in stagflation rather than ordinary wage-price inflation, given the likelihood that the economy will remain weak. Stagflation would be very negative for Treasuries. Rates would rise in general, and the Fed would have to follow.

It would take something very serious, like stagflation, to get the Fed to raise rates with the economy still weak. We have to wonder how badly higher rates would affect the economy and the servicing of US debt, which suggests that recovery through inflation is a self-limiting process.

No Inflation at Present

However, inflation risks are for the future and not the present, according to Gross. He sees even the low yields of short Treasuries as "safe" at the present time. "A two-year Treasury and a three-year Treasury only yield 37 to 60 basis points, but that's safe yield because the Fed isn't going anywhere."

Gross also suggested that the Fed may not be able to go much farther with monetary policy, and that fiscal policy will have to take over soon. "We've been willing to accept the lower yield in anticipation of a hand-off to federal officials maybe six months down the road."  Gross didn't say, but this would be after newly elected Congressmen have taken office in what is expected to be a more Republican House. Given the likely stalemate in Congress, it is hard to understand exactly how this "hand-off" is to work.

Does This Mean Anything?

Gross loves to dampen his clients' expectations by expressing caution. A look at his past commentaries shows that he has called for the end of the bond bull before, only to be followed by huge bond rallies. Maybe this is another of those times, but on the other hand, maybe his remarks are justified and even prudent at this time.  No one knows what the Fed is going to announce next week or the market reaction. The stakes of the anticipated QE II are huge, and it would make sense to hedge bond portfolios ahead of the meeting. Gross's comments aren't much at odds with the fears that most bond investors hold these days, and at least we have another plausible scenario for consideration.

We definitely need some scenarios to think about to protect our portfolios.  Another PIMCO guru, Mohammed El Erian, also said this week that Federal Reserve purchases of Treasury securities likely will spur inflation, while leaving unemployment untouched.

Saturday, October 23, 2010

Bond Risks and Opportunities

"This was a great nation until the robo-signers came."

Following a run-up in response to prospects for further Fed asset purchases, the bond market has turned more cautious. Perhaps this caution is in response to prospects of an intensified round of currency devaluations, with its implications for domestic inflation, or maybe the advance was just getting ahead of itself. Let's look at what people are saying about bonds.

Portfolios Shift Out of Short Term Treasuries

On October 8 PIMCO's Bill Gross gave in interview on Bloomberg television, in which he described how the advance in parts of the Treasury curve had caused him to adjust his portfolios. I watched part of the interview of Bloomberg Surveillance, where Gross said the yields of 2-, 3-, and 4-year Treasuries are getting so low that alternatives are now preferable in terms of taking on a little more duration or credit risk in return for more yield. In fact, he found no advantage for 2-4 year Treasuries over the money market. Instead, traders are moving out to the "belly" of the curve, and Gross said they should buy 5-, 6-, or 7-year maturities if they buy Treasuries.

"Look, Timmie, Someone Spent a Dollar!"

This move seems consistent with the prevailing pubic view that the Fed has gone as far as is practical in lowering yields in the shortest maturities, and that we can expect to see the Fed gradually walk its way out the yield curve, lowering rates in longer and longer maturities until the curve is flat.

Seeing the End of the Bond Rally

Then on October 14 Bloomberg summarized an interview with Douglas Hodge, the COO of PIMCO, about recent changes in their portfolios. The basic message was a little stronger than Gross's earlier statements, and Hodge warned that the strong bond gains of recent months are unlikely to continue:

“From where we sit, it’s very hard to suggest there’s going to be that kind of price appreciation that we’ve seen in bonds over the last 12 to 24 months.”

“Even if the QE process is large and rates decline further, in our view we’re approaching the end of the bond market rally.”
Hodge reinforced Gross's earlier message about the portfolio implications, saying that “We have reduced our Treasury holdings, the lowest yielding instruments.” Hodge mentioned that increased positions included emerging markets, such as India, China, and Brazil, with infrastructure debt looking particularly attractive. They are buying high-quality corporate bonds in India and are making investments in China via the non-deliverable forward market.

"This meeting of the Federal Open Market Committee will come to order!"

Seeing Increasing Credit Risks

In an email to Bloomberg, Bill Gross described the strategy underlying these portfolio changes, which involves much more than simply moving out the Treasury yield curve:

“Pimco Total Return currently is employing what we call a ‘safe spread’ strategy, which seeks to identify sovereign countries best able to handle a new normal global economy that envisions slower growth and therefore increasing credit risks in fixed-income markets.”

Perhaps PIMCO is expecting the Fed to keep the world's financial bubble primed through eternal quantitative easing.  As ridiculous as that sounds, maybe we should consider the possibility that the Fed is not going to let the US slip back into recession, no matter the inflationary consequences.

He also remarked that this has definite implications for portfolio allocation:  It looks like they are moving gradually away from the US to where the growth and improving creditworthiness may lie. This would be a good strategy if the emerging markets are not hurt when the economy of the developed world again takes a dive, which seems likely at some time in the next few months or years. Unfortunately, emerging economies like China are still extremely dependent on their more developed customers.

"The printing press is out of control!"
The worrying part of these pronouncements is that Gross's email emphasized the "increasing credit risks in fixed income markets" in a world of low growth. They still have a lot of their portfolio in the low growth US, but the percentage of the money there has been gradually reduced in recent months, particularly in the Treasury component. Many people are worried that high government debt problems will eventually catch up with the US and other advanced economies, and it would appear that PIMCO is starting to adjust its portfolios incrementally in that direction.

Buying Mortgage Backed Securities

If you look at PIMCO's most recent portfolio statistics, the message is a little different from that given by Hodge. Bloomberg published an article an article about this just the past week. You see that they still have large amounts of Treasuries, but the relative mix has been shifting in the past few months in favor mainly of mortgage-backed securities, which are the largest category in their funds (and which Hodge did not mention). Increases in emerging markets were much smaller.  This move is quite consistent with Bill Gross's statement that Treasury yields are so low as to be unrewarding in some parts of the curve, and that it is necessary to look elsewhere.  Apparently their thinking is that, with the US government backing them, agency-issued MBS offer more yield reward with only little more risk than Treasuries.

"These oddballs are ruining the neighborhood."

There is another, more speculative issue with MBS.  The general press is that QE II will focus on purchasing Treasuries somewhere out the curve, extending the flattening of yields that has already occurred at the short duration end. However, the Fed may have reasons for including considerable amounts (a billion or so) of MBS in QE II, especially now that there is a crisis brewing with rotten MBS that the big banks sold to investors at the height of the mortgage boom. With so many investors pressing the banks to make good on their agreements to buy back such rotten MBS, there is some increased level of risk to the survival of some of the big banks, and the profitability of others. The Fed may want to help the banks get rotten stuff off their balance sheets sooner rather than later, so as to avoid another possible financial crisis. Just maybe we might see some mortgage backed securities included in the Fed's asset purchases during QE II.

Timing the End of the Bond Bull

Bloomberg published a worrying article on October 21. It reported that Mark Kiesel, global head of corporate bond portfolios at PIMCO, said in a CNBC television interview that he sees interest rates going higher. He also said that PIMCO is increasing its stakes in investment grade companies. There was no word about whether this was a cyclical or secular rise.

"Is this the food stamp line?"

Other PIMCO pronouncements convey a different slant and suggest that the bond bull still has some chances of continuing in their opinion. Just prior to Kiesel's comments, a senior VP of PIMCO, Tony Crescenzi, said on Bloomberg television that bonds will suffer only when bankers start to lend money and when businesses and individuals ask for loans. Further, a "Keynesian endpoint" will really come only when all major economies "max out" their balance sheets. Given the likelihood that this event is some years in the future (albeit highly uncertain), the time for bond suffering is evidently not just around the corner.

The Risk of a Liquidity Trap

Perhaps a more serious threat to bonds is the threat posed by the Fed itself. Or, more properly, the threat is that the financial crisis has only been patched over, and could arise again to drag the economy and the financial system down in a deflationary liquidity trap.

This past weekend's New York Times carried an article on the dangers that the Fed sees with deflation, which the article referred to euphemistically as "persistently low inflation."  It is widely expected that the Fed will respond to this risk by attempting to lower long term interest rates. It is also expected that the Fed will do this by announcing of another asset purchase program -- QE II -- at its meeting in November.

The problem may be worse than generally appreciated until recently. Charles L. Evans, president of the Chicago Fed, said plainly at a recent conference that the economy is in a "liquidity trap." He announced his support for a strategy known as “price-level targeting,” in which the Fed would permit inflation to run at higher-than-normal rates in the future to make up for inflation being lower than desired today. In other words, Evans was proposing inflation targeting.

"Don't pull on your leash, Timmie."

Evans did not say how the Fed would accomplish this at a time when no one wants to spend money, and it seems unlikely that ordinary monetary policy (or asset purchases) could do this. However, even an official Fed statement saying that it is targeting higher inflation rates would raise considerable fears in the bond market that the Fed might embark on reckless actions.  Unfortunately, such actions would be self-defeating to the Fed's goals of keeping credit easy and cheap.

The Risk of Repressive Monetary Policy

Many commentators have commentated on the likely fruitlessness of further quantitative easing, which raises the question of what happens next. Maybe it is just idle speculation, but some of these commentators raised the possibility that the Fed will eventually be forced to turn to more repressive measures to force people to spend their money. By "repressive" they mean such things as motivating banks to charge their depositors for holding funds at the bank, rather than giving them interest on deposits. (Perhaps the Fed would charge a fee for holding banks' required reserves.) This means that the Fed would force negative short-term interest rates on the public and business.

There's nothing like seeing your money disappear before your eyes to motivate people to convert their money into real things, like cars, houses, or gold bullion. Would this restart the economy? It seems doubtful. But it would get money moving.  Money would flee the country and go to places that have saner central banks.

"We'll get those lazy bums off Social Security and Medicaid!"

Repressive monetary policy seems unlikely from today's perspective. The majority of observers seem to think that the Fed will simply continue with QE until it debases the dollar, and the recent drop in the dollar seemed to be tied to that worry. That would be another way of targeting inflation, which gets us back to the stopping problem of when to sell bonds and dollars ... and presumably buy gold and wheat.

Betting on the Inevitable

Not everyone is convinced that the Treasury bull is over. Gary Shilling, for example, still expects years of a deflationary environment and a continuing Treasury rally at the long end of the curve. David Rosenberg of Gluskin-Sheff has a similar view. Rosenberg believes in deflation, and he remarked in a recent newsletter that, despite all of the Fed's intervention, consumer prices have continued to fall, and core inflation is at four-decade lows. His reasoned:

"Therefore, it would make sense to assume that once we get pass this bump in the form of a weaker U.S. dollar and surging commodity prices, the risks of deflation will intensify again."
"Right now, the long bond yield provides a 150 basis point premium over 10-year Treasury notes at the price of taking on nearly nine extra years of modified duration. Sounds like a handsome trade-off ... a 3% real yield still looks fairly attractive from our lens."

"This wll give us exactly 3% inflation."

The Prospect of Fiscal Prudence Next Year

A problem with the deflationary argument is that many forces point to a different environment next year: That's when questions of fiscal austerity will start to come to the fore, and when we can expect real discussion of how to cut back on the US fiscal deficit. If this results in fiscal prudence, we can look forward to a slowing economy but perhaps also to a relaxing of worries about government debt, which could be good for the dollar and the long bond. On the other hand, if a Republican win in the elections should produce a political stalemate, there arises the prospect of a Congress unable to do much to reduce the fiscal deficit. A continuation of the present trajectory of budget deficits would heighten worries about the US, weaken the dollar and the bond, and raise again the specter of increasing inflation.

What to make of this dichotomy?  One point of view is to go with the inevitable. What is the most inevitable, unstoppable force affecting our society today? Why, it's the faltering economy. And what is ailing the economy? Why, it's debt, of course. It is hard to argue with trillions of dollars in debt (manifested in foreclosures, unemployment, and budget cutbacks) as an inevitable force.  Particularly when the deleveraging of the consumer sector has hardly begun, and when banks are still constrained by bad debts.  Driven by the weight of all this debt on our collective backs (and by its political masters), what else can the Fed do than feed the asset bubble until it bursts ... again?

"They bought it.  Only billionaires can vote, now."

Saturday, October 2, 2010

A Night on Bald Mountain

Bald Mountain in Fantasia

A Mountain of Debt

In his latest monthly commentary, Bill Gross of PIMCO warns that there is no way back to the "good old days" of high returns in investing. Decades of double-digit returns were made possible because easy credit provided more money than could be put to productive uses in the real economy, but the credit bubble has burst. The bursting of the debt bubble means that days of easy credit are over, and it will be many years before debts are paid off or defaulted sufficiently for better days to return. This is the New Normal that PIMCO has adopted as its mantra.

As harsh as the New Normal sounds, I think that PIMCO does not go far enough. I would add that the buoyant economy we experienced ever since the end of World War II has never been normal. It was based on special circumstances and can never be the same. A generation of Credit Excess was preceded by centuries of Good Luck for America and the West. There is no way to get back to the "old normal," and the economy will never be the same.
Satan Contemplates the Mortal World

The Fantasy of Normalcy

Why can the economy never be the same? We had a long run of good luck in the US, and our luck seems to have run out. It's right there in our history. We exterminated entire peoples to conquer an entire continent and exploit its resources, we were in the right place to be beneficiaries of multiple industrial revolutions, our industries were relatively unscathed by global conflicts, and then we prospered even more by refitting the bombed-out industries of a war-broken planet. No wonder we believed in "progress."

The problem now is: Those advantages are gone. Information and capital can flow anywhere instantly. Former colonial subjects and former slaves of Communist ideology are no longer exploited but are now investing their sweat in modernization and increasing competition. They want the good things and they are willing to work for them. There is no more monopoly market for America or the West to exploit.

About three decades ago, when America started to find the going more difficult, we didn't scale back our inflated expectations. Instead, we clung to our outsized expectations and financed current consumption by borrowing from the future. In fact, our government encouraged borrowing by instituting a policy of easy credit. Citizens responded, used their housing ATMs, and piled up debt. It was an unsustainable process and the mortgage-credit-finance bubble was the terminal phase.

Satan Spreads the Seeds of Evil

Our only hope now is to get through the debt mess and -- probably after decades -- get back to a growing, sustainable economy. We are far from creditworthy now, and our competitors continue to grow lot more capable. There are no "good old days" to go back to.

Illusion Has Replaced Reality

No, the debt load does not mean that America is doomed, but it suggests that many or most of us are bound to be disappointed that our outsized expectations are not satisfied.

Debt is too high, and trust is too low to restart the economy. Time is the only real solution to deleveraging, but government and the people have no patience. QE will not work, and it will raise the level of risk to our national credit and currency, but the Fed will proceed anyway. Illusion has replaced reality in the minds of the policy makers.

The Spirits of the Dead Rise on All-Hallows Eve

A Declining Dollar and a Lower Standard of Living

In his latest monthly PIMCO commentary, Bill Gross pointed out that the economy is mired in the deflationary process of debt deleveraging and is likely to stay there for years. Quantitative easing (QE) is the Fed's attempt to jump-start a moribund economy by igniting a process of inflation. (More precisely, they want to bring about price inflation by increasing the velocity of money in an already inflated monetary base.)

After some years, price inflation should reduce the real value of debts to a more manageable level. The problem with inflating our way out of debt is that America will have to pay a very painful price:

"And the most likely consequence of stimulative government policies that strain to get us there will be a declining dollar and a lower standard of living."

If the dollar is worth less, we are poorer. We would have to cut back on what we import from the rest of the world, but rises in exports would be of little importance, because we export so little. A country that has invested so little in productive technologies would stand little chance of expanding the scope of its exports. Such lazy countries suffer a declining standard of living.

Gross's point of view isn't the only one with credibility, but the alternatives are also depressing. There are other kinds of "soft default," such as reneging on promised social entitlements. There are also ways that governments can "stick it" to creditors, such as revoking the terms of existing debt securities (perhaps converting inflation indexed securities to fixed rates). None of it would be pleasant.
Mere Toys in Satan's Power -- Satan Increases the Velocity of Money

Terminal Competitive Devaluation

As SoGen's Albert Edwards mentions in a recent report,
"Our economists made a very interesting point in the Economic News, 17 Sept. They believe the BoJ's actions may be the start of a more general period of competitive devaluation; with the US authorities tacitly allowing the US dollar to decline in an environment of QE2 (no wonder gold looks so perky!)."

According to Edwards, there is good precedent for using currency devaluation as a tool to combat presistent deflation, and good indications that the Chairman of the Federal Reserve, Mr. Bernanke, has considered devaluation seriously as a policy tool.  In his 2002 speech Deflation: Making Sure "It" Doesn't Happen Here, he said:
“The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt."
"Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange … there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation."

Not that I necessarily agree, but Zero Hedge interpreted Bernanke's statements very liberally as "the blueprint for the endgame," meaning that a competitive round of international currency devaluation will soon be upon us:

"Hence Bernanke openly stated back in 2002 that the end game, especially when all else fails (fiscal deficit too high and QE shown to be impotent), is to print money to drive down the dollar. This is default in all but name. Investors ignore this at their peril."

I have no idea of whether or not the Fed can actually bring about currency devaluation and inflation, but there are ominous signs. As a likely program of QE II approaches, the dollar has been declining and gold has been rallying. Now, noted investment managers such as Bill Gross are warning of inflation and currency devaluation in our future.

Satan, Like the Fed, Can Extinguish His Creations

On the other hand, bonds are still performing well. They need to, because the Fed is enforcing low rates to keep banks solvent, to let debtors refinance, and to let the Federal government roll over its debt at affordably low rates. The strong dollar has been a big help in doing this. It is also fortunate for the US that no country wants to endanger its exports by letting its currency rise against the dollar. Since the dollar started sliding recently, countries around the world have intervened to weaken their currencies and maintain their export competitiveness.

If the Fed promotes currency devaluation, it will be walking a tightrope between driving down the dollar (to cheapen our debt) and keeping the dollar strong (so that we can afford to roll over our debts). Something will have to give.

Maybe the currency game is not a total standoff. As Edwards put it:

"The good news is that this is not the zero sum gain that most commentators suppose. For if all central banks are printing money to drive their currencies downward, exchange rates may not change, but the money supply does. It is easier for the US to "guide" down the dollar with its burgeoning current account deficit, and to the extent bond yields rise as foreigners back away, the Fed will just keep printing money to hold them down!"

So, maybe the US really can devalue the dollar relative to other currencies, at least those that are not pegged. In that case, there would be all those "printed" dollars waiting to enter the real economy and, if the velocity of money increases, the eventual inflation in prices.  That is what Edwards argues.

Of course, there are problems with this scenario.  To get inflation, individuals and businesses would have to want to borrow and spend, and it would take a lot of devaluation for that to happen (which hardly seems in the cards now that Congress has caught the austerity bug).  Not that I doubt the ability of politicians and bureaucrats to make mistakes, but it is hard to imagine an environment that would encourage much additional spending, short of some kind of currency crash or bond panic. 

Maybe a really repressive Fed policy (like incentivizing banks to charge negative interest on deposits) could do the trick, but that would have risks too.   Another problem is that devaluation would not help against currencies that are pegged to the dollar.  In fact, modest dollar devaluation would make China even more competitive against the rest of the world, as long as the dollar-yuan decline wasn't so great as to price them out of the commodities markets.

What Will Dawn Reveal?

The Fed has already responded to the slowing economy with one round of extraordinarily accommodative monetary policies, and they seem ideologically inclined to try it again. Extraordinary policies can be risky -- and we had better think hard about that risk.

The End Game -- Doomed Souls Return to Satan

What about the risks of accomplishing another round of QE?  Zero Hedge wrote that $1 trillion of Treasury purchases a year (as widely expected) means that the Fed will be purchasing nearly all of the net debt that the Treasury will issue this year. That means the Fed will be financing all of the Treasury's debt issuance, which might raise a few eyebrows, because the Fed would actually be monetizing the debt. Will anyone lose confidence in the US as a result? I don't know, but it sounds strange.

The most popular view in the media is that QE II will cause nearly all asset classes to rise in price, but will have only a very minor and transitory effect on the real economy. This is a very short term point of view. In contrast, Edwards takes a very extreme but more serious view. He believes that citizens of the mature Western economies are being pinched to the point of social unrest, and that the inflation resulting from competitive currency devaluation could be the breaking point: "what do devaluation, high unemployment, inequality and food prices spell? C-H-A-O-S."

I hope that everyone had a good time!

Despite worries about social trends, I certainly do not see social chaos affecting the US anytime soon.  Rather than some kind of social chaos, the risks at present seem more tilted toward policy mistakes.  Politicians do have a way of catering to the base needs of their constituents, no matter the long-term consequences.

Perhaps devaluation and inflation are future risks, but I am not sure if they can affect us greatly in the near term.   For the near-term future, disinflation and economic stagnation seem more likely to continue  as the dominant forces, but the destabilizing risks posed by QE II are worth contemplating very seriously. 

   Happy Halloween!!!  


Monday, September 6, 2010

Bonds, Bubbles and Busts

A Bubble in Treasuries?

Is there a bubble in Treasuries? This question has recently been discussed by nearly every financial commentator on the web and in the press, with both sides having amassed convincing but conflicting arguments. Value investor James Montier of GMO had something interesting to say about this question in his blog recently.  You would expect a value type like Montier to warn that Treasuries are overvalued compared to historical norms, and you would be right. The only trouble is that I'm not sure that I agree, and I'm not sure that his argument is even a valid value judgment is today's situation.

In his blog Behavioural Investing Montier published an article on August 31 titled "Bond Bubble - a sterile debate on semantics," which asked : "The issue shouldn’t be whether bond are a bubble or not, but rather are bonds a good investment or not?" Using Ben Graham's definition of an investment as an operation that promises "safety of principal and a satisfactory return," Montier proceeded to estimate the return from Treasuries over the next ten years, so as to see if that return would be in some sense "satisfactory."

Are Bonds a Good Investment or Not?

To do this, Montier estimated the three components of return -- the real yield, expected inflation and an inflation risk premium -- for 10-year Treasuries over the next ten years. He estimated the real yield as 1%, based on the yield of 10-year TIPS. For expected inflation, the inflation swap market implies 2% over the next ten years; alternatively, the nominal bond yield minus the TIPS yield implies 1.5%. For the inflation risk premium, which is a way of accounting for uncertainty in future inflation, he used 0.5%, which is the upper range of current estimates. This implies a return of 4% annually under "normal" inflation conditions. Montier upped the estimate of longer term average 10-year Treasury yields to the 4%-5% range because he questioned whether the current market real yield of 1% is really a "fair price," and because the longer UK experience with inflation linked bonds suggests a somewhat higher number.

Montier's conclusion is "In the ‘Normal’ state of the world bonds sit at close to equilibrium, say 4.5%." The implication is "The current 2.5% yield on the US 10 year bond is clearly a long way short of this." In contrast, a Japanese outcome for the US over the next ten years would have rates around 0%-1%, and an inflationary outcome would have yields around 7.5% (with inflation at 5%).

Montier interpreted these numbers as saying that "In essence, the market is implying a 70% probability that the US turns Japanese."  Maybe 2.5% Treasuries are attractive if you are certain that the US is becoming Japanese, but that is a lot to assume. A rise in yields even to the long-term average level implies some losses.

A Satisfactory Return?

I think that we knew this already, at least in a qualitative way, before Montier published his calculations. We already knew that T-bonds are overpriced according to historical metrics. We understand that an all-out bet on Treasuries at this point is risky, but we also know that all-out bets on other asset classes are also risky. Montier did not address the right question.

The problem is that Montier is arguing on the basis of the range of Treasury bond prices over the limited history of those securities. That history is limited in time extent and in the range of conditions that were sampled. It is not an average over an infinite sequence of all possible financial histories going through all possible states of the world. In other words, it is a sample average, not a known parameter. The values and frequencies seen over the recent past were dependent on the unique and contingent conditions pertaining during exactly that period of time. Why should we assume that the future will be like the past?

Today's financial state is highly peculiar in the US. It is a state of high indebtedness occurring at the end of a period of easy credit and overconsumption. If we look over longer periods of time than Montier examined, we see that periods of excess are regularly followed by periods of sub-par growth and financial crisis. We have examined the work of Reinhart and Rogoff in this blog before. We place much more weight on several centuries of world financial history than we do on the limited history of the past few decades of a peculiar and distinctly American era.

Bubbles are followed by busts, and long term averages can be violated for a considerable period of time. Excessive debt weighs down with an inexorable burden that has to be worked off over time. As a result, the "long term" average may not re-emerge for a long time. I don't think that any Roman descendants are waiting on their British estates for the legions to return from over the channel.

The Only Things That Really Matter in Investing Are Bubbles and Busts

Montier's colleague Jeremy Grantham suggested how to frame problems of this sort in the GMO Quarterly Letter of April 2010. In an article titled "Friends and Romans, I come to tease Graham and Dodd, not to praise them" he wrote on some potential disadvantages of Graham and Dodd-type investing. Grantham attacked the "preposterous belief" that all information is embedded in securities prices and that bubbles and busts can be ignored. Grantham said, in fact, that "I am at the other end of the spectrum: I believe that the only things that really matter in investing are the bubbles and the busts."

In support of this belief, Grantham presented a variety of statistics illustrating that even such "standard" stock valuation criteria as the price-to-book ratio come in and out of fashion, and can over-perform or under-perform over extended periods of time. To extrapolate a little from Grantham's examples, we are already familiar with the work of Reinhart and Rogoff and other historical studies showing how financial crises spawn more crises and are regularly followed by extended periods of sub-par economic growth.

Grantham quotes from Securities Analysis: "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time … and the same applies to inflated prices caused by over enthusiasm or artificial stimulants.” Graham adds: "If ever we were living in a world of artificial stimulus, it is now."

When there is no bubble or bust around, "if you keep your nose clean, you will probably keep your job," by which he probably means that prudent value principles are usually the best investing guide. During bubbles and busts, however, the usual value principles may not be the best way to go. He exhorts: "But when there is a great event, that’s the time to cash in some of your career risk units and be a hero." The end of the age of credit excess certainly qualifies as a great event in my book.

A Margin of Safety

Should we base investment decisions on recent historical distributions or on the dynamics of bubbles and busts? Where does the margin of safety lie? If we take Grantham's advice, "the only things that really matter in investing are the bubbles and the busts." If you are living in a bust, maybe the future consists of something other than a statistical sample of the recent past. Maybe you should think seriously about the life cycles of bubbles and busts.

Treasuries look dangerously over-valued to our eyes, but our eyes have been trained by lifetimes spent in a credit-crazed culture worried about inflation. It is not surprising that, since Montier's article, the yield has fluctuated from 2.50% to 2.70%.  Howewever, if we are in a debt deflation, supported by extraordinary government intervention, maybe there is a better than average chance that Treasury yields will stay low for longer than Montier suggested. It also helps that a contraction in private debt issuance has made room for expanded government issuance without a backup in yields. Or maybe the economy will come back and tank bonds. There is no sure thing here.

Whatever the eventual outcome, there is much more to the Treasury bond situation than a simple comparison to historical average yields. Past returns are no guarantee of future results.

Sunday, August 15, 2010

A Stochastic Stopping Problem

Police stand guard outside the entrance to New York's closed World Exchange Bank, March 20, 1931

How safe are Treasuries? Won't Treasuries fall when enough people start worrying about the ability of the US to finance its national debt? I recently read an article in Capital Gains and Games saying "the bond market today is exhibiting no worries about the deficit or federal borrowing at all" and "there is little or no concern on Wall Street about the government’s borrowing, either short- or long-term." In other words, the article says that we should have confidence in the markets to price risk.

Such confidence in the markets is totally wrong, I believe. Market prices fluctuate over time, and attitudes toward risk change over time. Today's markets prices only tell us what participants believe today. Sure, from today's perspective, with the Fed buying Treasuries and the economy heading lower, it looks profitable to hold Treasuries. But today's market conditions won't last forever, and we need to ask "When will these conditions end?"

The condition of the fixed income markets is hardly normal today. The Fed has bought nearly a trillion dollars of mortgage-backed and other securities in order to keep interest rates down and to encourage markets to operate. Other governments buy Treasuries to meet their currency and interest rate goals. Governments buy for policy reasons, and they will sell for policy reasons.

Other market participants buy Treasuries for their own reasons. Sovereign risk troubles in Europe have pushed huge amounts into the dollar for safety, and US bankers also need safety and park their funds in Treasuries. When the Fed guarantees easy monetary conditions and the economy is weakening, it is only logical that money managers shift their money into Treasuries. But these are all short-term perspectives. When the risk-safety equation changes, money managers will shift out of Treasuries and into whatever offers safety or return at that time.

This is a familiar situation: Three years ago commodities were high and climbing. Five years ago housing prices were high and climbing. Fifteen years ago, internet stocks were starting their climb. Eighty-one years ago, stocks had reached a "permanently high plateau". People lost fortunes believing that the prevailing conditions would continue indefinitely.

Many people feel that Treasuries are a good buy today, and it sure looks profitable, but this is short-term thinking. No serious investor plans to hold long or intermediate Treasuries to maturity. They hold for today and they have plans that define when they will sell. It hasn't been long since we heard the slogan "Now is the best time to buy a house." It hasn't been long since people bought "good" stocks and planned to hold them forever. These were mere slogans serving the purposes of narrow interests.

John Singer Sargent, Orestes Pursued by the Furies (mural, 1921), Boston Museum of Fine Arts

Economic indicators look weak, and the Fed is telegraphing the intent to keep monetary conditions extremely accommodative. How long will these conditions continue, and how will Treasury investors know when they should sell? How can they avoid getting caught in the last-second stampede for the exit?

All of you operations research types will recognize this as a stochastic stopping problem -- we get a reward for investing in Treasuries as long as the environment is disinflationary and accommodative, but we lose a whole lot if we still hold Treasuries when the Final Trump sounds. Although there is a world of contingent risks, the predominant controlling factors are in fact very few. The stopping problem is a bet on what politicians and the Fed will do.

Formulate a payoff function and a risk curve, and then answer me this: How much should we bet on Treasuries, and when should we sell?

NOTE: In classical times Greeks and Romans did not speak the name of the Furies out loud, lest they attract the Furies' attention. It was considered more prudent to refer to "the Friendly Ones" or a similar euphemism. Perhaps the Fed is now in the position that saying anything at odds with an accommodative monetary policy is like shouting out the true name of the Friendly Ones.

Wednesday, August 4, 2010

What's in Store for QE II?

There has been much talk in recent days of policy changes that the Fed might make at its meeting next week. Such talk has heightened in the wake of last week's statements by St Louis Fed President James Bullard that there is a need for more quantitative easing, and Chairman Bernanke's warnings not to tighten policy too soon. The Fed's balance sheet has been contracting as its portfolio of securities gradually matures, taking badly needed money out of the struggling economy. Another round of QE might reverse or compensate for this trend.

Given the likelihood that QE will impact my portfolio in one way or another, I decided to check out recent news stories for a small sample of what other market watchers anticipate.

Option: Stop the MBS Roll-Off

An article in the WSJ "Fed Mulls Symbolic Shift" predicts that the latest plan is for the Fed to use proceeds from maturing mortgages on its books to buy Treasuries. Paul Sheard, chief global economist of Nomura Securities, also published a note guessing that this would be the Fed's move (as reported in The Telegraph).

The Fed has a lot of mortgage-backed securities on its books from its previous QE program, and as these securities mature the proceeds remain at the Fed and the amount of easing achieved through the mortgage purchase program gradually falls. This amounts to a gradual tightening process that the economy hardly needs right now. "Buying new bonds with this stream of cash from maturing bonds—projected at about $200 billion by 2011—would show the public and markets that the Fed is seeking ways to support economic growth."

Giving some support to the option is that Charles Plosser, president of the Federal Reserve Bank of Philadelphia, said in an interview last week that he was open to reinvesting proceeds from maturing mortgage bonds into Treasury securities.

Option: Roll Off the SFP Program

A different guess was put forth by Barclay's Joseph Abate, who believes that the Fed will allow the Supplemental Financing Program to roll off, which would free up the $200 billion that the Treasury holds on its books for that program. According to Zero Hedge, Abate thinks that this would have a bigger impact than merely letting $10 billion a month of MBS roll off the Fed's books, which he thinks would be too gradual to have little impact on rates.

Recall that the SFP consists of a series of special Treasury bill auctions, the proceeds of which are maintained in a Fed account in order to drain reserves from the banking system, so as to offset the reserve impact of other Fed lending and liquidity initiatives. Abate's suggestion was that the Treasury will roll off the SFP by ending the 56-day Bill auctions, thus pushing almost 200 billion dollars into the banking system in only 56 days.

As for impact, Abate thinks that the disappearance of SFB would likely push bill and repo rates well into the single digits, without needing to buy additional securities, and it would then allow the natural attrition of the Fed's portfolio to slowly proceed, as had been the intention when the economy was expected to do better. Some commentators have referred to this option as QE Lite.

QE Is Just a Way to Inflate Asset Prices

The prospect of renewed QE has not been entirely popular. One of the critics has been PIMCO's Bill Gross who said on Bloomberg that QE cannot be very effective since it is just a shuffling of financial assets, and that it would inflate asset prices more than consumer prices. These are valid criticisms, but of course, maybe rising asset prices are what the Fed wants. Chairman Bernanke has said that a rising stock market would be a big help to the economy -- even thought that is kind of like getting the cart in front of the horse.

Gross also repeated his criticism of whether the US can get out of debt by issuing more debt. As much as I poke fun at Gross on occasion, he is right on target there.

Who Benefits?

Any extension of the Fed's earlier asset purchase program will just stimulate the markets to buy up more of the riskier assets. None of this gets into the real economy. Because banks need to control risk , they aren't lending. New money stays with the banks, who will continue to speculate in ways that will merely levitate asset prices -- bonds, stocks, commodities, etc.

This is good for the financial elite who profit from this speculation. Of course, we taxpayers are the ones stuck with paying the interest on those Treasury securities and making good on losses from all the other asset purchases that have propped up asset prices and forced interest rates so low that leveraged speculation is nearly free.

According to a comment to a related Zero Hedge article: "Our government and the federal reserve run a massive Ponzi scheme. Take from the bottom and transfer to the top. Been going on for 30 years. ... the only people who keep ahead of inflation are those that benefit from cheap credit and leverage. The great majority loose."

The financial elite don't even have to wait for the Fed to act. By telegraphing its intentions, the Fed has given the highly leveraged speculators another chance to score "as the market attempts to front run the Fed in buying up Treasuries."

The Fallout

The Fed is betting that the US can grow its way out of its debt mess, and it sees QE II as a way to move the economy forward again. In other words, they think that more debt can get us out of debt. Does anyone else believe this idiotic idea? Worthless debts must be written off and the losses recognized before the US can start on the road to healthy growth again.

Those in power can become blind to the truth. In his book Collapsed, Jared Diamond gives good examples of societies that have adapted to crisis and societies that have failed to adapt to crisis. The failures that Diamond uses as his examples either misunderstood the nature of the crisis, recognized it too late, or chose to ignore it. It is fair to say that the last group were arrogantly wedded to the status quo -- sort of like the US financial oligarchy. Maybe the Fed should read Collapsed.

The Bottom Line

As much as I enjoy Marc Faber's commentary, I don't take seriously his warning that investors avoid bonds, and that the US is at the edge of "the final crisis." Not yet anyway, because the US still has an economy, is still viewed as credit-worthy, and because in the developed world, the US is still the best of a bad lot of heavily indebted nations. But the day of crisis could come eventually.  But maybe later.

We need to consider about what the Fed does next, after QE II fails to stop the US from falling deeper into recession. This may happen sooner than some anticipate. Private forecasters generally expect real GDP to grow by an annual rate of about 2¾% in the second half of 2010. If the picture deteriorates and they forecast growth falling below 2%, which seems increasingly likely, the Fed would be more likely to act in a way that could alarm some holders of US securities.

To get an idea of what might follow in the future, we will need to pay attention to what the Fed does this time, and to the markets' reactions to this coming round of QE.

Tuesday, July 13, 2010

Shared Sacrifice

Edward Hopper, Railroad Sunset, 1929.

A Prolonged Economic Slump

With the recently renewed concern that the economy is faltering, a number of writers have been hazarding guesses at how the debt crisis may eventually resolve itself in the context of an economic downturn. Especially interesting are the recent writings of David Rosenberg, Bill Gross, Niall Ferguson, and Edward Chancellor, which contain a number of common threads on this topic.

These threads combine to make a scenario that differs from some of the more extreme forecasts, in that it does not necessarily sound like a complete disaster for the US -- no deflationary spiral, out-of-control inflation, or currency crash. Just a prolonged economic slump driven by austerity and the rebuilding of balance sheets.

Fiscal Prudence Means Shared Sacrifice

David Rosenberg, Chief Economist at Gluskin Sheff, makes the argument for a prolonged economic slump in a recent Globe and Mail opinion piece.  According to Rosenberg, fiscal prudence is taking over at the individual and government levels. Without credit or spending to fire the economy, it will limp along with some degree until balance sheets are sufficiently repaired to bring growth again. This will take time. He bases this scenario on the assumption that the US population is sufficiently shocked from the debt crisis to change its economic behavior permanently:

"It is reasonable to assume that the economic behavior of the population in general, and the baby boom cohort in particular, is on the precipice of a dramatic change, as Main Street has enough understanding of the situation to start to take action to get its balance sheet in order."

He assumes that the economy does not fall apart in a deflationary collapse, allowing debts eventually to be paid off enough that economic growth can begin again -- although it may take some time:

"Most likely, what happens next is that the credit collapse proceeds on the back of a severe form of the “savings paradox,” resulting in a prolonged economic slump. The good news is that it will ultimately lead to a balance sheet rebuilding process, both at the household and government level, that can sustain the next secular economic expansion."

That doesn't sound too bad, because he says that the US will avoid total catastrophe, like debt default, currency collapse, or hyperinflation. However, working down debt will require fiscal austerity by everyone in society, which will not be a pleasant experience for the participants:

"In the meantime, an enormous amount of shared sacrifice will be required." (My emphasis.)

Individuals can rebuild their balance sheets by sacrificing consumption if they have incomes.  A problem is that employment will continue to suffer as government will be unable to substitute for private spending:

"Initially, we can expect to see less government, fewer entitlements and higher taxes. ... Less government will require balanced budgets and this will contribute to continued stress in the job market, at least for a while."

Not only consumption, but entitlements will be cut back:

"Currently, the seeds are being sown for a radical restructuring of entitlements. ... Across the nation, sweeping changes are taking place as pension trustees and legislatures push for higher monthly contributions to pension plans, a later retirement age and lower annual cost-of-living adjustments for current and retired workers."

Cutting back entitlements will force much of the population to cut back spending and save:

"Out of necessity, the boomer population will be pursuing a strategy of working longer, saving more and reducing their debt obligations in order to secure a comfortable retirement lifestyle, while at the same time the public sector moves in the very same direction toward fiscal probity."

This of course guarantees the the downturn is prolonged.  One has to wonder how boomers can work longer and save for retirement if there are no jobs for them. One also has to wonder how the unemployed, the disabled, and the elderly are going to survive if entitlements are cut to the bone. The payoff for all that suffering could well be that it buys enough economic and financial stability for the US to dig itself out of the hole:

"... what we could well be in for is a prolonged period of price stability or modest deflation. It is reasonable to assume that a resumption of strong GDP and earnings growth in the future and a resumption of inflation and appropriate inflation investment strategies will have to await the end of the rebuilding phase as it pertains to the household and government balance sheets."

Harry Sternberg, Builders, 1935-36.
The Lenders of Last Resort Are Out of Money

The latest monthly commentary latest monthly commentary by PIMCO's Bill Gross supports important parts of Rosenberg's scenario. Part of PIMCO's New Normal is the notion that the advanced world has run out of funding sources with which to restart economic growth. If not even sovereigns can lend, economies will remain subdued and there will be "low total returns on investment portfolios" until debts are paid down.

"Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened."

Shared Sacrifice Includes Default on Unfunded Liabilities

Harvard history professor Niall Ferguson also sees the US as avoiding an inflationary outcome, but he foresees problems with the deleveraging process. In fact, he does not see how the US can work off its debt without some kind of default.

The problem, he says, is that extreme debtors have rarely been able to grow their way out of debt in the past, and the conditions that allowed the rare historical case (like Britain after the Napoleonic wars) just don't pertain now. (We aren't the beneficiaries of a new industrial revolution.) This leaves inflation or default.

"Right now there is no sign of inflation. We have monetary contraction at an alarming rate, and zero inflation in terms of core CPI, so the option of inflating this debt away doesn't seem to be there right now. What you are left with is therefore default."

This could but doesn't necessarily have to include outright default to bondholders. Ferguson doesn't mention it, but we will later discuss a point of view saying that US outright default on its debt is very unlikely, given the past situations where this has occurred. Ferguson suggests this kind of default:

"And I think it is a fair bet that US will default at least on the unfunded liabilities of Social Security and Medicare at some point in the foreseeable future."

So we have another voice suggesting that the solution will include the dismantling of social programs. This would be part of the American people's if there is a prolonged slump.

No Default, but Bond Yields Are at Risk

GMO analyst Edward Chancellor has written a very interesting paper on the dynamics of extreme sovereign debt loads, which also contains a very interesting comparison to the current debt cycle. Given the historical preconditions for default, Chancellor concludes that the "US is not on the verge of a default." The US has carried high debt loads in the past and not defaulted outright, and it has the advantage that its debts are denominated in its own currency (although a lot of debt is foreign-owned). He agrees with the other forecasts in this respect, although not in others.

Chancellor thinks that "inflation is more likely than default in the US" because "public finance is a ponzi scheme." This makes the current environment of low government bond yields a very risky one for the bonds of the advanced economies:

"Under only one condition - that the world follows Japan's experience of prolonged deflation - do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don't appeal to us."

Despite this admirable risk aversion, Chancellor is self-contradicting in one respect. First, he says that US debt can be paid off only if interest rates remain low. Then he says that inflation is the likely outcome, and that bond prices will suffer then. He glosses over the implications for servicing the interest and rolling over maturing US sovereign debt (and private debt) if rates rise. Perhaps this contradiction is an honest reflection of the impossibility of forecasting, but the contradiction also masks the ugliness and unpredictable instability of debt servicing under rising yields.

Such uncertainties reflect real risks in future outcomes. Even if we end up in a deflationary economic slump, there is no guarantee that it will provide a smooth ride with price stability or mild deflation all the way to recovery.

Thomas Hart Benton, Mine Strike.

How the Sacrifice Will Be "Shared"

The "shared sacrifice" is really a "soft default" on entitlements, which are seen by the financial elite as mere promises of hippie liberal governments. However, so-called entitlements are in fact the foundation of life planning for a good part of the US citizenry. Such promises include essential components of a retirement plan, including program like Social Security and Medicare, which many people have already paid for during their working lives.  If people have paid for Social Security and Medicare during their entire working lives, and planned their retirements based on these payments, they don't look at those programs as "soft" entitlements. In fact, they deferred consumption in order to pay for these insurance programs, and they planned the course of their lives around them.

Rosenberg says that boomers will work longer, in order to save for retirement. How are they to do this when there are no jobs? They are hardly likely to work longer when they have no jobs in the first place. They will just languish in poverty and illness until sinking away to an early death. That is the "shared burden" that Rosenberg is really writing about.

Not everything will be sacrificed. You can be sure that zero-interest money will continue to flow to banks, who will use that money to engage in more speculation and provide bonuses to their most "productive" parasites.

Sacrificeing to Pay Down the Debt

There are many ways of achieving "soft default" on the programs that the common people have worked so long for. In the case of Medicare and Social Security, the government can raise age limits, reduce inflation indexing, phase in benefits over longer periods, index to individual net worth, or other tricks.

At the local level, education, public safety, and other basic services are already being sacrificed in order to avoid raising taxes. State governments have already started cutting back on essential social and health services such as meals for shut-ins, family crisis centers, and higher education. There are many more elements of civilized life that the elites will find a way to cut.

Don't forget tax policy. The elites will be sure that unearned income (economic rent) is taxed at lower rates than earned income. If taxes on earned income are raised, what do they care? If you complain, you are just opposing the wonderful capitalist system that rewards risk taking. Never mind if you invest your life and effort in training and labor, and then end up supporting the rich with your taxes.

This is only one, alternative scenario, but perhaps it is what the elites of the developed nations are hoping for. It is easy to believe that their cries for "austerity" are really calls for "soft default" in the form of fewer entitlements. After all, the financial elites managed to default on the losses that the banks suffered in the wake of the mortgage crisis due to their greed and incompetence. The taxpayers shouldered that burden. Why stop there?

The "prolonged deflationary slump" has a lot going for it as a plausible scenario for the future of the US, but it assumes that the US taxpayer can pay down much of the private and public debt loads.  Unless the US frees itself of the financially-driven bubble economy grows and restores a foundation for real, organic growth with employment and income growth, the slump may turn into something worse.