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.