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.