I have a book on my shelf, called The Money Market, by Marcia Stigum. It covers the workings of the capital markets, from basic instrument details of bonds, commercial paper, and so on to detailed discussions of how banks operate in the money markets to service client needs. There are chapters on futures, options, and swaps, government securities, repo markets, and bankers’ acceptances. When I first came into the market, in 1990, I bought a copy of this book and read it cover to cover – all 1250 pages of it. Together with Money Market Calculations: Yields, Break-Evens, and Arbitrage (also Stigum), it was absolutely essential reading for people entering the bond market.
The third edition was published in 1989, and is fairly out-of-date by now. Unfortunately, Ms. Stigum died in 2003 and so the fourth edition (now called Stigum’s Money Market), although updated by Anthony Crescenzi, is not quite on par with the prior versions. I would still recommend the fourth edition, however, to anyone who is actively considering entering the bond markets as a career.
But I have another book that I would recommend both to the people who are thinking of trying to get onto a Wall Street trading floor to pursue a career in finance as well as to those people who are just curious about how the trading floor really works. It is called, appropriately enough, How the Trading Floor Really Works. It is published by Bloomberg Financial, and written by Terri Duhon. (Disclosure: I worked with Terri for a brief time when we were both at JP Morgan, so I know she is writing from a position of knowledge on the topic).
This is not meant to be a mechanically precise book, like Stigum’s books on money market calculations. For example, in the section on derivatives, Duhon dispenses with such details as the fact that in a USD interest rate swap Libor is typically paid quarterly on an actual/360 day count basis, while the fixed side is paid semi-bond. That’s a detail that is utterly irrelevant for the purposes of this book, which is to illustrate how and why a Wall Street broker/dealer does what it does: how it makes money, how it services clients, how it balances the short-term profit and long-term profit motives, and what the different functions on the trading floor are (and how they fit together). The book begins with chapters on “What Are Financial Markets,” and “What Role Do Banks Play in Financial markets,” and later discusses “How Do Traders Make a Market,” “How Is Proprietary Trading Different from Market Making,” and “What Is the Relationship Between Sales and Trading?” The book addresses cash, derivatives, how “structurers” and “quants” are engaged in the bank’s business, and how risk is managed.
Crusty Wall Street veterans will not find anything in here that is terribly surprising, but most people with a “Main Street” view of Wall Street probably will. One really neat feature of the book is the generous sprinking of market anecdotes describing actual episodes on various trading floors (thankfully without names). These give the book an honest verisimilitude – I can attest that these things actually happen on trading floors, and indeed I am pretty sure that I was actually present for one of the vignettes.
I really enjoyed the book. If you are curious how Wall Street actually works – this is a book you should consider reading (and it’s only about 1/3 the cost of the Stigum book!). You can go to the Amazon page from the link above.
Things are getting a little chippy in the EU, and I don’t mean on the soccer pitch. While in the U.S., the economic data continues weak (with Consumer Confidence and core Durable Goods the latest numbers to fall short of expectations, although not terribly so), the important drama is still on the continent.
Temperatures are rising, at the EU summit meeting and outside of it. George Soros has started the Countdown to Disaster; the three days he declared Europe had left to act to avoid a “fiasco” ends tomorrow (generously, let’s give him until the end of the week). But years from now, we may look back on the behind-closed-doors, but widely-reported, declaration by German Chancellor Angela Merkel that Eurobonds and other forms of pan-European debt sharing would not happen “as long as I live” as being the moment of clarity. If it were just Merkel saying this, it would mean little. But Merkel’s position has not been softening with time, but hardening; she is, in short, moving to a position more in tune with her electorate. Germany is not going to agree to Eurobonds. Europe better hope that the EFSF and ESM are enough, because that seems to be about the extent of what it is willing (or able) to give.
Some observers think this is just a hard bargaining line, and that Germany will agree to union as long as it’s a German-dominated union. I don’t think it is a bargaining line, but for a minute let’s suppose it is and let’s ignore the touchy question about whether the other creditworthy Eurozone entities – Finland springs to mind – will blithely hand the checkbook over to Germany. If such a fiscal and political union actually happened, it might defer the Euro crash for years or even a decade or two. But European union will not work in the long run if one country is put in the driver’s seat. Because what happens when Germany’s time to be ascendant is over? Can you imagine if the EU was led today by Italy? Well, between 300BC and 300AD, Rome was the unquestioned seat of European power. Spain was also a world power once, as was Portugal, and of course France during Napoleon’s time. The only way that a confederacy works, such as the one that includes such different populations as Texas and California, is if none of them is in charge.
In other words, the best chance that Germany has to remain the unquestioned leader of continental Europe is for it to remain independent, not for it to accept vassal states. To me, it looks like that nation is gradually figuring out that its interests are not in fact shared sufficiently with its neighbors to continue down an irrevocable path. I suspect Greece is as well, for the opposite reason.
Meanwhile, although U.S. growth indicators have been surprising on the downside (the Citi Economic Surprise Index for the U.S. is at -60.9, but it was as low as -117.2 one year ago), European indicators are significantly worse. The Citi Economic Surprise Index for Europe is at -90.5, just about as bad as in the months following the Japanese disaster last year and otherwise the worst levels it has seen since 2009 (see Chart, source Bloomberg).
The chart doesn’t illustrate the level of economic activity, but rather the severity and frequency and degree of the miss of the actual data relative to expectations. A big negative number means things are getting worse faster than economists predicted (or it could mean, in a different context, that they’re not getting better as fast as they had predicted). In that context, consider the next story, which ran on Bloomberg today: “Draghi May Enter Twilight Zone Where Bernanke Fears to Tread.” The article suggests the ECB is considering cutting interest rates to zero in fairly short order, and might even make ECB deposit rates negative as a spur to get banks to take money out of the ECB vaults and lend it. Gee, what a fine idea – I wonder where I’ve heard that before?
The Fed doesn’t want to lower the overnight deposit rate below 0.25% because they are afraid of damaging the money market industry irreparably. The lack of confidence that the Fed has in capitalism to figure out a way that the money market can survive and/or regenerate once rates rise again is appalling. Sure, I know that the government is doing everything it can to destroy the finance industry so that it can never regenerate, but I think Fidelity would figure something out if money market interest rates were negative. For example, it could design a money market fund that wasn’t guaranteed at a buck. See? That wasn’t hard.
Yes, doing this would hurt the credit quality of the European banks. Golly, that was hard to even write with a straight face. Look, the sovereigns will end up bailing out many or most of the banks anyway. So what if they make some negative-expectation loans? Isn’t that whole point of forcing negative real rates anyway?
I have some comments on oil and TIPS but I will save them for tomorrow. I want to make sure I say congratulations and welcome to a professor (and good friend) of mine who recently posted his first on-line article here. Dr. Huston is an outstanding economist, a very creative thinker, a fine nurturer of student minds, and an enthusiastic lecturer. His article points out the current status of the “Fed model,” and illustrates the point that stocks are quite cheap relative to bonds on that model (although it’s a bad model for trading decisions!). I agree that stocks will probably outperform nominal bonds over the next ten years, although neither return series will be very exciting and inflation-linked bonds stand a chance of beating both of them depending on how much margins compress and multiples fall when inflation first rises. Congratulations on your first post, John. (By the way, he and co-author Roger Spencer – both of Trinity University – wrote an outstanding quantitative history of the Federal Reserve called “The Federal Reserve And the Bull Markets: From Benjamin Strong to Alan Greenspan.” At $110 I can’t recommend you buy it, but persuade your local library to buy it so that you can check it out! Or better yet buy it, donate it to the library when you’re done, and get a tax benefit.)
Over the weekend, the Spanish crisis was semi-resolved with the EU agreeing in principle to give money from the ESM (which isn’t operational yet) or the EFSF to the FROB (the Spanish banking entity). The €100bln will likely be senior to other Spanish government obligations, although this is not clear.
In fact, there is a fair amount that isn’t clear. Equities shot higher by 20 S&P points overnight, only to fall back to +7 before the NY open and finishing the day down 16.7 points, -1.3% on the day.
Stocks may have been taking a cue from Spanish and Italian bonds, which were smashed today. Spanish 10-year yields rose 30bps (see Chart, Source: Bloomberg) while Italian 10y BTP yields rose 12bps.
It may seem like the market is lodging a no-confidence vote, but I am not so sure that’s indeed what is happening. Yes, in general it has been a good trade over the last couple of years to bet that the grand plans will come to nothing, and quickly, but this is still the most decision-like announcement that we have yet seen come out of one of these weekend meetings. Yes, this only helps the Spanish banks, and Spain is likely to still need money while the ESM/EFSF now has €100bln less in capacity. But depending on the details, this isn’t a horrible attempt to address a very specific problem. The question, of course, is whether this is a specific problem, or a general one! (Pete Tchir had a great line; he said “Fixing Spanish banks is a bit like drowning one lawyer – a good start.”)
But the rise in Spanish government bond yields doesn’t necessarily mean investors view the announced measures as a failure. Rather, it might indicate that investors view the announced measures as a success and likely to happen – since once element of that program would be (probably) the subordination of the claims of Spanish government debt holders. It is entirely rational to mark yields higher when debt goes from a senior position in the capital structure to a junior position in the capital structure. The question is, what does it do next? That will be the real indication that the announcement quelled some of the fear that had developed…or did not.
Let’s not forget that Greece goes to the polls next weekend, so even if you thought the result of this weekend’s meeting was terrific, we still might be sitting here in a week staring down a Euro exit or breakup.
Book Review: Finance and the Good Society
Today’s is a short article, so I thought I would take a few paragraphs to review briefly a book I just finished reading: Bob Shiller’s Finance and the Good Society.
I took up this book expecting, frankly, that it would be far too left for my personal tastes. I have great respect for Dr. Shiller, and like many other people I thoroughly enjoyed Irrational Exuberance. I was less impressed by Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, which he co-wrote with George Akerloff, but still judged that to be a book worth reading. In general, while I enjoy the application of behavioral economics insights to real world problems, I feel that Dr. Shiller sometimes goes a bit off the rails with redistributionist perspectives.
The reason that redistribution schemes don’t tend to work well in real economics can be illustrated with a simple, familiar example. Suppose that in a poker game, whenever a player won a pot he collected only a fraction of the pot; specifically, the larger his stack of chips already is, the smaller a share of the pot he gets and the more is distributed to the shorter stacks. Obviously, such a scheme is redistributionist, but if the measure of “good” is taken to be the Gini coefficient or some other objective measure of the evenness of the wealth distribution then this may seem to be a positive improvement to the normal way of winner-take-all from each pot. But advocates of this sort of policy tend to overlook what will happen to the game: if you are sitting on a big stack, you will tend to avoid playing most hands, since your benefit from victory is less the larger the stack you start with. The economic equivalent is that in heavily-taxed societies, the wealthy do not provide as much capital to the system – and so it isn’t a priori clear if more-progressive tax rates will create a more-balanced distribution of wealth. Unless you force them to ante, via a wealth tax…but let’s not go there.
Anyhow, I’m drifting off-topic: Finance and the Good Society pleasantly surprised me. What is great about the book, and surprising I suppose, is that Dr. Shiller spends a great deal of time explaining why the practice of modern finance is mostly good. In Part I, he devotes one (short) chapter each to CEOs, Investment Managers, Bankers, Investment Bankers, Mortgage Lenders and Securitizers, Traders and Market Makers, Insurers, Market Designers and Financial Engineers, Derivatives Providers, Lawyers and Financial Advisers, Lobbyists, Regulators, Accountants and Auditors, Educators, Public Goods Financiers, Policy Makers in Charge of Stabilizing the Economy, Trustees and Nonprofit Managers, and Philanthropists. In each chapter, he explains why this particular role is necessary. Honestly, it’s worth the price of the book just to read an outstanding explanation of why Derivatives Providers, Financial Engineers, and Mortgage Securitizers aren’t inherently evil.
In Part II, Shiller dwells on the problems of modern finance. These we know all too well due to the events of the last five years: problems like “An Impulse for Risk Taking,” “Debt and Leverage,” and “Some Unfortunate Incentives to Sleaziness Inherent in Finance” among others. But unlike in his book Animal Spirits, he does detail some policy prescriptions (including how certain institutions could be redesigned to have the proper incentives). I must be very clear that I don’t agree with all of his policy prescriptions, but I tended to agree with his assessment of the problems.
All in all, this is an even-handed book that makes a distinction that has been rarely made in the post-crisis witch-hunt: hate the sin, love the sinner. The people involved in finance are, in general, good people and the structures, in general, work well most of the time. Improvements can be made, and when the serial crises are over in a few years, hopefully we can discourse intelligently on these improvements. Dr. Shiller has made a good contribution to that discourse with this book.
 In fact, if the proportion of the pot that you get to keep if you win is p, and the expected amount that you have to invest in the pot to win, as a share of the total pot, is y, then you will only play in a hand if your expected probability of winning the hand is at least y/p. Therefore, you will only play if you can win very large amounts of money relative to the amounts you bet, or if the odds of your winning are high. In normal poker where p=1, you will bet if your “pot odds” are better than your chance of winning. But in “taxed-winnings” poker, you need much better pot odds relative to the chances of winning.
I begin to wonder how much more ‘flight to quality premium’ there can be in U.S. Treasury bonds. Today Greek 10-year yields rose 59bps to match the old highs around 17.7%, Italian bonds rose 20bps to a new high of 5.95% (and the 10y BTPei real bonds +33bps to 4.13%), and Spanish bonds rose 25bps to a new high of 6.27%. The dollar rallied (a little), and equities dropped fairly sharply for a day with no news although indices recovered half of their losses by the close (S&P -0.8% and now down for the month after a torrid start).
And Treasuries? Unchanged.
TIPS rallied 3bps to 0.50% on the 10-year issue – I pointed out last week that weakness in Italy could perversely benefit TIPS and other ILB markets – but the real winners on the day were Precious Metals, +2.1%. Are precious metals becoming the new flight-to-quality (FTQ) instrument?
Please, gold bugs, don’t plaster me with hyperventilated assertions that precious metals have always been “the” safe-haven instrument. They have always been “a” safe-haven instrument, but as they are less liquid than Treasuries and much more volatile, they have not traditionally been a flight-to-quality investment for institutional investors. Buying a billion dollars’ worth of gold is not something you can do in ten minutes to hide out for the weekend, but you can do that in T-Bills. Actually, in T-Bills it will take you less than a minute.
Perhaps a more-nuanced answer (that will keep my house from getting egged by “the gold people”) is that while precious metals are not a flight-to-quality instrument for normal crises, they do serve as a FTQ instrument for catastrophic crises, and while we have never really had one of those during the life of this republic, arguably our crises are starting to look less and less normal and more and more catastrophic.
But the simple answer to my hypothetical question is “no,” for the reasons I have just given. But then, what is the FTQ investment these days?
It needs to be something with a stable value (preferably, stable in real space), and part of a deep and liquid market. This is why short-dated Treasuries have historically been the FTQ investment: the market is huge, you can buy and sell a whole lot of them very easily, and for short-dated maturities there isn’t much price risk (because you’re assured of par at maturity). TIPS would be better, because you’d be protected from inflation (albeit with a lag), but there aren’t nearly enough short-dated TIPS to serve the function. T-Bills historically have tracked inflation with a lag and provided a small negative real return; in a crisis this isn’t going to happen since the Fed will tend to clamp short rates at zero and intentionally produced a large negative real yield, but it’s as good as it gets.
However, if the crisis involves the solvency of the U.S., then what?
We don’t have to worry about that yet. T-Bills can trade (and have in fact traded) with negative nominal yields, so there’s always a price at which you can buy some. But the reaction today in fixed-income land despite significant moves in some other markets suggests that investors who are buying Treasuries – especially longer Treasuries – for something otherthan a FTQ reason are already paying a not-insignificant FTQ premium to do so. There are other solutions, but this article is too small to contain them.
The main U.S. contribution to trading intrigue will actually come in the evenings. Kansas City Fed President Hoenig will be speaking on Tuesday night on “Monetary Policy and Agriculture.” As a frequent-dissenter, his speech will be a decent indicator of how tight Chairman Bernanke has pulled the choke-collar with the new communications policy. On Wednesday the head of the NY Fed’s Markets Group, Brian Sack, will be speaking to the Money Marketeers. That’s the group before which, in December 2009, he delivered a great speech (which I discussed and excerpted here) about the effects of large-scale asset purchases on market rates that had one glaring error. I like to call it “Dr. Sack’s Perpetual Motion Money Machine.” Dr. Sack proposed ways to drain liquidity from the market when it was time to do so, and seemed to think that although the Fed pushed rates lower by buying securities (anyway, that was the whole point of it), they wouldn’t push rates higher by selling securities. If that’s true, then the Fed ought to do this constantly, in the largest size they can, because they can add tons of liquidity without any market cost and can drain it at will without ill effect. I discussed the perpetual motion machine here. There is another speech by Dr. Sack that I excerpt here.
Dr. Sack is unusually clear in his exposition, and worth listening to for several reasons. One is that you will usually get something pretty close to the party line; the other is that you’ll probably learn something about how monetary policy works – or how the Fed thinks it works, which is even more useful.
However, I probably shouldn’t beat up Dr. Sack too much, since I will be a presenter myself tomorrow evening (which is the reason I am mentioning Wednesday’s data – I won’t be posting tomorrow). I will be speaking at the NY QWAFAFEW meeting on the topic of “Quantitative Estimation of Inflation Perceptions.” Let me know if you’d like me to come speak to your group about something exciting like that!
 A reference to Pierre de Fermat’s teasing theorem in the margins of a copy of Arithmetica. For a wonderful, entertaining, and easy-to-read book about Fermat’s “Last Theorem,” I heartily recommend Fermat’s Enigma: The Epic Quest to Solve the World’s Greatest Mathematical Problem.
Energy prices jumped today on news that OPEC was unable to reach consensus on an increase in the output ceiling. This would be much more important – and NYMEX Crude prices would have risen more than 1.7% – if OPEC wasn’t already exceeding the quotas by 2mbpd, as I pointed out yesterday. Moreover, there is no real reason, other than political posturing, to raise the quotas in order to lower prices. The world can already take pretty much everything that OPEC can pump right now. When is a cartel unnecessary? When prices don’t need to be jacked up!
Still, equities and bonds hardly needed anything that might be construed as bad news. The S&P dropped -0.4%, while the 10y note rallied 6bps. Now, notice that the Dow fell only -0.2%, and the NASDAQ dropped -1.0%. That is a subtle “flight to quality” into bigger stocks while maintaining exposure to the market, and is consistent with investors’ fear that growth is hitting a rocky patch longer than one month in duration. The old maxim was that in a bull market everything goes up and in a bear market everything goes down, so if you’re bearish you should just get out of the market. But many, many investors these days aren’t motivated by absolute return. Active equity managers are still equitymanagers. Pension funds have policy weights that are adjusted infrequently and don’t usually vary a ton anyway. So much of the money flow isn’t in and out any more, but up and down (in size and quality). CDS spreads have also been widening, with the Markit Investment Grade 5y (June) index up to about 98 from 89 last Tuesday (although as the chart below, of the June14 basket, shows that’s not entirely surprising. Actually, I also throw the VIX on here – the VIX and CDX are inverted – and you can see these are all virtually the same charts. You can buy equity risk in equities, in vol, or in corporate bonds. It’s all the same risk).
This is a good old fashioned growth scare budding. And yet, I am amazed at how much I am reading about inflation. Really, with housing prices dipping again and 10-year inflation swaps 20-25bps off their highs (see Chart below – in fact, since early May the decline in inflation accounts for all of the decline in nominal rates since real rates are approximately unchanged over that period while nominal 10y rates have fallen 20bps or so), you would think that inflation chatter would be ebbing.
But just today, the NY Fed blog had a piece called “Will ‘Quantitative Easing’ Trigger Inflation” from old friend Ken Garbade, who was once the chief bond strategist at Bankers Trust. Ken is a very sharp guy and his 1996 book “Fixed Income Analytics” was (and probably still is) a must-have book for bond traders and strategists.
Anyway, Garbade in that blog article gives the best and simplest explanation I have seen about why the Fed’s payment of Interest on Excess Reserves (IOER) is crucially important in keeping QE1 and QE2 from flowing out into the market and affecting economic activity. Of course, it begs the question what the hell is QE doing if it isn’t supposed to affect economic activity! And there are added questions around the policy, such as whether the Fed is really prepared to continue to pay higher and higher IOER in order to keep that money out of the economy, and also whether they can really calibrate policy so finely. Garbade highlights the issues well.
But that isn’t the only recent piece on inflation from Fed sources. Last week there was this one from the Atlanta Fed’s blog [my comment: inflation traders have long known that the core and headline inflation converge over a period of roughly 15-18 months, so this isn’t exactly innovation but the interesting point is that they’re discussing inflation]. The same day, the NY Fed blog had another piece, by Eggertsson, entitled “Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?” Here is a teaser:
“The Mistake of 1937 was to relinquish the benefits of reflation and to set all policy levers in reverse. The Fed and key administration officials hinted at interest rate hikes and endorsed austerity in fiscal policy; the key concern now was containing inflation rather than sustaining recovery.”
Just yesterday there was another NY Fed blog piece called “A Closer Look at the Recent Pickup in Inflation,” which made the surprising argument (coming from the Fed, anyway) that
“the recent pickup in inflation is indeed quite widespread across a broad swath of CPI goods and services, but no one item has registered inflation increases that are clearly outside the norm of the last decade, not even among the volatile food and energy categories.”
…although they somehow take a benign message out of that when prospective monetary policy is considered. And, finally, last month the Chicago Fed Letter was on the topic “What are the implications of rising commodity prices for inflation and monetary policy?”
This flurry – this is just over a period of a week or two – is noteworthy since the behavior at the top (i.e., Bernanke) is so boringly stable right now. As QE2 winds down and growth is weakening, there is an increasingly wide range of plausible arguments. While Dr. Bernanke has made clear a number of times that he has no concerns at all about making an error (which implies that either the path forward is clear, or that it doesn’t matter), plainly not everyone in the Federal Reserve System is as sanguine. So on the one hand some observers would consider QE2a, reinvesting the maturing bond proceeds ad infinitum, others would wind down the balance sheet over time and still others would start winding it down aggressively. The response of inflation to these actions, indeed the response of inflation to actions already taken, is open for debate.
But while debate is good for the soul, too much of it can be bad for organizations since it tends to produce wishy-washy decisions that displease the fewest number of decision-makers. And in the case of the Fed, too much of it in public is especially bad. The Chairman is trying to appear calm and placid, but his minions are anything but. There is conflict and disagreement around.
And this makes more obvious the fact that the path forward is fraught with risks. And that, in turn, should increase the discount afforded risky assets (actually, the notion of a discount for risky assets is kinda quaint, since most of them are trading with hefty premiums).
Tomorrow is Initial Claims (Consensus: 419k from 422k), the only important data of the week. Look out if the number actually rises, rather than shrinks. That shouldn’t be a terrible surprise at this point, since the context has changed quite meaningfully since April when the series first started to rise. We now know the economy is weakening, so a 430k or 435k shouldn’t change many minds. But there is still disagreement about whether this period of weakness is a ripple or a wave, and every piece of weak data increases the odds that it is a wave.
There was no new growth-related news today, but the markets continued to adjust to last week’s news. After getting smacked twice last week on the same news, markets seem to be shrinking from contact. Oil prices fell 1.5%, and other commodities besides metals (notably Softs and Grains, each down about 3%) were weak. Stocks dropped 1.1% and seem anxious to re-test the lows for the year which lie a mere 3% away and coincide with the 200-day moving average on the S&P.
Nominal and inflation-indexed bonds were both essentially unchanged, and volumes overall were light.
News off the Continent was also anti-climactic, but stocks in Peru dropped 12.5% on the victory of Hugo-Chavez-Facebook-Buddy (and former rebel) Ollanta Humala won a runoff election. This would seem like a one-off affecting only Peru, and perhaps it should be. Indeed other emerging markets ignored the first 9% or so but ended up closing lower. From a practical standpoint the vehicle for contagion is the fact that investors often participate in EM via funds and those funds will take a (small) hit because of Peruvian investments. To the extent that investors scale back EM positions as a result, it will affect many related (perhaps I should say “associated”) markets. Fortunately, Peru’s weight in the indices is pretty small, so even the 18% fall from the highs of last month will have only a small direct impact and the bigger effect is likely to be emotional. But this bears watching.
In a week with little in the way of scheduled economic news, it isn’t surprising to see previously-established trends following through. There is no economic data due tomorrow either, so I expect the beatings to continue.
I read an article recently entitled “Inflation as a Redistribution Shock: Effects on Aggregates and Welfare” that is interesting because of the non-intuitive conclusions it draws. Although the paper is five years old, it comes from the respectable NBER and one of its authors was in the Federal Reserve System when the article was written.
The paper concerns the effects of unanticipated inflation. We all know that unanticipated inflation transfers wealth from lenders to borrowers (although anticipated inflation does not – if the inflation is anticipated, it is reflected in the nominal interest rate), and that also implies that unanticipated inflation causes medium-wealth households – who tend to be borrowers – to gain at the expense of higher-wealth households, and for domestic households as a group to gain at the expense of foreign (nominal) bondholders. The authors also found several redistributive effects among age cohorts, and overall; for example, even though unanticipated inflation has a ‘persistent negative effect on output,’ it surprisingly improves the weighted welfare of domestic households. From the paper,
“Despite the fact that inflation-induced wealth changes sum to zero across agents, the responses of winners (net borrowers) and losers (net lenders) do not cancel out. Among households, the key asymmetry is that net borrowers tend to be younger than net lenders.”
This leads to various effects on the supply and demand of labor and of savings that flow from the fact that a windfall received by the young causes different behavior changes than the (opposite) effect of a negative wealth shock paid by the aged.
But the really interesting part of the result is that most of the losers in a period of unintended inflation can be compensated fairly easily from the windfall that the government experiences (since the government of course is a huge lender). Again, from the paper:
“Thus, while the poor as a group experience a negative direct redistribution effect, this loss turns out to be easy to compensate, precisely because it does not take much in terms of transfers to improve the well-being of the poor.
“From a political economy perspective, these findings lead us to conclude that the government can adopt simple fiscal policies in reaction to an inflation shock which imply that the shock benefits a majority. Thus, policymakers may be tempted to inflate the economy not just because they take some direct interest in the fiscal position of the government, but also because such a policy may actually have wide support if the losers from inflation receive some compensation. It is intriguing to observe that the U.S. inflation episode in the 1970s started right after Social Security was first indexed to inflation in 1972. While this policy change is unlikely to have been the main cause of the episode, it certainly lowered the political cost of inflation…” [emphasis added]
And in their conclusion:
“Our findings therefore lead to some doubts regarding the conventional wisdom that low inflation is always in the best interest of the domestic population. There is a sizeable fraction of the U.S. population which would stand to gain if another inflation episode such as the one in the 1970s were to occur…
“One of our key findings is that the cohort welfare effects are highly sensitive with respect to the fiscal policy regime followed by the government…If the windfall is used to raise pensions, …the poor as well as the old middle class are compensated for all their losses, and most groups, apart from the very rich, stand to gain from inflation.”
Well, oh my as my sainted aunt might have said. This is an interesting thought process, because the conventional wisdom (and what the Fed has said many times through many different mouthpieces) and research generally holds that aggregate social effects of an inflationary period are negative, at least partly because of economic frictions created by rapidly-changing prices. But these authors illustrate that isn’t necessarily true when one considers the different effects that inflation has on different economic actors, and the way government can respond.
It isn’t like the Fed needed any more ammunition to risk an inflationary debacle; they’re doing that already. But it is worth thinking about whether we might have it all wrong, and that all the talk is mainly meant to ensure that the inflation remains unanticipated. What if the Fed was actually trying to cause a general inflation? Especially if you’re one of the “very rich” who would be sacrificed in that situation, it is worth considering that possibility!
 Although in itself this isn’t particularly noteworthy. The Federal Reserve System is far and away the most popular single U.S. destination for economics PhDs.
Although commodities do occasionally crash, in general commodity prices are positively kurtotic (fat-tailed) and positively skewed. This is in contradistinction to equity prices, which are positively kurtotic but negatively skewed. In English, that means that both stock prices and commodity prices crash more than we would expect them to if price changes were random, but while stocks tend to crash down, commodities tend to crash up.
The reason for this is simple: commodity supply curves become very inelastic (steeper) when the level of actual, current inventory is fully allocated. There are only so many soybeans available right now. But at low levels of demand and lower prices, the supply curve gets more and more elastic (flatter), which means large declines in demand don’t drop prices as sharply as large increases in demand can increase them at the other end of the curve.
The practical import of this observation is this: one must be more careful shorting commodities than shorting stocks, because while a bull market in stocks can grind you to death, a bull move in commodities can rip you to suddenly to shreds (the fact that in a limit up market there is literally no price at which you are allowed to cover, while this situation rarely exists in equities, means that market infrastructure contributes to the danger).
Today, this lesson was made painfully when energy markets jumped about 6%. This was no ‘dead-cat bounce,’ which often follows a sharp move down. Last Thursday and Friday, NYMEX Unleaded dropped about 23 cents. Today, it rallied back 20 cents. The reason? Well, there was a rumor that NATO was bombing Libya, but that can hardly be surprising can it?
The bounce in Silver was more like 7%, but in the context of the 1/3 decline over the last week or so that really may be a ‘dead cat’ bounce. Silver really had gone too far too fast, and while I think at the current levels it is probably a reasonable wager I wouldn’t expect (or want) it to rally sharply back to the highs. As I said last week, commodities are generally in bull trends over the last year because of the oversupply of dollars in the market relative to “stuff.” But that is both a reason to rally and a speed limit. If the amount of money in circulation goes up 10%, commodity prices shouldn’t be doubling. I continue to be a commodity bull (although I invest through indices where there is some expectation of positive returns from rebalancing effects, rather than directly into specific commodities), but a patient one.
Skewness and kurtosis, in addition to being great cocktail-party words, are also important concepts for investors to understand. More specifically, it is important for investors to think carefully about the difference of the “higher moments” (as skewness and kurtosis are sometimes collectively called) between asset classes and particular investments. Given a choice between two investments with the same expected return and variance, a long-only investor should always choose the one with ‘fat tails’ on the upside rather than the one with ‘fat tails’ on the downside. This is true for two reasons. First, the marginal pleasure of a gain, for most investors, is lower than the marginal pain of a loss, and this is increasingly true for large gains and losses. Second, a large gain increases the bankroll, but a large loss can be a portfolio-ending experience. All of the rules about long-term investing are based on the assumption that the long term can be reached – or, as Warren Buffett has said, one “-100%” really messes up any series of portfolio returns.
Recently, in a great customer letter called “Five fallacies about inflation (and why global policy rates are too low),” Markus Heider, Jerome Saragoussi, and Francis Yared of Deutsche Bank made some very adroit observations about the risks of inflation going forward. The quick summary is that they see inflation as the greater risk than deflation because 1. The output gap is smaller than suggested by the high unemployment rate; 2. A negative output gap does not imply declining inflation [frequent readers know I harp on this a lot]; 3. EM countries are exporting inflation rather than disinflation; 4. Commodity price inflation is becoming structural and is exacerbated by low global real policy rates; and 5. Central banks’ credibility is at risk of being eroded.
But the single best part of the report, in my opinion, is the chart they created to summarize the effect of their views on the distribution of possible inflation outcomes going forward. That chart is below (reprinted with permission):
In short, the higher expected value, flatter distribution, and fat upper tail combine to make long-inflation bets worthwhile even if they are somewhat expensive right now. This is one reason that TIPS are seemingly egregiously priced. It’s all about the skew. If we don’t get inflation, we probably bounce around between 1% and 3% inflation for a while. If we do get inflation, it could get ugly. Therefore, it makes sense to give up some current return to ‘buy the tail option.’ I agree, and think their picture is truly worth a thousand words. (I still think that TIPS are too expensive for my taste even with this fact, but it is the reason I was willing to be long them when 10-year real yields were as low as 1%. It’s just a harder call at 0.65%!).
I highly recommend you contact your Deutsche Bank contact to get a copy of this report (from April 1). Honestly, while the overall state of inflation research is clearly better now than it was, just a few years ago, these guys at DB seem to me to have some of the most consistently high-quality research in the space.
The rally in equities (0.5%) and commodities comes with the caveat of occurring on low volume. I am clearly less sanguine about the former rally continuing than I am about the latter rally. Bonds also rallied slightly again today, with the 10-year yield falling to 3.14%. That is the rally that is a serious head-scratcher to me right now. I guess it is part and parcel with the current optimism that the Fed has engineered a recovery – at least, a modest one – without serious signs of widespread inflation in the sticky prices. But if I think about ways that optimistic assessment is likely to prove to be inaccurate, it seems to me that it is far more likely that the outcome is going to be much worse (in terms of the growth and inflation mix) than investors/economists currently expect, rather than much better.
In other words…I think we’re skewed.
A small aftershock is rippling through EU bond markets these days. Today Moody’s downgraded Greece 3 notches to B1, citing lagging tax collections and “implementation risks” that are increasing odds of a default event. In general, I am not a big fan of ratings agencies and I think they tend to be considerably behind the curve when it comes to ratings changes (and sometimes, in the wrong direction), but this serves to highlight the fact that not everyone thinks the European sovereign bond crisis is over. While it is no surprise that Greek 10y bonds did poorly on the news, you may not be aware that Irish and Portuguese 10y government bonds are also both at long-term highs today as well (see Chart).
Oil was up again today; although it backed off to end up only 1% or so, WTI is above $105 now. RBOB Gasoline declined 4 cents but is still over $3.
The stock market dashed out of the gate, and then subsequently dashed itself upon the rocks. The S&P ended 0.8% lower but had been toying with last week’s lows around mid-day. The VIX moved back above 20. Volume was again right around 1bln shares.
Bonds, despite the decline in stocks, also fell slightly with the 10y yield up to 3.503%.
The movement of stocks and bonds are consistent with markets that are working off over-bought and over-sold conditions and just chopping around in the meantime. That is more than likely what is going on. But the movement of European bonds is less hopeful. The movement to lower volatility but a consistent slip higher in yields could be a sign that pressure is slowly being released, that these markets were being artificially supported by the ECB and are gradually being allowed to slide back to their true equilibrium levels. If this is true, it is just a water torture being visited on the banking institutions that hold so much of this risk, building pressure there.
Alternatively, the steady move to higher yields could be a sign that banks are releasing their bonds steadily into a market that keeps backing up bids. In that case, the pressure is being released from the banks but building on the market itself. At some point, either the banks will finish selling and the bond market will stabilize, or – and this is the bad case – the bids will decide they’ve had enough, the market will evaporate, and a sharp break will occur. Given the size of the exposures that many European banks have to periphery sovereigns, I’m not super optimistic that homes can be found for all the paper at yields that allow the sovereigns themselves to continue to access the capital markets and thereby service the bonds.
But notice that if either of these are true (and it may be that neither is true, and that these are just markets adrift with no one participating or having much exposure – but I doubt that), the formula is that steady pressure is being applied either to banks’ economic capital (although not regulatory capital since sovereigns can be treated as being worth par at maturity) or to the bond markets themselves.
Perhaps I’m just thinking in this way because today I have been musing about nonlinear effects in financial markets as I am working on building a model of inflation expectations in which expectations are anchored within a range defined by the way people think about inflation (“low”, “medium”, or “high” for example) and remain in a range as pressure builds until abruptly there is a regime shift to another equilibrium. So, for example, perhaps people perceive inflation as “low,” and will persist in that belief for a while even if inflation outturns are “medium” for a while. But eventually, I think, the herd shifts to the new equilibrium in what is probably a non-linear break.
Lots of ink has been spilled on the issue of non-linear dynamics in complex systems. Some of my favorites are Ubiquity: Why Catastrophes Happen by Mark Buchanan, Paul Ormerod’s Why Most Things Fail: Evolution, Extinction and Economics, and Why Stock Markets Crash: Critical Events in Complex Financial Systems, by Didier Sornette. The simple summary is that if you apply a steady force away from equilibrium in a system that wants to return to that equilibrium, something’s gotta give. Either the system returns to the equilibrium position, or it moves into a new equilibrium (if this is a piece of steel, the transition is called “breaking”). In principle, the system can stay near a transition point for a long time, but sooner or later it goes one way or the other.
(Don’t quibble about the finer points of my definition – it was after all a very brief summary).
Applied to the European periphery, the “transition” could come when suddenly bank credits adjust, or it could come (in the other case) when the bond markets collapse. Of course, neither transition is assured, and the system might return to a stable equilibrium.
Applied to the economy, growth might do just fine with oil at $95, $105, or $115/bbl, but then the economy abruptly rolls over at $118.21.
Applied to inflation, CPI might move gently from 1.0% to 2.0% to 3.0%, and then snap suddenly to 6.0% (this sort of outcome is more likely if expectations serve some sort of anchoring function/feedback mechanism, which I am not confident of).
I am not predicting, mind you, any of these things. My point is only to highlight that markets are generally in equilibrium but it need not be a stable equilibrium. Markets that are at extremes are prime candidates for ones that are nearing transition points, which is why we watch breakouts.
With little on the calendar for today, trading started out sluggishly but began to get more interesting as the day wore on. I am writing this comment earlier-than-usual today, because I am leaving soon to head to NYC and attend a very exciting meeting of the QWAFAFEW Quantitative Investment Society. The topic is “Chasing Bernie Madoff,” and the speakers are Harry Markopolos, Erin Arvedlund, Frank Casey, and Michael Ocrant. You will recognize these names if you read the excellent book No One Would Listen: A True Financial Thriller, which details the efforts these guys made to get the SEC to investigate Madoff – efforts which the SEC managed to ignore for a decade until Bernie basically turned himself in. It should be very exciting, but it means I won’t be able to see if the present (2:00pm ET) 0.6% decline in equities (and 19/32nds decline in TYZ0) turns into a rout or instead (more likely) recovers to end the day down only a little bit. Either way, the market continues to rest uneasily in a fairly unstable equilibrium, near resistance but seemingly out-of-gas for a further rally.
Tomorrow’s trading ought to be slow; the only data are the trade balance (Consensus: -$45.0bln from -$46.3bln) and an Initial Claims (Consensus: 450k from 457k) figure that was pushed to Wednesday due to the Veterans’ Day holiday on Thursday. I would think that ‘Claims has some chance of exceeding expectations, since the earlier release may make it more difficult for all states to get their data in on time – and we have seen recently that when this happens, the BLS estimates tend to be mildly optimistic. (It isn’t an important enough report or likely to be an important enough difference that I would put any money on that supposition, but just be aware when the number is released that you need to ask “how many states didn’t report on time?”).
I need to make a quick note about yesterday’s comment. A reader who was confused (misled??) by my chart suggested that since the decline in the M2/M0 ratio wasn’t associated with deflation, the rise in the ratio may not be associated with inflation. I realized upon reading that remark that I probably should have shown a different chart because focusing on the ratio can be confusing. The point is not the level of the ratio, but rather the change in the level of M2 – that is what causes inflation. The ratio itself fell because the level of M2 didn’t change much when M0 ballooned, but that was (I think) because of IOER and perhaps other factors as well. The ratio fell, in short, because the denominator exploded. So, if the ratio goes back to its former level because the denominator (M0) collapses but the numerator (M2) is unchanged, that’s okay. But if it goes back to its former level because M2 explodes, that’s highly inflationary. So it isn’t the ratio you want to look at, it’s the level (really, the change) in M2. The chart below uses the same data, but separates the components. If you compare this chart to the ratio chart, it’s plain to see that it is the rise in the monetary base that drove the ratio lower. The question isn’t really whether the ratio moves, but whether M2 “catches up” or M0 declines back to its old levels. My math yesterday was meant to illustrate what M2 catching up would imply. To repeat yesterday’s caveat: I have no idea what will happen, and the point is, neither does the Fed…but the range of potential outcomes is large.
Thanks to the reader for pointing out this confusion.
A brief aside here on some other work I’ve been doing that may be of interest to readers, retail investors, or their advisors. I have written a paper called “Maximizing Personal Surplus: Liability-Driven Investment for Individuals” that is available at SSRN (here). Here is the abstract:
To date, the financial literature has focused on very simple algorithms designed to improve the solution to the two-part challenge of determining the optimal portfolio asset allocation strategy and determining the maximum sustainable withdrawal rate for retirees. Most research, for example the well-known “Trinity Study” of Cooley, Hubbard, and Walz, pursues the asset-allocation problem by maximizing long-run asset growth subject to a withdrawal rule and a given acceptable probability of remorse (a.k.a. shortfall). However, the Liability-Driven Investing (LDI) thought process improves the approach by seeking instead to maximize return for a given level of volatility of the portfolio surplus, rather than optimizing on the basis of the volatility the assets themselves; by more closely matching assets and liabilities, the sensitivity of the strategy to unexpected returns, risks, and correlations is greatly decreased. I update the Trinity Study to incorporate inflation-indexed bonds and then illustrate how the LDI thought process may be applied to individual investors.
One of the important things I do in the paper (at least, I think it is important) is to update a table that appeared in the original Trinity Study showing “portfolio success rates” for various combinations of stocks and bonds. When the original study came out, inflation-linked bonds were just getting started, so this important asset class wasn’t included. The analogous chart, based on Monte Carlo simulation (see the paper for more details) and including TIPS, is below.
If this interests you, take a look at the paper. I also illustrate how the “portfolio success rate” doesn’t necessarily tell the full story; you also care how long it takes, if the portfolio fails, for that failure to happen. Is it one year or 20? It makes a difference in planning. Moreover, the structure of your own “liabilities” matters in terms of finding the right allocation for you. If you’re interested, and read the paper, I am always interested in feedback.
Apparently, it was too hot to do anything today but stay at home and put in equity bids, and stocks responded to the recent expression of market-indecision by rallying sharply. It surely didn’t hurt that Kansas City Fed President Hoenig opined that “current Fed policy makes asset bubbles more likely;” of course, equities are priced generously and buyers are seriously desirous of a bubble to jump aboard. I do not disagree with Mr. Hoenig, but in the current circumstance “more” likely is still pretty unlikely while wealth continues to be destroyed by a lengthening recession in employment. When the economy someday recovers and begins to grow, then he will be correct, but that bubble will take time to form. Today, I worry that several markets are priced – as I said – ‘generously,’ but I wouldn’t characterize stocks or bonds or credit or gold as being in “bubble” territory at the moment. For example, while 10-year yields sub-3% represents an investment that is very likely to be quite disappointing over that 10-year horizon, for it to be a true “bubble” I’d want to see near-unanimity of thought that there is nothing else that is a sure thing like owning 10-year Treasuries at 0%. I rather sense that skepticism about the bond market is quite high, and rightly so.
Since there weren’t any new economic data of note today, I want to tie up a few loose ends/idle thoughts I have had recently that didn’t necessarily fit at the time I thought of them, or that I recently thought of.
Inventory of homes
I read somewhere that “the national inventory of [new] homes available soared to an 8.5 months supply in May…” The market’s fascination with the months’ worth of inventory is unhealthy. The problem is that in a ratio such as this, it is probably worthwhile to separate the numerator and the denominator. In this case, the fact that the ratio shot up was due to the very low selling pace of new homes last month. In fact, the total seasonally-adjusted inventory of new homes is quite manageable, and suggests that builders have done a reasonable job of cutting back the supply (indeed, some of the low New Home sales rate might even be caused by the low inventory). See the chart (source: Bloomberg).
The market made the reciprocal mistake in 2006, when the inventory was under 7 months of sales, but that was only because of a ridiculously high selling rate. The total inventory number told the real story: that there were an awful lot of homes out there, and if the pace of sales were to decline there would be a big problem. Looking at the ratio obscures this important detail. (People make the same mistake with the semiconductor book-to-bill ratio, where each part of the ratio matters too). Ratios like this are only particularly useful if the denominator is pretty stable.
Now, the bad news is that the inventory of existing home sales is still pretty high (see chart below, source Bloomberg). Why the difference? I suspect it is in the intake pipe…home builders are slowing their additions to inventory, but on the existing home side the bank REO will continue to add inventory for the foreseeable future. This hurts the builders too, of course, because the ready availability of a substitute keeps the lid on new home sales (and prices) as well. I think that when you eventually see the inventory of existing home sales dip back below 3mm again, it may be time to consider the builders.
Problems with recession forecasting models
I am not a big fan of Goldman, but economist Jan Hatzius generally does a terrific job at spotting the key issue. In a recent article, he noted that “Typical recession forecasting models estimate a near-zero likelihood that the economy has entered recession again, or that it will in the near future. But they suffer from a serious bias: most models use the slope of the yield curve as a forecasting variable, with a flat or inverted curve a classic warning sign of a slowdown or recession.” This is a great point. Recently, Gene Epstein at Barron’s – who is the anti-Hatzius, and mostly misses the key points – has been touting the Credit Suisse “recession model” as virtual proof that there will not be a double-dip recession – see here for example. (My opinion is well-known. We are probably not going to have a double-dip because we are still in the primary recession, which will probably last for a while). Hatzius makes hash of these models by pointing out that the yield curve factor, which is normally a very important indicator of tight money and hence recession risk, is completely useless when the Fed has pedal pressed to metal. He reports that a forecasting model that leaves out the yield curve and also adjusts for “employment related distortions” (presumably Census stuff) estimates a 25% chance that the economy will be in recession six months from now. I would add, “still.”
Animal Spirits: A Book Worth Reading
Although Animal Spirits, by Akerloff and Shiller, isn’t the best book I have read that Shiller has written or co-written (that honor goes to Irrational Exuberance, of course), it is thought-provoking. The authors take issue with the current state of the economic “science,” which models economic actors as rational even while acknowledging that they are not. We all know this, but economics doesn’t really have any clever solutions or “workarounds” for the fact that there are many phenomena that aren’t explainable as the result of interactions of coldly-rational automata. Akerloff and Shiller, of course, are leading behavioral economists and believe that adjustments need to be made to the standard models to incorporate behavioral phenomena.
The best part of the book is Part One, where they discuss several aspects of “animal spirits”: Confidence, Fairness, Corruption and Bad Faith, Money Illusion, and Stories. I find especially compelling their suggestion that confidence and a “confidence multiplier” ought to be added to standard policy-multiplier models and find intriguing their speculation that confidence may be “contagious” and be model-able as an epidemic. My biggest complaint about the book, in fact, is that while they talk about such a thing they don’t actually propose the form of these adjustments (that point may be too academic for a popular book, but perhaps it will follow – or is already out there and I’m just unaware of it – in journal articles. Just because the standard models ignore behavioral factors doesn’t mean we can’t try and model these behavioral factors. Surely something between economics as pure science and economics as pure art is reasonable?). The authors go on in Part Two to discuss how such an approach to economics can help solve some of the classic conundrums: why depressions happen, why the labor market doesn’t clear, why personal savings is so arbitrary, etcetera. Some of the things they discuss in that section have been addressed by standard economics and the authors are just not happy with the answers…and they’re probably right.
In any event, this is a book worth reading, and it’s a fairly quick and easy read. You can find it on Amazon here.
On Thursday the calendar has Initial Claims (Consensus: 460k from 472k). For 13 of the last 14 weeks, the economists have estimated too low compared to the eventually-revised number – on the June 18th week, the actual turned out to be 3k less than the consensus estimate. That is an amazing run of unrequited optimism about the economy, proving that economists don’t learn quickly. To be fair, the consensus estimate has risen from a low of 435k on the April 2nd week to the current 460k figure, so eventually economists will be in the right neighborhood.
The Treasury will issue $12bln in TIPS tomorrow. Dealers are very concerned about whether this issue will clear well, considering the low level of real yields (about 1.30% right now in the WI). They shouldn’t be. They should be concerned about the overall low level of yields (including nominal yields), but real yields are currently 41% of nominal yields, and haven’t been at an appreciably higher percentage since October. Put another way, the 10-year breakeven implied by TIPS and 10y nominals is around 1.72%, after having been as high as 2.43% as recently as April. That means that TIPS, while arguably expensive on some metrics, are still cheaper than they have been in a while. The auction may be sloppy, because dealers don’t have a lot of risk to take down paper like this, but I suspect the central bank bid will be pretty reasonable and the issue should clear up fine. I’d certainly bid for a tail.