Government Growth and Split Power

First I’d like to stake out the claim that most regime studies that I’ve seen about market and politics are bad.  For the most part they are oversimplified; for example the stock market goes up X on average during a Democratic executive administration and Y during a Republican administration.  First off, most of the time its not about policy but about the economics.  And even if it was and the market had some serious insight into policy the discounting mechanism would put the return right after the election not after the inauguration.   On top of this policy has a lag time as well.  With this scepticism about regime studies in mind I’d like to present a plausible one.

First this is not between politics and markets but rather between politics and the growth in government expenditure.  I’ve argued before that voting should be strategic in that you are voting for a government in entirety not a single politicians.  I tend to believe that a split in government is good in that it will force compromise and disallow the hi-jacking of government by special interest (or cynically it disallowing from doing anything) which is a good thing.  When the data is looked at in a raw form this doesn’t appear to be true because the size of government (expenditure/GDP) grows faster during split regimes (when the legislature and executive are in separate hands) than during joint power, but when you look at the data it is clear that this is due to the fact that governments grow during a recession.  Once the aggregate is condition on a recession it shows what logically makes sense: that government grows slower when power is split. 

We now have perfect growth conditions: a massive recession and strong joint power…is this a good thing, we’ll have to wait and see how it plays out. 

 

Too Good to be True

Performance charts of the Madoff’s fund are ridiculously good.  When someone is doing well and statements come in month after month , year after year, ‘confirming it’ I can imagine being very pleased and becoming comfortable; arguing against the one managers who is your star is not the easiest thing to do.  Will people get to the point where occassional underperformance will be a benefit because it will increase believability.  I hope not in that understanding the logical process and reasons for excess return is a better way to handle managers.  I like to perform thought experiments and imagine how I would have responded if I was given a presentation about one of his funds.  It impossible to know for sure, but if you are truly self-reflexive – which most people are not – you might be able to learn something this way. 

The above chart is amazingly good.  My first reaction would have been (1) How? Since I already know that lot of dumb simply strategy can appear to outperform for a long time and then get crush (capital decimation fund).  I would have heard about buying equity, hedging with a long put, and financing that with a short call.  I think I would have been suspicious because I would expect that to have t-bill-ish return; not the ~1% monthly return.  One possible reason for the outperformance would security selection, so I would have needed to work through how that process was done.  If I was told it was just index buying not security selection I don’t think I would have believed it.  If I was told that they had a security selection based on informational advantages (order flow); I’d swallow in amazement (talk to a lawyer) and then ask why it isn’t leveraged up….it is well below the geometric mean.  Why waste the alpha? This is very different than I would expect from a typical hedge fund.  Not sure the response I would have received but if they had offered a leverage up version; a 100% return with 20% vol (same ratio of 5), it would have been tempting.  I’d then ask why they offered this product at all; you should just close down the fund and manage your own money.  You’d make so much more and you could in a small number of years be the richest man on the planet (assuming you weren’t liquidity capped too soon, but if this is simply god like security selection in equities that shouldn’t be a huge problem).  Don’t know what they would say to that either.  Given that I can’t think of acceptable answer to both of these question I would have to fall back to my rule that if I really don’t understand I put a very small weight on this.  It would have been a painful walk because it looks so pretty but I think I would have avoided the temptations, but who knows. 

Side Note: Are Madoff’s loses a big deal?  My read it probably not, in large part due to the fact that it did not impair the banking system.  Yes it hurt certain people; there will likely be knock on effects on Upper East Side and Palm Beach real estate but the pyramid wasn’t on leverage.  I’m under the impression that it was based on equity capital and thus the contagion is not a problem.  The fraud hurt wealthy people; and yes they have feelings too, but it doesn’t break down the system.  So there may be some knock on affects as they individuals adjust their portfolios but it’s really not a big deal from a systematic perspective.  And once again it is not the end of capitalism.

History: Condemned to Repeat It

In an era when we are said to be living through a historic moment, I ask myself some questions to decern the truth.  How do I know if something is truely historic rather than simply a marker?  How is it going to change the path of reality?  I’m haven’t achieved the degree of peace to try to answer these but I think I can address the question of how to approach the challange.  You must familiarize yourself with history in an attempt to understand and test the theories you have about how the world works. 

Many of us are familiar with the George Santayana quote, ‘Those who cannot remember the past, are condemned to repeat it.’  Not only does this sound good, a key element for a quotes survival, but it is true – to an extent.  It is true enough that it provides a good argument for a vigorous study of history stretching from Kennedy’s The Rise and Fall of The Great Powers to Zinn’s A People’s History of the Unites States to Maddison’s Contours of the World Economy to Kissenger’s Diplomacy to Hayek’s History and Politics.  Now this list is not sufficient or necessary but I would recommend starting the work – and it is hard work – of developing a historical knowledge framework by reading Hayek’s essay History and Politics (or at least the first few pages). 

The reason that I suggest starting with this essay is that it gives you the lenses to pursue the rest of your study of history (or at least the first few pages do).  It begins,

Political opinion and views about historical events ever have been and always must be closely connected.  Past experience is the foundation on which our beliefs about the desirability of different politics and institutions are mainly based, and our present political views inevitably affect and color our interpretation of the past.  Yet, if it is too pessimistic a view that man learns nothing from history, it may well be questioned he always learns the truth.  While events of the past are the source of the experience of the human race, their opinions are determined not by objective facts but by the records and interpretations to which they have access. … Yet the historical beliefs which guide us in the present are not always in accord with the facts; sometimes they are even the effects rather than the cause of our political beliefs. 

So a indepth study of history may allow you to avoid condemnation but only if it is a true study of history.  Historical, so called, statements of fact are simply a human evaluation of them.  If you can admit to yourself that the historical picture your reading is certainly a partial truth, not because of intentional deceit, but due to human incapacity for truth due to limit in our ability to communicate (and understand) you will be able to approach history with the proper degree of skepticism.  If you accept this as a backdrop for your study of history and replace fact based history with distributive or a uncertain view of history in your pursuit of teasing out logically relationship (the cause and effect), your ability to use history to develop strategies for the future will be greatly improved.

Christmas Writedown

As the US struggled through the early stages of the financial crisis, schadenfreude was in full force both in the US and around the world.  Foreign leaders thought that this would weaken American financial power in the world while leaving them unscathed, and main street Americans thought that a slice of humble pie would be good for Wall Street.  Since then, both groups have learned how interconnected the world is and why it is essential to have an operating banking system.   Main street Americans have seen their 401ks destroyed, they can’t sell their homes, and they can’t get auto loans.   The rest of the world has seen the crisis spread to their own countries. 

The team over at CFR’s Center for Geoeconomic Studies has put together a chart to demonstrate the knock-on effects of the crisis on the Christmas season.  They defined the Christmas season as the amount of time before Christmas that interest in ‘Santa Claus’ is greater than ‘foreclosures,’  then applied that to the best and worst performing portions of the real estate market.  Those in strong-performing real estate markets saw the Christmas season shortened by about 10 days, while those in poor-performing real estate markets saw the season shrink by about 25 days.  Does Christmas need a bailout?

Where are we in the deleveraging: Bank Write Ups?

The 4th quarter for the banks seem to be more of the same, namely more losses.  What made the incremental losses scary was that they dug deep into the mortgage book and agency bonds that were supposedly insured by the government. The downward spiral seemed like it was uncontainable.  High yield spreads were making new highs, and 10-year Agency spreads widened from 80bps at the end of the 3rd quarter to 180bps in late November (foreign sales).  This increase is in large part due to 10-year treasuries rallying from about 3.75% and breaking the 3% mark before December (thus losses on agencies outright were not as great those hedged to treasuries), but since late November fixed income assets have rallied nicely (in no small part due to the Federal Reserve coming out and saying it was going to buy anything and everything).  Now 10-year treasuries have dropped near the 2% rate (which is suggestive of basically flat rates near over the next 10 years).

What is the size of the gains for the banks?  The FDIC provides a nice data set that reveals the aggregate balance sheet of ‘All FDIC-insured institutions,’ which at this point is really everybody (few have survived without some form of government backing).  As of September 30^th, the banking system had a $13.5 trillion balance sheet of which $2 trillion was in securities (about 13%).  Of these $2 trillion, $1.8 trillion is AFS (available for sale, meaning that it is marked to market). If the AFS portfolio is similar to the total securities portfolio, then there are slightly over $1 trillion of US government securities (mostly agency mortgage debt), which have rallied by 300bps since mid-November (only about 200bps since the end of 3rd quarter).  If one assumes that this debt has a duration of 5 years, then its value has gained 10% in the 4th quarter, or slightly over $100 billion (just on agencies, the overall rally has been stronger).  Will this be enough to offset losses in other securities?  For some investors yes, for others no.

The question that is on the mind of many smart folks watching the banking system is when will the deleveraging be over?  The equity injections from the treasury were essential and don’t be surprised if we seem more of them.  Let’s consider what these injections have done to the FDIC data aggregations.  As of September 30^th, the leverage ratio (assets/equity – this is a measure of risk-taking where a higher number means more risk) of the banking system was 10.4.  Before the crisis (end of 2005) the leverage ratio was 9.7.  What I interpret from this is not that banks wish to be more leveraged after the past year, but they haven’t been able to deleverage fast enough (either by selling assets or raising equity).  [Read the primer if you want a walkthrough of this process.]  Does this mean that we are still deleveraging?  We need to factor in the capital injections ($250bn) and the gains on the securities rally ($100bn). This brings the pro forma leverage ratio to 8.4, which is below the pre-crisis level (ignoring any new losses, which there are some).  I don’t think the deleveraging is over – in part because of the distribution; expect the next year to be full of bank failures – but I think we’ve made a lot of progress.  There’s a decent chance the Senior Loan Officer Survey will improve in January 2009. We’ll have to wait and see.

Oil, How low can you go?

It is my personal view that black gold (oil) five or ten years out will have appreciated in real terms, in large part due to dollar depreciation, continued world growth, and the mix of oil coming from higher cost sources. In the short run, however, I think there is a decent chance that oil prices will fall further.

Off and on in the news you hear that OPEC is meeting to cut production. On the surface, this makes sense.  It is a cartel; member countries coordinate production in order to hold the price of oil above what it otherwise would be in order to make more money.  Why aren’t there more cartels out there?  Yes they are (in some cases) illegal, but that is not the primary reason.  The primary challenge of a cartel is that the incentive to cheat is too great, and unless there is a barrier to entry in the market, the cartel has no chance of holding together.  Oil producers have a good barrier to entry (you can’t produce oil), but they still have incentives to produce a little extra in order to make more money.

Nowadays, the incentive to cheat is big across the board.  The breakeven fiscal oil price in 2009 ranges from the mid 50’s to the mid 60’s, below that the government has to borrow money to pay for its cash outflow.  The breakeven oil price for the current account ranges from the mid 20’s to the low 70’s, although most countries are in the high 60/low 70 range.  Given that oil is below these levels, countries and governments will either have to borrow to pay their expenses, or increase oil production to bring in more revenue.  Of course if they all increase production the price will go down, making everyone worse off.

The cartel has worked in the past when there was a strong marginal producer who was willing to take the cash flow hit (by producing less) in order to maintain the price level.  Saudi Arabia did this for a while in the early 80s but in August 1985 they linked their output to the spot market.  Their production increased from 2 million barrels per day in August 1985 to 5 million barrels per day in early 1986.  What happened to the price of oil? (See chart-remember this was in the middle of the Iran-Iraq war and during a period of mild economic growth.)

Capping Volatility: Why price caps may have lead to oil volatility.

It is not surprising that congressional hearings on oil prices are asymmetric.  When the price goes up, legislators are up in arms demanding to know who is responsible, but when it goes down, the explanation is irrelevant.  It was less than a year ago that the heads of regulatory agencies, hoping to prevent a populist and foolish response to the new economic reality, were appearing before congress to argue that the price move was not driven by speculators.   (CFTC testimony)

Admittedly, new demand for something, regardless of its source, will push the price up. But portfolio demand, unlike product demand, seems unlikely to be able to cause increases in prices without causing inventories to increase which at some point would push down the price and are thus less consequential over the long term. And as demand wanes prices will fall but why have the price movements been so large?  Higher volatility makes it harder for firms to plan (and increases the cost of hedging). 

The underlying reason for the large drop in oil prices is a drop in global demand related to the economic slowdown.  But let me try to explain why I think the price movements have been so dramatic.  One portion of the conversation during the price run-up in oil was that emerging market price caps were causing excess demand.  This may be true, but it misses that price caps can also cause excess volatility.  .  Yes, Venezuela gas prices being 12 cents a gallon induces more consumption than the market price would  As long as the governments of these developing economies can pay for the price caps, demand for oil in the marketplace is much more inelastic than it otherwise would be.  The onus of adjusting to movements in the price of oil is therefore on developed countries. Since fuel is a smaller portion of income for consumers in these countries, they respond less quickly to price movements. This requires the price movements to be larger than they otherwise would be in order to affect demand.  Consider the pre- and post-demand contraction chart below.  The movement of the ‘Market Price given price cap’ is larger than that of the ‘Market Price without price cap’.

Pre-Demand Contraction

Post Demand Contraction

It is true that a major factor of the current price drop is a drop in product demand.  But it is interesting to note that a large part of the drop is a function of investor deleveraging (which in many ways has prevented the market from fulfilling its long term planning role), and it is not unreasonable to believe that, if the price continues to fall, it will be a function of oil producers trying to cover their import and fiscal bills by expanding production. But when thinking about the volatility of oil markets over the past year, one important factor is the effect of market caps in developing economies on movements in demand.

Ten Years of Uncertainty

Today’s FOMC releasediscussed the Fed’s decision to continue the quantitative and qualitative easing programs which have allowed the Fed to play the role of the banking system-performing credit and maturity transformations-while ensuring that the money supply doesn’t collapse.  The release also mentioned that the Committee was “evaluating the potential benefits of purchasing longer-term Treasury securities.”  That may have triggered the large rally in treasuries that pushed the 10-year yield down to 2.27% (down 25 bps). With this in mind, I’d like to expand on yesterday’s post.

First, consider that an arbitrage relationship exists between a 10-year rate and 40 sequential 3-month rates.  You could finance the purchase of a 10-year bond with funding from the next 40 3-month rates.  Next, imagine that market expectations are that the 3-month rate will be 25 bps (the high end of the new fed funds target range) over the next 10 years.  If the market were certain, then the ten-year rate would be 25 bps as well, but the situation changes when those expectations are uncertain.  Let’s say that market expectations are normally distributed with annual volatility of N (a stylized assumption to illustrate a point).  As the range of plausible 3-mth rates expands, the bottom of the distribution is cut off by a certainty, the zero nominal rate.  The market 10-year rate ends up being a value based on the weighted average of the expected rates. The truncated distribution thus moves the expected rate away from the first guess (25bps).  This can be thought of just like an option (selling the bond has limited downside in a nominal sense).

You can now see how uncertainty affects rates.  How much does this upward pressure on rates matter? The soft floor on the 10-year rate will be a function of the uncertainty about the future path of the 3-mth rate, as illustrated by the following chart.  The open question is what you think the proper degree of uncertainty is for the 3-mth rates.

 

Update: It is worth nothing that Japanese 10-yr rates fell below 1% (although they’re usually in the high 1% range).  One plausible explanation for this is that in a deflationary environment (inflation is running at -5%) where the nominal short rate is 0% but in real terms it is higher at 5%, it is hard to imagine the monetary authority actually wanting a tight monetary policy.  This may give you a large degree of confidence that the nominal rate will not increase, meaning that the distribution contracts and thus the 10-year rate is able to fall.

Federal Reserve Challenge: When normal just doesn’t cut it.

When the economy slows, the first responder is the Federal Reserve. It eases monetary policy by lowering the bank reserve rates (it is often tight monetary policy which triggers the slowdown in the first place).  This time around, the Federal Reserve responded more aggressively than usual, but they quickly realized that in this cycle problems would not be solved by decreasing the interest rate paid on loaned reserves.  As the reserve rate was cut, the rates that were paid by consumers and businesses did not drop-in some cases they even increased because spreads increased faster than rates fell.  The Fed’s efforts were ineffective.  Now the rate is approaching the 0% nominal floor, which means that this type of intervention (in a nominal sense) is about to run out of bullets. 

 But the Fed did not settle for the standard policy tools; it has gone well beyond what is normally done to stimulate the economy.  One means to stimulate credit is to guarantee bankers access to liquidity, so bankers need not worry about liquidity risk when doing maturity transformations (borrowing short and lending long).  With this in mind, and a focus on preventing widespread banking failures, the Fed started to push out liquidity to banks through programs such as the Term Auction Credit program (after discovering that no one would use the discount window).  This program was useful in that it held the system together (we would be a lot worse off without it), but for the past few months the Fed hasn’t been able to push money out the door. This means that for every 100 dollars it auctions, only a fraction, say 60 dollars, is bid on.  Banks are so focused on deleveraging that they have no interest in doing maturity transformations even with cheap Fed money. 

 As things continued to fall apart, certain markets, such as commercial paper, were on the verge of collapse. The Fed’s response was to set up a program to provide liquidity so that bankers could buy the CP, but it quickly realized that it wouldn’t work because bankers were not interested in expanding their balance sheets.  The Fed then set up a program to take the CP on its own balance sheet.  We have now reached the stage where the Fed has taken on the maturity and credit transformation responsibilities which were once the role of the banking system.  Examples of this include the money market investor facility, the commercial paper facilities, and the new GSE purchase facility (and possibly a program to buy long term government debt).  In addition, the Fed has held together the fragile banking system by facilitating the JPM-Bear Stearns deal and providing ‘liquidity’ to AIG. 

 Now that I’ve gone over what the Fed has done so far (and how unconventional its actions have been), a fair question would be ‘what else could the Fed possibly do during its meeting on Dec 15/16?’  It could expand the existing programs and commit to buying more risky assets (thereby committing to do more maturity and credit transformation).  Even though this seems like more of the same, it would be beneficial.  I think the Fed should also provide transparency to the market on the duration of these programs.  While this would require the Fed to keep these programs in place or interest rates low for a certain period of time, which bears some risk, it would also allow the market to start pricing in the continuation of these programs and possibly encourage bankers to take advantage of the subsidies provided.

 To show the effect that future assurances could have, look at the forward interest rate picture.  The most likely path as imputed from Fed Futures (financial instruments used to transact on future rates) is that rates will fall to 25 bps (0.25%) and stay there throughout 2009.  But the futures curve for the same interest rates has them priced at around 80bps (0.80%) at the end of next year.  Why the difference?  Because as time increases, so does the uncertainty surrounding the expected rate.  If you look at the -1 SD (standard deviation) and +1 SD line, you’ll see a plausible distribution for future rates.  Think about it this way as the prediction is about a further point in the future you become increasingly uncertain about the prediction.  The expected rate ends up being the average of this distribution of rates. The problem is that the low side is truncated at zero so even if one does not expect rates to increase, the fact that your uncertainty increases as the duration of your prediction increases means that the forward curve prices in higher rates.  If the promise were made to hold down the rate at 25bps through 2009, then the forward curve would drop because the +1 SD deviations would drop (based on our confidence in the Fed’s statement).

 

Remember flatting out the short rate curve will pull down long rates.

May you live in interesting times

Depending on whom you ask, the above statement may be perceived as a blessing or a curse.  Whatever your answer, it is fair to say that the 3rd quarter Flow of Funds released by the Federal Reserve last week suggests that we are living in interesting times.

After reading the full release, I decided to go through a thought exercise.  I pretended that I’d been on vacation and out of touch with the news for the past 18 months, then asked myself how I would have interpreted the Z.1 (flow of funds) report had it been the first piece of information I came across upon my return.  I would’ve be disturbed.  I would have speculated that the world had been hit by a massive recession and economic collapse that was initiated by some large exogenous shock to the system which was being combated by massive monetary intervention.  Large scale war, an unprecedented terrorist attack, large scale epidemic, massive financial crisis, or trade war would all have seemed possible storylines.  In comparison to these scenarios, we are actually doing well.

The main theme of the report is that people want nothing to do with risk.  They are getting as far away as they can.  I recommend reading the tables for yourself, but I’ll try to pull out some of the more fascinating stats.  (Remember these are all annualized nominal numbers. )

Household debt fell by 0.8%, in large part due to the $258 billion dollar drop in home mortgages (aggregate drops are extremely unusual), while Federal debt grew by 39.2% annualized in the third quarter.  US borrowing dropped by $547 billion while money market mutual funds and ABS issuers pulled $177 and $376 billion from the credit markets (because they couldn’t finance the intermediation anymore).  The Treasury issued $2.08 TRILLION in debt while corporate debt and open market paper (CP) dropped by $537 and $382 billion, respectively.  The Federal Government acquired $1.25 trillion in FX.  The monetary authority (the federal reserve) increased its balance sheet by $2.3 trillion, sending $904 billion abroad to foreign central banks while the rest of it went into the credit markets (some to banks and some directly to borrowers).  Federal Agencies appear to be the only mortgage lenders, acquiring $508.3 billion in the 3rd quarter.  Money market mutual funds have grown by $75 billion but sold $486 and $422 billion of open market paper and corporate/foreign bonds while buying $608 billion of treasuries (shift in their asset riskiness).  Trade credit contracted by $251 billion (look how far the credit market freeze has gone – trade credit is unable to finance).  The rest of the world sold $241 billion in government agencies and bought $818 billion in treasuries with demand coming from both the public and the private sector.

The selling of risk seems to be occurring across the board and the only place that it is being picked up is by the Federal Reserve.  This is not only happening at the ‘extreme’ risk segments like equity and securitizations; simple home mortgages – including agencies, which have a nearly explicit government guarantee – have been shunned.  Another fact to consider is that this was the third quarter (July, August, and September), and things have gotten worse since then.  This avalanche of capital away from risk and the monetary authorities of the world stepping in to hold the system together seems like a story that will stay with us for some time.