E-piphany

The Federal Reserve has begun conducting small-scale tests of its mass-reverse-repo tool. This suggests, as many observers have already noted, that the Committee is thinking very seriously about whether it is time to withdraw the extraordinary stimulus measures put into place last year (which became necessary, by the way, partly because the Fed at the time of the Lehman crisis had the Fed Funds rate at 2.0% and was exceedingly shy about injecting the liquidity the market needed – so let’s skip the Bernanke-worship for “saving the system” when in fact the FOMC was partly responsible for making the crisis so bad in the first place). This is not the same as raising rates – which is something which will eventually happen, but far down the road I think – but it is a contraction of liquidity.

It isn’t crystal clear to me why the liquidity needs to be withdrawn quite so soon, but let’s leave that aside for now. The argument for not pulling back liquidity is that bank credit is still contracting (see Chart, sourced from the Fed’s H.8 report); the argument in favor of pulling it back is that asset prices – stocks, bonds, commodities – seem generally bubbly and this is partly because of all the extra money sloshing around.

Some money is going into Treasuries rather than loans

As I said, let’s leave that argument for another day. My concern is about the transition to the end game.

The Fed’s plan is to borrow money from banks, collateralized with some of their massive holdings of Treasuries and other detritus. This is a reverse repo transaction (what we used to call “matched sales”), it subtracts reserves from the system, and it’s not mechanically difficult except on the scale the Fed wants to conduct it, and because they want to widen the potential counterparty list.

What happens to all of the asset markets when the money starts to exit the system? Asset markets will go down, that’s what. The same way all of them went up, from commodities to real estate to equities, they’ll go down if the exit is premature.

I suspect that is part of the idea: scare banks into letting go of some of the safe Treasury paper whose yields are about to rise (if the Fed has its way). Distribute some of that paper to other holders, and maybe the banks will use the freed capacity to lend. But this is a delicate exercise, because maybe the banks find there’s no one to sell to and rates adjust quickly, leading to an abrupt economic adjustment and more losses at banks! The best part of the year to be long rates (early Sep to early Nov) is past, and we are moving into the spring; moreover, it seems more and more people are concerned about rates going up either from supply pressures or because they think the Fed wants to tighten. It won’t take a lot to get banks, and others, to start to unload Treasuries. And I have trouble figuring out who wants to own a lot more of them.

Economically-speaking, there doesn’t appear yet to be any reason to fear much higher rates, and until year-end is past I doubt we need to worry about a big move in bonds, but it’s the potential for volatility that has me covering my eyes. Even if everyone is prepared for the elephant sneeze, everyone still gets wet.

As I noted when I began to write this blog…and as I have noted repeatedly over the years!…one of the reasons I write the blog is because the comments and feedback make me analyze my own positions.

A friend who read the early blog posts wrote to me privately and objected, quite reasonably, to my negative spin on the entire behavior of the government (Fed and Treasury) through the recent crisis. In thinking through my response to him, I hit on what I think is a pretty decent analogy and, since there wasn’t a lot of news today worth talking about (unless you want to reflect on the fact that Bernanke’s remark about how the economy faces “significant headwinds” is curiously – and I think not accidentally – evocative of Greenspan’s phrase to describe the challenges the economy faced in late 1991, which became the title of Chapter 7 in Maestro, My Ass!: “fifty mile-per-hour headwinds”) I thought I’d relate the analogy.

I think that one’s analysis of what the Fed should do in the crisis circumstance depends on (or anyway should depend on) whether you believe fundamentally that the financial system is stability-seeking or instability-seeking. Is the Fed supposed to dampen swings and control a system that is fundamentally out of control without its oversight, or is it supposed to avoid unnecessary interaction because the system is fundamentally self-stabilizing?

Both sides of that argument have some history to them. The Federal Reserve, of course, was founded because Congress thought the cycle of financial boom and bust was fundamentally destructive and needed taming. While this is arguably a paternalistic view of the role of government (we’re not safe unless the government is in charge), there are clearly some roles that governments need to play…or there wouldn’t be any need for government at all. We accept that having a cop on the beat is necessary, to preserve, protect, and defend. To provide for the common defense, promote the general welfare and secure the blessings of liberty (and so on).

But there are also many areas in which we think the government has little reason to be involved. Frighteningly, the number of these seems to be shrinking, but it is still generally conceded that the government doesn’t do well at running competitive industries – I think they don’t do well at running monopolies either, but some people would debate that point I suppose. (Interesting side note: does government involvement in the auto industry make sense because the American auto industry isn’t particularly competitive, in either sense of the word? Discuss.)

I think that financial systems, left to themselves, tend to be stability-seeking. That doesn’t mean that they are always stable, because they are always being perturbed by outside forces. I am saying they are stability-seeking. There is lots of evidence to support this: many asset return series display mean reversion tendencies. Volatility itself is mean-reverting. I would argue that many of Kahneman and Tversky’s observations about the behavioral tendencies of individuals provide something of a mechanism for such self-stabilizing behavior. And, if you want to get metaphysical, we can note that the entire universe tends towards greater stability, aka higher entropy, at least if you buy the Second Law of Thermodynamics. The physical system is always “seeking” the local state with the lowest energy, which is why atoms are stable. Why should non-physical systems be different? Was the Architect just playing with us?

But I digress.

So the question is – and here comes the analogy – should Bernanke push the swing? Should the Fed, generally speaking, be pushing the swing?

Assuming that we agree that stability is a nice thing, then certainly if the swing happens to actually be at rest the Fed ought to keep its hands off. But what about when Johnny has kicked the swing up and it is out of control? Should the Fed push against a swing that is out of control, to bring it under control, or better yet should it push against the swing to keep it from getting out of control in the first place?

Here we have two problems: theory and practice. Other than that, I would say yes.

The theory problem is that, as I discuss more fully in my book (two plugs in one blog!), if the authorities intervene to keep the system stable in the short run, that action is inherently destabilizing in the long run because the guy in the swing grows to expect that external controls will keep him safe.

The practice problem is more poignant. The idea that the Fed should push against the swing is hardly new. Fed Chairman William McChesney Martin referred to the Fed’s “leaning against the wind” in 1951, and the Fed has often tried to tilt against prevailing speculative opinion. Unfortunately, in 96 years of history the Fed has yet to engineer a ‘soft landing,’ and herein lies the problem in practice. Any given action by the FOMC might dampen the swing’s amplitude, or might increase it! In truly catastrophic crises, it is at least plain which direction the Fed ought to be pushing (more liquidity!), and then the main problem is the theory one. But even in such times, once the swing’s amplitude has decreased somewhat then the Fed ought to step back lest they start to do more harm than good.

So should Bernanke have left well enough alone? I assert that if he had, or at least stayed within the Fed’s mandate, then the crisis might have spun further out of control – but it would have stopped eventually, and we would be healthier now, and 5 years from now, for it. However, I will grant that doing nothing was not a politically viable option. But he surely could have done less, even if Hank Paulson was yelling at him to do more.

The Fed’s role in my view is to make sure the components of the swing are in good working order, and then if Johnny wants to take his life in his own hands, it’s his choice. The Fed is not Daddy.

Are we finally seeing some “green shoots” that are actually green? Or is this just a premature germination caused by unseasonably warm weather (in this case, exceptional Federal spending)?

What many people applauded as “green shoots” earlier in the autumn/summer was nothing more than the ‘dead-cat’ bounce after the exceptionally depressed post-Lehman levels. Into the teeth of the crisis, initial claims for unemployment benefits spiked to a four-week average above 650,000 per week and net Payrolls were contracting at 700,000 per month. When those figures subsequently improved to -550,000 and -300,000, it was hailed as a harbinger of an imminent recovery when all that had really happened was that the economy had returned to its already-bad pre-Lehman trend.

That didn’t stop the equity markets from partying like it was 1999, of course. (What was really impressive about the rally that unfolded, though, was that even once the data leveled off for a while and the Unemployment Rate resumed climbing, stocks kept steady-to-higher.)

The Claims and Payrolls data from the most recent few weeks and months, though, finally give some cause for cautious optimism among people who are not genetically predisposed to be cheerleaders for higher equities. Yesterday’s Employment release, with the exception of one smudge that mars an otherwise happy picture, was the best piece of economic data we have had in quite a long time. Now, partly this is because we have fallen so far that almost anything looks “up” to us, but with the Street looking for a loss of 125,000 jobs on the month, the actual figure was -11,000 and subsequent months were revised higher by a net of 159,000 jobs. In other words, the Street’s “miss” was 273,000 jobs (from -125K to +148k). The unemployment rate unexpectedly dropped to 10.0% from 10.2%, and even the weekly hours figure rose 0.2 hours.

Misses in forecasts are commonplace, but given the noisiness of the data they are not generally large enough to be able to reject the null hypothesis that the real underlying rate was roughly what you thought. But with a miss that large, there is a very real chance that the underlying rate of job loss is currently less than most economists thought. In other words, we can with some reasonable confidence reject the notion that Payrolls are still contracting by 125k or so per month.

Now, hold your horses before getting too excited. Here are some caveats to that good news. First, even if the true rate of job creation is as high as zero – no longer in the realm of job destruction, that is – then the Unemployment Rate is still going to march higher. Even if Initial Claims is really running at the 457,000 level of the latest report, that merely puts it back near (and actually still above) levels that were sustained for extended periods coming out of the last two recessions (see Chart below):

400K Claims pretty common coming out of recessions

Moreover, there is the one smudge that I mentioned. An indicator I have recently grown fond of is the number of people who are not in the labor force (because they haven’t looked for work recently – actively looking for a job is a prerequisite to being considered to be “in the workforce”) but who want a job. Though this series is noisy, it very clearly identified the breakdown in the employment situation and has not yet begun to improve. Indeed, the series reached a new high yesterday, as you can see in the next chart, sourced from the Bureau of Labor Statistics (seasonally adjusted, numbers in thousands).

There are still 6 million people wanting a job and not even looking.

The reason this matters is that when these people start actively looking for work, the first thing they will do is raise the Unemployment Rate (since they will then be counted as unemployed), which will then gradually decline as they find work. In other words, until this series begins to decline, the prospects for a sustained decline in the Unemployment Rate are dim. And, with this many people out there who would like a job, even when the ‘Rate begins to decline it will take a long time before it reaches levels that we have grown to consider acceptable. By “a long time,” I mean four or five years at best.

Now, that doesn’t mean that it won’t feel like recovery – assuming, and these are big assumptions, that the improvement is sustainable without continuation of unprecedented fiscal and monetary stimulus and that the commercial real estate crisis doesn’t cause another shoe to drop and that the sovereign debt crisis remains just a possibility and not a reality. Those are a lot of assumptions…but of course it’s also fair to note that, at the beginning of a recovery, there are always a lot of things that might still go wrong – the point is that if the economy has enough endogenous positive momentum it can deal with occasional setbacks. I have my doubts on that score, but the data currently do have some positive momentum.

Now, the real question for investors as opposed to economists is this: even if these are finally green shoots, it isn’t clear how you ought to invest – because the market already priced in the green shoots when they were just fake green shoots! The fact that the stock market was unable to rally on Friday, in the context of the best economic data we have seen in years, is concerning. Current valuation levels suggest that sustained gains, even if the economy is improving, are far from a sure thing and there is a significant degree of risk if, on the contrary, one of those setbacks happens. I am sure I will return and develop this thought in future posts.

Ben Bernanke seems to spend far too muck time on the Hill (I am sure he thinks so, too). Personally, I think it’s a bad sign when the Chairman of the Federal Reserve spends more time before Congress than at the office.

As usual at these highly-productive Congressional inquisitions cross-examinations, we learned a lot. We learned that Dr. Bernanke wants to help grow the economy and provide jobs, while also restraining inflation. Truly shocking stuff like that. He urged the Congress to “take care that the Federal Reserve remains effective and independent,” which is confusing until you realize that the word “remains” should be “becomes.” And Bernanke made the bold prediction that real interest rates will rise if deficit spending is not restrained.

I know the shop at 20th and Constitution is dedicated more to crisis planning these days, but if this is what passes for analysis at the Bernanke Fed then we may be in worse trouble than I thought. Of course, he is right that real rates will rise…but he is right about that mainly because real rates (that is, TIPS yields) presently are negative for the first four years or so of the curve and only 1.18% all the way out to 10 years. There’s little hope they will fall much further, and if they do fall then it means we are really in a pickle, economically speaking.

What the Chairman was trying to tell us is that deficit spending should, in theory, cause real rates to rise because the additional demand for credit should push the cost of credit higher, if the supply of credit is unchanged.

Of course, all of the rising deficits of the 1980s were associated with declining real rates, and the surpluses of the late 1990s with rising real rates, so the evidence here is, shall we say, something less than compelling. Moreover, thanks to the (so far, modest) decline in societal leverage induced by the economic crisis, credit demand is slackening elsewhere so it isn’t clear whether government borrowing is crowding out private borrowing, or replacing it. In any event, as I said earlier, Bernanke’s prediction is pretty safe given the starting point of real rates today.

***

I have been, as most conscious people are, critical of Bernanke’s actions as Fed Chairman, from his verbal gaffes with Maria Bartriromo to his preternatural fear about inflation right as it was plainly ready to collapse and his hijacking of the Fed during the crisis, bending it to do things the Fed was not meant to do. I am not alone in this; a Rasmussen survey found that the “common man” thinks 2:1 that Ben should not serve a second term. But it may surprise you to find that I say he should stay for another round. My reasons:

1. You break it, you bought it.
2. I don’t trust the Obama Administration to nominate anyone other than a political hack, and
3. I don’t yet have enough material for Bernanke, My Butt.

I am pretty sure that, given another term, this last issue will be remedied.

I was reading yet another article (here) about the unmasking of the global warming theory conspiracy – I find it hard to get too much of this delicious story – and was struck by the author’s assertion that “the importance of healthy skepticism in the face of conventional thinking is, once again, validated.”

Sure, skepticism is important in some vague societal sense, but it also carries high costs. Social structures are naturally evolved to condemn those who stray from the herd. Indeed, we can certainly argue that “skepticism” from a herd animal is probably not “important” in any real sense, and in fact probably quite dangerous. I suppose the value of skepticism probably increases with the size of the societal unit. Being skeptical if it’s just you and your wife discussing your future together is probably not useful and may be hazardous to your health…better to be a herd animal in that circumstance. Trust me.

But once you’re beyond the immediate group, and are discussing beliefs and norms held by large groups, nations, or society as a whole, then skepticism has some value because it occasionally breaks the self-reinforcing symmetry of views that can turn a crowd into a mob. It is healthy to have widely-held views occasionally re-examined so that the less-useful ones can be rejected, but if there are no skeptics then there is no catalyst for such re-examination.

So, I buy the argument that skepticism is “important,” but that doesn’t explain skeptics. Are skeptics skeptical because they are altruistic and want to help society, enough that they are willing to bear society’s opprobrium? Is their love of others so great that they willingly crucify themselves for the collective’s greater gain?

Baloney!

Skeptics tend to be skeptics because it pays well. The old saying goes “if you go with the crowd, you get no further than the crowd,” and this is literally true especially in finance. The payoffs of counter-crowd bets tend to be systematically too large after adjusting for the probability of the outcome. This is why, for many years (I don’t know if this is still true, and anyway I don’t condone gambling), a bettor could systematically bet against the Dallas Cowboys – and, later, the San Francisco 49ers – and make money over time. The action was so far on the side of the ‘popular’ team that the book would pay you (in a risk-adjusted sense) to take action on the other side.

Now, there’s a difference between being a skeptic and being a contrary ass. A skeptic is someone who can coolly evaluate the payoff to the skepticism strategy and pursue it when it is worthwhile; a contrary ass is basically a misanthrope who doesn’t like seeing other people do well, make money, or be happy. Both of them managed to avoid the 1999 stock market bubble, the recent housing bubble, and the developing re-bubble in equities. But the skeptic bet against the Dallas Cowboys while the contrary ass also cheered against them. Jerk.

The quasi-default of Dubai’s semi-sovereign entities is unlikely to be the last, just as each routine bank closure in the U.S. is unlikely to be the last.

We have moved into a new phase of the economic debacle. The “financial crisis” phase ended around October 14th, 2008, with the implementation of the Fed’s Commercial Paper Funding Facility and simultaneous strong-arming of certain banks to offer funding for terms more than a day. The “market panic” phase ended in late March this year; although the stock market may ultimately plumb new lows over time (especially on an inflation-adjusted basis) the joint actions of Fed and Treasury (and monetary and fiscal authorities around the world) finally achieved traction at that point and chances of a second crash have receded.

But those actions by fiscal and monetary authorities, a series of escalating programs promising to spend and print more and more money until finally the tsunami of liquidity overwhelmed our best intuition about what sort of market behavior might well be rational in a disaster, were just IOUs. I don’t mean, here, that they were IOUs in the usual cynical sense of the gold bugs that any fiat money is an IOU. They were IOUs in the sense that an athlete (or frat boy, but in a different sense) makes demands on his body that are borrowings against the period of recovery tomorrow. You can’t escape the payback; you can only bargain for a bit more today in exchange for a bit less tomorrow.

Those IOUs, of course, will come due. Fiscal and monetary policies are currently unsustainable – to say nothing of the ultimate sustainability of running up huge public debts once interest rates begin to rise. Dubai is unusual since it doesn’t have anything in common with the future wave of sovereign borrower instabilities (which will happen when those IOUs taken out to ‘save the system’ in ’08 and ’09 come due) but rather should probably be thought of as part of the current wave of real estate debt defaults. However, the chilling effect this episode has had on global markets is instructive. We will probably see this again.

That said, I think it’s important to remember that a debtor who hits the wall has only the bankruptcy code to rely on, but the rules (and list of alternatives) are very different when it is a sovereign state that is overwhelmed. Default is an option, but a poor option if the state controls the currency in which the debt is denominated. It would be absurd for a country that owns a printing press to actually default rather than print the money to pay the debt.

There are, though, many countries that don’t own the right printing press. Lenders to emerging markets, of course, are generally reticent to lend in the local currency. But thanks to monetary union, every country in the EU has the same problem. Greece can no longer print drachmas, and the ECB is not going to monetize its debt. Those are the countries where eventual default is a real possibility.

Raising taxes is an option if a country wants to really crater its economy. Cutting spending is an option if legislators act very un-legislature-like. But the problems we are talking about are too big to solve with little adjustments.

I hesitate to note – but it needs to be noted – that there is another alternative available to some heavily-indebted nations. There is precedent for societies saddled with suffocating debt to lurch towards socialism, to reach for a charismatic leader, and to turn outwards to find a solution to their domestic troubles. I don’t see that coming… but then, almost by definition we won’t see that coming.