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Fatter Cats Mean Bigger Tails


It isn’t yet clear to me whether the rally in stocks today was a rip-snorter or a snoot-ripper, but either way it was successful. The S&P rallied 1%, mainly because of positive spin on Greece’s condition. I do say “spin,” because the EU didn’t announce anything specific other than the standards they will demand from Greece. They promised “determined” action, but exactly what that means seems not to have been determined yet. Sort of an indeterminate determination, if you will. But the equity market, which as we all know loves clever sophistry, figured that news was better than a sharp stick in the eye and recent trends (strong dollar, weak commodities, strong Treasury market, weak stocks) continued to lose steam. The 10y T-Note contract lost 4.5 ticks, which actually isn’t that bad a show considering the 30y bond auction was a bit weak (but better than it could have been!) and Initial Claims was much stronger than expected…although in this latter case, the Department of Labor implicated some seasonal distortions as partly to blame. It’s hard to get anything out of Claims these days to make sense.

The 10y Treasury note itself ended up at 3.72%, 10y TIPS at 1.45%, and 10-year inflation swaps at 2.64%. The shape of the inflation swaps curve implies that the market is discounting 1.3% inflation for calendar year 2010, 2.0% for 2011, 2.4% for 2012, 2.6% for 2013,  2.8% for 2014, and then leveling out at 3.0% or 3.1% thereafter. All in all, a very regular inflation curve, as it has been for some months now, and fairly optimistic about the Fed’s ability to neutralize all of these dramatic swings in liquidity and the fortunes of various governments around the world. I can’t say I’m so sanguine. If you buy 10 year inflation swaps at 2.6%, what’s your downside? Is inflation likely to average 1% for ten years? But just one or two bad years of inflation, even if the Fed ultimately wrestles the genie back into the bottle, means a lot of upside to that mark. (That being said, these were a heck of a lot more interesting below 2% early last year!) Put in terms of stuff most people can actually trade, 1.45% real yield looks to me as though it has a lot less downside than 3.72% nominal rates. But that’s just me.

Capitalism Revisited

I want to quickly address a couple of comments that were made to me yesterday about my built-in-ten-minutes model of the mixing effect of stochastic risky outcomes on the wealth distribution of society. One insightful comment (and a shortcoming I recognized in my model) was that the outcomes ought to be phrased as a percentage of the risk-taker’s wealth, since wealthy people can take bigger punts. I suppose to be even more accurate, the percentage also should be inversely related to your wealth since at low wealth, any risk at all is a big risk, but again: I’m not trying to perfectly model society, merely approximate some general effects for demonstration purposes. But I put in the percentage-of-wealth method, with the additional modification that the “risk” can’t be less than $10,000 (since otherwise someone with $0 would be stuck at $0 permanently). Otherwise, the model is as it was.

So the three charts below are for the same initial endowment as before, but the first one shows the future jumble at 10% risks, the second at 20% risks, and the third if people are taking crazy 30% risks. The red line indicates what it looked like pre-jumble. Clearly, the bigger the risks people are encouraged and allowed to take, the bigger the inter-class mixing.

Std Deviation of risks is 10%

Std Deviation of risks is 20%

Std Deviation of risks is 30%

So, riskier bets means that more people move from rich to poor and poor to rich. Not surprising, I hope. Now here is something which is perhaps not completely intuitive. Let’s look at the wealth of the person at the 0%, 10%, 20%, etc percentile all the way until we have the fattest fat-cat at the 100% percentile.

Having some REALLY fat cats is a natural result of capitalism

So here’s your tradeoff. If you want more inter-decile mixing, and more capitalism, and more risk-taking, and more successes and failures, you will always have one lucky sumbitch who never loses and ends up with a huge stack of chips (again, think Bill Gates). In fact, I will go further. I’ll bet you can evaluate a country’s historical embrace of capitalism by the proportion of super-rich people compared to the median, and the way that changes over time (this is a bald assertion, a speculation, with no supporting facts. Just intuition based on the above).

I should make explicit one thing that is important in my argument from yesterday: yes, an important facet of capitalism is that risk-takers should be free to win or lose, and the issue of too-big-to-fail institutions is an important way in which we have deviated from capitalism. Now, I do not favor having the government break up the banks, since the banks belong to the shareholders and not the government. But the government doesn’t need to break them up if they just give shareholders at the large institutions an incentive (or remove the disincentive!) to break them up themselves. Citigroup isn’t the size it is because it’s efficient but because the government is giving the shareholders a more-or-less free option because it is too big to fail. Remove that protection, and perhaps give some tax disincentive for size, and the institutions will split themselves up.

Note that there is a really big difference to society, though, between a Wall Street where there are giant banks that aren’t allowed to trade and a Wall Street where all the firms are small, many are partnerships (as it used to be when Goldman, Sachs were two people and Lehman Brothers were the brothers Lehman), but they are allowed to trade their own proprietary capital (and to blow themselves up, possibly). The latter situation will result in more market liquidity and, by the way, there are lots of other ways for banks to blow up besides risking proprietary trading capital (see: Continental Illinois).

One final note I should make. I think that honest capitalists embrace the fact that they may lose. Speaking personally, I am presently involved in a venture on which I am willing to stake everything meaningful that I have accumulated (if I had no family to worry about, I would push all of the chips in). I do that because I don’t think that I will lose, but I certainly acknowledge that I can. And I do that because I think that if it works, I might some day be a fat cat. So I am not writing about something that is entirely sterile to me. That might color my argument, but now that it is disclosed you can be the judge of that.


One of the sad repercussions of the financial crisis was the decision by SIFMA (Securities Industry and Financial Markets Association) to eliminate most early market closes from the calendar. Until 2009, most three-day weekends were preceded by an early close in the bond market; most of those are gone, including the one before President’s Day. So, we’ll be working a full day (wink, wink) on Friday.

Assuming that the people in Washington, DC finally have learned how to shovel snow, the government will re-open and release the Retail Sales report for January (Consensus: +0.5%, +0.6% ex-auto) at 8:30 ET. Last month’s report showed a decline, and there haven’t been two consecutive declines since last spring, so the consensus seems reasonable to me. At 9:55 ET the Michigan Consumer Confidence figures (Consensus: 75.0 from 74.4) is worth paying attention to, more than it usually is, since indicators like Claims are kinda messed up right now. If the employment situation is improving, then the Michigan numbers should improve. A decline isn’t quite as significant since other things (such as movements in the equity markets) could explain a fall in the index.

Stocks have managed to bounce enough that some oscillators will be turning and perhaps give a bit of a technical boost to the bounce. Supply is out of the way for the bond market, but both stocks and bonds face the question of what to do about a three-day break with Greece still on a one-headline-per-day diet. How we trade into the final hour tomorrow may tell us something about whether risk appetite is already coming back.

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