E-piphany

Many historians believe that, among the cocktail of things that produced the Great Depression, the Smoot-Hawley tariffs figured highly. Conventional wisdom seems to hold that natural forces can cause recessions but only boneheaded policy can turn those into depressions.

I don’t know if that is true, but I hope that we are not looking back in a few years and murmuring about the idiocy of the financial regulation bill of 2010. Today the U.S. Senate voted amid much fanfare to ban taxpayer-funded bailouts of Wall Street firms. That also means, of course, that the Senate voted “if we had to do it all over again, we would have let all those banks collapse in 2008.”

Now, I am all for removing the stink of moral hazard from policy decisions, and I am fine with letting poorly-run companies (although not just banks, mind you, but car companies and mortgage finance companies and airlines too) go bankrupt and be wound down. But this action is the height of cynicism: it was, after all, Congress who approved TARP and passed it despite loud objections from the People and dramatic market signals that this wasn’t wanted. Since Congress cannot bind a future Congress, this law doesn’t really seem to have any important force (and the banks, which know this, will be unlikely to change their behavior in response) other than political. And if it did have force, then it is a silly idea because it takes away tools that policymakers could use in a crisis. For example, while I haven’t read the bill this could limit the Fed – which exists on taxpayer funds – in some way…although come to think of it, the Fed didn’t have any problem doing things that were ostensibly illegal in the last crisis.

And while we’re discussing federal government largesse there is this. I think it may be time for Warren Buffett to pass the reins. A Bloomberg story today attributed this thought to him:

“It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they’ve gone to General Motors and other entities and saved them,” Buffett, 79, told shareholders in Omaha, Nebraska, at the company’s May 1 annual meeting. “I don’t know how you would tell a state you’re going to stiff-arm them with all the bailouts of corporations.”

There was a time when such a simple concept as taxing authority wouldn’t have escaped the Oracle of Omaha. The difference between a state in trouble – which can compel its citizens to pay taxes – and a corporation in trouble – which has no way to do the same – is pretty dang clear to just about anyone who has taken high school civics. If what he says is true, that the feds just can’t say no, then every state should instantly cut state and local taxes to zero. Why make the locals pay for the benefits the state provides, if the federal government can tax the whole nation to provide those same benefits?

Now, perhaps Mr. Buffett meant that the federal government would be hard-pressed not to guarantee state bond issues, since it has guaranteed bank issues, or perhaps he is making a political statement of some sort. Here’s a tip, though, to the federal government if it wants to help: just suspend all rules that create unfunded mandates, and the states can cut those programs. That would create huge savings. The fact that the feds do not do that is a sign that the politics in fact run the other way: Congress would rather add benefits and make state and local officials raise taxes to fund them, rather than raise federal taxes to pay for state and local benefits.

.

It seems timely to be talking about crisis response when the next crisis may be building right before our eyes. We should hope that the riots in Greece don’t turn even uglier overnight and into tomorrow, but mob dynamics are the ultimate nonlinearity and it could go either way fast. I am not sure there are many direct investing implications, however, from the riots that we shouldn’t have already drawn. It should come as no surprise that the Greek austerity measures are highly unlikely to ever be fully implemented if the bailout is completed, since it would be economic and political suicide to do so. It should come as no surprise to other EU countries that there is such social unrest, and that they may also face domestic political consequences if they approve a disbursement to Greece. And that shouldn’t be a surprise to us! We shouldn’t be surprised that Portugal is on watch for a credit downgrade.

The investment conclusion, I suppose, doesn’t follow from the fact of the riots, but from the fact that the televised nature of the riots may begin to make clear the real depth of this problem to all of those who weren’t paying attention, or who were hoping blindly that the EU would skate by this crisis without trouble. And those folks are now starting to jump out of risky assets. What that means is that we should be careful to assume that this movement out of risky assets, only a couple of days old, will reverse quickly. Many investors have been waiting, assuming that they could exit risky positions in plenty of time when it became time to do so; but the liquidity is likely to vanish far faster than it did in the 2008 crisis if this continues for very long, and the door to get out may be very narrow. The VIX, at 16 less than a week and a half ago, exceeded 27 today. That is the right direction, but it was almost 90 during the 2008 crisis. That is to say, if this continues for another week then 27 will look cheap I suspect.

In inflation markets, breakevens declined only 3-4bps after being down 9bps early in the day. Some inflation market observers attributed that to the increase of TIPS auction frequency and annual issuance target amount announced by the Treasury today (there will now be a total of six 10-year TIPS auctions annually, two new issues and four reopenings). But I don’t think so. I believe this is a continuation of yesterday’s pricing down of inflation expectations. Gasoline prices have been plummeting, with the front RBOB (wholesale gasoline) futures contract down more than 20 cents, or 9.1%, in two days. The market is pricing in the increasing chance of a second dip in this recession.

TYM0 rose another 17/32nds, with the 10y note yield down to 3.54%. That’s the lowest since December although still well above levels that would imperil the longer-term case that the secular bull market in bonds is over (as I believe). That case will be challenged if yields drop below 3.37% (the monthly closing level from May 2003) and 3.11% (the low yield from June 2003), and I will re-think at those levels. For now, I remain neutral on fixed-income.

On Thursday, preliminary Q1 Productivity and Unit Labor Costs data (Consensus: +2.6%/-0.7%) will be released, along with the weekly Claims figures (Consensus: 440k). Economically speaking, the real game is on Friday with the Employment data, and with ADP on target today I doubt the market will react to the economic figures. It’s all about Greece, and about reflexive investor responses to changes in prices that can cause further changes in prices. Expect trends in place to reinforce themselves the longer this goes on.