Archive for February 10, 2011

Risky Assumptions and Assumption of Risk

February 10, 2011 3 comments

It is a valuable lesson, but no matter how often taught it seems never to be learnt. Assumptions are dangerous. Overconfidence is the most common, and from the point of view of an investor the most perilous, cognitive error. You have all heard about the experiments: a person is asked to estimate the weight of an elephant, and then asked to put a range around that estimate so that there is a 90% chance that the true weight is within that range. The range is always too tight, by orders of magnitude. We do not know what we think we know. Or, as the old saying goes “it isn’t that he knows so little; it’s that he knows so much that just isn’t so.”

Today this bias was on full display as Egyptian state television announced that President Mubarak would address the nation this evening. Celebrations were widespread as the rumor passed that he would be resigning his office. It may be that these rumors were passed intentionally with the purpose of embarrassing certain other leaders who tried to “scoop” Mubarak by intoning something to the effect that “we are witnessing history being made in Egypt today.”

When still-President Mubarak appeared before the cameras, after several hours of letting the world media whip itself into a fever pitch, it was to tell the rest of the world to mind its own business. He says he will leave in September. Exile? Uh, no: “I will die and be buried in Egypt.”


Now, there was no reason that anyone needed to put a high confidence on what the President (Egypt’s, that is) was going to say. Just wait and see. When we feel that we need to act on our anticipations of events, it is important to correct for our overconfidence. (This is one reason that having a “margin of safety” is such a key investing concept).

The market effects are hard to read, because the announcement came just before the end of trading, but appear to be muted. Oil prices rallied slightly; the S&P is down in the evening session as of this writing and bonds are unchanged from the close.

Earlier, however, bonds traded weak and the new 10y note’s yield rose back to 3.70%. The long bond auction went fine (with that much duration, the hurdle must be pretty low of course) but dealers tried to flip the Dutch treat and the market traded down in the late session after struggling up to nearly unchanged.

Some of the pressure on bonds may have been related to the 383k print on Initial Claims, but this again is very likely to be weather-related. I guess I jumped the gun on expecting the number’s volatility to be declining! Predictably, dealers who have been bullish trumpeted the “best Claims number in several years” as “continuing the downtrend in Claims.” The chart below shows the last quarters’ worth of Initial Claims. If you can see a downtrend in that, I’m impressed.

It takes creativity to see a "continuing downtrend" in claims.

One thing that the strong number this week does, especially when combined with the overconfidence bias, is to make disappointment easier next week. You can see at the top of the chart that the consensus forecast for next week’s number is 400k; only in the week of 12/24 (and this week) has anything lower than 400k printed, so this seems very aggressive – especially since half of the country was shut down for portions of last week and it would be remarkable indeed if the greatest snowstorm in 40 years didn’t keep some filers away.

In addition to the unrest in Egypt there was unrest at the Fed. Governor Kevin Warsh, who had been openly critical of the Fed’s decision to implement QE2, resigned his post after five years on the FOMC. While this supposedly has nothing to do with policy disagreements, there is room for skepticism on that score.

Speaking of the Fed, I had mentioned recently the speech that Brian Sack, head of the NY Fed’s Open Market Desk, was scheduled to make last night. Mr. Sack’s job as head of the System Open Market Account (SOMA) is to execute the monetary policy directives of the FOMC through open-market operations (system repos and repurchases, asset purchases and sales), and his topic last night was the implementation of the Fed’s Asset Purchase program. Mr. Sack is definitely a company man and would not be long in his role if he did not hew to the party line. Although the role is very important, there would be very low tolerance if he were to say anything important that wasn’t a more or less consensus view at the Fed, or at least shared by Chairman Bernanke (unlike with a regional Fed President, which have at least nominal autonomy). So it is useful to read the speech at least as an indication about what is “assumed” to be true at the Fed. Below are a few snippets of the speech and some of my reactions.

“The flexibility of this procedure can be seen in the patterns of our purchases over time. Earlier in the program, we ended up purchasing a large concentration of off-the-run securities, including bonds that were issued 15 to 25 years ago. Given their age, these bonds are generally less liquid and less valuable to market participants, and hence dealers were willing to sell them to us at cheaper prices relative to other securities. At more recent operations, however, we have received a greater share of offers to sell more recently issued Treasury securities, including on-the-run issues, and our purchases have shifted accordingly. This suggests that older, off-the-run securities may have become harder for dealers to obtain, and that they have increasingly found it appealing to offer more recent issues, which are available in greater supply and are generally more liquid. Our procedure allows this shift to take place, as long as the more recent issues are offered to us on generally favorable terms.”

This is a fascinating observation to me as a former fixed-income relative-value strategist. There are many opinions about the efficacy of the Fed’s asset purchase program, ranging from “no effect at all” to “the only thing keeping rates low. This snippet indicates that the Fed is having a fairly large effect. We can’t measure how the purchases have affected interest rates, because we don’t know where rates would have been if the Fed had not been buying. But this observation implies that with only $220bln, the Fedwere able to remove one of the most persistent arbs in the fixed-income markets. For as long as I have been in the bond market (more than 20 years), one dependable truth has been that off-the-run Treasury securities almost always trade cheap to near-the-run and on-the-run securities. On-the-run securities are in high demand for both longs and shorts, and frequently trade very special in the financing (repo) market. This is much less true for off-the-runs. The effect is pronounced enough normally that in order to create a good smooth model of the yield curve one typically needs to adjust the on-the-runs or ignore them. With less than half of their bankroll, Sack says the Fed eliminated most of this arb. What about the next 220bln?

“Since early November, one of the notable developments in financial markets has been the sharp increase in longer-term interest rates. At first glance, this change may seem at odds with the portfolio balance channel. However, it is important to understand the factors that led to the increase in interest rates in the current circumstances.

The upward movement in longer-term interest rates in large part reflects the greater optimism among investors about the outlook for economic growth. Investors revised up their baseline forecasts for the economy and reduced the perceived downside risks that they see around that outlook. This shift in the outlook led the market to price in the possibility of earlier increases in short-term interest rates and to scale back the size of asset purchases that they expect from the Federal Reserve. Both of those developments contributed to the significant rise in yields.”

The flexibility of the Fed’s theory as it concerns their asset purchases is somewhat disturbing. We are now told that the Fed expected rates to rise because of “greater optimism among investors about the optimism for economic growth.” I remember from Logic class back in college this simple admonition (and little else): if a statement is not falsifiable, it is false. If it is true that lower rates prove the efficacy of the Fed’s program (which is what they originally told us, that they wanted to hold rates down and in fact move them lower) and it is also true that higher rates are consistent with a successful program, then what would indicate a failed program? The answer is: none. The program is successful by assumption.

“In contrast, the rise in yields does not appear to be driven by the concerns expressed by some that the asset purchase program would unleash a considerable rise in U.S. inflation and inflation expectations to levels well above those consistent with the Federal Reserve’s mandate. Such an outcome would be detrimental to the economic outlook, leading to downward pressure on risky asset prices and a substantial weakening in the value of the dollar. However, what has taken place in U.S. markets to date does not resemble this outcome. Indeed, over the period since the November FOMC meeting, longer-term inflation expectations have remained at levels consistent with the Federal Reserve’s mandate, risky asset prices have advanced and the dollar has held its ground.”

The dollar has held its ground because everyone is monetizing, and Mr. Sack surely knows that there is no reason for the currency to collapse unless the relative supply of dollars, not the absolute supply of dollars, increases relative to other currencies. Longer term (and by this Sack means 5y, 5y forward – he has written about that in the past) inflation expectations have remained “contained,” and this is encouraging but hardly definitive.

Finally, why is it good that “risky asset prices have advanced”? He’s asserting that we want risky assets to be expensive, and therefore riskier? I thought the whole source of this problem was that risky assets were too expensive, and then when they re-set suddenly many institutions were undercapitalized?

All in all, I was very disappointed by this speech for Mr. Sack. I have come to expect very little from Fed mouthpieces, but since Mr. Sack is a relatively new addition to the institution I had hoped he wouldn’t allow himself to parrot this internal party-line nonsense. It is discouraging.


I said yesterday that I would write today about the conditions in the U.S. inflation markets. I am postponing that discussion until tomorrow. I think the biggest mystery about Friday is how the markets react (a) to Mubarak’s refusal to exit in short order and (more interesting) the question of how investors want to lean going home over the weekend. It isn’t clear for me whether Mubarak’s departure would be bullish or bearish for bonds (on the one hand, it means more short-term uncertainty in exchange for less long-term uncertainty, but it probably depends on how the transition of power occurs. Since he has declared that he isn’t going anywhere, and has passed up several options to gracefully exit the stage (by seeking “extended medical care” in Germany, for example), any change of government in the near-term would likely involve some degree of coercion/violence and at least a brief period of total chaos before it becomes clear who exactly is in charge. All I know is that somehow it will be bullish for equities no matter what happens (we are, after all, in a manic phase).

The economic data is second-tier with Trade at 8:30ET and Michigan Sentiment (Consensus: 75.0 vs 74.2 last) just before 10am.