Wednesday, June 25, 2008

Economy to the Fed: I thought I told you to remain on the command ship

The Federal Reserve is set to announce its rate decision today, and is broadly expected to hold their Fed Funds target rate steady at 2%. However, despite the weak economic growth picture and continued pressure on the banking system, most traders now expect the Fed's next move will be a rate hike. Energy and food prices are creating substantial inflation, and the Fed must snuff it out, so the argument goes. Futures on Fed Funds suggest about a 40% chance of a hike at the August meeting, with at least one hike fully priced in by the December meeting. Indeed the 2-year Treasury yield, trading around 2.90%, suggests an aggressive path of Fed rate hikes in the near future.

Would the Fed hike rates with the economy growth and employment picture so weak? Their recent rhetoric would suggest they would. Nearly every speech by Federal Reserve board members and regional presidents during June has mentioned the problem of inflation expectations. Inflation expectations can be a self-fulfilling prophesy, and the Fed must act to prevent such expectations from becoming ingrained in consumers minds. In the late 1970's, as inflation ballooned, expectations for inflation became unhinged, forcing the Fed to tighten monetary policy in an unprecedented way, creating two recessions in the process.

The comparison between the late 1970's and today are particularly chilling. Both periods saw rising energy prices and a stagnant economy. Are we reliving those times?

A look at the correlation between the change in the overall price level (measured by the consumer price index (CPI)) vs. the same measure excluding food and energy (Core CPI) is revealing. If food and energy prices are rising because of loose monetary policy or the weak dollar, then the Core and total CPI figures should rise and fall at the same time. In other words, the correlation will be high.

1970 to 1982, was a period marked by predominantly rising energy costs. The "energy" portion of CPI rose at an annualized rate of 12.1% during this period. The correlation between total CPI and Core CPI was 72.7% when measured monthly and 89.5% when measured annually. Note that a perfect correlation of 100% would suggest that core and total CPI always moved in tandem, whereas a correlation of zero would indicate no relationship between the two figures.

1983 to 1999, was a period of mostly falling energy prices. During this period, energy CPI was a mere 0.1% on an annualized basis. Yet the correlation between total and Core CPI remained relatively high: 58.5% monthly and 85.8% annually.

So over a period of three decades, it was rare that a move in Core CPI would not be mirrored in headline CPI. If one was elevated, the other was elevated. If one was tame, the other was tame.

However, the 21st century hasn't followed the same pattern. From 2000-2008, the correlation between total CPI and Core CPI has broken down: only 7.6% measured monthly and 21.4% measured annually. This despite the energy portion of CPI rising at a 1970's style 9.5% annualized. During the current decade, there has been no particular relationship between total inflation and core inflation.

What does this mean? The data is telling you that rising energy and food prices have been due to supply and demand conditions in those markets. Not classic inflation, which is a monetary phenomenon. In other words, rising oil is indeed due to strong demand from emerging markets and a lack of new supply. Not the weak dollar or loose monetary policy.

The Fed can't do anything to create more oil or temper demand from China. The Fed can only influence the money supply. For the Fed react to a non-monetary phenomenon with a monetary response would be a colossal mistake. Especially when the economy and banking system are as weak as they are.

So the Fed will talk a good game to try to keep inflation expectations low. They might even hike by 25bps to keep inflation expectations under control. But a long series of hikes? No way. Not until the economic growth picture is improving.

This makes 2 to 5 year bonds very attractive, especially for investors holding large money market positions. 2-year Agency bonds are yielding over 3.5%, and 2-year municipals are in the 2.6% area. Both promise to out-yield money markets easily over the next two years should the Fed remain mostly out of the picture.


Anonymous said...

That would only make sense if you believe in the value of the dollar. At 3.56% for the 5yr US Treasury, it barely covers current inflation. And that is for the official headline number. I am sure anecdotal evidence point to significantly higher inflation. It begs the question whether rates in the US is really high enough to prevent capital flight due to high inflation rate.

Anonymous said...

I guess we will never learn. Official foreign purchases are the only thing keeping the dollar from collapsing and people think surging commodity prices have nothing to do with monetary policy.

Pray tell what incentive do Oil producers have to extact more Oil when they are swimming in dollars and have to live with over night rates of 2%. Why would they add to their hoard of dollars at these rates.

Anonymous said...

"During the current decade, there has been no particular relationship between total inflation and core inflation.

What does this mean? The data is telling you that rising energy and food prices have been due to supply and demand conditions in those markets." this means is that the data is phony. And you don't need conspiracy buffs to tell you that; just check how the various CPI calculation methodologies have"adjusted" since the early '80s.

We have a choice: (1) bail out the banks, bury our head in the sands, try to define inflation away and trash the US Dollar, or, (2) face reality, take the pain and return to a semblance of sound money policies.

I'm betting we continue to live in denial for a while.

Still love your blog, though.


Anonymous said...

you fail to mention any inflationary impact from the Feds cuts as they relate to all the dollar pegged currencies...........

Anonymous said...

what halfway intelligent person quotes CPI as a measure of inflation? Heck, even the talking heads on CNBC mock the CPI figures when they come out.

The Boskin Commission pretty much "defined" away CPI. Other websites calculate CPI the "old way" (pre-Boskin) and they say CPI should be 6-7%.

Broad money supply figures like M2 are also up at least 6-7% yoy

Only traders and foreign central banks trying to prop up exports are interested in buying Treasury bonds now.

You only get 3-4% (less for 2yr bonds that you recommend here). You have to pay federal taxes on that "profit"... and then you have to subtract out inflation.

Using bogus CPI numbers (4% yoy), it means you are locking in a LOSS.

Using actual changes in the cost of living, you subtract 6-7% and have a big LOSS.

So note to Wall Street traders who are too young to remember what a certificate of confiscation is:

Treasury bonds are a lousy investment here.

Anonymous said...

AI: do you pay any of your own bills? Do you know what school for children costs? Do you know what college costs? Have you noticed the price of healthcare lately? Have you bought any food?

I would hope that a guy who authors a blog called "accrued interest" would understand that a bond (or any investment) is first and foremost supposed to be a good store of purchasing power.

Why would a smart person lend money to a stranger today so they can consume less tomorrow?

That's basically your suggestion in buying 2-5yr Treasuries.

I have been reading your blog for over a year -- this has to be your worst post. I think it speaks to how completely out of touch with reality Wall Street has become.

Bernanke isn't talking about raising rates to upset Wall Street -- he is doing it because inflation has become so bad that even members of Congress have noticed.

Lowering rates to bail out incompetent banks is not a legitimate economic policy -- and everyone outside of Wall Street is letting Bernanke know.

Anonymous said...

As other people have already noted, CPI is a thoroughly discredited measure of inflation. Ever since Nixon started focusing on "core CPI" (to remove all the items that were going up), there has been a steady erosion in how useful CPI is.

Even on a pre-tax basis, US Treasury rates do not compensate a buyer for loss of purchasing power. As noted, once you pay tax and subtract inflation, you are locking in a negative return.

viking said...

But AI, they've changed the methodology of core CPI measurement. If you went back to 70s methodology you would see the historical correlation in the 21st century too.

viking said...

this was a real credibility killer AI

Anonymous said...


I have to echo the sentiments above. Investors in bonds want a real return. Should cpi inflation average, say, 3.5% over the next two years, the real return on 2yr notes will be negative. It would be really useful for your readers if you could explain how this is a "good investment". Perhaps you believe the cpi average will be closer to 1.5%. Fine, then please say so, as I could find no such positive-real return prediction in your post.

I suspect what is at work here is a professional money manager mind-set. You feel you've done your job if you pick the part of the curve that returns the most. Your basis for doing so is a prediction of what the Fed will do. Whether the ultimate return is real or not is an after-thought.

In the real world, even this "relative" bet only works as long as China is happy with negative real returns. If that were to change, then not only real but also nominal returns in 2yr notes will be negative, no matter what the Fed does.

Accrued Interest said...

I'm well aware that CPI has gone through various revisions in its methodology. My numbers were based on the "current" series throughout. If you want to start making the "numbers are cooked" argument, I point to the fact that the housing component has shown 7 straight months of increases.

The question isn't about purchasing power. Its about what the Fed is going to do. Currently the Treasury market is pricing in several Fed hikes. Not going to happen. So the value of shorter Treasury bonds will rise.

Put another way, what else are you buying? Money markets at less than 2%? The only way holding MM will work is if rates keep rising.

Now those who believe in a foreign flight thesis, they'd clearly ignore what I'm saying. But if you buy that argument, inflation is also pretty irrelevant.

Anonymous said...


Very simply, if you expect a negative real return on any short-term US$ bond, your option is to not invest in US$, or to invest in commodities. Over any time period where real rates are negative, I'd expect foreign currencies and gold to outperform short term US$ bonds.

This gets back to the "money manager" mind-set. For you, a bet away from US$ bonds is irrelevant -- a choice only your investors can make. Once they put their money in your fund, then the question is only "which US$ bond loses the least money in real terms?"

BTW, its entirely possible for the Fed to cut rates AND for 2yr rates to rise. In fact, given the negative real rate impact on inflation, I would think this scenario is quite likely. The Fed does not set 2yr rates. At the moment, China and other reserve accumulators do. You're basically making a bet on their inflation problems disappearing without impacting dollar recycling.

PNL4LYFE said...

My main takeaway from this post is that

1) Most commodity inflation is due to supply/demand fundamentals rather than loose monetary policy.

2) The yield curve is pricing in more fed hikes than are likely over the next few years. Therefore, holding a two year note for two years will outperform cash.

I think the first point is probably true and the second is almost certainly true. I would add that the other types of inflation that people mentioned such as education and healthcare aren't due to monetary policy either. We could argue about whether they are also supply/demand issues or the result of horrible public policy, but they aren't the Fed's fault.

Anonymous said...

Inflation is a monetary phenomenon: Increasing numbers of dollars chasing the same amount of goods and services. Classical inflation involves increases of all inputs, including labor costs. The wage price spiral of the seventies occurred as a result of inflation expectations becoming embedded in everyone's economic decision making. Prices go up and incomes go up.

Higher energy costs are working their way through the economy, resulting in higher prices. However, wages are not keeping pace with this increase. This is not inflation. This is getting poorer.

If wage pressure gets more intense, ala "I'm not coming to work unless you pay me more money for my gas" than we may see an inflationary cycle start to crank up. It's just that we haven't seen falling real income in a long while, so people think that this is inflation.

Anonymous said...

Chris Wheeler: Inflation is a monetary phenomenon ... However, wages are not keeping pace with this increase. This is not inflation. This is getting poorer.

No, inflation is a monetary phenomenon, and wages have nothing to do with it. All those Latin American banana republics had no wages, but they had plenty of inflation.

M2 and MZM are both increasing 6-7% yoy (or more). Check the Fed's website

Anonymous said...

AI: Put another way, what else are you buying? Money markets at less than 2%? The only way holding MM will work is if rates keep rising.

If I absolutely must buy U.S. bonds (and I don't see why you think that is the only choice) -- GNMA bonds with effective durations similar to 2y - 5y Treasuries pay 200bp more and have no credit risk. They carry the exact same full faith and credit of the US Treasury.

As for what the Fed is going to do, I would strongly question your certainty that they must keep lowering rates -- or even that rates stay where they are.

Bernanke isn't paying lip service to inflation because he wants to; and he may also end up raising rates not because he wants to.

I think you forget your place in the world. The U.S. is no longer THE great economy in the world-- it is one of several. Further, it is the biggest debtor the world has ever known, with chronic spending, trade and current account deficits. Consumers are in debt up to their eyeballs.

The need to attract credit means the U.S. no longer gets to run monetary policy based solely on what is happening in the U.S. Global factors weigh in, and often times will dominate.

The rest of the world does not care that a bunch of incompetent U.S. bankers shot themselves in the foot. That is no reason to give money to the United States -- it is arguably a reason NOT to give money.

Foreigners do not have to "flee" the U.S., they just need to stop lending more. If this happens (when?) -- the U.S. would be forced to live within our means (HA!) or pay much higher rates.

I don't know that this will happen, but I certainly wouldnt be as arrogant as you and presume that it won't or can't.

Foreigners do not "owe" us credit, nor do domestic savers. High time for pompous Wall Streeters to figure that out.

If the U.S. doesn't pay a positive real rate of return, the savers of the world will take their marbles somewhere else

Anonymous said...

all this talk of inflation and we're going through the greatest credit contraction of all time, am I missing something??

Anonymous said...

Lots of market timers on this thread!

Accrued Interest said...

Look, consumer prices can't rise unless consumers are spending more money. Its pure math.

As for me having a money manager bias, that's a fair accusation. I do think most investors should have commodity exposure, especially now. As oil rises, stocks fall, and vice versa. Oil is currently the best hedge going. It sure hasn't been bonds.

As for MBS, they are going to have much longer average lives than you think. People just won't be moving from their current residences until the housing market improves. I'm not optimistic that's happening for 18-24mos. Plus even if it bottoms there, HPA will plod along for several years after that. I mean, I'd see negative numbers for another 2 years, then 1-2% real return for the next 5. That means very slow housing turnover.

Anonymous said...

AI: Look, consumer prices can't rise unless consumers are spending more money. Its pure math.

Not sure what math class you took that discussed consumer spending.

If you pick your head up out of your Bloomberg and go out into the real world, CONSUMER PRICES ARE GOING UP. No one cares what your model says is supposed to happen- LTCM made that mistake and we know what happened to them. The important thing is what is actually happening; and that is PRICES ARE GOING UP.

Plenty of Latin American countries experienced inflation even though their consumers were dirt poor-- literally.

Inflation is a monetary phenomenon, not a consumer spending phenomenon.

Anonymous said...

ez$:all this talk of inflation and we're going through the greatest credit contraction of all time, am I missing something??

Inflation is a monetary phenomenon, not a credit phenomenon.

When home prices were going up 15% per year (and the dot coms were collapsing), plenty of people claimed we were in danger of deflation. Bernanke even got his helicopter license at the time proposing to dump money if needed to counter deflation.

Now housing is down 15% and you claim that is also deflationary?

Nonsense. Credit has nothing to do with it, never did. If you read international newspapers, you will see that inflation is ravaging countries everywhere -- including countries in Asia and the Middle East where there is no credit problem at all.

The Treasury and the Bank of China are busy monetizing over a trillion dollars of US debt. The US trade deficit ensures that there are piles of dollars all over the place, but what are they supposed to buy with them?

The Bank of Japan is printing money as fast as their computers can run... the yen carry trade is exporting this inflation all over the world.

Even the ECB, which is raising rates, is releasing billions of Euros into the banking system to try to prop up insolvent banks.

That's where the inflation is coming from. Same place it always does: central banks

Anonymous said...

All of you discussing cpi as THE crux of the decision on whether 2's are a good investment or not are just wrong. i agree, too, that cpi is understated (or just plain b-s). i also agree that cb's cause the monetization that creates inflation. nevertheless, the only thing that you care about in purchasing 2's is your EXPECTED funding rate (or alternatively how the market will alter its expected funding rate). why is this? simply because you can leverage your investment to overcome the drage from inflation.
please do not take my statement that buying 2's is such a good investment that one should lever up. i am merely pointing out that if one does think the cb will keep rates at 2% and 2 yr notes are 3%, then buying them is, in fact, a good do. even if cpi is 8%. of course, the cb will likely take such a number into account in making its policy decisions.
one additional note is that i think it does matter that there is a credit expansion. the money multiplier does matter for cb's. they might choose to open the spigot to overcome that, but a lower money multiplier will slow the cb down.

Anonymous said...

Anon 8:55 -- finally an intelligent argument about why 2yrs might actually be a smart "trade".

You are basically saying that Bernanke is trying to reinflate insolvent banks by lending taxpayer money below cost and then borrowing it back at the 2yr rate. No, I don't want to split hairs about which part of this is done by the Trsy vs the Fed. The government is lending money at 2% and borrowing the same money back at 3-4%.

Great for bankers who are too stupid to spell risk management... really bad for everyone else.

There in lies the problem. 2yrs might be a good idea if you believe Bernanke can keep this tax payer theft going indefinitely...

AI seems to be arguing that there is no end, and he is absolutely positively 100% certain.

Well, millions of registered voters who are also AARP members are seeing their savings disappear and their bond based income stream decline. They aren't happy with Bernanke to put it gently.

The Chinese government doesn't care what happens to AARP members or Wall St traders-- they want to stay in power. China cannot continue to import inflation forever unless they want to be overthrown. Once the olympics are over, they have every incentive to stop financing Uncle Sam. I doubt they are going to yank all their money out -- but its in their own self interest to stop putting more money into the US.

Uncle Sam has no money. I know Obama wants to increase taxes, and odds are he will roll back most/all of Bush's tax cuts... but that will barely cover the on-budget deficit. It won't pay for any of his spending ideas, and it won't even dent Medicare which becomes cashflow negative almost the day Obama takes office. If McCain wins, he wants to make more tax cuts.

Whether Wall St wants to admit it or not, the next president is going to have less resources with which to pay for ever increased promises. Something has to go. And an unpopular subsidy to Wall St is 100% certainly not immune from the cutting block as AI and others suggest.

Mortgage rates did not and are not falling with Fed Funds (nor would any half wit have expected them to). Bank's balance sheets are in a shambles, and many large banks are defacto insolvent.

Arguments about Citi or JPM or BofA being too big to fail don't hold up. None of the big banks existed in their present form 30yrs ago. Bank of NY is the only major bank that existed 100yrs ago (and even then, not in its present form).

Continental Illinios failed, but life went on. We will live without a few of these other stupid banks as well.

The fact is, these big banks are too big to save-- even for Uncle Sam. The Fed exchanged half its balance sheet trying to save Bear Stearns, which was puny by comparison.

100 years ago, Great Britain was the world economic power. Now they are a side show to continental europe, never mind the US or BRIC countries.

Unless the U.S. pulls its head out of its rear end, we will be in the same place by 2030.

The U.S. cannot afford to keep subsidizing poorly run banks (via this 2yr-FF "trade"). If we keep doing it, it guarantees that every US bank becomes a second tier.

Everyone knows this. Everyone knows that bailing out wall St mistakes is politically unpopular. Everyone knows Uncle Sam doesn't have the money to keep all its promises (even assuming some tax increass) -- so something is going to be cut.

Its just the arrogance of Wall St to figure that Wall Street's subsidy won't be on the chopping block.

Bernanke may very well be forced to increase rates -- by politics, by OPEC/China, by AARP, or all three. This is true even if the economy stays in the crapper (which I think it will). The Fed is no longer in a position to act solely off what is happening domestically.

And politically speaking, if a Wall Street has to downsize, and a bunch of pompous, overpaid yuppies get laid off -- do you think that middle America (which was already laid off) is going to worry?

Once the banks lay off their bloated staff, they won't need as much of a spread to stay afloat. Spreads between mortgage rates (that voters care about) and bank funding will fall back to historical levels, and the politicians will have a few billion in extra money (that formerly went to the 2yr-FF spread trade) to spend on their constituents.

Populism is on the rise, capitalism is on the retreat. History suggests the Fed will not remain beholden to Wall Street's wishes.

And if you are one of the Wall Street traders who lost money on a bad 2yr Treasury bet, guess who is going to get trimmed first?

Anonymous said...

Here here to anon 4:36!!!

The Federal Government does not have unlimited funds. Its one thing when "tree hugger liberals" lack common business sense, but when the so-called titans of capitalism fail to grasp it... well, you get the situation we are in now.

The U.S. is acting like a banana republic... its not just dimpled chads on voting cards. Its in the way business and finance leaders (outside politics) act and think.

When traders do their 2yr - FF spread trade, they really don't get it.

First, you are stealing from taxpayers. Traders are not known for their ethics, so maybe that doesnt bother them. But sooner or later some populist congressman is going to return the favor.

More importantly, the trade betrays the ignorance that got Wall Street into the mess it is in.

If you buy 2yrs with your own money, you lose. That's been explained well in earlier posts.

As Anon 8:55 explained, you can lever yourself (with taxpayer money) to increase your return. Lets think that one through a bit:

Your true inflation cost remains 6-7% (lets stay with 6%). We will say you are collecting 3% on your note (although current rates on 2yrs are less). So you net 1% extra for each "time" you lever up.

After taxes, you are starting 5.5% behind (6% inflation plus taxes is around 8.5% minus the 3% you collect).

So you have to lever yourself 5.5x just to break even... well, not so fast. You have to lever yourself more like 8x to break even after paying taxes on the full 3% you think you are earning. 8x leverage just to break even.

If you lever 10x, you are making about 2% (actually less, once you pay taxes).

If 2yr rates move against you and you are levered 10x, it doesnt take much of a backup in rates to bankrupt your fund. Actually, if 2yr rates back up to 4.1% (the most recent CPI figure) -- you are in Chapter 7.

If you think 2% upside, and bankruptcy on the downside, is a good risk reward trade-off -- then you shouldn't be trading anyone's money, not even your own.

Then again, if Wall Street traders understood risk management, they wouldn't be taking hundreds of billions in write downs.

Anonymous said...

and I forgot to mention the other problem with the levered trade:

if wall street is going to be sucking at the tit of the Fed, it stands to reason the Fed will impose leverage limits -- same as they do for banks

The Fed doesn't allow 10x leverage.

Anonymous said...

17 or 18 years ago, Japan found itself in a similar situation as the U.S. is now.

The Bank of Japan cut rates to zero (or pretty close)-- the same "prescription" now being championed by AI and many on Wall Street.

Well, after suffering through a lost decade, and then 7-8 years of perennial predictions that "this time, Japan is going to come out of it!!!" ... Japan is still in a funk.

All those insolvent Japanese banks still ended up failing. A large number of small poorly capitalized banks were merged in shotgun weddings to create a small number of really big, really poorly capitalized banks. None of them are the powerhouses they once were.

The Japanese economy remains in a funk. Japanese stocks have not returned to their lofty heights. Japanese real estate hasn't returned to its lofty heights. Financial payrolls (both in headcount and in yen) are a fraction of what they were 17 years ago.

Fool me once, shame on you. Fool me twice? Wall Street are not the smartest guys in the room by a long shot.

I agree with earlier posters that there is a non-zero chance that U.S. rates are headed higher...

...but if you agree with AI and other "Fed on hold" thinkers, then your best trade is to change jobs and get out of Wall Street.

Buying 2-5yrs is either a losing trade or its masochism. Its not a smart trade no matter what scenario happens

Anonymous said...

Recent quote from the Economist:

Veteran investors may recall 1962, when the Treasury bond yield was less than 4%. Those who bought bonds then earned negative real returns over the succeeding five-, ten- and 20-year periods. They should be very careful about making the same mistake again.

Journalists were warning about the bubble in real estate for years before the collapse, but somehow Wall Street was caught by surprise in this "once in a lifetime" collapse (which seems to happen about every 7-8 years).

Now AI is setting himself up for the next crisis, which he will claim no one saw coming.

Anonymous said...

I have been saying to AI for months now that this is not a liquidity crisis, but he refuses to listen.

When an economically viable entity (that is not suffering massive losses) cannot get a loan, that may a liquidity crisis.

When someone who is taking massive losses and has an inviable business model can't get a loan, that's just lenders acting out of common sense.

I hope I don't have to mention the almost $400 billion in write offs that Wall Street has taken so far. There's probably another $800 billion to go IMHO.

But the bigger issue (that relate to buying 2-5yr Trsy) is that Wall Street's business model is no longer viable. Wall Street basically makes its money in one of three ways:

1) Market making... here the banks make the bid-ask spread for providing liquidity to a market. Bid/ask spreads in many markets are zero (no profit) and in certain products there is an ask, but no bid because the assets are garbage (no profit)

2) Securitization. Take loans (good ones or garbage) and securitize them, sell 100 cents worth of loans cut up into tranches for 105 cents (or more).... No sane person trusts the securitization models behind many CMOs much less CDOs. Securitization will make a come back in 3-5 years, but it won't be as big as it was last year -- so it won't support even the reduced headcount wall Street has now.

3) Leverage. Spreads (LOAS on mortgages, corporate credit spreads, or the spread between Treasury yields and repo rates) are historically very very thin. In an era of absurdly easy money, Wall Street made money anyway via massive massive amounts of leverage.... The more people levered up, the more they bought (higher demand), prices went higher (spreads got narrower), which necessitated even more leverage-- and so on. I think George Soros called this reflexivity?

Two problems here. The obvious one is that firms are being forced kicking and screaming to delever. Without 30-1 leverage, the narrow spreads in many products are not profitable.... this includes buying Treasury bonds at only 100bp over cost of funds.

The second problem is that delevering causes people to sell (duh!), meaning reduced demand / lower prices. Lower prices means other people now have a loss and they have to sell --> more reduced demand / lower prices. Soros' reflexivity working in reverse... all the artificial "demand" created by leverage is unwound, leaving only the "true demand", of which there is none at current spreads. You need lower prices for the true (less levered) demand to kick in.

The higher spreads / reduced leverage that will make for liquid markets means many assets will have lower prices over the next few years (and many Wall Street firms won't survive).

Until this delevering / spread widening runs its course -- you don't want to be buying anything that Wall Street owns in bulk.

Merril is now rumored to be selling their crown jewels (positions in Blackrock and Bloomberg). These are arguably some of their best assets. But in desparation, they sell what can be sold (better assets), not the garbage they would like to sell.

Anonymous said...

anon 5:16 & 5:22 :

a few things:
1) i find the wall street cheating taxpayers statement as diminishing your argument. many entities choose to pay more for funding longer term than shorter. this is called the liquidity premium. you, in fact, criticize wall street for borrowing short and lending long. it is not theft. in any sense of the word. this does not belong in an analysis of the finance of this trade.
2) wall streeters are not dumb. but their game is not obvious to outsiders. there is no doubt many employees of bear (and banks that have lost market value) have been set back -- some, i'm sure, crushed. but, to my knowledge, no actual bonus money paid out has been returned by wall street employees. the wall street trader and senior executive owns an option on their pnl. if it wins, they win. if it loses, well, they might lose their job. no doubt to turn up somewhere else. how does an option work every well for the holder? with LOTS of volatility. so the best game plan for a wall street trader is to swing for the fences. this is an artifact of the somewhat recent conversion of wall street from private partnership to public company (ie. limited liability and easy ability to cash out).
3) your analysis is fine. but you neglect certain things. i noted that it may not be wise to lever up to buy 2 year notes. i also stated that inflation is one of the inputs to an EXPECTED path of interest rates. my statement was merely that if one felt strongly enough about the path of o/n ff that one could leverage the investment to overcome inflation. that is still true. it may be a bad risk-reward trade but it is, in fact, accurate.
4) your leverage figure is incorrect. to the best of my knowledge one is able to obtain 10-1 leverage for USTs. for institutions i believe it is even higher. in fact, even were that not the case, you could do even "better" on the CME in the 2 year note futures and create synthetic 2 year notes.
5) you ignore that money needs to be put to work somewhere. unfortunately for both of us, there is not a true inflation indexed bond (i heartily agree with all who believe that cpi is understated). but i hardly think that for a usd based investor that taking all of one's money out of usd and into foreign currencies is a trade without substantial risk (esp compared to a leveraged 2 year note trade). after all, you just created a basket of non-dollar assets to fund future usd liabilities (retirement, kids college, etc). this doesnt hold, of course, for non-usd investors. but frankly, my reading of elsewhere is that inflation is an issue globally. i guess that leaves you holding gold or crude oil. at this point, im not so sure those are good trades. or at least, im not willing to put 100% of my assets to work there. some small amount, sure.

in closing, i think that our thinking is rather similar on a macro basis. but for this one, small detail -- are 2 year notes a good buy here, i have shown where we disagree.
and, if you have good ideas about how to put money to work for my futures usd liabilities, i am all ears. because i, for one, don't have any terrific inflation beating ideas. and i dont plan to leverage 8 or 10 to 1 on 2 yr notes -- even though i do think they are a good do here.
best regards,

Michael Krause said...

Fascinating discussion of a bunch of anonymous posters.

The better question: After $140 crude, how much more inflation can we possibly have from this point on before aggregrate demand in the economy falls rapidly?

Credit contraction equates to a reduction in monetary supply, I have no doubt.

You guys are mostly caught up arguing about the wrong issues. The reduced banking leverage, potential insolvency, and the potentially leveragable gains that the FF-2yr spreads can provide to banks are all distractions from the core.

The core issue: investor psychology has made stocks and bonds worthless versus crude oil. And because crude oil is indexing future inflation expectations, its own gains are amplifying expectation of even more pessimistic returns on financial assets going forward.

This is bubble psychology. The future view (which is based on trending assumption) on crude oil (transitively inflation) is unrealistically depressing the value of financial assets. Just watch the stock market. Its pretty clear that the quants are running a 'if crude > crudeyesterday, short S&P' program as we speak.

AI's assertion to buy 2-5yr assets is valid if you step back and realize the fundamentals: we are in a recessionary environment and crude will come back to earth as the bubble pops. Suddenly you'll have deflation expectations in a global recession environment, and 3% will look great.

Furthermore, high transportation costs are wreaking havoc on trade relationships. It now costs more to import Chinese steel than to produce it in the United States. Current shipping rates make Mexican labor much more competitive right now.

The Chinese are dependent on exports, just like Japan, and can not afford politically to dump their US assets in the face of whats going on.

The trend is strong in crude right now, but there is no way on earth it will sustain in the face of the global economic slowdown we're facing right now. Demand destruction from recessionary, policy, and speculative forces will halt the advance, dampening inflation expectations to justify the argument to buy financial assets here.

The leveraged banking model has always been a flawed one, and I have no doubt that the sector's historic cumulative profits must be near zero sum (or negative) due to these subprime, savings n loan scandal, etc. wipeouts that happen on occasion. No doubt.

But the negativity on financial assets we are witnessing no doubt is exacerbating the bubble that is 'short financial assets, long hard assets'. That's some 'reflexivity' for you - price begets new price, until the trend is no longer sustainable and reverses.

(Now what is everyone thinking of a short 4x 20 yr treasury, short 1x crude spread here?)

Anonymous said...


The sky is falling crowd has been yelling about demand destruction causing oil to top since oil was trading at $70/bl.

Whatever you may think of Jimmy Carter, he is the author of the current U.S. Energy Policy (ie "Put on a sweater"). However absurd that policy might be, it is the defacto energy policy. We've had Democrat and Republican Presidents and Congresses -- but our energy policy is either "Put on a sweater" or "Let someone else worry"... after a while that catches up with you.

And rather than address the problem, Congress now wants to blame speculators... even though CFTC reports show the speculators are (in aggregate) short oil. Did any member of Congress ever propose making house speculation illegal? They are cowards, trying to pass the blame to anyone but themselves.

According to figures from the Dept of Energy, gasoline demand has fallen 1% yoy as of the end of May (when oil was in the high 120s). Hardly the stuff of demand destruction.

I don't know anyone who has quit their job because car commuting costs have become too high. They cut out restaurants or hobbies or what not first. Taking the kids to soccer practice (usually by car) does not get cut either. All of suburbia has to drive their car to the grocery store if they want to eat. And truckers have to burn gasoline or diesel to get the food to the store.

In short, a large part of oil demand is price inelastic. People will bitch and whine, but in the short run they have little choice. In the long run, we would have to have a well thought out energy policy -- but since we don't, we will just have to bitch and pay more.

And that is Bernanke's problem too. I have little doubt that he would prefer not to raise rates. I am merely saying that the choice is no longer his alone-- and arguments could be made that the choice is no longer his at all.

The point I was trying to make is that 2-5yr Treasuries are far from the risk free investment that AI suggested. Quite the contrary, I think one would be locking in a small loss (after taxes and "true" inflation). Perhaps, if you are a fixed income only money manager, you might argue that a small loss in Trsy is better than a big loss in CMOs. But they are far from risk free assets

Anonymous said...

Lots of "anon" posters here... just click the "Name/URL" button and make up a name so we aren't all starting our replies with "Anon xx:xx"

On AI's post: maybe the crux of the issue is what sort of benchmark you are managing against.

Hedge fund managers typically get "2+20", and many other managers get some percentage of the upside. The majority get judged against whatever benchmark, which often is some mix 60/40 or 70/30 of S&P / Lehman Aggregate.

Hence, most "professional" money managers don't care if they beat inflation, and don't care about after tax returns. As long as they beat their "bogey", they think they have served their clients well.

Only the more sophisticated clients judge their managers based on after tax retention of purchasing power, and hopefully a little expansion of purchasing power. These clients are (at the moment) a minority.

Those managing their own money also tend to look at things on an after tax, purchasing power basis -- although they may not articulate their need in so many words. Many elderly persons fall into this boat, as they are on fixed incomes and don't want to have to ask their families for money.

Apologies in advance to AI and other professional money managers, but Treasuries really only look good to you because your clients judge you relative to a somewhat bogus metric (S&P/Lehman).

But if you think about why people save or invest in the first place, why would a person forgo consumption today in order to get less tomorrow? Who cares if your "gross return" exceeds a random metric, if your "net return" (after taxes and loss of purchasing power) is negative?

That's the difference between a Warren Buffet type money manager, and the majority of hedge / mutual fund managers.

Anonymous said...

gramps - at some point, i'll probably create an identity.

all investors care about after-tax returns and beating inflation and beating 0 (i.e., don't lose money, i don't care if you beat the dow).
you are missing the point behind being a fund manager and the benchmarking issue. the fund manager has a certain mandate. it can be broad -- just make money. or narrow, this is a short-term govy fund.
the investor in the fund makes his/her allocation and NEEDS the manager to stick to the mandate. in other words, the investor decides he wants to be in short term treasuries. he then has two choices -- follow the lehman aggregate, do it himself, or hire a manager. that is what the benchmark is all about -- the alternative to hiring the manager. in this case, the lehman aggregate.
in the case of a hedge fund type scenario, your criticism is far more accurate. but what inflation measure does one use? in what currency? and most hedge funds don't get linked to the lehman aggregate, they usually get benchmarked against a hedge fund index, i.e., their peers.
and i still don't know what to do with my retirement account. it is very hard to overcome 4-6% inflation in a 2% FF world. which is, why, no doubt gold is near $1000 and crude $140 (and i agree with the prices beget prices argument from above).

Anonymous said...


hedge funds get judged against whatever hedge fund index. Mutual funds get judged against whatever S&P/Lehman mix (some are 100%/0% or 0/100).

I would advise any client with such simple (naive?) expectations to just buy index funds. Over a medium to long term horizon, you will beat 85-90 percent of professional money managers-- mostly by not paying the management fees. If this is your target, then you don't need a manager to stick to his mandate, and you are foolish to pay active manager fees for index results.

For hedge fund / alpha managers, creating a benchmark isn't that hard. You have a ready made benchmark made up of the client's liabilities... the elderly are particularly concerned with keeping up with rising health care costs; those are running 8-9% yoy right now. You have to take a fair amount of risk to hit that bogey, and its virtually impossible if you are buying Treasuries (even levered).

Other clients are worried about being able to retire "on time" (this is a strange concept to me, but apparently one must retire no later than 65 or else the boogie man gets you or something). Anyway, these people want their nest egg to grow, after taxes, fast enough that investments can meet living expenses, after taxes and inflation, with minimal depletion of principal...

Once you get a client to clearly articulate what their long term goals are, its pretty easy to develop a "liability index" that you want to target. How much risk do you have to take to hit that target and are you comfortable with that level of risk? Yes, OK. No, then you need to save a lot more.

At any rate, most of the people I work with would not be happy with what they could get with Treasuries, even if a moderate amount of leverage was used.

Even from a portfolio viewpoint (buy a combination of Trsy plus something more volatile), you can do much better on a risk adjusted basis.

I agree with other posters here that there is about equal chance that Bernanke is forced to raise rates (however unwillingly) as there is chance of him lowering rates further. He got himself into a catch-22 situation where he no longer has any "good choices".

When buying bonds (any kind), you have to ask if the return you get covers the risk you are taking... At sub 4% yields, Treasuries don't even cover cost of living before taxes. The risk is high, the return is negative -- what's to like about them?

Accrued Interest said...

I've been on vacation for the last week so I've been remiss in responding to some of the comments here. Great discussion tho.

My point in the post is to say that Fed expectations are too agressive and therefore 2-5 year bonds will rise in value. That's a short-term view. If you forced me to make a decision now on Treasuries for the next 12-18 months, I'd rather be short than long. But as a money manager, I can have whatever time horizon I want. Some trades are long-term some are short-term.

I've also been right for once. We've rallied about 20bps on 2's since I wrote this post.

Accrued Interest said...

Also, I've never said Treasuries were risk-free. I would never say such a thing except in an academic context. I.e., you will get back the dollars you were promised. Whether or not that's an adequate return or how much those dollars are worth is another question.

Accrued Interest said...

Another point: in the long-term, short-term Treasuries usually don't cover inflation and taxes. Since 1995 or so, t-bills have almost always been 5% or less. If you lop off 30% for taxes that's 3.5%, which is basically inflation over that period. So even at the higher levels, short-term T-Bills suck.

Accrued Interest said...

And Gramps:

Everytime you post about my "liquidity crisis" argument, you act as though its a black and white situation. That I can't possibily believe that liquidity is a problem AND credit is a problem. Can you please explain why you hold this view?

Anonymous said...

AI: I understand that you think the situation we face is a liquidity AND a credit problem. I understood your position a long time ago.

But I disagree. I don't think anyone has an in-alienable right to credit. There are perfectly legitimate reasons why some entities would be denied credit that have nothing to do with a "liquidity crisis".

For example, if a bank's assets are predominantly bad loans, and if the bank is run by managers who clearly wouldn't know risk management even if you beat them with a risk management book -- I would argue that either of those are perfectly legitimate reasons to be denied credit.

And most money center banks meet both those descriptions.

Bernanke is stealing money from savers (of which the U.S. has a shortage) and using it to support bad business.

That is not central banking. That is crony capitalism.

Bernanke could lower rates to zero, and it won't make bad loans somehow good. It won't fix galactically stupid risk management systems. It won't fix bank pay structures that pay rather generous cash payouts now against potential revenue for the bank in the future.

Banks do not face a liquidity crisis-- at all. No economically motivated player wants to lend money to a deadbeat, especially a foolish deadbeat.

If the banks had a good business model, if they practiced good risk management, if they aligned bankers long term interest with the banking system -- then I don't think they would have a problem borrowing money. Your claims of a liquidity crisis simply don't make any sense -- we know that OPEC and Asian investors are struggling to find enough places to put trade surpluses. They are desparate to find places to park cash -- but quite understandably, they aren't going to lend to insolvent idiots.

What Bernanke is doing is crony capitalism, pure and simple. Our economy will not get fixed by central economic planners propping up poorly run (and insolvent) companies.

Accrued Interest said...

Gramps: My view on what constitutes a "liquidity crisis" isn't exactly what you are describing, but once again we're going to have to agree to disagree.

King said...

We all know what's happening: The Fed is bailing out the banks' bad loans by killing the dollar. This is protectionist monetary policy. By crushing our currency we're effectively exporting a sizeable amt of our economic contraction to China, our biggest creditor. Parts of US manufacturing have remained stable, and should continue to remain stable as it will be cheaper to produce here than import from China.

The argument that supply/demand is driving oil price is only half true. Crude oil is a commodity traded in dollars that is primarily produced in anything BUT dollars. So if you kill the dollar, there's no question: crude must rise.

This inflation starts at the trade defecit and works inward. We are seeing it begin to show in consumer goods as manufacturers costs for energy and raw materials are rising due to the Fed's actions.

The reality is that everything has worked well between our Chinese creditors as long as we continue to buy their exports. The Fed has always respected that relationship. Now they view the health of Wall St. as tantamount to our trade relationship w/ China. They have crushed the dollar, are crushing Chinese exports and consequently a large part of the Chinese economy. China will cease to own our treasuries (lend us money) and will opt to loan to a more "diversified basket" of countries. This will obviously lead to a drastic rise in long-term rates. The fed can prevent this... but only by raising rates.

When will this unfold? That is debatable, but the fed won't cut rates lower. So the questions are: how long until the interest rate increases? and will China begin to dump our treasuries before that? So are 2 yrs a good buy? I guess. But if you're betting against rate hikes over that same period you might as well buy any globally traded commodity for slightly greater risk and much greater upside.

The fate of oil and inflation all ride on the fate on interest rates. Interest rates are in the hands of the Fed and China.

As far as equities go: unprecedented emergency rate cuts? unprecedented standards for collateral on loads? continued rate cuts? None of these will budge the indices? Wait til rates start going the other way. The safest, surest play is selling long-term US bonds. TBT?

Blog Sahibi said...

I don't think the Fed should respond to changes in oil prices either. This is a supply and demand issue. Especially in the past few months there is a significant reduction in demand for oil. For example in Turkey oil demand wend down by 10% in the past 3 months.