Thursday, November 19, 2009

Taylor Rule: There's nothing for me here now

We've been talking a lot about the Fed lately so I thought I'd share my version of the Taylor Rule calculation. I've built this myself so it might not exactly track other versions that are out there, but I did follow Taylor's basic methodology. Bear in mind that this isn't meant to predict Fed Funds. I use it more as a reality check. If my Taylor Rule calculation is falling I'm not likely to make a call that Fed Funds is going to be rising.

Anyway, here is a recent chart of the output. Taylor Rule in green, actual Fed Funds target in blue. I took it out to 4Q 2009 assuming that 4Q GDP and CPI comes in equal to Bloomberg's economist survey (3%).

Holy liquidity trap Batman! Its sharply negative, suggesting that monetary policy can't get easy enough. Thus it justifies the Fed's current stance.

Now consider what it looks like if I carry out the Bloomberg median survey result for both GDP and CPI through 2010.

Suddenly the "correct" Fed Funds level according to my model is 2%, by the first quarter! Will the Fed actually hike by 200bps between now and 1Q 2010? Even assuming that GDP comes in as expected in 1Q, I highly doubt the Fed gets this aggressive. But could they start hiking? I think its possible.

I think readers should consider the following:

  • Potential GDP is probably falling due to a less levered economy. That means a lower level of GDP would be considered above potential and thus potentially inflationary. It probably also means a higher level of NAIRU.
  • There is room to remain accommodative in policy but be above zero on Fed Funds target.
  • The fact that we're far below trend GDP levels doesn't matter. In a Keynesian world, its a question of whether Aggregate Demand is outpacing Aggregate Supply. What Aggregate Demand would have been in 2006 isn't relevant.
  • As a trade, if GDP does improve but the Fed doesn't hike at all, then it will be time to put on a bear steepener!

Monday, November 16, 2009

I warn you not to underestimate my power

A warning to all you exposed to the dollar carry trade, either directly or indirectly. A group which includes:

  • Anyone borrowing in USD to buy short-term assets in another currency.
  • Anyone borrowing short-term in USD to buy long-term USD assets, i.e., every U.S. bank.
  • Any U.S.-based company selling their product to non-USD consumers.
  • Anyone invested in a U.S. company who is borrowing short-term in USD and buying long-term assets and/or selling products in non-USD currencies. That is, anyone long U.S. stocks or U.S. corporate bonds.
  • Any U.S.-based investor long any non-USD asset, i.e. any investor in foreign stocks or bonds.

So basically anyone holding anything other than cash.

Below is the intra-day chart on USD/EUR.

What the hell happened at noon? Bernanke made a passing reference to the dollar. That's it. Here's the whole quote:
The foreign exchange value of the dollar has moved over a wide range during the past year or so. When financial stresses were most pronounced, a flight to the deepest and most liquid capital markets resulted in a marked increase in the dollar. More recently, as financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains. The Federal Reserve will continue to monitor these developments closely. We are attentive to the implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability. Our commitment to our dual objectives, together with the underlying strengths of the U.S. economy, will help ensure that the dollar is strong and a source of global financial stability.
Now really, there is absolutely nothing there that suggests the Fed is going to do anything about the weak dollar. In fact, all he's doing is justifying the recent decline in the dollar. You can think what you want about why the dollar is weak or even whether its desirable or not. Bernanke doesn't care about the dollar.
And yet with this tiny nod to doing something about the dollar, the euro plummets. Just think about what's going to happen when the Fed actually hikes rates. There are so many dollar shorts out there. We will be looking at the mother of all short covering rallies. And the carry trade crowd is going to get absolutely crushed.
Will this happen this month? This quarter? This year? I don't know. How impactful will this event be on financial markets? I think it will be quite large, although whether that means S&P -10% or -20% or -30%, I'm not sure. I'm also not sure that we don't rise 10% between then and now and only correct back to where we are. I actually think 2-5 year bonds, including Treasuries, are the most exposed U.S. assets, not stocks, but we'll see.
Either way, I'd love to see the Fed make some kind of move, even if its hiking from 0% to 0.5%, to stem the tide of constant USD selling. The dollar weak crowd is too confident and all that confidence is what causes bubbles. Alas, I don't think its going to happen.

Friday, November 13, 2009

Don't get technical with me! 11/13/09

Yesterday's long bond auction was very interesting. I had been bearish going into it, went long some TBT, was feeling very good about myself until...

That my friends, is a bullish reversal. I've circled the auction time in red. The auction was a disaster, with almost a 5bps tail. I'm sure there have been worse long bond auctions, but not many. Anyway, the sell-off lasts for about 10 minutes before the short covering began. It took us all the way to the previous high on the day (yellow line) before tailing off slightly at the end. Still, quite a move.

Interestingly, the momentum chart has converged, producing a slightly bullish signal.

Otherwise I'm having a hard time seeing much in the charts. Looks range bound to me. In fact, I ran the tick-by-tick data on the old 10-year from September to now to see where the most trading has occurred.

42% of the trades have occurred between $101.2 and $101.9, which translates to roughly 3.48% and 3.39%. I had noted the 3.48% as a major support/resistance point in the past, so this graph validates something I'd been seeing in the chart. Anyway I highlighted in yellow the price we closed at today, meaning we're right there in the thickest part of the recent range.
I wanted to put on some 10-years today thinking we'd hit 3.48%, but we just didn't quite get there. I'm going to be patient and wait for us to get back to that level, then play it from the long side. I might be willing to leg into it at a level slightly below.

Tuesday, November 10, 2009

Fed on Employment: Well, forget the heavy equipment

The other day I speculated that the Fed was paying less attention to employment than most marketeers seem to think. Specifically, I question whether the Fed will wait for an outright drop in unemployment before tightening monetary policy, or if other factors will be viewed as more important.

Today we're getting four Fed speeches, which gives us a chance to see exactly how employment is characterized by the various Fed officials. So the following is the quote on employment from two of the four (Dallas Fed President Fisher doesn't speak until tonight, and Boston Fed President Eric Rosengren made no mention of employment in his speech on the Too Big to Fail problem.)

Atlanta Fed President Dennis Lockhart:

At this juncture, it's hard to be encouraged about a fast rebound in job growth. As you know, last week's employment report pushed the official unemployment rate to 10.2 percent, the highest since May 1983. Net job losses continue on a monthly basis but at a declining pace. Because employment growth tends to lag recovery from a recession and because of factors such as small business credit constraints, my current outlook for employment is one of very slow net job gains once the trend reverses, in all likelihood sometime next year.

If you believe in "very slow net job gains" even once we start getting gains, the unemployment rate isn't likely to fall at all for a long time. It could even rise if employment gains aren't enough to make up for new entrants into the workforce. Still, Lockhart acknowledges that employment lags.

San Francisco Fed President Janet Yellen:

The U.S. experienced so-called jobless recoveries following the previous two recessions in 1991 and 2001, when job creation remained weak for several years following the business cycle trough. In both cases, output growth was less robust than in the typical recovery and, unfortunately, things seem to be shaping up similarly this time around.

Less verbose, but could be construed as the same basic view. Weak job growth "for several years."

My question is, could the Fed hike to some number above zero even if unemployment is above 10%? Yellen and Lockhart are describing a situation where unemployment remains high for 2-3 years at least. What if at the end of 2011 unemployment is better, but still over 9%? I've got to think the Fed would have hiked.

Monday, November 09, 2009

Clumsy and Random Thoughts 11/9/2009

  • I know I didn't post a technical piece on Friday. I've been looking at the charts in my normal course of business and can't find any worthwhile patterns. Didn't want to bore you. I do think a short going into this week's auctions is a smart move. I don't think we can rally much beyond 3.44% whereas I think we can easily get into the 3.70's. In other words, good risk/reward.
  • Following that up, did you notice that the 10-year and 30-year auctions have been massively upsized? October's 10/30 auctions were $20 and $12 billion respectively. In November they will be $25 and $16. Ooo tee dee! And yet if the Treasury really wants to get to a 6-7 year average maturity for U.S. debt, these auctions are only going to get larger.
  • This is also the first set of auctions in the post QE (at least for Treasuries) world. Not that I think the lack of QE will show up in this auction per se, but let's watch.
  • Meet the new Kraft/Cadbury bid. Same as the old Kraft/Cadbury bid. KFT bonds moving tighter. Don't really agree with that move. I think this thing turning hostile is more uncertainty. Not less.
  • Back bid striking back in corporates. I'm short and frustrated.

Friday, November 06, 2009

Fed Rate Hikes: Your employment statistics. You will not need them.

On Wednesday I posted a poll on when the Fed would make its first hike. So far about half of the responses have been "After September 2010" with the other half being mostly between April and September.

Let's go over my view for what will drive the Fed's decision. If we look at the last Fed statement, the key new section is the following (its in the 3rd paragraph): "The Committee ... continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

The bold section is new, and if taken at face value, it tells you exactly what the Fed considers the sign posts for higher rates. Inflation. Nothing else.

Notably absent is employment, home prices, the dollar and anything related to the carry trade.
If take the Fed at its word then you can't possibly expect any rate hike until the end of 2010 if not well into 2011. In other words, some time period far enough into the future to make it difficult to see. We have so much slack right now that it would take tremendous growth to close the gap. If you start where GDP was at the beginning of 2008 and assumed potential GDP was 3%, we're currently about 7.7% below potential. Hell, my version of the Taylor Rule says we need -3.13% Fed funds right now. The Fed doesn't have to wait for us to close that output gap entirely, but you aren't likely to see any inflation until it gets much closer to zero.

So the question is should we take the Fed at their word? Are they worried about employment and/or the carry trade? I don't know the answer. I'm going to be intently reading upcoming Fed speeches to see if these other factors are mentioned and in what context. I believe the Fed is going to be increasingly conscious of explaining their monetary stance. Take high unemployment. I'd expect this to get some play in most FOMC speeches, but it depends on the context. If the speaker explains why unemployment is a secondary concern to inflation, then I think we should likewise pay less attention to employment-related statistics.

I'm more worried about the carry trade and its potential for creating distortions. If those distortions are dealt with near-term, then I think the pain would be marginal. If we wait a year to do anything about it, then I'm very concerned. I don't think circumstances warrant a hike right now per se, but I want to see the Fed acknowledge the risk. And I need more than just Fisher and Plosser talking about it (by the way, neither are voting FOMC members currently). I want to hear everyone discuss the risk. They can't ignore the fact that excess money creation can flow places other than consumer goods, and therefore monetary stimulus can cause asset inflation.

For what its worth, I think the Fed considers bringing down their balance sheet as a bigger priority than altering rates. This is my impression from taking the mosaic of Fed interviews and speeches I've heard in the last couple months. That view reiterates the idea that short-term rates remain low for a long time, but it brings into question what happens to other assets, especially long-term Treasuries. The Fed bought 23.5% of Treasuries issued in 2009. In 2010, it is projected that the budget deficit will ease somewhat, but it will still be sharply negative. I think Treasury issuance rises. So with out the Fed buying, don't intermediate-term rates almost have to rise?

Wednesday, November 04, 2009

New Polls: Sounds like a dictatorship

I posted two new polls. One serious, one not so serious. We got horrible turnout on the last poll (Q: Best quote for the current stock market... most popular answer: "They've gone to plaid!"). First new poll is on when the Fed finally hikes. Just want to know your opinion on the very first hike.

Second poll is on the best pairing of a CNBC personality cast as a Star Wars character.

1) Charlie Gasparino as Greedo. High opinion of himself but ultimately not a very important character.

2) Rick Santelli as Salacious Crumb. Kind of funny but everything that comes out of his mouth is just noise.

3) Bob Passani as Moff Jerjerrod. Promised Darth Vader that the Second Death Star would be operational on schedule when he knew full well that he needed higher employment figures.

4) Mark Haines as Sio Bibble. Sour old man. Where are the chancellors ambassadors? Communication interruption must mean invasion! Bartiromo gets all the good interviews... blah blah blah...

Tuesday, November 03, 2009

Financial Regulation: How would you have it work?

Yesterday myself and several other financial bloggers got the chance to meet with several senior Treasury officials, including the Secretary himself. It was a fascinating experience and I have to admit, it was just plain cool to be within the bowels of power like that.

I am also on record as saying that Geithner was a good choice for Treasury secretary. We needed continuity as the bailout process was on-going. Geithner knew exactly where the bodies were buried in a way that other choices, such as Summers or Goolsbee wouldn't have. I have since come to view Geithner as a pragmatist, which I appreciate in anyone elected from the other party. And truth be told, a lot of the Treasury department's plans are working. I can't deny that. I panned the stress tests when they happened, but I can't deny that it worked. It created confidence where there was none. Say what you want about whether or not banks are still in trouble, I'm not terribly confident, but we're sure a lot better off today than January 19.

All that being said, I don't think much of the Administration's attempt at improving bank regulations, and I told them so. I even managed to do it politely without lacing in a Star Wars quote. Here is my main beef. I will explain myself in classic Accrued Interest style: very very long form.

The Administration's new regulatory scheme seems to focus on reducing bank risks. Higher capital requirements, more disclosures, etc. That all seems fine, except that is it really fundamentally different than what we have now? That is isn't it just an expansion of the same basic regulatory scheme that currently exists?

And if it isn't fundamentally different, does increased capital really solve anything? Citigroup had a large percentage of its risks off-balance sheet. Lehman's capital ratios were nominally quite strong on Friday, bankrupt on Monday. Both firms had adequate capital, and both either did or should have failed.

When this was pointed out to certain senior Treasury officials, their response was basically that they won't allow those sorts of games in the future. They were closing the loopholes that Lehman, Citi, and countless others exploited to hide their true leverage. I respond that even if you stop the games that banks were pulling in 2008, won't the banks come up with different games in the future?

The reality is that even if we do nothing, we might not have another financial crisis for many years. Let's say its 2022. Let's say we've just gone through 6 years of tranquility in the financial markets. Let's also say that banks have come up with some new and creative security where they get to keep all the upside with 85x leverage, but by the existing banking regulations it shows as a fully cash funded position against the bank's capital. Will bank regulators be motivated to ban this new security? I doubt it. Why do I doubt it? Because current regulators around the world looked the other way at CDO^2. Regulators aren't going to have the courage to challenge the banking industry during a period when the banking industry seems to have been right.

For the same reason I reject the notion of "regulatory supervision." Not to say that I think regulators are nefarious people, but are they going to understand the risks as well as the bank itself? And if the bank has a good reputation for taking risks, will regulators challenge them? Bear Stearns was known as the best mortgage shop on the street. Let's say you gave regulators dictatorial power, they could do anything they wanted. Would an omnipotent regulator have told Bear they were taking undue risks? Or would Bear have explained their positions, the regulator not understood them and assumed Bear was smart enough to handle it?

Transparency isn't a panacea either. Do you really think you are going to fully understand the risks at Goldman Sachs? As Yves Smith said yesterday, you'll never have Goldman revealing their trading book. And even if you did, it might not tell the whole story. By the time the disclosure, is published, their positions might be different. So what do you do? Put risks into categories? Like what? Credit ratings? We saw how well that worked! More transparency is better than less, but I'm asking the reader to be realistic about how much we're really going to know.

I'm a free market guy. I'd like to see any business be allowed to take whatever risks they can get funded. I don't want to tell what risks banks can take any more than I want to tell Macy's how many stores it should open or what flavor ice cream Coldstone should be selling.

Yes, I know. Coldstone isn't J.P. Morgan. But why not? Only because J.P. Morgan's failure has major consequences for other banks. But in a perfect world, we'd let J.P. take whatever risks it thought would make them money. That is, whatever risks the market would fund by buying J.P.'s debt and equity instruments. And if J.P. failed, then those investors would get burned.

Notice that this world wouldn't require regulators to predict where the next crisis would come from. It wouldn't even require banks to hide their leverage. The relative risk of a bank would be reflected in their cost of capital. If one bank was more aggressive than another, it would have to pay more for capital. I know, it sounds so idyllic, it can't be possible, right?

I argue that the only reason why it isn't possible is because we can't deal with a large bank (or insurance or brokerage) failure in isolation. There is always contagion. But there doesn't have to be. What if government regulation was aimed at limiting contagion post failure? It might be somewhat complicated and it might not completely eliminate all moral hazard, but its doable. Say that the government set up an FDIC-style insurance pool for over-the-counter derivatives and prime brokerage. Think of how radically different the AIG and Lehman failures would have been if no one was worried about having to face a bankrupt firm in a derivatives contract!

Like deposit insurance, I'd argue that such a regime wouldn't necessarily be costly to the government. Just like deposits, its likely that any firm's derivatives book could be sold to another firm, maybe at a loss, sure. It would be all the more easy so set up such a system if the more plain-vanilla derivatives, like interest rate swaps and most CDS were exchange-traded.

I know what you are thinking. Basically I'm saying to forget about preventative medicine and treat all patients only once they are in the ER. The problem is that regulation has done an absolutely horrendous job of preventing every crisis to date. Why do we think it will work this time? In fact, Yves Smith argued with me last night that the Basel II regulations, which are heavily credit rating oriented, helped to fuel the rise of the CDO. I agree completely. Where I disagree is the notion that a different regulatory scheme will somehow produce different results. I expect banks to do what they are incented to do.

We're seeing it already. Banks are loading up on Treasury bonds anticipating that those will get more favorable regulatory treatment in the future. Are we fueling a bubble in Treasuries? Maybe not, but the point is that regulation is inherently distortive. Replacing the old regs with new regs isn't going to change that simple fact.

So yes. I'd rather the government get out of the prevention business and get better at unwinding complex and systemically important financial institutions. It was really cool that I got the chance to tell Treasury just that. I don't know that its actually going to make a difference. But it was cool anyway.