Tag Archives: fed policy

Collapse Can Wait, Part 2

Aaron is right about America’s reserve currency status, and also there is the petrodollar in addition to the ‘flight to safety’ and other factors that are keeping interest rates low and the dollar high, all thanks to American exceptionalism. As bad as the US economy may seem, other countries are worse, although I am more optimistic about America’s economic prospects than many on the ‘alt right’.

Economically, America is like the smartest kid in special ed.

I’ve discussed the debt situation earlier here and here. It’s not as bad as it may seem.

However, the treasury prints money, not the fed. QE is not the same as debt monetization. This is distinction explains why the money supply has not increased in spite of QE.

The story here couldn’t be more self explanatory. The US M2 money supply is simply not expanding anywhere close to its historical rate.

As you can see, the growth of the M2 money supply is still inline with historical trends:

This explains why inflation as measured by CPI is still very low. Another reason for low inflation is that the money velocity is still very low:

Loan activity is stagnant. Monetary policy can be likened to taking a bunch of money, sticking it in a safe, and melting the key. Monetary policy seems to be more psychological (as a way to boost confidence) than to alter the structure of the economy itself.

The reasoning is simple – the money multiplier is a myth. So, it doesn’t matter how many apples (reserves) the Fed puts on the shelves. It doesn’t result in more apple sales (loans). Banks are never reserve constrained. The explosion in reserves and continuing decline in loans makes this crystal clear. The Fed can continue to stuff banks with reserves and unless we see a substantive increase in lending the expansion of the monetary base will continue to be insignificant.

QE is just another tool in the fed’s toolbox to lower interest rates on the longer-duration of the yield curve after conventional monetary policy has been tried.

Pensions funds are playing a larger role, which is why it’s not such a big deal that China is dumping US debt:

For all the dire warnings over China’s retreat from U.S. government debt, there’s one simple fact that is being overlooked: American demand is as robust as ever.

Not only are domestic mutual funds buying record amounts of Treasuries at auctions this year, U.S. investors are also increasing their share of the $12.9 trillion market for the first time since 2012, data compiled by Bloomberg show.

American funds have purchased 42 percent of the $1.6 trillion of notes and bonds sold at auctions this year, the highest since the Treasury department began breaking out the data five years ago. As recently as 2011, they bought as little as 18 percent.

There is so much demand for low yielding, safe US debt that the bigger concern is deflation, not inflation.

Aaron mentions the stock market going up a lot since 2009, and this is true, but this has more to do with strong economic fundamentals (profits & earnings, globalization, consumer spending, technology, rich people consuming, etc) than QE or money printing.

Just look at multinational companies like Google, Amazon, Apple, Disney, Microsoft, and Nike, all of which keep posting strong earnings quarter after quarter. The new Star Wars movie set a box office record and is expected to gross over $2 billion globally. People are buying stuff, and businesses are transacting with other businesses. The S&P 500 is up 25%, and the QQQ tech index up 40%, since 2013 when the fed announced they were going to end QE. That is evidence economic fundamentals, not the fed, are driving this economic and stock marker expansion.

Although valuations have risen since 2009, they are still well-below the 2000 highs in spite of the market tripling since 2009, and are still within the historical average, again evidence that fundamentals seem to be at work here:

Also, too add, foreign countries don’t want to dump their US dollar holdings, because they are devaluing their currencies to boost growth, as part of the global ‘race to the bottom’, which America is the beneficiary in the form of a strong dollar and low inflation.

However, as I have argued numerous times before, America’ reserve currency status is not an invitation for reckless spending.

As I’ve written about in the past, with the exception of certain bright spots in the US tech sector and retail, the entire global economy is lethargic, creating a flight to safety and thus low rates, especially for American, Germany, and Japan. Also, deflationary forces from falling commodity prices. Deflation is a bigger concern than hyperinflation.

To end with, Aaron is right about the limitations of the CPI, and I discuss this further in Bifurcated Inflation. While there is very low inflation as measured by the bond market and certain items like apparel and electronics, prices for services such as healthcare, tuition, daycare, cable & internet, insurance, rent, and textbooks have outpaced inflation. The idea behind ‘bifurcated inflation’ is that services will become more expensive on an inflation-adjusted basis to compensate for real price declines in hardware and other tangibles. A television set is very cheap, but the cable required to make it functional is becoming more expensive. Netflix, on the other hand is cheap, but streaming internet (required to make Netflix functional) is not, and has outpaced inflation:

The Big Short: Market Genius or Luck?

There are a lot of finance articles lately due to the hype over the film adaptation of Michael Lewis’ book The Big Short.

Interview with Michael Burry, Real-Life Market Genius From The Big Short

Is he a market genius or did he just get lucky? There is evidence of genius, in that between 2000-2008 Michael Burry returned 500% to his investors vs. a flat market, quite possibly the highest return of any fund that decade. Even more impressive, he did not get wiped out in the 2008 bear market, capturing both the bull market and the bear with perfect timing. That kinda throws water on the whole leftist belief that the market is rigged or a scam, or that the only way people make money in the market is with luck, cronyism, or deception instead of skill or talent. Obviously, he had no connections with Washington. He didn’t engage in insider trading. Using his superior intellect, he was able to find slivers of opportunities in a market that is otherwise impenetrably efficient.

But back to the original article, is there a crisis coming? The odds of another crisis are slim.

From a discussion, someone list some possibilities:

1) Some kind of dollar, global reserve crisis that rocks the global economy for a while. Spurred on by the US debt and projected near future large budget deficits due to welfare and entitlement spending.

2) Broader bond market. I think this is a well understood threat, and doesn’t require much elaboration.

3) A specific junk corporate debt crisis. About half of the major corporate defaults in 2015 were US companies, which have levered up significantly on the back of the Fed’s super easy money policies.

4) Another significant drop backwards in the asset bubbles the Fed just got done re-inflating. If the Fed’s policies fail to provide enough to sustain those huge asset classes (real estate and equities primarily), then when they tip over it’ll pull the US economy down into a protracted recession. The global economy is practically in a rolling recession as it is, if the US goes next it would cause a lot more global pain (including amplifying the problems in China and Japan, both big exporters to the US). There’s a real debate to be had about whether the Fed can ever actually create a scenario in which the intentionally inflated assets can sustain (stand alone without Fed props), or if they have to always deflate backwards with a hefty penalty for the market manipulation / forced capital misallocation (which then prompts even more dramatic action at each turn, to try to re-inflate).

Dollar collapse & hyperinflation seems unlikely, for reasons I give here and here. Despite all of the debt, the data suggests America is not at risk of defaulting from a genuine inability to pay; however, a technical default due to gridlock is possible.

The fed balance sheet is big, but interest rates are very low. The fed has posted a large profit, a 30% gain in 2015 for a profit over over $100 billion, which is sent back to the treasury.

Due to the mathematics of the yield curve and the composition of the fed’s holdings, the the odds of the fed losing money on its holdings are low.

“Short-term interest rates would have to rise rapidly to quite high levels — in the neighborhood of 7% — for the Fed’s interest expenses to surpass its interest income. Such an outcome appears very unlikely,” the paper said. In the event that the Fed did face a loss, it could simply hand no money back to the Treasury and, “in the most extreme case, future remittances would also be reduced (and recorded as a change in deferred credit), but the Fed’s capital base and financial position still would remain completely secure.”

Japan has a much bigger debt, they seem to be doing fine. Low interest and strong dollar is due to reserve currency status, flight to safety, emerging market weakness, commodity weakness, petrodollar, the large size of the US economy, and other factors.

Corporate profits are at record highs. A crisis in the corporate debt market would require either a major decline in profits (from a deep recession, for example) or a spike in interest rates, neither of which show any signs of occurring.

Overall though, a bet against the US stock market is probably doomed to fail, unless your lucky or skilled like Michael Burry was. Here’s why:

1. Nowadays, options are priced in such a manner that the expected value of buying out-of-money hedges is almost always negative. This is due to the inflated volatility for out-of-money put options and other factors.

2. It just so happened that the subprime mortgage meltdown coincided with Michael’s career; for the period between 1935-2007, his strategy would have failed. It also would have failed between 2008-present. Maybe it would have worked in 1987, so we’re talking three instances out of a century.* Right now, the evidence suggests banks have reformed their lending practices, with higher credit scores for new homeowners, so the odds of another banking meltdown in America are slim.

3. Then you have the constant stock buybacks, tame inflation and modest valuations, record high profits & earnings that keep growing, consumers that won’t quit consuming, and so on. A totally different landscape than before 2008 when Taleb, Michael, and other bears made their fortunes. I just don’t see a compelling reason for stocks to fall much.

4. A bet against the stock market (especially tech) is a bet against capitalism, technology, high-IQ, and the best and the brightest. Do you really want to bet against Amazon, Facebook, Microsoft, and Google? Do you want to bet against the fed and a billion consumers from all over the world, along with all wealthy consumers from China? I sure as hell don’t. Just because bears made money in 2000 and 2008 doesn’t mean it will work again. It may be years or even decades before there is another a big selloff. For every success story of someone who bets against the market, there are a dozen losers, although no one makes movies or writes books about them.

5. Perpetually low interest rates makes stocks more attractive at a higher valuation than usual. The price part of the P/E ratio is reduced when inflation is very low. When inflation is high, cash is more attractive.

Profitably betting on the collapse of the financial system is obviously much harder than merely betting on a decline. When you restrict the payoff to near default (>80 or greater loss of price of the underling security), the math shows that only 1929 (around that period) and 2008 would have yielded a positive return.

Of course, leftism is to be expected in anything even tangentially related to Michael Lewis, from the article:

The zero interest-rate policy broke the social
contract for generations of hardworking Americans
who saved for retirement, only to find their
savings are not nearly enough.

There isn’t really a ‘social contract’ in the Constitution, Declaration of Independence, or anywhere. There is no document that stipulates that the government owes anyone anything beyond ‘life, liberty, and the pursuit of happiness’, which are intentionally vague. The expanded ‘social contract’, which includes housing, jobs, guaranteed income, welfare, education, healthcare, high interest rates,…etc, is a construct by the left to justify more wasteful entitlement spending, to make the rich feel guilty for not spreading their wealth more than the high income taxes they already pay.

The evidence actually shows that a better returns can be had with stocks than cash (bills). Even with rates at 4%, stocks way outperform cash:

Putting cash into a bank is a poor way to save for retirement, if past performance is any clue.

The ‘hardworking person’ saving for retirement by stashing all his money in the bank may more myth than reality.

The majority of Americans have little to no savings, so the difference between 0% rates and 4% is immaterial if your expenses exceed your income.

The problem is not that interest rates are too low, but rather people suck at personal fiance. But on the other hand, the Paradox of Thrift suggests that it’s ‘good’ for the economy that people don’t save too much.

Those who have more wealth put it in bonds, collectibles, real estate, or index funds. They seldom just keep it in cash.

Another thing that’s kinda annoying are all these people who think their predicting of the housing market bust in 2006 is attributable to some sort of profundity on their part, rather than just broken clock theory.

Contrary to popular belief, many pundits were actually bearish on housing in 2004-2007. Given the enormity of the crash, it makes these predictions seem more prescient than they really were, but such predictions were hardly unique. Of these pundits, very few actually made money betting against the housing market. A Google news search from 2004 to 2006 shows many pronouncements of a bubble or crash in housing, as well as much skepticism of the housing market.

About half of the entries are pessimistic about housing (articles by CNN, NY Times and Bloomberg, Mises Institute, Robert Shiller), and the other half are bullish, dismissive of a bubble, or neutral (Cato Institute, WSJ).

By late 2006, being bullish on housing actually made you more of a contrarian than being bearish. As a rational realist, I’m not too impressed that someone predicted something that hundreds of other people also predicted in that same time period, and then didn’t even act on it by shorting the market. Also, the vast majority of pundit predictions are wrong (like all those failed predictions between 2009-2014 for the stock market to crash and or for a double dip recession), so being right once out of dozens of incorrect calls is hardly a sign of innate skill or prescience at forecasting.

* Restricted only to American financial institutions. Foreign ones have had many more crisis.

Why Interest Rates Are Unlikely to Rise Much, If at all

The first rate hike in almost a decade is expected this week. Historically speaking, rate hikes are not always bearish for stocks, provided rates don’t go up too much too quickly. But because the fed has been dovish for the past three decades, not hawkish, that should be a concern. In the 90′s, the S&P 500 rose 400% despite high interest rates. Same for the 2002-2007 bull market, which was undeterred by rising rates:

A cursory observation of the chart above shows that in 2000 and in 2007, stocks entered a bear market after interest rates exceeded 5%, but 5% is a long way from now. There are plenty of reasons for the fed to raise rates very slowly, or not at all, such as:

1. A labor market that, while improving, is far from overheated. Labor force participation still very low, wage growth is also sluggish.

2. Low CPI-based inflation:

(Yes, I’m aware of other types of inflation and the potential flaws of the index, but the CPI index is among the most important indexes used by the fed in determining policy.)

CPI hasn’t budged much despite record high stock prices.

3. Oil prices keep falling, acting as a deflationary force.

4. Weakness in foreign markets, particularly Western Europe, Russia, Australia, China, and South America.

5. Strong US dollar, which is also deflationary.

6. Monetary velocity still at rock-bottom levels:

7. Private residential construction spending is well off the 2006 highs

8. US GDP growth is below the historical average

I would not be surprised if the fed does not raise rates this week, choosing to delay rate hikes yet again to the dismay of many.

How Bonds Respond to Rate Hikes

There’s a lot of hand wringing about rising interest rates and how it will affect bonds and other income-based investments. There’s a lot of doom and gloom, too, predictions that the bond market will crash if the fed raises rates.

There’s a few things to keep in mind:

Bond ETFs and futures have mostly priced in a December rate hike, with possibly more hikes down the road. When you buy a bond and rates go up, it makes your existing bonds less valuable (because why would someone want a bond that pays less interest over one that pays more). Short-term bonds are more insulated to rate hikes because they are replaced more frequently. If you have a 30-year bond and rates begin to surge, you may feel regret being locked into an existing low rate for so long, because you will have to wait 30 years until it’s renewed at a higher rate. The ETFs and futures which track bonds in real-time try to account for how the yield curve responds to rates, and new bond replacements. The results are somewhat counterintuitive. So long-term bonds should get bludgeoned when rates rise, right, because you’re stuck with them for so long? Not so fast. The yield curve, unlike the federal funds rate, cannot be directly controlled by the fed. When interest rates rise, the long-dates bonds respond much more slowly because we’re looking 10-30 years ahead and no one really knows what will happen that far out. Just because interest may be at 5% today doesn’t mean they will be at 5% in 30 years, especially if there is deflationary pressure such as impending economic weakness or the ‘flight to safety’. The result may be an inverted yield curve, where the long-term rates are lower than the short-term ones. If rates rise from 0% to 5%, the 30-year rates won’t also rise 5%, since, as mentioned before, long-term bonds are much less sensitive to fed policy.

With this is mind, I’ll test how various income products perform during rate hikes. I’ll use bond ETFs as proxies for the bond market and etfreplay.com as the becktesting software. If rate hikes are bad for bonds, we would expect the prices for these ETFs to fall after adjusting for dividends (interest). The period tested is 2004-2006 when the fed raised rates from 1% to 5%:

As you can see below AGG, an ETF of investment-grade 4-5 year bonds, fell in Q2 of 2004, possibly in anticipation of the rate hikes, only to rise 10% as the fed raised rates between 2004-2006. Not bad. Had you sold in early 2004, when it would have made the most ‘sense’ to do so due to all the headlines about rising rates, you would have missed out on a large rally. That’s why you cant base your financial decisions on the news. Everything is priced in, in accordance with the EMH (efficient market hypothesis).

A similar outcome is also observed for LQD, an ETF of 7-8 year duration investment grade corporate bonds.

The 2-year treasury bond (ETF:SHY) also held-up well:

Including interest, holders of 10-year treasury bonds (ETF:IEF) made about 12% from the nadir of the rate cycle in 2004 to the peak in 2006:

30-year treasury bonds (ETF:TLT) performed the best, netting holders over 25% as the fed raised rates:

Based on the performance of these ETFs during the last fed tightening cycle, rising interest rates should not be a concern. After factoring in dividends, all the bond ETFs made gains.

As an addendum, I only recorded nominal returns. The real returns are slightly harder to obtain and requires integrating the yield and then discounting this from the nominal. I think <3 year duration bond may have lagged cash on a real basis, but longer-dated duration bonds still outperformed cash in a bank account. According to data compiled by 7-12, between 2004-2007, bonds lagged cash in 2005 and 2006, but this was by a small margin, and they didn’t make a distinction between different bond types. As interest rates spiked to double-digits between 1977-1981, bonds performed badly relative to cash, but I don’t foresee interest rates rising any higher than they were in 2006. Most people when they access their stock and bond accounts, don’t care so much about real returns. Just not seeing losses on an absolute basis is good enough.

Bailouts, Obama, and Debt

From Christopher Cant-think-well:

And Then The Market Crashed Anyway

He writes:

You might recall that incident, when George W. Bush said he had “abandoned free market principles to save the free market system,” don’t you? Lotta good that did.

Last time I checked, it may have done a lot of good. The S&P 500 has surged 100% since TARP, and earnings have more than doubled. There are other factors besides TARP for the post-2008 rally, but the consensus is that TARP was a success far exceeding anyone’s expectations, and the money was repaid in 2011.

That catastrophe was followed by a two term Obama presidency, the Orwellian named “Affordable Care Act” (Obamacare), staggering increases in taxes, regulatory burdens, and government debt.

I agree the Obama presidency has been more or less a failure. It only ‘succeeded’ because it wasn’t as bad as it theoretically could have been, thanks to congress for at least trying to curtail Obama’s power. I opposed the auto bailouts and the Obama stimulus (American Recovery and Reinvestment Act of 2009), arguing that unlike TARP such programs were a waste of money, and most economists agree the Obama stimulus was ineffective. The stock market is rallying in spite of Obama, not because of him. Thank Bush, Bernanke, free market capitalism, low taxes, foreign investment, the tireless consumer, high-IQ, and web 2.0 for the post-2008 recovery, don’t thank Obama. Same for the success of the war on terror an the killing of Osama…thank Bush, not Obama.

The debt is high, but it would have still been high with 8 years of Mc Cain or Money..maybe not as high, but still high. And it wouldn’t matter that much, as inflation is still low and debt repayments as a percentage of GDP are near historic lows:

If you call yourself a ‘realist’, as Christopher Cantwell does, that means having to confront economic reality, even if you don’t necessarily like it or agree with it. You can’t call yourself a realist and then go about picking and choosing the ‘reality’ that confirms your preexisting beliefs and ignoring the ‘reality’ that disagrees.

Alexis Tsipras, the Greek Prime Minister, has resigned and called for snap elections – which he is expected to win – in the wake of abandoning his campaign promises and accepting a third round of European bailouts in exchange for austerity measures he campaigned against. Further adding to political and economic uncertainty in Europe.

This statement has nothing to with stocks, and anyone with a working brain cell knows Greece is a basket case, anyway.

In China, following a massive drop in stocks which occurred in late June, the Chinese central bank responded with a rate cut. That didn’t stop their markets from dropping another 7 percent shortly after. The Chinese government responded with a series of measures aimed at propping up the stock market, like further rate cuts, government backed stock purchases, and halting the sales of some shares. That didn’t prevent their steepest one day drop in 8 years on July 27th. The Chinese government did everything they could imagine to prop up the market.

But that isn’t proof that the programs were ineffective. Instead of falling 7%, without such programs it may have fallen 27% – we don’t know. If the goal was preventing any subsequent decline, then yes it was failure. But when there’s a crisis, due to the ‘flight to safety’, borrowing costs for reserve economies to plunge, making the bailout effectively free. Small economies tend to have the opposite situation of money fleeing during crisis.

Far from securing our futures, our as of yet unborn children are saddled with debts so massive we would never dare contemplate taking them on ourselves

No one actually pays the debt all at once. It’s continuously rolled over. The only reason why taxes went up in 2013 was because of Obama’s refusal to compromise, not out of economic necessity. As I explain earlier, America’s reserve currency status is keeping borrowing costs relative to GDP very low. Here is the debt pie chart:

But a large portion of the debt is held in funds that will never sell even if the dollar does weaken. All interest paid to the Federal Reserve is returned to the treasury. For all the hype over China dumping debt, they control only 8%.

The System Worked: How the World Stopped Another Great Depression

Found this gem on Amazon that somehow eluded my attention until today, The System Worked: How the World Stopped Another Great Depression

In The System Worked, Drezner, a renowned political scientist and international relations expert, contends that despite the massive scale and reverberations of this latest crisis (larger, arguably, than those that precipitated the Great Depression), the global economy has bounced back remarkably well. Examining the major resuscitation efforts by the G-20 IMF, WTO, and other institutions, he shows that, thanks to the efforts of central bankers and other policymakers, the international response was sufficiently coordinated to prevent the crisis from becoming a full-fledged depression. Yet the narrative about the failure of multilateral economic institutions persists, both because the Great Recession affected powerful nations whose governments managed their own economies poorly, and because the most influential policy analysts who write the books and articles on the crisis hail from those nations. Nevertheless, Drezner argues, while it’s true that the global economy is still fragile, these institutions survived the “stress test” of the financial crisis, and may have even become more resilient and valuable in the process.

Agree. Despite all the whining from the left about moral hazard and printing money, economic policy during the 2008 financial problem – and after – has been a resounding success. And don’t think for a second that I’m giving Obama credit for it – this is still the Bush boom because his policies (along with Bernanke and Paulson), not Obama’s, saved the economy. But not only thank the ‘four musketeers‘, thank the cognitive elite who create innovative companies like Facebook, Tesla, Uber and Snaphap, as well as the spendthrift US consumer. The evidence of America’s economic comeback is overwhelming: stocks keep making new highs, profits & earnings, exports, and consumer spending – all at record highs. Given all these positives, in retrospect, TARP was a bargain and succeeded beyond anyone’s wildest expectations. The left, including Peter Schiff, Taleb, Roubini, and Shiller all got it wrong – there was no relapse of 2008, no double dip, no bear market, no hyperinflation, no dollar collapse, an no ‘Greece-like’ collapse of the system. Even Krugman was wrong in that the sequester and cutting entitlement spending didn’t lead to a double dip recession; the economy and stock market just laughed it off. Other libs, such as Joseph Stiglitz and the vertically challenged Robert Reich intimated, incorrectly, that widening wealth inequality would lead to a crisis – wrong again. What gets lost in the partisan finger pointing is that policy makers are better at solving economic problem’s than predicting them, and Drezner writes, whether it’s TARP, QE, or the maligned but necessary bailouts an austerity in Europe, they, the global central banks, did indeed rise to the occasion.

This review is better than my own:

“If you find yourself disagreeing with Drezner, you need to take a good hard look at yourself and what you are doing with your life… this detailed, knowledgeable and cogent book is required reading for everyone in the global governance field — and anyone who wants to know how, bad though things have been since the global financial crisis, they might have been a hell of a lot worse.” –Alan Beattie, Financial Times

Agree..instead of being a liberal who whines about things like too big to fail, the fed, wealth inequality and the debt being too high, you need to take as look at your own life an ask yourself, ‘Am I projecting my own personal failings, frustrations, and cognitive shortcomings on the otherwise strong economy?’ No one forced these losers to sell their stocks at the bottom in 2008 or buy a crappy overpriced home in the exurbs in 2006, nor is it the fault of Wall St. bankers, the Fed, and Washington that millions of Americans are simply not smart enough to participate in the strong economic recovery and the post-2008 wealth creation boom. If you have a room temperature IQ or you majored in ‘stupid shit’ in college and cannot find a job with your worthless degree, tough luck. There’s always going to be winners (cognitive elite) and losers (the left side of the Bell Curve); makers (the cognitive elite, the creative class) and takers (the growing underclass that Charles Murray writes about in Coming Apart and The Bell Curve).

The events of 2008 could have been worse, and the left wanted things to get worse to, first, get Obama elected and, second, destroy the wealth of the rich. That’s why you have the Schiff-tards allying with Barrack Sanders in attacking Wall St., web 2.0, and the fed. Their approach is different (the welfare left wants higher taxes and more regulation, the other left wants high interest rates and to somehow eliminate the national debt), but the end result is the same: the destruction of wealth that mainly hurts the 1%. If the fed were to come out and heed Schiff’s advice to raise rates to 4%, the stock and bond market would be annihilated, and although things would probably recover, there is no need raise rates when virtually every economic indicator is signaling low inflation. It’s just bad policy that would hurt millions of Americans who have equity in stock and real estate. Prematurely raising interest rates would also push the economy into a recession, hurting business owners and causing all sorts of problems. Despite being a proponent of Reaganomics, my only criticism is Volker’s unnecessary and economically deleterious crusade on inflation, which pushed the economy into a severe recession.