I guess I should have posted this interview on Gold and Silver back on December 12th when it aired. I get a lot of questions on my views, and I had been meaning to write a piece. But, because I never got around to it, my views are reflected in this interview, and it is turning out to have been more or less right, I was reminded by this tweet from Rich Ilczyszyn that I should’ve posted the video. Plus, I love their headline.
For me the EM switch flipped in 2012. We’d had inflows and bull markets for 12 years—well before QE. Now, the outflows come. Doesn’t matter what the trigger was. It’s on. It was just a matter of time.
The path, the tricky part, will be in fits and starts. Valuations won’t matter until we can tell a compelling growth story, and too many EM countries have to work through all the domestic debt they built up during the boom. Currency spasms and deleveraging raise the risk of policy errors in certain cases. EM fixed income is most vulnerable because outflows haven’t really even started there. And it would be worse if I were really bearish Treasuries, which I’m not.
People will overstate how bad fundamentals are as price action worsens. Tourists (crossover investors), who are in control of the flows, will mostly revert to old school EM biases, even though many things, fundamentally, are different (better) this time. Gone is the fixed FX regime and the original sin. Domestic EM financial markets are deeper. Reserves are higher. But don’t try and fight the Old School and their anachronistic biases. They are bigger than you are.
I need to start off by saying I am a big fan of Robert Shiller’s. “Irrational Exuberance” and “Animal Spirits” were excellent books, pointing out so many of our cognitive shortcomings in all things financial. And “Irrational Exuberance”, which was strongly recommended to me by David Lipton in March of 2000, about a month before the peak of the Tech Bubble, probably saved me a good deal of money as well. Moreover, these books came at times when the reigning ideology was ‘the freer the market the better’. Shiller was certainly swimming upstream by driving home the point that markets fail. The growing relevance of behavioral finance owes a lot to his work.
At the same time we have Robert Shiller, financial evangelist. He has long been a font of ideas on how financial education and innovation might make our lives better. And this brings us to the problem: How can a man who believes human nature is magnetically drawn to stories over facts, momentum over mean reversion, believe, for example, that encouraging the average person to hedge his/her home value in a futures market will not likely, at some point, end badly? If markets do fail, and if the frequency of market failure seems to be positively correlated to financial innovation, why would anyone want to give people even more weapons with which to hurt themselves?
This at its core is really a version of the very same problem Alan Greenspan had some years back. On the one hand, Greenspan asserted that financial innovation in general and derivatives in particular would be used to dampen market risk, not increase, because banks’ were profit maximizers, and their incentives meant we could trust them to self-regulate. And we know how that turned out. On the other, however, his book “The Age of Turbulence” explained various market crises under his watch by pointing out that the psychology of crowds, when under pressure, cannot be counted on to do the rational thing. Often, he argued, this negative psychology was self-reinforcing and there was little one could do to stop it.
It is conceivable that Shiller is at some level just being naïve, and that he believes with sufficient education we can overcome our animal spirits. Personally, I think it is a bridge too far, and Robert Shiller, like Greenspan, by advocating democratization of financial innovation while arguing that human nature is hard wired to make bad decisions, has succumbed to his own little version of cognitive dissonance.
Three reasons why this morning’s NFP is unlikely to change the odds of September taper
This morning’s employment data were not dramatically out of line with the current trend. They did, however, fall meaningfully short of expectations—especially at a point in the recovery where data have historically tended to surprise to the upside. And even though nothing about this crisis and recovery maps to other periods we have lived through, this has to be seen as a significant disappointment.
But it would be wrong to think that this will significantly alter the Fed’s reaction function come September 18th.
Beyond the obvious that the Fed—unlike those of us in the market—is unlikely to overreact to one data point, there are three reasons why the Fed is likely to stick to its current course and that odds still favor a September tweak to their current policy stance (read taper).
One, the Fed thinks in balance sheet terms. We in markets are slaves to flows, but the Fed all along has said that to the extent QE has a mechanistic effect on financial conditions it comes through reducing the available stock of USTs and mortgages to financial institutions and the broader investing public. And the fact the yields have tended to go higher when the Fed initiated purchases under its series of programs, but each time to lower highs—notwithstanding improvement in the economy—supports its case. In short, the Fed doesn’t view taper as reducing accommodation.
Two, the Fed is increasingly cognizant of the data that suggest QE has passed through to the real economy much less than its staunchest proponents hoped. At the same time collateral costs—though far, far smaller than hard money advocates had forecast—have been creeping higher. At home, markets have been distorted in exchange for less benefit. And abroad, to paraphrase the famous John Connolly quote: the Fed is our monetary policy, but your problem. Both the risk and the reward may have turned out smaller than many hoped/feared, but be that as it may the risk-reward equation still continues to drift away from more QE. And the Fed gets this.
Three, it’s all about the signal. QE has triggered significant effects in markets and indeed helped buy precious time for household balance sheets to heal and animal spirits to revive. This has been an important contribution. But it is now clearer that the primary channel through which this has taken place is psychological. Most everyone now knows that the money “pumped in” by QE has largely remained as reserves on the balance sheet of the Fed. The money that “flowed” into asset markets here and abroad came from us, not the Fed, as our risk appetites increased.
It was virtually impossible for the Fed to have gauged ex-ante the magnitude of our psychological response to its easing. But because the market response has been so large yet the economy is still far from where the Fed would have hoped to see it by this point in time, the weaning of market psychology off of the Fed teat now has to be handled in a balanced and incremental fashion. Signaling will play a central role in this process.
The Fed already took the first step in this process. Many Fed members seem anxious for the data to let them take that next step. And this morning’s data won’t do much to alter this monetary landscape.
Unbelievable investor letters like this are why people think gold bugs are stupid
Here’s an excerpt from the Q2 letter to investors from John Hathaway, of Tocqueville Asset Management’s Gold Strategy Fund. All you really need to read is the first paragraph.
7/3 John Hathaway - Tocqueville Gold Strategy Investor Letter, Second Quarter 2013
Tocqueville Gold Strategy Investor Letter
Second Quarter 2013
In light of the dramatic developments of the past six months, this letter addresses seven key investor concerns:
What is happening to gold?
In our opinion, the severe pressure on gold prices since April 16, 2013 has been caused by a coordinated bear raid orchestrated by large bank trading desks and hedge funds. The method used was naked shorting of gold contracts on the futures exchange (Comex), which means that physical gold was never sold, only paper. Gold was rarely, if ever, delivered to a buyer. Trades were settled in cash. The notional amounts of the transactions on many days exceeded annual mine production, absurd on the face of it. The motive was most likely to break the gold price for profit. The result is that short positions of these traders are higher than at the bottom in 2008 (chart below), after which gold rallied 167% and mining shares 256% (basis XAU).
The sentiment has dramatically shifted on precious metals. The gold bugs have gone silent or are desperately trying to reframe their pitches, the bears have gotten loud, and people previously claiming neutrality—in no small part out of fear of the wrath of the gold bug crew—now feel free to pile on. With sentiment having shifted so far, is the slide in precious metals over?
Short answer: no. Here are a few points from the longer answer.
Gold is a bubble. The selloff is not recent. It has been going on for two years. What has changed is that we’ve entered the acceleration phase of the decline.
If you have resisted this idea up until now, you’re still in time to come clean with yourself. The legs on which the post-QE phase of the gold ramp was built have cracked. No hyperinflation, no systemic collapse, no fiat debasement. The biggest misconception of all—that ‘printing money’ causes inflation—has been thoroughly discredited by anyone who followed the debate closely. In fact, collective fears seemed to have tipped in the direction of deflation.
This shift in thinking has been mirrored in the precious metal markets. They reacted to QE1 and QE2, but by the time QE3 rolled around monetary stimulus lost its juice, as investors increasingly got past the arm waving and came up to speed on how monetary policy actually works.
You can see this on this chart:
The leftmost yellow line shows the sharp upward turnaround in the price of gold when the Fed first went nuclear in November 2008. Similarly, when Fed Chairman Bernanke dropped heavy hints at Jackson Hole in August 2010 that more monetary easing would follow, the precious markets responded strongly and positively (2nd yellow line).
However, as time marched forth and the inflation/debasing that motivated much of the rush into gold didn’t materialize, the economy continued to heal below the surface, and the positioning in gold became heavy, the shiny metal rallied progressively less to every accommodative twitch out of the Federal Reserve. Those of us watching this market closely also noticed the gold’s correlations to other assets were also changing. Gold’s positive correlation to the equity market was all but gone, and it’s negative correlation to the US dollar had declined considerably. In fact, things had changed to such a degree that by the time QE3 was trotted out, there was a brief bump in the gold price, followed by a sharp reversal. Gold has been on a one-way slide ever since (3rd yellow line).
So, how far do we fall?
It is important to note that the peak in precious metals coincided with the peak in emerging markets equities (silver and EEM peaked, in fact, the same week). This is not random. The commodity boom had two phases (both, BTW, turbo-charged by the arrival of ETFs). The pre-QE phase was driven in large part by the paradigm shift in emerging markets and the extrapolation of their appetite for ‘scarce’ commodities. Both asset classes are now well into their unwind. (More on that here, for those interested.)
The post-QE phase of the commodity boom was more narrow. In fact, it may surprise many readers that the price of oil is roughly unchanged since QE started. The big run up in the price of oil came in the pre-QE phase, driven by the EM story, as you can see here:
The gist is that the post-QE commodity rally was heavily concentrated in precious metals. This matters a lot if you want to make an educated guess as to how far gold can fall. The chart is pretty ominous:
Why does this mater a lot? The implication is that if you believe—as markets increasingly do—that the Fed will let it’s book of QE roll off and their much discussed exit strategy will transpire without systemic collapse or rapid inflation, we are likely to revert roughly to pre-QE levels for precious metals. (NB: You may still believe catastrophe awaits, but by now you should at least concede that the scope for saying “no, no, not yet; I was just early” is unambiguously contracting.)
What does that reversion look like? Here:
I am not a huge fan of targets. But I am a big fan of concepts. And if you think the market got its monetary gloom and doom QE analysis wrong, it does make sense that pre-QE levels is where cruel reversion is likely to take us. That range you see on the chart above is $700-$900 for gold. (If you think any of the emerging market/pre-QE phase of the gold rally should unwind, then gold would have to fall of course further.)
There is another reason to think there is much more selling to come. The chart below shows Total Known ETF Gold Holdings.
You can see that gold holdings have fallen less than the gold price. As an economist would say, this means the price elasticity of gold demand is very low. In other words, the price of gold fell disproportionately to the quantity of gold the sellers were able to unload.
Many like to say “for every seller there is a buyer, so what’s the big deal?” This misses the important point of elasticity. It is not symmetrical. And elasticities are extremely sensitive to animal spirits. Buying $300mm of gold can move the market up by less than a percent in a normal market. But when sentiment for gold turns adverse, selling $300mm can drive it down, say, 2-3%.
The upshot is this often leads others who have decided to sell but have not executed to freeze. Just like when it comes to selling your house and you don’t “like” the market price. This leaves a backlog of trapped longs and results in many praying for an uptick. I think we all know how this story ends.
The trapped long chart for silver is even worse:
There are ways to manage your position and (importantly) your mental capital if you are a trapped long. If you haven’t been involved and are looking to go short, there are also ways to get into a short position that mitigate the risk of ‘chasing’. I intend to write a post later today on how to go about these strategies. Until then, good luck.
Trading Fixed Income: Falling Knives, and EM local (market views)
Do you think the selling in the Treasury complex is over—at least until next Friday’s NFP? It you are a trader, this is really the only question you have to ask yourself right now.
There has been massive pain in the fixed income world over the past three weeks. The backup in Treasury yields finally attained the speed necessary to shake carry traders across the FI spectrum into shedding risk. It got particularly ugly in EM local fixed income and currencies (more on that later). The risk-shedding eventually spilled over into the equity markets.
Odds are good now that we are at that kind of win-win juncture for FI risk that you don’t that often see. Kind of a David Tepper moment for FI traders. I think the selling in the T-plex has been strong enough for long enough that it would take big fundamental news to drive them further down from here. And I can’t see anything important enough in front of the NFP to fit that bill.
This leaves us with two basic scenarios. One, if the equity market rebounds, the ‘fear discount’ now built into a lot of FI instruments will come out and Treasuries should stabilize if not rally, given the speed, fear and volume behind the recent selling.
Two, if, instead, the equity market sells off further from this point—which we got a taste of on Friday—then Treasuries will rally, as they tend to when risk aversion rises far enough or fast enough in equities. In fact, we got a taste of this on Friday as well. This scenario should trigger at a minimum a modest rally in the some of the FI instruments hit hardest by the bond selloff.
Both scenarios have implications for the dollar and tend to be bearish, but more on that below.
Of course, if your scenario doesn’t envision Treasuries stabilizing, then you stay just out of the way.
If, however it does, you then have to consider the follow-up, investor question as well: Has the market too aggressively discounted the timing of the Fed’s exit process? This is not the same as the first question. If you believe the answer to this question is also yes, then this is probably a good entry point to buy beaten up FI instruments for a longer timeframe, not just for a trade (FWIW, less than 3 months is the trading bucket, more than 3 the investment bucket).
Three FI sectors warrant separate discussion here, IMO: Agency mortgage REITs, currencies and EM local currency bonds.
Agency Mortgage REITs
- Selloff started last September
- The sector is now retail-dominated and emotional
- I put the current discount to NAV at ~10%—but this is a guesstimate, conditioned in no small part by the magnitude of the decline in book value last quarter
- The sector is in cyclical downswing, but discount to NAV and carry offer good protection right now against being wrong, even when dividends are cut.
Ccy, PMs and EM local FI
Correlations have been low, making things tricky. Positioning is heavy and will be the driving force in the near term, IMO, especially if the equity market tumbles further. If you believe USTs will stabilize, you are likely to see a decent rally in funding and hedging currencies (EUR, GBP, AUD, NZD, CAD), and in JPY where positioning is so heavy even higher UST yields were unable to lift USDJPY. You’ll also likely see a squeeze in precious metals, where a lot of shorter-term traders and CTAs are positioned short. Even though I dislike precious metals in the longer term, I think odds right now favor an especially good trading opportunity in the gold miners. There’s a fair number of people long dollars against the majors and precious metals at this point. Caveat: short dollars anywhere except JPY gets a lot trickier if USTs stabilize and SPX sells off hard.
It is less clear how much EM currencies rally if the big dollar sells off, if at all. This is an area where there still is short-dollar positioning, and, frankly, it is humongous. USDMXN has moved 80 big figures and long-term holders were only just roused from their slumber last Wednesday. My guess is any rally in EM currencies will be used by institutional investors to lighten up, driven by this wake up call and their longer term cyclical views.
The big trade for many macro types has been long EM currencies and short a basket of developed currencies. This allows macro guys to be long EM ccys while diversifying away much of the EURUSD risk by using a funding basket. Shorting AUD hedges SPX and Asia slowdown risk as well. This trade is as old as dirt. Problem is there are many more guys holding dirt these days. And RM, both dedicated and crossover, have piled into EM local ccy bonds (look at the ticker $EDD). Few outside the asset class know how large it has grown relative to the target market. And those in the asset class have kept mum to increase AUM.
These local bonds are too difficult to sell in size, so if redemptions get large enough where RM funds have to reduce bond holdings, it will get ugly. In the meantime, the big investors will buy dollars against their EM local bond holdings to protect those positions as best they can. Few investors in EM local ccys bonds realize the extent to which overall returns in the space are driven by currency and not the bonds themselves.
I know EM fundamentals are better in most EM countries these days, but that is not much of a defense once we tip over into the liquidation mindset—and odds are good that we have. The participation in the asset class is just much, much broader than it has ever been. Plus, the sell-side market-making is a lot thinner. So, even if you think USTs stabilize, this is not the asset class to play. Many large players will be looking for the exit on any decent bid.
I spend more time than I probably should exchanging views with other market participants, most of whom are friends. It can take up a lot of time. My exchanges with one guy in particular, a macro guy with a strong background in economics, usually capture best where I’m at. I’ve posted my side of these exchanges a few times in the past. The similarity in backgrounds usually leads to a very efficient exchange of ideas—even when we don’t agree. We just speak the same language.
I had the impulse this weekend to write up my views because I changed my positioning last week. But, busy with other stuff, I never got around to it. Lucky, my macro/economist friend wrote me an email today soliciting my views. This forced me to hammer them out. Here they are, excising, of course, the personal pleasantries in the first para, and the salutation in the last:
“As for the markets, I just took down much of my long equity exposure, the day USDJPY broke 100. I think the dollar has more to rally and, even though the correlation to equities has been low, if for whatever reason the dollar rally accelerates, stocks could take a breather. I have had a good run so I don’t mind taking equity risk down and re-assessing. I am keeping positions in less than a handful of key equity names and will continue to watch. Still have long AAPL, short precious metals, for example.
My only high conviction positions right now are: being long dollars (biggest position is USDMXN, which I think is technically most vulnerable) and short silver, gold and a little bit of oil. My view on there being a bubble in commodities that is unwinding has not changed, despite the mini-crash in precious metals last month. On a scale of 1-10, risk is now a 5 for the book. I had been running closer to 9 for a while.
I am still bullish on the fundamentals in the US. Europe’s day of reckoning will come, but in my base case it is a fair ways down the road. EM will grow less than expected, but expectations are not too high. I don’t expect any blowup in EM. Further upside in USDJPY is mostly idiosyncratic here, and fairly heavily positioned, but USDJPY coming off hard would be one of the clearest indications of risk off/position liquidation I can think of.
I feel there is too much fear of a Fed exit (there is risk, of course, but IMO we are overpricing it, both in timing and magnitude of impact). And the wedge between valuations and fundamentals is less than what ppl argue, not least because the macro continues to heal under the surface (HH debt better, jobs slowly better, budget improving fast and not “priced in”).
US growth will still be anemic—structural/latent globalization issues will keep a lid on US wage growth, but too many ppl are too deeply pessimistic and are hanging their hats on the Fed blowing things up—because all their theses so far have been wrong. It’s like at the end of the football game and the team is betting everything on the long pass (the Hail Mary play) because they are so far behind in the score.
The above language may seem a bit cryptic and not fully fleshed out, but I hope it’s better than not putting the views out at all.
There is zero correlation between the Fed printing and the money supply. Deal with it.
There is zero correlation between the Fed printing and the money supply. If you don’t believe this, you owe it to yourself to study up on monetary policy until you do.
This is an issue that brings them out of the bunker like no other in economics. But if you are an investor, trader or economist, understanding—and I mean really understanding, not just recycling things you overheard on a trading desk or recall from econ 101—the mechanics of monetary policy should be at the top of your checklist. With the US, Japan, the UK and maybe soon Europe all with their pedals to the monetary metal, more hinges on understanding this now than ever before.
And, as we saw this week, even many of the Titans of finance and economics have it wrong.
“Wrong? You’re saying they’re wrong? They have tons of money. They have long track records. I mean, they’ve seen it all. How can you say that? That’s just arrogant. Besides, did I mention they have tons of money?”
Here’s why the Titans are wrong
Brad DeLong had an entertaining piece on whales, super whales and men who hate the Fed, but the answer is much simpler than the one he offers. In fact, if you’ve ever been in the belly of a hedge fund, you know the answer to most everything is much simpler than it appears to the mere mortals on the outside.
The bottom line is the titans are working from the wrong playbook. We’re all, to varying degrees, slaves to our experiences. Their formative experiences, almost to a man, were in the early 80s. This is when they built their knowledge and assembled their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.
This understanding implies that an increase in bank reserves deposited at the Fed (i.e. “printing”) eventually feeds credit growth and thereby inflationary pressures; in other words, no base money increase, no credit growth. Only one problem: reality disagrees.
Here are the facts
From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.
How is that possible? I thought in a fractional reserve system base money had to grow for credit to expand?
The answer is structural. The financial deregulation that began in the early 80s (significantly, the abolition of regulation Q) and the consequent development of repo markets fundamentally changed the transmission mechanism of monetary policy. Collateral lending is now king. Today, length of collateral chains and haircut rates—neither of which are determined by the Fed—define the upper bounds of the money supply, not base money and reserve requirements.
What about the relationship to inflation? Isn’t base money correlated to that? Here’s a graph, from this piece by central banking expert Peter Stella.
The X axis shows 5-yr growth rate of base money (loosely defined) and the Y axis shows annual yoy inflation. That’s right. Nobody home here, either.
Don’t confuse liquidity with credit
The Federal Reserve only provides liquidity. The amount of liquidity it puts in the reserve system has no direct impact on the issuance of credit by banks or shadow banks. Only banks and shadow banks can create credit. And they lend either out of cash on hand or by repo-ing treasuries, mortgages, or deposits, if cash on hand is insufficient. And collateral that is pledged once can be pledged over and over and over (collateral chain). So, even though credit increases, the total amount of banking reserves on deposit at the Fed remains unchanged (though composition across banks may change).
So if the banks and shadow banks can just as easily repo their Treasury and mortgage holdings to finance lending, and there is no link between base money and credit creation, why is the Fed doing QE in the first place?
By keeping rates low well out the yield curve and providing comfort that the Fed will be there to fight the risk of recession and deflation, it creates an environment that enables, over time, a normalization of risk taking in the real economy. Our revealed belief is that the Fed can chop these nastier outcomes off the left-hand side of the distribution. As a result we start feeling better about putting our getting our money back out of the mattress and putting it back to work.
Risk taking always starts in financial markets, but eventually bleeds it way into the real economy. And, if you listen carefully, you can hear over the pitched squeals of fixed income investors, who are suffering from sticker shock and low yields, that this is exactly what’s transpiring. The time bought with aggressive monetary policy is allowing household balance sheets to the labor market to slowly heal. Heck, even the fiscal position is rapidly improving.
Again, it is important to underscore that it is the indirect psychological effects from Fed support and the low cost of capital—not the popularly imagined injection of Fed liquidity into stock markets—that have gotten investors to mobilize their idle cash from money market accounts, increase margin, and take financial risk. It is our money, not the Fed’s, that’s driving this rally. Ironically, if we all understood monetary policy better, the Fed’s policies would be working far less well. Thank God for small favors.
This is not a semantic point. I can hear traders saying “yeah, whatever, who cares, don’t fight the Fed, just buy”. But this concept has huge implications for the phase where the Fed decides to remove the training wheels. If the Fed money is not directly propping up the stock market and the economy underneath has been healing, the much talked about wedge between “Fed-induced valuations” and “the fundamentals” is likely considerably smaller than the consensus seems to think. It’s less “artificial”. In short, what all this means is the day the Fed lets up off the gas might give us a blip, or maybe that long-awaited correction, but ultimately the Policy Bears will end up getting crushed, again.
The other, more mechanical, implication is that financial sector lending is neither nourished nor constrained by base money growth. The truth is the Fed’s monetary policy can influence only the price at which lending transacts. The main determinant of credit growth, therefore, really just boils down to risk appetite: whether banks and shadow banks want to lend and whether others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share?
These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around—in large part because of what Econ 101 misguidedly taught us about the primacy of price, incentives and rational behavior. If you answer the behavioral questions and ignore the endless misinformation about base money—even when it’s coming from the titans of finance—as an investor you’ll be much better off.
I’ve written a couple of times already about the yield spread between 2s and 10s being an excellent contemporaneous indicator of risk appetite in equities. Macro guys look at a variety of “flattener/steepener” indicators, but this one is the granddaddy. It is something stock-jockeys often overlook.
The downdraft that started in March presaged the April volatility. It is a tribute to market strength that we only got volatility and not a more meaningful sell off.
It is now turning up. It’s worth you while, IMO, to sit up and take notice.
You Don’t Really Understand the Carry Trade, Do You?
This is the question I always fantasize an insightful CNBC interviewer will ask of his/her guest after the guest offhandedly mumbles something about ‘the yen carry trade’.
Odds are, though, it’ll never happen.
What is a carry trade and why is it so pervasively misunderstood?
First, a quick bit of history (Quick. I promise).
Back in the mid-90s it became increasingly clear that the BOJ was going to become much more aggressive in the battle against Japan’s deepening deflationary pressures. This unleashed monetary experimentation that eventually brought us concepts like ZIRP (Zero Interest Rate Policy) and QE. Fun stuff.
This produced the following investment backdrop: Japanese rates quickly going to zero, US rates north of 5 percent, and influential economists (including He whose name cannot be uttered) exhorting Japan to induce yen depreciation to reverse inflationary expectations. With this scenario, what was a hedge fund to do? Short the yen against the US dollar. In size.
Not only could you expect yen depreciation, but the large interest rate differential gave the trade a sizable tailwind, or, as fixed income guys refer to it, positive carry. On this position, the yen would have had to move against you (appreciate) 5 percent per year to breakeven. This led, over the 1995-98 period, to a move in USDJPY from 80 to 140. Since the positive carry was a sizable part of the ex-ante total return, it soon became known as the yen carry trade. (Side note: the memory of the move from 80-140 is behind much of the hedge fund community’s enthusiasm for the long USDJPY position today.)
But this yen carry trade was largely unknown outside of practitioners until 1998. Up until that point it was the purview of secretive hedge funds and fixed income wizards. The smart guys. However, that year, triggered by the Russian default, markets saw a disorderly unwind of the considerable risk built up in the previous few. From Russian GKOs to Danish mortgages to NJA currencies, it seemed everything was “funded” by a short yen position. Long-Term Capital Management—and the Wall Street prop desks that saw their trades and copied them for their own books—was at the center of much of this. But many, many others, notably Julian Robertson’s Tiger Management, experienced enormous pain.
The phrase ‘the carry trade’ soon became common parlance in finance. So common, in fact, that these days any time anyone shorts the yen—or any currency with below average interest rates for that matter—it gets referred to by some strategist or equity investor as ‘the carry trade’.
People say this because: one, it vaguely fits people’s memory; two, jargon makes people sound ‘in the know’ like the smart guys; and, three, to the legions of those still consumed by their anger at the Financial World it is laden with all the right pejorative connotations—secretive speculators blowing up our world.
But it is wrong.
Think about it. Who has lower interest rates today, the US or Japan? Right. There is no carry there. How about Europe vs. Japan? Right again. Investors short the yen because they are betting on yen depreciation. Carry plays no role.
What, then, do the pros consider a carry trade? The calculus is really simple. If, when you establish the position, the majority of your ex-ante return comes from the interest rate differential between the asset you short (this can include cash) and the asset you go long, then you are putting on a carry trade.
This implies that the price volatility of the paired trade is low RELATIVE to the interest rate differential.
Example: if you buy the Australian dollar against the US dollar, the interest rate differential these days is about 3 percent. Not a lot of carry. The volatility of the pair these days, while very low by historical standards, is still about 10 percent. This means your return will be dominated by the appreciation/depreciation of the pair, not by the carry. You can say this trade has positive carry to it, but you cannot call it a carry trade.
The classic carry trade in currencies came from the days where many emerging markets had pegged FX regimes and high interest rates—due mostly to shallow financial markets and lack of policy credibility. But those days are mostly gone. There are very few true carry trades left in the currency space. Currency volatility relative to potential carry is just too high. The only real carry trades these days are in credit—like them or not. And with low policy rates and steep yield curves in the main financial markets, some of them are quite attractive. Carry on!
Everything you think you know about the Fed is wrong
by Mark Dow and Michael Sedacca
Few would still argue against the assertion that the Federal Reserve has been central to the financial stabilization and economic recovery from the 2008 crisis. They fixed the plumbing and are now trying to incentivize animal spirits to pump water through the pipes. The debate has now migrated to exit strategies and whether growing side effects from exceptional monetary accommodation outweigh incremental benefits.
Nonetheless, it is the Fed, views are heated, and many misperceptions persist. The concept of money printing resonates strongly and intuitively with almost everyone, but most of the intuitive reactions to the Fed’s QE are turning out to have been wrong. Here are some of the major ones that linger.
1. Money printing increases the money supply. The Fed does not control the money supply; they control base money (or outside money), which is a small fraction of the broader money supply. In our fractional reserve system, the banks (loosely defined) control the other 90% or so of the money supply (a.k.a. inside money). And the banks have not been lending. This is why the money supply has not grown rapidly in response to years now of QE.
2. QE is “pumping cash into the stock market”. The truth is little of this money finds its way into the stock market. When the Fed implements QE, they are buying low-risk US Treasuries and agency mortgages from the market, mostly from banks. About 82% of the money the Fed has injected since QE started has been re-deposited with the Fed as excess reserves. With the remaining 18%, banks have tended to buy other fixed income assets of a slightly riskier nature—moving out the risk spectrum for a bank doesn’t mean jumping into equities, especially given the near-death experience that most of them have just gone through.
Of course, not all of the USTs and MBS were purchased from banks. And some of the money does end up in equities. But, really, not all that much. The other big holders of USTs/MSBs who’ve been selling to the Fed for the most part have fixed-income mandates too, and they are also unlikely to take the cash from the Fed and cross over into equities with it.
So, the natural question is why—if the above is true—have equities gone up so much in response to QE? The simple answer? Psychology and misconception.
By taking an aggressive stand, the Fed signaled to markets that “I’ve got this”. The confidence that the Fed would do everything it could to protect our economic downside stabilized animal spirits. Then it slowly but surely enabled risk taking to re-engage. The fact that so many people believe that the Fed would be “pumping money into the stock market” and so many buy into the aphorism “don’t fight the Fed” (notwithstanding September 2007 to March 2009) made the effect that much more powerful.
3. QE will create runaway inflation. “Yet” has become the favorite word of the inflationistas. As in, “Oh, it’ll come, just hasn’t yet”. And the magnitude of that expected inflation has been dialed down from ‘hyperinflation’ to ‘high inflation’.
But some continue to hang on. The most extreme inflationistas insist that it is here now and the Fed is cooking the books. The reality, of course, is the Fed has nothing to do with the compilation of US inflation statistics, which is done by the BLS. Moreover, for those who are worried that all departments of government are conspiring against the American people, you would also have to believe the MIT is in on it too. MIT runs the Billion Price Project, a means of testing, using broad-based internet price sampling techniques, the extent to which the government’s measure of CPI reflects reality.
But, there really has been no inflation, even with rounds of QE and interest rates stuck at zero. What we have learned in this crisis has driven home the points that the lending and borrowing that drive the money supply are more sensitive to risk appetite than they are to the price of money.
Is it possible that this will end in a bout of inflation? Yes. But the odds are lower than consensus had been thinking and they are dropping—fast , as inflation continues to be well anchored and people come to understand better how the transmission mechanism of monetary policy actually works.
4. QE is the reason we have high oil/gasoline prices. This very deeply-held view is just as deeply mistaken. As the chart below shows, post crisis/post QE, oil prices on average (red line) have gyrated around 80-90 dollars per barrel with no ascending trend. The ascending trend came well before we knew what QE even was, in the 2002-2007 period. And the most rapid phase of its rise took place as the Fed was raising rates from 2004-2006.
Paying high prices makes all of us angry, and it feels good to have someone to lash out at, but, alas, reality disagrees.
In any event, it’s pretty clear it was not a result of the Fed and QE.
5. QE has debased the dollar. Good luck convincing people this hasn’t been the case. This is an excellent example of repeating a falsehood until it becomes accepted as true.
Again, roll tape…
This is the trade-weighted broad-dollar average. It, much like the oil chart above, shows all the action took place before QE and the crisis. From 2002 to 2007 the Big Dollar, as currency specialists like to call it, depreciated some 20%. And the fastest depreciation came…that’s right, when the Fed was raising policy rates. Since the crisis the Big Dollar has been roughly unchanged, with gyrations suspiciously similar to oil’s.
Bottom line: Anyone alleging debasement is working from hearsay and priors, not the scorecard. And there are some pretty high-profile people still throwing around the ‘debasement’ word.
In fairness, the Fed did assume that their exceptional monetary accommodation might result in some depreciation of the dollar. But because the US is a closed economy (exports and imports make up a relatively small share of GDP) the Fed felt—correctly in our view—that it should be setting monetary conditions based on the larger domestic economy. And if dollar depreciation were to ensue, so the thinking went, it would at the margin be positive for US growth, as long as the depreciation was orderly.
Why, then, did the dollar depreciate so much in the 2002-2007 period? Pretty much the same reasons as with oil: it was a period of risk-taking, leverage and deepening optimism regarding emerging markets. All three factors led to dollar selling—well before QE ever made its first appearance in the US.
In sum, much of the received wisdom surrounding the Fed and the effects of its actions is misplaced. Through repetition and ex-ante biases, deep misunderstandings have become ingrained in market psychology.
Importantly however, the recent rise in the dollar and fall in commodities suggest that these long-held misguided views are becoming dislodged. There is plenty of risk ahead and the Fed’s task is far from easy or over. But the Fed, for the most part, is ahead of the curve. Make sure you and your views don’t get caught behind it.
Every once and a while you have to go back and see how your views have held up. Good traders do this as a matter of course. Economists, well, not so much.
This interview, with @aarontask from July 2010, covers economic views ranging from QE to fiscal austerity, to deleveraging, growth and comparisons to Japan.
Bottom line: I underestimated the psychological impact of QE2, but the rest holds up okay. If you are vapid enough to be interested in my economic babblings, this is as good as any tour d’horizon of the economic mechanics I work from.
Before I start, I want to send wishes and prayers to Boston and my many friends there. I went to graduate school in the area, and my wife and I lived seven years at 780 Boylston Street, on the same block as today’s fateful blast. There are no words…
There’s another preliminary point I want to make. It is my view that gold is a deeply flawed investment vehicle that will hurt a lot of retail investors, investors who have listened to the predatory promoters with business models designed to stuff these investors with their products. I very much sympathize with those who have lost and will lose money due to this bad investment. It happens; we all get things wrong—sometimes dramatically. I can only hope the retail trapped longs have a risk management exit strategy and that they don’t override it.
Where I have no sympathy whatsoever is with the charlatans and hucksters. For them I can only wish pain. It’s too bad too many of them have already taken out enough fees and commissions in this gold bubble to set themselves up for life. But they are not going to get any of my sympathy when their businesses crumble, just as Countrywide, New Century and the like crumbled after their bubble popped.
So, with that, where are we now?
Up until last Friday we saw a steady and somewhat orderly decline. Tourist macro with the big positions (Einhorn, Loeb, Klarman, Paulsen, etc..) and commodity funds getting redemptions were the sellers. On the other side, retail investors continued to buy.
I stole the chart below from J.C. Parets’ write up of the MTA 2013 Symposium (h/t Josh Brown). It shows the retail buying as the professionals began to sell. The total ETF gold holdings continued to climb higher as gold prices went sideways. Even a tourist technical analyst like me knows what that means. I also know first-hand that mutual funds have been seeing inflows into gold funds as recently as last week.
All this ended on Friday, when, as I read the psychology and price patterns, we entered the acceleration phase of the decline. Nothing shakes emotions like speed. Those who thought last week they were seeing a buying opportunity suddenly froze: neither buying nor selling. And pros are not going to initiate shorts here. So, all that leaves us with is a handful of intrepid true believers and short coverers on the bid side, versus forced sellers on the offer—either because risk management is forcing them to do so or the margin clerk is. Either way, no one is selling down here because they want to.
I do expect that once the forced sellers at this level are spent, we will see a bounce. I think this starts tonight or tomorrow. Once the bounce plays out it would be a good time, IMO, for trapped longs to exit and those who share my thesis to re-establish shorts.
Let me trot out a couple of charts. I did these charts on Saturday, in the hope of writing something sooner, but today’s price action has only strengthened the case.
Here’s a 10-year chart of the GLD. It looks like a massive top. The hope that it was forming a basing wedge or whatever was dashed by the price action on Friday. This chart looks like the top is in and it could fall a long, long way.
Some of you might be tempted to suggest that this “consolidation” doesn’t look much different than the one you can see in 2008 (above the lavender arc). For argument’s sake, let’s pretend they are similar.
In 2008, gold fell from the blue line down to the support represented by the red line. The red line is the base from which gold broke out in 2007, and hence, support. If a similar consolidation were to happen today, gold would fall back to the base from which it broke out in 2009—the blue line. That level is 100 on the GLD and about 1000 on gold futures. This would not be a comfortable consolidation to try and ride out from here.
But 2012-13 is not 2008. Back then, we were in crisis mode, with no clear bottom to our economy in sight. Inflation emerged as a big fear once the Fed started expanding its balance sheet aggressively in late 2008.
Today, we are on the back side of all that. The economy continues its anemic recovery. Inflation is really only a worry for the tin foil hat crowd. Joblessness is still very high, but it is grinding the right direction and household balance sheets have come a long way. The financial position of our financial and corporate sector is far, far better. In short, there are still fears, but they are fewer and less life threatening. This, plus the positioning and the fresh shift in psychology, will make it hard for gold to find a durable bottom anytime soon.
Again, here’s a clean chart of gold futures going back 14 years. Even my friends who are ideologically predisposed in favor of gold said this chart is a massive top.
Remember this post back in January? It said, inter alia, to watch the spread between the yield on the US 10yr note and the 2yr. It suggested something good was happening (US healing) and that we should all take note.
Here’s the chart today:
It doesn’t look so good for risk taking. It doesn’t mean the world will end, or that you have to join the Policy Bears in the bunker, but it means you have to protect yourself.
It also means I have to be careful with my precious metal shorts.
Looking to add equity risk but are afraid at these levels? Look to copper and the Commodity Unwind
What we are seeing in the commodity complex is the drip, drip, drip of orderly liquidation. Commodity funds are losing assets and/or being shut down. Tourists who ventured into commodities to protect against macro fears that didn’t materialize have started to sell. And the sell-side commodity hype machine is now behind us. This is why commodities have stayed so oversold for so long with high negative sentiment readings, yet still go down pretty much every day.
When performance is dragging, less experienced traders often lock in profits on their winners and double down on laggards. The pros, however, prune their losers, and pros are the big holders of commodities. Hence, the drip, drip, drip. (NB: liquidations usually start with drip, drip, drip and end with flush.)
How far does the unwind have to go? These things are always hard to say with precision. But what we do know is that the commodity unwind should be a function of the size of the build-up—plus a reverse-bubble psychological dynamic once the selling gets going. Rapid rate of change influences emotion much more than level.
Since I believe the buildup was significant, with a good portion of it predating QE, I expect the unwind to be large and sustained. But, ultimately, every investor/trader has to come to his/her own determination of how big the unwind will be.
Do you think the US has put crisis behind it? This is really the only question you have to consider when you look at the above chart of gold since 2000.
What we have been seeing is that silver and gold are developing an increasingly negative correlation with the S&P. And it is in the precious metals where most of the tourist dollars reside. So hedging your equity longs with silver and gold—though it has worked very well for the past few months—will become more painful to hold onto in countertrend days, and possibly brutal in a selloff (both your longs and shorts may well move against you). It you have a cast-iron stomach, you should be fine. The reality is, however, that most of us don’t—and hanging on to a winning trend is the single hardest skill to learn in investing. A better hedge will help you do that.
Enter copper. During the speculative run on commodities, there was a lot of broad allocation to the asset class as well. This means copper (and to a lesser extent oil) will correlate in part to precious metals, and in part to the S&P, since, as an industrial metal it is more sensitive to growth. The bottom line: copper right now makes for a better macro hedge than silver or gold.
The point of this is that if you have been suffering from being underinvested and you are looking for a way to add stock risk to your book, a really solid way to do it that minimizes the risk of being the goat in two months’ time is to buy the stock you like based on your process, and hedge the beta out by shorting copper. It sensitivity to growth should make it go down on down equity days, but on up days it should lag—or even outright decline—based on the drip, drip, drip of the commodity unwind.
Here’s the chart of copper of the same time horizon, FWIW:
Apple and GDX, the ETF for gold mining stocks have very little in common—or so it would seem. One is a major technology stock, the other, a leveraged play on precious metals. Apple has tangible value, which at some price point will matter; Precious metals have whatever value we assign to them—the ultimate greater fool trade.
But the chart below shows a striking similarity. Both have been highly correlated to the downside in an overall up market.
Why? A tale of two bubbles. Both were the objects of excessive enthusiasm. This enthusiasm is now unwinding. My guess is that AAPL is close to finding a bottom. Precious metals—where there is no tangible anchor—look set to go much, much further.
The other interesting observation is the evolution of the rolling correlation between AAPL and the SPX. One thing to watch for is this correlation picking back up—implying the idiosyncratic component of the AAPL unwind is mostly behind us.
Framework for Thinking about the Buck: It's an Overhang, not a Hangover
This was originally written for a blog over at the CFR. The framework is still useful today, IMO. At least you can compare it to how things have kind of turned out. Here is the link to the original.
The Dollar: It’s an Overhang, not a Hangover
By Mark Dow July 6, 2009
Few things are more confounding to economists and traders as forecasting currencies. However, as I have come to realize, the approach each group takes is very different. Economists are never wrong, only early; traders are often wrong, but never in doubt. Economists look at interest rate differentials, growth differentials, current account positions, and other fundamental factors. It doesn’t always help much, but it is a defensible place to start. Traders, on the other hand, cognizant or not, focus not on the fundamentals, but on the “fundamental story”. These stories typically emerge to fit recent price action and are then coupled with what economists refer to as stylized facts. Unlike facts, stylized facts are not stubborn things. Some stories turn out to be true, others false, but whether they are true or not the most powerful ones share two characteristics: they are easy to explain and intuitively appealing. And once a good story takes root it can be very difficult to dislodge it—irrespective of how untrue it may be.
“Stories” that drive the dollar abound. They are usually easy to explain and intuitively appealing. Most of them turn out to be wrong. Excessively low interest rates in 2003, the Fed “printing money” today, large current account deficits, increasing budget deficits, Chinese concerns, all of these are given ample airtime. In short, the core story we have been hearing is that the dollar is now suffering a hangover from the fiscal, monetary and external account binge it has been on in recent years.
How well does this hangover story hold up? Not well.
First, dollar weakness has not been as dramatic as the story that has accompanied it. The only big decline came in 2007 (red arrow in the chart below) when the world was in massive risk seeking mode, loading up on carry, reaching for yield, constructing CDOs and CDO-squareds, and using the dollar as a funding currency. Much of this decline was unwound over the past year as the world began to deleverage. In fact, the dollar is right about at the same level as it was when Lehman went bankrupt.
Second, much of the story centers on the Fed’s expansion of base money. This is wrong on many counts. To begin with, the Fed is not printing as much as you might be led to think from listening to financial commentators on TV. Base money (here) has been flat lining since early this year (total liabilities are in the leftmost column). Moreover, the money multiplier has continued to decline, as credit is destroyed and the private sector delevers. (I think many commentators end up confusing base money with the broader money supply, but there is no need to get into this now). In addition, when the expansion of base money was truly rapid, from September to December of last year, the dollar was getting stronger. Why? Because that’s when the demand for dollars was strongest. Memories of Econ 101 and quotes from Milton Friedman have encouraged an excessive focus on the supply of money, when the real driver has been the sharp changes in demand. As funding pressures in the financial system eased, the dollar started to decline again. It is not a coincidence that the DXY (dollar index) made a high in early March when the S&P made its lows. Lastly, there is an article in this week’s Economist, pointing out how the ECB has been as expansionary as the Fed, but have been lower profile about it. But I haven’t heard any talk about the debasing of the Euro. In sum, sexy though the story might be, I don’t think the “Fed-is-printing-money-like-Zimbabwe” theme is really driving anything but the psycology of a few.
What about the current account deficit? No one home there either. As soon as the deleveraging accelerated, the US current account took a sharp turn northward. In the chart below I use the trade balance, which comes out monthly, as a proxy to capture the rate of change.
Ultimately, the current account story is much more a credit story than an FX story, in my view. And it is fixing itself without much help from the exchange rate. In fact, as you can see above, the increase in the trade deficit coincided pretty well and pretty monotonically with the great credit bubble in the US. So it shouldn’t surprise us that the decline in credit reverses it. (This also has implications for the need for foreign purchases of Treasuries, which has been cited as another concern.)
Fine. If these stories are wrong, does that mean I am bullish the dollar? The answer is no.
The dollar has an overhang problem.
For the past 60 years the dollar has been the only game in town. It was the lubricant for financial and trade globalization, the undisputed store of value in the international monetary system and the primary medium of exchange/unit of account for commerce. The world held more dollars, and the world transacted more often in dollars. Demand outside the U.S. for dollars grew rapidly for many, many years. For monetary balance inside the U.S. to be maintained, the Fed had to provide these dollars; otherwise interest rates at home would have been much higher.
Fast forward to today. The world has undergone a radical transformation. Abstracting from the current global recession, most countries across the world are in much better economic shape than was the case 15 years ago, and their currencies are more stable and increasingly more freely convertible. People trust their own currencies more, as well as the currencies of other countries. Dollar holders — central banks, sovereign wealth funds, international corporations and individuals alike — realize they have accumulated too many dollars over the years. Holding such a high percentage of one’s precautionary balances in dollars no longer makes sense in today’s world. Not because the dollar is bad per se, but because there are so many opportunities to diversify safely.
Mexicans no longer have to keep as many dollars under the mattress. Brazilian companies no longer need to keep a war chest of dollars hidden in the Cayman Islands in order to ensure access to imported inputs. Sovereign wealth funds have realized that it is neither wise nor prudent to keep so much of its stock of wealth in one currency. Investment management firms are starting to offer more non-dollar share classes for their products. And Italians, Poles, and Turks — peoples closely linked in one way or another to the euro — are thinking less and less in dollars (it is amazing that they still do at all).
The transactional demand for dollars is also declining. This too puts downward pressure on the dollar. In countries like Brazil and India, hotel bills used to be presented in dollars. Not any more. Cabs in emerging economies used to prefer payment in dollars. Now it’s not worth the hassle. Many countries that historically quoted real estate prices in dollars are doing so less and less. Bilateral trade, on an ad hoc basis, is ever more frequently eschewing the dollar for other currencies.
With the demand for dollars structurally falling, the dollar should face headwinds until currency stockpiles have adjusted and a new equilibrium is found. With some 70 percent of dollars in circulation held outside of the US, unwinding this overhang may take a long time. This doesn’t mean we can’t have vicious countertrend rallies in the dollar. Every time risk aversion gets intense enough, the dollar tends to do exactly this. But it does suggest that you can expect the dollar to be undervalued relative to any intertemporal, goods market concept of its underlying value for quite some time.
Commodities as a group have been underperforming equities for about six months now. The correlation between the two groups has been grinding lower. Even more important, I think the underperformance of commodities—and by extension emerging markets—will persist for some time.
Hang on. If the backdrop is improving growth expectations and continued, if not increased, global central bank base money expansion, why have they underperformed and why should it continue? Here’s my answer.
Misunderstanding Monetary Policy
This is going to sound bad so I’m just going to say it: Most investors and commentators have a deeply flawed understanding of monetary policy. Very few have any direct experience in this complex issue area. Many equate printing money with the money supply. They think changes in base money drive currencies. Most haven’t internalized that the money supply in a modern monetary system is endogenous (i.e. created by banks and risk appetite, not the central bank).
It is for these reasons people feared inflation, higher Treasury yields and a collapse in the dollar in response to the Fed’s exceptional measures. Remember stagflation? Me neither. None of these things happened.
People are now catching on to this. The percentage of investors who now think the Fed balance sheet will provoke a new crisis or that the ONLY possible solution to the US debt is inflating it away has shrunk considerably. This reduces the demand for hard assets.
Many may have forgotten by now that the first massive wave in commodities was in 2007-2008, back before we knew what QE was. The story then was China and the Emerging Markets were rapidly plugging into the grid, set to consume our finite reserves with their vertiginous growth trajectories.
Subsequent boomlets in commodity prices, the ones that came post-crisis, were linked mainly to monetary stimuli and the flight into hard assets.
Together, this imprinting led us to reach for emerging markets and commodities any time we had a risk-on phase. In this last phase people have again reached for commodities and emerging markets to express their bullishness, but I’m suggesting this time they are setting themselves up for disappointment.
The first reason is that the emerging markets have downshifted their rate of growth. Some even have their own processes of credit digestion to contend with. Moreover, before the downshift we feared EM could grow to the sky, leaving many of us guessing at how intense the competition for scarce resources would become. We now have a better handle on “how high is high”.
Second, we have been coming around to a better understanding of monetary policy. We now increasingly get that the effects of monetary policy will be largely psychological and transitory until the deleveraging process approaches completion. At least, I hope we do. Otherwise, the fall in commodity prices will be deeper and the pain trade will last longer.
These developments will, eventually, reprogram our reaction function. The days where we’d say, as someone else recently put it, “it’s going to be a risk-on day, let’s buy 200m AUD”, are likely to fade further and further into the recesses of our memories.
Beware the Hype Machine
When the sell-side makes “a thing” out of an asset class, there is usually considerable downside and unwind at some point ahead. The length and depth of the downside is typically a pretty clean function of the length and breadth of the hype. And in 2011 commodities became a thing.
Sell-side firms were sending team after team of analysts and strategists to explain exotic commodity trades, often to hedge fund managers who had no experience in them. Buy-side firms started to scramble to build their own teams and launch new strategies. John Paulson was still in hero mode and he was buying gold, thus giving cover to others’ hubris. And, of course, the gold ads on television were busy shifting into a higher gear. I could just close my eyes at night and hear the sound of central banks printing money.
The apex came in the spring 2011, a month or two before the final parabolic burst in silver. The Morgan Stanley commodity specialist came in to visit with his 8-man team. When he recommended, as his best idea, a pairs trade “long rhodium and short molybdenum” (really, I’m not kidding), I knew that the time for shorting precious metals would be soon upon us.
The bottom line: the speculative demand for commodities is likely to become less robust over time, and the growth rate of emerging markets more modest and definable. We are in the midst of the process of pricing these factors in. And the good news is the decline in commodity prices need not presage a collapse in global growth if it is mostly a function of a slow unwind of past excesses and the market’s previous monetary miscalibration.
A friend of mine from London (a currency-oriented macro guy) with whom I regularly exchange ideas asked me my views this morning. I’ve posted my side of these exchanges before. Here’s the latest:
I think the story with gold/silver is the same one we’ve been discussing since May 2011. The fever peaked (with the parabolic silver spike), and now we realize that (1) monetary easing isn’t as powerful as the markets had been thinking and (2) all the “tail-risk reasons” for owning gold and silver are melting away. And it is still a crowded trade amongst the macro tourist crowd that hate US monetary policy, but, when you read what they write, clearly haven’t understood it (e.g. inflation, higher yields, US-is-Greece, pick your variant). Think Einhorn, Loeb, Paulsen, Dalio (though Dalio’s not a tourist), etc.
In short, the monetary tables are now turned: it’s not Bernanke who needs an exit strategy, it’s them.
More broadly, I am bullish, structurally. Growth will be mediocre, with scope for upward surprise only in the US—and even this would be modest. Plus in the US we have to slog through a fair amount more of fiscal drag. Growth everywhere else is not great, and in Europe it’s downright terrible. There is not enough lipstick in the whole Sephora chain for the PIIGS, and I expect more downside surprises—both with respect to depth and duration, but at least the surprises should now be of a lesser magnitude.
We will likely have risk hiccups out of the Old World, but the end game there (re-memberfication of the euro—I know, not a word) will be further out in time and only after years of economic contraction bring radical political alternatives more solidly into the mainstream. For now these forces are still dancing around the fringes.
But, for the medium term, I think low-ish but steady global growth is good for equities. Notice below how the amplitude of the surprise index swings post-crisis has been contracting. Textbook disaster myopia. Bottom line: People will need to take risk. Multiples should expand. Dividends are still a draw. Cash hurts.
I have been long equities (admittedly a little slow in jumping back on after getting off end-December) and short gold and silver. I haven’t needed to trade much. I took down equity risk on Friday for the first time in a while. I don’t like what I see in the European indices of late and if gold and silver accelerate further to the downside (which is my base case) the old correlation to equities would likely come back, dragging equities down along with the shiny stuff.
The equity market is loaded enough with “late purchases” that it wouldn’t take a huge story to generate a shakeout. A hard fall in precious metals could catalyze such a story. What would that story be? It really doesn’t matter much; we market participants always reverse engineer something plausible whenever we see sharp price action.
I am holding core long positions, now partially hedged with European “stuff”—in addition to the precious metal shorts. I hope we get a selloff in the next month or so, so that I can increase equity exposure. I suspect I am not alone in this, which of course complicates my odds of being right. If the selloff in precious metals accelerates too much I will probably trim some futures and sell some puts against a good part of the rest. But sooner or later—who knows when?—we are going to get a whoosh-type selloff in precious metals for the reasons outlined in my framework, so it’s very unlikely that I would take my exposure to zero. In my dream sequence, I am hoping that the market will let me keep my long equities, short precious metals positioning for the bulk of this year if not longer.
The 2s-10s steepener trend looks robust, not tired. A great sign for risk taking.
EURAUD and EURCHF are signs of financial normalization. Don’t worry that AUD is considered a growth currency (more on this below), the bigger signal is that people are crawling out of their bunkers.
Mortgage rates (above) look set to go higher. Wait. Isn’t this bad for housing and therefore for the overall US recovery?
Answer: no, for two reasons. One, from a financial point of view it shows investors are moving out the risk spectrum. And two, price hasn’t been holding buyers back. Down payments, job security, and tighter lending standard have. Levels are still plenty low enough for solid borrowers who can make the down payment to buy.
If indeed this is the structural shift in risk taking that it appears to be, it will be more about normalizing financial risk appetite than a rapid acceleration in growth—either here in the US or globally. This means the reflexive reach for commodities and commodity proxies (e.g. AUD) that has accompanied every risk impulse for the past five years may come a cropper this time—particularly since we have seen behind the Great Monetary Curtain and realize the machine is being run by mortals (i.e. The broader money supply is endogenous, and is driven by risk appetite and not money printing).
The portfolio implication for the investor? Structurally long equities, hedged with structural commodity shorts.
Four charts tell a powerful story of where we are. They all say “It’s Structural this time”
Four charts tell a powerful story of where we are. They all say “It’s Structural this time”. Safe Haven Exodus.
Yes, I know a correction could happen at any time. I myself got caught out jumping off the train a little too early back in late December. But longer-term, if you do the impossible and look out over the news cycle, these four charts below tell us a structural shift in risk allocation is afoot. The Policy Bears, the Central Planning Truthers, are either getting tapped on the shoulder or rounded up to be executed. How fitting: Death by stocks.
I am not talking about short- and medium-term positions, the kinds that get picked up in sentiment surveys and overbought/oversold oscillators. I am referring to the structural hedges big, slower-to-move strategic investors have had on to protect against the next macro crash. These massive structural trades—and make no mistake, they are measured by the ‘yard’—appear to be in a fairly early phase of unwinding.
Above is the yield spread between the 2yr and 10yr UST yields, charted on a weekly basis back 5yrs. Moving higher is referred to as curve steepening, and is associated positively with growth expectations and risk taking. If you think about where this spread was in 2011 and how much better we feel about today’s economy and financial landscape, this spread could easily get back to well north of 200bps.
Another structural Safe Haven position has been to be short EURCHF. In size. Long CHF and short EUR. The reasoning is clear. Europe bad, Switzerland safe. I don’t think Europe is anywhere near out of the woods, but between the LTRO and the OMT, they have “merely” a growth problem now—or, at least for the next year or two. Rightly or wrongly, people are assigning a higher probability to Europe muddling through, causing the macro monsters to unwind the flight-to-Zurich trade.
A first cousin of the EURCHF position is short EURAUD. Again, the logic is clear. Europe has no growth prospects and risked imminent financial meltdown. AUD, on the other hand, lives where the growth is, with a commodity kicker/China play thrown in. It has also trended for a long time, suggesting that a lot of trend following CTAs and hedgies have been riding it. The chart here two, suggests this trade too is now in the early phases of getting unwound.
Lastly, a more exotic version of these Safe Haven positions is Short TRYZAR. This, too is unwinding. This trade is trickier because there are idiosyncratic moving parts in both countries, especially South Africa. But it does reflect global normalization from crisis mode coupled with modest growth. It also suggests, as do the 2s10s steepener and long EURAUD, that commodities will not bounce back as forcefully as they have in the past few years on bouts of risk appetite.
But I should finish by being clear about my views: Don’t confuse me with a growth bull. Both the developed and developing economies have “digestive” issues they need to grind through, and economic expectations have improved to the point that when fiscal drag in the US starts kicking harder there will be room for disappointment. But the incipient unwind of these positions is nonetheless a strong long-term positive. It tells us a broader investing audience is, in deed and not just in word, coming around to realizing the next financial calamity, the Lehman II, that lurking “Other shoe”, is just not on the horizon.
Remember, a positive reading of the Index suggests that economic releases have been, on balance, beating consensus. So a lower positive number means less positive surprise. It doesn’t mean negative surprise until it crosses zero.
The Effects of QE on UST Yields—Now the Answers Start to Matter
The debate about the impact on US treasury yields from the Federal Reserve’s LSAP programs—often referred to as Quantitative Easing—is raging into its fourth year. In fact, now that the time series are getting long enough for more robust number crunching, I suspect academics are going to really start diving in and begin the writing of history.
Practitioners, however—both policy makers and those of us who have money on the line—don’t have the luxury of time. We are entering a critical phase right now. Why? Household leverage has been the prime impediment to a normal functioning of monetary policy. And it is now starting to get down to a point where monetary policy will start gaining traction. Not a lot of traction, because these processes are slow, but any traction at all means the days of the dreaded liquidity trap are numbered.
So we are now going to have think harder, and in more practical terms, about the counterfactual: where would UST rates be without the exceptional monetary stimuli the Fed hath wrought.
There are two basic camps in this debate, and from where I sit, neither side has it quite right.
One camp says the Fed’s massive purchases of USTs and agency mortgages have artificially lowered rates a lot. Looking at UST yields and spreads throughout the fixed income complex gives them sticker shock. Some fixed income managers are even mad. They fear that this is inducing a misallocation of resources, incenting higher government spending than would otherwise be the case, is hurting savers, and might constitute a new bubble. Many in this camp fear high inflation will follow. Their prediction for when the Fed stops buying? Pain—pain in markets, pain in the economy, and pain in the budget, stemming from the higher UST rates they assume will follow.
This camp comprises much of the professional fixed income asset management crowd, the majority of sell-side strategists, a fair number of economists (e.g. the recent op-ed by Marty Feldstein in the WSJ), and virtually all of the Policy Bears (think, for example ZeroHedge or CNBC’s Ric Santelli).
The second camp claims it is all about expectations, not physical purchases, and that QEs have actually raised UST yields relative to where they would otherwise be. Joe Wiesenthal over at Business Insider was perhaps the first to propagate this view. Others, like Matt O’Brien at the Atlantic and Matt Yglesias at Slate, have more recently laid out the same basic case: looser monetary policy from central bank bond buying raises, rather than lowers, rates because the indirect effect through expectations on future nominal GDP growth is greater than the countervailing pressures from bond purchases.
This camp comprises an increasing number of sharp-eyed financial/economic journalists, some of the more nuanced fixed income veterans, most salt water economists, and a lot of equity managers (who always seem to be on the lookout for a bullish story).
This view is always buttressed by some version of the very convincing chart shown below, in this instance lifted from Matt O’Brien:
In it, one can see very clearly that when the physical purchases of USTs and mortgages were taking place bond prices were indeed going down and yields higher.
Conversely, the moves higher in price and lower in yield happened when the Fed “wasn’t in the market”.
The rationale is simple: the Fed tended to hint at or announce QE programs when the economy and markets appeared to be weakening sharply. The chart shows that even though we were in the throes of a deep in a liquidity trap, the psychological effect of Fed support was strong enough to snap us out of slide into self-reinforcing pessimism and move us away from nastier equilibria.
Okay, that was easy. So, case closed? QE means higher rates, right?
Not so fast. Look more closely at the chart.
The idea behind large scale asset purchases, of course, is that they are supposed to drive down interest rates and facilitate the healing of bloated private sector balance sheets, in our case, in the household and financial sectors. This, in turn, would lead ultimately to a resumption of lending, once the lenders and borrowers have worked themselves back into stronger financial positions.
The theoretical debate has taken for granted that LSAPs lowers rates, and instead focused on the channel through which the purchases would achieve this. Thinking about these channels is important.
First, there is the “Flow” channel. Some academics and most markets participants have been inclined to believe that LSAPs lower rates through a flow effect, that is, through the physical purchases. The intuition here is powerful: sharply increased demand means higher prices, lower yields.
On the other hand, many academics and policy makers—including the bulk of the Fed—believe rates are lowered through a stock effect. That is, asset purchases reduce the available stock of assets, and so, for a given view, the clearing price will be higher (and the yield lower) than otherwise would have been the case. The implication is that this affects, over time, the level of yields, even if the oscillations in yields are driven by other factors, such as economic expectations.
Now, let’s go back and look at the chart again. You will see what technicians call “lower highs and lower lows”. And it’s important to note that this pattern was taking place against the backdrop of an improving economy which would normally push UST yields higher.
This to me means two important things: one, LSAPs have almost certainly over time lowered the clearing rate for UST yields—even though the impulse correlation, driven by economic expectations, has worked in the short-term in the opposite direction.
The second observation is that the “expectations effect” was of lesser amplitude with each Fed announcement, again, against the backdrop of an improving economy. In fact, after QE3, there was virtually no bump at all. This is because sentiment surrounding monetary policy has done a 180 over the past two/three years. Because the shifts in expectations were not subsequently validated by fundamentals, market participants progressively came to view effects from Fed policy as psychological and ephemeral. It went from ‘very hard’ two years ago to make the case that QE wouldn’t be inflationary to ‘fairly easy’ today. Most everyone by now has wrapped their head around the notion of “liquidity trap”.
Two conclusions can be drawn from this. One, the end of LSAPs will matter for yield levels—even if the Fed decides not to sell any of its holdings and let their book run off. So, if you think it is entirely about economic expectations you are likely to underestimate the magnitude of yield “normalization”.
Two, many investors and analysts have settled into the notion that we are in a liquidity trap, and that monetary policy here is largely “pushing on a string”. While this is still for the most part the current environment, it is finally, slowly, starting to change. Monetary policy can be very, very powerful when the soil is fertile. This is not the time to become complacent about the impotence of monetary policy. That time has passed. It may not be tomorrow, but the efficacy of monetary policy has now become, as the economists might say, a positive function of time.
Trading note on Silver and Gold (A quick post from il Bel Paese)
The only asset that can embarrass you faster and more brutally than silver (and to a lesser extent, gold) is natural gas, the nitroglycerin of futures trading. With that firmly in mind, and in light of the recent price action, here are my current thoughts:
My fundamental views about silver and gold are, gulp, on record here and more recently here. What has changed recently is that the impulse correlations of precious metals to stocks, the US dollar, and bond yields, which have been steadily declining for a long time, have now flipped signs.
Despite all the talk about safe haven status in recent years, PMs have had a strong positive correlation with stocks and risky assets more generally. Their correlation with the dollar, of course, has been strongly negative. Less intuitively, the impulse correlation of PMs to treasury yields has been positive, even though low levels of yield (more precisely, real rates) is an important driver of higher PM prices.
These correlations have flipped in the last few days in a way that is apparent to everyone. The decline in gold and silver in the face of a strong bid to risky assets will now likely force people to reconsider their investment hypothesis for holding them. Big events and correlations that change signs often do. Specifically, a lot of big macro tourists hold large PM positions, and what I believe we are seeing is some of them starting to hit the bid. It is also possible that some of them are also facing redemptions, since those clinging hardest to their PM positions are also those most likely to have been working under the wrong economic assumptions and underperforming all year. So, the year-end dynamic may be exacerbating the pressure we are currently seeing
On the technical side, though I am not, ahem, a master technician, it is apparent that gold and silver yesterday broke medium-term trend lines. But I actually don’t think that is unusually significant. As I said before, PMs are notoriously tricky to trade on a short-term basis. I’m sure even the best technicians have great war stories about being fooled by gold and silver. What I think is hugely significant is the 1600 level on gold (Feb 2013 contract). If it breaks below that level I think the warning flare goes up for everyone to see. Gold has rebounded from strong corrections before and may well rebound from this one. But I have a strong sense that if we get below 1600, it will matter in a way it hasn’t in many years, and all (gold) bets will be (taken) off.
Sentiment and trading views, feat. Gold, Silver, AAPL and Mortgage REITs
I am not a consumer of the big, bold predictions and the surprise lists that roll in this time of year. They mostly serve marketing purposes, or as a call option on self-aggrandizement, or our desire, at some level, to be told what to do. But many people like them. Uncertainty—the kind investors face daily—is draining and unpleasant. These things help fill that void. And they give us a reference point against which to calibrate our own views, however uncertain those views may be.
But, at the end of the day, whether you like forecasting or not, we have to make a call. Especially if your process is trading-oriented. Buy or sell. Long or short. Beta or alpha. Bonds, stocks or cash. Investing and trading require us to try to look out around the corner, even if only a little bit, and even if it is only probabilistic. So, with that caveat, this is what I am currently seeing around the corner:
On the Economy. The US economy is steadily improving, but expectations are catching up. You can see this in the Citigroup Economic Surprise Index for the US, which is stalling here and appears more likely to revert than not. (A positive reading of the Index suggests that economic releases have been, on balance, beating consensus. So a lower positive number means less positive surprise. It doesn’t mean negative surprise until it crosses zero.)
On Positioning. The short-term positioning seems to reflect (1) increased recognition of the improving US economy, (2) belief that Europe will remain in recession but not produce a Lehman II, and (3) that expectations with respect to Emerging Markets have finally receded to a place where it makes it safe to put a foot in the water. You can see this in the price action, in some of the sentiment surveys/technical indicators and in the chatter coming from other traders and investors.
Lastly, the discussion of the fiscal cliff seems to have morphed from “I think they get a deal, but I will wait to buy because they are likely to disappoint us first” into “the market will rip as soon as a deal is announced and it is too risky to be out and miss the move”. This changes the payoff structure.
The longer-term positioning, however, still reflects a fairly negative outlook, which is positive. Many investors, still clutching their rear view mirrors, are still afraid to commit to equities. The scars are just too deep.
Then there are the policy bears. They believe government intervention has made all this artificial and at some point “we will all have to pay the piper”. They disagreed with TARP, said the Stress test wouldn’t work, thought QE would be inflationary, asserted big deficits would drive yields higher, believed austerity in Europe would be good for growth, and compared the US to Greece. They have been wrong, underperforming and are increasingly angry. Rather than admitting they were wrong, many are pushing out the timetable for their forecasts to materialize, or quietly walking them back and hoping if the transformation is gradual enough no one will notice. Because when you’re wrong it is hard (and reputationally costly) to change your views. And, behaviorally, constantly questioning your own views requires much more effort than settling into certainty.
This is what the inner monologue of the policy bears sounds like right about now: “if I get long after fighting it for so long and the market turns around my clients will think I am a fool with no process”. Plus, it always sounds smarter to be bearish. And sounding smart helps underperformers hold onto assets.
So, what do they do? They play light, wait to go short, or take repeated stabs at the short side with stops. The takeaway, though, is that at some point they will recognize that below the surface of the policy drugs there is a healing process: household deleveraging. We are already seeing the effects of it. And as this becomes clearer both scarred investors and policy bears will get dragged into the market.
On Monetary policy. Sentiment surrounding monetary policy has done a 180 over the past year or two. A couple of years ago it was very hard to make the case that QE wouldn’t be inflationary as long as the household sector was deleveraging, and that the market effects from it were predominately psychological. I still have the scars from those debates. Using technical jargon like ‘endogenous money supply’, in an attempt to recover some credibility, only got you more dismissive looks.
However, since then, markets have been (for the most part) coming around to this view, and consequently the half-life of a market reaction to the announcement of fresh monetary stimulus has fallen to about zero. This is new.
It has two implications. First, assets that have rallied from the flight into inflation hedges will continue to leak. It is not a coincidence, in my view, that the ‘evolution’ in the understanding monetary policy began right about the time gold and silver prices peaked last year. Ever since, the diminishing market impact of Fed announcements has become apparent to all, and the commodity complex has correspondingly stayed well below its 2011 highs. Yet virtually everyone is still calling for gold to make new all-time highs in the coming year.
From where I sit, many people have crowded into gold and silver (and oil—don’t even look at cotton!) on, inter alia, this flawed understanding of the monetary policy transmission mechanism and this will create selling pressure for quite some time. Will it be enough to offset the diversification demand from central banks and the income effect from the Chinese and Indian markets? This is a harder call, but I think the answer is yes—virtually certain if the recovery in the US gains traction and the Treasury curve steepens. It also bears recalling that central banks since the 80s have tended to be net sellers of gold when prices were low and net buyers when prices were high. So I wouldn’t count on central banks being there below the bid for too long if prices really start to drop. But it really is hard to say whether this will be a drip, drip, drip or something more sudden.
Here’s a crude chart of silver to illustrate how far it could fall if my hypothesis plays out. (I confess: I am Tourist TA.) That support from the parabolic breakout in 2010 would correspond to a futures price of about 20.
The second implication is that just as everyone has bought into the “impotence” of Fed policy, we are starting to see signs of it having an effect. There has been a lot of head scratching and soul searching in the economic community (including Fed governors) about the efficacy of monetary policy. Has the transmission mechanism structurally changed? Are there new features we don’t understand? It is that policy is not aggressive enough?
It seems to me the answer is very simple: pretty much no amount of QE will work until (1) the household deleveraging is mostly over and (2) people feel better about job security and prospects. It is on these two factors that most people set expectations and consumption patterns, not on base money quantities or things like NGDP targeting. Expectations, in turn, set risk appetite and risk appetite drives the endogenous money supply.
And on a small scale this is happening. Prepay speeds in the mortgage market have picked up, indicating more refis, and there is more activity in the primary housing market. Household formation has picked up, too, as young adults are increasingly getting out from under their parents roofs for the second time. The job market, for its part, seems to be grinding in the right direction.
The simple way to look at it is that the Fed’s aggressively accommodative policy didn’t directly cause these things to happen. But by facilitating the deleveraging process, it likely moved forward the date by which households will have their balance sheets sufficiently repaired to normalize their rate of consumption, with knock-on effects to the rest of the economy. We are not there yet, but we seem to be getting closer, fiscal drag notwithstanding.
I know, I know. Buy or sell? Okay, here are a few more concrete markets observations.
First, it really is a stock-pickers’ market. It’s a phrase I don’t like because it is overused by guys on TV who want to sell you there stock-picking services. Somewhat fitting I guess that just as everyone scrambles to go macro, stock picking seems to be working. On what basis do I say this? Look at the index of implied correlation of the elements of the S&P, to start with.
The implied correlation amongst S&P components has been heading downward all year. In case you can’t make it out, it falls from just above 80 percent last January to just below 65 percent in December. This tends to be both a bullish sign as well as an indication of less ‘macro’ and more ‘stock picking’.
Second, we have seen of late many of the crowded positions underperforming and many of the hated positions doing better. Precious metals and AAPL crop first to mind, but there are many others. And some of the hated positions, e.g. RIMM, NOK, X, have been perking up. I don’t know how long this lasts, but it is the theme for now and it makes no sense to fight it.
While I’m here, let me make a quick, behavioral point on AAPL. AAPL has been THE story stock in the market over the past few years. It has been our collective obsession. It has sucked all the oxygen out of every financial chat room and could do no wrong. I can’t speak to the fundamentals, which may or may not have changed, but I do know this: once the fever breaks on a story that is so beloved, sentiment usually doesn’t stop deteriorating until the pendulum has overshot to the other side. And I get no sense we are near that point yet. I still see virtually all knife-catchers and no momentum shortsellers, and until this changes, it is probably not safe to buy the fruit.
Oh, and by the way, if the stock continues to go down, even if there aren’t good reasons for it, convincing-sounding reasons will be found. In the near-to-medium term story follows price more than price follows story more often than we are inclined to think.
Simple technical analysis suggests AAPL could go back to the area it broke out from in January, when the AAPL fever really took hold. That would correspond to price of about 425.
Finally, the other beloved sector that has just begun the beat-down process is the mortgage REITs. High dividends are a drug once you get used to them, and retail investors and high net worth individuals are in deep. With double-digit dividends it is easy to get lulled into believing that they will paper over any capital losses. However, the combination of reinvestment risk and a highly levered product means the cutting of dividends that we have just begun to see have a long way to go. And retail never leaves gracefully. (The closed-end muni funds will, I fear, have their reinvestment comeuppance pretty soon as well. The math there is brutal.)
The bottom line is that it makes sense to be balanced here, with a constructive bias. This is not the fat pitch for a directional view. But it does make sense to bet on balance sheet reparation, financial normalization, and continued recovery in the US, and against crowded story trades where the story may already have changed—no matter how much we may love them.
The majority of the financial industry is built on the proposition “if the investor just had better info, he/she/they would make better decisions”. Think about it: financial media, newsletters, online brokers, — hell, CNBC’s Cramer has built an entire platform on it. It’s a big lie. Investors want to believe this because it is empowering. The financial industry wants to sell it to us because it is enriching and aggrandizing. But it’s wrong.
It’s not lack of information that holds us back. The binding constraint is emotions. This doesn’t mean information is not good. It is good, but only AFTER you’ve got your emotions harnessed. And very few of us have.
Hubris when things are going well, paralysis by analysis when they are not, impulsiveness when things are moving fast, impatience when things are really, really slow. This is a partial list of the behavioral shortcomings that make us suckers.
Most importantly, you, YES YOU, are not exempt from these flaws. This includes me too.
The difference between ‘you’ and the pros is that the pros have built systems to keep these demons in check (mostly)—whether they are conscious of it or not (Pros are incented to succumb to the self-aggrandizing belief that their superior intellects and info is their replicable “edge”. Also, selling this line helps them hang onto assets when performance flags).
Portfolio construction, sizing, stop losses/profit targets, technical analysis, asset allocation models, rules, decision by committee, all of these things reduce the frequency with which emotions slap us and take our lunch money.
Individual investors would add more value to their own portfolios if focused on building an investment approach that mitigated emotional impulses. Until this is done, ain’t nothin’ gonna work.
(The original Big Lie is the one called out by Barry Ritholtz: “..banks and investment houses are merely victims of the crash. You see, the entire boom and bust was caused by misguided government policies. It was not irresponsible lending or derivative or excess leverage or misguided compensation packages, but rather long-standing housing policies that were at fault”.)
AIG/TARP/Stress Test: C’mon, say it. Thank you Tim Geithner, Hank Paulson, and Ben Bernanke
The US Treasury this morning rid itself of the last piece of exposure it had to AIG, the insurer at the center of the 2008 financial crisis. Both the Fed and the US Treasury intervened heavily during the crisis, with the ostensible objective of stabilizing the system and circuit-breaking the self-reinforcing fear that was already rippling through the financial system.
As of today, taxpayers have been fully repaid. The Treasury reports a combined profit of $22 billion. Detractors have been quick to suggest/insinuate/allege the number isn’t real, the Treasury portion lost money, the government is making the number up, etc. When really pushed they nit pick at accounting concepts, broaden the argument, or bring up other second order issues.
What one has to keep in mind is many if not most of these detractors also claimed that the government’s intervention in AIG and other financial entities would not be effective in its basic objective of stabilizing markets.
The most common phrases were “$700b down a rat hole”; “bad money after good”. Pointing out that the money was loaned only served to damage the credibility of the person foolish enough to trot out the argument. It was a given that the money would be all lost. The only debate was over whether it would bring stability to the financial system.
As stability appeared, the argument evolved (i.e. goalposts moved). Those who once argued that it wouldn’t stabilize the system started shifting to discussion of the burdensome cost to the taxpayer. Once it became clear TARP would turn a profit, detractors alleged accounting games or invoked broader costs from Fannie and Freddie.
The bottom line is this: it worked wildly better than anyone could have hoped for—even for those of us who thought at the time it was the right course of action. Markets were stabilized, the private sector banking system was recapitalized at the end of the day with private sector money, and the US taxpayer pretty much got it for free—whatever you think the final bill will turn out to be. Anyone still trying to move the goalposts should be gently reminded that reality disagrees.
So, go ahead. Today is the right day to say it. Thank you Tim Geithner. Thank you Ben Bernanke. Thank you Hank Paulson. We were wrong. You were right.
It is easy to see Silvio Berlusconi as an egocentric and ageing clown figure desperate to stay relevant—especially when looked at from outside Italy. But this would be a mistake. He is no Donald Trump. His message is real and should be heeded, both in Rome and Berlin, even if his odds of winning are nil.
Let me be clear: It would be a disaster if Berlusconi were to return to power. Even if you support that part of Italy’s political spectrum, you should recognize that Berlusconi is too polarizing a figure inside of Italy, and too compromised a figure outside of it to manage the country effectively in what will surely be a progressively more difficult economic and political landscape.
The reality is that economic contraction is weighing on the Italian people. And when people are in pain, they tend to look for someone to blame. It is in our nature. Witness Greece.
Berlusconi is tapping into this. Increasingly, Italians will blame austerity and Germany for the persistent and deepening economic contraction that the process of internal devaluation is visiting upon them. In fact, as I started to write this, the FT came out with a survey providing evidence that this is more than just conjecture. Say what you will about ‘Berlusca’, but he has always been the consummate salesman, one with a keen sense of the issues that resonate with the Italian people. Once again, he seems to be one step ahead of the curve.
And it doesn’t matter how much Germany is actually to blame. Nor does it matter if less austerity—within the context of Italy’s real financing constraints—will meaningfully change Italy’s growth path (I don’t think it would). What matters is that this perception in Italian eyes is real and this sentiment will only grow, especially when stoked by the months of campaign rhetoric that now lie ahead. The forces unleashed are centrifugal. Moreover, Italy is not the only EZ country in the pressure cooker.
Fair or unfair, if Germany wants to keep the single currency together, it must hear the Italian message that Berlusconi is tapping into and find ways to accommodate it. Big decisions await. And this is going to be one for the ages (and, actually, the aged).
The chatter over who will the next Treasury Secretary has heated up now that the election is behind us. Given that the position will likely be—as things stand right now—central to the nation’s next four years, the attention is understandable and warranted.
Much of the talk seems to focus on the traditional discussion about the attributes a Treasury Secretary should typically have. Wall Street or Main Street? Public sector background or private sector background? I think this approach leans us in the wrong direction. Instead, we should focus on what we need now. And today’s context is fiscal and political, not financial and technocratic.
The last four years, actually five, were about financial repair. The Treasury Secretary was in triage mode, trying to fix the plumbing of our financial system and trying to support an environment that would allow balance sheets to heal ASAP. You wanted someone with deep financial expertise.
Today, as I see it, our future challenges will be predominately fiscal, not financial. Fiscal issues are profoundly political. And the only path to sound fiscal policy runs straight through Capitol Hill.
We all know, at some level, we need a deep fix of our entitlement commitments. We simply promised too much. I am tempted to repurpose Churchill’s famous WWII phrase: “Never was so much owed by so many to so few”.
We also have a revenue problem. Revenue as a share of GDP is just too low by historical standards. And, unlike spending to GDP, Rev/GDP, because of the way the math works, will not improve that much as the cycle improves (Revenue is positively correlated to GDP through a cycle, whereas counter-cyclical stabilizers make spending negatively correlated to GDP through the cycle).
Revenue is a difficult issue, not just for fundamental reasons, but also for behavioral ones. Two jump to mind. One, taxes are painful. We perceive immediate pain in exchange for future, often intangible benefits that are hard to perceive. And this often makes taxpayers resentful and, at times, indignant. The second problem is our resentfulness makes us susceptible to almost any economic theory that allows us to stave off paying more taxes. The phrase “never get in between someone and what they what to believe” comes to mind here.
Lastly, we need structural reform to compete globally. The last 20 years of credit expansion made us flabby. The faux prosperity that came from household leverage and financial engineering papered over declining competitiveness. Many of the relevant issues lay beyond a Treasury Secretary’s remit. But many of them, such as corporate tax reform, do not. And these issues too are highly political.
The other large issue area that will continue to be important is international relations. Economic policy long ago stopped being a domestic issue area. The world is getting smaller, our trading partners are getting wealthier, global competition is fiercer than ever, and the world’s international economic infrastructure is at the leading edge of an overhaul to reflect these emerging realities. This overhaul matters critically to us, as raw imposition of our will is no longer a viable alternative.
The ideal candidate, therefore, is someone who meets these basic criteria:
—Has the strong trust and confidence of the President. No freelancers or peacocks need apply.
—Excellent political skills. Well respected by Congress.
—Knows where the bodies are buried on Capitol Hill; knows where are the hot buttons are for the key players.
—Strong international experience and knowledge of the international political landscape, plus diplomatic ability.
It may be controversial to suggest at this point in time that deep financial expertise is not a principal criterion for Treasury Secretary. And the assertion that it doesn’t really matter whether a particular candidate has or hasn’t met a payroll might not sit well with many. But, if you believe, as I do, that the next four years will be all about fiscal and structural issues, and that our ability to shape international economic relations will only grow more important, than we have to get past the backward-looking temptation to root for a financial wizard or green-eyeshade type. We need a politician, one with international street cred.
Who might that be? Well, it is easier to look at the presumed front runners and say who it is not. But when I look around, the far and away best candidate is one who probably doesn’t want the job: Hillary Clinton.
I just wrote this note to a friend of mine on where I stand. I don’t talk that much about my trading, and I tend to post a lot less when I am in California (opportunity cost is very high here), but I thought the note below might be a useful follow-up to the Toxic Migration case I made a few weeks ago.
I am riding the equity calls I bought a week or two back, and actually added to them late last week. I closed out my USDMXN short yesterday. And I got scared out of my EUR position before today’s move (emotions got the better of me. Bad process on this). I rebought silver in much smaller size and sold that this morning. The copper chart had been shaping up since 8/21. This had added to my bullish bias, and had me looking for a place to get long. The slight pullback after the breakout of 3.50 gave me my chance, so now I am long copper futures and riding it. Entry pt was about 3.50.
I think the tail risk reduction was the impetus for all of this and it has triggered the post-Labor Day underperformance anxiety we talked about. I thought it was going to happen before Labor Day, but it didn’t. Now the bears are back on their heels and worried about career risk. Moreover, the ECB and the Fed haven’t put their cards on the table yet. They are more powerful when we have to guess which cards they are holding. For these reasons—unless we get truncated by Sept 12th—we should continue to run. I don’t know what the odds are for Sept 12th and I suspect there are workarounds anyway (more lifting by the ECB), so I am going to continue to run with my positions.
It’s not as fun to be bullish. Bears are smart. Bulls are wide-eyed optimists. Bears have data. Bulls tell stories. Bears make money when everyone else is in pain. Bulls make money when everyone else already claims to be a genius. In short, many of us get more satisfaction being bearish because the psychic payoff is greater: we calibrate our own self esteem not by our victories in absolute terms, but in our victories relative to others.
So, with personal biases disclosed, let me lay out the bullish case. I don’t want to get carried away. For one, I know that if the market goes down in the next five minutes there will be all kinds of snickering from the cheap seats. Bearish calls gone wrong aren’t as easy to ridicule as bullish ones. Plus, we’re at 1400 on the S&P, not 1250. (And, yes, I know the VIX is at 14.)
The serious reason not to get carried away, however, is that world growth is not good. And it is not poised to turn around for a while, I suspect. US growth is anemic, and it feels like an achievement at the moment to be the tallest midget. Europe is in recession and this will persist for the foreseeable future. China is slowing cyclically and downshifting secularly, and China sets the tone for Asia (and, arguably, for emerging markets in toto). Moreover, the developed world is wracked by deleveraging, and the combination of globalization and excessively generous government promises pose potentially lethal structural challenges that we haven’t shown any appetite for addressing.
So, wait, how is any of this bullish? It’s not, but there is a long-term reason and a short-term one that make things less dark. Let me start with a question: Where do you think the S&P would be trading if we could take a European Lehman II off the table? My guess is meaningfully higher. Without financial contagion it becomes much, much harder to push the US into recession. And the fiscal cliff, while a real risk, is likely to be handled differently this time around much for the same reason we in the markets have fairly well discounted it: disaster myopia. We are much more prone to make a new mistake than to repeat our most recent one.
The basis for taking Lehman II off the table is the slow but steady migration of Europe’s toxic assets from the private sector to the official sector. This is a big deal. By the time this is over (and I think it will end by a number of countries leaving the single currency), the overwhelming majority of the bad debt will be in the hands of the EFSF, ESM, ECB, IMF, and in national banks that are de-facto (probably soon to be de-jure) nationalized. With each round of intervention, the private sector sells to the official sector. And the official sector won’t be subject to marginal calls/forced selling when the Schatz hits the fan.
The Lehman bankruptcy had such a nasty impact on markets because at that point in time the toxic assets were in the hands of hedge funds, investment banks, the prop desks of investment banks, and in their hands on a massively leveraged basis. Once the selling started it fed on itself because the funding of those positions got taken away. That’s not going to happen with the official sector holdings of peripheral European debt. With private sector investors much less leveraged and virtually clean of this toxic debt, the contagion impulse from Europe—whenever the dismantling of the euro happens—will be much weaker. Again, I am not suggesting the end of correlation, nor that the contagion impulse will be zero, nor that the economic impact on the defaulting countries won’t be very painful. I am merely saying that it won’t trigger anything close to a repeat of the wholesale portfolio liquidation we saw in 2008. And because many at some deep dark level still fear precisely this kind of repeat, the realization that this is not a realistic scenario will be a positive for risk taking.
The shorter-term consideration is that the recession in Europe and the slowdown in Asia are largely discounted. This wasn’t the case at the beginning of the year. We are finally starting to see the bad European growth numbers come in in line with forecasts, rather than continuing to surprise to the downside as they have for the past 18 months. And in Asia, while people are still hoping against hope that China stimulus will swoop in and save the day, it is become clear that the days of 10 percent growth are over and making the 7.5 percent target the country has set for itself this year will be an achievement. Again, I think there is more slowdown to come in China, and there are still people who will be caught off sides by this. But my unscientific sense is that the market has priced in as much as two thirds of the slowdown we are going to see from China.
The bottom line is that given the growth scenario that the market has been pricing in, the budding recognition that the progressive migration of the system’s toxic assets to official balance sheets will take Lehman II off the table, and the light levels of risk taking amongst the big players (who have been playing not to lose rather than to win) we would need to rekindle financial meltdown risk very hard and soon to send markets down in a sustained and meaningful way.
One thing about Paul Ryan’s nomination that really matters
I am reluctant to wade into the polarized waters of politics. But there is an important point about Paul Ryan’s nomination I haven’t seen made (hard to believe, I know).
We all know the next four years will be about fiscal issues. And the sense, increasingly, is the Democrats could be forced at gunpoint to compromise on entitlement spending. There are no indications, however, that the Tea Party Republicans would be willing to come off their ideological stance against raising revenue.
So, if Obama were to get reelected, it is hard to imagine that the more ideological elements in the Republican party would suddenly have a change of heart and soften their current stance.
We know as well that compromise, eventually, is the only way out. One of Romney’s strongest selling points to moderates has been that he would have a much better chance than would Obama of cracking the log-jam of the anti-tax right. Now, by bringing on board Ryan, Romney’s odds of dragging them into a compromise just went up a lot further.
Ryan knows this group of house member well, he carries enormous credibility on fiscal matters with this group, and he knows where the political bodies are buried on all the hot-button issues. This political reason, for me, is the most compelling one for Romney to bring Ryan on board, even if I personally think the supply-side baggage and excessive faith in efficient markets that he brings with him are ill-suited for the problems we face and are about three decades past their sell-by date.
4. Most seem to be doing their best to milk the 2 percent management fee for as long as investors allow.
How did we get to this point?
First, a bit of history. Pre-crisis, there were three basic types of global macro players. There was Old School Macro. Think George Soros. There were many others. These guys placed massive, fundamentally-driven bets and would come back in X months’ time to see if they broke the Bank of England or whatever. They tolerated huge P&L swings. These were the guys who made global macro sexy.
Then came New School Macro. These guys mostly grew up in the investment banks, either as prop traders or flow traders, or both. Their motto is risk management über alles. These funds—though they are loath to admit it—are driven by risk management much more than by fundamental ideas. They have tended to inhabit the more liquid end of the investment spectrum and manage drawdowns aggressively.
Lastly, there has been the steady growth of Tourist Macro. These are the guys whose expertise was in another market sector, such as credit (e.g. John Paulson) or long-short equity (e.g. David Einhorn), who became enamored of a macro view (short Europe, long gold, short US Treasuries, etc.) and placed big bets, Old School style. The common denominator was that they were bottoms-up guys who got seduced by top-down ideas. And below these marquee managers there is no shortage of erstwhile bottoms-up guys who have been assiduously trying to rebrand themselves as global macro thinkers or strategists.
After the crisis, several things happened. One, Old School Macro quietly went away. Some blew up. Many discovered that the new class of hedge fund investor couldn’t stomach the P&L volatility that came with their style. Others converted to family offices to avoid, inter alia, the hassle of defending their positions to fund-of-fund MBAs armed with sharp ratios.
Two, New School Macro came into its own. Performance in the crisis was good, most of them didn’t “gate”, or lock-up investors when the crisis hit, and they held out the promise of managing drawdowns aggressively. All this, plus the strong instinct to chase returns, made New School Macro look pretty good when investors gazed at them through their rear view mirrors.
The inflows into New School Macro and the nature of the fundamental events unleashed by the crisis increased massively the popular focus on macro issues. This, in turn, fed the growing trend toward Tourist Macro. Everyone constantly talked global macro. Everyone wanted to be global macro.
Why does this matter today?
The attention on and inflows into global macro, coupled with the risk management style of the New School, has produced the choppy (rip, then air pocket; air pocket, then rip) market with high correlations across asset classes that we have come to know all too well in the past two years. Why? Because New School global macro feels enormous pressure to take risk and justify management fees. They need to be involved when the market is moving—especially when the S&P is going higher (“You are getting paid to take risk. So, take risk”). But they also have promised their investors that they will manage their downside aggressively if their positions turn against them.
Having to be in the market, but not being able to stomach drawdowns is what has led lots of large players to stop in at local highs and stop out at local lows; broadly the same positions, broadly at the same time. It has been hugely frustrating for them. But this is largely where the high-correlation choppy market has come from.
How can an investor take advantage of this?
This dynamic will persist until the strategy falls enough out of favor that the big inflows of 2009-2010 flow back out (which has started to happen), or other investors emerge that can “arbitrage” the herd.
The way to arbitrage the herd is to be able to keep your bat on your shoulder for months at a time if necessary, and deploy capital in the assets you fundamentally like when the dislocations from the global macro chop fest eventually materialize. And they will materialize. Then, when you do commit, widen your stops so as to increase your staying power.
It sounds simple, but any professional hedge fund manager will tell you (perhaps only after the application of sufficient sodium pentothal) that running less than say 30-40% of targeted VAR (or whatever your risk benchmark is) for any meaningful length of time is next to impossible if you are clipping 2 percent management fees.
(Lastly, a pro tip: When a global macro investor tells you he expects to see greater market “differentiation” going forward, he is really saying the global macro equivalent of “it’s a stock-picker’s market”. Caveat emptor.)
Apologies to interested readers for the extended absence. I have been self-indulgently enjoying the longest vacation I have ever dared to take, in my favorite place on the planet earth. And, guess what? It didn’t suck.
I did, however, continue to accumulate things I want to write about, and hopefully I will start to pump them out in the coming days.
I will start today with a piece on why Global Macro hedge funds are struggling. Stay tuned.
A lot of heavy breathing for very little oxygen intake. This should be the take away from this morning’s flurry of central bank activity from the ECB, the BOE and the PBOC.
The market is finally coming around to the realization that risk appetite is more important to sustainable monetary stimulus than central bank actions. Absent risk appetite—and it is absent—there is little risk of inflation and efforts to reflate will eventually fall back to earth.
The US, Europe, the UK and, I would argue, China are in liquidity traps, and the effects of monetary policy have proven to be largely psychological. The market now gets this. I believe this is what the underperformance of gold and silver is trying to tell us.
This doesn’t mean there is no role for monetary policy. There is. I will circle back to that below. But first I want to run over the implications for China and the ECB of this morning’s actions.
The PBOC cut its one year lending and deposit rates. The important thing to know about China is that even under normal circumstances lending in China is driven quantitative credit targets and not by price. But even from a micro prospective pricing is next to irrelevant. Think about it: when nominal GDP is growing at 15 percent, borrowing at four percent or seven percent starts looking like the same number. It really doesn’t matter. You just borrow.
If, however, your firm is under pressure, and you are concerned economic growth is falling precipitously—which I suspect is currently the base case in China—four and seven percent still look like the same number, but no longer in a good way.
Right now, however, the micro view matters less. The dominant point is that macro credit targets will no longer produce the results we all have become accustomed to. In the first place, they will be pushed less aggressively. As a consequence of the credit boom in 2009-10, the absorptive capacity of the Chinese economy is now diminished. Everyone who could borrow, has, and time is needed to digest the rapid credit growth (Brazil, mutatis mutandis, has a similar situation, IMO). Second, an important source of collateral behind the boom, local government ‘land banks’, have essentially been taken away by the decline in property values. And, finally, the central government—always incremental and afraid of the law of unintended consequences—is going to be extra careful this year given the political turbulence and upcoming transition. Put all this together and it becomes hard to imagine that the 8-8.5 trillion Yuan credit target analysts had penciled in for the PBOC in 2012 will be hit.
Bottom line: If you are banking on policy to save a constructive view on Chinese growth, there is still much scope for disappointment.
The ECB: Anderson Cooper is not alone
Mario Draghi finally came out and said what most of us already knew: the binding constraint on the flow of credit is on the demand side. In other words, Europe is in a liquidity trap. Yes, there are still more supply issues than Draghi implied given the need to recapitalize a fair amount of the EZ banking system, but even if the system were already properly capitalized the weakness on the demand side would keep growth in check.
There are two implications from this. One, the lending dynamic in the EZ is not sensitive to price. Second, the ECB’s forecast for a gentle recovery in the second half of 2012, which as Draghi today came out and said was predicated on low interest rates eventually kicking in, is, to put it charitably, highly suspect.
So why cut rates if lending is price inelastic? The first reason is signaling. The ECB has long had a reputation for erring on the side of tightening and being overly mechanistic in its approach (remember the hikes of July 2008, April 2011 and July 2011?). Cutting now shows that they recognize the issues and are not asleep at the wheel. Some might also be tempted to argue that the gesture was a hat tip to the EU for the recent summit agreements.
But I think the market will gravitate towards a simpler interpretation, now that participants better understand lower rates aren’t likely to stimulate credit growth or risk inflation. The market will conclude that the ECB is trying to engineer a weaker euro.
There is something to this. I’m sure the ECB wouldn’t mind seeing a weaker euro—at long at it comes in an orderly way. But we have to be careful not to over interpret. I think we in the market make two mistakes when we think about FX policy and the ECB. The first is overestimating the extent to which a reserve currency central bank can control its FX rate. We do this regularly. Yes, lowering rates matters, and signaling intentions does too, but ultimately it comes down to the stock adjustments and financial imbalances of major financial actors much more than it does the flows from economic fundamentals. This is much of why the Japanese yen defies the country’s poor fundamentals and why the euro has been stubbornly strong for so long relative to the EZ’s deteriorating economic backdrop. Those who have argued the Fed has been trying since 2008 to debase the dollar by printing trillions should also be naturally sympathetic to this view.
The second mistake we make is overestimating the extent to which a weaker euro will help growth. The EZ is a closed economic block. Exports are roughly 10 percent of EZ GDP. Most EZ trade is with other EZ countries (and this is also where the imbalances are). As a result, it would take a monster boost in exports to turn the GDP dial in any discernible way.
In addition, exports from the EZ tend to be more price inelastic than those of other economic blocks. Europe is a high-cost producer. People often buy from the EZ when they can’t get the quality they need anywhere else. They are sensitive to quality, not price. If they were highly sensitive to price, it is likely that they would already be buying from China or another developing country.
So, if your economy is closed and the price elasticity of demand for your exports is low, your currency would have to be much, much weaker to generate the change in quantities necessary to support GDP. And, guess what? This is likely where we are headed with the euro.
Final quick comment on monetary policy in the context of a liquidity trap
I don’t mean to suggest that monetary policy is useless in this environment. There are a couple ways in which it can still have a meaningful impact. Indeed, there is a fairly robust debate going on about the extent to which central banks can influence inflationary expectations if they were to really go all in. I remain skeptical of the argument, and I think going all in along the lines advocated by the most aggressive proponents is highly unlikely in all but the most dramatic of circumstances, but I understand that I may be wrong and that in certain circumstances it might be worth running the attendant risks. But what is more germane is that central bank action can still elicit a psychological response, even if only a diminishing one. It still has enough juice, in my view, to short circuit the periodic self-reinforcing negative feedback loops that markets have been stumbling into since the Great Deleveraging began. And this, still, can be a valuable card to keep up your sleeve.
A lot of people have a hard time understanding why base money growth (i.e. Fed printing) doesn’t necessarily lead to money supply growth. I’ve been beating this drum for a few years now, and I get the question a lot. So here’s a quick, non-technical answer:
Say base money is 10% of the money supply (close enough for illustrative purposes). Then, if the 90% portion is contracting because banks aren’t lending and consumers are deleveraging, it doesn’t take much contraction for this to more than offset almost any increase in the 10% (base money) portion. This is the basic concept.
Reality is a bit more complex because pre-crisis, much of the growth in credit came from the “shadow banks”, which were outside of the existing regulatory framework and weren’t part of the fractional reserve banking system. They financed their lending through the repo market. The shadow banking system has delevered/is delevering as well. In short, the increase in base money would have to offset both the reduction/contraction in bank lending and the reduction/contraction in the shadow banking system for there to be overall growth in the money supply.
So, even though the money supply of the banking system has returned to modest growth, the broader point is that there is no one-to-one correspondence between base money and the broader money supply. You can get rapid growth in the money supply when there is no base money growth (which happened pre-crisis), and you can get contraction in the overall money supply when base money is growing rapidly (which happened post-crisis).
The main determinant, therefore, is really risk appetite: do banks and shadow banks want to lend and do others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share? These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around—in large part because of what Econ 101 taught us about the primacy of price and rational actors.
If you want to know what is happening in the money supply, look to the lending portions of the economy, not base money, to get the real story. Don’t let the shrill cries of the inflationistas throw you off course.
Gold and silver have become very popular investments in recent years. I’m sure you’ve all seen the ads pitching it. The reaction to this last Fed policy meeting and press conference makes it a good time to go over the main reasons people have had for owning it, and how those factors have been evolving.
Low real rates. Commodities in general tend to do well in environments of low real interest rates. None more so than precious metals. The two reasons are (1) the opportunity cost of holding precious metals is low and (2) periods of low real rates often precede periods of inflation, for which precious metals historically have been used as hedges.
Systemic risk. The US banking system was on the verge of collapse back in 2008, counterparty risk had already broken down, and those living in the bowels of global money markets believed—with good reason—we were hours away from seeing lines of people in pajamas in front of ATM machines hoping there would be cash still in them. And history has seared into our collective memory the role of gold as a time-tested refuge in systemic crises.
Fear of high inflation. Central banks around the world have been expanding their balance sheets. Aggressively. When this started in late 2008, the consensus view was that this would cause inflation, perhaps hyperinflation. This led to a surge in the interest in precious metals, and to many high-profile hedge fund managers buying gold to protect against it. The list is long: John Paulson, David Einhorn, George Soros (though he has reportedly since sold), and countless others.
Fear of fiat currencies/gold as an alternative currency. “All currencies are in a race to zero” seemed the mantra for much of 2010-2011. The belief seemed widespread that in a desperate quest for growth there would be a no-holds-barred currency war, with the US as the instigator. If everyone was going to debauch their currencies, the word was holding gold—which many have come to view as an alternative currency—would be the natural place to go.
Diversification and the Dollar Overhang. The global financial system has been massively dollar centric for the past 60 years. Two things, around 2002, catalyzed a major diversification wave away from the dollar. The first was the plugging-into-the-grid of emerging markets (Brazil came back from the brink; China joined the WTO, etc). The newly found growth and macro-economic stability in these countries led to them trusting their home currency more, and needing the dollar—in which they were all heavily loaded—a lot less. Dollar-denominated funds joined the BRIC party, intensifying the decline in dollar demand. I’ve written in greater detail on this subject, one of the most misunderstood in global macro investing, here, here, and twicehere.
The second was the emergence of the euro. The euro came into existence as an exchange rate regime in 1999, but only in 2002 did it become a deliverable currency. With central banks around the world holding reserves almost exclusively denominated in dollars, a liquid currency that could reduce their concentration in US dollars and better reflect their patterns of trade was a godsend to many. This too put downward pressure on the dollar.
Once the diversification away from the dollar gained momentum, its decline boosted demand for precious metals, first because of the traditional correlations, but second because it also led to fears that something was wrong with the dollar (nothing brings out sellers like lower prices). This further reinforced the diversification bid for precious metals.
Income effects: China and India. China and India have grown spectacularly over the past 10 years. The past decade really was their coming-out party. But these economies have woefully underdeveloped financial systems. Savers and earners have had very few investment vehicles from which to choose. Capital controls have limited choices even further. As a result, Chinese and Indians have resorted to the time-tested investments their grandparents told them about: real estate and precious metals. As their incomes grew, so did demand for both. The fact that precious metals were going up in price only fed the fever. (Nothing brings out buyers like higher prices.)
Where do we stand today?
You can go over each of the above factors, assign weights to them, and decide for yourself if in the aggregate they are waxing or waning. But let’s run through them quickly:
The low real rate environment persists. This, ceteris paribus, will be supportive of precious metal prices. However, the fear that these rates are going to lead to rapid inflation has faded considerably, as investors (and, embarrassingly, many economists) are slowly coming around to a better understanding of the transmission mechanism of modern monetary policy and negative money multipliers. We’ve also seen the serial predictions of those promising that Zimbabwe or Argentina-like inflation was ‘just around the corner’ fall repeatedly flat. Even Peter Schiff must be getting tired by now.
Systemic risk is still an issue, with Europe far from resolved, but with much of global financial system having successfully delevered, it is much less of one. US banks have issues, but the focus is on earnings run-rates in the new environment, not (for most of us) sovlvency. Heavily levered carry-driven investment strategies (remember Peloton and its ilk?) are the exception rather than the rule as risk aversion has pushed aside the pre-crisis go-go mentality. Plus, the EU has a better understanding of the kinds of problems they are likely to run into in crisis, given the Lehman dress-rehearsal, as well as which measures will be required to fix them—even if they are so far reluctant to fully engage them. Lastly, the better understanding of the deleveraging process has led many to conclude deflation may be the greater risk, and it is not clear precious metals will be good hedges for this.
The fever surrounding the currency race to the bottom seems to have broken when the US dollar stopped its decline. As is often the case, the bottom in the US dollar was found exactly when the predictions of its crash became loudest. Investors are coming around to the realization that expanding base money is not the same as expanding the money supply. And, while the link between the money supply and currency rates may tickle investors’ memories of Econ 101, this relationship can’t be found in the data of financially developed countries over the past 20 years. As a result, to the extent the fear of fiat currencies abates, investors who have been holding precious metals on this basis will likely become more nervous and look to reduce (especially when prices go down). Indeed, this explains a lot of the price action in gold and silver over the past year.
The secular diversification away from the dollar should be supportive for precious metals, in theory. In the near term, however, this is somewhat irrelevant: the currency flows related to EU deleveraging and global risk aversion should keep the dollar well supported (NB: irrespective of where funds are domiciled, they are still overwhelmingly denominated in dollars). Longer term, diversification away from the dollar will persist, but whether the main beneficiary of this will be precious metals or other fiat currencies will depend on whether fear of the latter continues to subside.
China and India for their part will continue to grow. And it is unlikely that the development of financial markets there will be fast enough to divert savers, structurally, away from precious metals and real estate for a number of years. But for now, growth rates in both countries are slowing sharply, ahead of expectations, and their real estate markets are under pressure. This, plus declining precious metals prices, is putting China and India off their traditional zeal for gold. (Again, prices and demand are positively correlated. It amazes me we still put so much equilibrating faith in the price mechanism, but that is a post for a future date.)
In short, the reasons for owning precious metals are waning rather than waxing. Some of this is cyclical, but the main reasons for owning precious metals are being revealed as conceptually flawed. And this, to me, is significant. The growing recognition of the impotence of central banks when faced with deleveraging is finally, it seems, driving this point home. More ominously, positioning in gold and silver is still heavy, as macro tourists and retail investors are slow in giving up on their investment theses.
Precious metals are notoriously difficult to trade. Even if I turn out to be right, knowing when to place and press your bets won’t be easy. But I do know this: gold and silver are small, fairly illiquid markets relative to the kinds of positions the biggest macro tourists have on. And when they decide to leave, the escape hatch is going to look very, very narrow.
What if the Fed doesn’t throw a party and everyone comes? (market view)
I don’t write very often about market views, especially short-term ones. There’s excess supply of that already in the system, and my comparative advantage should be melding policy, economics and behavior to try explain things that I think are misunderstood. At least this is what I try and stick to.
But I am a trader, and I follow markets very closely, even when I am running low risk. And I have been getting a lot of inquiries about my views at this juncture. So, here they are.
Prospectively, I think guys are salivating to short risk in run up to/aftermath of the Fed tomorrow. I think a selloff is likely and will be short lived. The short-term indicators are quite overbought, but the intermediate-term indicators are very oversold, still. (Helene Meisler over at RealMoney.com lays these indicators out very well; in fact, she’s the only reason I’ve kept my subscription.)
A selloff that sucks the shorts back in followed by a return to rally is my base case. I don’t think the rally lasts too long, but breaks of 1410 in S&P, 1.31 in the euro, 1.03 in AUD, 13.40 in MXN, as indicative levels, seem doable—even if for the way I trade I care much more about the dynamics and sentiment than the levels themselves.
Part of the reason I have this view is because everyone is asking “What if the Fed throws a party and nobody comes?” Increasingly, people have recognized QE is largely psychological and the psychological response is diminishing. Even the Fed has. So a lot of bearish traders would like to see the Fed do something and then have the market selloff anyway. This would be ‘the dream sequence’. It would validate the bearish market view, vindicate the “it’s all artificial” theory of monetary policy, AND cast the Fed in an unfavorable light. Hat trick.
But the bigger pain trade right now seems to me the opposite. It’s the question in the market that no one is asking: “What if the Fed DOESN’T throw a party and everyone comes anyway?” This would imply the Fed announces no balance sheet expansion, the market sells off at first, then, once the bears feel like they’re back in control, a rally.
Reinforcing this whipsaw is my fundamental view that the Fed will disappoint. Expectations seem unrealistic. As traders we often act as if our anxiety level should be the principal criterion in the Fed’s reaction function. That, and, of course, the most recent move in the S&P. And our anxiety level has been high.
We have a strong tendency to project onto others our own thinking and preferences. But the Fed doesn’t think the way we do. I think we in the markets are projecting a bit too much here. So, I expect Son of Twist, with commitment to lower rates forever, or something along those lines.
There is very little short-term paper left on the Fed’s balance sheet to sell for a continuance of the current Twist, so I’m guessing they might buy further out and sell a little further out to continue the program. A twist on Twist. Just to be doing something. And because it can’t hurt. It doesn’t matter that I think it is pointless.
There are three main reasons I don’t think there will be any balance sheet expansion at this point—though the Fed will almost certainly discuss options for expansion should they need it further down the road:
1) The bar to expanding the balance sheet is high given domestic politics, international politics, and the Fed’s recollection of the sharp market reaction to QE2. I think they are still chastened, despite their intellectual recognition of its diminishing psychological effect;
2) Inflation and inflation expectations are running higher than in August 2010, when they were low and falling off a cliff. And they have a clear trend since last year;
3) They need the optionality now. “Taking out insurance” is pre-emptive. The US economy is healing, albeit slowly. So insurance is less necessary. The bigger risk is that of an exogenous shock from Europe or from a fiscal cliff (or hostage-taking in the run up to a fiscal cliff). The timing of these events is uncertain. Thus, the optionality of holding off with warheads that have been losing throw-weight anyway seems the superior risk-adjusted strategy. Again, I think these policies at this point are not very useful. But they can still short circuit negative sentiment in extremis when it gets to the point where that sentiment starts to feed on itself.
A little longer-term, I think the EZ did buy more time with Spain than the market is recognizing, and there is plenty of scope for further announcements in the coming days/weeks that could hurt those short risk.
To get a good entry point for my fundamentally bearish worldview, I would like to see the bearish tone subside and the bulls to get some chirping chips, to use another poker expression. I would like to see analysts on TV again saying “buy any dip” with the kind of confidence we saw in March/early April. We are not there yet. Until then, my strategic bias is to keep my bat on my shoulder. Often the most profitable trade is the one where you sit on your hands.
The short-term market reaction to the Spanish bank deal should not blind us to the important longer-term implications: Germany is now pot committed.
Most of you know the poker term, I suspect. Pot committed is when you have bet such a large percentage of your chips that you cannot fold your hand. You are not all-in yet, but you eventually will be unless the others fold. (“Crossing the Rubicon” has roughly the same meaning, but seemed a little too evocative in the present context).
The Spailout, as it is being called, is the biggest one-shot resource commitment the EZ has made in this crisis. In fact, the commitment seems somewhat open-ended. And it is the first one explicitly made (SMP purchases are really indirect) to a large EZ member state. Moreover, reading between the lines of the official statements from inside and outside the EZ indicates a fairly high degree of commitment to going further and forging a banking union. There are increased murmurings of fiscal union as well. Greece may be already outside the circle of trust, but all this suggests that the EZ—and Germany—very much wants the rest of the EZ to be indivisible.
I have serious doubts about the feasibility of these ambitions, but this is not germane to the point here. What is germane is this: If Germany is indeed pot committed, and you believe as I do that the other players are not going to fold (i.e. the crisis will continue), then we now know on whom the peripheral countries will default.
It will be the official sector and local banks, where the risk has been increasingly concentrated with each round of official intervention. The supranational institutions take down a lot of the bad assets, plus Spanish banks buy the Spanish debt, Greek banks the Greek debt, Italian banks the Italian debt, etc. This is, has been and, we now know, will be the dynamic.
Whether the bulk of default falls on the official sector and local banks, or the default falls on markets makes a big difference for contagion beyond the defaulting countries. If market participants are levered long troubled assets, or own troubled assets and are elsewhere leveraged—as was the case for markets pre-Lehman—contagion will be severe and collateral damage great. If, on the other hand, the official sector and the local banks (de facto official sector) own the bulk of the risk and market participants are not, in general, highly leveraged, the consequences—while still brutal for the defaulting countries—will not propagate through the rest of the financial system with anywhere near the same violence.
I am not arguing there will be decoupling. But for a number of months now I have been trying to gauge on whom EZ defaults will fall, the private sector or the official sector, because, ceteris paribus, the contagion implications are vastly different. And now I have my answer: Germany is pot committed, and the other players are not about to fold. This might not be fair or even efficient, but it matters a lot for eventual burden sharing, and on this count we just found out that markets are going to come out well ahead.
The Spanish loan and the statements around it are a big deal, IMO. That a deal for Spanish banks was in the works has been clear. What the statements and official comments have brought into sharper focus for me is how much commitment there already is to build a banking union and, in the more distant future, fiscal union.
The takeaway, however, is not that I now think they are going to make it, at least not to fiscal union. Nor do I think this will materially change Europe’s fatal flaw: its growth prospects. But there are two significant positive implications from a market perspective:
It is now more clear to me than ever that the bad risks in the system will migrate fairly fully to the balance sheets of the public sector (either explicitly of by contingent liability) by the time this is over.
They’ve bought themselves another chunk of time.
Together, this suggests that when—X years from now—the peripheral countries realize their growth trajectories are insufficiently robust to get them out from under their debt burdens, and some enterprising politician tells them they should not subject themselves to the Nth round of belt-tightening, the reverberations through markets when countries leave the single currency will be much less than they would have been if markets hadn’t already largely passed the hot potato to the public sector.
I was surprised when I saw Tim Duy’s post, via Mark Thoma (Tim Duy is a blogger and economics professor at the University of Oregon) that took Bernanke to task for his poor management of market-based inflation expectations since the 2008 crisis.
This is what he says:
“Bernanke doesn’t appear to see that the inability to hold market-based inflation expectations at a consistent level as a problem:
What’s wrong with this picture? Notice the volatility of expectations after the recession (Ryan Avent has made this point as well). The Fed claims to have some mythical “credibility,” but it certainly isn’t evident in this graph. If anything, it is clear that the Fed has failed miserably in establishing credible expectations for either 2 percent or stable inflation. Instead, what they have created is very unstable expectations because of start-stop policy. It is almost ludicrous to place so much blame on Congress for the unstable fiscal picture when they themselves are creating an unstable financial and economic environment.”
Psychological testing has shown than in building a story what matters most is not the completeness or quality of the information set, but rather its coherence relative to one’s priors. In other words, simple wins. And I’ll take this a step further: often the less we know, the easier it is for us to build a coherent story. (This is yet another well-kept secret of the money management business). The bottom line is that if a story is simple and intuitively compelling, it is fiendishly hard to disabuse people of it, no matter how false it might be. (Why do you think it was so hard for NBA talent scouts to give Jeremy Lin a shot?)
One would have thought that academia would be one of the spheres in economics best insulated from this confirmation bias. Evidently not.
I have three problems with his assertion.
The first is the premise. The volatility patterns exhibited in his graph of 5-year and 10-year breakevens (the Fed’s preferred market-based inflation expectation input is the 5-year breakeven, 5-years forward, commonly denoted as 5y5y breakeven) is no different from the volatility pattern is ALL markets since the crisis. A good proxy for this is the VIX.
You will note that the pre-crisis average level of the VIX was 14.3 percent (green line), while after the crisis (using the same date used in the first chart) jumped to almost 23 percent. Moreover, as one might expect after a crisis, the volatility of the volatility also increased significantly.
In fact, as a market participant, I recall thinking in early 2009 how remarkably stable market-based inflation expectations were, given the prevalence of the fear of hyperinflation and overall levels of market volatility. You can get a sense of just how prevalent the talk of hyperinflation was if you look at the timeline of Google search for that word:
We frequently hear in market commentary that every tick up in inflation is a tax on the consumer and every tick down is a windfall. But that’s not so much the case here at these levels of inflation. In reality, the level matters. A lot.
From low levels, upticks in inflation levels tend to indicate an increase, or an expected increase, in economic activity. And downticks, especially when growth is punk, are bad. The structural break in this relationship comes, again empirically, when inflation gets north of, say 5-8 percent. At this point the function that relates inflation to economic growth goes non-linear and the effects of inflation get very bad very quickly. So even if inflation expectations were more volatile, as long as they are well south of 5 percent it is not likely that they do much damage.
The third issue is conceptual. I could imagine someone looking at the chart of the VIX and the chart of breakevens and saying, okay, there was volatility in all markets, but that too was all Bernanke induced. And there may be some truth to that. But after a shock or crisis, normalization in markets typically follows the pattern of what is called disaster myopia: the acute memory of a disaster leads us to overstate the probability of its recurrence. In markets, that means volatility stays in the system. Volatility of the volatility stays too. Then, over time, as the memory fades, we progressively ratchet down our fears. (And, if a long enough time has passed, normalization eventually crosses over into complacency, FWIW.)
This is the pattern that you would expect to see across markets after a financial crisis like the one we had in 2008, and indeed, that is what is happening. Fear of the next Lehman, or the ‘next shoe to drop’ are waning, spasmodically, but waning. Hopes of a V-shaped recovery have exhibiting a progressively less amplitude as well.
Though there is much debate over whether the Fed has done too much or too little, it is hard to imagine that a radically different policy approach from the Fed would have led to a markedly different behavioral pattern, or to a rapid return to pre-crisis levels of volatility.
How you can go broke taking profits. Really. Reflection effects.
How many times have we all heard the line “You can’t go broke taking a profit”? Jim Cramer says it all the time on CNBC. Unfortunately, it’s dead wrong. Perhaps the dirtiest of secrets amongst professional money managers is that ideas—the primary basis on which they sell themselves to clients—come in third behind risk management and portfolio construction in generating replicable returns.
It doesn’t matter how much you explain to clients the centrality of risk management, they obligingly nod, wait for their turn to speak, and say, “Oh, that’s great, Mark. Very nice. And you were great on TV last week. Now, what do you think about the euro here?” Clients, like traders, crave stories. They want to believe the people to whom they entrust their money are genetically superior, multi-lingual polymaths. We managers want to believe this about ourselves, too.
But the truth is that in addition to loving stories we are all hard wired to be poor risk managers. Behavioral studies show that we are risk adverse when it comes to losing money, but we take on much more risk when we are trying to ‘get back to even’. This is referred to as the reflection effect (Tversky and Kahneman, The framing of decisions and the psychology of choice, 1981). Translated in trading, this means we tend to harvest profits too early, and tend to let our losers run. This is where the famous “I’ll sell it when it gets back to where I bought it” comes from. The reflection effect generates negative payoff asymmetries
One of the most important risk management tools I know, therefore, is doing the opposite: generating positive payoff asymmetries. Risking one to make three. Risking two to make five. This is what good traders do, even if they claim their P&L comes from superior intellect. And, of course, if a trade breaks your way you can use trailing stops and/or other techniques to improve your payoff asymmetries even further.
So, what one really needs to do is set up trades so that winners run and losers are dumped quickly. Think about the math. If you are risking one to make a minimum of three, and your ideas are right 50 percent of the time, you will be doing very well. In fact, your batting average could be far less than 50 percent and you’d still make money. If you regularly take profits quickly, as nature (and Cramer’s saying) would have us do, your batting average needs to be far higher. Anything that appeals to our instincts to take profits quickly is likely to make us worse traders, not better. And trading is hard enough as it is.
This may seem obvious, but if it were that obvious, no one would ever again say “You can never go broke taking a profit”. Ever.
Eduardo Porter captured the sentiment of many in the run up to the launch of the single currency when he said this the other day in The New York Times:
“Virtually every economist on this side of the Atlantic – and most of those on the other – figured out that the euro would be fatally flawed. What took economists some time to understand was that Europe’s leaders didn’t much care what they thought.”
I’ve been getting a lot of requests for a book list on behavioral economics, finance, etc. I promised a few of you I would post one.
Here are what I find to be some of the best books on these subjects. I picked books that are aimed at the intelligent reader who does not necessarily have specialized training in economics, sociology, or evolutionary psychology.
But I would also suggest you start with the 30 minute video of Daniel Kahneman’s Nobel price lecture. Videos are always easier than books, and it’ll open your eyes to our cognitive limitations as a species. Yes, that means you, too. Especially you.
And, my favorite all time book—though I don’t recommend this if you are interested exclusively in how behavior affects finance, and only should be read if you have a hard-core interest in evolutionary psychology—is:
Since I first put this book list together, Daniel Kahneman came out with an accessible version of his life’s work, Thinking Fast and Slow. I highly recommend it. I have read many of his papers over the years, but this book is by far the most jargon-free of anything I’d seen from him.
A quick note on how the IMF works with its member countries (in this case, Spain).
The IMF is always monitoring its members. There are teams with desk officers assigned to each country. They track all the data, news, policy measures and political backdrop. As times get tougher in a particular country, or set of countries, the resources allocated to tracking increase. Communication with the member is also stepped up.
If things get bad enough and/or the country is systemically important enough, the IMF will “war game” contagion effects. They will also get as prepared as they can for “the call”, the moment when the authorities of the member country formally ask for assistance in putting together a program. A country asking for a program has a stigma attached to it—especially for a wealthy, developed one. So the IMF is painstakingly scrupulous about “not getting out in front of” a member request. This is what is going on here.
So, up until “the call” the IMF will publically say “we are not in talks with country X about a program”. This may lead to some confusion because many wrongly infer preparations are not being made. But they are. They always are.
The IMF is an extremely professional organization. The most impressive bureaucracy I’ve ever seen (and I’ve seen a lot of them). Trust me; they are putting on the face paint.