Monday, December 31, 2012

Zero-sum society redux

PJ O'Rourke wrote a thought provoking WSJ editorial on zero-sum economics, but he is not the first to bring up the issue of zero-sum macroeconomic behavior. One of the best-sellers in economics during the early 1980's was Lester Thurow's Zero-Sum Society.  

This is a recurring theme when growth slows. If there is no increase in the economic pie, there will have to be discussion on how to take some of the economic share of another group. Growth theory  has always been one of the difficult modeling issues of economics. Growth is often driven by innovation but the factors that will drive innovation are often not clear. Hence, a slow growth period will bring out the doom-sayers because they cannot see a path to higher growth. Consequently we then focus on the zero-sum argument. If the president believes there are limited growth opportunities, there will more focus on redistribution of wealth. Growth will not be a viable solution. It belays a lack of optimism on future economic prospects that effort will be rewarded with economic expansion. This is consistent with the Fed view of limited growth. An Age of Pessimism could be upon us. This is similar to the early 1980's, yet the markets were surprised by the faster growth of the post 1982 period. 

Monday, December 24, 2012

Economics and social interaction

"Man's economy is, as a rule, submerged in his social relations." - Karl Polanyi

from Capitalism takes Command: The social transformation of nineteenth-century America edited by Michael Zakim and Gary J. Kornblith

A quote to keep in mind as we head into 2013. We have spent the last year focusing on the view that there is large inequity and capitalism is bad. The rich are evil and should have their money taken away. The rich, however defined, should not be allowed to have their wealth and it is actually the work of others. 

There is a problem of inequity in the US and other countries, but forcing change in social relations will not provide us with a better economic system.  The solution to problems in the US is growth and opportunity and not fighting over what is viewed as a limited economic pie.

Catastrophe risks are real

By definition, all but the last doomsday prediction is false. Yet it does not follow, as many seem to think than all doomsday predictions must be false; what false is only that all such predictions but one are false.

Catastrophe: Risk and Response  Richard A. Posner

Judge Posner provides a nice little book on issues of catastrophe risk. These risks are real and need to be addressed even if the events are very unlikely to occur.  Cost benefit is not easy to apply in these cases but it still serves as a way to judge the size of the problem. Yet, how can it be easy to judge the cost of a pandemic, an asteroid hitting the earth, global warming? It is not, but just because it is hard does not mean that we have avoid the discussion and not try to plan for these events. As aptly put in the quote, most predictions will be false except for the last one.

EM central banks gold buyers

Brazil and China are among the EM central banks that are buying gold. They are starting at a low base relative to G7 countries but there is a clear indication that holding gold reserves is believed to be  a good diversification strategy.

Philippines     +36% or 1.6 mm oz
Brazil             +56% or   .6 mm oz
Mexico          +17% or   .6 mm oz
South Korea  +79% or 1.0 mm oz

In six of the last seven quarters, central bank buying has been above 100 tonnes. Still central bank buying was only 9% higher over the year while ETF buying was up over 50% for the year. The major Eurosystem, Sweden and Switzerland  central banks are still subject to the third gold agreement which does not expire until 2014. The agreement limits sales but central banks have not fulfilled the maximum allowable tonnes that can be sold. It is not binding like first agreement when central banks were active sellers. 



The reason for central bank buying is separate from the usual view that gold is an inflation hedge. With interest rates near zero, gold  can be viewed as a good reserve currency hedge.  Gold is the only safe assets as defined by the IMF which is not a liability of a someone else. Gold is being proposed as a zero risk weighted item by the FDIC per a Financial Institution letter from June 18, 2012.

Of course, this is still a drop in the bucket relative to what was sold during the 19 years ending in 2008. Central banks then sold about 10 million ounces a year. What is clear is that central banks especially in emerging markets want to hold other assets than dollars, euros, or yen.

Wednesday, December 19, 2012

Moynihan on facts and motives

“Hannah Arendt had it right,” declares Senator Daniel Patrick Moynihan to New Yorker correspondent Jeffrey Toobin in the February 8 (1999) issue. “She said one of the great advantages of the totalitarian elites of the Twenties and Thirties was to turn any statement of fact into a question of motive.”

In The New Yorker, Toobin writes “To [Moynihan] character is based on intellectual integrity, on describing the world as it is, regardless of the political consequences.”


Too often the discussion of facts is assaulted as political. The fact is that we have a deficit problem. The fact is that the size is large and cannot be controlled through simple increases in taxes on households above $250,000.  The facts are that we have growth and underemployment problem. Monetary policy is not going to be the solution.

Why is this relevant for the investor? The truth and facts will prevail, so investment decisions should be based on what is real and not what is hoped for. Politics do matter because it can change timing and direction, but without a change in politics the assumption should be that facts will prevail.

Saturday, December 15, 2012

Fiscal cliff and foreign bondholders

"You Americans love the dramatics of a cliff." This could be a comment from any international investor, yet there has been little consideration of foreign investors on the US debt problem.

1. Raising the rate on high earners will not raise significant revenues. The expectation is that the rate will increase revenues by $800 billion over 10 years with closing deductions raising another $800 billion over ten years. This will be $1.6 trillion over ten years. Some have already stated that a compromise will have this number be more like $1.4 trillion which is just over the annual deficit for one  year.

2. Revenue will not increase without growth and there is no growth strategy.

3. Additional spending will increase by $50 billion which is close to 75% of the increase in taxes.

4. 45% of the tradeable debt is held by foreigners. They will control the fate of the rates in the US. The Fed cannot buy all of the new debt even with a program of $85 billion per month broken between $45 billion in Treasuries and $40 billion in mortgage debt. Japan is only in debt to other Japanese while the US is in debt to other parts of the world. 

5. Total debt is $16 trillion so a 1% increase in interest rates will add over time $160 billion per year in transfer payments form taxpayers to debt holders.  

6. Sovereign debt is no long risk-free debt, so the assumption that US debt being safe is wrong. The demand for US debt may change.

7. The debt ceiling debate is not part of the fiscal cliff at this point.  

8. The dollar is important to any discussion of debt because foreigners hold Treasuries in dollars. The desire to push the dollar lower will hurt the Treasury debt holder. 

9. The rate and float of all Treasuries will be determined by Fed buying. Th float of long-term Treasuries with maturities more than 10 years is only $750 billion. 

10. Financial repression is controlling the demand for Treasury debt. The financial repression may not work with foreigners.  

11. Foreign bondholders do not like negative real rates. The safety of a rising dollar will not solve the negative rate problem forever. 

Bernanke solution 6.5/2.5

Now we know the new Fed goals. Bernanke has been willing to try almost anything to solve the slow growth problem which in reality may be out of his control. Unemployment has to get down to 6.5% from the current 7.7% and inflation has to be no more than 2.5% one or two years in the future. 

The monthly buying program was increased to $45 billion Treasuries from "just" $40 billion in mortgages per month. So now the Fed will be growing its balance sheet each month by $85 billion, over $1trillion in a year. The Fed balance sheet in total was just under $1 trillion just a few years ago, now it will be growing by that amount in 12 months. By 2015, the balance sheet will be close to $5 trillion. 

The doves are in control, or so it seems. More interesting is the fact that this combination of policy is a variation of the Taylor Rule that some would say the Fed has been following for the last two decades. The differences is that there will be more weight on the unemployment portion and the inflation target will be higher. The most interesting part of this view is that it actually creates new uncertainty. What happens if the tamed inflation of today actually reaches 2.5% before the unemployment rate hits 6.5%. Alternatively, what will happen if unemployment does hit 6.5%? Will we see the fed reverse policy. Clarity actually can increase the number of questions that investors may have. 

Negative real rates and Keynesian euthanasia

Keynes, at the end of the General Theory, poetically called for the “euthanasia of the rentier".  Eliminate the premium associated with the scarcity of capital. This was a view that was not followed by Keynesians of the post-WWII period, yet this may be policy of choice around the Western world. We have gotten negative nominal interest rates in the Eu-zone and negative real rates is part of the normal policy choice. No ventral bankers is interested in what "rentier" think or what the impact will be on their wealth portfolios. there is talk about entrepreneurs, equity holders and homeowners in debt, but the people who clip coupons are just not that important. The policies of financial repression are in place to make sure that rentiers do not avoid their fate. Place capital controls and regulation on the movement of capital and negative rates will strangle the bondholder. 

However, if we euthanize rentiers who will finance the future we want. 

Friday, December 7, 2012

COCO and bond, equity, and tax vigilantes

Where are bond vigilantes? The guys who will sell bad bond credit. Where are the equity vigilantes? The guys who will sell poor economic growth and bad cash flows. The tax vigilantes who will take capital gains now to avoid taxes tomorrow. The markets do not seem to be reacting to the fiscal cliff. 

Yes, there are declines when there is new announcement in press conferences, but the trend is at worst sideways. There is no cliff as measured by the behavior of markets. There only is two weeks before liquidity starts to evaporate. Then it is almost too late. 

Is there the assumption that the life will be avoided before Christmas? That does not seem likely. Even if there is an agreement on taxes for the 2%, there is still the problem that capital gains taxes are going up. Dividend taxes are going up. The ObamaCare taxes are going into effect. Payroll taxes are going higher. 

The sentiment seems like we are bored by the process, yet the end is coming it is just beyond the Mayan calendar issue. We need market vigilantes to send a message.Where are these people? The foreign bond holders should speak.

Sentiment and markets

A person is smart. People are dumb, panicky, dangerous animals and you know it!

Men in Black (1997)

Great quote on the behavior of the crowd and why it cannot be trusted. Most people are rational when isolated from the group and given time to thing. It is very different once you put them in a group. Forget the wisdom of crowds. Emotions take hold and thinking is gone.

Thursday, December 6, 2012

Trend-following and the RORO (risk-on/risk-off) regime



The talk of risk-on/risk-off trading has been the key uncertainty driving markets for the last few years. It could be one of the chief reasons for why longer-term trend-followers have recently had a hard time making money and why fundamentalists have been unable to exploit economic imbalances across countries in the FX markets.  It may not be appropriate to call RORO the period’s defining market paradigm or regime, but it is clear that RORO behavior was not strongly present prior to the financial crisis.

There is no agreed definition of what is a risk-on/risk-off trading behavioral regime. However, we can identify environments that are more subject to this type of risk, those with increasing correlation across markets.[1] We have informally discussed these environments before through comparing correlation heat maps which provide a static snapshot of changes in correlation. In a RORO regime, markets move together in a manner that is reinforcing; however, this is without clarity on the direction of causality.[2] Sensitivity to a single macro factor will create higher correlation across markets. More highly correlated markets suggest more RORO behavior to any single market event.

Clearly, RORO switching between safe and risky assets is focused on changes in common macroeconomic expectations which cause all markets to move together. Nevertheless, it is hard to define what specific economic events will drive RORO trading. It can be a policy or data announcement or even a press conference comment by a government official. Risk aversion indices can also capture some of the factors which seem to lead to RORO trading unrelated to specific macro-events. Factors which express investor sentiment on risk aversion such as the VIX index or credit spreads are indicative of market risk perception. 

All these events cause markets to quickly adjust asset allocations in order to avoid market downturns or participate in market gains. Nonetheless, the sets of factors which drive RORO behavior are unclear. Hence, there needs to be a more precise way to isolate and research RORO trading as something unique.

How does this relate to trend-following? One of the key characteristics for longer-term trend-following is that trend are relatively smooth. The volatility around the trend is not large and there is diversification across markets. 

The diversification across markets is necessary because the success rate for most trend-following models is low. If there is more correlation across markets, there are fewer trends and the risk associated with any program of trend trades actually increases. Hence, the risk for a trend follower is higher. 

The type of volatility is important because trend-followers are actually long long-term volatility and short short-term volatility. The trend-follower likes long-term volatility because this supplies or represents market range. If there is no range over the long-run, there is no opportunity for the trend to establish itself and have a chance for accrued profits.  With RORO trading, there is less chance for long-term trends because the market moves between holding risky assets and safe assets. The switching causes significant short-term price reversals which create noise for the trend-follower. It is the short-term volatility which is disliked by many longer-term trend-followers. Short-term volatility will increase the amount of noise which will reduce the change of finding trends. The noise will be unrelated to the supply and demand of a specific market dislocation. The trend has to be stronger to provide a clear signal around the noise. 

Since trend-followers often have stop loss provisions with their models, short-term volatility increases the chance that stops will be hit. A good trend trade could end because of the stop. Hence, short-term increases in volatility actually reduce the success of trend-followers. A RORO environment will increase this short-term volatility. This will be bad for trend-followers. It should not be surprising that trend-followers have underperformed. They will have to wait for larger moves with one directional volatility that can be exploited. 

If RORO lasts for a long period, that is, risk-on or risk-off lasts for an extended period, there will a chance for strong profits. Periods of strong managed futures performance have been associated with extended risk-off behavior.  


[1] Research on changing correlation across asset classes has been undertaken by both academics and major banks. The focus of this work has been on how correlations across a broad set of assets change through time.  In particular, a large correlation matrix of assets can be adopted to measure joint correlation for the entire set. Statistical analysis, using principal components, can measure the extent that a single factor or component is associated with the correlation change.  This type of work has shown that correlations across asset classes are on the rise since the financial crisis of 2008. The higher correlations across all assets find markets more susceptible to a single factor driving performance.  

[2] The reasons for the higher correlation across markets are manifold. The globalization of financial markets with limits on capital controls allows the free flow of funds to impact multiple markets over short time periods. The focus on asset managers to tactically move money across asset classes and manage the entire portfolio has also caused a stronger link across markets. Research has also found that correlations will increase during market downturns and recessions which will explain the jump in correlations during the Great Recession. Research has also found correlation of asset classes increases when volatility increases which we suspect causes more risk averse behavior. The RORO regime may be with us for some time.

Paul Volcker as financial savior



The talents of Paul Volcker have been wasted on the Volcker Rule. There is nothing wrong with the concept of the Volcker Rule and in fact, it is useful to have especially if the government is providing a deposit guarantee to banks. Yes, it would be hard to determine prop trading, but policy should not let banks take excessive risks with taxpayer guarantees.

Paul Volcker could do more to help with the current crisis and has done more to solve some of the biggest financial problems facing the US over the last 50 years.  Bill Silber has provided a very good biography of a great public servant. At times Silber may be excessive in his praise, but Paul Volcker has provided invaluable service to the US through working through some of the most difficult financial and monetary problems of the last 50 years. The two key battles he fought was the US's movement away from  the Bretton Woods fixed exchange rate gold standard system and breaking the back of inflation during his time as the Chairman of the Fed.The Fed period is the most controversial. He was a pragmatist who used a smokescreen of monetarism to raise rates and break inflation even in the face of intense pressure form the Reagan administration. He could have folded under this pressure but he kept rates high even with significant budget deficits.

Most important, Volcker stuck to principles on what is good policy even in the face of strong political pressure. He understood the politics and could be loyal at implementing the policies of the administration he worked for, but he always tried to move policy in the right direction. 


Lower top rate and gain more revenue?


You cannot get a clear test on tax policy to determine the revenue gain from a change in rates unless you can control or isolate other factors. This is what makes economics so difficult and this is what makes economics different from other hard sciences which allow for experimentation. Nevertheless, the following graph has to be considered when discussing policy. The tax cut occurred at the highest marginal level and revenues actually increased. If the policy of raising rates is to get more revenue, the conclusion may be flawed.