Archive for November, 2007

One kind of commentary I keep running across, even from people 26 sigmas smarter than me, goes like this: “Inflation fears are overblown. According to the Treasury Inflation-Protected bonds (TIPs) market, inflation is deteriorating rapidly because …”

Let’s go over the reasons why this kind of analysis is false and misleading:

1) It’s not very true according to its own (flawed) benchmarks. 5-year Treasuries issued at a coupon rate of 3.375% are now trading at 3.39%, basically the same yield as the coupon. 5-year TIPs, issued at a coupon rate of 2% (implying 1.375% CPI), are now trading at 1.12% yield. That’s nearly HALF the original coupon, and it implies that TIPs are almost twice as valuable (yield somewhat over half as much on the bond) as they were at issue. Additionally, the difference between TIPs yield and Treasury yield, as you can see for yourself, is not 1.375%. It’s 2.27%. That’s a huge increase in CPI inflation expectations relative to identical bond issues from earlier.

2) CPI is an extremely political benchmark, because all mandated growth in entitlement spending is indexed to it. So the government has an obvious incentive to understate it, and perhaps more importantly, there is an elite consensus on the issue. Therefore, it’s highly likely that CPI will be held down by all kinds of statistical magic, or less conspiratorially, the divergence between CPI and headline inflation should widen over time. Therefore, the Fed faces heavy political pressure (and everyone agrees that the Fed reacts to political pressure, at least slightly) to keep CPI down.

3) If you think inflation will rise, you probably don’t trust the Fed very much, since low inflation is part of the Fed’s job description. Therefore, you probably won’t trust the Fed’s measurement of CPI very much. Therefore, the last place you’re going to go to bet on rising inflation is the TIPs market. People who don’t trust the Fed have lots of better ways to bet on inflation than TIPs.

It’s analogous to walking up to a Wal-Mart checkout, slipping the card through the reader, and then saying to the clerk, “I think your products have been deteriorating in quality, and I think they suck!” You’re an idiot if you’re wrong and a bigger idiot if you’re right.

4) Even significant inflation fears now will only be a warble in the 5-year TIPs market, let alone longer-term TIPs, just because the length of the time horizon overshadows most current events. As long as people are willing to trade a Treasury/ Fed market, and thus trust it even to a lessened extent, there will always be the presumption that a spike in headline inflation will be met with subsequent money withdrawal to bring inflation back in line.

5) Even if you think CPI will exactly track “real” inflation, and that political considerations have nothing to do with CPI calculations whatsoever, you’re still not capturing the full effect of inflation. So you’re still missing out on some of the payoff of rising inflation. The methodology of CPI was altered dramatically in 1993 to effectively lower the stated rate of inflation by multiple percentage points per year, because the previous rate of inflation allegedly did not account for substitution effects, and so on and so forth; but under pre-1993 methodology, current inflation would be running over 7 percent, which incidentally is much closer to MZM minus real GDP.

For these reasons, I wish people would stop referring to the TIPs market as a valid indicator of inflation expectations. It isn’t.

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More Sivs freezing over

Florida isn’t the only state being left as a bagholder for the SIV mess. After a run started on a Florida SIV (causing FL to freeze withdrawals), Montana is also discovering that above-market yields are no free lunch.

SAN FRANCISCO (MarketWatch) — Florida’s investment troubles have triggered withdrawals from other states’ funds as the subprime mortgage crisis continues to spread.


Florida halted withdrawals from a $15 billion local-government fund on Thursday after concerns over losses related to subprime mortgages prompted investors to pull roughly $10 billion out of the fund in recent weeks. See full story.


Other states are experiencing similar problems on a smaller scale.


The Montana Board of Investments, which manages the state’s money, has seen $247 million withdrawn by local governments in the past three days from a $2.5 billion money-market-like fund called the Short Term Investment Pool.

It won’t be any consolation to them, but the Treasury/Libor spread shrank a lot today, so the interbank seizure has calmed down a lot since yesterday’s worst-in-21-years 3-month Ted spread of 2.26 (it’s at 2.05 now). However, I think it would be foolish to assume that yesterday’s peak fears will not go unrealized.


I’m also surprised by the dollar’s rally after Kohn and Bernanke gave the markets their early Christmas present yesterday and the day before. The fed funds gamblers have now priced a 25bp cut as 100% likely, and a 50bp cut at 34 percent.

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When Mideast analysts who know what they’re talking about (i.e. Stratfor) have previously gotten all giddy about prospects for peace in the Mideast, I have always had this kneejerk roll-eyes reaction. Not that their relatively pricey news isn’t worth it (far, far from it). But from my vastly less informed viewpoint, there are simply too many people invested in continuing the “stable disequilibrium” of the Iraq mess–both inside and outside the Middle East–for Mideast “peace” to be anything but an accidental, inevitably-aborted pregnancy.

For example, if Baghdad ever stopped cannibalizing itself, Kurdish independence would be jeopardized. The Kurds are probably not involved in any Iraqi sectarian problems right now, but they have 100,000 very well-equipped and well-trained soldiers. The Kurds could easily scuttle Iraqi unification if they wanted to.

The rest of our Gulf “friends” have enjoyed a half-decade windfall from oil’s “structural upward volatility” in oil prices, primed by Alan Greenspan and sparked by the Iraq war.

Ratcheting up Gulf tensions, and thus upping the perceived risk premium of oil, is easy for Iran. Sunni actors for their part tremble at the Iranians’ rise (a derivative of the Iraq mess) but they have no complaints about higher risk premia for oil, as long as it’s not their pipelines getting bombed.

Iraq has also been a godsend to the Saudi royal family, because Iraq has effectively imported all radicalized Saudi youths who would otherwise have followed in Juhaiman al-Utaibi’s footsteps. For the Saudis, although Iraq has powered international volatility by abetting the rise of Iran (bad), Iraq has soaked up the blood of every Saudi kid who would otherwise be throwing Molotov cocktails at the Saudi royal family (very good). (The best measure of supposed Saudi internal reform, btw, will be changes in the proportion of Saudis among the Iraqi body count.)

But the actor with by far the least to lose and the most to gain by sparking the Mideast powder keg is Russia. Russia is the world’s number 2 (I believe) oil exporter. It instinctively distrusts the United States on a visceral as well as a strategic level. Although it is no longer communist, Russian commodities interests (i.e. the people who run Russia) find Americans as their main competitors in global export markets, the Rusal-Alcoa rivalry being just one example.

So, the Russians have a lot of reasons to keep the Mideast on fire. Iran does too, for its own reasons. An alliance was born.

However, Soviet-Iranian relations have never been very stable. Stalin even occupied Iran in 1945, withdrawing only after the United States threatened one-way nuclear war over the issue. Iran’s current “friendship” with the Russians is very skeptical and opportunistic. Much as the Americans and Russians always, regardless of changing historical tides, find themselves fighting each other, so it is with Iran and Russia on a somewhat smaller scale.

Presumably, once the Americans are bled white enough to quit the Mideast, Russo-Iranian competition for Syria, Azerbaijan and the Central Asia ‘stans (“the Great Game”) will be the decisive factor in the Iranian-Russian relationship. It’s a lot like with Sauron and Saruman in the Lord of the Rings, with Saruman, the weaker warlord, happy to align himself with the “Great Satan,” but only to the extent that it helped Saruman.

This long-run ‘inevitability’ has manifested itself in Russia’s ‘assistance’ for Iran’s nuclear reactor at Bushehr. The Russians, who built the reactor themselves, are basically one fuel shipment away from revving up an autonomous Iranian nuclear program. Russian intelligence and armaments exporters are up to their eyeballs with the governments of Iran and Syria. However, when it comes to nuclear technology (to Iran), the Russians have been a much more capricious counterparty, constantly inventing new reasons to delay completion of the reactor. The Russians know they will lose a lot of leverage over Iran once the fuel is shipped, thus a mini-soap opera of Russian hemming, hawing, intransigence and general bad-faith behavior.

Unfortunately, the Russians are highly alarmed at the progress of American-Iranian negotiations. There is obviously a huge lobby in the United States to wind the war down in acceptable fashion. There is a large Iranian lobby, as well–even among the military, which is intricately involved in all parts of the economy. The American financial embargo of Iran has caused Iranian economic growth to be much lower, and inflation significantly higher, than it otherwise would be. The Iranian opportunity costs for ongoing hostilities are rising, if not as rapidly as for the United States.

Iran needs more concrete, long-term reasons for being a Russian proxy in the Mideast, than structurally upwardly-volatile oil prices and broken promises from the Russians over the Bushehr reactor.

It now appears that Sauron is willing to give his Saruman the ultimate ring of power in order to maintain the tempo of tension in the Mideast.


Russian President Vladimir Putin on Nov. 30 signed into law a bill that formally suspends Russian cooperation with the West on the Conventional Armed Forces in Europe (CFE) Treaty. On the same day, the International Atomic Energy Agency approved a shipment of Russian nuclear fuel for transport to the Russian-built Iranian reactor at Bushehr.

The CFE — a treaty that regulates how much conventional weaponry NATO and former Warsaw Pact states can have, and where — is the cornerstone of Eurasian security architecture. … But registering Russian displeasure with the treaty is one thing; leaving it is another.

Similarly, the Bushehr reactor — so long as it is not yet on line — is Russia’s primary lever for inserting itself into Middle Eastern events. But as soon as it goes on line, the West has no reason to engage the Russians on Iranian issues, and Iran shifts from needing tutors for its nuclear program to having the infrastructure in place to be self-taught. In the Russian mind, ending that influence could be worth the cost if it locks Iran and the United States into a protracted struggle.

The bottom line is that both leaving the CFE and making Bushehr operational are not rhetorical moves, but bridge burners that will force other powers to adjust their long-term security policies. …

Russia feels forced to take such actions because its world is quickly evolving in a direction it greatly fears. The European Union and NATO take up Russia’s entire western horizon and show few signs of being finished with their enlargements. The United States might have achieved some breakthrough in the past week on both the Israeli-Palestinian issue and relations with Iran. Simply put, things are coming to a head. …

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Good stuff.

Is the financial world about to collapse? You’d think so if you listened to the financiers

What on earth is happening in the financial markets? Last week Northern Rock was going bust, stock markets were collapsing and the world banking system seemed to be going down the tubes. Now everything has reversed. Markets are soaring. Northern Rock shareholders, instead of losing everything, as expected a week ago are threatening to sue the Government unless they double their money. The Abu Dhabi Investment Authority (ADIA), the world’s biggest investment institution, suddenly launched a dawn raid on Tuesday to snap up $7.5 billion worth of shares in Citicorp, the world’s biggest and most troubled bank. So is the financial world about to collapse or are all the crises over?

The answer, of course, is neither. Markets always go up and down and these short-term fluctuations tell us nothing about the world outside the City and Wall Street. This is particularly true today because the markets’ recent gyrations are caused mainly by short-term factors that will soon ebb away.

Investors are obviously still worried, as they have been since August, about the weakness of the US housing market and the exposure of banks to defaulting low-income mortgage borrowers, but these risks have not changed since mid-October, when stock markets all over the world were hitting record highs. What has changed is the emotional response of investors to these risks.

In a nutshell, investors feel betrayed. The banks told investors and regulators before the summer that they had learnt lessons from previous crises and had found new ways of making profits without exposing their capital to old-fashioned lending risks. Instead, these risks had been transferred, through clever financial engineering, to pension funds, insurance companies, Asian governments and other long-term investors with deep pockets. This has now been exposed as a myth. As a result, the share prices of banks are collapsing and their managers are being fired — though, being bankers, their reward for incompetence and deception is a multimillion golden handshake from the shareholders and taxpayers whom they abused.

This naturally makes people angry and, to make matters worse, the full extent of the deceptions has yet to be revealed, so that only the bravest investors, such as ADIA, can contemplate buying bank shares, however far they fall. Most of this uncertainty, however, will soon be resolved as the banks close their books for the year-end results, with directors and accountants aware that any significant mis-statements could land them in jail.

Will these results produce further shocks, triggering another stock market collapse? I have no idea and neither does anyone else, which is why the markets are so twitchy. What I do know is that market gyrations in response to these disclosures will matter much less than most financiers believe.

Financiers naturally think that they are the world’s most important people, so when their own jobs and bonuses are threatened they assume that the global economy must be under threat. Most of the time this is simply not true.

Meaningful economic indicators come out only rarely but stock markets trade every day, so in periods of uncertainty they start reacting to their own daily fluctuations as if these provided “new” information. When bank shares fall sharply, investors treat this as evidence that the financial system must be in trouble and analysts who were saying “buy” only a few weeks ago begin to scream “sell”. This, in turn, causes shares to fall farther and proves the sagacity, and maybe even inside knowledge, of those who sold. As bankers see their share prices falling, they threaten to cut lending to the real economy of jobs, investment and housing. The fear of a weakening economy then makes bank stocks fall again.

This self-reinforcing process was defined as “reflexivity” by George Soros, in his classic treatise, The Alchemy of Finance. A substantial academic literature has now confirmed that Mr Soros’s “theory of reflexivity” is a big driving force of boom-bust cycles in financial markets. But the question is whether these financial boom-bust cycles are as significant for the non-financial economy as he believes. The big mistake made by Mr Soros as an economic analyst, though not as an investor, was to exaggerate the power of his insight about reflexivity and therefore to conclude that capitalism is an inherently unstable system.

In reality, a modern mixed economy, especially one with a central bank actively managing demand, is protected by self-stabilising mechanisms that are much more powerful than the reflexive boom-bust behaviour of financial markets. In the present financial panic, for example, the dollar is falling sharply and this is boosting US exports. The acceleration of export growth is easily offsetting the slowdown in construction and consumer finance � at least so far. Another stabilising offset comes from long-term interest rates, which have now fallen back to the levels that triggered the global credit boom in 2004. As a result of such self-stabilising feedbacks, financial cycles tend to reverse of their own accord and almost never produce outright economic disasters. The 1930s Depression and Japan’s recent stagnation are often cited as counter-examples but these were caused mainly by central bank policy errors that were amplified by unstable financial markets, not the other way round.

Which brings me to the most important stabilising mechanism: the central banks. The true reason for this month’s grim mood in global stock markets has been disappointment with the US Federal Reserve Board. The Fed cut interest rates by a quarter point on October 31, believing (probably rightly) that this would be enough to avert a recession, but Wall Street wanted more. Since many investors think Wall Street is the economy, they believe the Fed has a duty to protect stock markets and banks against excessive losses, similar to the attitude displayed by the shareholders of Northern Rock. They therefore felt righteous anger when the Fed refused to promise another rate cut after October 31.

Wall Street in the months since the August panic has been like a spoilt child who has grazed her knee. As long as the Fed offered attention and sweeties, investors stopped screaming. But the moment the sweeties ran out, the screaming resumed. Like a weak parent, Ben Bernanke, the Fed Chairman, encouraged this naughty behaviour with indecisive policy flip-flops. In the next two weeks, however, the screaming will probably stop. On December 11, at the next Fed meeting, Mr Bernanke will doubtless back down and give Wall Street its extra rate cut. The tantrum will then be over and it will be cuddles all round in the City and Wall Street, at least until the next grazed knee.

He’s missing the FHLB bailout, though. $200 billion in liabilities for Uncle Sam that nobody has a clue about. Just go to the Federal Home Loan Banks’ website and look at their outstanding discount loans. $160bn to $330bn in 10 months.

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Ted spread update

3-month Libor: 5.12%

3-month Treasury: 2.86%

3-month Ted spread: 226bps

Ted spread precedents: Black Monday 1987 (~255bps), and before that, the 1979-83 bear market.

Suckers’ rally.

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Fed Up


We’ve been told not to imagine a world without the Federal Reserve. Maybe we should.
Post Date Wednesday, November 28, 2007

WASHINGTON–Recently, The Washington Post carried a front-page story about a federal raid on the headquarters of the National Organization for the Repeal of the Federal Reserve Act and Internal Revenue Code (Norfed). The Indiana-based company, which advocates “sound money,” has been selling coins and paper certificates backed by gold and silver for years, in effect trying to compete with the dollar.

The government ignored Norfed’s “Liberty Dollars” for a long time–until the group started selling thousands of coins with Ron Paul’s likeness to show support for the Republican presidential candidate. Paul also wants to abolish the Federal Reserve.

To the public at large, the activities of Norfed seem utopian, naive and even downright fraudulent. The idea that the world’s greatest economy could be run without a central bank and private parties could replace the government as issuers of currency is one that many people will find scary. With the dollar in something of a free fall and the United States in the midst of a housing and credit crisis that has sent some of the nation’s top CEOs packing, Americans will be looking for financial security, not monetary adventures.

And yet it is precisely in such a financially wobbly environment that the actions of Norfed should invite a critical look at the way money is managed. Some of the country’s greatest economists, including Nobel Prize winners, have been saying for years that the Federal Reserve has probably caused more problems than it has solved since its creation in 1913. Its role in the last century’s boom and bust cycles is a matter of record; it looks as though it played a similar role in the current housing market crisis too.

While the creation of the Federal Reserve was essentially a response to a series of bank runs, those crises were mild compared to the ones that were to follow. In 1913, the United States was under the gold standard. Although the government issued currency, the fact that currency was tied to gold meant the authorities could not manipulate the money supply easily. The Fed’s initial mission was to guarantee the convertibility of deposits into currency on demand. A few decades later, the United States abandoned the gold standard and the Federal Reserve became the country’s most powerful economic institution, exercising its monopoly in issuing currency based on the discretionary power of its board of governors.

All in all, financial instability has been far greater since the creation of the Federal Reserve. What did the Great Depression teach us? Essentially that even with the best of intentions, it is impossible for the authorities to manage the supply of money in accordance with the exact needs of the economy. A country’s economy is the sum of millions of people making decisions that no single individual is in a position to anticipate. As economist Murray Rothbard showed in his book America’s Great Depression, in the 1920s the Federal Reserve pumped up the money supply, expanding credit by more than 60 percent. Because the economy was very productive, this monetary expansion did not show up in the regular inflation figures. But, as is always the case with inflation, many resources went to the wrong kind of investments–until the crisis hit. The late Milton Friedman showed how the Fed made things worse by not providing the system with enough liquidity once the Depression was obvious.

The current housing market and debt market crises are in good part the children of the Federal Reserve. By cutting rates 13 times between 2001 and 2003, and then keeping them very low for years, monetary policy contributed to the housing bubble. That is not to say other factors–including financial instruments that made it difficult to see that the underlying foundation was not as solid as it seemed–did not play a part too. But, once again, the Fed has turned out to be a factor of financial instability.

In this context, Norfed’s attempt to prove to the Fed that the market is ready to trust private currency backed by gold is a welcome occasion to take a second look at some of the economic institutions we take for granted. Naive and utopian? You bet. But that is probably because of how far the world has moved from the time when money was too important to be left to the politicians.

Alvaro Vargas Llosa, author of Liberty for Latin America, is the director of the Center on Global Prosperity at the Independent Institute.

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Apparently, once again there are grounds for hope for a “more lasting accommodation” in the Mideast, judging by the latest kabuki signals between Pres. Ahmonajihad and Uncle Sam.

And, oh, right: Don Kohn said that we needed some more of that pragmatic flexibility on interest rates.

And there was much rejoicing.

My hobbyhorse du jour, the difference between the 3-month London interbank offer rate and 3-month Treasurys, stands at 212 basis points. The last time confidence was this low was… Black Monday, 1987.

Another way to look at it would be to examine the T-bill/Fed funds ratio 2.96/4.60 ~= .64. Except for August 20, 2007 (when the 3-month tbill divided by the effective fed funds rate was 3.06/5.03 ~= .62), this is the lowest the ratio has gone since the bona fide 26-sigma event of 9/11/2001, and its echo defaults–Enron and Worldcom. It is equal to the LTCM rate, and you’d have to go back to 1982 to find a comparable level of panic.

Somebody with much better information than me is calling BS on this rally.

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