I did an interview at the Metals and Minerals Investment Conference in San Francisco. I gave a talk with more details on gold at the same conference. I comment on stocks vs. bonds. This is my 11 minute interview starting 30 seconds into the interview time.
Leo Jia writes:
That is a very interesting interview. Thanks Bud.
Regarding big banks' manipulation of gold and silver, I have read such speculations for a few years. I often wonder how this can be possible given that there are big capital in the world that is not part of the banks. Why wouldn't they come in and break the manipulations and make money at the same time? Perhaps in the way Soros broke Bank of England?
Bud Conrad responds:
Yes, Leo, you have read those speculations for years — and for years those who put them forth have been viewed as members of a lunatic fringe. The most frequently heard dismissal of the case was, to the effect, "anything that big could not go un-noticed." Yet, as we have discovered in recent years, the LIBOR market and the swap markets have, in fact, been rigged. Each, as I understand it, are much larger and more vital than the gold/silver markets. Why anyone remains doubtful puzzles me…
Corn had a horrific report earlier today. It rallied early, but sold off sharply. Buying opportunity or reason to jump ship…that's the conundrum. The mistress of the market sometimes plays games to separate us from our money.
Gary Rogan writes:
I just came across this snippet:
"Corn prices fell in today's pit trade despite a bullish corn production forecast by the USDA due to dry/hot weather. CNBC suggested that one of the reasons for the slide was that the USDA will help farmers with the drought."
Can this be actually a cause of a sharp sell-off? How would anyone know to sell so quickly?
Also a more general question: what is the general lesson here, don't act on any news?
Bud Conrad writes:
I used to call myself a grain trader. The game was to predict the USDA numbers, then to see if you are more right than the consensus predictions. There is no secret that the Midwest is hot and killing corn. The question is how much?
If you know something that the market or the government don't, you have a chance. So today the government confirmed the well known situation. It common to see the markets "Sell the news". The question is whether it will continue to get worse (stay hot) in the future. Any few day of rain before July 4 can turn things around. At this date it looks like permanent loss.
I have no positions, but am sorry that the last month was a pretty good run on the situation that I should have seen. Aren't you afraid that the broker could be stealing your stash? I'm not reopening my futures accounts because of the lack of protection, which may be what the government wants, so prices won't be driven by speculators.
Unless I am mistaken, the "twist" is not duration neutral; whereas
real bond investors tend to be duration sensitive. That is, selling $1
billion at the short end and buying $1 billion past the 10 year is
roughly equivalent to putting 7x the amount of real investor money into
the market. This is a point that has not been widely discussed — and
may explain why the bearish effects at the short end will be dwarfed by
the bullish effects at the long end.
Alston Mabry replies:
If 'duration' is the sensitivity of price to a change in 100 basis points of yield, and the Fed sells 2's and buys long bonds in equal amounts, and the Fed is effectively increasing their portfolio duration, does it follow necessarily that the Fed is putting around 7x more money into the bond market?
Doesn't it matter how the rest of the market participants decide to adjust to what the Fed is doing? What if long rates go up? I'm not saying they will, just wondering. Once QE2 was announced, the 5-year rate went up and stayed up until the end of QE2 was in sight. Now the Fed was actually printing money with QE2, and so the rise in the 5-year rate was coincident with a huge run-up in the stock and commodities markets. But it wasn't unreasonable to predict that QE2, aimed at 5-6 year maturity, would push the 5 year yield down.
Paolo Pezzutti writes:
For those who want to try and find quantitative relationships between Fed intervention and market moves…this operation schedule may be useful.
Bud Conrad writes:
I still wonder how they sell off the short end and maintain ZIRP. Something will have to give, and I expect it to be the selling of short term.
Yesterday's across the board collapse of ag futures is a very serious move. Lock limit in most grains etc.
It looks like wheat and soybeans started to roll over a few days ahead of cotton. The nearby is down almost twice the daily limit, and the rest are all locked. It certainly is unusual and may be a solid confirmation.
Steve Ellison writes:
Has the "realizing market" begun? Roy Longstreet in Viewpoints of a Commodity Trader said that some of the best profit opportunities are in realizing markets, when price is driven by the market's realization of some fact. For example, stock investors realized in 2000 that most of the Internet companies that had been valued on clicks or eyeballs would run out of cash long before they could become profitable.
Russ Sears writes:
The agri oil boom bust is a spiraling cycle. Oil goes up lowers economy growth, commods like grains go down but then grains substitute, grains go up oil countries populace go hunger/revolt oil goes up, less economy growth but …the cycle is becoming clearer.
Gary Rogan replies:
Russ, I appreciate the explanation, this is very helpful. On the other hand, the original contention was that this is now a "realizing market". Has the market suddenly figured out this spiral, in the sense that oil going up will definitely (in the economic, not speculative sense) cause agri price to go down because the middle east is on fire? A case can be made that fertilizer prices or agri fuel costs are more important than some destitute people becoming even more destitute b/c of high oil prices and what, not eating any more? Or that raging inflation can manifest itself unpredictably in various commodities, or that transportation costs will raise import agri prices. I'm not sure this is equivalent to everybody figuring out in March 2000 that the Internet emperor was a bit on the under dressed side.
February 16, 2011 | Leave a Comment
The attached plots log(SP500) monthly for the then-current Fed funds rate (1954-2011). Various dates are marked:
1981: Peak Fed rate of 19%, following a period ranging as low as 4%, with relatively range-bound stocks of the 70's
1984: Stocks rose as the rate fell from 10% to 8%, punctuated by a pause as Fed rate jumped and declined again around 1984
1989: Stocks rose as the rate declined from 9 to 6%, rose more as the rate went from 6 back to 10% in 1989, and continued to rise as the rate fell from 10% to 3% in 1993.
2000: The vertical rise in stocks from mid-90's to 2000 occurred while the rate stayed around 5-6%
2000-2011: Rates varied from 6% to the current zero, while stocks were substantially stuck over the decade. The back and forth in stocks and Fed rate over this decade approximates a line with positive slope: high (low) rates with high (low)stocks, which fits with a market-fixated FED (easing/tightening when stocks fall/rise).
The little vertical line between 2009 and 2011 is stock drop and rebound during the unprecedented (in this series) zero fund rate regime - giving the impression the FED might like to move things out of the endzone in order to keep playing.
Bud Conrad writes:
What a confusing way to present data. The usual Fed Model compared earnings yield against interest rates like the 10 year Treasury.
The conclusion is that lower Treasury yield supports stocks (through lower earnings yield (higher P/E)).
The only indirect indication in this chart is that as the Fed funds dropped, stock went up, sort of. (Negative slope after 1981).
Kim Zussman writes:
The point of plotting this way (stock per fed funds rate) vs other conventional published methods was to see what, if any, correlation Fed rates have with stocks. The Fed can and does vary this rate, but not long rates and not stock earnings.
If you are looking for a good book, try The Shadow Elite by Janine Wedel. She coined and documented the flexions of all stripes. Also very good is The Short Stories of Jack Schaefer, and Mathematics Unlimited, 2001 and Beyond by Engquist, Schmid et al
John Tierney writes:
OK, if you are looking for non-fiction try The Invisible Hook: The Hidden Economics of Pirates
Kim Zussman recommends:
"This Time is Different" by Reinhart and Rogoff
(Spoiler hint: the common ploy of sovereign debt default via confiscation and hyperinflation appears not to apply to U$)
Scott Brooks writes:
We've talked about it on the list before and I I found it very good: Amity Shlaes "The Forgotten Man"
Easan Katir writes:
To the Last Penny is an excellent but little-known Edwin Lefevre work, which, thanks to Google books, one can read online.
Bud Conrad writes:
How about my book, which explains how the economy works from the view of an engineer looking at the total system. It also gives investment recommendations in the second half. It is titled Profiting from the World's Economic Crisis and published by John Wiley. Amazon has reviews and some sample pages. It is number one in one category on interest rates.
Craig Mee adds:
I recommend the Book on Games of Chance. A few of you may be no doubt already connected with it. Here is an interesting excerpt about it:
Cardano was an illegitimate child whose mother had tried to abort him. His father was a mathematically gifted lawyer and friend of Leonardo da Vinci. Cardano studied medicine at the University of Pavia, but his eccentricity and low birth earned him few friends. Eventually, he became the first to describe typhoid fever, a not inconsiderable achievement in itself, but today, he is best known for his love affair with algebra. He published the solutions to the cubic and quartic equations in his 1545 book Ars Magna, but Cardano was notoriously short of money, and had to keep himself solvent by gambling and playing chess. His book Liber de ludo aleae ("*Book on Games of Chance*") written in 1526, but not published until 1663, contains the first systematic treatment of probability, as well as a section on cheating methods. I told you he was bad.
Vince Fulco adds:
A little late to this thread but "Panic" by Andrew Redleaf and Richard Vigilante is proving to be a good read. Redleaf is a convert arb manager out in my neck of the woods who runs Whitebox Advisors. He is in print in his Dec 2006 letter stating, "Here is a flat out prediction for the New Year. Sometime in the next 12-18 months there is going to be a panic in credit markets. Spreads which now hover at an extremely tight 300 bps or so, will gap to more than 1,000. To put it another way, prices of HY securities will drop by something like 20 percent with some weak paper plunging even deeper"
A few powerful paragraphs from the first chapter:
The ideology of modern finance tears capitalism in two, then abandons the half beyond the ken of bureaucrats and the professors. Capitalism demands free markets because it needs free minds. Modern investment theory says efficient markets can moot the minds entirely. The entrepreneur cherishes freedom including the freedom to fail. The bureaucrat of capital dreams of a world in which failure is impossible. Confronted with demons of uncertainty, the entrepreneur wrestles with them till dawn. The bureaucrat of capital crafts idols of ignorance and worships in the dark.
Prevailing in Washington as on Wall St. were the most vile and self-destructive assumptions of anti-capitalists everywhere who imagined they could wield capital while abandoning the principles that created it; that systems could substitute for the moral standards they once embodied; or that men who lost trillions of dollars of other people's money might somehow recover it if only the govt gave them trillions more. Crony capitalists on the right and socialists on the left united as always behind their most fundamental belief, that wealth is to be captured by power and pull rather than created in the minds of men.
March 17, 2010 | 1 Comment
VIX Doesn’t Work as Signal for U.S. Stock Returns, Birinyi Says
March 17 (Bloomberg) — Investors looking for clues about the U.S. stock market should probably ignore the Chicago Board Options Exchange Volatility Index, according to a study of the VIX by Birinyi Associates Inc.
Speculation that equity returns will be positive after the volatility gauge decreases and negative when it climbs has little basis in fact, Birinyi said. "The VIX is alleged to be an indicative indicator and has become a staple of analysts and journalists alike," Laszlo Birinyi and analyst Kevin Pleines wrote in a report to clients.
The following is a table of the S&P 500's average gain or loss during periods after implied volatility climbed above or fell below the 50-day average: (since September 2003)
1 Month 2 Months 3 Months 6 Months
VIX 20% Below 0.09% -0.49% 3.33% 5.84%
VIX 20% Above 1.25% 0.50% 0.95% -4.51%
Source: Birinyi Associates
Larry Williams writes:
As I have always postulated, the VIX is just the Dow/S&P upside down. It's hard to predict A with A.
Jason Goepfert comments:
I'm not a VIX fanboy by any means, but that article was ridiculous. It only looked at returns since September 2003. And it only tested a strategy of crossing 20% above or below the 50-day average. Why 20%? Why the 50-day average? Why just since September 2003? Did they test anything else? Or is that the one they found that supports their (so far very correct) bullish view?
The ridiculous part is taking such a weak study and then proclaiming "the VIX doesn't work."
Allen Gillespie adds:
He doesn't have enough bins — bins of 5 show something different.
Kim Zussman writes:
- Volatility was extinguished by fiat liquidity
- The only double-dippers left are Jibao, Roubini, and Michael Moore
- Nothing to fear above moving averages
Marlowe Cassetti responds:
I have always doubted the assertion that VIX is a measure of market fear and greed. Years ago I read Whaley's academic paper and I was not satisfied with the author's fear/greed connection. To me VIX is simply the volatility number you plug in to make the Black-Scholes option equation work.
Bud Conrad answers:
My detailed review of VIX concluded that the VIX followed stocks (inversely) a day later. It was not predictive. Longer term charts seemed to indicate opposite movements, but the data could not be used as expected.
There is a very big "shoot the moon" increase in the Base.
Bud Conrad comments:
Here is a chart from St Louis Fed of Monetary base
Bill Rafter adds:
Terse: a big increase in money stock (money supply). That would normally tend to be inflationary, but BSB just yesterday told us there is no inflation. (And he was correct.) Typically the Base tends to grow at an exponential rate in the low single digits. However with the banking rescue programs there was an astounding 100+ percent increase from Sept 08 to Jan 09, and another big increase from Aug 09 to Dec 09, and now we are at it again.
The reason there has not been inflation is that this expansion has not gone anywhere beyond the (big) banks. If you look at other versions of the money stock such as M2, you see that there has been no such increase. In fact, M2 has been showing contraction relative to its long-term target. It will be most interesting to see the M2 numbers to be released today. A big increase in M2 would make the case that inflation is finally coming. No increase in M2 would state that we are just getting more of the same, specifically that the Fed has been putting money out to the big banks (at zero interest) and then allowing them to simply leave that money on deposit with the Fed (at interest). This process is just a subsidy to the banks.
The important question to me now is why the latest increase? Are the banks in further trouble? Does this anticipate more trouble, say with commercial real estate?
Given the colossal increase in the Base, some of it will bleed through to M2, which probably explains the current increase. However note that M2 is still below its long-term growth rate (what I call the fit or target), so effectively practice (as opposed to policy) continues to be restrictive.
At some point "somethin's gotta give": The Fed could start taking down the Base. They probably will just reverse the policy of paying interest on deposits left with the Fed. At that point the banks will return much of their borrowings back to the Fed. Some of them may not, and choose to start pushing commercial loans out the door. Then you will start to see increases in M2 and the earlier increase in the Base will become inflation. That at present is the only reason why I watch this data.
Mick St. Amour comments:
Bill, this proves my theory that fed is fighting deflationary forces given contraction in lending and collapse in monetary velocity. Given we are in balance sheet recession, reflation of assets/collateral values is main goal of central banks everywhere. It is key to stoking animal spirits in the markets and in real economy. I suspect this provides tailwind for asset classes such as equities and commodities.
Rudolf Hauser comments:
It might be worthwhile to remind readers of what the demand for money is in a non-inflationary economy. It is the amount of money people in the aggregate wish to hold (emphasis on hold, not spend) plus that needed for transition in transactions (the amount involved that is held up by the clearing process) in an environment of just real growth or decline. That applies to both high-powered money (the monetary base) and measures such as M2. If that amount is not provided banks will attempt to increase reserves by reducing investments and loans. Paying interest on reserves increases the banks demand for reserves (excess reserves), as does increased caution on their part. You will only get M2 to grow if banks are more aggressive in investing and lending. Since there are no longer reserve requirements on (M2-M1) all of the reserves related to this are excess reserves. If the Fed were to stop paying interest on reserves a bank could profit from such reserves by buying 3 month or probably even 1 month Treasury bills as long as the return were in excess of their processing costs since the reserves used to buy those securities is zero percent financing. But to buy treasures they have to pay the buyer, which increases bank deposits, i.e., M2 (and M3). The banks cannot drain total reserves from the system– only the Fed can do that. If the Fed wants to keep excess reserves from being used it can discourage that use by raising the interest rate it pays on excess reserves. To repeat, lowering that interest rate only leads to more rapid monetary creation-something that I suggested would be desirable here to accelerate M2 growth to a rate that does not drive us into another economic down-leg in a few quarters from now.
September 11, 2009 | 1 Comment
There is something missing in the article from Zerohedge.com, "Correlation Of S&P 500 Performance With Fed Monetization". The Quantitative Easing of buying $917b more securities went nowhere as shown by the big increase in deposits ($886b) at the Fed by the same institutions that sold the securities. They just left the newly created money sitting on the Fed's balance sheet, earning the modest interest that the Fed now pays. They didn't go buy stocks with it. Yes they could have, but the Fed balance sheet doesn't suggest that as a likely action. Furthermore, the Fed didn't really create new money for QE because many of their direct loans were paid down. The Fed balance sheet has been flat during this time frame. The banks, who had been paying interest on their borrowing, sold MBS and Treasuries to the Fed, and now are collecting interest rather than paying it. It would have to be some back channel of additional off Fed balance sheet funding to claim that the Fed is the source of money for the stock market rally IMO. Yes, it does seem that the QE lines up with the increase in stocks. Zerohedge suggests there is a multiplier on Fed money, and that could be the case. Then the big financial institutions would have to be borrowing, perhaps pointing to their big deposits at the Fed to justify big loans, to invest in the stock market. Maybe, but I haven't seen evidence of that either. I'd be delighted if the proposed relationship were valid as then that would explain the surprisingly big jump in stocks as being Fed monetization induced, since I still see great weakness in the overall economy that doesn't justify stocks rising. But the proposed link doesn't hold from what I see. Anybody else see how the link would work?
Rocky Humbert offers:
Another possible explanation:
As part of QE, the Fed bought MBS securities from the open market, which reduced their supply and increased their price. This caused some marginal participants to purchase other, less expensive fixed income assets. In this case, corporate bonds.
The Vanguard Short-Term Investment Grade Bond Fund (VFSTX) has returned 12% year-to-date and the Vanguard Intermediate Investment Grade Bond Fund (VFICX) has returned 15% year-to-date. These are huge moves.
As the cost of corporate debt financing declines, it’s logical equity valuations should benefit.
Dr. Humbert is a quantitative analyst and speculator who blogs as OneHonestMan.
Our money and credit expert Rudolf Hauser writes:
From the Zerohedge article "And instead of this excess money hitting broader aggregates such as M2 or MZM, it is held by the banks, who proceed to buy securities outright on their own, either Treasuries or Equities."
When banks purchase securities they pay for them with those Fed created reserves. The person or institution selling those securities now has a bank deposit. The impact on M2 is the same as if the bank had made a loan. But if the high-powered money created by the Fed is kept at the Fed M2 is not expanded. In short the article is incorrect.
Much of the creation of money over the last 15 years was induced by low Japanese interest rates on the order of 1% per annum. However since March of 2008 the Japanese money stock (M1) has fallen year over year in every single month.
In the US, part of the problem is the inherent contraction in money supply caused by people repaying their loans. When a loan is repaid money disappears from circulation.
There is another more insidious problem in the economy these days. It is really a form of fear. Everyone is afraid to make a decision, to invest, to spend or otherwise do something with their money. Thus the money that does exist has largely frozen up. This is best measured by the velocity of money also called the money multiplier. We recall that the multiplier is not an observable number but is simply given by the formula:
G = V * M or V = G / M
where G is the Gross Domestic Product, V the velocity and M is the Money Supply, in this case M1. The latest data shows that velocity has fallen from about 1.6 a year ago to .88 in the most recent numbers. A number below 1 means that the average dollar of M1 is turning over less than 1 time per year. A chart can be viewed at the St. Louis Fed site.
To compensate the Fed is aggressively easing M1, the monetary measure they can influence directly. In just a few months they increased M1 from 1.4 trillion to 1.6 trillion, an increase of $200 billion.
Part of the question of how we got here can be seen in the history of M1. On April 3, 2006 M1 peaked at $1402.5B. For the most part this peak was not exceeded and as late as Sept. 1, 2008 M1 was still at $1391.9B. That means there was essentially no growth in M1 for 17 months!
2008-09-01 1391.9 No growth for 17 months
Somebody at the Fed must have awakened from his snooze and noticed that TARP, TAF and alphabet soup was not quite working. So he started aggressively adding more than a trillion in garbage (the polite term) to the Fed balance sheet. This had the happy result of pushing more than a trillion in cash into the economy. So M1 money supply grew from 1391.9 in September to 1638.1 on Jan. 5th, 2009. The $1T bought us an increase of $200B or about 20 cents on the dollar. Don't ask where the other $800B went. After all they are still trying to figure out where the TARP money went.
2009-01-26 1548.2 -5.5% decline in January
More ominously during January M1 began to tank again. It was down 5.5% in January.
Looking at the broader measure of MZM, money supply with zero maturity we see that it has grown from about $8 T to about $9.3 T during the last year.
Thus M1 represents about 16% of the broader MZM metric. The current unpleasantness began with the decline in real estate and will not end until the real estate market stabilizes. There is more to be done.
Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008
Bud Conrad replies:
The topic is one of great importance as to whether we return to inflation from the deflation we are experiencing, and when if it happens.
One of the problems in our fiat money system is that we have lost the definition of money. It used to be what we could turn into gold. M1 was distorted by the money market funds that replaced much of demand deposits at banks so under reported what was available for transactions. M2 included small savings. M3 had large savings. The Fed stopped reporting M3 which also included some strange measure of Eurodollar accounts and repos that they said they didn't want to spend the money to collect.
MZM seems the most sensible for the measure of money as it is accounts where money can be immediately used to buy things (Money of Zero Maturity).
When the M1 Money supply (Currency plus demand deposits including Reserves at the Fed) changes dramatically higher as it did from September because banks now have gargantuan ($700B) of excess reserves, which is higher than ever before even as a measure of GDP), it is logical to expect Velocity to decrease just from the increase in money supply. GDP is much less fast to respond, but was declining adding to the slowing of velocity. All we have done is let the banks hold a big bunch of money on deposit at the Fed, where they got the deposit invented out of thin air. The low velocity is not a reflection of consumer and business behavior, as much as it is a measure of money expansion. GDP movement was relatively, in % term small. The velocity concept is not wrong, it just shouldn't be a reflection of consumers, but a reaction of Central bank money creation that is stuck at the banks not yet flowing loans to the economy.
The measure to watch should be the Excess Reserves, which is declining some. As to whether this Fed buying assets is inflationary is crucial, and it is the lack of bank lending that eviscerates the Fed, as it is just pushing on a string. My own expectation is that foreigners may come back with their dollars accumulated form our trade deficits to buy real assets instead of financial assets to cause inflation. Such action would also increase Money supply measure sand be inflationary. But foreigners are reluctant to tell us that is what they are doing so we will only know after the fact. We would also see that action in the velocity measure.
Stefan Jovanovich comments:
These speculations assume that money is still somehow a "supply". Not now. It has become only a residual - the amount of stuff available to buy things and pay debts, including what can be instantly converted to legal tender. It is what is actually left over after businesses make or lose money, people borrow or save, governments borrow more than they spend. In an age of Bill Rafter and George Zachar and all the other smart people and smartly-programmed computers, central banks no longer enjoy the privileges of seignorage, nor can they conjure up "new" loans by using a magic wand to create reserves. Neither can the Congress and the Treasury "create" jobs using the magic wand of the multiplier. That is why Timmy looks so utterly helpless and Ben so tired. If you are looking for a physical metaphor for the monetary present, try water out here in the West. No one has yet to figured out how to make it rain; and when the ground supplies are depleted or the reservoirs not built and filled, you have a drought. Evaporation is not the source of your scarcity; it is simply the constant. Desalination, like "stimulation" (truly the appropriate metaphor for academic economics in the age of porn), offers the illusion of an answer but only if you ignore the fact that creating fresh from salt water is 2-3 times the cost of simply buying it from the people who have some to spare.
Bud Conrad responds:
I agree that there is no good definition of money, but the Fed can contribute to expanding the measures that are almost always included in the narrow measures of money, and then also therefore in the bigger measures. It seen best in conjunction with the real source of new credit (money), the deficit of the Federal government. The Treasury prints up new Treasuries. The Fed (usually through middle parties but leave them out for simplicity) creates a new demand deposit at the Federal Reserve Bank in the name of the Treasury out of thin air, in payment for the Treasuries. The Fed's books are balanced with more Treasuries as an asset, and a deposit as a liability that the Treasury can write checks on to buy bombers or pay Social Security. When the Social Security recipient deposits their check in their bank, the deposits of the whole banking system are increased. The usual narrow money measure is M1 that is basically currency plus demand deposits (checking accounts).
To be clear, If a foreigner with dollars from a trade surplus (our buying their products like computers) bought the Treasury, that would not add to the traditional money measures. That would then be considered that the Treasury borrowed the money for the deficit, rather than have it Monetized by the Fed. The distinction is probably over emphasized in money and banking texts, but the reason I bring it up is to be clear that the Fed can create what is generally called money.
You then need to know that the most of the money (demand deposits) is not created by the Fed. It is created by the banks making loans. The banks must set aside a little as a reserve against any new deposit but can loan out the rest. The borrower buys something like a house or car, the seller then deposits the proceeds, and that new deposit minus the reserve requirement can be loaned out again. In that fashion, banks make something like 6 times more money than the Fed does in total. The problem now of the Fed "printing" (= creating demand deposits out of thin air), doesn't work (have much effect), when banks don't lend. The Fed addition is not very big if the loans aren't made. That is called "pushing on a string", as we have now. And that is why we have deflation in the face of the most extreme Fed expansion and the Treasury $2 trillion deficit this year.
Legacy Daily comments:
It seems to me that a rosy outlook is in order. When the government and key "experts" say the worst is yet to come, I (and everyone else with me) fear to take on additional loans not knowing if 1) we can pay back 2) we'll make money from the loan. While the Fed/Treasury can create reserves (and pressure the bankers to state how much they're lending), unless there's increasing demand for loans, money will not be created to the degree it was created when every American thought they could buy a house and sell in a year with at least 20% profit.
Unfortunately, this type of shift in outlook will probably roughly coincide with the proverbial "capitulation" when I (and everyone else with me) can no longer imagine the situation getting worse. Until greed comes into the picture, money will not be multiplied to the degree it was multiplied in the past bubbles. The problem is that when greed becomes the key driver, we'll have incredible amounts of reserves - causing "sales" of money and the officials will be late to throttle back the system to prevent inflationary bubbles.
The "assets" are "toxic" because the outlook of getting the promised cash flows is negative. When that outlook changes (the poor guy who borrowed more than he should have sees the possibility of his house appreciating), the "toxic" will actually become like gold that never tarnishes.
What is the flaw in my logic?
February 17, 2009 | 7 Comments
This question is akin to an inverse of the rabbit from the empty hat trick. The rabbit has to be there in the hat before it has been taken out. The inverse of this trick would be that the affairs of men relating to wealth and money during a downturn and crash are prone to imagining a rabbit vanishing into a hat that was never put into the hat.
Money in its broadest realm is a state of the mind. Cash and currency are but one tangible subset of money, a much smaller one. There are many other tangible subsets. Then there are the intangible ones. The wealth effect espoused by financial behaviorists is but nothing else. Today's context is nothing different really conceptually from the Tulip mania or any other that has happened in between since.
Value is what money is supposed to store. Cash is one form of money. Central Banks are creating money in modern times as their dutiful function. Financial markets are producing money and consuming away their own and others' money creations periodically as a by-product of their other core functions. Whatever can be a store of value and a medium of exchange is money. That's how there was a time not too long ago when the Tulip bulb was the most important store of and producer of more money. As confidence and thus belief in the existing amount of collective wealth and value goes up so does the amount of money perceived goes up. When the amount of money perceived around exceeds far beyond the utility or the utilizable value, mankind is presented with the bills enabling reality check.
Where would the money go that never existed? That rabbit was never put in to the hat. No point in searching it there at least. But then in such cases, there were several rabbits that never existed.
Now markets, crowds, societies and the entire mankind are known to have swung from one extreme to the other one. So, as this all gets prepared to be relegated back behind to leaves of history, yet again the real rabbits will be put into the hat and won't be visible before being pulled out. In markets, non-existent rabbits are being put into hats and existent rabbits don't get seen inside the hat. Men of the markets are indulging in relishing and enjoying the magic of both kinds they are themselves creating again and again.
George Parkanyi asks:
But where has the actual cash that's been created (not the intangibles) gone? Every balance sheet begins and ends with the current assets line-item Cash. I understand that the Treasury can create money out of thin air - but whatever dollars it has created to date exist somewhere as cash - net of those dollars that have been taken out of circulation. It cannot not exist. A big chunk of it may not be CIRCULATING, or at least not in our economy, but it's SOMEWHERE. My question is where? and what would cause the money not circulating to begin circulating again?
Now some balance sheets are of course over-stated because they value assets at a market value that is not realizable. And real cash was lent against those unsustainable values. This just means that a significant amount of cash was deployed unproductively buying a house for $1,000,000 that could be replaced for $400,000, or a $1,000,000 mortgage backed issue that may only receive back $300,000 of principal. But even where cash went to purchase intangibles, the seller of the intangible still received the cash, and either "saved" it or went and bought something else.
If we assume that the cash the Treasury has created over time still mostly exists, then I believe the question becomes to what extent have balance sheets been bloated with unrealizable intangible values? And to what level do these intangibles need to readjust down for businesses to again begin investing and for people to still show up for work and maintain and grow an economy?
There are some potential implications. For example, if you have $30 trillion of cash around the world (I have no idea what the real number should be), then adding another 2, 5, or 10 trillion may not necessarily be all that inflationary. Also, if intangible "assets" on books are 3 or 4 times the amount of cash available, and they suddenly go out of favor (e.g. real estate prices drop, no-one wants junk bonds, no-one wants to pay more than book value for stocks), then demand for cash and "safe" cash equivalents will soar (and cause one godawful depression- especially if the cash is just hoarded). There may even be bank runs despite federal deposit insurance. And what if the real cash is mostly overseas, and we're holding the bag with mostly intangibles? Ouch.
I would expect that the tipping point to inflation will come when we begin to see shortages (or perceived shortages) in real assets (e.g. from droughts causing food shortages or commodity shortages due to global supply disruptions) to meet current needs, but especially if there is a fear-driven demand to acquire and hoard real assets (loss of confidence in the currency), possibly leading to hyper-inflation. That doesn't seem to be the case right now, especially in North America and Europe.
My gut reaction on this is to lean toward the deflation scenario, because even though the Treasury may throw a few $trillion out there, much of it may be absorbed by born-again savers and foreigners, and still mostly stay out of circulation while asset prices fall. However, that deferred latent purchasing power, when unleashed, could be enormous when asset prices finally turn.
Easan Katir comments:
George, here is the train of thought I think you're asking about/ applying your line of questioning to what everyone says is the root problem: housing.
Trillions were in pensions and sovereign funds. Pension plans, sovereign funds, no doubt Orange County ( they get in on all the deals ) bought CDOs from investment banks. So their cash went to investment banks. To create the CDOs, the banks had to buy mortgages from lenders. So the cash went to mortgage lenders. To originate the loan, mortgage lenders gave cash to home sellers. At this point in the logic train we have two layers of paper, not cash: CDOs and mortgages, which have had to be reduced in value because the home buyers overpaid.
Buyers and lenders gave their cash to the homebuilders, who were of course, sellers. So the homebuilders should have mountains of money. Since they don't appear to, one assumes they must have taken their money and bought more land, built more houses, which they couldn't sell, and have had to write down. Some cash went to the land sellers, the subcontractors and the materials suppliers. Private homebuilders bought more investment real estate, and gave their cash to those sellers.
Those who now have the trillions don't seem to be standing up and waving "it's here. I've got it", do they….
So a "nutshell" answer to your question, "where is the cash?" might be, it's in the bank accounts of anyone who was a seller of houses, land or stocks a few years ago. Herb and Marion Sandler, for example, who sold in 2006.
Stefan Jovanovich comments:
Most of "the money" is gone. Some very little of it is sitting in safes and vaults in the form of greenbacks and bullion, but most of it is simply up in smoke. Very few of the people invited to the A-List party have the wisdom to want to leave early or the guts to be seen leaving early. The homebuilders here in California put most of the money they made into options for and outright purchases of new lots, heavy equipment and (in the case of the public companies) stock buy-backs. They also paid a lot of money in income taxes. The value of the lots they bought or optioned here in California is close to zero, and I assume it is the same in Florida and the other places that saw a boom. The heavy equipment is worth between 10 and 25 cents on each dollar they paid in 2005, 2006 and 2007. (It is not just the slow-down in orders from China that is killing Caterpillar right now; the competition from used equipment is murderous.) The idea that somehow only we poor Americans were the suckers is funny. If anything, we have gotten off comparatively easy. The property markets in Europe and the Middle East and Asia have, as the Beach Boys might have put it, all become California dirt; and their central bankers bought far more of our crap paper than Helicopter Ben bought of theirs. What is also funny is the notion that the money center banks need to start lending again to get the economy moving again. They ARE lending - to the Treasury. Why, in a world of ZIRP, should they do anything else?
Bud Conrad writes:
There are so many good questions and answers it is hard to focus on simple explanations. But first a few clarifications on George Parkanyi's initial point of view: Money is not a real thing of substantial value, and it is not created by the Treasury, but by the Federal Reserve. The Dollars in your pocket are Federal Reserve Notes. This is a minor point because your question makes perfect sense if you wrap the word "government" around both the Treasury and the Federal Reserve, and replace your use of the world Treasury by the word government.
Then your question still stands: Where did the money go? First, the real assets of homes and land and factories still exist, and they are still owned by someone. What disappeared was the value expressed in dollars. This is a form of money implosion as experienced by holders of deeds of trust that don't cover the defaults. It means less money in total. That is why we have deflation.
But as you say the government (Fed) can print money pretty much at will to keep things going. The system of fractional reserve banking is set up so that most of the "money" comes from the banking system as it makes loans. For example, mortgages are used to buy homes, not the money from a down payment. These mortgages were based on the banks making money by creating loans. About 6 times as much "money" was made by the banking system as by the Fed. In boom times and according to theory, banks always want to make more loans as that is the way they make money. They are constrained by having enough reserves to meet the Fed's requirement of supposedly 10% of deposits put on deposit at the Fed. When the Fed adds new reserves by buying Treasuries from banks, the theory expects the banks to make new loans an "multiply" the money throughout the economy making new loans. In this situation today, the Fed has bought Toxic waste giving the banks new money that could be lent. But the banks aren't lending because they have bad debts, and need to have capital adequate to meet regulatory review and because they can't find lenders they can trust who want money. So the banks have piled up "Excess Reserves" at the Fed and the money multiplier is leaving the Fed "Pushing on a string" getting no expansion of the money, even after their bailouts that they thought would be stimulating.
P.S. I like the rabbit that isn't there being put in the hat as explanation as it makes as much sense as all the details here. It is only an illusion that money is worth anything, that is left over from convention before 1971 when foreign central banks could convert dollars at $32 per oz for gold. De Gaul reached for the gold and Nixon slammed the window on his fingers after we sold off half our store. Since then it is mere historical convention, image and illusion that keeps the dollar afloat.
Nigel Davies offers:
Here's another take on it. What if most energy in any system is lost simply through friction, this frictional tendency actually increasing during an asset bubble. When the bubble deflates again, most of what you have left is the huge waste caused by people chasing something that never really existed in the first place. They were pursuing an optical illusion caused by increased liquidity and dissipating real wealth via their frenetic activity.
Jim Sogi writes:
Money, cash, and credit, is merely a counting method for confidence, or now, the lack thereof. It is created as an ether, and disappears as the fog. It is a strong only as our full faith. With mass communication, global memes seem to spread faster, turn on a dime, so to speak. I wonder if there is a correlation between speed of decline and recovery time?
Vincent Andres responds to Nigel Davies' questions about China:
Once upon a time they did build a big wall, I would posit it's now imprinted in their DNA. The surface inside the wall + the number of people there seems already a nice piece to manage. And btw, In 2008, everybody also knows how too big empires end.
So, I'm really not worrying too much about China. China managing China is already a really great challenge. Kudos if they succeed.
Just my two cents feeling, I would like to hear the flaws/missing points above.
George Parkanyi adds:
The mitigation of risk and the collective formation of capital in the capitalist system incents exploration, invention, innovation, and experimentation. Look around you at the marvellous things it has built, and the amazing discoveries it has facilitated. Next time you take a flight think about all that went into you being able to do that. Or even just driving a car. There's nothing really wrong with the current monetary system other than we've allowed it to run amok. Credit is fine as long as there is a reasonable expectation of most of it being repaid. (But even if it isn't the stuff gets built anyway; someone eventually just takes a haircut.) With some better checks and balances, there is no reason we can't dust ourselves off from this face-plant and continue to progress - hopefully a little less rough-shod over the environment and each other. The key is to keep enough people incented to keep innovating and working productively to sustain the complex societies and systems we have built.
I went to a presentation by Martin Eberhard, co-founder and President of Tesla Motors, on Wednesday. I've seen one of the eight cars built and it is slick: 0 to 60 in 3.86 seconds with no shifting. And Eberhard is a slick presenter. Arnold Schwarzenegger has ordered a car.
But they have a huge mountain to scale with gargantuan problems, not the least of which is the distribution and service. They have taken the unprecedented step of making a completely new car that is to be status symbol and new technology at once. It is a complete design from bumpers and fenders to suspension and the electronically controlled antilock breaks. I think they have bitten off too much. Battery technology is the latest lithium, but with stacks and stacks of cells, it is a huge battery. It takes all night to charge from a 220 electric dryer but does go for 250 miles. The electricity is cheap at pennies per mile. The car is expensive at over $100K. Divide that by 100,000 miles of useful life and you have capital costs of $1/mile.
Great breakthroughs in technology, but the take-out is a rich Asian car company with lots of dollars. Reminds me of Tucker Car that after WWII developed the best technology but was squashed by the big guys.
Alan Millhone adds:
Nice to see something new and innovative in the automotive area! My first car was a 1964 Mustang fastback that was raven black with a white interior, 289 H.P. and a Hurst shifter and Hurst mags. I ordered it from the factory for $3,105! I still have the original owner's manual, bill of sale and a sterling Mustang tie-tack (still on the card). The car is gone, but the memories of taking possession of that car at the dealership will stay with me like it was yesterday. America has always had a love for the automobile and I hope the Tesla will have its own following.
J.P. Highland remarks:
For $100,000 I would rather buy a Porsche Cayman and a Toyota Tundra, one for the fun and the other to be my workhorse.
March 20, 2007 | 2 Comments
A Swiss bank's research says Alt-A and Subprime adjustable mortgages account for 13.8% of outstanding first lien mortgages. Let's say a third of those were issued most recently, populating the oft-cited cratering indices. That would be around 4.55% of outstandings.
Now, let's say a quarter of those are in trouble. That would be 1.14% of outstandings. Finally, let's say the underlying value of the paper is only 60 cents on the dollar, for a 40% haircut. Forty percent of 1.14% is 0.46%, a loss of 46 bp of outstandings.
Away from the human tragedies of folks losing their houses, etc., it is very hard for me to come up with a scenario where a market-wide loss of less than half a percent foreshadows material macro fallout.
Bear in mind the securities losses will be concentrated in funky first-to-die paper, much of which is held overseas. And the unfortunate folks losing their homes weren't among the economy's biggest spenders.
Bud Conrad writes:
I like your method of looking at the situation. I come up with a worse number starting with the Alt A added into the sub prime as likely candidates for failure added in. Another view has Alt A about 18% of new issues in 2006 for $350B according to inside MBS & ABS. Subprime was 25% of new lending in 2005 and was said to be $600B.
Combining these gets closer to 40% or say a third of the loans for a guess. I leave one reduction step out entirely, the number of such loans just recently, as they might all have some risk.
I give a higher recovery rate of 75% so 25% loss. Now apply the 25% in trouble, and I get 30% X 25% X 25% = 1.9%
2% loss on all mortgages would be much worse in the sector that I suggested was 30%, more like 6% to them. So I can concoct a problematic, if not catastrophic scenario on this back of a napkin.
Charles Sorkin adds:
I'm not sure the focusing on the dollars lost directly through bad loans is the proper approach for predicting the impact on the economy going forward. After all, with prices of lower-rated residential mortgage backed securities now well below par, much of that money has already been lost, and with the GSEs playing a diminished role these days, much of that money has been lost by private entities.
Tighter lending standards will reduce the amount of consumer spending that was derived from cash-out refinances. Homeowners that do not default on their ARMs will still have less discretionary income to support purchases of big-ticket items (cars, appliances, retail electronic gizmos, etc.). Consumer psychology is generally such that negative headlines can easily convince the marginal buyer to put off homebuying for a couple of quarters. So on and so forth.
Will it be enough to generate a recession? Futures markets are now implying 2-3 rate cuts in 2007, so perhaps we are at a key rate-setting juncture Fed-wise. Keep in mind that if a rate-cut is implemented with the expressed hope that it will support adjustable-rate mortgage debt, it is important to keep in mind that many loans reset only annually.
The current popular explanation for the market's persistent strength is "worldwide excess liquidity" (a la Sam Zell's singing Christmas card).
Under this view,
1) Where is all the excess liquidity coming from?
2) And why is there more liquidity being created now than in normal other good economic times?
Dan Grossman writes:
Maybe the world is awash in liquidity and maybe it isn't. But the central banks of the number 1 and number 2 economies are restrictive and have been that way for some time:
Jim Sogi writes:
I am sure everyone has noticed that the market refuses to go down. Every time the bid pauses, after a small airdrop, buyers come back to bid it back in force. The liquidity is a tectonic event, like the movement of plates. Once put into motion by years of pump priming in the US, in Japan, in China, it is hard to hold back.
While the monetary authority is restrictive in its pronouncements, it is not necessarily so in practice, with low rates below short-term rates, which would cause liquidity to flow to equities under the Fed model. Typically, as with any political movement or group situation, once a consensus is created it is hard to change the direction and the momentum tends to overshoot the changing circumstances. It is a typical group dynamic caused by the difficulty of getting people to agree. And as with the gambler's being more certain once the bet is made, decisions become etched in stone and are hard to change. When currencies move, they tend to overshoot their mark. When risk is deemed to be low, the consensus continues even beyond the time and circumstances justify. Remember 1995? It seemed the market was really high then. But it shot up like crazy over the next five years.
Old metrics of liquidity such as M3 don't work. George and Phil mentioned the role of derivatives. Is there a way to measure the derivative market? What are the indicators? Currencies measure the relative strength of flows of capital, goods, and fiscal and monetary balances between nations, and are important measure to consider in a multivariate way similar to gold and commodities that reflect and predict equities.
Japan's new equity highs and yen lows reflect a political and economic dynamic of a growing economy with its monetary gear in reverse. Very odd. Both the US and Japan benefit from weak currencies against the Euroland, and despite the jawboning and posturing, the currencies stay low. The fiscal power is exercised by the Executive but the power, in theory, is in Congress. This is separate from the monetary power of the central banks. The two are related, but are not formally coordinated. The size of the currency markets surpasses equity and debt and is subject to intervention in scope beyond both.
As the floating fiat currencies mature, the competition between nations may become more intense. While liquidity is good, now, there is not much of a squeeze. Reading some of the old books, there were some tense moments when bars of gold had to be shipped from England to New York to keep things afloat. Benjamin Franklin argued for printing money to stimulate commerce. All nations have incentive to inflate their currencies to keep growth from falling back into recession. What happens when the confidence, rather than gold, that keeps the currencies afloat turns dark?
It's a very difficult issue to understand. Thanks all for your help.
Bud Conrad writes:
Nice charts. I appreciated your sharing them. I agree with your base point, and want to see if I understand the importance of this analysis.
A little more explanation would help me apply the observations. The red curve fit looks like it is at a higher rate for the Japanese. Can you give me your fit percentage annual growth for each? The size is hard to read on my small screen.
Do you have an explanation of the big drop in Japanese monetary base? I think there were shifts in the policy of the BOJ in May 2006, around going off the Zero Interest rate policy but I can't recall the actions taken. Would they fit though the Japanese end point were higher or lower than the US? Is the monetary base an important measure now that there is so much credit created outside the banking system that is not regulated, and for which there is no reserve requirement, and now people prefer paper money to credit cards?
From Bill Rafter:
U. S. Monetary Base is the combination of currency in circulation and deposits in Federal Reserve Banks. It is released bi-weekly in seasonally adjusted form by the St. Louis Fed. It is also released weekly in non-seasonally adjusted form. I can seasonally adjust the weekly data myself, but then I would be the only one with that data. Since much of market action is sentiment-based, it's best to see what everyone else is watching, so I use the default.
The Base must grow at the rate of the population growth and economic growth or risk causing deflation. Thus in the long run the Base growth will be exponential with some positive and negative feedback influences. The best way to fit it would be with a parabola. That's what the red line represents. The software that I use (our own*) does that easily and produces the formula giving the growth rate. Off list, I will send you a text file with the base and parabolic fit numbers. What is absolutely amazing is that the fit is so perfect from inception. To me this means that there is a "natural" target for the Base. Whether the Fed admits to a target or not is inconsequential. One exists. Once you have acknowledged that, then it is a small step to say that growth in excess of the target is accommodative, and less than it is restrictive. The two spikes (Y2K and 9-11) prove that the Fed has control.
The Japanese Monetary Base numbers are available monthly. They consist of currency and deposits and are available raw and ARIMA adjusted. I used the latter in my chart. The Bank of Japan did have an inflation epiphany last May, when the numbers showed a huge contraction. Some have attributed the sell-off in our equities markets at that time to the BOJ action. Yes, the growth rate in the Japanese Base is considerably greater than that of the US. Please don't flame me for saying so, but I attribute that to (a) inexperience and (b) BOJ having less independence from the government than our own Fed does.
Credit is created outside the central bank infrastructure, but sooner or later, that money hits the banking system where it is recorded in the Base.
Note to members: I would be happy to produce additional information based on monetary numbers from other countries. Send me links. Europe would be particularly useful. Australia and Russia are probably just warts on the elephant's butt. China is a question mark. I assume that even the rural areas are somewhat dollar-influenced. I don't know how China's banking system works, but assume it is run by benign neglect. Therefore, a lot of what goes on there shows up in the U.S. numbers.
* To all: I have previously offered the software free to list users. That offer still holds. Just send me an email if you want a serial number.
I have no response that could place this within any kind of rational frame of reference.
Very little of what is occurring in the capital markets today makes sense to me and I understand it less every day. Twenty percent on the SPX in the last seven months…VIX and spreads are at all-time lows…talk of a permanently flat yield curve…infinite capital?
Maybe it really is different this time, no more recessions, no more business cycle, and we all live happily ever after. Except me - I am still here with my tinfoil dunce cap on, waiting for the sky to fall.
Bud Conrad writes:
This is one of the best summaries of the changes in the new Financial Engineered Credit markets I have ever seen laid out. Thanks very much. If you have some sources on the bigger credit picture, such as where are the numbers on percentage of loans from outside the banking system, that would be of great interest.
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