Bullish Bonds Spell Worry

Bonds don't rise this sharply, and interest rates plunge similarly, unless there are concerns in the financial markets. Note the last candle at the far right. That sharp buying binge for bonds is indicative of grave worry in the financial markets because investors are running for cover by buying bonds, which they consider to be the safest investment available.

Great Explanation of Why Inflation Is So Low

Interesting insight from clovisdad, a commenter on another website:

Let's use Japan as an example.   Cutting through the "old language" of bonds and interest rates, bond vigilantes, taxes and balanced budgets, the Japanese (Bank of Japan) has concluded it can simply print all the money the government needs to borrow; and it does.

So now what's wrong with deficits?   Well, we all know that too much money chasing too few goods would cause inflation, but there's not a lot of that.  Why not? Because these economic policies murder savers, so people are forced to cut back on their purchases and contract their lifestyles, thus no inflation; while the government feasts on cheap debt for its ever expanding power..

The real consequence is that government has found an unbounded means of expansion on the backs of the citizens, who are thereby proportionately impoverished.

There is no free lunch; but governments, including our own, are now eating ours.

David Rosenberg at Strategic Investment Conference

Submitted by Lance Roberts of Streettalk Advisors
Guest Post: Strategic Investment Conference: David Rosenberg

STRATEGIC INVESTMENT CONFERENCE – DAY 1
If you haven’t read the notes from the first two speakers, Niall Ferguson and Dr. Woody Brock, I encourage you to do so. The next speaker at the conference is a friend of mine and one of the most widely regarded economists today. David Rosenberg was previously the Chief Economist at Merrill Lynch and is now the Chief Economist and Investment Strategist at Gluskin-Sheff.   Here are his thoughts.
The 3-D's Deflation, Deleveraging and Demographics
“People continually label me a “perma-bear” which is very inaccurate. I have been a perma-bull on fixed income for a very long time. The reason that Gluskin-Sheff hired me is that my job is to take the economic data points and put them together in a structure from which investments can be made.”
"A Forecast is nothing more than the midpoint of a distribution curve."
When you talk about risk often enough you get classified as a “perma-bear”. The corner stone of asset management is not capital "appreciation" but capital "preservation".
In the second year of this economic recovery (2011) the economy was growing at 1.6%. This is important to understand because in a “normal” recovery the economy should be growing at 5-6% at this same point.
Bob Farells' 10 Market Rules: The 10 Commandments To Remember

1. Markets tend to return to the mean over time
2. Excesses in one direction will lead to an opposite excess in the other direction
3. There are no new eras — excesses are never permanent
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
5. The public buys the most at the top and the least at the bottom
6. Fear and greed are stronger than long-term resolve
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
9. When all the experts and forecasts agree — something else is going to happen
10. Bull markets are more fun than bear markets.

These are the ten commandments of investing. Not understanding this is what leads to individuals losing large amounts of money over time.
Rules #1 and #9 are the most important to conversation today.
The markets tend to return to the mean over time. Understand this. Just this year there have been two very important covers from Barron’s.
February 2012 - Barron's Dow 15000
April 2012 - Barron's - Outlook Mostly Sunny.
Barron’s has an absolutely horrible track record of putting on their covers bullish sentiment at just about the peak of the market. (He showed many examples of Barron’s covers going back over the past decade.)
At the point of peak bullishness by investors and money managers is when the “reversion” effect will occur. In other words, whatever Barron’s puts on their cover you are wise to do the opposite.
The “Fiscal Cliff”
Under status quo at the end of 2012 roughly 42 tax benefits will expire at the end of 2012. At that point there will be record drag (roughly 4%) on GDP from reduction of those tax benefits to spending. Since the economy is currently barely growing at 2% do the math – a negative 2% economic growth rate is a very large recession.
Ben Bernanke - the Fed has NO ability to offset the impact of the “fiscal cliff.” By the way - recessions tend to happen in the first year of the Presidential cycle.
The last two times, 1960 and 1969, that there was a fiscal retrenchment of the same magnitude both ended in recessions. If there is any one thing to worry about it will be this particular event more than just about anything else.
What about government spending? US government spending runs at approximately $1.50 for every $1.00 brought in. This level of spending is unheard of outside of WWII and is very unsustainable. Furthermore, the longer that this excessive level of debt based spending occurs the more that it becomes a structural problem. Interest payments are at a record share of total revenue as well as the debt as a share of GDP. The high level of debt to GDP, and the subsequent servicing of that debt via interest payments, reduces economic growth. This leads to the real problem facing the U.S. today…Deflation.
Outside of commodity based inflation there is deflation running in everything else from incomes to real estate. This deflation impacts the base of the consumer and the economy. Take a look at the current output gap which is still at some of the largest levels on record. The current economic growth rate is too weak to offset the current slack in the economy.
This is why QE3 is coming and is just a matter of timing.
The deflation in housing is going to continue. Housing is only about 40% through its reversion process. In fact, along with housing, the entire household debt deleveraging process is still in progress and still has a tremendous way to go. This deleveraging cycle will remain a dead-weight drag on the economy for quite a long time.
It is important to understand that the debt bubble didn't happen in 3 years and it won't be cured in three years either.
According to the recent McKinsey study the debt deleveraging cycles, in normal historical recessionary cycles, lasted on average six to seven years, with total debt as a percentage of GDP declining by roughly 25 percent. More importantly, while GDP contracted in the initial years of the deleveraging cycle it rebounded in the later years.
A further pressure on the economy remains excess unemployment. There are roughly 20 million still unemployed versus the long term average of about 13 million. The excess capacity of labor suppresses wages and economic growth. In other words, excess employment leads to deflationary economic pressures.
In regards to employment the only real report to watch is the U-6 report, versus U-3, because it is the most inclusive measure of unemployment. If two full time employees are converted to part time they are not included in the U-3 report but will show up in the U-6 report. The U-6 level of unemployment is still at a higher level than at any other recessionary period.
As I stated, high levels of unemployment, or excess slack in the labor market, leads to deflation in wages. Deflation is wages is very problematic and has a lot do with deflationary prices in the economy.
So, deflationary pressures are why I am still bullish on bonds versus stocks.
Here is an interesting side note. What correlates with bond yields?
88% Fed Policy
75% Core CPI
64% CPI inflation
With the Fed keeping yields at zero through 2014 there is NO rate risk in owning bonds. When bond yields jump up for any reason it is a buying opportunity UNTIL the Fed starts taking the punch bowl away.
Historically, the average yield curve spread between the short and long dated maturities is about 160 basis points. Currently, that spread is about 330 basis points. That spread will revert to the average over time which means that the long bond yield is going to 2%. Buy Bonds and you will get a better return than owning stocks with dramatically less risk.
What type of bonds? I like corporate bonds. Corporate balance sheets are great and have been cleaned up tremendously since the recession. The current corporate default rate is 2% and companies that are BB or BBB rated that have an A rated balance sheet make a lot of sense. There is no debate between stocks and bonds. Bonds are a contractual agreement to pay interest and repay principal over a specified period of time.
Stocks are currently priced for a 10% growth rate which makes bonds a safer investment in the current environment which cannot deliver 10% rates of returns. We are no longer in the era of capital appreciation and growth. The “baby boomers” are driving the demand for income which will keep pressure on finding yield which in turn reduces buying pressure on stocks. This is why even with the current stock market rally since the 2009 lows - equity funds have seen continual outflows. The “Capital Preservation” crowd will continue to grow relative to the “Capital Appreciation” crowd.
Investment Stategy - Safety and Income at a Reasonable Price

1. Focus on Safe Yield - Corporate bonds
2. Equities - Dividend growth and yield, preferred shares
3. Focus on companies with low debt/equity ratios and high liquid asset ratios. The balance sheet is more important than usual.
4. Hard assets that provide an income stream - oil and gas royalties, REITS.
5. Focus on sectors or companies with low fixed costs, high variable cost, high barriers to entry, high level of demand inelasticity.
6. Alternative assets - that are not reliant on rising equity markets and where volatility can be used to advantage.
7. .Precious Metals - hedge against reflationary policies aimed at defusing deflationary risks.

Please Destroy Us, Mr. Bernanke!

from Testosterone Pit blog:

Dear Ben,

Please print us more money. We want you to prop up the stock market. Everybody knows it's a Ponzi scheme that will collapse without your support. You don't want us to end up like Bernie Madoff's clients. No, Ben, we love Ponzi schemes. We get in early and get out before they collapse. That's why we're rich. The bad thing is that they sometimes collapse before we can get out. But you already bailed us out twice in the last couple of years through printing trillions of dollars. Why not a third time?

That will also keep the bond-market bubble inflated. We have to admit that you've done an excellent job there, hands down. Negative real yields all the way up the yield curve! Awesome. Now if you could just print a few trillions and buy up the sovereigns from the PIIGS. Euro crisis over. End of story. And we'd get richer because we'd sell them to you at face value though we bought them at fifty cents on the dollar.

And why not forever? Just keep printing. Because as soon as you stop, stock markets will crash again, and credit markets will seize, and then we're back on this awful ride to hell.

Of course, it'll cause inflation, which is good. You yourself said that. You stated many times that you want inflation. In fact, you said that one of the goals of the Fed, after propping up the markets, is to create inflation. So stick to it, Ben. Don't slack off suddenly just because some cowboy threatened you.

Inflation, in conjunction with your near-zero yields, has all sorts of benefits. For example, it will eat up the Social Security trust fund, whose $2 trillion balance is invested in treasuries. Fixed-income investors, retirees, and everybody who has any savings will also be demolished. And homeowners. But don't worry. They won't figure it out. They don't get a statement every month that shows how much inflation cost them. It's a quiet way of stealing from them, and it'll impoverish them over time, but it'll make us, the recipients of the money you print, richer.

You see, Ben, we can charge higher prices for our goods and services. And even if we have to pay more for raw materials, we look good. Our inventories increase in value, and we can claim sales jumped 10% because we raised prices by 10%. Analysts dig that.

Recently, Ben, you've done a decent job on inflation. In July, we were running at an annual rate of 6%. Not bad. But you need to preempt any cooling off. So keep printing.

Now, we're not talking about wage inflation. Oh no. We have to keep wages down. We need cheap labor, or else we'd have to send these jobs to China—which we're doing anyway. And not just to assemble iPhones. Heck, our lawyers in India are doing the same work as our local lawyers for one-tenth the pay. So, if our local lawyers want to be competitive.... Just think how much more profit we could make if wages collapsed!

Real wages have been declining for ten years and fell another 1.7% since July 2010. But that's not enough. So get with it, Ben. Print more. And don't worry about the wusses out there who say that choking the middle class like that will put us into a permanent recession. Just get the banks to loan them lots of money so they can buy our stuff, and when the loans blow up, you buy them from the banks at face value. Full circle, Ben.  

The trillions you've printed and handed to us, well, we put them to work, and we created jobs in China and Mexico and Germany, and we bought assets, and it inflated prices, and now we're even richer. We're proud of you, Ben. Think of the influence you have. And not just here. Around the world, Ben! Look at the Middle East and North Africa. See the food riots, rebellions, and civil wars it caused? Thousands of people died and entire governments were toppled.... Oh, wait. That's a bad example.

And then there is Congress. We invested in them through campaign contributions and other mechanisms to get them to spend trillions of dollars every year on our products and services, and they even started a few wars, and it made us richer—without taxing our companies or us. It's a wonderful system.

But the deficits have become so huge that they exceed what the Treasury can borrow. So we're glad, Ben, that you stepped up to the plate and printed enough money to monetize the deficit. But Ben, you can't just stop now! You've got to keep at it. Or else, the whole system will blow up. Well, it'll blow up anyway, but we don't want it to blow up now. So, Ben, you don't have a choice. Otherwise, we'd lose a lot of money in our schemes, and nobody wants that.

Treasuries Skyrocket on the Bad Jobs News

Treasuries to Rise Counterintuitively

This seems counter-intuitive, but he may be spot on! As equities sink into the end of QE, there is a reflexive run for bonds and treasuries as a measure of safety. I think gold is a better bet than fiat currencies or sovereign debt.

(Reuters) - U.S. Treasuries will perform well following a downgrade by Standard & Poor's on Monday of the rating agency's credit outlook for the United States, DoubleLine Chief Executive Officer Jeffrey Gundlach said on Monday.
Gundlach said Treasuries, whose major holders include foreign investors, will be in high demand as the U.S. economy will "soften subtantially" with no monetary stimulus in the pipeline.
The S&P warning, which cited a risk that policymakers may not reach agreement on a plan to slash the huge federal budget deficit, is "good for Treasuries and bad for the economy and stocks," Gundlach, who oversees $9.8 billion at the Los Angeles-based firm, told Reuters.
Last week on an investor conference call, he said: "By now it's getting relatively close to June 30 and it's about time for the markets to start discounting the end of QE2 and a weaker economy."
Gundlach is referring to the Federal Reserve's end of its purchases of $600 billion in long-term Treasuries until June 30, as part of a second round of quantitative easing.

Treasuries Drop To December Support

It will be interesting to see if interest rates continue to rise, dropping through support at these price levels. We have so far touched the same price level as the November lows.

Black Swan Events and How to Hedge Them

from Zero Hedge:

With all the hoopla over Egypt some have forgotten that this is merely a geopolitical event (one of those that absolutely nobody, with a few exceptions, was talking about less a month ago, so in many ways this is a mainstream media black swan which once again exposes the entire punditry for the pseudo-sophist hacks they are), and that the actual mines embedded within the financial system continue to float just below the surface. Below we present the five key fat tail concerns that keep SocGen strategist Dylan Grice up at night, which happen to be: i) long-term deflation, ii) a bond market blow-up, iii) a Chinese hard-landing, iv) an inflation pick-up, and v) an Emerging Markets bubble. Far more importantly, Grice provides the most comprehensive basket of trades to put on as a hedge against all five of these, while also pocketing a premium associated with simple market beta in a world in which the Central Banks continue to successfully defy gravity and economic cycles. For all those who continue to trade as brainless lemmings, seeking comfort in numbers, no matter how wrong the "numbers" of the groupthink herd are, we urge you to establish at least some of the recommended trades in advance of what will inevitably be a greater crash than anything the markets experienced during the depths of the 2008 near-cataclysm.
But before we get into the meat of the piece, we were delighted to find that Zero Hedge is not the only entity that believes that providing traditional annual forward looking forecasts is nothing more than an exercise in vanity (and more often than usual, error).

At this time of the year we’re supposed to give our predictions for what’s in store for the year ahead. The problem is I don’t have any. Not because making forecasts is difficult. It isn’t. It’s just pointless. Instead, I suggest getting in touch with our inner Kevin Keegan, the hapless former England football manager who, facing the sack after a bad run of results famously lamented “I know what’s around the corner, I just don’t know where the corner is.” The more people construct portfolios on the assumption that they can see the future, the greater the opportunity for those building portfolios which are robust to the reality that we can’t.

That said, no matter how ridiculous the act of Oracular vanity ends up being, those who charge an arm and a leg for their "financial services" continue to do it, only to be among the first carted out head first when reality is imposed upon them and their blind belief that this time is different and the crowd is actually right. Few are willing to accept and recognize the humility that they really know little if anything about how a non-linear, chaotic system evolves. Which is once again why we believe that Grice is among the best strategists out there: in his attempt to hedge the stupidity of the crowd, he has coined a term that may well be the term that defines 21st century finance and economics: instead of foresight, Grice believes the far more correct term to explain the process of prognostication should be one based on foreblindness.

In financial markets, craziness creates opportunity. It affects only prices, not values. And one of the craziest afflictions I know of is our faith in our ability to see the future. Indeed, there isn't even an appropriate opposite to the word "foresight"  in the English language. So I'?m going to make one up. And rather than build a portfolio based on the pretense we have foresight, let's explore some ideas for building one that is robust to our foreblindness.

This is the kind of insight that one will never find from a TBTF "strategist"... And one wonders where all those softdollars go.
So now that we know that unlike the traditional cadre of sell side idiots who are always wrong in the long-run, Grice actually admits that he has no clue what will happen, which is precisely the reason to listen far more carefully to what he has to say.
Let's dig in:

Here are some things I think are true:

• developed economy governments are insolvent
• Japan is the highest risk developed market (DM) to an inflation crisis (though it might be Greece)
• there is too much debt around
• China?s economic model is biased towards misallocating resources
• every country which has industrialized has experienced nasty bumps on the way
• China and the US are in the early stages of an arms race
• demographic trends suggest more conflict in the oil rich regions of the world
• bottlenecks are developing in key commodity markets
• the only thing central banks are good at is blowing the bubbles that cause the crashes which are used to justify their existence
• market prices only reflect fair value by accident and in passing
• most people don't think these things are important
• they might be right.

Here are some things I know are true:

• perceived uncertainty causes emotional discomfort which isn't conducive to good decision making
• all the above situations have the potential to cause significant asset price volatility
• I have no idea when.

What to do? To my mind, the ideal is not to make huge bets on particular events happening because failure of the expected event to materialize will materially endanger your capital. Instead, the ideal is purchase insurance at a price which won't materially pressure the returns from your core portfolio of investments if the event fail to materialize, but will protect capital from significant impairment if it does.

Is such an ideal attainable? By evaluating insurance and using the same valuation discipline you'd apply to anything else, I think it is. So what follows is not a list of recommendations here, or even any suggestions. Everyone should do their own homework. What follows is an illustration of why I think the macro research we've been doing is relevant and can be used to lower portfolio risk. The insurable risks I'm most worried about at the moment are:

• long-term deflation
• a bond market blow-up
• a Chinese hard-landing
• an inflation pick-up
• an EM bubble

The first thing you?'ll notice is that these aren't all consistent with one another. It's difficult to get a Chinese hard landing and an EM bubble at the same time, for example. But internal consistency is overrated. It's only relevant for point-in-time forecasts, and the assumption underlying this entire exercise is that I haven't a clue if/when any of what follows is going to happen. At the risk of repetition, I'm interested in the possibility of building a profitable portfolio which is robust to my ignorance.

Let's take a look at the five fat tails in detail:
Long-term deflation
Not surprisingly, Grice gives the least amount of weight to the one thing most troubling to such economic disgraces as Ben Bernanke and Paul Krugman. Yet it should not be avoided. After all there are many deflationists out there, who believe that the Fed, which has now clearly telegraphed it is all in on reflating (or after the Fed, the monetary collapse deluge) may actually succumb to what has been ailing Japan for two decades.

According to economists the primary risk faced by economies is that a huge deleveraging spiral becomes self-fulfilling: deleveraging reduces demand, which lowers prices, which further lowers demand, and so on. The idea was first developed by Irvine Fisher in the 1930s to describe the great depression, and has been used to explain the ?First Great Depression? of the 1870s and Japan since the early 1990s.

Paul Krugman says everything has changed because we?re in a liquidity trap. The fear of prolonged deflation is what keeps poor old Ben Bernanke awake at night. And maybe that's the clue. At our London conference this year, James Montier said that Bernanke  as the worst economist of all time. Now, I'm not sure I agree with James on this one because I can't make up my mind, sometimes I think it's the Bernanke, other times I think it's the Krugman. But usually I think nearly all economists to be the joint worst economists of all time. So I have a lot of sympathy with the idea that if the consensus macroeconomic opinion is worried about something, it probably isn't worth worrying about. In fact, if they worry about deflation, I'm going to worry about inflation.

We couldn't have said it better ourselves.
So how does one trade deflation insurance?

More importantly though, deflation insurance is expensive. The following chart shows the price of 5y 0% US CPI floors to be trading for just under 200bps. The way these floors work is that they provide the owner of the contract with the right to payments equal to the rate of deflation. Since the floors in the chart have a five-year maturity, they entitle the owner to five annual payments. For example, if inflation was -1% in year one, the owner would receive 100bps of the notional value of the contract. If inflation was -1% in year two, he'd receive another 100bps. And if the rate of deflation remained at -1% for years three, four and five, he'd receive 100bp cash flow for each of those annual payments so that over the life of the contract he'd have received a total cash flow of 500bps. So if you're worried by the prospect of CPI deflation, this is the product for you.

And skeptical though I am of the debt deflation hypothesis, Western demographics worry me. Although we don?t know what aging economies look like, we know that the glimpse into the future provided by Japan isn't encouraging. So I do take the scenario seriously and would be happy to put the hedge on at the right price. The problem is, I don't think the price is right. I think this insurance should be sold, not bought.

Chinese Hard Landing
While Grice is obviously far less worried about a systemic deflation scenario arising out of events in the US, what may happen in China is obviously a far riskier proposition, and one that could generate deflation out of the proverbial "Hard Landing." Luckily there is an instrument with some wonderfully convex properties to hedge this...

Albert calls China a ‘freak economy.’ Certainly, running with an investment to GDP ratio of over 50% doesn't seem normal. Neither does keeping interest rates at 5% when the economy is growing by 15% in nominal terms each year. Such lax monetary conditions have helped land prices rise by 800% in the last seven years, according to NBER economists. And when you come to think of it, more recent examples of real estate inflation fueled by negative real interest rates: Ireland, Spain, the US didn't end too well. Jim Chanos says China is a shortseller's dream and that there's not one company he's looked at that passes the accounting sniff test. And if Jim Chanos, who built a very successful business around spotting accounting gimmickry says something like that, my guess is he's right.

Taking a step back though, as far as I?m aware all industrialized countries have experienced financial crashes. It seems a part of the maturing process. Why should China be any different? A credit crisis wouldn't necessarily mean the end of the China story any more than the panic of 1873 meant the end of America's, (though US demographic prospects were considerably more favorable at the end of the 18th century than China's are today). For the record, I think the Chinese have a bright future. My son is learning Mandarin. But when I look at the numbers I can't help but think there's going to be a crash and that it's going to be  quite unpleasant. It's just that my guess as to when it's going to happen is as good as Kevin Keegan's.

What happens if and when the inevitable crash happens? One word - Australia. Another word(s): 10x-20x payout.

When it does happen though, the Australian economy will be toast and its government bond yields will collapse. During the panic of 2008, AUD 10y swap rates fell around 3% to 4.40%.

The panic of 2008 was a "good crisis" for Australia though. A Chinese crash would be more serious.

And you can get pretty attractive odds on AUD rates collapsing. The following chart shows the payout available using AUD receiver swaptions prices with a three-year maturity, based on the 10y swap rate. Effectively, these are put options that pay out when rates fall below the strike price. The prices I've used here are from Bloomberg based on the swaptions striking at about 5.5% (i.e. 100bp below the current rate of 6.50%). What's interesting is that at current prices, if Australian swaps were to break their 2008 lows, you'd be making about 10x your premium (for the record, these swaptions are priced at about 120bps, or 40bps per year over three years, which is about the same as the annualized revenue you'd get if you sold the CPI floors discussed above). If swap rates fell by 300bps as they did during the panic of 2008 the rate would fall to 3.5% and you'd make nearly 15x your premium. To repeat the point I made earlier, this isn't a recommendation. It's just a starting point (my guess is that you'd find more attractive payouts as you went further out of the money with the strike price, and that  capital structures of Australian banks, property companies and levered resource stocks would be worth looking into too).

Asset Bubbles
Grice provides one of the best and most succinct explanations of bubble mentality we have read to date:

For reasons I won't go into now, but which are probably obvious from what I just wrote about China, I think EM is riskier than it seems. I'm not even sure I feel comfortable valuing EMs yet. So should EMs bubble up, the risk for investors sharing my concern is that they'll be faced with quite a nasty dilemma: do they buy something they don't feel sure is cheap because everyone else is and they're scared of underperforming, or do they stick to their principles and prepare themselves to take on the business and career risk of underperforming their competitors, seeing clients withdraw their funds, and possibly finding themselves out of work?

And the sad reality is that ultimately nearly everyone gets hurt during a bubble. Sceptics get hurt as it inflates, believers get hurt when it bursts. George Soros says when he sees bubbles he buys them. He?'s been pretty good at selling them at the right time too. But most of us aren't so clever.

Regardless of the psychology behind each and every bubble, the good thing is that there is a good way to hedge this risk outright.

One way to hedge the inflation of a bubble, rather than its bursting, is to buy out of the money call options on the equity indices. Calls are usually cheaper than puts ? I think because fear is a more powerful emotion than greed and the tails in equity markets tend to be on the downside. But the following chart shows that that difference (or skew, the difference in implied volatilities between puts and calls) is close to unprecedented highs, at around 4.5 vol points (the chart shows skew for the S&P500 though other equity indices show a similar picture).

In other words, the upside is close to unprecedentedly cheap relative to the downside. If you could get two year call options 30-35% out of the money for 130bps per year you?'d be getting good value (of course you could make this zero cost, or even ve cost by selling puts to fund the purchase, and you could do it in such a way that your downside risk would be similar to that of holding stock, but I'm no derivatives strategist- as usual, if you want to talk about this stuff to people who know more than I do, speak to your SG derivatives salesman, or ask me and I?'ll put you in touch).

Hyperinflation
A topic near and dear to many. Luckily, once again, one which can be hedged proximally in a form that generates massive returns should it transpire there where it most needed: no, not the US. Japan. In fact, if Grice is right about Japan, his proposed trade takes the returns generated by Paulson in shorting subprime... And magnifies them by about a million.

Historically, bankrupt governments have used inflation to alleviate their indebtedness. I doubt things will ultimately be different this time. And as regular readers know, I think Japan is the country closest to the edge. All DM governments have the same problems: they've made promises to their electorates which they're unlikely to be able to keep. But while there's time for European and US governments to fix the problem, for Japan I think it's already too late. John Mauldin says the Japanese government debt position is a “bug in search of a windshield”. I agree with him.

I've already written too much this week, so I don't want to rehash all the stuff I've already written on Japan and which regular readers will be familiar with. But if you chart past episodes of extreme inflations with how stock markets behaved during the episodes, you invariably find something similar to what happened to Israel in the 1980s.

In Steven Drobny's excellent “Hedge Funds Off the Record” (which I consider a must read - almost every interview oozes with profound risk-management wisdom), Steve Leitner talks about buying out of the money call options to hedge against such a hyperinflation. Buying 40,000 strike Nikkei calls with a ten- year maturity, with a payout in a strong currency can be done for around 40bps per year. And to give you an idea of how explosive that asymmetry might be, if Japan was to follow the Israeli experience from here, the Nikkei- currently 10,500 would trade at around 60,000,000 (sixty million). So putting even one-tenth of your notional into that kind of hedge would cost 4bp per year (for reference, the Nikkei currently offers in excess of a 2% annual yield, while some JREITS offer in excess of 4% - I'd argue that 40bp is a bearable burden, and 4bps certainly is).

Bond Market Blow-up
When a few weeks ago we presented Sean Corrigan's chart which we dubbed the Great Regime Change, few put two and two together, and realized the vast trading implications of this chart. And they are profound. As Grice rightfully observes, they stand at the base of nothing less than the hedge against that most critical of fat-tail events: a bond market blow up, one which is getting increasingly more probable with every single $X0 billion UST bond auctions (the bulk of which is now monetized directly by the Fed).

One obvious way to hedge against a bond market blow-up is to use the swaptions market as we did in the Australian market to hedge a Chinese crash, only this time buying payer swaps, which are effectively call options on rates. But I thought I'd show you something I think is a bit more interesting: the correlation between the S&P500 and bond yields.

Bonds represent poor value in my opinion, with little margin of safety to protect against the very real risk that governments try to inflate away their debts. But one good reason to continue holding them is that they protect risk asset positions during the '?tails'?. The following chart shows that over the last ten years the correlation has been volatile, but positive: when equities have fallen so have bond yields, offsetting losses in the equity portfolio as bonds benefit during "risk-off" events.

When inflation expectations were (probably) around zero (before the 1960s) the correlation between bonds and equities was zero too. But look what happened during the 1960s when inflation expectations broke (this was during the Vietnam war, as the Bretton-Woods system was coming under pressure and as the bear market in bonds was getting into full swing). The chart shows that the correlation went negative. When bond yields rose equities fell because government bonds were reflecting the same tensions that were pulling down equity valuations (fear of ever-higher inflation).

As the bond bear market reached its climax in the early 1980s, the correlation remained negative. But as the worm turned, and central banks across the developed world made new and credible commitments to stop printing money, a bond market rally was born. And as inflation expectations began to fall, what was good for the bond market was good for the equity market. Now, falling yields coincided with rising equity prices and so the correlation remained negative. But during the last ten years, inflation expectations have been roughly stable and, if anything, slightly biased towards the deflationary side. So what?s been good for bonds hasn't been good for equities, and the correlation between yields and equity prices has been positive to reflect that.

The point is this: if governments are insolvent, and the government bond market becomes a source of risk once again (as opposed to the nonsensical "risk-free" description it has somehow obtained in recent years) what's bad for the bond market will be bad for risk assets too. As yields rise, risk assets will fall. The correlation will go negative. Bonds will provide less protection against the tail events than they have done in recent years because they will be a source of the tail event.

For all those who figured this out based on the Corrigan chart, congratulations. This could well be the holy grail of the biggest black swan insurance trade of all. For those who haven't quite grasped it, here is some more from Grice:

This correlation is tradeable. Any bank with a derivatives operation must have an implicit correlation exposure between products they've sold options on. So for derivatives houses, correlation is a by-product in much the same way that molybdenum is a by-product of copper miners. and correlations like this trade in the IDM market. And sometimes that means you can get it for a very good price. I recently heard of a correlation trade between the S&P500 and the US 10y swap rate done at 40 correlation points, which seems a decent enough price to me (of course, selling at 50 points would give you even more margin of safety), although current pricing is at around 30 I believe. Pricing can be volatile though and waiting to sell in the 40-50 range seems sensible to me. It would hedge risk positions against a regime in which government bonds were seen as the source of risk, rather than the reliever of it.

Finalizing the Black Swan Insurance basket.

Let's add it all up and see how much it would cost to insure our portfolio. If we were to sell the 5y US CPI floors for 200bps (40bps annualized); buy the 3yr AUD receiver swaption for 120bps (-40bps annualized); buy 2yr 30% S&P500 calls for around 130bps (-65bps annualized) and bought one tenth of our notional on NKY calls for 40bps (-4bps annualised) the net upfront cost would be 90bps (200bps-120bps-130bps-40bps). If we wanted to hedge the risk of bond market turbulence with a correlation product, this would cost nothing upfront because it would be done on a swap basis with the bank. On a roughly annualized basis our cost would be 69bps each year.

Of course, we'd have a maturity mismatch because our hedges would have different time horizons. So we'd have to adjust them from year to year. We'd also be more vulnerable to deflation because we don't think the deflationary hedges offer value. So our portfolio wouldn't quite be bullet-proof because it would be tilted towards inflationary outcomes. But we'd have insurance against deflation with the Australian receiver swaption. And since the correlation swap hedges us against any bond market blow-up which also blows up the equity market, we can feel more comfortable allocating some capital towards bonds we think might offer good value (not that there are many, I'd say maybe about 20-30% in Australian and New Zealand bonds).

I'd put 10% in gold. I'll explain more in another note but for now, although I've said I'm not a fan of plain commodities as investment vehicles because buying commodities was equivalent to selling human ingenuity, I exclude gold from that logic. I prefer to see buying gold as buying into the stupidity of governments, policy-makers and economists, and I'm comfortable doing that.

With the exception of Japan (which we'd be hedged against anyway) I'm not so worried about "traditional" CPI inflation any time soon. At the moment, I think the first signpost on the way to that kind of crisis will be via the bond market, which the correlation swap should protect us against. That and my gold holdings would make me comfortable allocating 20%-25% cash. I still think risk assets are generally overvalued and cash is the simplest insurance "option", whose relative value rises proportionate to the decline in other assets. So let's say I'm 20% in cash,10% in gold, and 20% in mainly Australian and New Zealand government bonds. That leaves just under 50% of my capital for me to put into the equity market (the 69bps per year for my insurance bucket to be precise).

Which equities? I've always thought investing in index funds to be crazy, but nearly everyone does it and it's a part of the craziness we can use to our advantage. The EMH says that market prices are always broadly efficient because all market participants respond to all available information. But around 10% of the market is explicitly passive and probably another 50% is benchmarked and therefore implicitly passive. In other words, the overriding variable for the majority of equity investors is a company's weight in the index! Intuitively therefore, the prices can't fairly reflect fundamental value, which means that at any point in time, there will be lots of stocks which are mispriced.

The following chart shows two lines. The red line shows the cumulative return to buying stocks in the cheapest decile, while shorting stocks in the most expensive decile (I define value as the discount relative to the estimated intrinsic value - a methodology I've been meaning to write up in detail for several months now but which I will definitely do within the next few weeks). Using a monthly rebalance, the annualized return is 750bps. This shows that there is meaningful alpha in identifying and owning those stocks trading at a discount to intrinsic value. The black line shows the relative outperformance of the top decile against our wider stock universe. (In passing, note that this value strategy underperformed in the late 1990s during the tech bubble, and remember that this is the reason our hypothetical portfolio has out of the money call options.)

The relative outperformance of this long-only basket has been 330bps. If I expect a stock market return of 5% per year over the coming years, that 330bps outperformance is highly significant. It means we only need to put 60% of our capital into that basket of stocks to generate the same incremental return as a market portfolio would generate. So owning 50% isn't as cautious as it sounds.

The bottom line, and the reason why we think this is a great basket trade, is that it makes money in a normal environment while at the same time, providing great positional hedges to those 5 events which sooner or later are bound to happen.

In the sort of world in which everything is normally distributed, well behaved, and in which our insurance expires worthless (i.e. the sort of world most economists forecast), we'd still be making decent returns. And while there's no such thing as a truly bullet proof portfolio, we'd have done so with far less embedded risk. Because if any of the scenarios I've explored here come to pass we'd be in a much better position to take advantage of the distressed selling of others.

That said, and as Dylan would be the first to acknowledge, if and when everyone is positioned with precisely this hedge on their books, it will be something totally different that will cause the next great financial wipeout. But until then, those who step in first, will benefit from appreciating prices precisely on their hedges. At that point it will be up to the principal to decide whether to take profits or to hold off until the bitter end. The problem, however, at least the way we see it, is that should any of these five black swans occur, any currency that one generates as a result of a successful trade, no matter the P&I, will probably not be all that useful for the world that materializes at T+1.

Hoisington: Low Growth Ahead

Growth Recession Continues
Factoring in a 4% Q4 growth rate, the U.S. economy expanded by 3% in real terms from the 4th quarter of 2009 through the 4th quarter of 2010. Despite this rise in GDP, the unemployment rate remained stubbornly high at 9.6% in the last quarter of 2010, only slightly lower than the 10% rate it averaged in the same quarter one year ago. Positive real GDP growth with high unemployment is the definition of a growth recession. An even slower growth rate of real GDP should be recorded over the next four quarters, suggesting the unemployment rate will be essentially unchanged a year from now. As we have noted previously, this modest expansion is due to the significant over-indebtedness of the U.S. economy. We see seven main impediments to economic progress in 2011 that will slow real GDP expansion to the 1.5%-2.5% range.
First, fiscal policy actions are neutral for 2011. Second, state and local sectors will continue to be a drag on the economy and labor markets in 2011. Third, Quantitative Easing round 2 (QE2) will likely produce only a slight economic benefit as the Fed continues to encourage additional leverage in an already over-indebted economy. Fourth, while consumers boosted economic growth in the second half of 2010 by sharply reducing their personal saving rate, such actions are not sustainable. Fifth, expanding inventory investment, the main driver of economic growth since the end of the recession in mid-2009, will be absent in 2011. Sixth, housing will continue to be a persistent drag on growth. Seventh, external economic conditions are likely to retard U.S. exports.
Fiscal Policy in Neutral
The recent tax compromise between the President and Congress merely extended existing tax rates for another two years and provided a transitory 2% reduction in social security tax withholding. Personal taxes, including federal and non-federal, rose to 9.44% of personal income in November, up from a low of 9.1% in the second quarter of 2009 (Chart 1). Even with the tax compromise this effective tax rate will continue moving higher as a result of higher state and local taxes. Economic research has documented that temporary changes in tax rates are far less beneficial than permanent ones since consumers spend on the basis of permanent income. Higher outlays for unemployment insurance were also legislated, but these were negated by cuts in other types of spending. Federal spending through early March will mirror its pace in fiscal 2010, and the rest of the 2011 budget will decline slightly in real terms. Therefore, total real federal expenditures are likely to contract in real terms this year.
Chart 1

If fiscal policy becomes focused on long-run considerations (e.g. deficit reduction) economic conditions will improve over time. But, if fiscal policy remains focused on short-term stimulus, the economy's prolonged under-performance will persist since the government expenditure multiplier is less than one, and possibly close to zero.
The recent scientific work on the expenditure multiplier is aligned with the Ricardian equivalence theorem as well as the views of the Austrian economists who continued to follow Ricardo even when the Keynesian revolution was ascendant. Economist Gary Shilling made this point very well in his outstanding new book, The Age of Deleveraging – Investment Strategies for a Decade of Slow Growth and Deflation.
Dr. Shilling's analysis of the simplified and unsubstantiated Keynesian multiplier (p.216) still taught in many colleges and universities is extremely insightful. ÒBut the Austrian School of economists like Friedrich Hayek and Ludwig von Mises believed that the economy is much more complicatedÉ The Austrian view suggests that the government spending multiplier may be only 1.0 and that there are not any follow-on effects. More recent academic studies indicate that the multiplier is less than 1.0, and perhaps much less.Ó
After recognizing the difficulty of calculating the multiplier, Dr. Shilling writes, ÒAlso, the inherent inefficiencies of government reduce the effects of deficit spending and lower the multiplier.Ó Thus, if steps are taken to reduce deficit spending, the economy's growth rate will recover after the initial transitory negative impact as additional resources are provided to the private sector.
State and Local Governments Drag
Municipal governments face substantial cyclical deficits and significant underfunding of their employee pension plans. In addition, municipal bond yields rose sharply in the second half of 2010, increasing borrowing costs, probably an unintended consequence of QE2. The municipal bond market proceeds are used primarily for funding capital projects, which suggests that such projects will be delayed. State and local governments typically do not undertake capital projects freely when they have large cyclical deficits.
To reign in these financial imbalances, state and local governments have five choices: (1) cut personnel; (2) reduce expenditures including retirement benefits; (3) raise taxes; (4) borrow to fund operating deficits; or (5) declare bankruptcy. All retard economic growth. Any trend toward increased bankruptcy would raise caution in the broader municipal market and add to higher borrowing costs. Raising taxes may give bondholders more confidence, but such actions can fail to raise new revenue as slower economic conditions retard spending. The demographic trends in the decennial census also show that people are increasingly moving to low tax regions, contributing to worsening fiscal imbalances from the exited areas.
QE2's Problems
Clearly, Fed actions have affected stock and commodity prices. The benefits from higher stock prices accrue very slowly, are small, and are slanted to a limited number of households. Conversely, higher commodity prices serve to raise the cost of many basic necessities that play a major role in the budget of virtually all low and moderate income households.
For example, in late 2010 consumer fuel expenditures amounted to 9.1% of wage and salary income (Chart 2). In the past year, the S&P GSCI Energy Index advanced by 14.6%. Since energy demand is highly price inelastic, it seems there is little alternative to purchasing these energy items. Thus, with median family income at approximately $50,000, annual fuel expenditures rose by about $660 for the typical family. In late 2010, consumer food expenditures were 12.6% of wage and salary income. In the past year, the S&P GSCI Agricultural and Livestock Commodity Price Index rose by 40%. If we conservatively assume that just one quarter of these raw material costs are ultimately passed through to consumers, higher priced foods will have added another roughly $626 per year of essential costs to the median household budget. These increased costs could be considered inflationary, however, with wage income stagnant, higher food and fuel prices will act like a tax increase. Indeed, the approximately $1300 increase in food and fuel prices is equal to 2.6% of median family income, an amount that more than offsets the 2% reduction in the social security tax for 2011.
Chart 2

Reflecting the inflationary psychology of the higher stock and commodity prices, mortgage rates and municipal bond yields have risen significantly since QE2 was first proposed by the Fed chairman, increasing the cost and decreasing the availability of credit for two sectors with serious underlying problems. Also, Fed policy has pushed most consumer time, money market, and saving deposit rates to 1% or less, thereby reducing the principal source of investment income for most households. Clearly the early read on QE2 is negative for the economy.
Substitution Effects
In a November speech in Frankfurt, Germany, Dr. Bernanke said that the use of the term Òquantitative easingÓ to refer to the Federal Reserve's policies is inappropriate. He stated that quantitative easing typically refers to policies that seek to have effects by changing the quantity of bank reserves. These are channels that the Chairman considers relatively weak, at least in the U.S. context. Dr. Bernanke goes on to argue that securities purchases work by affecting yields on the acquired securities in investors' portfolios, via substitution effects in investors' portfolios on a wider range of assets. This may well be true, but the substitution effects are just as likely to be detrimental (i.e. the adverse implications of increasing commodity prices and rising borrowing costs for some and reducing interest income for others). Importantly, the Fed has no control over these substitution effects.
In his reputation-establishing 2000 book, Essays on the Great Depression, Dr. Bernanke argues that Òsome borrowers (especially households, farmers and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe, but not unprecedented downturn of 1929-30 into a protracted depression.Ó Interestingly, when QE2 drives up borrowing costs for homeowners and municipalities, thereby restricting credit, the Fed is creating (according to Dr. Bernanke's book) the exact same circumstance, albeit on a reduced scale, that helped cause the great depression---rather bizarre!
Liquidity Mistakes
For the past twelve years the Fed's policy response to economic problems has been to pump more liquidity. These problems included: (1) the failure of Long Term Capital Management in 1998; (2) the high tech bust in 2000; (3) the mild recession that began with a decline in real GDP in the fall of 2000; (4) 9/11; (5) the mild deflation of 2002-3; (6) the market crisis and massive recession and housing implosion of 2007-9; and now, (7) the lack of a private-sector, self-sustaining recovery.
The Fed diagnosed each of these events as being caused by insufficient liquidity. Actually, the lack of liquidity was symptomatic of much deeper problems caused by their own previous actions. The liquidity injected during these events led to a series of asset bubbles as the economy utilized the Fed's largesse to increase aggregate indebtedness to record levels. The liquidity problems arose as the asset bubbles burst when debt extensions could not be repaid and generally became unmanageable. Each succeeding calamity or bust reflected reverberations from prior Fed actions.
While governmental directives to Fannie and Freddie to increase home ownership clearly also played a role, the Fed supported this process by providing excessive liquidity to fund the housing bubble as well as other unprecedented forms of leveraging of the U.S. economy. The heavy leveraging and the associated asset bubbles, however, produced only transitory and below trend economic growth. Similarly, like its predecessors, QE2 is designed to cure an over-indebtedness problem by creating more debt.
In addition to failing to revive the economy permanently, major unintended consequences have arisen. The LTCM bankruptcy created a $3 billion loss, a very modest amount in view of the sums required by subsequent bailouts. The Fed's reaction to LTCM served to give market participants a signal that the Fed would back-stop those regardless of whether they engaged in or enabled bad behavior. Also, Fed actions have conditioned Wall Street to seek Fed support whenever stock prices come under downward pressure. In fact, the process of leaking out QE2 began in the midst of a stock market sell off.
Well-intentioned actions to promote growth and fine tune the economy by micromanagement have instead produced failure. Although the Fed had little choice in massively supporting financial markets in 2007/8, no Fed intervention would have been a more long-term productive stance in the previous economic events. QE2 is another example of flawed Fed policy operations.
The Saving Rate Decline
In the second half of 2010, real GDP grew at an estimated 3.3% annual rate (assuming the fourth quarter growth rate was 4%), up from 2.7% in the first half of the year. Transitory developments in two of the most erratic and unpredictable components of the economy---the personal saving rate and inventory investment---accounted for all of this acceleration.
From 6.3% in June 2010, the personal saving fell by a significant 1%, to 5.3% in November (Table 1). Consumer spending is slightly in excess of 70% of real GDP. Without the one percentage point reduction in the personal saving rate, the second half growth rate would have been 2.6%, a shade slower than the first half growth pace, and materially less than the presumed second half growth rate.
Table 1

When job insecurity is high, and defaults, delinquencies and bankruptcies are at or near record levels, a drawdown in the saving rate would seem to be an unlikely event. This development is certainly viewed favorably by retailers but the issue is whether the economy's future is better served by using the funds to make mortgages current, pay other debts and prepare consumers for potential emergency needs. Thus, the lowering of the saving rate is similar to running monetary and fiscal policy to meet short-run needs while ignoring long-term consequences.
Inventory Reversal
Inventory investment was the main driver of economic growth since the recession ended in mid-2009. Based on published data, real GDP grew at a 2.9% annual rate over this span. However, real final sales, which excludes inventory investment from GDP, increased at a paltry 1.1% pace. In the third quarter, inventory investment surged to 3.7% of GDP while preliminary fourth quarter figures on retail, wholesale and manufacturing inventories indicate this figure might have reached 4% (Chart 3). In the final quarter of the recession, inventory investment was -5.1% of GDP. Since 1990, the period of modern inventory control mechanisms, inventory investment averaged only 1.1%. At a minimum, the dominant source of aggregate economic strength will not repeat in 2011.
Chart 3

Housing Drag Persists
Housing will remain a drag on economic activity in 2011. Prices have re-accelerated to the downside over the past four months, as mortgage yields have risen and the housing overhang has increased. The housing overhang, as explained by Laurie Goodman writing in the Amherst Mortgage Insight, "is not caused solely by the number of non-performing loans that exist in the market. The problem also includes the high rates at which re-performing loans are re-defaulting, along with the relatively high rates at which deeply underwater loans that have never been delinquent are running two payments behind for the first time."
Another major problem is that home prices are still too high. An excellent and well-researched study by Danielle DiMartino Booth and David Luttrell in the December 2010 Economic Letter from the Dallas Fed documents this issue very authoritatively. Booth and Luttrell write, "As gauged by an aggregate of housing indexes dating to 1890, real home prices rose 85% to their highest level in August 2006. They have since declined 33 percentÉ In fact, home prices still must fall 23% if they are to revert to their long-term mean."
From the standpoint of most households, the home is the main component of wealth, not stock market investments. The continuing drop in housing prices serves to underscore the ill advised and likely temporary drop in the personal saving rate that was so critical to economic performance late last year.
Adverse Global Considerations
The global economy since 2009 may be referred to as a two-speed recovery, with China, India, Brazil, and other emerging economies at the high speed and the U.S. and Europe at the slow speed. That pattern is likely to continue, but with an important difference. China, India, and Brazil are likely to slow adversely affecting the U.S. and Europe. Thus, the two-speed recovery will continue, but with the entire world growing at a much more modest pace. Two major considerations point to this outcome. First, the higher food and fuel prices discussed earlier will serve to significantly depress growth in countries like China, India and Brazil where food and fuel are known to be a much higher percentage of household budgets. Already reports have surfaced from international agencies on the growing adverse consequences of higher food prices, and social unrest has also been witnessed on a limited basis.
Second, Chinese economic policy is designed to slow growth and reduce inflationary pressures. Although the People's Bank of China (PBoC) has already taken several actions to contain surging inflation, more steps may be needed. In China, as elsewhere, inflation is a lagging indicator. It is worth considering that the PBoC has never been able to engineer a soft landing, which suggests that ultimately a downturn in China may be greater than the prevailing consensus.
Thus, changing global conditions should serve to moderate U.S. exports. Ironically, the U.S. current account deficit still may continue to improve. A stabilization of the saving rate will reduce U.S. imports, while a higher saving rate will cut imports significantly. Already this two-speed global economy has resulted in a reduction in the U.S. current account deficit of approximately 3% of GDP (Chart 4). A continuation of this trend will serve to underpin the value of the dollar, which rose in 2010. The firm dollar, in turn, will serve to keep U.S. disinflationary trends intact.
Chart 4

Bond Market Conditions
In spite of the adverse psychological reaction to the QE2, long Treasury bond yields dropped to 4.3% at the end of 2010, down 30 basis points from the close of 2009, producing a total return of slightly more than 10% for a portfolio of long Treasury and zero coupon bonds. The problematic economic environment and its depressive effect on inflation suggests long Treasury bond yields could easily decrease another 30 basis points in 2011, which would produce another double-digit rate of return for a similar portfolio. The probabilities of even lower yields are significant.

Fed Must End Bond-Buying Program

from economics21.org:

In the just-released minutes from the Federal Open Market Committee’s December 14 meeting, the Fed defended its massive bond purchase program (QE2), explaining away the sharp rise in Treasury bond yields and the clear evidence that a rebound from the mid-2010 soft patch was already well underway when the Fed began buying bonds in November. Fed Chairman Bernanke is expected to make some of the same QE2 arguments when he testifies to the Senate Budget Committee on Friday, his first congressional testimony since announcing QE2.
The Fed’s rationale for buying a stunning $75 billion per month of Treasury notes and bonds (almost the entire issuance) has been its fear that the economy was slowing and its hope that Fed bond purchases would lower Treasury and corporate bond yields in a stimulative manner. Neither part of this logic is working. Bond yields have risen sharply, while recent economic data – from rising auto sales to falling jobless claims to ADP’s report yesterday that its customers added record jobs in December – is contradicting the Fed’s thesis of an economic slowdown. The Fed’s December 14 minutes still fretted about deflation even as this week’s two ISM surveys confirmed the surge in prices that is being recorded in global commodity markets.
Under the Fed’s have-it-both-ways logic – buy more bonds if growth is slow (in order to speed it up) and buy more bonds if growth is fast (on the view that bond buying is working) – the Fed’s massive new program will quickly take on a life of its own. Just as Fannie Mae and Freddie Mac became instruments of Congress’s social policy, Fed bond purchases will become one of the Executive branch’s favorite growth policies – “costless” stimulus through a huge expansion of the Fed’s turf, with minimal Congressional oversight.
A growing worry, this Fed program, like almost all other Washington power grabs, may never die. The Fed has now established the precedent that it has the power and, under its reading of its full employment mandate, the responsibility to buy long-term assets to boost the economy. The Federal Reserve System (including the regional banks) already has 22,000 employees. Its assets will soon top $3 trillion if it continues with QE2. That’s way too big for safety. Despite having little in the way of equity capital, the Fed is leveraging itself up using overnight deposits from commercial banks to buy very long-term Treasury, MBS and agency bonds. This is creating what must be history’s biggest, most leveraged maturity mismatch.
Even if the Fed stops buying bonds at its January 26 meeting, as it should, it may take years or even decades for the Fed’s existing multi-trillion dollar bond portfolio to mature and burn off. The Fed’s large bond holdings distort prices, expose the Fed (and the taxpayer) to interest rate risk, and create a conflict of interest for the Fed in setting interest rates (since rate hikes will hammer the Fed’s bond portfolio.)
The Fed is already worrying that a decision by the Fed to not buy bonds risks higher bond yields, a recipe for the Fed to buy all kinds of bonds. The Fed’s minutes from December 14 said: “In the weeks following the November meeting, yields on nominal Treasury securities increased significantly, as investors reportedly revised down their estimates of the ultimate size of the FOMC's new asset-purchase program.” Thus, the Fed staff seemed to be blaming the rise in Treasury yields on the absence of QE3 (rather than the good news that economic growth expectations were rising in contradiction to the Fed’s growth forecast.) Following this logic, the Fed will be inundated with political requests that it buy other assets like muni bonds or infrastructure bonds in order to keep their yields from rising. Every rising bond yield can be blamed on inadequate Fed purchases.
The Fed already has a huge self-interested constituency, Wall Street, primed to support broader Fed bond purchases. The Fed’s August preannouncement of Treasury bond purchases gave the bond market a juicy buy-the-rumor, sell-the-news opportunity to buy ahead of the Fed and then use the Fed’s purchases as an exit strategy, taking a huge market profit off the Fed. This strategy also worked on the Fed’s December 2008 MBS purchase announcement, giving Wall Street a huge profit buying MBS in advance of the Fed. The cost to the economy and savers of these concentrated profits is spread across the entire system, and will grow as the Fed expands. There’ll be another round of concentrated profits whenever the Fed buys a new asset class or ultimately tries to divest itself.
The best outcome from this policy nightmare would be for Chairman Bernanke himself to wind down the program in the next few weeks and then try to set the economic history books straight – putting aside whether Fed asset purchases were justified in 2008 when the global financial system was at risk, they are not now an appropriate Fed policy tool. The Chairman has an opportunity to start signaling this on Friday, when he testifies. The only other scenarios that might stop the Fed’s bond purchases are three or more voting dissenters at an FOMC meeting, an unlikely boardroom coup that would undercut the Fed’s credibility; or such rampant inflation that even the Fed won’t be able to ignore it. Since inflation is a deeply lagging data series – the Fed was able to claim throughout the 2003-2007 monetary bubble fiasco that inflation was “moderating” even as the core PCE deflator, upon revision, was rising and always exceeded the Fed’s 2% ceiling -- it’s unlikely that inflation will ride to the rescue in time, nor does anyone other than commodity buyers really want that outcome.
The Fed has a ready-made out-clause. Its December 14 statement promised: “The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.” The latest strong economic data gives the FOMC, and Congress, an opportunity to critically review the whole flawed idea of the U.S. Federal Reserve, one of the world’s bedrock financial institutions, leveraging itself to over $3 trillion in assets in a vain attempt to hold bond yields down.
David Malpass is President of Encima Global and Chairman of GrowPac.com’s Stop the Fed campaign.

Poor Treasury Showing Collapses Bond Market

The Looming Bond Crisis

from NYT:

The State of Illinois is still paying off billions in bills that it got from schools and social service providers last year. Arizona recently stopped paying for certain organ transplants for people in its Medicaid program. States are releasing prisoners early, more to cut expenses than to reward good behavior. And in Newark, the city laid off 13 percent of its police officers last week.
While next year could be even worse, there are bigger, longer-term risks, financial analysts say. Their fear is that even when the economy recovers, the shortfalls will not disappear, because many state and local governments have so much debt — several trillion dollars’ worth, with much of it off the books and largely hidden from view — that it could overwhelm them in the next few years.
“It seems to me that crying wolf is probably a good thing to do at this point,” said Felix Rohatyn, the financier who helped save New York City from bankruptcy in the 1970s.
Some of the same people who warned of the looming subprime crisis two years ago are ringing alarm bells again. Their message: Not just small towns or dying Rust Belt cities, but also large states like Illinois and California are increasingly at risk.
Municipal bankruptcies or defaults have been extremely rare — no state has defaulted since the Great Depression, and only a handful of cities have declared bankruptcy or are considering doing so.
But the finances of some state and local governments are so distressed that some analysts say they are reminded of the run-up to the subprime mortgage meltdown or of the debt crisis hitting nations in Europe.
Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country.
Mr. Rohatyn warned that while municipal bankruptcies were rare, they appeared increasingly possible. And the imbalances are so large in some places that the federal government will probably have to step in at some point, he said, even if that seems unlikely in the current political climate.
“I don’t like to play the scared rabbit, but I just don’t see where the end of this is,” he added.
Resorting to Fiscal Tricks
As the downturn has ground on, some of the worst-hit cities and states have resorted to fiscal sleight of hand to stay afloat, helping them close yawning budget gaps each year, but often at great future cost.
Few workers with neglected 401(k) retirement accounts would risk taking out second mortgages to invest in stocks, gambling that the investment gains would be enough to build bigger nest eggs and repay the loans.
But that is just what Illinois, which has been failing to make the required annual payments to its pension funds for years, is doing. It borrowed $10 billion in 2003 and used the money to invest in its pension funds. The recession sent their investment returns below their target, but the state must repay the bonds, with interest. The solution? Illinois sold an additional $3.5 billion worth of pension bonds this year and is planning to borrow $3.7 billion more for its pension funds.
It is the long-term problems of a handful of states, including California, Illinois, New Jersey and New York, that financial analysts worry about most, fearing that their problems might precipitate a crisis that could hurt other states by driving up their borrowing costs.
But it is the short-term budget woes that nearly all states are facing that are preoccupying elected officials.
Illinois is not the only state behind on its bills. Many states, including New York, have delayed payments to vendors and local governments because they had too little cash on hand to make them. California paid vendors with i.o.u.’s last year. A handful of other states, worried about their cash flow, delayed paying tax refunds last spring.
Now, just as the downturn has driven up demand for state assistance, many states are cutting back.
The demand for food stamps has been rising significantly in Idaho, but tight budgets led the state to close nearly a third of the field offices of the state’s Department of Health and Welfare, which take applications for them. As states have cut aid to cities, many have resorted to previously unthinkable cuts, laying off police officers and closing firehouses.
Those cuts in aid to cities and counties, which are expected to continue, are one reason some analysts say cities are at greater risk of bankruptcy or are being placed under outside oversight.
Next year is unlikely to bring better news. States and cities typically face their biggest deficits after recessions officially end, as rainy-day funds are depleted and easy measures are exhausted.
This time is expected to be no different. The federal stimulus money increased the federal share of state budgets to over a third last year, from just over a quarter in 2008, according to a report issued last week by the National Governors Association and the National Association of State Budget Officers. That money is set to run out next summer. Tax collections, meanwhile, are not expected to return to their pre-recession levels for another year or two, given that the housing market and broader economy remain weak and that unemployment remains high.
Scott D. Pattison, the budget association’s director, said that for states, next year could be “the worst year of this four- or five-year downturn period.”
And few expect the federal government to offer more direct aid to states, at least in the short term. Many members of the new Republican majority in the House campaigned against the stimulus, and Washington is debating the recommendations of a debt-reduction commission. 

So some states are essentially borrowing to pay their operating costs, adding new debts that are not always clearly disclosed.
Arizona, hobbled by the bursting housing bubble, turned to a real estate deal for relief, essentially selling off several state buildings — including the tower where the governor has her office — for a $735 million upfront payment. But leasing back the buildings over the next 20 years will ultimately cost taxpayers an extra $400 million in interest.
Many governments are delaying payments to their pension funds, which will eventually need to be made, along with the high interest — usually around 8 percent — that the funds are expected to earn each year.
New York balanced its budget this year by shortchanging its pension fund. And in New Jersey, Gov. Chris Christie deferred paying the $3.1 billion that was due to the pension funds this year.
It is these growing hidden debts that make many analysts nervous. States and municipalities currently have around $2.8 trillion worth of outstanding bonds, but that number is dwarfed by the debts that many are carrying off their books.
State and local pensions — another form of promised debt, guaranteed in some states by their constitutions — face hidden shortfalls of as much as $3.5 trillion by some calculations. And the health benefits that state and large local governments have promised their retirees going forward could cost more than $530 billion, according to the Government Accountability Office.
“Most financial crises happen in unpredictable ways, and they hit you when you’re not looking,” said Jerome H. Powell, a visiting scholar at the Bipartisan Policy Center who was an under secretary of the Treasury for finance during the bailout of the savings and loan industry in the early 1990s. “This one isn’t like that. You can see it coming. It would be sinful not to do something about this while there’s a chance.”
So far, investors have bought states’ bonds eagerly, on the widespread understanding that states and cities almost never default. But in recent weeks the demand has diminished sharply. Last month, mutual funds that invest in municipal bonds reported a big sell-off — a bigger one-week sell-off, in fact, than they had when the financial markets melted down in 2008. And hedge funds are already seeking out ways to place bets against the debts of some states, with the help of their investment banks.
Of course, not all states are in as dire straits as Illinois or California. And the credit-rating agencies say that the risk of default is small. States and cities typically make a priority of repaying their bond holders, even before paying for essential services. Standard & Poor’s issued a report this month saying that the crises that states and municipalities were facing were “more about tough decisions than potential defaults.”
Change in Ratings
The credit ratings of a number of local governments have improved this year, not because their finances have strengthened somewhat, but because the ratings agencies have changed the way they analyze governments.
The new higher ratings, which lower the cost of borrowing, emphasize the fact that municipal defaults have been much rarer than corporate defaults.
This October, Moody’s issued a report explaining why it now rates all 50 states, even Illinois, as better credit risks than a vast majority of American non-financial companies.
One reason: the belief that the federal government is more likely to bail out a teetering state than a bankrupt company.
“The federal government has broadly channeled cash to all state governments during recent recessions and provided support to individual states following natural disasters,” Moody’s explained, adding that there was no way of being sure how Washington would respond to a bond default by a state, since it had not happened since the 1930s.
But some analysts fear the ratings are too sanguine, recalling that the ratings agencies also dismissed the possibility that a subprime crisis was brewing. While most agree that defaults are unlikely, they fear that as states struggle with their growing debts, investors could decide not to buy the debt of the weakest state or local governments.
That would force a crisis, since states cannot operate if they cannot borrow. Such a crisis could then spread to healthier states, making it more expensive for them to borrow, if Europe is an example.
Meredith Whitney, a bank analyst who was among the first to warn of the impact the subprime mortgage meltdown would have on banks, is warning that she sees similar problems with state and local government finances.
“The state situation reminded me so much of the banks, pre-crisis,” she said this fall on CNBC.
There are eerie similarities between the subprime debt crisis and the looming municipal debt woes. Among them:
¶Just as housing was once considered a sure bet — prices would never fall all across the country at the same time, conventional wisdom suggested — municipal bonds have long been considered an investment safe enough for grandmothers, because states could always raise taxes to pay their bondholders. Now that proposition is being tested. Harrisburg, the capital of Pennsylvania, considered bankruptcy this year because it faced $68 million in debt payments related to a failed incinerator, which is more than the city’s entire annual budget. But officials there have resisted raising taxes.
¶Much of the debt of states and cities is hidden, since it is off the books, just as the amount of mortgage-related debt turned out to be underestimated. States and municipalities often understate their pension liabilities, in part by using accounting methods that would not be allowed in the private sector. Joshua D. Rauh, an associate professor of finance at Northwestern University, and Robert Novy-Marx, an assistant professor of finance at the University of Rochester, calculated that the true unfunded liability for state and local pension plans is roughly $3.5 trillion.
¶The states and many cities still carry good ratings, and those issuing warnings are dismissed as alarmists, reminding some analysts of the lead up to the subprime crisis.
Now states are bracing for more painful cuts, more layoffs, more tax increases, more battles with public employee unions, more requests to bail out cities. And in the long term, as cities and states try to keep up on their debts, the very nature of government could change as they have less money left over to pay for the services they have long provided.
Richard Ravitch, the lieutenant governor of New York, is among those warning that states are on an unsustainable path, and that their disclosures of pension and health care obligations are often misleading. And he worries how long it can last.
“They didn’t do it with bad motives,” he said. “Ninety-five percent of them didn’t understand what they were doing. They did it because it was easier than taxing people or cutting benefits. We’re getting closer and closer to the point where we can’t do that anymore. I don’t know where that is, but I know we’re close.”