12 Observations on Current Market Stress

1) What a mess. I had been lightening up on equity exposure over the last week, but seemingly not enough. The last three months have been hard for me, with my performance trailing the S&P 500 in each of the last three months. Well, at least I admit it when I lose; let’s see if I can’t do better in the future.

2) The rally in long Treasuries is the cousin to the fall in equities.

(Click charts to enlarge.) A $4 move in the long bond would be significant enough — that is a top 5 move, but the shocker is seeing the 30-year yield near 3.20%. That should lead to lower mortgage yields, refinancing, and perhaps, lower rates in the short run. The long run is another matter.

3) Part of this came from Bernanke’s comments that the Fed would buy Treasuries. If I may, what isn’t the Fed going to buy? Do they really want to flatten the yield curve when the long end is this low already? Don’t they have enough to do with instruments that have credit risk? They can flatten the Treasury curve, but the corporate yield curve is out of their reach for now.

4) One example of that is the junk bond market, where the average yield is now over 20%. Areas where the government does not guarantee see little liquidity, because government guarantees in other areas help siphon liquidity away.

5) So I’m not impressed with the FDIC insured bond offerings from a public policy standpoint. They crowd out non-guaranteed bonds. But I would be inclined to buy the bonds in place of allocations to Treasuries or Agencies.

6) TIPS, excluding the long end, are trading below par.

Also, the on-the-run securities are trading at a premium, because their inflation factors are close to 1 because they are young securities. The inflation factors can’t go below 1, but older securities can see more past inflation erased, should we get a period of sustained deflation. I don’t see that coming over the intermediate-term, but in the short-term we could see that. Eventually the Fed will have to monetize many of the promises that it is making.

7) Perhaps we need another means of calculating how bad it is for non-guaranteed areas of the market, like A2/P2 CP. That is a true horror. I remember criticizing those investing in levered nonprime CP back when I was writing for RealMoney, but most of those investors are dead or gone now. My measure of credit stress, the 2-year Treasury less A2/P2 yields, is at a new record.

8 ) It is no surprise here that GM is scrambling, as are the other automakers. Let them try to get debtors to compromise. They will try to get the PBGC to take on the pension liabilities in foreclosure, though that may not be so easy. They have refused to accept some liabilities in the past.

9) I was an early critic of reverse auctions organized by the US Treasury, largely because of the complexity involved. I guess it took Paulson longer to realize the immensity of setting up those auctions. It’s not as if the problem is unsolvable, but it would take a lot of work, and the payoff at the end is uncertain.

10) Is anyone else concerned that the Yuan is falling relative to the US Dollar? This graph gives the history since they “floated” the Yuan. (Note the dirty float free market-like movements.)

Granted, it is a large-ish 2-day blip, but for the global economy to heal, we need China to begin to use the large surpluses that they have built up, buy abroad, and build up their domestic markets.

It would be a simple matter of fairness as well. As it is, the surpluses in the government’s hands fuel a bloated financial system and inflation, which could be partially solved by importing more goods for their citizens to buy.

11) It’s my view that the economics profession comes out of this crisis with a black eye or two. There is a lot of room for humility here. Neoclassical economics does a lousy job of understanding how the real economy (goods and services) interacts with the financial economy (stocks, bonds, etc.). That is a strength of the Austrian school, though.

Even on a microeconomic basis, periods of stress like this can make one question some of the theorems of Modigliani and Miller. The way that assets are financed does make a difference when there is financial stress, and even more in insolvency. Also, the financing windows are not always open. Theories that rely on markets remaining open and liquid, such as many arbitrage-type arguments, are not valid except when the market has “fair weather.”

12) There is no shortage of liquidity for the US Treasury, which takes that liquidity, gives T-bills to the Fed, which uses them to replace bail out specific lending markets, and downgrade the quality of their balance sheet buy up securities where liquidity is temporarily in short supply. Personally, I don’t think it will work. It is much easier to get into a market than to get out, particularly if you are a large player with no profit motive. Three last semi-related articles that I found interesting:

• Quantitative easing: printing money like mad to ward off deflation
• Should We Penalize Liquidity Preference?
• Profiting off the Liquidity Preference

T-bills are in high demand, perhaps the government should take advantage of it and issue a lot of them. There are some dangers though:

a) This could be what finally does in the dollar.
b) The US debt maturity structure has been shortening of late — I wouldn’t want it to get too short, or we could face rollover risk, as Mexico did in 1994.

It might be better for the US Government to lock in long funding rates while they are available. Who thought the 10-year or 30-year could be so low?

Comments

[Jason Rines...:]

I admire the ability for you to self-reflect honestly with yourself and the public Mr. Merkle. I learned some lessons the hard way as well along the way.

I also appreciate your time to report as you do using facts and numbers. Now when individuals such as yourself are in Washington we'll get much resolved and back to business.

Unfortunately, those in power intend to stay there and milk it until the citizenship wakes up and begins researching which individuals have caused the damage, are continuing to cause it and vote them out and good leadership in. This sounds like a broken record from me over the last year in the investment community. I am not glad or happy I am proven correct. Over the last two years on economics and politics I wish I was very, very wrong. Hopefully, I am also correct the depressionary conditions the U.S. will face will be temporary and we'll return to a bull market by 2013.

2008 Dec 02 12:50 PM

[SW Richmond:]

David,

Great article, thought-provoking and stimulating. I've also just finished reading the first link you provided on quantitative easing. I want to point something out, I haven't seen it expressed clearly anywhere yet. I could be way off, comments appreciated.

Given these assumptions:
1. "Credit" is collapsing
2. The "credit" that is collapsing was born in an Investment Bank / Fannie & Freddie system that was leveraged at 30:1 or 40:1.
3. Bernanke is trying to replace that credit with new credit, born in a 10:1 leveraged bank system.

Question: How many new dollars will he need to inject in order to create enough new "credit" to reignite the system? 3 or 4 times as many as have disappeared? And if this is so, then what affect will that have on the value of the dollar?

Is the answer "A catastrophic number"?

2008 Dec 02 01:33 PM

[bobbobwhite:]

Hard to imagine myself reading and caring about statements written by a guy who has stayed the course in his portfolio til very recently, and is trailing S&P performance.

Judgement is what matters most in overall portfolio performance, and David's is not what I would wish to emulate, no matter all the quant info in his article. Why would I want to do as he does if it doesn't perform?

2008 Dec 02 03:48 PM

[Steven Hansen:]

david, another great article. just a question - if the fed / treasury print money to buy treasuries, are they not simply wiping the debt off of the government balance sheets as if it never existed? and won't the fed be able to just pocket the yield?

i simply love economists. i would have never thought of printing money to buy up my own debt.

2008 Dec 02 11:11 PM

[John Lounsbury:]

Great article, Dave.

As The Hand posits, the idea Bernanke has put forward to increase liquidity by the Fed buying treasuries is a way of retiring market held public debt. It is potentially very inflationary because it is monetizing the national debt in two ways:

(1) It reduces the national debt by putting new money into circulation (buying up debt).
(2) It the new money devalues the existing currency reducing the real value of the remaining debt

It is likely to work in the very short term as the Fed purchase reinforces the flight-to-safety demand for treasuries, driving bond prices even higher. But this has a limited useful life because it simply drives the dollar level higher against the dike and hastens the day that the dike breaks. What I have called The Great Bond Bubble of 2008-2009 will burst with even greater force. And if the Fed uses the sale of treasuries in the future to fight inflation, it will be buying back what it has sold at much lower prices. So yes, Steve, the Fed does get to "keep" the interest, but it will be a pittance in comparison to the loss of principal.

2008 Dec 03 01:26 AM

[fran:]

won't the answer depend upon when lending begins in earnest and the subsequent velocity of money? if the velocity begins to grow excessively, can it be controlled/contained to allow growth in the economy without creating hyper- inflation. just like the three bears--not too hot/cold, just right. i bet long range on large inflation.


On Dec 02 01:33 PM SWRichmond wrote:

> David,
>
> Great article, thought-provoking and stimulating. I've also just
> finished reading the first link you provided on quantitative easing.
> I want to point something out, I haven't seen it expressed clearly
> anywhere yet. I could be way off, comments appreciated.
>
> Given these assumptions:
> 1. "Credit" is collapsing
> 2. The "credit" that is collapsing was born in an Investment Bank
> / Fannie & Freddie system that was leveraged at 30:1 or 40:1.
>
> 3. Bernanke is trying to replace that credit with new credit, born
> in a 10:1 leveraged bank system.
>
> Question: How many new dollars will he need to inject in order to
> create enough new "credit" to reignite the system? 3 or 4 times as
> many as have disappeared? And if this is so, then what affect will
> that have on the value of the dollar?
>
> Is the answer "A catastrophic number"?

2008 Dec 03 06:13 PM