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Goldman gets it wrong

One interesting thing about markets (and politics and foreign policy) is that predictions from gurus and self-important experts have a remarkable tendency to turn out wrong. Take this Bloomberg report:

Goldman Sachs to clients: whoops. Just six weeks into 2016, the New York-based bank has abandoned five of six recommended top trades for the year.

The dollar versus a basket of euro and yen; yields on Italian bonds versus their German counterparts; U.S. inflation expectations: Goldman Sachs Group Inc. was wrong on all that and more.

In fact, the best investors tend not to show significantly better predictive ability than anyone else either.  The brutal truth is no-one is reliably good at predicting short-term market movements, although smarter players are more alert to some of the potential mistakes in their perspective.

Instead, they’re mainly better at changing their mind quickly – cutting their losses and getting out of positions that move against them. They manage their risks and survive to fight another day.  They figure out when they are wrong faster.

They don’t make huge overconfident predictions. Instead, they watch their exposure, as Nicholas Nassim Taleb argues.

Of course, it’s unlikely that Goldman was putting its own money behind these predictions to the bitter end. The successful traders at investment banks historically don’t pay much attention to their own economists and research in any case. As they see it, the research is really for the pension fund managers in Cleveland or Edinburgh. And press reporting of market swings is the lowest “dumb money” tier of all – something to bear in mind when the markets are scary like today.

2017-05-11T17:32:40+00:00 February 11, 2016|Current Events, Expertise, Market Behavior|

Market Pessimism: Nothing left to shoot the bear?

So as we all dig ourselves out from the snow on the East Coast, the S&P is sliding again. There’s no sign of hibernation from the bears.  In fact, there seems to be an unusual amount of pessimism and angst out there among professional investors, and wider unease among the public which shows up in support for populist or socialist candidates in the Presidential race.

So how much should we worry? Is it time to plunge our head in a snowdrift and hope for the best? Let’s take the positive view first, and then go to the dark side.

So far the stock market slide is nothing out of the ordinary, of course, uncomfortable and morale-deflating as it is. We usually get a 10% correction in equity prices every two years or so, based on the historical record. So far it’s a bear cub, rather than a raging grizzly.

Let’s say it gets worse from here. 20% corrections are more lumpy in when they occur, but the long term average is they hit every 3 1/2 years or so. That’s a definite scrape from the bear, but not life-threatening. And we’re still very far away from that.

50% or more plunges, like 2008, are extremely rare, far out the tail of the probability distribution, occurring every generation. Or two. Or three.  But because we have painful memories of the most recent collapse, press stories about “worse than 2008” sell newspapers right now. Everything looks dangerous, but just like major earthquakes or hurricanes, it is likely to be decades before another hits us.

Putting this together, the most likely outcome, just in bare statistical terms, is a kind of regression to the mean and therefore recovery rather than another 2008-style catastrophe. That happens much more often in situations like this than a further slide to doom.

The trouble is frequency statistics can mislead. What if something more fundamental is broken? What if there’s cumulative damage?  There are always plenty of “This time it’s different” arguments for potential disaster when markets are weak.

So what is different right now?  What is so deep-seated and cumulative it could put us in 50% territory?

The main cause of recent market weakness appears to be the slide in oil prices, as well as concerns about a slowdown in China with knock-on effects on commodity producers. Add to those multiple pressures  on emerging markets the recent Fed rate rise, which may have disproportionate impact on the outer fringes of the dollar zone.

Yet oil and commodity price swings are anything but unusual. A decline in oil prices is bad for the energy sector but good for just about everyone else in the major western economies. The same applies to a first Fed rate rise in a cycle, even if it does tend to upset markets.

And it isn’t at all clear yet that China really has had a ‘hard landing’, as opposed to volatility on its equity markets. Many people have lost their shirts predicting collapse in the Chinese economy over the last ten or fifteen years.

There is clearly a massive debt hangover, and massive surplus capacity. Let’s affirm it: China has plenty of problems. But it could be a chronic gradual headache for years, rather than a spectacular meltdown which causes the whole world economy to crash. Or a painful temporary interlude, like the many spectacular crashes as the US nonetheless rose to the pinnacle of the world economy between 1865 and 1914.

The same applies to tension in the Middle East. There is obviously a heightened chance of serious conflict, as low oil prices cut budgets and the Saudis are increasingly fretful about Iranian resurgence. But that too could be a chronic, slow-moving problem rather than an immediate hot war. Sunni-Shia tensions date back to before 680AD, after all.  This is not unprecedented or unusual territory. “Trouble in the Middle East” is barely even news these days. And if a ship does get sunk or riots break out in a smaller Gulf state,  oil is likely to spike – offsetting other worries.

None of this is likely to derail the US economy. It’s compatible with a rotation in economic activity from emerging markets towards the US, rather than a collapse in the world economy. On this story, the US with its relatively minimal exposure to foreign weakness takes over its usual role as the  ‘locomotive’ pulling much of the rest of the world economy.  Safe-haven capital flows to the US, interest rates rise as the Fed normalizes, the dollar accordingly rises giving a boost to exporters in other countries, and the locomotive is on its way.

Sure enough, there are some reasons to doubt that it is happening just yet – American consumers may be saving some of the dollars they are not spending at the gas pump, or driving more miles than before.   But there is no reason to despair, or disbelieve altogether than the US is not going to gain significant impetus from lower energy prices before long.

There are other reasons many people worry about western economies,  most notably rising inequality  and technological threats to labor. There may be hidden bubbles after all the monetary liquidity we’ve had washing around.  I’ll look at those another time – but there’s no reason to think that markets have suddenly become much more concerned about these explanations  since New Year’s Day.

The deeper, different problem

Instead, the most interesting possibility is markets are concerned at a deeper level about what we can call the ammunition argument. Let’s say any of these potential threats materializes.  We don’t have to predict which one, or time it to the day. Then what?

The US recovery is still fragile. The EU is beset by problems of its own making. The central banks are already at or extremely near the zero lower bound for conventional policy. Fiscal policy is more constrained by the massive buildup of debt from the last major collapse. There is much more suspicion (especially in the US Congress) about bank rescues or lender-of-last resort functions, including more legal chains on Fed actions in a crisis.

So if something does go wrong – the Fed misjudges the strength of the recovery and raises rates too much, say, a Chinese credit crisis leads to emerging market commodity disasters which cause strains in European banks who have lent too much money to middle-income countries – there is no ammunition in the locker.

If we take out the rifle to defend ourselves agains the charging bear, we’ll just hear a muted empty “click” and the bear’s jaws will close on our throat. Unlike any other potential crisis in the last hundred years, we’re defenseless.

On this argument, no-one can really predict the stock market (or the Middle East). It’s not a matter of predicting specific outcomes. But if anything goes wrong, we’re bear food.  Talk to Murphy about his law.

And then? This is the deeper fear. Policymakers can’t do anything.  They may stage a few theatrics, write “bang” on a piece of paper and wave it at the bear, perhaps. And whatever they do, they’ll likely mess it up. (They’ll probably misspell “bang”).  It’s also linked to wider suspicions that elites don’t know what they’re doing.

This ammunition argument is the really important question, and deserves more consideration in the next post. It’s probably not true, but it’s a serious argument.


2017-05-11T17:32:40+00:00 January 25, 2016|Central Banks, Cyclical trends, Economics, Equities, Financial Crisis, Market Behavior|

Hedge Funds: So much for the upside

There's been plenty of market volatility in the last few weeks, as if you did 't know. That's the time the major hedge funds are supposed to justify their keep – especially as the hedge fund industry has dramatically lagged the S&P for years. According to this Bloomberg article, now is the time the funds should really shine and outperform. So what happened in August?

David Einhorn’s Greenlight Capital flagship fund fell 5.3 percent in August, putting it at –14 percent so far for 2015, according to Bloomberg News. Third Point, run by Daniel Loeb, saw a 5.2 percent decline in its main fund in August. Ray Dalio of Bridgewater Associates saw his macro fund decline 6.9 percent last month. These superstars performed more dramatically badly than the HFRX Global Hedge Fund Index, which was down 2.2 percent in August and 1.42 percent for the year. The Standard & Poor’s 500-stock index lost 6.3 percent in August and is down about 4 percent in the year to date.

The intellectual capital of the industry has dwindled away. Too many people reading the same old academic finance journals, too much “me too-ism.” But it's still good at persuading other people to let it manage their money.


2017-05-11T17:32:41+00:00 September 10, 2015|Industry Trends, Investment, Market Behavior|

Entrenched thinking and Greece

Investment adviser Ned Davis has a wonderful phrase which sums up how markets often work: you can be be right, or you can make money. (He wrote a book about it.) Everyone makes mistakes all the time, he says. Most of Wall Street is in the business of making predictions, but

Perhaps the biggest myth in financial markets is that experts have expertise and forecasters can forecast. The reality is that flipping a coin would produce a better record.

[..] So if we all make mistakes, what separates the winners from the losers? The answer is simple – the winners make small mistakes, while the losers make big mistakes.

Investment survival is everything,  he says, and most of that comes from a willingness to recognize mistakes and adapt quickly.  Many investors make a blazing impact through one successful, “right” big prediction which turns out to be a lucky bet, but then almost inevitably flame out. Big heroic predictions tend to lead to overconfidence and meltdown.

Instead, what is needed for survival is in essence a kind of agility, and being overcommitted to one particular view as “right” or “correct” defeats that.  Davis advocates quantitative timing models and indicators, which I don’t believe in, but his effective point remains: you usually don’t do better by having better forecasts or information, but in how you change your mind in response to evidence.

As I’ve argued many times on this blog, people mostly don’t change their minds. People fall in love with a view.  Or they change with a lag, or in simple-minded imitation of what others are doing. That’s the main problem confronting decision-makers in financial markets and business, especially at senior levels.

That kind of rigidity has bedeviled discussion of events in Europe in recent years, because so much of it gets caught up with emotional commitments to (or sometimes against) the larger European integration project. For most euro enthusiasts, it’s not ultimately about exchange rates or economics. It’s the issue of deeper legitimacy of a project rooted in memories of the destruction of two world wars. The trouble is that can lead to very entrenched and moralized views on the issue.

But there tends to be a natural rhythm to most economic policy: successes cause side-effects which cause new problems. Media cycles exaggerate and then ignore problems. Market attention focuses on an issue and then wanes. Periods of apparent success set the grounds for subsequent failures, and vice versa. So the effective thing to do is avoid large mistakes about the ultimate success of decades-long projects and big commitments for or against, and look at how people are thinking and adapting to current evidence about specific problems. It’s about the right amount of flexibility now and responsiveness to the rhythms, not commitments about who the superpowers of the 22nd century will be.

In that sense, the latest round of “grexit” talk has been usefully more technical and local in focus, centering on the potential failure of Greece rather than the potential failure of the wider euro project. That has reduced the rigidity of the discussion so far, as the EU institutions and the Greek government play their game of chicken. But suspicions of “Anglo-Saxon speculators” are now surfacing again, as in these comments by Juncker. It’s a sign of rigidity.

What causes a game of chicken like this to go wrong and produce a crash or meltdown? Of course, people overestimate or misread their chances. (The Greeks may have done so far, but events are forcing them to reconsider. ) People believe their own propaganda.  It often happens decision-makers get so entrenched in a view they don’t realize the situation is moving against them. Looking at people’s stretchiness, or sensitivity to contrary evidence, is the key. And what they say is often a poor guide to how their underlying view is changing.

The other reason for crashes in games of chicken is that there are timing or side-effects which mean the situation gets out of control even if the participants realize to their horror too late that they need to change course.    This is often a matter of technical issues – things like cross-default clauses or the minutiae of how settlement systems work. I always think of it in terms of the mobilization railway timetables in the run-up to the First World War. Or, more recently, the bullet-to-the-heart impact of Lehman’s failure, which was far worse than the Fed or Treasury expected.

For the time being, the seemingly endless dragging out of the Greek drama is boring. But if the current scene is about Greek overconfidence and increasing desperation,  the next scene will probably be problems caused by EU overconfidence and hubris that they can control the situation. The notion of hubris, after all, is a Greek invention.


2017-05-11T17:32:41+00:00 May 6, 2015|Adaptation, Current Events, Europe, Market Behavior|

Another day, another (Apple) disaster for prediction

Barry Ritholz at Bloomberg View is dazzled by the latest Apple earnings, but asks a tough question.

Far beyond what anyone forecast, the figures show Apple arguably had the single-greatest quarterly performance in U.S. corporate history. … The rest of the numbers were, by all accounts, stupendous, enormous, mind-blowing, record-breaking. Yet it seems analysts were, once again, blindsided by the data.

How is it even remotely possible that Wall Street analysts have no idea what the biggest company in the world is doing?

The answer is complex, involving many elements in the quarterly earnings dance.

[…]. But the shorter answer is that Wall Street analysts are not especially good at forecasting.

The deeper reason, he says, is analysts and traders get locked into narratives, and that leads to confirmation bias and cognitive dissonance.

Traders and investors might prefer the way technical analyst Ned Davis reduced it to its most important element: “Would you rather be right or make money?”

People most often prefer to be “right”, all the way up to the point of losing everything. That is our focus. Prediction sound good in principle, but fails in practice. It’s looking at assumptions and scripts and avoidable mistakes that actually moves the needle.


2017-05-11T17:32:42+00:00 January 29, 2015|Assumptions, Confirmation bias, Industry Trends, Market Behavior|

Markets are Complex Systems – but most people don’t get that

One of the most successful investors of recent times has been Howard Marks. I took a look at his book about markets here. You can’t outperform if you don’t think better.

Thus, your thinking has to be better than that of others—both more powerful and at a higher level. Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different.

First-level thinking, he says, is just having an opinion or forecast about the future. Second-level thinking, on the other hand, takes into account expectations, and the range of outcomes, and how people will react when expectations turn out to be wrong. Second-level thinkers are “on the alert for instances of misperception.”

Here’s a parallel. Marks doesn’t put it this way, but in essence it’s a matter of seeing markets as a nonlinear adaptive system, in the sense I was talking about in the last post. Second-level thinking is systems thinking.  Instead of linear straight lines,  markets react in complex feedback loops which depend on the existing stock of perception ( i.e expectations). Some of the greatest market players have an instinctive feel for this. But because of the limits of the human mind when it comes to complex systems,  most people have a great deal of trouble understanding markets.

That includes many mainstream economists. One obvious reason is price and price changes are one of the most important feedback loops in markets, but not the only feedback loop. A deeper reason is that most academics tend to be hedgehogs, interested in universal explanatory theories and linear prediction and “one big thing.”  But complex systems frustrate and falsify universal theories, because they change. The dominant loop changes, or new loops or added, or new players or goals change the nature of the system.

There’s another implication if you have a more systems-thinking view of markets. Complex adaptive systems are not predictable in their behavior. This, to me,  is a deeper reason for the difficulty of beating the market than efficient market theory. It isn’t so much that markets are hyper-efficient information processors that instantaneously adjust, as the fact they are complex. So consistent accurate prediction of their future state is impossible. It isn’t so much that markers are clearly mysteriously prone to statistically improbable 100- or 1000-year risks happening every 10 years. It’s that markets evolve and change, and positive feedback loops can take them into extreme territory with breathtaking speed that makes their behavior stray far from norms and equilibria.

“Tail Risks” are not the far end of a probability distribution,  as standard finance theory and policy thinking believes. They are positive feedback loops: cascades of events feed back on each other and change the behavior of the underlying system.  It’s not variance and volatility and fat-tailed distributions, but a matter of stocks and flows and feedback,  and tipping points which shift the dominant loop, and the underlying structure and changing relationship between components.

This view also helps understand why markets and policy resist change and stay in narrow stable ranges for long periods. Balancing feedback loops tend to kick in before long, producing resistance and inertia and cycles and pendulums, and making “this time it’s different” claims frequently a ticket to poverty.  Delays and time effects and variable  lags and cumulative effects matter profoundly in a way that simply doesn’t show up in linear models. Differential survival means evolutionary selection kicks in, changing behavior.

How can you make money if you can’t predict the future in complex systems, then? It’s clearly possible. Marks is a dazzlingly successful investor whose core belief is to be deeply skeptical of people who think they can make accurate predictions.

Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing. I’m firmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage.

You might be able to  know more than others about a single company or security, he says. And you can figure out where we might be in a particular cycle or pendulum. But broad economic forecasts and predictions are essentially worthless. Most forecasting is just extrapolation of recent data or events, and so tends to miss the big changes that would actually help people make money..

One key question investors have to answer is whether they view the future as knowable or unknowable. Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth—in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.

In other words, a belief in prediction tends to go with a belief in making overconfident, aggressive big bets, sometimes being lucky –  and then flaming out. The answer? Above all, control your risks, Marks says. Markets are a “loser’s game”, like amateur tennis. It’s extremely hard to hit winners. Instead, avoid hitting losers. Make sure you have defense as as well as offense.

Offense is easy to define. It’s the adoption of aggressive tactics and elevated risk in the pursuit of above-average gains. But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Thinking about what can go wrong is not purely negative, however. It’s not a matter of being obsessed with biases. Instead, it’s a way to be more creative and agile in adapting to change. If markets are complex systems, the key, as Herbert Simon puts it, is not prediction but “robust adaptive procedures.”

To stress the point again – people don’t intuitively understand systems. And many of our analytics and standard theories get them even less.  But it’s the way markets and policy work.


2017-05-11T17:32:43+00:00 August 9, 2014|Decisions, Human Error, Investment, Market Behavior, Perception, Risk Management|

How to tell when “sticking to your guns” is stupid

Hedgehogs, who look at everything in terms of “one big thing”, tend to make poorer decisions than foxes.

Yet markets are full of hedgehogs with big opinions, because big opinions help you raise money or get notice for research, or get invited on CNBC.

The trouble is hedgehogs tend to be closely related to lemmings when there is risk of danger involved. They often don’t last long. They get too attached to positions and too rigid in their views. They don’t see anomalies or contrary evidence. They resolutely go over the cliff together.

Nate Silver (continuing on from the last post) has a beautifully written way of putting it.

Every hedgehog fantasizes that they will make a daring, audacious, outside-the-box prediction—one that differs radically from the consensus view on a subject. Their colleagues ostracize them; even their golden retrievers start to look at them a bit funny. But then the prediction turns out to be exactly, profoundly, indubitably right. Two days later, they are on the front page of the Wall Street Journal and sitting on Jay Leno’s couch, singled out as a bold and brave pioneer.

Of course, sometimes being right means you have to be lonely for a while, and take a contrary view even when it’s unpopular. But it can also be a sign of being out of touch, or prejudiced, or unable to read the evidence objectively, or overconfident, or a crank, or naive about the limits of your domain knowledge. It can mean you’ve fallen for the dream of sitting on Jay Leno’s couch to the exclusion of reality.

Sometimes when your golden retriever looks at you a bit funny, even your dog realizes you’re wrong.

So it is essential to tell the difference between brave contrarianism and rigid imperviousness to contrary evidence, because the latter will kill you.

Once more, the key to success is a matter of the right degree of adaptiveness, which is usually a matter of maintaining a sense of balance. You adjust your view the right amount, at the right time. You need to be open, even eager, for things which might disconfirm your point of view, because you will always automatically seize on things that demonstrate your current view is correct.

Good traders set a stop-loss where they get out of a trade, and live to fight another day. Bad investors and amateurs ride losses all the way down, often becoming even more entrenched in the process. Even if the markets ultimate turn their way for a while, they’re already bankrupt.

Sticking to your guns.. till shot dead

I’ve found in practice one prime danger sign is when people start talking about “sticking to their guns,” especially when they disdain or even refuse to consider contrary evidence. It is the prime hedgehog virtue, or even fetish of rigidity for its own sake. The key distinguishing feature is their view is no longer falsifiable. It becomes a matter of ideology. In the worst cases, people will even try banning mentioning or thinking about any contrary evidence.

There are some terrible examples of this over the years, especially over Europe. It tends to bring out the true believers of one sort or another.

Let me give an example. The right wary to play Europe (and many other issues) is to recognize there is a cycle of overoptimism and pessimism, and lean against it – not go to one fixed rigid extreme or another. For example, in early 2012, the right way to trade was to think the prevalent “Europe has solved its problems” market view was going too far one direction, and prepare for bad news instead. When that indeed came, as Europe went to the brink of meltdown that summer, the right way was to recognize that is often the only thing that motivates action in the EU is the threat of disaster. So sentiment had become too pessimistic about the potential for policy shifts like Trichet’s “whatever it takes.”

The situation was still dangerous – as with the US government shutdown, there was still a small risk of catastrophe through accident or miscalculation. But chances were the danger would motivate an agreement. So the “risk-reward” calculation was to lean against pessimism, the other way.

In other words, to be contrarian at the right times you have to be agile and flexible, not fixed and rigid and devoted to one position.

Culture and foxes

Importantly, the right level of adaptability or flexibility is often embedded in a particular company culture. I worked at one market advisory firm when it was at a spectacular peak of success. In retrospect our “special sauce” was to get the right amount of flexibility and “foxiness” in the culture, which then reinforced itself as it produced strings of accurate calls. Remember, research shows that foxiness is the only thing that reliably separates out better performance at predictions.

We were multidisciplinary, with people from many different backgrounds. We went out of our way to find and understand different perspectives on events and people in their own terms, and then pinpoint the differences with conventional wisdom. We would talk and argue and debate for hours what events meant, what might happen, what people’s motives were, and what the right risk-reward ratio was on different angles of view. We agonized over balancing different points of view and “what-ifs.” It added up, organically, to the right level of adaptation.

One of the keys to our success at reading the Fed was a similar flexibility and ability to recognize cycles. The market tends to swing between “Fed not doing enough” and “Fed is behind the curve” like a sine wave. You just have to lean against extremes.

The right level of adaptiveness and flexibility and detachment usually beats deep domain knowledge (from hedgehogs) or raw information almost every time.

The Fed fears the markets

I've been thinking about yesterday's FOMC minutes, which try to explain why they shocked the markets by not tapering QE on September 18.

The discussion is unusually long and somewhat muddled, but I think this is the most important bit:

Moreover, the announcement of a reduction in asset purchases at this meeting might trigger an additional, unwarranted tight- ening of financial conditions, perhaps because markets would read such an announcement as signaling the Committee’s willingness, notwithstanding mixed recent data, to take an initial step toward exit from its highly accommodative policy. As a result of such concerns, a number of participants thought that risk-management considerations called for a cautious approach and that, in light of the ambiguous cast of recent readings on the economy, it would be prudent to await further evidence of progress before reducing the pace of asset purchases.

They are still a little traumatized by the sharp market reaction in May and June, which they still struggle to understand. Even if the markets were expecting a taper, the committee didn't want to risk a big reaction last month, at least without further efforts to decouple the idea of tapering QE from raising rates.

I had thought the FOMC would take a small first step to minimize the risk of such a major disruption, and if they did not take a cautious step, then the disruption would be much larger when they did eventually move. The first move is inherently dangerous, but you were never going to get better circumstances for it than having the market calmly and confidently expecting a small taper.

But they felt that they were risking too much of a major disruption if they began tapering, given the events of the spring, and were too nervous to risk it when other data was still mixed. They worried given the mixed data they could be misread as more aggressive. It's a judgment about market behavior.

What the committee can't understand, or are unwilling to admit here, is that there are limits to the effectiveness of their forward guidance, and they have undermined much of the effectiveness it did have. Markets do not adjust smoothly. There is a risk of a “door-shut panic” when the direction of policy turns, regardless of what beliefs are held about the Fed's timing for raising Fed funds. The best thing the Fed can do is handle the market in a way which doesn't make a dramatic rise in long-term yields (and hence mortgage rates) more likely.


2017-05-11T17:32:51+00:00 October 10, 2013|Bonds, Central Banks, Federal Reserve, Market Behavior, Monetary Policy, Risk Management|

First stirrings of fear in markets

The market reaction to the government shutdown and debt limit has been relatively limited so far. But there are stirrings of fear as people start to contemplate what even a “technical default” would mean. The mood is beginning to deteriorate.

No-one thinks that the US will outright refuse to pay its debt so that it becomes worthless. But a gap of two or three days before meeting a payment now looks like an outside possibility, even if it is still not probable. People are beginning to discuss just what it would mean in practice.

And the market does not like the thought. It could wreck the delicate “plumbing” of the financial system. Small details like cross-default clauses, collateral rules, pension fund credit rating limits, payment system capacities, reference rates for derivative contracts could all be thrown into uncertainty or breakdown by even a brief US default. It would be extremely dangerous.

The trouble is players don't back down in a chicken game until there is real fear – which is why much of the liberal press has been dismayed there has been little impact from the government shutdown so far. But technical details of payment system breakdowns may not be enough to make Congress fearful.

As I said earlier this week, this infrastructural “nuts and bolts” is crucial.

It puts the Fed in a difficult position. There is potentially enormous systemic risk which could conceivably cause markets to freeze solid. If necessary, they ought to find a way to lend the government enough to cover a temporary gap in payments. They already own $2.069 trillion in treasury securities because of QE, after all, so covering a $30-50bn repayment is small change.

They can't buy treasuries direct from the government, under the Federal Reserve Act. But I don't think they are prohibited from other forms of lending, especially if lawyers get creative. The Fed was noticeably resourceful about inventing new programs at short notice during the crisis. They could perhaps call it temporary excess float in Fedwire, or suchlike, a mere facilitation of the payment system. They could organize a special purpose vehicle to provide the funds to meet government debt payments, like Maiden Lane.

Of course, direct funding of government by the central bank is one of the greatest no-nos in central banking, in normal circumstances. That way lies Weimar. They can't even hint that they could do this until it became unavoidable, as politicians would be let off the hook to do a deal. It would raise constitutional issues – the power of Congress (Article 1) versus the public debt shall not be questioned (14th Amendment) that would reach the Supreme Court later.

But even a technical default could take us into potential meltdown territory.

There's not enough fear yet to resolve this. That is something we should get a little fearful about.


2017-05-11T17:32:51+00:00 October 9, 2013|Central Banks, Crisis Management, Market Behavior, Monetary Policy|

To taper or not to taper?

So the payrolls number came in fractionally below expectations (169k compared to 180k) and the revisions were not good.  However, the markets always get excited about things which are essentially within the margin of error for this number.  For the establishment survey, the number is plus or minus 90,000 with a 90% confidence interval. The total civilian labor force (household survey) is 155,486,000 this month, so a miss of circa 11,000 is a sliver of a sliver of a sliver of a very large number.

The Fed looks at it and takes it seriously, sure. It’s the most important number they have. But they are not quite as binary about it as the markets.  They look at a range of data, and how it changes over a period of months, to avoid getting blindsided by any one number.

So what does it mean for tapering? I still think the economic data is a little too weak to justify tapering this month, if that was the only consideration. But it isn’t. The Fed also wants to minimize potential instability and volatility when it tapers. $10bn off bond purchases each month will make an infinitesimal difference to monetary accommodation for the real economy. But timing the first move correctly could stop financial markets overreacting, driving up long rates disproportionately, and damaging the recovery.

Tapering isn’t guaranteed on September 18. But the burden of proof will be in favor of getting the first step out of the way, to reduce the chance of major volatility later. As of today, I’d still incline to think they’ll taper, so long as the markets do not swing so far as to make it a shock which causes instability.

2017-05-11T17:32:52+00:00 September 6, 2013|Bonds, Central Banks, Market Behavior, Monetary Policy|