The Seven Deadly Sins

By David McWilliams

At school, our Religion teacher, a wise Catholic priest known as ‘Doc Carroll’, urged us to read St Thomas Aquinas on sinfulness. As you can imagine, in an Irish Catholic boarding school, sin was a big deal. The 1980’s moral tug of war for my soul pitted Aquinas at Mass against Bananarama on Top of the Pops. Guess who won?

However, Aquinas has proved more enduring. I can only remember Bananarama chorus lines after too much wine at 50th parties (not pretty); but Aquinas’ observations have stayed with me.

He believed in the idea of a ‘just price’ whereby a ‘good man’ shouldn’t knowingly sell anything for more than it was worth and, under no circumstance, should he lend money for interest to anyone. Usury was a clear sin; absolution from this crime demanded deep penance as the common or garden “a dozen Our Fathers and hail Mary’s” wouldn’t suffice. In Thomas’ world, speculation was a venial sin and using borrowed money to speculate verged towards a mortal sin.

Of course, the reason the great Catholic philosopher was interested in money is because he was interested in human nature and how money affects human nature. He was also interested in the flock or the herd: anything that moves the herd in a certain direction needs to be watched, and speculation (especially leveraged speculation) does strange things to the herd.

The word speculation comes from the Latin ‘speculare’ which is to be on the look out for trouble. The Roman forum with its whores, thieves and moneychangers, had a special corner reserved for the speculari. They’ve been around for a long time. Bulls and bears have long dominated markets, manipulating human nature and undermining rationality in the pursuit of riches.

When other peoples’ money is cheap, the incentive to borrow to drive up prices and sell on to the next guy, pocketing the difference, is as old as humanity itself.

But as Aquinas understood, speculating is a very different business to investing.

In a nutshell, the speculator starts with a small amount of money, hoping to make a lot, quickly. The investor, in contrast, starts with a lot of money and hopes to make a little more, slowly.
It’s all around us

Innovation has always excited the speculator, so too has cheap money. Although investments are subject to wasteful booms and busts, it doesn’t mean they are useless.

Many innovations that have been the subject of wild speculation have lasted or had a profoundly positive effect on the productivity of the economy. Speculation isn’t useless but it is dangerous and with leverage it can link bits of the global economy, which otherwise have no obvious connection.

The legacy of various speculative manias is all around us.

For example, I live in a truncated terrace of houses built just after the Napoleonic Wars when Dublin and the rest of urban Britain was in the grip of a building boom. The boom was fuelled by paper profits generated by exotic investment in the first emerging markets mania.

Following British victories over France, the colonies were seen as a place to make fortunes – which in some cases they were. Once the war was won, yields on British government bonds (Consols) collapsed and interest rates fell dramatically. Between 1820 and 1824, powered by the confidence that followed the military victory abroad and rock bottom interest rates at home, local speculators played the arbitrage between the paltry yields on British Consols and the stellar yields of colonial debt. Colonial projects promised vast fortunes. Punters piled in. Banks lent using existing colonial debt as collateral, encouraged by the exciting mathematics of notional arbitrage.

This is a common feature of many booms. The bank’s balance sheet plays tricks on itself, whereby expensive collateral is mistaken for good collateral. Money gushed into the system, linking for the first time, credit with the business cycle. Up to the 1800s, wars and agriculture drove the vagaries of the business cycle. Once credit emerged, it came to dominate the business cycle.

The modern cycle, whereby credit begets credit, first emerged in the 1820s.

In 1825, the Bank of England, fearing that asset price inflation was getting out of control, raised rates and the highly leveraged, post Napoleonic boom came crashing down, driving banks to the wall.

Building on the terrace where I live was stopped as the developer went bust.
Things that last

As I write, looking out the window over Dun Laoghaire harbour towards Wales, Dublin’s only efficient metropolitan railway trundles reliably along just across the road, hugging the coastline. This line was one of the world’s first suburban railways, completed in 1834 to whisk the wealthy Victorians out from the fetid city centre to the refreshing air of the seaside. Following the emerging markets crisis of 1825, the next big financial boom in these parts revolved around railways.

The first railway boom, or ‘railway fever’ as it was called at the time, broke out just after the 1825 crash with the opening of the Stockport / Darlington line. In no time – and again driven by easier monetary conditions after the crash – ‘railway fever’ engulfed both islands, with Liverpool, Manchester and Dublin vying to match London’s enthusiasm for new railway companies.

Not unlike the dotcom boom a few years back and today’s tech boom, the technological revolution wrought by the railways was real. It brought massive social change.

The 1840s and 1850s witnessed a speculative mania like no other in terms of participation and excitement. Railways captured the imagination of all with the promise of cheap transport for the masses, opening up the countryside and connecting people like never before. It’s hard to overstate the impact of cheap transport on a society where up to then, a significant proportion of the population had barely travelled more than a few miles beyond their own villages. The place was giddy with railway exhilaration. As more lines were laid, more railway shares were issued and more and more people were sucked into the financial vortex.

John Mills, head of the Manchester Statistical Society, looked back at the railway boom in the 1860s and noted that “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.”

Railways were the future but they still had to make money. Mass transport means cheap transport and the cheaper the tickets the more compromised the revenue stream of the newer lines, which were being built in more and more remote places. In time, the disparity between the soaring speculative share prices buoyed up by ever increasing leverage and the underlying modest profitability of many of the lines themselves, coaxed some to take profits.

The very psychological act of defiance that is selling early, undermines the shaky edifice of the boom.

In the end, the railway boom came to a shuddering halt weighed down by its own internal contradictions between price and value. As always, value elbows its way into the speculative group trip and wrecks the buzz.

That’s not to say the railway mania was an irrelevant wasteful period in our history. Not at all. In fact, after I finish writing this I’m going to hop on a new train on the old Victorian line into the city. But the point is that boom and bust cycles tend to follow similar paths.
The most expensive four words of all are: “This time it’s different”.

Credit cycles, as Thomas Aquinas understood, are part of human nature. Boom / bust episodes do strange things to us. It is easy to be caught up in the effervescence, misdiagnosing flakey speculation in the asset of the moment for a solid long-term investment.
The Kindleberger / Minsky framework

When thinking about asset bubbles, I frequently turn to the work of two economists whose work on credit bubbles, booms and busts seems, to me, extremely accurate. Charles Kindleberger and Hyman Minsky, rejecting classical economics that took the irrational human out of the equation, both recognised the importance of the human propensity to panic, indulge in herd behavior and believe our own propaganda. They outlined the stages of a credit boom, where investors go from optimism and euphoria to depression and panic – a journey that leads to the destruction of wealth.

Like Aquinas, they understood human nature.

Because we are a flock or a herd, we are essentially pro-cyclical. That is why we tend to act in ways that reinforce whatever economic trend prevails at a given time. In other words, most people are what is known in financial markets as ‘momentum investors’, who follow the crowd, buoyed up by the excitement of it all, rather than value investors who are constantly asking themselves whether prices are reflecting real value or something else. The predominance of momentum investors has the effect of amplifying the high and low points of cycles.

It is this sort of behaviour that leads to bubbles and can also push the economy out of kilter for long periods of time. It is simply not true that the self-interested economy naturally rights itself and finds equilibrium. In fact, the opposite is the case. The self interest of banks, market players and leveraged speculators can lead the economy to long inflationary periods or can find itself stuck in long periods of unemployment and deficient demand.

Kindleberger’s seminal work – Manias, Panics and Crashes – is well worth a read over Christmas. In it he rejects two widely-held views in classical economics: that financial markets are efficient and that people are rational. He quotes Isaac Newton, who lost a small fortune on the great 18th century speculative punt, the South Sea Bubble, “I can calculate the motions of heavenly bodies but not the madness of crowds”.

Kindleberger observed that panic can be sparked by a relatively trivial event. Once there is leverage in the system, small events have the tendency to become amplified, particularly if there is no hegemon that will backstop the system when a panic occurs.
Such a hegemon in a financial crisis is a large active central bank with sufficient ammunition to mollify the panic. If a panic occurs when rates are high and unorthodox monetary policy has not been used, the central bank’s powder is dry so to speak. But today, after nearly a decade of QE, this is not the case.

Looking at the Great Depression and sharing some of Kindleberger’s analysis, Minsky observed how the financial system can go from rude health to fragility extremely quickly. He also identified the five sequential stages of a credit crisis: (1) displacement; (2) boom; (3) euphoria; (4) profit-taking and (5) panic.

At the beginning something real happens to displace or disrupt the old order and replace it with something new. This can be a monetary event like the ZIRP or QE where monetary conditions are changed dramatically. This has a real impact on valuations. The displacement or disruption can also be an innovation, which changes the market, such as the emergence of railways, the Internet, Amazon or Uber.

Prices of assets start to rise rapidly and people who usually remain aloof from these events become involved. The boom period leads to gearing as the banks fall over themselves to get involved. The next stage is euphoria, when the herd gets excited. This is when balance sheets play tricks on both lenders and borrowers. But of course success breeds a healthy disregard for the chances of failure. The thundering herd is galloping.

During the euphoria stage, leverage amplifies prices. At these lofty levels, some savvy players take this as a signal to cash in their chips. A prescient few take profits. This begins the process of unraveling when the herd realises that prices are falling and, in an effort to get out, everyone rushes for the door in panic. The edifice collapses, fortunes are lost and we start again.

The essence of a credit cycle is a debt build up combined with old fashioned human nature fueling humanity’s pathological optimism as we end up believing our own propaganda.

Minsky made another crucial observation which helps us to understand panics; it is important to look at the types of borrowers who obtain financing during a boom.

There are the ‘hedge borrowers’ who can finance their borrowings, both the capital and the interest, out of their own income.

Then there are the ‘speculative borrowers’ who can finance the interest on their borrowing but need to roll over the principal.

Finally, there are the ‘Ponzi borrowers’ who can’t afford the interest or principal; only the rising value of the asset makes their investments viable. In this type of deal, money doesn’t change hands. The Ponzi borrowers buy ‘on paper’ and sell ‘on paper’ and if the market goes up quick enough they make a tidy killing. If the market falls, they are goosed and so too are those who lent to the Ponzi borrowers!

When the bubble pops, the first guy to fall is the Ponzi borrower – but it doesn’t stop there. The generalised fall in asset prices affects the speculative borrower too, because the bank will only allow him to rollover the principal if the asset has value; if the asset value falls, the bank slams on the brakes.

As the withdrawal of credit causes the economy to seize up, everyone’s income falls. This affects even the hedge borrower’s position because although he could finance both interest and capital out of income, as everyone’s income is falling, his is too, making it difficult for even the hedge borrower to meet his payments.

As markets go ever higher and the gap between valuation and prices becomes more and more stretched, it would seem injudicious to ignore the repeated warnings from history and overlook our human capacity for individual and collective self-delusion.

At Christmas time, even the faithful could do with a little self-doubt.

Donald Trump’s big choice at Davos

Will he reassure his audience that the US believes in strong global institutions?

Lawrence Summers

If the short run concern of those gathered in Davos is how the world will deal with the next recession, the long run one has to be the declining appeal of democratic global values © AFP

Donald Trump will be attending this year’s World Economic Forum. Inevitably, attention will focus on whether the US president projects a commitment to internationalist values or reiterates his commitment to truculent nationalism in the name of making America “great again”. Attention will also focus on the question of the durability of the current economic and market upswing that has buoyed the spirits of businesses and investors around the world.

While President Trump will probably try to take credit for all the economic good news, it is unlikely that he deserves it. He is president of the US, not the whole world. And the economic surprises in the rest of the world have been more favourable than those in America. The scale of upwards revisions of growth forecasts for 2017 and 2018 is higher in Europe, Japan, China and emerging markets broadly than it is for the US. Many other stock markets have outperformed those in the US. If Mr Trump’s pro-business policies were driving the global economy, one would have expected an increase in net capital flows into the US, and so a stronger dollar. In fact, the dollar has weakened significantly in the last year, despite more Federal Reserve tightening than was anticipated at the beginning of 2017.

In the 1990s and again in 2006, I remarked that “the main thing we have to fear is lack of fear itself”.

Today there is an undercurrent of geopolitical concern that was not present at those times. Yet there are important similarities between the situations then and now, where households and business come to fear missing out on good things more than getting caught up in irrational exuberance.

Complacency about the economy can be a self-denying prophecy when it leads to excessive valuations, lending and spending. We are surely closer to such a point than we were a year ago. Sooner or later another downturn will come, perhaps because central banks overreact to what they perceive as inflationary threats, perhaps because elevated financial markets converge to more normal levels, or perhaps because of a geopolitical shock.

The world will have much less room than usual to manoeuvre if and when recession comes. From a narrow economic perspective there will be much less room than the usual 500 basis points of space to bring down rates. There will also be much less room for fiscal expansions than there was when countries were less indebted. At the political level, the kind of agreement forged in London in 2009 between the G20 group of most developed countries to keep markets open, support international institutions and co-operate to stimulate their economies seems much more difficult today. And there is the real risk in many countries that recession will reinforce tendencies towards authoritarian nationalist politics.

If the short run concern of those gathered in Davos is how the world will deal with the next recession when it comes, the long run one has to be the declining appeal of democratic global values. In countries as diverse as the US, UK, Turkey, Russia, Israel and China, it appears the governmental platform that commands the most popular support is rooted in nativism, nationalism and negativism. Populist nationalism eventually produces bad economic results, leading to more pressures for anti-establishment leadership and for extreme policies. It is far from obvious what re-equilibrates the system.

It is hard to predict whether the president will seek to reassure or provoke his audience in Davos. The president’s speech will most probably be compared with President Xi Jinping of China’s rousing defence of globalism at Davos last year. Mr Trump will be further challenged by the suspicion that his rhetoric cannot be relied on to be consistent from speech to speech, let alone to be consistent with subsequent action.

What should he say? It depends crucially on what he believes and that is far from clear. The world can accept a message that the US wants a fairer allocation of the burden of upholding the global system, that after a period of weak economic performance America needs to concentrate more efforts at home, and that it will be guided by its economic and security interests, and not the promotion of abstract values.

But such a message needs to be accompanied by clear signals that the US will strive to be a reliable and predictable partner, that it understands its interest in strong effective global institutions, and that it recognises that even self-interested nations can benefit from thoughtful diplomacy. If this is the combination of messages that comes out of Davos, a nervous world may become a bit less nervous. That would be a very good thing for those gathered at the forum — and everyone else as well.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary

Ready or Not for the Next Recession?

Barry Eichengreen  

Woman counts out customer's change

COPENHAGEN – A sunny day is the best time to check whether the roof is watertight. For economic policymakers, the proverbial sunny day has arrived: with experts forecasting strong growth, now is the best time to check whether we are prepared for the next recession.

The answer, for the United States in particular, is a resounding no. Policymakers normally respond to recessions by cutting interest rates, reducing taxes, and boosting transfers to the unemployed and other casualties of the downturn. But the US is singularly ill-prepared, for a combination of economic and political reasons, to respond normally.

Most obviously, the US Federal Reserve’s target for the federal funds rate is still only 1.25%-1.5%. If no recession is imminent, the Fed may succeed in raising rates three times by the end of the year, to around 2%. But that would still leave little room for monetary easing in response to recessionary trends before the policy rate hits zero again.

In the last three recessions, the Fed’s cumulative interest-rate cuts have been close to five full percentage points. This time, because slow recovery has permitted only gradual normalization of interest rates, and because there appears to have been a tendency for interest rates to trend downward more generally, the Fed lacks room to react.

In principle, the Fed could launch another round of quantitative easing. In addition, at least one of US President Donald Trump’s nominees to the Federal Reserve Board has mooted the idea of negative interest rates. That said, this Fed board, with its three Trump appointees, is likely to be less activist and innovative than its predecessor. And criticism by the US Congress of any further expansion of the Fed’s balance sheet would be certain and intense.

Fiscal policy is the obvious alternative, but Congress has cut taxes at the worst possible time, leaving no room for stimulus when it is needed. Adding $1.5 trillion more to the federal debt will create an understandable reluctance to respond to a downturn with further tax cuts. As my Berkeley colleagues Christina and David Romer have shown, fiscal policy is less effective in countering recessions, and less likely to be used, when a country has already incurred a high public debt.

Instead of stimulating the economy in the next downturn, the Republicans in Congress are likely to respond perversely. As revenues fall and the deficit widens even faster, they will insist on spending cuts to return the debt trajectory to its previous path.

Congressional Republicans will most likely start with the Supplemental Nutrition Assistance Program, which provides food to low-income households. SNAP is already in their sights. They will then proceed to cut Medicare, Medicaid, and Social Security. The burden of these spending cuts will fall on hand-to-mouth consumers, who will reduce their own spending dollar for dollar, denting aggregate demand.

For their part, state governments, forced by new limits on the deductibility of state and local taxes to pare their budgets, are likely to move further in the direction of limiting the duration of unemployment benefits and the extent of their own food and nutrition assistance.

Nor will global conditions favor the US. Foreign central banks, from Europe to Japan, have similarly scant room to cut interest rates. Even after a government in Germany is finally formed, policymakers there will continue to display their characteristic reluctance to use fiscal policy. And if Germany doesn’t use its fiscal space, there will be little room for its eurozone partners to do so.

More than that, scope for the kind of international cooperation that helped to halt the 2008-2009 contraction has been destroyed by Trump’s “America First” agenda, which paints one-time allies as enemies. Other countries will work with the US government to counter the next recession only if they trust its judgment and intentions. And trust in the US may be the quantity in shortest supply.

In 2008-2009, the Fed extended dollar swap lines to foreign central banks, but came under congressional fire for “giving away” Americans’ hard-earned money. Then, at the London G20 summit in early 2009, President Barack Obama’s administration made a commitment to coordinate its fiscal stimulus with that of other governments. Today, almost a decade later, it is hard to imagine the Trump administration even showing up at an analogous meeting.

The length of an economic expansion is not a reliable predictor of when the next downturn will come. And the depth and shape of that recession will depend on the event triggering it, which is similarly uncertain. The one thing we know for sure, though, is that expansions don’t last forever. A storm will surely come, and when it does, we will be poorly prepared for the deluge.

Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is Hall of Mirrors:The Great Depression, the Great Recession, and the Uses – and Misuses – of History.

What the Bond Market Turmoil Really Means

By Randall W. Forsyth

     Photo: Getty Images/iStockphoto 

I’m not dead!

The bond market these days seems to be acting out a scene from Monty Python and the Holy Grail: During the Great Plague, a collector of corpses making his rounds encounters somebody who protests he hasn’t died yet. Another fellow, who wants his buddy to be removed presently rather than risk being stuck with his remains until the corpse gatherer returns in a few days, counters that “he will be soon; he’s very ill.” Eventually, the problem is solved when the poor guy is whacked over the head and tossed in the cart with the rest of the bodies.

All of which may serve to demonstrate that the Pythons’ brand of humor appeals mainly to males of the baby-boomer generation—and everybody else, not so much. Yet the rise in yields has spurred any number of investors and analysts to declare the death of the bull market in bonds, which began in 1981 when long-term Treasury yields topped 15%. Since then, there has been a steady, stairstep decline to a low of 1.36% on the 10-year Treasury note in mid-2016. (Bond prices and yields move in the opposite direction.)

Last week, as the benchmark yield topped 2.5%, the calls declaring the 36-year bond bull dead grew louder, as the Current Yield column details. Whether the bull has actually met its demise remains debatable. But even if that is the case, whether it means the end of the climb in the stock market and the expansion in the global economy is at hand is another matter altogether.

To be sure, there have been earlier, but premature, declarations that the bond bull market had met its demise, including in Up & Down Wall Street’s online edition back in October 2012, which cited a call by Bank of America Merrill Lynch’s chief strategist Michael Hartnett. Yields—then a bit under 2% for the 10-year Treasury—did have further to fall. But Hartnett also recommended overweighting assets that would benefit from central banks’ liquidity expansion, including U.S. stocks, and especially technology. That advice proved profitable. Over that span, the Standard & Poor’s 500 index nearly doubled in price, while the Nasdaq Composite has done even better, in case you haven’t noticed.

Throughout most investors’ careers, interest rates have been in a broadly declining trend, which provides a tailwind to the prices of most assets, from stocks to high-yield credit to real estate. As DoubleLine’s Jeffrey Gundlach observes in the Barron’s Roundtable, when he got into the investment business, the Treasury long bond yield hit 14%, while inflation was 4% and falling.

This combination appeared in May 1984, providing an unparalleled 10% real return on a U.S. government obligation, a never-to-be-repeated opportunity. Barron’s online files don’t go back that far, but I vividly recall our Robert Bleiberg pounding the editorial table to buy bonds at those yields. The Dow Jones Industrial Average then hovered around 1,100 (no, I didn’t drop a zero), which shows just how much stocks and bonds alike have benefited from the three-decade-plus decline in interest rates.

It would seem we’re now at the polar opposite moment, with 10-year Treasuries, at 2.55%, barely yielding more than inflation. (The consumer-price index is up 2.1% in the past 12 months, according to the latest data out Friday morning.) If the long-term secular trend in interest rates is beginning to reverse, is that fatal to the bull market in equities?

To a couple of pros, whose perspectives extend beyond a market environment in which falling interest rates presented a boost, rather than a barrier, to investment returns, that’s not a worry.

Higher bond yields, along with higher stock prices, would be like “ice cream on top of the cake” for much of Corporate America, says Dan Fuss, the octogenarian vice chairman of Loomis Sayles, who has 59 years of investment experience. That combination would bolster the pension plans for the companies that still provide them.

To illustrate, despite the stock market’s sparkling performance in 2017, pension consultants Milliman found that the top 100 corporate pension plans experienced a $2 billion worsening in their funding status. That’s because their discount rate for future liabilities fell to 3.53% at the end of 2017 from 3.99% a year earlier, raising the present value of those liabilities.

For those who didn’t suffer through Finance 101, think how easy it would be to save for retirement if you could lock in yields of 7% or more without risk. Companies with defined-benefit retirement plans have to assume a return of about half that, based on the yield on investment-grade corporate bonds. That means they have to sock away much more to meet those future obligations, just as folks scrimping have to set aside more in their 401(k)s to provide for their golden years. (This leaves aside the many public pension plans that have much larger deficits, given their unrealistic return assumptions, which is a discussion for another time.)

OVER THE TRULY LONG TERM, there are other factors to consider. Louise Yamada, who heads the technical advisory firm bearing her name, looked at more than two centuries of U.S. interest rates and found several recurring characteristics.

First of all, rate cycles have lasted from 22 to 37 years, so the current one of 36 years is at the lengthier end of the range. Secondly, reversals of trends have tended to be sharp, as when yields fell from double digits in the early 1980s or when they bounced from their extreme lows in 2016. That said, the transitions from declining rate regimes to rising ones have been very slow, shallow affairs “that have taken two to 14 years,” she says.

Investors need to bear in mind the historical pattern. As Fuss of Loomis Sayles has suggested for some time, interest rates are in the “foothills” of a climb. Yamada’s work shows the early years of a climb in rates corresponds to an abatement of deflationary pressures. As long as those depressants on prices remain in place, rates don’t rise enough to hurt.

An analysis of charts can tell what is happening. It doesn’t explain why, however.

With that in mind, Yamada’s work shows Treasury yields have moved above downtrend lines on charts extending back to 1981. In particular, the two-year Treasury note yield topped the 2% mark on Friday for the first time since 2008. The 10-year note also moved up to key levels. It hit 2.6%, short of the 2017 peak of 2.63%, and ended the week at 2.55%.

Yamada calculates that a bond bear market would begin in earnest whenever the 10-year Treasury yield breaches the 3% resistance level that has persisted for six years. That’s far off at this point, but she suggests selling longer-duration fixed-income assets into strength, that is, lower yields, and shifting into shorter assets (more on that later).

For stock investors, the direction of interest rates seems to matter less than the point at which we stand in the cycle. At the extremes, it’s negative. Soaring rates when inflation is high, or plunging rates when deflation takes hold, correspond to structural bear markets, Yamada’s work shows. Reversals from those extremes support new, structural equity bull markets.

In other words, moderation in all things is a good thing. So, if interest rates rise from a historically low level, it’s not necessarily a bad thing.

A modest rise in yields suggests an abatement in downward price pressures. In the event of an extreme jump in rates, Fuss argues, the Federal Reserve will resist a destabilizing surge. All of which would translate to a gradual rise in interest rates, but from historically low levels. That shouldn’t be too painful for the stock market or economy.

For those who want to ride out rising rates, the Fund of Information column points out money-market mutual funds finally paying something visible to the naked eye, over 1% in many cases, as the Fed has raised its target rate to a range of 1.25% to 1.5%.

In an interview with CNBC last week, Berkshire Hathaway CEO Warren Buffett said his firm stashed its cash in Treasury bills and estimated that Berkshire owns about $100 billion in T-bills. Emulating the Oracle of Omaha rarely has been a bad thing, and that goes for savers now.

One-month bills yielded 1.3% Friday, while three-month bills yielded 1.44% and six-month bills returned 1.6%. Hardly anything to send your heart aflutter, but a darned sight better than what most bank accounts, brokerages, or money funds yield.

It goes without saying that T-bills are the gold standard in terms of safety and liquidity for institutional investors such as Berkshire. And for individual investors in high-tax states, the elimination of the deduction for state and local taxes under the new tax law makes Treasuries’ exemption from state and local income levies all the more attractive.

Buying government securities at auctions via its website,, is relatively simple.

Many major online brokers, including Fidelity, Charles Schwab, E*Trade, and Vanguard, charge no fee to purchase or sell Treasury securities.

What could be more contrarian in a market melt-up than cash?


Investment banks’ cull of company analysts brings dangers

The baby of astute analysis risks being thrown out with the bathwater of corporate soft soap

THEY are not extinct, nor even on the endangered-species list. But company analysts, once among the most prestigious professionals in the stockmarket, are being culled. New European rules, with the catchy name of MiFID2, have just dealt analysts another blow. A study by Greenwich Associates estimates that the budget for the research they perform may drop by 20% this year.

In their heyday in the late 1980s and early 1990s, analysts could make or break corporate reputations. A “buy” or “sell” recommendation from the leading two or three analysts in an industry could move a share price substantially. Fund managers, and many financial journalists, relied on analysts to spot those companies that were on a rising trajectory, and those where the accounts revealed signs of imminent trouble. And the best analysts were very well paid.

But that golden age was built on some rusty foundations. Analysts were well paid because they worked for the big investment banks. But those big banks made money not just by helping investors to trade but also by advising companies on new issues, and on mergers and acquisitions. In such circumstances, there was an implicit bargain that analysts would be positive about a company’s prospects. If they were not, the chief executive might take his business elsewhere. Over time, “buy” recommendations far exceeded “sell” suggestions. This looked less like dispassionate analysis than marketing.

A second problem came in the 2000s as regulators cracked down on the way that companies released news to the market. Information could no longer be selectively released to favoured analysts. By the same token, those “Sherlock-like” analysts who liked to spot trends through independent company visits faced difficulties. Everything came to depend on the profits guidance issued by companies for the next quarter or year. And analysts dared not let their forecasts stray too far from what the companies suggested. The paradoxical result was that finance, an industry whose acolytes often trumpet the superiority of free-market economics, had created a poorly functioning market—one that was oversupplied with analysts who mostly offered the same product.

Why, then, did it survive at all? The conventional way that investors rewarded banks for good research was not to pay for it directly, but to funnel securities trades their way. This system of “soft” commissions created two conflict-of-interest questions. Were fund managers trading more than they needed to just to pay for their research? And were they getting the best terms available when they did that trade? In both cases, the client, not the fund manager, was in effect paying for the service. There was little incentive to change.

Under the new MiFID rules, banks will not be allowed to bundle research up with other products. Fund managers will have to pay for it separately. As a result, they are expected to be much more selective. This recalls Dr Johnson’s response when Boswell asked whether the Giant’s Causeway in Northern Ireland was worth seeing. The great man replied: “Worth seeing, yes; but not worth going to see.” The suspicion is that, for many fund managers, the work of analysts is “worth having, but not worth paying to have”.

The rules may technically apply only to Europe but even American investment banks are expected to adjust their business models to cope with MiFID. The employment prospects of analysts had already been hit by index-tracking, or “passive” fund management, which simply buys all the shares in a benchmark, and by the growth of quantitative hedge funds, which use computer programs to select stocks.

But the best analysts need not despair completely. The biggest fund managers employ in-house research. Some may be willing to pay for analysis from independent boutiques (as has been the case in the world of economics).

The fear, however, is that something will be lost in the process. For all their faults, analysts acted as conduits for company information to be passed to investors who could not afford their own research (charities and small pension funds, for example) and, via the media, to the general public. A few heroic analysts (one thinks of Richard Hannah, a long-term Eurotunnel sceptic) proved adept at exposing corporate flimflam.

Alas, the industry generated far too few sceptics and far too many corporate cheerleaders. The baby is being thrown out with the bathwater—but in recent times it was a very small baby amid an awful lot of murky water.

Who Wants America's Debt? A Closer Look

by: The Heisenberg

- In light of the ongoing debate about China's alleged plans to "halt" U.S. Treasury purchases, I thought I'd go over some of the scenarios for you.

- Obviously, this is an important issue given the Fed's efforts to shrink the balance sheet and Treasury's increased borrowing needs.

- What other options does China really have and what other factors are at play here?
Unsurprisingly, people are still debating whether China truly intends to "halt" their purchases of U.S. Treasurys or otherwise rethink their strategy with regard to how they allocate their reserves.
The Bloomberg story on this hit early Wednesday morning. I talked a ton about it over at Heisenberg Report and I wrote a piece on it for this platform as well.
Officially, Beijing suggested the Bloomberg story "might have cited wrong sources or may be fake news." I shouldn't have to say this, but somehow I feel like it's necessary: just because China says it's "fake news" doesn't mean it's not true. Increasingly, Americans seem to believe that when a story comes out that either reflects poorly on a third party or else puts the subject of the story in an uncomfortable position, the ultimate arbiter of truth is somehow the subject of the story. Clearly, that's absurd. Something like: "your Honor, my client is accused of robbing the local McDonald's, but I asked him and he said that's 'fake news', so I rest my case." Additionally, assuming nothing was lost in translation, the above quote from SAFE makes no sense. How does SAFE not know whether it's false or not? That is, what's with the "might" and the "may"? There is only one entity who knows this for sure and it's SAFE, so even if you can't necessarily trust them when it comes to whether they'd admit it if the story were true, they definitely know whether it is or it isn't, so it makes no sense for them to use the terms "might" and "may."
Anyway, there are a couple of obvious conclusions one can pretty quickly come to about this. First, China wouldn't jawbone the value of their Treasury portfolio lower if they were about to sell. That wouldn't make any sense. So if they are considering diversifying away from USD assets, it's going to unfold over the longer term. Second, this was almost surely an intentional leak designed to send a message to the U.S. about China's capacity to retaliate in the event the Trump administration gets aggressive with the trade rhetoric. I talked about this in the second linked post above. (Basically, China can drive up rates vol. and if suppressed rates vol. is what's ultimately keeping cross-asset vol. tamped down across the board, then China could theoretically try and engineer a jump in the VIX and an equity selloff in the U.S. by pushing up Treasury yields with vague threats about halting purchases.)
All of that said, this is something that's worth discussing, especially in light of the fact that Treasury's borrowing needs are set to rise going forward thanks in part to the tax bill increasing the deficit (see full projections here) and the Fed allowing its balance sheet to run off.
Additionally, it seems like some coincidence that Bloomberg just happened to get the information that served as the basis for their story on Wednesday when 10Y yields had just hit 9-month highs following the BoJ cutting purchases on 10-25Y JGBs and amid calls from the likes of Bill Gross for the beginning of a bond bear market. It is not at all far-fetched to suggest that Beijing saw an opportunity to amplify the message they wanted to send to Washington so they threw a bit of gas on the fire.
Well, according to Morgan Stanley, it's not realistic for China to make a concerted push away from U.S. debt. For one thing, comparable debt (in terms of quality and liquidity) simply doesn’t yield as much. Here's the comparison:
(Morgan Stanley)
Deutsche Bank made a similar point on Friday evening on the way to adding a bit of additional color the gist of which is that the sheer size of the flows make the U.S. market the only realistic option. To wit:
It remains the case that the US, and perhaps more broadly speaking members of the dollar bloc, generally offers the highest nominal yields – this is the “cleanest dirty shirt” argument. However, the sheer size of Chinese flows creates a natural limit to the ability of investors from this market to diversify away from Treasuries.  
Indeed, the flow of funds report and reserve balance data illustrate that the average increase in Chinese FX-valuation adjusted reserves has frequently and significantly exceeded the total net flow of capital into debt securities from the “rest of the world”.  
The simple fact remains that in the short run, the US fixed income market is the only market with sufficient size and depth to accommodate the bulk of the demand from China.
BofAML (and Bloomberg's Richard Jones) suggested that the timing of the news out of China isn't coincidental for another reason (i.e., in addition to the fact that it seemed deliberately timed to coincide with a burgeoning selloff in Treasurys). Here's BofAML:
The announcement is timely as it coincides with French President Macron’s official visit and an interesting takeaway from the comments is that China officials have cited trade tensions as a factor in their decision. With politics in the Euro Area on a more stable footing, improving macro fundamentals and the end of ECB QE in sight, the EUR as a reserve currency appears to be an increasingly attractive long-term proposition.
That QE bit is important. As the ECB tapers, UST-EGB spreads should narrow, making the latter more attractive than they are currently. But that seems like a shift that would take place over the longer term. (I mean, I don't even know if this would be a concern, but if you moved into EGBs too quickly, the mark-to-market losses as the ECB tapers would offset the yield pick-up, so you'd probably want to wait until that had played out.)
Moreover, China still runs a trade surplus and assuming exporters repatriate the dollars they receive; the PBoC will have to do something with those dollars or else exchange them for other currencies in order to buy non-USD assets. Here's Morgan Stanley on that (from the same note cited above):
If China’s central bank keeps the US dollars instead of converting them into other currencies, what does it buy that is (1) cheaper and (2) offers comparable liquidity to US Treasuries?
That's a rhetorical question. Morgan Stanley doesn't think China has any good options in that regard.

But look, the bottom line here is that international demand for Treasurys is something to keep an eye on in an environment of rising supply and decreased Fed support for the market.
Reduced policy divergence between the ECB/BoJ and the Fed (i.e., the ECB taper and presumed 2019 hike and the BoJ's first steps away from accommodation) will naturally play a role as will the evolution of hedging costs (basis swap levels).
The irony is that in the event a severe Treasury selloff triggers a tantrum that flips stock-bond correlations positive (i.e., there's no diversification and balanced portfolios experience a drawdown), the flight to safety could end up underpinning the very assets that sparked the panic in the first place.

US housebuilder’s debt deal sparks outcry 
Traders say Blackstone-led refinancing undermines legitimacy of $5tn CDS market
Joe Rennison in New York

Derivatives traders are crying foul over a Blackstone-led refinancing deal for the US housebuilder Hovnanian, saying the controversial arrangement threatens to further undermine the shrinking market for credit default swaps.
Hovnanian, which is based in New Jersey and is one of America’s largest homebuilders, has agreed with Blackstone-owned hedge fund GSO to refinance up to $320m of its debt — but the deal has a catch.
In order to secure the funds from GSO, Hovnanian has agreed to skip a payment on some of its existing bonds, triggering a technical default and a big payday for the hedge fund, which placed bets on a default in the CDS market.

While legal, traders say the arrangement makes a mockery of a market designed to be used to hedge the risk of real defaults at companies in genuine financial distress.

“We fear that the Hovnanian situation could embolden investors to pursue manufactured credit events with other corporate issuers, which would undermine the true intention and spirit of the CDS market,” said Adam Savarese, co-head of leveraged finance trading at Goldman Sachs.

GSO is able to offer attractive financing terms precisely because they stand to receive a payout on its CDS contracts. Others, including Goldman and credit hedge funds Citadel and Solus Alternative Asset Management, are on the other side of the CDS trades and stand to lose money, according to people familiar with their positions. Goldman and Solus had offered Hovnanian an alternative refinancing deal.

“You can do your credit work but you may not know what is going on behind the scenes where someone could be trying to manufacturer a credit event,” said another fund that had sold Hovnanian CDS.

Hovnanian’s investors face a deadline of this Friday to give a green light to the plan, although it also rests on the approval of a market committee of banks and credit investors, which will have to certify an event of default to trigger the CDS payout.

The tactic of making refinancing conditional on triggering CDS has been used on occasion before, although the Hovnanian situation is unusual because of the size of the deal and because the company is not in financial distress, according to analysts and traders.

CDS fell out of favour after the credit crisis and trading has further shrivelled as market players complain about a lack of transparency and liquidity. The value of outstanding “single-name” CDS, designed to hedge the risk of default on individual companies, has fallen from $33tn in November 2008 to $5tn in the middle of 2017, according to data from the Bank for International Settlements.

GSO and Hovnanian say their deal represents the best financing that was available to the company for replacing debt coming due in 2019. “The company appropriately utilised the most attractive financing techniques available,” said a GSO spokesperson.

But Peter Tchir at Academy Securities, who spearheaded the use of CDS during the early 2000s, said the controversy would have an impact on the market. “CDS was never designed for something like this,” he said. “I think this is going to create more and more pressure to create a better synthetic hedging vehicle than CDS.”