The "I" Word

There is a much-hyped editorial in the WSJ today regarding inflation. The first part of it talks about the effect of inflation on the value of money over time. While accurate, it is certainly not earthshattering or groundbreaking (unless you believe the talking heads on TV). Perhaps the editorial is getting so much attention is that inflation hasn't been a real problem here for a long time. Maybe inflation is high due to the efforts earlier this decade by the Greenspan Fed to "re-inflate" the economy (remember that?)? It certainly has almost nothing to do with the current Fed attempts to lower rates, although that may nudge inflation higher down the road.

The second part of the editorial regarding the the author's calculation of inflation using the price of gold is nothing short of nonsense. Gold, the most overvalued commodity given its lack of intrinsic value, is a misplaced measure of anything. People have turned it into a measure of inflation expectations, but it's relative lack of real uses (I don't count jewelry as a real use) makes it a poor measure. If the oil or copper were used, then maybe this calculation would have credibility. In addition, the author only goes back to 1999. That works conveniently for him, but he seems to have forgotten that the price of gold was $850/oz. in 1981, not much lower than it is now. Using his calculation going backward, this country would have experienced deflation through the '80s and '90s that would have made the Depression look like a picnic.

Commodity prices have increased over the past decades partially due to worldwide growth and globalization, both of which have come about due to the policies and beneficence of the United States. The rest of the move is due to the massive amounts of speculative capital that have rushed into these markets. Electronic trading has made it much easier to trade and to execute complex strategies on a global basis. Remember what happened when equity markets opened up similarly in the '90s? I'm not calling for a crash like the NASDAQ disaster, but there are some parallels. Let's face it, should the price of oil be double what it was last year? Should wheat be four times higher, and then drop 11% yesterday? These markets have gotten ahead of themselves and price adjustments will come. Using only one of them to come up with an inflation calculation is irresponsible, to say the least.

Part of the reason for the run up in inflation recently is the uncertainty in the United States about the future, both economically and politically. While what can be done is being done on the economic front (it has to run its course) and the election won't be decided for eight months, Congress could act on future tax policy now, specifically making the 2001 tax cuts permanent, which would go a long way to reducing the uncertainty. That's not going to happen. The other option would be for all the Presidential candidates come out and say they are committed to not allowing tax rates to rise, but that isn't going to happen either. I guess we're stuck with the uncertainty, higher commodity prices, and higher inflation for the foreseeable future.

A Few Random Observations

During my week-long hiatus, I stumbled across a few random observations during my travels. First of all, the demise of the US economy has been greatly exaggerated. Judging by the number of Americans willing to shell out fairly obscene amounts of money to take a February vacation, it would seem to me that things are not as bad as the instant gratification media would have you believe. The corollary to this that things on Wall Street aren't as bad as we are being led to believe, as most of the people I ran into during my time off make a living on the Wall Street gravy train. After being intensely wrapped up in the investment world for over 20 years, it is necessary and positive to step back from it all and see what is going on elsewhere.

The second observation is that the current value of the dollar is really paying off for this country. Sure, I know your thinking, "What about the imported inflation that a weaker dollar is creating?" Of course, it's something that needs to be monitored, but, with economic globalization it is dubious as to what can be done about it, short of throwing the worldwide economy into recession. What I'm referring to is the relative to the export boom; the number of foreigners visiting here, and spending money, is skyrocketing. Even in my little corner of Vermont this week, I met numerous foreigners, and not just Canadians. People from far-flung places like South Africa and Australia, as well as many Europeans. Let's face it, these people could probably go skiing anywhere, but chose the US, and in particular, Vermont. Certainly the Europeans have closer, easier to get to, and probably better (sorry, Vermont) ski options than Vermont. This is just a testament to the strength and attractiveness of the US.

Finally, as a few of you may already know, people with serious and insightful fixed income knowledge are being treated like rock stars, after years of being shunned to the periphery of the investment conversation world. For the past six months, the media has bombarded the world with overly complex definitions and acronyms, making all bonds and all bond markets seem sinister. Unfortunately, those people being interviewed are the same one that dumped us into the current situation. This past week, I had numerous conversational snippets with all sorts of people. Without exception, I was thanked for providing a straightforward and common sense explanation for what is happening, followed by the handing out of my business card. The bottom line is that the market for valuable advice regarding current market conditions is vast, and the supply is limited because the "experts" concentrated all their efforts on equities and basically ignored what is really important.

How the World Has Changed...Or Not

Here's a quick note before the long weekend. According to Bloomberg, GE 10yr paper is trading at the same absolute yield today as it was one year ago. GE is about the best corporate credit there is, certainly of any issuer that is consistently in the market. Other credits are generally trading at higher yields than one year ago, despite the decline in rates. The difference is the much wider risk premium being demanded now. The point of this is that the Fed can cut rates until the cows come home, but until investors are willing to commit capital and liquidity returns everywhere, the markets, particularly fixed income, will languish here in the netherworld. That will only happen once there more certainty around asset valuations. As mentioned yesterday, the mindset of the major players hasn't changed, and we're stuck here until that happens.

Just an Observation...

Here's a couple of quick notes on the auction rate market. First, it is truly amazing to me that there are so many people that call themselves market professionals claiming to have never heard of this market. It's been around for a long time. I remember back in the late Eighties when my bonus got dinged because of a truly "failed" auction (the issuer filed Chapter XI). Back then, the dealer-manager of these things had to eat the failure. Second, other than the Port Authority, who is really upset about being "stuck" accepting a 20% tax-free yield? Put it in perspective, that's almost +1700 to Libor. Are the buyers really concerned about the Port Authority going bankrupt? Are they only willing to accept 20% if it has a bond insurance wrapper? Do the buyers have all their liquidity tied up in this product? (if the answer to this one is yes, then that is their mistake, especially in this environment). I'm not a table pounder, but if someone wants to assign me their Port Authority auction product, send me an email and we'll discuss it.

This morning, Hank Paulson paraphrased me (probably not directly) regarding the pricing of risk. He said that risk had been underpriced and now it had probably swung back too far the other way. This is similar to the pendulum swinging too far one way and when it comes back, it swings far in the other direction. It is hard to describe, but if you weren't involved in it, you can't believe how far risk had been mispriced. I think a lot of that had to do with the concept, which unfortunately is still prevalent and valid on Wall Street, that it is possible to completely define and quantify all risks in some mathematical formula. My last observation in this piece it is a shame that this concept hasn't been supplanted everywhere (it does exist in a few places, look at the successful firms) with one that actually works and makes sense.

It's Different for Bonds

Given all the failures in the auction market recently, I'd just like to highlight, for those of you out there that aren't aware of it, that the bond market is not the stock market. Stocks are generally exchange traded securities driven by sophisticated order matching networks. The difference in the number issues can best be described, for those of you more familiar with equities, as imagining the entire universe of equities as being the 30 stocks of the DJIA. The bond market would then be all other stocks that exist in the world. With a nod to Joe Jackson, I've written some new lyrics to his song It's Different for Girls to explain further.



What the hell is wrong with bonds today?

There are no bids on any at all

Sellers say that this just isn't right

Dealers pass, and shun every seller's call



They say, we can't believe it

You can't, possibly mean it

In stocks, this doesn't happen

In stocks

Well, who said anything about stocks?


No, not stocks they said

Don't you know that it's different for bonds?

(Please give me bids...)

No, not stocks they said

Don't you know that it's different for bonds?

They're not the same



Buy side talks about a level field

Transparency and e-lectronic exchange

Sell side says without risk capital

Fixed income ain't worth more than loose change



Why's this? There's order matching

Networks, they are a-hatching

Dealers say, we're not buying

Not at all

Well, at least give us a throwaway bid



No, not a throwaway

Don't you know that it's different for bonds?

(At least this time)

No, no, no, no, not stock they said

Don't you know that it's different for bonds?

They're not the same

They're not the same

etc.

Decoupling

A good friend of mine and of theis blog wrote a piece yesterday on the decoupling of the US from other world economies. Here is the link http://mksense.blogspot.com/ . Since this topic is of interest to me, I have decided to put forth my two cents here.



Today, I listened to an interview with Mohammad El-Erian, formally of the IMF, Citi, Harvard and now co-CEO and co-CIO of Pimco. He shares that role with Bill Gross, of course, and their relationship has quickly developed into Mr. Inside/Mr. Outside relationship. (no, I am not old enough to have seen Davis and Blanchard play). Mr. El-Erian rarely speaks in public, so when he does it is usually worth listening to given the amount of money he controls. Mr. Gross, on the other hand, is available everywhere talking about the fixed income market as if he were an independent observer rather than the world's largest bond fund manager. While he has gotten better recently, if Mr. Gross had been an equity fund manager saying the types of things he does, let's just say he wouldn't enjoy the unimpeachable reputation he seems to have in the market.



Anyway, Mr. El-Erian was speaking on the topic of decoupling. His expertise is in the area of emerging markets. He had one very good point on decoupling. Mr. El-Erian made a strong and logical case that there are two components of decoupling: markets and economies. His point was that as markets are so interwined, one cannot truly decouple from the other, particularly when the one market is the United States. Where he misses the point, in my opinion, is that he believes the economies, particularly emerging economies, can decouple from the US indefinately. Mr. El-Erian gives all the standard answers for this that have been bandied about for months: continuing growth elsewhere; increasing domestic demand; yada, yada, yada. He maybe right in certain circumstances, but not everywhere.

My abovementioned friends writes on his blog about the developed countries turning downward. If anyone questions this, I suggest you read the front page article in the WSJ from Thursday (here's the link, but the WSJ isn't free http://online.wsj.com/article/SB120234240716748807.html ) about the UK. The emerging markets will be affected as well. They have experienced market declines so far, although, in general, not to the degree of developed markets. If it wasn't for the the speculative bid propping up commodity prices to artificially high levels, the selloff in EM would be much worse.

In this selloff, sovereign wealth funds have been falling all over themselves to invest in Western companies, especially the US. I'm not trying to make the case that these funds are the most astute investors out there, but they do have long time horizons. Why not plow more money into EM? The growth rates are higher and they already have big investments in developed countries. I'm sure they could find suitable EM investments. The reason is simple, and one the Mr. El-Erian discounts way to much. These investors, more than funds' investors, are concerned with return OF capital in addition to return ON capital. What seem to get lost in the discussion (or isn't discussed at all) is that the much badmouthed and reviled United States of America has created a worldwide environment where these types of investments can occur. Without that environment, who knows how many Hugo Chavez's we'd have running around? The largest of the EM countries, the so-called BRICs, do not have a long history of democratic rule, or any history of democratic rule, with the notable exception of India, of course. The legal systems in EM countries do not offer the same protections as in the West. Anybody that invested in APP and got their head handed to them knows this well. Even the bigger players in EM, as they done for decades, have invested the bulk of their funds in the West.

But, I digress (or decouple). The market declines worldwide will have a noticeable effect on worldwide demand. Like Reaganomice, it eventually trickles down to everyone. Does that mean worldwide recession? Probably not, but like in the US where the quarter to quarter growth rate went from 4.9% to 0.6%, it will feel like one. If the post-Olympic growth rate in China drops, to say, 5%, wouldn't that feel like recession there to? For better or for worse (I think for better), both markets and economies are entwined to some degree, leading to mutual growth or weakness.

Give It Up For Lent

Yesterday was Ash Wednesday, the first day of Lent. As all good Catholics know (and do, of course), during the season of Lent, in additon to the fasting each person is supposed to abstain from something that has meaning to that individual. I'd like to extend the opportunity to abstain to the Federal Reserve Board, to abstain from cutting the Fed Funds rate further during this season of Lent.



As often happens in the market, and this one is no exception, the market has gotten way ahead of itself. This can be seen most notably in the Fed Funds futures market, where the front month contract (February) is pricing in a rate cut this month. The problem with this is that the Fed doesn't have a meeting this month, so, in effect, Fed Funds futures are pricing in an intra-meeting move, one that would occur before the expiration of the contract. (On a related topic, at some point I will elaborate on why the Fed Funds futures is basically akin to placing a bet in Vegas. Suffice it to say that futures usually for hedging or price discovery, the former doesn't generally apply and the latter shouldn't be possible as the rate is set by the Fed, a theoretically independent body. But, I digress...). It really shouldn't be difficult for the Fed to stand pat here on Funds. There is only one meeting and it's just a few days before Easter.



However, what about all of the pundits and experts crying (in some cases, literally) for more rate relief? One of the biggest cheerleaders of this movement (both figuratively and literally) was on TV this morning asking one of his guests (another reporter of the news jumping over the fence acting as an expert), "Is there no light at the end of the tunnel?" (The answer was no). If what we're in is a tunnel, the light won't be seen until we are speeding out of it at 75 MPH, only to have to slam on the breaks at the expensive toll barrier on the other side (read: rate hikes). It has been said here many times, the market needs to work out its excesses before it can move forward. A one-time selloff does not portend a new 25 year secular bull run. The technical analysis mentality that most players seem to have fallen prey to does not fit in with the larger macroeconomic problems we are experiencing.



Why should the Fed stay put? I'll list some reasons. The first should be obvious. Since mid-September, Fed Funds have already been cut 225 bps, the effect of which has yet to be felt. The marginal benefit of further cuts now is dubious. Second, and even more important than the first, is that the markets must be weaned off of its addiction to continual Fed Funds cuts. I can point to Japan as an example of where that policy didn't (and doesn't) work. Ask the "experts" why stocks are lower and the answer you will get is that there won't be Fed Funds rate cut today. The markets need a market-based solution to this problem. If that means something (s) go bankrupt to resolve things, then so be it. That is capitalism. Government can and should try to soften the blow, but at the end of the day, companies, markets, and people, etc. need to succeed or fail without being completely propped up by outside forces. My final point here, and there are many others, is that the Fed has to keep something in reserve on the Fed Funds front in case it is really needed down the road.



The Fed has done a good job at keeping the markets moving in this period of credit crisis and illiquidity. What the vast majority needs to remember is that markets need to be aable to move in both directions in order to function properly.

Hey, It's Triple-A

By far, the title of this blog was the most common phrase I would when being asked to bid on some unknown piece of paper that I didn't sell to a client. Generally, my response was either A) pass-ola; B) tell me who you bought it from and I'll ask them to bid on it; C) sell it back to whomever sold it to you: or D) I'll put it out to the street and work it on a best efforts basis. Not to pat myself or my colleagues at the firm where I used to be employed on the back, but we didn't sell these CDOs, et al to our investor base (Full disclosure: the department I worked for did sell structured products to individual investors, the structures were straightforward, the risks generally quantifible by the lay person, and the buyers were subject to some serious scrutiny before being allowed to purchase such a product.). Our reasons were threefold. First, there was little liquidity in this product (even before the meltdown), particularly in the sub-$10 million amounts we would normally deal in. Each one of these instruments was basically a proprietary product of the firm that created it. That brings me to reason number two, which was that we had no way of valuing it. In retrospect, this is the crux of the problem for the market (I wish I had written this two years ago, then I could be on TV every day). Just because these items (I hesitate to call them bonds as many had non-bond like features) had an ISIN that one could type into a Bloomberg terminal didn't mean that there was any meaningful information (read: information used in generating a value) available. Finally, and I thank God (or the Securities Act of 1933) for this, most of these things were not registered in the United States, putting their purchase out of the reach of most of our primarily domestic investor base.

That brings me back to, "Hey, It's Triple-A". That nugget of information was the one thing that usually was available to us. It was probably the one piece of information available, along with expected return and purported cash flows, to the unsuspecting, yet allegedly sophisticated, foreign high net worth investor that would ask me for a bid on $100,000 face value of this stuff. This investor class had been buying triple-A bonds for years (in some places in the world, triple-A would be the only bonds available) so the thinking in general was that was no different than buying some German Landesbank paper, with an implicit or implied government guarantee. For the most part, this type of buyer doesn't have the most rudimentary notion of how the US mortgage works, and certainly has little clue of how something as complex, as these structures had become, works. (Point of Information: Mortgages and mortgage market vary widely around the world.) As it turns out, very few people understood the workings of these products.

Which brings me back to, "Hey, It's Triple-A". I would have thought that when someone sticks a rating on something, that some significant amount of due diligence was done to arrive at that rating. The pressure has been on the bond insurers, which for a fat fee, certainly more than they were getting from insuring a municipal bond, were extending their triple-A imprimatur on this stuff. However, the real problem here is the rating agencies, which grant those ratings based on thieir due diligence. The bond insurers can only operate successfully with the triple-A blessing of the raters. Unless there is a massive and conspiritorial fraud being purportrated, the blame needs to rest with the Big Two. This is just another instance in a long line of lax standards that got us into this market mess.