Sunday, November 26, 2017

Cato Journal: "Was the Fed a Good Idea?" & The Eventual Sovereign Debt Crisis

Some highlights from pieces in the Summer 2014 Cato Journal issue, Was the Fed a Good Idea? The first is a piece by Kevin Dowd and Martin Hutchinson, How Should Financial Markets Be Regulated? [pdf]:

Speaking to the UK Parliament's Treasury Select Committee in June 2013, [Andy Haldane] said that the "biggest risk to global financial stability right now" is that posed by inflated government bond markets across the world. He then told astonished British MPs: "Let's be clear... We have intentionally blown the biggest government bond bubble in history."

The same could be said for the policies pursued by the Federal Reserve: the financial system wouldn't be so unstable if the Fed hadn't tried so hard to stabilize it. The Fed's response to the bubbles it has created is to blow even harder and hope for the best. The Fed has got itself into a corner and has no credible strategy to get itself out. We know that the latest bubbles must burst at some point and when they do interest rates are likely to rise sharply as bond market investors attempt to dump their holdings. When that happens the financial system will collapse, again. The temptation will then be to prop up bond prices by monetizing what could well be the entire government debt, at which point the Federal Reserve's balance sheet would explode from $4 trillion to $16 trillion or more almost overnight and inflation will be off to the races. [...]

Zero-Risk Weighting of Sovereign Bonds.
In the original Basel Accord, or Basel I, the debt of OECD governments was assigned a zero risk weight. This implies that all such debt, including Greek government debt, was assumed to be riskless. Its effect was to artificially encourage banks to hold higher levels of government debt than they otherwise would, and was a major contributor to recent EU banking problems. When the Eurozone sovereign debt crisis escalated a couple of years ago, many banks then suffered major and otherwise avoidable losses on their holdings of government debt. This rule has been repeatedly criticized, but is still on the books.
And then a piece by John A. Allison (former CEO of BB&T), Market Discipline Beats Regulatory Discipline [pdf]:
On a related point, there has been a massive failure of mathematical modeling (see Dowd et al. 2011, Dowd and Hutchinson 2013). The Fed’s models failed, and all the large financial institutions that failed were experts at mathematical models. We were told by regulators multiple times that BB&T ought to have models like Wachovia, Citigroup, and Bank of America, all of which had major problems during the correction. Mathematical modeling was forced on the banks and then the banks lulled themselves to sleep believing their models were properly assessing risk, which justified taking excessive risk. What is really ironic is that the Federal Reserve is now forcing all large financial institutions to manage by mathematical models, which will ultimately create significant risk in the financial system.

Modeling can be used as a background tool for managing risk, but overreliance on models leads to dangerous decisions. One of the major problems is that mathematical risk models always assume normal distributions, which have small tails—because if they had "fat" tails no one would pay any attention to the models. Of course, what happens is the tails (the unexpected, extraordinary events) are always bigger than predicted by a normal distribution, and tails are the only events that matter. However, the biggest issue is that mathematical models delude managers into believing they are managing risk and they become overconfident. This overconfidence creates a massive incentive to take too much risk because your models indicate you can manage the risk. Of course, in the long term, if managers take on too much risk, they eventually will pay the price. The Fed now is forcing all large financial institutions to use the same mathematical models, which means all banks are going to make the same mistakes. This same type of approach led to excessive risk taking in the subprime lending business. The concentration of risk created by regulatory mathematical modeling significantly increases the overall financial system’s risk.
As we have been observing over the two years or so, the mistake that this has led to is a consensus to be long Treasuries in the belly of the curve (5-15 year); including banks piling into these Treasury tenors to the tune of several multiples of their equity. Some recent highlights to refresh your memory:
  • "[T]he US has a very short maturity structure, so higher interest rates turn into higher debt service quickly. We live on the edge of a run on sovereign debt. The US has a shorter maturity structure than most other countries, and a greater problem of unresolved entitlements. Despite our 'reserve currency' status, we may actually be more vulnerable than the rest of the high-debt, large entitlement western world." [April 2017]
  • Ultimately, debt implies a future transfer of purchasing power, and provides only a few choices. Either you raise adequate tax revenue, or you denominate the debt in long-term bonds and devalue them through inflation, or you default, or you violate the social contract made with those who don't hold paper claims (e.g. Social Security beneficiaries) in preference for those who do. Had the borrowing resulted in productive investment, future output would be easily available to meet those claims. Instead, what’s going on is a quiet dilution of future living standards. [December 2016]
  • [Y]ou're looking at the endgame of a Ponzi scheme that ended when it caused the total fertility rate, and thus - eventually - the worker retiree ratio, to drop too much. To put in a different perspective, the total equity value of the S&P 500 companies is less than $20 trillion. Imagine the federal government exhausting that much capital in ten years. I don't know when it will happen, but I think the bond market will choke. Occasional spikes in bond yields will be the signal that no more can be borrowed. [December 2016]
  • The next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest extraordinary popular delusion. This week has illustrated my point. The election of Trump led to an immediate 25 bp increase in the 10 year bond yield, which means an instant 2.3% loss in value. More than a year's worth of interest. [November 2016]
  • There could be a period when stocks and bonds go down together. For example, instead of stock declines -> people wanting the security of bonds, people might decide that stock declines lead to bailouts which are really stealth currency devaluations, and decide they want no part of the long end of the yield curve. It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. And every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle. If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. [May 2016]
  • We can see with Trump's tax plan (implausible tax cuts and no specific expenditure cuts) that the personalities no longer really matter to the ultimate outcome: sovereign debt crisis, inability to debt finance expenditure, followed by loss of legitimacy of government. [September 2015]
  • Having $3 trillion of assets under management puts you in the top handful of asset management firms. Owning $1 trillion of treasury debt (like China or Japan) makes you one of the largest holders. Who, then, is going to be buying the $3 trillion a year that federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls? [June 2015]
  • For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped. [May 2015]
  • The legitimate purpose of public debt is to borrow money to build infrastructure improvements that have a positive net present value. However, a vast portion of federal expenditure now leaves nothing tangible, leaves no collateral. A treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military "jobs". The lack of collateral makes these treasuries creatures of social mood. In a way, they are as valuable as tulip bulbs or south sea shares. What is a treasury going to yield when mood darkens, and a distressed investor who looks over the enterprise for scrap value is the marginal buyer? [February 2015]
This blog was bullish on Treasuries as far back as 2010, when the "marketable" federal government debt (consisting of securities that traded and excluding intragovernmental holdings) was $8.1 trillion. In March 2017 it is now $14 trillion. Yet the 10 year yield has fallen from 3.3% to 2.3% even as debt/GDP has grown from 53% to 74%.

As the fundamentals of owning government debt have gotten worse, the prospective gain (yield) from owning has fallen! We can see that the federal government deficit is on the order of a trillion dollars per year, since there has been a $6.7 trillion increase in the marketable debt in just under seven years.

Someday when the economy experiences another recession, the debt to GDP ratio will climb faster than it has during this expansion, since three factors will be working to accelerate it: GDP will fall during a recession, lowering the denominator; and debt will increase because tax revenue will fall while at the same time transfer payments will increase.

Meanwhile, despite the booming economy the government debt keeps growing because the federal government runs an enormous deficit. It is politically imperative for whatever party is in power to borrow at low interest rates and maintain spending rather than try to balance the budget. Otherwise that party would be displaced by a different coalition willing to borrow on behalf of its voters. Trump has consistently said that he would grow the national debt, and his ideal budget consists of tax cuts, substantially more spending on defense and infrastructure, and no cuts to entitlement programs. The big drivers of the federal government deficit and therefore the increasing federal debt are the entitlement programs: Social Security, Medicare, and Medicaid. Defense spending is of course enormous but unlike the entitlement spending it does not scale with the growing aged population.

The Congressional Budget Office just predicted that the federal debt will grow by another $10 trillion dollars over the next decade (optimistically projecting the same rate of increase of one trillion dollars per year) to reach $25 trillion by the end of 2027. When George W. Bush took office, the debt was only $3.4 trillion and now the government needs to borrow that much money every two to three years.

It is easy to lose sight of how much wealth these sums represent. There are only about 100 million federal income tax payers in the United States. The current marketable debt is $140,000 per taxpayer and is projected by the CBO to be $250,000 per taxpayer in 10 years. The total equity value of the S&P 500 companies combined is just over $20 trillion. By the CBO's projections, the federal government will need to borrow that much additional capital in under twenty years.

The biggest asset managers like Vanguard and Fidelity each have a few trillion dollars under management. The biggest foreign buyers of treasuries like China or Japan each own about one trillion dollars of U.S. government debt, giving them a certain amount of political leverage. The assets of all the commercial banks in the United States total only $16 trillion dollars. So who is big enough to step up and buy all this government debt year in and year out?

The alternative to borrowing is to get expenses back below revenues. Some think that there are hard limits, like the Laffer curve, to the percentage of GDP that a government can collect, although quite possibly it could collect more than it does now. If so, taxes will be higher, not lower, and disposable incomes and corporate profits will decline. Significant cuts to expenses seem politically infeasible since the largest expenses are these entitlement programs, not discretionary expenses. However, it does not seem as though any serious effort to balance the budget will be made unless and until the bond market, through higher interest rates, forces the issue.

The bond market is often the smartest market and can anticipate an individual company or macroeconomy's fate earlier than equity market investors can.

Note that the 10 year and 30 year bonds have never come close to recovering from the election of Trump.

Perhaps the election of Trump will be end up being totally inconsequential as a historical event, except to inaugurate a new bear market in bonds?


The Lion said...

Is the US still a blue chip economy when its government is experiencing a sovereign debt crisis?

What happened to Argentina?

Anonymous said...

No, it's not.

The MERVAL is up huge in nominal terms:

Currency though:

Anonymous said...

I understand why you hate treasuries. The credit quality of the U.S. government has clearly deteriorated over the last decade.

However,a sharp spike in treasury interest rates implies an even bigger spike in lower credit quality issuers. It also implies an existential crisis in the stock market.

We can infer that if the treasury market turns really ugly, the rest of the capital markets are probably frozen. That means that all businesses would have to internally finance their operations from existing cashflow - cashflow that is probably dropping because of a contracting economy. Hello bankruptcy! I'm looking at you Tesla!

In other words, if you don't like treasuries as an investment, you must more or less hate every other conventional asset class with few exceptions. I'm actually sympathetic to this viewpoint. It is one of the reasons I started my website about art and antiques as investments - Antique Sage.

If a currency crisis is the ultimate outcome of our current situation, which seems highly probable, then conventional assets like stocks, bonds or cash are all pretty bad ideas. It may be time to start looking at unconventional alternatives.