Because I'm sick of R, R (and R)

I promised myself that although I wouldn't shut my eyes if i came across more RR to-and-fro (should we make that RRR now?), I would at least not ever blog about it again unless it was something seriously worthwhile.

I broke my promise and Michael Heller made me do it. Now to be fair, it's a bit unfair to say that this hasn't been going both ways because it has. The difference is that one side (PK, JBL etc.) has been substantive. They've focused on content, on causation and on concept...

...which (I may have got the chronology wrong)...led to a longg letter from Reinhart to Krugman, a sort of dismissive, lazy and im-tired-of-arguing-with-walls response and then....a severely ungracious piece on Project Syndicate by Michael Heller that reeks of being stuck in a corner and throwing jabs into thin air.

Dean Baker's retort includes a gem or two:

"This is the sort of piece that should really have the general public thinking about defunding economics programs everywhere"

"Anyhow, if Heller can read Krugman's latest column and declare R&R the winner, he must also believe that George Foreman defeated Muhammed Ali back in Rumble in the Jungle back in 1975. Such is the state of the economics profession."

WHY DOESN'T THIS END?!

Moby Ben and the Widowmaker - A Post Script

I'm late on this but it's worth thinking about. Post Bernanke-bashing at the Ira Sohn conference, JBL came out with one of the best pieces I've read in a while. What he essentially does is draw a contrast between two counter-parties with a common 'party' - the fund guys.

Of course, you know the backdrop to the London whale:

a) For while, he was more famous than Moby
b) He still ain't a patch on the real whale i.e: Moby Ben

So while the big funds may have finally sighed in relief as their counterparty could no longer continue (because naturally JP was seeing far too much red ink already), that logic doesn't apply to the Fed. And the way to go about this is to think along a more general line of thought and keep it simple.

If the treasury yield is reflected by the path of expected short term rates, inflationary expectations and the term premium, and the Fed shows no concrete signs of future QE moves then it's not entirely unreasonable to see why its easy to get attracted to the 'widowmaker'.

As JBL states, back in the late 90's toward the end of the Clintonia surpluses, the treasury bond traded between 5% and 7% while after the turn of the century, in a relatively much weaker economy, it hovered around the 4-5% mark. Hence the questions such as why was there a low-yield peak and why/when does it return to the 'fundamental'.

Cue Big Ben, printer of deposits, mass purchaser-in-chief of treasuries thus acting as chief culprit in pushing prices up well beyond 'fundamentals'. But here's where reason takes a short step out the window.

Rather than easing off, the buying persisted and fund managers made a very wrong comparison between the little whale and the big whale. While the little one was severely constrained due to obvious reasons, the big one should have been constrained by goals of financial stability and price stability. And just as the little one was answerable to Ina Drew and eventually Dimon, so should the big one have been....waitaminit...

Moby Ben answers to no one, and any dissent that he faces at the FOMC is not even worth writing home about relative to the broader consensus. While the CDX IG9 had a fundamental (the payouts of the bankruptcies times the probability of occurrence), the little whale could not alter the fundamental through his bets and positions.

And the key here is a healthy economy. Because in a healthy economy, the treasury has a fundamental. In a healthy economy, pricing power is partially determined by workers and the Fed's mandate is keeping inflation in check. Is this a healthy economy? No pricing power. Downward nominal wage rigidity. Unlimited market appetite for zero interest cash. Far from it.

Moreover, the Fed is not a profit-making enterprise. It's balance sheet stands at seeming odds with its goals. Unwinding positions and incurring portfolio losses is something the Fed will gladly take if it returns the economy to a steady and healthy state.

Now sure, it's logical to expect a rise in rates and you'd be well-off if you were a very patient investor. Use a crude Taylor rule (for example, the Mankiw rule) with an indicator of about 9.5 and you'll end up plotting an S-shaped curve picking up somewhere in the latter half of 2014.

And if you're screaming inflation and hyperinflation from every rooftop like a lot of people have over the past few years, then you might do well to read about the dog that never barked.

I don't know why exactly it's called the widowmaker but the real widowmaker is a coronary artery that is fatal if blocked.

The analogy seems dubious but still, shorting the bonds:

1) of a sovereign nation that
2) issues debt in not just a currency it controls
3) but a currency that acts as the global reserve currency
4) in a depressed economy
5) is foolish

Pooling Debt

Paul De Grauwe of the European Institute at LSE has a cry out for an EU fiscal union over at Project Syndicate. The good news is that he tries to be practical about it. As you might recall, De Grauwe sort of popularized the self-fulfilling prophecy theory for the EU - that namely the fundamental flaw of the EU is that its members issue debt in euros and the euro is a currency that they have no control of.

Thus, none of them can provide any sort of guarantee to their bondholders. A little fear in the markets prompts sell-offs that can lead to liquidity crises and drives these sovereigns closer to default. With not much to play with, they implement austerity programs that exacerbate recessions and lead to further banking crises.

De Grauwe used very simple univariate relationships among debt-to-gdp ratios, credit spreads, austerity, and growth to illustrate this concept. What you expect to observe is strong relationships between austerity and spreads (in 2011) - thus higher spreads -> greater austerity. you can consider the causation both ways here too.

Further, he charts the change in spreads to the initial spreads (to look at the impact of the ECB's announcement), the change in debt-to-gdp vs spreads (a negligible fit), and the usual austerity vs growth and austerity vs increases in debt-to-gdp.

But I digress: the voxeu article is here and the CEPS "Governance of a Fragile Eurozone" can be downloaded here.

To get past this fundamental flaw of the EU - that member nations have no control of the currency in which their debts are issued - debts must be pooled. The immediate response to this, of course, is that's not happening. Germany, for one, is highly unlikely to even look down that path.

Still, De Grauwe mentions the obstacles involved. The first obstacle is naturally that of moral hazard. But there are some more obvious ones such as the willingness of 'stronger' countries to accept inevitably higher interest rates on their own debts with the advent of any sort of joint liability.

To overcome these, he offers the following three:

1) The share of pooled debt must be strictly limited to the extent that each member nation remains largely responsible for a significant portion of their own debt (you can see the grey area already!)

2) An internal transfer mechanism between member nations to counter the "one-way-traffic" argument. Essentially, less credit-worthy countries must compensate their polar counterparts.

3) A supervisory authority to monitor members' progress toward sound public finances and the ability to implement consequences on those that don't adhere (remember the Maastricht treaty anyone?)

Just like the rest of us, de Grauwe understands that a fully fledged fiscal union a la the US is wholly unrealistic. The point is, however, to be practical and begin with really small steps. He emphasizes the need for the EU to convince financial markets that it is there to stay - permanently. And for this to happen, a process must start.

But see, that's the problem. If the process was to start, it would have started. The opposition is far too great and powerful and the false sense of contentment with a kick-the-can approach has manifested itself with the polity that makes decisions. There are factions, there are vested interests and then there are the people.

De Grauwe ends with the Alexander Hamilton narrative - that rather than wait for a political integrating process, he took action that spurred the United States to a full-fledged m-f-p union.

The question is, who on earth is Hamilton here? Rehn? Weidmann? Merkel?

Initial Claims vs the SP500

The initial jobless claims as a variable is basically a quicker indicative measure of what's happening in the labor market before you really see the effects. Because it reflects individuals filing official jobless claims (for unemployment benefits etc.), it's sometimes seen as a valuable enough indicator or measure-of-health by analysts. 

Starting from 2008, a simple plot between the S&P 500 index and an inverted claims variable reveals phases of high co-movement. Overall, there's a -.92 correlation and a simple regression line has a fit of roughly 0.85.  The key though, is not the relationship necessarily (right now, for example, the claims aren't low enough to justify the additional buoyancy in the stock market). Or for that matter, since the S&P 500 was/is close to 1620, a claims estimate would be around the 250,000 mark - a far cry from the 324,000 it is now. 

This is what the graph over time looks like:

And the scatterplot looks like this:

The main thing over this time period though (beginning 2008 to present) is the convergence of the two. The gap widens (I rebased them to start as an index and looked at the difference) till it peaks in March 2009 and then a convergence begins till it hits zero in January this year and turns once again:

A simple equities-fundamentals disconnect? A rotational impact? Where to now?