April 30. Arithmetic is the problem…or is it deeper than that?

The Undoing Project is the latest work by Michael Lewis.  Although many themes run through the book, a large part of it concerns decision making by experts (including, for example, sports scouts, economists and doctors).  In many cases, it appears as if simple models of complex problems can provide better decisions than relying on the (unconsciously biased) deductions of experts.  This goes to the heart of the Fed’s deliberations, to the Taylor Rule and to the choice of Randy Quarles to serve as Vice Chairman for bank supervision.  From an interview in 2015, Quarles said, “An important element of Republican thinking about monetary policy currently is that it ought to be more rules based.”

Doctors tended to see only what they were trained to see.  That was another big reason bad things might happen to a patient inside a hospital.  A patient received treatment for something that was obviously wrong with him, from a specialist oblivious to the possibility that some less obvious thing might also be wrong with him.  The less obvious thing, on occasion, could kill a person. From The Undoing Project.

We’ve been in economic ‘recovery’ for nearly a decade.  Is there something else going on?

I was struck late this week by a couple of experts’ comments about gov’t finances.  “We are on the path of exploding deficits,” Fink, chief executive officer of BlackRock, said at the Morningstar Investment Conference in Chicago. “We will have a severe issue if the reform increases deficits.” *  And, from former Chairman Greenspan, who simply said about Trump and his budget: “His arithmetic is the problem.”  The Bloomberg article goes on to cite Greenspan saying that the Trump plan is likely to lead to bigger deficits and higher interest rates.

This is what we learn from experts:  Higher deficits lead to greater bond issuance.  More supply means that prices adjust lower, i.e. higher rates.  Conversely, this is what we actually see: large deficits are typically related to slower growth and thus lower interest rates.  Certainly, with this administration we have more moving parts than before, and it’s rather difficult to piece together a cohesive picture.  There are many divergences, including a disparity between soft and hard data, with Q1 coming in at a weak 0.7%.  It begs the question as to whether Trump’s tax cuts can really unleash business capital investment, a key element for improved productivity and growth.  The markets seem split.  Stocks are apparently pricing odds of reduced taxes, while bonds embrace a mediocre growth outlook.  The two markets aren’t necessarily at odds; if stocks are pricing an increase in earnings due to lower taxes which are still discounted into the future by relatively low rates, then everything might be priced “right”.  The problem may end up being as much political as economic, in that those who are worried about the deficit may provide significant resistance to deep tax cuts.  It’s pretty obvious that there are ‘experts’ on both sides.

In fact, even for me, the warning statement that “stocks are priced for perfection” is like a stale piece of bread.  Anyone that is paying attention can see that there is deterioration in some economic measures, including auto loans, student loans, retail bankruptcies, and increased corporate debt that has diluted balance sheets.  Blackrock more or less shouted it from the rooftop: LARRY FINK SAYS U.S. IS TRULY SLOWING DOWN.  So, stocks are NOT pricing perfection.  They are pricing to model.

What I hypothesize in terms of a potential market problem relates back to the main theme of the Undoing Project.  That key idea concerns the results of expert decision making versus that of models.  Due to huge advances in computing prowess, the bulk of trading decisions are now made through algorithms.  There has also been an explosion in ETFs of all sorts, which, in my simplistic way of thinking, exponentially compounds trading positions relative to true values of underlying assets.  QE and the quest for returns in a zero-bound world have accentuated this trend.  So, when the computer is picking off disparities between a myriad of etfs and futures contracts, and specific stocks, and includes spot prices and vol, the ‘true intrinsic value’ of the underlying asset ceases to have meaning. “If I can buy X here and sell Y and Z there, I’m locked in.  It doesn’t matter what price A (the actual underlying) is.” It’s like the block stacking game.  And that can lead to problems.  Great insight, huh?  Well, not really, but it’s probably an improvement on the economic textbook description that more supply leads to lower prices.  It’s sort of like the essence of James Tobin’s Nobel prize winning theories on diversification of portfolios, which he explained to a reporter as “Don’t put all your eggs in one basket.”

In the grand scheme of things, the only metric that matters is debt servicing costs as compared to income.  And even that doesn’t matter in all cases, for example, student loan debt.  The US gov’t is the main holder of $1.4T outstanding.  What’s Uncle Sam going to do?  Re-possess nametags and hairnets?  Of course there is the power to garnish wages.   However, Fannie Mae made this announcement last week: New policies will help borrowers with student debt qualify for new homes, in part by rolling student loans into mortgages.  It’s called Student Loan Cash-Out Refinance on the press release (linked below).  I didn’t delve into details, but it sounds suspiciously like rolling NPL’s from one government entity to another.

Hoisington’s latest quarterly review notes that Total nonfinancial debt “surged to a record 254.8% of GDP in 2016, 5.6% greater than in 2009.” They further say, “Business debt surged to a record 72.6% of GDP in ’16…eclipsing the prior peak of 70.2% reached in 2009.”  Maybe the US can skate past these issues, and of course there is no telling when the ice might crack.  However, China seems to be embracing capitalistic tenets.  From the FT “China’s premier on Thursday described finance as the “core of a modern economy” adding that “accurate judgment of potential financial risks serves as a precondition for maintaining financial security.” Earlier in the week the PBOC’s Deputy Governor said NPLs are under control, but vowed to control asset bubbles and prevent systemic risks.  This, as China’s Q1 credit creation surged to over $1 trillion while 3 month Shibor rose from 2.9% in Q4 to 4.3% currently. China has become a much bigger block in the global economic stack.  Contagion risks have increased.


Trade thoughts

Last week’s action was primarily an unwind of bets made on the possibility of a HUGE ‘undoing project’ related to survival of the euro, as the threat of Le Pen receded.  Implied vol was crushed everywhere.  The US bond market, however, didn’t have much of a week-to-week change.  The ten year yield was up less than 5 bps on the week to 228, while the thirty year bond was up 6 to 295.  With the new two-year, the 2/10 treasury spread flattened slightly to end at 101.4. The same message was sent by the euro$ red/gold pack spread, which closed just under 66 from 67.25 last week.  July Fed Funds traded as low at 9891.5 during the week, and closed at 9893.0, indicating around 70% odds of a hike at the June FOMC.

This week’s data includes ISMs, the FOMC announcement on Wednesday and Employment Friday.  Friday post data will feature a slew of Fed speakers, including Fischer, Williams, and Yellen.  Bullard, Rosengren and Evans will also be appearing on a panel discussion.  French election is Sunday.

A friend (thanks AOK) notes that SPX had the first inside monthly bar since 1970.  Possible sign of exhaustion.



4/21/2017 4/28/2017 chg
UST 2Y 119.7 126.6 6.9
UST 5Y 175.5 181.4 5.9
UST 10Y 223.3 228.0 4.7
UST 30Y 289.1 295.1 6.0
GERM 2Y -79.2 -73.3 5.9
GERM 10Y 25.3 31.7 6.4
JPN 30Y 75.5 77.6 2.1
EURO$ Z7/Z8 37.0 37.0 0.0
EURO$ Z8/Z9 26.0 25.5 -0.5
EUR 107.27 108.97 1.70
CRUDE (1st cont) 49.63 49.33 -0.30
SPX 2348.69 2384.20 35.51
VIX 14.63 10.82 -3.81







Posted on April 30, 2017 at 8:00 am by alexmanzara · Permalink
In: Eurodollar Options

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