Thursday, March 19, 2015

How the Fed Told the Market What It Wanted to Hear

One of the most human things about humans is that they tend to hear what they want.  It's easy to take advantage of this trait. Politicians do it as a matter of course.  Many, and perhaps most, Congressional districts are gerrymandered to favor one party or the other, so that members of Congress can be elected, and then endlessly re-elected, simply for saying what their constituents want to hear.  Our gridlocked government doesn't actually do anything.  We pay members of Congress nice salaries simply to say what we want to hear--and in the final analysis the shame is on us.

Government officials aren't above telling us what we want to hear, either.  The Fed's latest policy statement is a good example.  The word "patient" was removed, indicating that there wouldn't necessarily be much warning of an interest rate hike.  This is hawkish. 

But the statement also tried to make nice-nice with all the skittish investors out there who bet on continued money printing by saying that a rate increase in April is unlikely, and that the timing of future rate increases would be dependent on economic data.  The Fed also continued from the previous statement to say that it anticipated moderate economic growth, lower than average inflation in the near term and a continuation of its practice of re-investing principal payments from its holdings of federal agency and Treasury securities into other agency and Treasury securities (thereby maintaining the size of its balance sheet).  These dovish statements softened expectations for rate hikes in the near future.

The market rallied yesterday (Wednesday, March 18, 2015), with the Dow Jones Industrial Average rising almost 230 points (more than 1%).  Today, the Dow dropped 117 points, or 0.65% (although the Nasdaq rose 0.2%).  What gives?  The market initially read the Fed statement to be dovish and drank deeply of the punch bowl.  But Fed Chair Janet Yellen also has made clear that there are no assurances as to June and a rate increase in June is possible.  The market evident sobered up today and took some money off the table.  The Fed statement didn't change from yesterday to today.  What changed was how the market read the statement.

The Fed is now in the position it wants to be in--it can move rates without giving a lot of notice.  It has much more flexibility to react to changes in economic data.  Investors who are caught leaning the wrong way can't expect a bailout.  We're back to the past, to the Fed of the 1970s, 80s and 90s, which tended to be opaque and liked it that way.  It had room to move.  For example, in 1994, the Fed decided to raise rates, when large swaths of the market didn't expect a rate increase.  Many hedge funds and other investors were seriously discombobulated, but there was no money printing done to make the boo boo go away.  All the losers could do was to reflect on how there's a certain amount of rancid cheese in life and you just have to deal with it.

Now, let the investor beware. 

Friday, March 6, 2015

Dreaming of Higher Interest Rates

Today's employment report, which shows a gain of 295,000 jobs and a lower unemployment level of 5.5%, knocked the wind out of the stock market's sails.  The Dow Jones Industrial Average fell almost 279 points or about 1.5%.  Bonds retreated as well, while the dollar rose.  The new employment data heightens the chances of the Federal Reserve Board raising interest rates as early as June, something that's detrimental to today's rosy asset valuations. 

In the past year, there have been innumerable rumblings from hawks and doves on the Fed about when to raise interest rates and how quickly.  As the economy has improved, the Fed's public signals have morphed from waiting a significant time and being patient, toward saying that their decision on rate increases will be data dependent.  That means rates could increase any time, if the Fed decides that the data warrants an increase.  Fed Chair Janet Yellen is a dove on rate increases, but she also wants to have a free hand without necessarily having to be patient.

There's so much debate and angst over rate increases that the sensible thing for the Fed would be to raise rates a quarter point this summer or fall.  That would give the markets a chance to adjust to a world without zero interest rates, something they haven't experienced in seven years.  After an initial tantrum, the market would probably figure out that 25 basis points is just 25 basis points, not the beginning of a massive depression and the end of civilization as we know it.  Some of the heat in the debate over rate increases would dissipate, and the dialogue could become calmer.  The hawks would have had their way, at least for a first step.  And the doves would realize they don't have much to worry about.

That's because economics would dictate that rates should remain low as long as inflation remains low.  Inflation, even without considering the falling price of petroleum, remains below 2%.  There is no economic justification for rates to rise much.  On or two quarter point rate increases would establish that the Fed is not locked into perpetual pedal-to-the-metal stimulus.  And low inflation rates would give the doves a basis for tightening ever so gently--and patiently.

So, if you're dreaming of higher interest rates, dream on.  When you wake up, you'll find that our low inflation reality means it was just a dream.

Wednesday, February 25, 2015

Fighting ISIS: Are We Ready To Invade Syria?

As Congress mulls the issue of authorizing the President to wage war against the Islamic State, there is a lot of discussion of how much involvement U.S. troops should have.  Should they be involved in training, advisory roles during combat, or actual combat?  But these may put the cart before the horse.  Before talking about where on the battlefield U.S. troops should be located, we should talk about what it would take to win the war. 

The Islamic State's attractiveness to its young, disaffected recruits is that, more than anything else, it is a caliphate--an actual geographic location where Islam in its supposed purest form can prevail.  ISIS offers a promised land to go to, a place where you can not only go yourself, but take your family and raise your children (as some jihadists have done).  You aren't just fighting for a cause.  You and your family can live a life of holiness and purity. 

The caliphate is a safe haven for ISIS jihadists.  Defeating ISIS requires conquering its territory--all of its territory, in Iraq and in Syria.  There is no debate over whether U.S. troops should operate in Iraq--they already are, and nobody argues they shouldn't.  But the elephant in the discussion is what to do if the U.S. and its allies succeed in pushing ISIS out of Iraq and back to its lair in Syria.  America currently has no proxy troops to attack and seize the ISIS heartland in Syria.  No other forces in Syria--the Assad regime, the moderate rebels, non-ISIS Islamic extremists, the Kurds, or anyone else--can defeat ISIS in Syria.  But if ISIS is able to maintain its safe haven in Syria, it can persist and even renew its conquering ways if and when America tires of endless troop commitments in the Middle East.  The only way to suppress ISIS is to seize control of its safe haven in Syria.

Simply authorizing the President to wage war against ISIS for three years, as he has requested, only tells ISIS that it needs to hold the fort in Syria for the next three years.  Under present circumstances, it may well be able to do that.  One reason the U.S. lost the Vietnam War was it had no way to effectively control Communist safe havens in Laos and Cambodia.  Not having a strategy for eliminating ISIS in Syria precludes victory.  We need to hear from the President and other proponents of waging war against ISIS how the war will be won in Syria.


Friday, February 20, 2015

Better Science, Please

There's nothing wrong with cholesterol in your diet.  After four decades of admonitions to the contrary, federal authorities are reportedly about to withdraw recommended limitations on cholesterol in the diet.  Lovers of eggs, shrimp and shrimp omelettes can rejoice. 

But, if dietary cholesterol isn't bad for you, why were we badgered for decades about eating more than two egg yolks a year?  The answer is bad science.  Researchers weren't careful enough to separate the consequences of high cholesterol in the blood (which can be a real medical issue) from the consequences of a lot of cholesterol in food (which is not proven to be a risk factor). 

This isn't the only instance in recent years of bad science.  Three decades ago, it was often claimed (although not by federal authorities) that high doses of antioxidant supplements would be beneficial to health.  Now, we know that some antioxidants, like Vitamin A, can increase cancer risks if you take large doses of supplements. It's nice that the truth finally emerged, but what about the people who might have increased their cancer risks through mistaken reliance on this advice?  How do you explain to a man dying of prostate cancer that he shouldn't have taken Vitamin A supplements even though various supposedly knowledgeable medical researchers said that Vitamin A in large doses was a good thing?

Then there were the lobotomies.  Some decades ago, there were physicians who believed that a crude and imprecise surgical procedure that involved pushing a surgical instrument into the brain and making various cuts was an appropriate way to treat mental illness.  If this sounds horrendous, well, it was.  There were often some reductions of the symptoms of mental illness, but many patients were left with intellectual and personality deficits and some had to be institutionalized.  Lobotomies produced change, but it was debatable in many cases whether they made the patient truly better off.  Lobotomies haven't been done in 40 years and today are generally regarded as abhorrent.  Yet, the 1949 Nobel Prize for Medicine was awarded to a doctor for helping to develop lobotomies. 

And, before World War II, there were many scientists who seriously claimed that science could prove that some peoples were superior or inferior to other peoples.  These claims contributed to the ethnic and religious cleansing of millions, a scale that would seem beyond contemplation in any civilized nation--except that it wasn't.

The vaccination deniers have it wrong.  Vaccines are a good thing and kids should be vaccinated.  The climate change deniers are being pressed hard by the recent and ongoing snowmageddon in New England and the record cold now sweeping the Southeast and Midwest.  But scientists--and those that evaluate their work--need to do better.  If you do a little channel surfing on cable TV, you might find people who would prosecute teachers for teaching evolution.  The dietary cholesterol goofup involves much more than what you should have for breakfast or an hors d'oeuvre.  It undermines belief in science, which is one of the foundations of modern society.  Science is the reason we have the comfortable lives and wondrous technological conveniences we now enjoy.  We don't want to go back to a world without electricity where people are prosecuted for contending that the Earth is round.  Ignorance is an everpresent threat, even in the most techologically advanced nations.  If science loses its credibility, it will be replaced by far worse alternatives.  Scientists should be careful, cautious, and above all, accurate.  Pride goeth before the fall.  The incautious scientist can do more harm than good.

Sunday, January 25, 2015

Obama's 529 Mistakes

President Obama's proposal to tax earnings distributed from 529 college plans derived from future contributions is one of the worst ideas he's had in tax policy.  He would make withdrawals derived from earnings on new contributions taxable to the student (although withdrawals derived from earnings on funds already contributed would remain tax-free).  Let us count the ways this makes no sense.

Defies Tax Logic.  The redistribution of income through a progressive tax structure is a concept that virtually all Americans agree on, including many who are very wealthy.  However, Obama's 529 proposal creates a much smaller redistribution loop consisting of college students (and perhaps indirectly their families).  Students from more prosperous families will pay taxes that will subsidize students from less well-off families.  Why have a redistribution loop consisting of only the student community?  If that makes sense, why not have wealthier farmers subsidize less wealthy ones?  And why not have higher earning servers and bartenders (e.g., those at high end restaurants and hotels)  subsidizing the employees at Mickey D's.  Since college educations are so important to America's future, subsidies for middle-class and less fortunate students shouldn't come at the expense of other students who, through no choice of their own, were born into more prosperous families.  If redistribution of income is a societal goal, it shouldn't be done in a distorted way like this. 

Bad Social Policy.  Having children and raising them well is beneficial for America as a nation.  A healthy birth rate is crucial to America's future success as a nation.  More prosperous families are better able to afford to have children and raise them well.  The extremely low birth rates in Japan and Europe have seriously impaired the economies--and futures--of those nations.  Disincentives to have and educate children shouldn't be built into the tax code.

Bad Trickle Down.  Obama's 529 proposal effectively raises the cost of college for students from more prosperous families.  It defies economic logic to believe that won't have consequences.  Some students might lose opportunities when this happens.  Let's take this hypothetical example to see how that could work.  Valedictoria, a brilliant high school student from a well-off but not rich family, might barely be able to afford the unconscionably high costs of an Ivy League school if 529 plans remain unchanged.  But she would opt for a less expensive school (the well-regarded University of Home State) with the Obama changes because she doesn't want to or can't take on the additional debt required for the Ivy League (and wants to spare her parents that burden).  She opts for the less expensive school.  Her enrollment there could bump out a student who was marginally able to gain admission to the University of Home State.  The marginal applicant then goes to a less-well regarded school, perhaps losing educational quality and opportunities he might have had at the University of Home State.  Is the nation somehow better off if this happens?

Punishes Self-Sufficiency.  The people who fund 529 plans are the kind of people who, in past generations, would have been viewed as good citizens prudently saving for the future education and improvement of their children.  They hope not to rely on handouts or loans or governments to finance their childrens' educations.  They'd like do it themselves, thank you.  Indeed, self-sufficiency was once regarded as one of the most golden of American virtues.  In a land where there were many opportunities, but also many hazards, the self-sufficient were the bedrock and pillars of a growing nation that wanted to keep growing.  To be self-sufficient, you necessarily have to build your wealth.  Why penalize self-sufficiency by taxing college savings?   We have become a nation obsessed with instant gratification, the faux celebrity status offered by social networking, easy credit for all, and bailouts for almost every need imaginable.  Will discouraging self-sufficiency improve things? 

Friday, January 16, 2015

Did Someone Blow Up the Swiss Currency Peg?

Much to the surprise of numerous market players, the Swiss National Bank yesterday (Jan. 15, 2015) dropped its commitment to peg the Swiss franc at 1.20 to the Euro.  The Swiss franc suddenly rose some 20% in value, a price shift that clobbered anyone betting the peg would hold.  Losses have been sudden and very sharp.  A major foreign exchange broker, FXCM, has received an emergency $300 million bailout loan from Leucadia National.  Another forex broker, Alpari UK, has entered insolvency proceedings.  A new Zealand broker, Excel Markets, has been knocked out of business.

The Swiss National Bank's reasons for abandoning the peg aren't very clear.  But the abrupt demise of the peg is reminiscent of the UK's withdrawal of the British pound from the European Exchange Rate Mechanism in 1992, after a large hedge fund shorted over 10 billion pounds on September 16, 1992.  The Bank of England was trying to fight market forces that dictated a lower valuation for the pound, and in the end couldn't win that fight. 

A news story reports that in December 2014, there was a very large capital inflow into the Swiss franc, with some 34 billion francs being bought up.  See http://www.cnbc.com/id/102343957.  This is about 10 times the monthly average.  One can wonder whether this flood of capital was the result of a calculated move by one or a few big market players.  While there has for some months been a flight to safety resulting from the EU's economic slowdown (and the likely de facto devaluation in the near future of the Euro via ECB quantitative easing), Vladimir Putin's banditry in Ukraine, and the never-ending turmoil in the Middle East, December's inflow is so abruptly large than one cannot exclude the possibility that it was a move made by a few powerful players.  And if it was, they would have profited handsomely from the Swiss franc's recent price rise.

Thursday, January 15, 2015

Artificial Intelligence in the Stock Markets

Artificial intelligence has been much in the news recently.  Well-recognized deep thinkers have propounded profound thoughts that predict good and bad outcomes for artificial intelligence as it becomes ever more of a reality.  The takeover of the world by machines is inevitable--with monstrous consequences--or not, depending on who you ask.

There isn't much real-world empirical data relevant to the opposing sides of this argument.  But one big clinical trial is underway:  in the stock markets.  Most of the trading done today in the stock markets consists of computerized trading.  Institutional investors, like mutual funds, pension funds, and so on, comprise most of the rest.  Mom and Pop, trying to invest a few nickels for their retirement, are like pedestrians surrounded by massive semis barreling along at interstate speeds.

Much of the computerized trading is done by dynamic computer programs.  In other words, the computer doesn't buy and sell based on a static algorithm embodied in the program coding.  The program can change itself in response to market conditions and activities.  In essence, depending on what the program detects is happening in the market, it can alter its own coding without the need for a human programmer to keypunch and proofread line after tedious line of code.  The details of how these dynamic programs work are generally shrouded in commercial secrecy.  But we have a situation where computer programs take note of what's going on in their working environments, think about how to change themselves to be more effective (i.e., profitable) in light of changing conditions, and then alter themselves to do better.  That's getting rather close to what people do: try to change and improve themselves in order to advance their careers or make more money in their professional activities.

We have seen in recent years how computerized trading can cause mini-crashes and other short term  turbulence in the stock markets.  Mom and Pop are often finding the waters too rough, and suddenly see the virtue in the paltry returns of passbook savings accounts or certificates of deposit whose yields have been flattened by the nearly supine yield curve.  Even some professional money managers are looking for ways to fly over or around the storm clouds of computerized trading, moving trading to venues that claim to allow only "natural" (non-computerized) investors to participate.

For academic researchers and other prognosticators, the dynamic computerized trading in the stock markets could furnish a useful body of data with which to work.  The rest of us, unwilling guinea pigs in a clinical trial we didn't sign up for, can only look to financial regulators and other government officials to ensure that the results of the experiment don't turn out too badly,

Tuesday, December 16, 2014

OIl's Great Fall: This Time, The Bailouts Will Be Harder

In a desperate move, Russia's central bank recently raised a key interest rate by 6.5% to 17%, propping up the ruble at least momentarily.  This was after the ruble had already lost about 50% of its value in the past few months.  Even if the ruble stabilizes, Russia verges on economic collapse. 

Venezuela was already hitting the skids when the price of oil began its big swoon.  Now, it will possibly default on its sovereign debt.  Other oil producing nations are hurting, too.  Some could survive by drawing down their financial reserves.  Others may not have adequate reserves on which to draw.

The impact of the oil price drops on major financial institutions and financial markets players is much more opaque.  When a key commodity like oil, and the currencies issued by its producers, belly flop as we have seen in the past few months, big losses are inevitable.  Some of these losses could be greatly magnified by the leveraging effect of derivatives.  A crucial question for regulators is where these losses are landing.  Surely there are losses on Wall Street and in the City of London.  But proportionately much greater losses may have been sustained by Russian and other European banks.  Dec. 31, 2014 will mark the close of financial reporting periods for many banks and other institutions. At that point, they will be required to disclose their financial conditions.  It wouldn't be surprising if the losses are big.  Talk of bailouts might follow.

It's one thing for the taxpayers of a nation to bail out the banks of their own nation.  They may be frustrated and outraged, and demand the punishment of bank executives and others.  But they have a strong interest in preserving their own financial system.  It's another thing when a foreign country wants a bailout, just after it sent its Special Forces surreptitiously into a neighboring country to seize territory by force, lied to the world about what it was doing, and then made aggressive moves against many other nations--especially those that border it and have historically been dominated by it.  The West has imposed sanctions on Russian banks.  It can't now bail them out.  It's attempting to force Russia out of Ukraine, using financial leverage as a key weapon.  It can't provide Russia with a financial bailout.

Venezuela has for years been seriously hostile toward the U.S., while getting cozy with Cuba.  Its current predicament is the result of spending way more than it was taking in.  A bailout for Venezuela has no chance of receiving Congressional approval, nor would American generosity do anything to ameliorate the key problem, profligacy by the Venezuelan government in order to win over voters.  The IMF would impose financial discipline on the Venezuelan government as a condition of any international bailout, something the current Venezuelan government surely wouldn't accept.

Free market advocates have railed for years about the bailouts made in the aftermath of the 2008 financial crisis, proclaiming that handouts to the wealthy and powerful would only foster moral hazard and encourage undue risk taking at the expense of taxpayers.  They may have their way in the wake of oil's great fall.  Some of the key players likely to need a bailout won't be getting them.  Chips will fall where they may, and we'll see how the markets operate in the absence of government intervention.  The results will be good for some, bad for others, and undoubtedly painful for many. 

A destabilized Venezuela will probably experience internal political change.  But a destabilizing Russia is much less predictable.  As long as Putin is in power, who knows what will happen?  And what is the potential for Putin to leave power?  Not much and it's not likely to happen in a gracious way.  Demagogues at risk of losing power sometimes turn to foreign adventurism to stay in control.  The farther oil prices drop, the harder these questions will become, and the more disturbing the potential answers. 

Wednesday, December 10, 2014

Oil Prices: The Next Test For Central Bankers

Most of the benefits of falling oil prices are obvious.  Consumers, whose median incomes have been falling too, are fist bumping over lower gas prices.  Businesses are seeing some energy costs fall, burnishing the bottom line.  Members of Congress, who aren't doing jack about stimulating the economy anyway, can breath a sigh of relief over the economic stimulus from the gas pump.

Falling prices, however, have downsides.  Today, the stock market tumbled because energy stocks are under stress.  The more vulnerable oil producing nations might default on their sovereign debt (think Venezuela, and maybe others).  Many oil frackers are heavily leveraged, and they could start defaulting as their cash flow sputters.  Some financial market players are surely taking losses on falling currencies of many oil producing nations (the ruble being Exhibit A).  More opaquely, but perhaps of great concern, big banks, hedge funds and other financial market players might well be taking losses on derivatives contracts bets linked to the price of oil or the currencies of oil producing nations.  With oil price losses approaching the 50% level in the past few months, it looks like we have a bursting bubble on our hands--and the potential for another financial crisis.

Recall that it wasn't falling real estate prices alone that triggered the 2007-08 financial crisis.  It stemmed from a poisonous synergy of massive quantities of poorly underwritten mortgage loans, falling real estate prices, defaulting mortgage borrowers (many of whom didn't have the ability to repay the loans, measured by any reasonable standard), a compounding of the losses because falling prices precluded the availability of refinancing, the massive impact of these losses on the financial system through diverse and obscure derivatives contracts not well understood by market players and regulators, and, ultimately, a surprising concentration of losses onto a single entity (AIG-Financial) to which numerous key players in the financial system had unmanageable exposures.  Only an unprecedented bailout by the federal government prevented the collapse of the world financial system.

A sharp fall in oil prices doesn't necessarily mean the financial system is at risk.  There was a proportionately larger oil price fall in the middle of the 1980s which didn't result in a financial collapse (although this occurred before the evolution of complex derivatives markets that allow risk to metastasize with blinding speed).  Another big drop in oil prices in 2008-09 also didn't tip the big banks into bankruptcy (although they were already in major bailout mode by this time because of the mortgage crisis, so this instance may not prove much). 

But the proliferation of risks created by today's highly imaginative financial engineering can mean that any major drop in the price of a key asset like oil could surprise us in unpleasant ways.  One lesson from the 2008 financial crisis is that regulators didn't know where the hot tamale would land, until it hit the fan.  Regulators worldwide should be sending their examination SWAT teams into the major money center banks and other key financial institutions to scope out the direct, secondary and tertiary impacts of falling oil prices.  And that should be now--as in right now--not weeks or months from today when it may be too late to take protective action. 

Tuesday, November 25, 2014

Less Heroic Policing, Please

One thing the shootings of Trayvon Martin and Michael Brown, both unarmed black teenagers, reveal is that there may be too much of a fixation on heroics in policing.  George Zimmerman, a policeman wannabe working as a community watch person, pursued Trayvon even after a police dispatcher instructed him not to follow the young man.  Trayvon, whose suspect activities consisted of carrying junk food while black and wearing a hoodie, evidently became unnerved by Zimmerman and an altercation ensued.  Because the victim was dead and therefore not available as a witness, the evidentiary record assembled by the State of Florida wasn't as fulsome as would be ideal, and Zimmerman was acquited.  But if Zimmerman had simply obeyed orders and let a uniformed officer handle the situation, in all likelihood nothing would have happened.

Perhaps the most critical moment in the Michael Brown shooting was Darren Wilson's decision to get out of his police cruiser and pursue Brown alone.  Even though backup was less than two minutes away, Wilson evidently couldn't wait for reinforcements.  It's standard police procedure to take on violent suspects with overwhelming force (which means several officers).  An officer shouldn't go one-on-one with a suspect who is much larger and stronger than the officer.  Wilson's decision to go it alone is mystifying.  He had already been hit hard a couple of times by Brown, and injured to the point where he evidently convinced the grand jury that he reasonably feared for his life.  If Brown was that dangerous, why was Wilson taking him on alone?  Given the disparity in their sizes, and the fact that Wilson was already injured, his only ability to control Brown, it would seem, was with his .40 cal. pistol.  And that turned out to be the case. 

Before the Michael Brown shooting, Darren Wilson was commended by the Ferguson, MO police department for physically subduing a drug suspect.  Physical courage and dominance, it would seem, were honored.  But the police aren't fighting wars.  Valor is something that is usually not needed in policing.  Good judgment, self-control, and non-violent outcomes should be, and for most police officers are, higher priorities.  When Darren Wilson first spotted Michael Brown, the worst things Brown apparently had done were steal some cigars and walk down the middle of the street.  This is not a situation that should have escalated into a shooting.  When it did, and Brown was shot and ran, Wilson should not have pursued him alone.  Not when the outcome of that solitary pursuit might well depend on the use of his pistol.

The grand jury decided that Darren Wilson did not act unlawfully.  But just because something's legal doesn't make it good or desirable.  Heroics in policing are sometimes called for.  But, by all indications, we need a lot less heroism and much more sound judgment.