Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Monday, August 8, 2011

Wonderland

Yep, things just seem to keep getting curiouser and curiouser...

For starters, I seem to find myself agreeing with Paul Krugman here: Credibility, Chutzpah and Debt. Well, except that it may not be as easy as he imagines to implement a sustainable fiscal policy, and I disagree with his laying the entire blame on an "extremist right." But what he says about the major ratings agencies may largely be true. Not that I can tell for sure...I am no expert in rating bonds. I'm not even sure about this claim (that I've heard repeated elsewhere):
And S&P, along with its sister rating agencies, played a major role in causing that crisis, by giving AAA ratings to mortgage-backed assets that have since turned into toxic waste.
I would very much like to know how many AAA rated MBS actually did turn toxic. Does anybody know? (Please send data, or links to estimates.)

I ask this because to some extent, I think that the bond rating agencies sometimes get a raw deal from public perception. It is my understanding (and I reiterate that I'm no expert) that what is being rated is the prospect of default on a set of debt covenants. While it may be true that MBS was treated as "toxic" by market participants (repo) during the crisis, this was more a "liquidity" event (perhaps based on the fear that some MBS were toxic, but not knowing the identity of which). As far as I can tell, bond ratings are not meant to capture liquidity risk. And perhaps most of that MBS continued to generate income. I'm just not sure how much of it did.

In any case, this takes me to the issue of the recent S&P downgrade of "long term" U.S. debt. The S&P statement can be found here.

Gosh, on the surface, the downgrade seems to be crazy. That is, the prospect of a nominal default seems remote; a real default (via surprise inflation) seems much more likely (though, this is not what is being rated). On the other hand, this is what a friend of mine had to say on the matter:

These ratings are educated opinions about how likely it is that holders of US debt will get their money back (including the yield). A AAA rating means it is basically a sure thing. AA- means there are conceivable, albeit not terribly likely, circumstances under which the funds will not materialize. This is not a direct comment on politics or the various reasons this event might happen. There are various reasons, including continued high spending, insufficient tax revenue, too little growth for the economy to pay the required taxes,... These are all lumped together in determining the rating. Of course, political types wish to point to their favorite reason, whether it is Democratic spending or Tea Party opposition to taxes. But don't let this confuse you. The point is simply that there is so much debt -- and it's growing -- that there is now real uncertainty about whether it can/will ever be paid.

What I find most interesting is the market reaction to recent events. First, I guess it's not too surprising to see how the price of gold has behaved recently; it has surged upward.


The "curiouser" part, however, is with respect to how the price of long-term U.S. debt has behaved. Here is a plot the price of Barcley's 20+ year U.S. bond fund.


Whoa! How do we make sense of the joint upward movement in the price of gold and (future) U.S. money; especially as the latter has just been downgraded?

The behavior of U.S. debt over the last few years has really intrigued me. Yes, the U.S. has a huge amount of outstanding debt out there. But you know what? The rest of the world seems to want it. Despite some bluster out there about replacing the USD (and US Treasuries) as the world reserve currency, I just don't see this happening any time soon. I know that a lot of people would like to see this happen. Might want to be careful what we wish for out there! 

17 comments:

  1. David,

    Welcome back!

    I know a little about bond ratings. They notoriously lag the market by several months. This one is more up-to-date since it seems the trigger event was the fracas over the debt ceiling, but I wager the market has already priced in U.S. default.

    I think it's also important to illustrate that a U.S. default can only be strategic. The Treasury can either cause money to be printed and inflate the federal government out of debt, or the Treasury can repudiate (is that the word?) the debt. I think there is an interesting research question regarding the politics here; namely, what age group would prefer which policy? The young would prefer growth, the old don't want to see their fixed incomes inflated away.

    I think one might explain the upward movements in gold and U.S. treasury debt through Europe. As bad as the U.S. might be getting, it remains a safe (or safer, anyway) haven. It's hard to know where to put one's money these days.

    Regards,
    Jeff

    P.S. Trepp might have the data you want; I haven't seen any research on this question.

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  2. Hi PJ,

    Sure, I'm aware that bond ratings tend to lag market assessment. And sometimes they matter; as when they downgrade from investment grade to junk status. I can't see how it matters in the present context (unless the effect was psychological in nature...but who knows how to measure that).

    Well, if interest rates fall to zero, there will never be any need to repudiate debt since it would be costless to roll over.

    I find the joint movement in gold and bond prices most challenging. I understand your "skinniest kid in fat camp" argument. But still...

    Thanks for the tip on Trepp...

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  3. Good to see you posting again David.

    My hunch: everybody wants US bonds *now*. Maybe they won't want to hold so many in future, when the global economy recovers.

    Two equilibria:

    1. Everybody wants to hold US bonds+cash, so AD is weak, so demand for real investment is weak, so US bonds+cash is a good asset to hold.

    2. Nobody wants to hold US bonds+cash, so AD is strong, so demand for real investment is strong, so US bonds+cash is a bad asset to hold.

    Not exactly a *theory*, of course.

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  4. Hi Nick,

    Thanks. Don't disparage your explanation in that manner! We know how to write down formal models with the properties you describe. The big problem is in terms of interpretation. I can also generate this behavior with standard theory appealing to a "rational pessimism" over the future after-tax return to hiring and capital formation.

    In either case, the predictions are similar (though policy implications differ). Once things turn around, watch the great cash dump.

    PS. Btw, I can't help but notice that your theory made absolutely no reference to sticky prices. Well done, you are making progress. ;)

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  5. "Whoa! How do we make sense of the joint upward movement in the price of gold and (future) U.S. money; especially as the latter has just been downgraded?"

    Welcome back.

    I would say that the downgrade is just noise and can be ignored.

    Not just US debt prices have been rising... Government of Canadas, German bunds, Japanese gov bonds, UK gilts, and many fixed income products have been rising relentlessly.

    People will buy gold and bonds when they're afraid and/or uncertain. Equities are less stable and will be sold out of fear.

    Right after 9.11 people bought gold/bonds, sold equities. Fall 2008 followed that pattern. The last seven days has also been marked by a general outbreak of fear.

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  6. Thanks, JP. Agreed on the noise. And sure, interest rates across the board appear to be falling. Are you sure that Fall 08 followed that pattern? (I don't recall gold spiking, but I do recall the yield on Treasuries going negative.)

    I still find it a bit of a puzzle from the perspective of the claim that people flock to gold when they fear inflation. If this is true, then what is making them flock simultaneously to nominal claims to future cash?

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  7. I still find it a bit of a puzzle from the perspective of the claim that people flock to gold when they fear inflation. If this is true, then what is making them flock simultaneously to nominal claims to future cash?

    Them ? Who's them ? The world is heterogeneous,
    There's simultaneously a great demand for diet products and potato chips.....

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  8. Anon: Sure. But there is also a relative price between low and high fat potato chips. Imagine that you receive information that high fat potato chips are toxic. Would you expect the price of both products to rise (relative to cash), but remain unchanged relative to each other?

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  9. "Are you sure that Fall 08 followed that pattern?"

    In Oct 2008 the USD price of gold did fall, but not near as much as equities, and it rebounded in November and December whereas risk assets continued to sell off. The price of gold denominated in almost all other currencies rose dramatically in October 2008, so from a Canadian perspective, for instance, gold was a terrific safe haven in Oct 2008, confirming the historical pattern.

    "I still find it a bit of a puzzle from the perspective of the claim that people flock to gold when they fear inflation. If this is true, then what is making them flock simultaneously to nominal claims to future cash?"

    Yes, it's odd. It seems to me that most of the marginal buyers pushing gold prices up are buying not because they fear inflation, but because they fear counterparty risk, they doubt the ability of the future to provide good returns, and they are generally uncertain about the world. Gold and bonds are good assets in that environment.

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  10. "But there is also a relative price between low and high fat potato chips. Imagine that you receive information that high fat potato chips are toxic"

    True, but I'm not sure we are in that clear of a situation. As I peruse the various financial blogs, there seems to be camps who think we are headed for 1930s style depression and deflation, and some who fear an outbreak of inflation. So...hedge your bets ?

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  11. from WSJ earlier this year:

    .P. Morgan Chase & Co. (NYSE: JPM – News) said it will allow clients to use gold as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.

    By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasurys, adding to a movement that places gold at the top tier of asset classes. It also is trying to capitalize on all the gold now owned by hedge funds and private investors that is sitting idle in warehouses.

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  12. Anon, I'm not sure I understand what point you are trying to make.

    So now one could put up gold as collateral for what? For a loan of USD.

    If gold is king, one would not need to put it up as collateral for anything; one could just use it as money.

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  13. Anonymous: Have JPM also said what is the haircut on gold? You can provide almost anything as collateral, with a sufficiently large haircut... As you mentioned, you can provide stocks as collateral as well, so I don't know where your claim "JPM is saying gold is as rock solid as AAA Treasuries" is stemming from.

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  14. One can interpret the increased use of gold as collateral as evidence for Caballero's thesis about excess demand for safe assets ?

    WSJ: "Gold's strong price gains in recent years have seen its appeal as collateral increase. Clearing houses and other institutions have looked at introducing new sources of collateral since the financial downturn in 2008 highlighted inadequacies in counterparty risk management in the global over-the-counter market. The G20 said it wanted to try to reduce financial market risks by putting more products into clearing houses, increasing the demand for collateral as security against risks."

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  15. Anon@6:31. Caballero's thesis is an asset shortage (not excess demand, cause prices can still clear markets). And yes, it is consistent with the asset shortage hypothesis. Any attempt to manufacture AAA assets is also consistent with this hypothesis.

    You might want to see my link here:
    http://andolfatto.blogspot.com/2010/08/asset-shortages-and-price-bubbles-new.html

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