Friday, January 30, 2009

Addendum To SPX Long Volatility and SPX Levels: Realized Long Dated Vol vs SPX

The above is long dated realized volatility for SPX - 220 days of realized volatility which is about 1 year.

Clearly shows the tracking of long dated volatility, or risk, and the price level of SPX.

The realized volatility explosion is "persistent" or even prescient where in the end the SPX trading level over the long run will be in accord with the SPX volatility. Notice how the drop in long dated realized SPX preceded the bull move in SPX from 2003 to 2007. Given the effect of correlation in the index, the rise in SPX volatility is more often coincidental - yet the obvious improvement in realized long dated SPX vol has to occur before a rally starts in a lag.

SPX Volatility: Long Dated Vol Not Correcting

SPX Vol surface not correcting - still building large "mid range" formation which means either new vol regime is low 40s and extremely large peak still to come, or that the rules of vol have changed. Vol regime in 40s is unsustainable and indicative of an economy in extreme stress for the the long run.

SPX volatility should be watched in the long dated implied, one year or longer, to consider the "risk" in the equity market and also to calibrate to ideas on credit spreads. SPX (comparable to AA plus credit) in the long dated implied space has not corrected form November crash. The short dated implied which the VIX picks up is incorrectly providing a sense of improvement. This explains why high grade credit spreads are sticky and haven't followed the SPX market when it moves upwards.

GDP Deconstructed: Financial World Trade Center Occuring

Written in a bit of a rush, GDP a catastrophe.

While the broad index is down "only" 3.8% versus expectations of down 5.5%, the parts tat matter were every bit as bad as expectations and in the case of prices far worse than imagined.

Personal Consumption (PCE) part of GDP was down 3.5% as expected.

Core prices (so no energy which would make this far far worse) for PCE was .6% versus expectations of 1%. Inflation is nonexistent and has obviously gone deflationary.

The broad deflator was down .1% versus the expected .4%

The pics below do not have detail (haven't figured out how to cut and paste to a blog higher resolution) but they are form 1956 so in a way they are better as force you to see the pattern.

Keep in mind all the following depicted recessions prior to this one were monetary recessions, with almost all econs agreeing that the slowdown in consumption, deflator, and personal consumption deflator were all directly related to a period where the Fed was tightening in response to either currency and inflation in the 50s and 60s or inflation in 80s and 90s and 00.

Though post 9/11 had some bit of a fiscal shock, this time around the drop in GDP is substantial and, more importantly, is occurring with the Fed starting in a neutral or, if you follow John Taylor (Taylor Rule), in an overly easy status. This crisis is all consumption and fiscal - not monetary and is preceding the Fed - a runaway train.

The Personal Consumption Price Index (core) since 56 - 4th Q 08 +.6%:

The Personal Consumption component (again all prior dips were result of Federal reserve monetary policy, this isn't) -3.5% 4th Q 08:

And the broad deflator - tracking and confirming the PCE deflator above:

Note how this time the personal consumption engine is leading GDP, not following.

The data as per the nations capacity and ability to employ people and a precursor of what the savings rate may do (rise substantially) are a catastrophe.

One should be seeing this data in same gut visceral feel you had when the World Trade Center went down. In crass economic terms it is far worse, and in terms of the safety, security, and well being of the American people - this data set is far worse htan World Trade.

Sunday, January 25, 2009

Where We Are Now; How We Got There - Morality and Geopolitics

I was stunned reading the NY Times this Sunday, article after article goes on to confirm my worst foreboding; or rather what were issues of foreboding are now here larger than life.

I. Where We Are Now; “All The Family to Dinner”

A great writer or trickster (often one and the same thing) is William Gaddis and in a few of his books he uses a fulcrum point of epiphany, of either finding what one fears or acquiring self knowledge of something one always was or knew but had hidden or was obscured. His key citation is of Emerson quoting Thoreau:

“What you seek in vain for, half your life, one day you come full upon, all the family at dinner. You seek it like a dream, and as soon as you find it you become its prey.”

That’s the feeling, the sense of dread but also one of “no way out” as you stumble upon the whole clan and find it all as you expected or imagined and the clan looking up, all of them, as they take you in and ready to respond to your intrusion.

I suspect this is the core feeling now for many depression economists of good character who like military commanders who learn their warcraft well but war finally occurs they are sickened and repulsed in the practice their craft and even at first falter. Depression Economists must feel that way now as they do know depressions and the mechanisms and the connections of them; but they also know the terrible wake the depression will lead. The economists and leaders they consul seem now like the person who just opened the door and there they are “all the family at dinner”. It seems most economists are silent and somewhat stunned and have yet to declare what their craft provides in prediction.

This is hopefully that stunned shock in finding what they seeked and explains the lack of vigor and action and intense commitment to forestall a tragedy now being shown by most economists, that it is just that, initial shock, as they stand looking the family over.

But the family, in the midst of dinner interrupted, will be, or is in midst of, taking action.

Back to the Sunday NY Times, once again a “movable feast” of gloom where only the tempo is picking up and more and more the results seem inevitable.

What is going on?

First, I know what is wrong in the majority of economic stances and views, and thereby what is wrong in resulting prognosis and prescriptions - a seriously misplaced moralism.

As we approach “our” depression, I am starting to realize that Keynes' most important attribute likely was that he was gay.

Why? I think it allowed him to consider economics and social construct with an absence of judgment, as I am sure as he was always on the anvil, in someway or somehow, of having to accommodate or explain or hide his homosexuality in Edwardian England; he knew firsthand the effect of the judgment on his homosexuality as a case of morality and likely realized that this was an avenue that provided little truth or improvement in the person judging him. This had to have developed a studied absence of values in Keynes economic thought, or applying the lenses of morality to viewing how an economy could take a crapper and how to get it out of that status. Yet this amoral stance was augmented with a very deep and fierce sense of civics. Keynes was a patriot.

Concentrating on civics and the status of civics, and freed from having to judge society, Keynes was able to see with a glance what almost all missed. That the core functionality and ability of the society was unchanged and the current times were actually more promising than prior times. The problem was the mechanism and structure of the economic structure of society and even there Keynes was a humanist and suggested that if Western societies wished to enjoy many of their finest attributes, then Western capitalistic democracies were required and always would have an inherent instability which would make for periodic crisis. That the central governments main purpose is to offset or make these periodic economic storms the least damage as possible. Minsky is of course the key “reader” of Keynes (how Minsky described his life’s work) who developed this aspect of Keynes which is most relevant to financial markets.

But Keynes not only felt that morality and qualifying merit in society was a totally useless avenue to pursue, but that it would even impede the solution.

All through this morning NY Times I see this terrible flaw of applying "judgment" in both the most usual analysis of how we got here and also in what the solution should be. All I read is economics as written in Leviticus. Blinder’s “Six Blunders” are all the blunders experienced formulated by base greed or selfish cunning gone astray. “..[P]eople in authority owe millions of Americans an apology.” September 11 was our fault as the NSA of the time Clarke told the 9/11 commission. Apologize! says Blinder.

Ben Stein this day and age’s Will Rogers or Mark Twain, our fabulist, recites tales of woe about a friend living in terrible denial who is likely gonna get it and get it good even though she is a “sweet lady”. But her shallow materialism and lack of reality is such a sin that this will be inevitable. Then he moves on to his own son’s lack of awareness of his plight. The core of the problem is American’s inability to be prudent and save. We must once again become a nation of savers and Stein suggests we should work harder and with greater acceptance to the reality of life.

Then the ill understood and thereby fearful credit default swap bogey man is trotted out by Gretchen Morgenson, who has the be the world’s master in diving into and intelligently writing upon areas and topics of great import which she has not even a clue as to their inherent reality. It makes her columns rich fields to help put together your own thoughts together, and her columns are fertile pre-finished intellectual ideas, much as a sour mash is required to make in the end good bourbon. But she shows again the central error, the great danger as out pundits and observers wade in – CDS market was where folks “raking in” premiums like river boat gamblers while regulators let this immoral casino carry on with no supervision as if the gamblers were slipping them C-notes at the end of every session. Then she goes on to mangle a very sensible “rule of law” idea which is an open outcry market for CDS – but quickly removes herself form being accused of anything sensible and wades into bizarre margin requirements completely out of accord to the nature of risk. Again, morality, or lack thereof, seeps throughout her thinking.

And of course evoking the great film “The Talented Mr. Ripley” in Creswell and Thomas “The Talented Mr. Madoff” article puts this cheek to jowl to all the other articles.

It seems the USA has never lost its Winthrop and Puritanism, always lurking to remind us that all is God’s and all form His grace and if we do not understand whether or not we are “saved” and lead a moral life to assist us in this revelation – well we are to be flung into hell. This is really still the main economic theory ruling the land. We are a sinful and willful people who must be brought back to Yah-Weh, to Jehovah, to the correct way of life.

I think a Mayfair Crowd meticulously educated Cambridge gay man of impeccable refinement would have either totally missed this message and if he did note it he would have realized the huge road black that attitude presented to the solution. First in most considering the solution as just more of the immoral behaviors that brought us to the crisis in moving the spend thrift ways of the populace to the national balance sheet, and second with most considering punishment be meted out to those who brought this on us be a critical part of the solution (Apologize! Repent!) and some measures of the pain and suffering they caused are self realized.

Both of those approaches are a catastrophe on their own right. Or existing rules and regulations are more than enough to find and eliminate the Mr. Madoffs of this crisis and this is solved through empowering the Feds and adding a few beds to a federal penitentiary. Mr. Madoff in house arrest is not our finest moment. But to go on from there and start witch hunts and financial pogroms and to not accept the basic sound and good character of our business leaders and politicians is a route of self flagellation and an attempt to appease Jehovah and will eliminate the necessary business leaders and financial risk takers we will desperately need.

The path to being prudent savers and sober cautious livers of American life is also an avenue of catastrophe. The core driver of all pain and suffering we may receive shortly is the savings rate of Americans going from 0% to in excess of 5% in short order. The shock in the complimentary drop in consumption (“jam today or jam tomorrow”) will force a massive over capacity in American industry and service. In short a depression.

As Keynes said:

“The resources of nature and men’s devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life.”

And more importantly:

“"...most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits--of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities...if the animal spirits are dimmed and the spontaneous optimism falters... enterprise will fade and die,"

The last quote taken from the all important “Chapter 12” of the “General Theory”

This exuberance, near irrational hope in a future better than today, a “rent” schedule of improvement of your lot in the future is the fundamental driver for all Western democratic capitalistic society. This central and indispensable notion of hope and spirit defies quantitative metrics and analysis and is not often embraced and more often than not shunned from debate and analysis and policy.

And this is the main attribute of the current crisis, despite our “audacity of hope” man in the White House, is actually the reverse – not only a crash in hope and spirits but even an embarrassment with our past enthusiasm. And a desire to stamp out the animal spirit and hope in some misguided and terribly cowardly and loathing of our present makeup in hopes a salvation results in the afterlife to save our sorry souls. This is what I think is really meant when we talk about the terrible burden a fiscal stimulus would impose on our future generations – it is really that to mollify or save ourselves from current pain and suffering prevents our salvation and throws into doubt our chances of the after-life.

II How We Arrived Here

The above American values of sin and redemption; crime and retribution – of seeing social values through a prism of morality and whether one is living a righteous life in the ways of the “elected” or “saints”, does allow society to bear down and produce great achievement under duress as our history shows. But it also has delivered great pain and suffering upon others who did not subscribe to our formula as to what the moral life is. It also is the greatest danger to reclaiming the “animal spirits”, the enthusiasm and belief in a manifest destiny, American exceptionalism which has also provided wonderful status of life from the third fourth generations of immigrants, towns in Mexico, and even African descendants who can become President.

We are not a lazy nation but one of the hardest working on earth. Anyone who has wondered at traffic jams as the midnight shifts end in Manhattan or that one has to get on NY City parkways prior to 6:00 AM can easily observe that.

Families are careful and prudent, work hard and save, and plan carefully for their children’s future and lay the base for generational success. Our loathing to retire, to stop work, is obvious, and no developed nation on earth has fewer holidays taken.

Lazy and spendthrift we are not.

Large dreamers, the masters of the animal spirit (at least so far) we are.

So how did we get to this point if it was not a sudden and bizarre dedication to immoral or at best amoral behavior and an orgy of enjoyment of the present?

That comes to the second series of NY Times articles that caused me much stress this morning.

The first article was discussing the unemployment situation in China. Now it should be clear that this is not really representative of China, but the employable part of China – the 250 MM educated and technically adept workforce. The other 750 MM is still mired in a peasant and vassal like existence. But 250 MM is about equal to the entire populace of the USA and dwarfs the educated and productive part of the USA population. So it certainly has great impact. What’s more that amount of world caliber productive employable people was about 25 MM only 20 years ago, so this growth is truly an incredible achievement and something the whole world has great interest in maintaining and promoting. What’s more the growth in those becoming educated and trained and making the transition from peasant and urban poverty to this world caliber workforce requires China to maintain a 7% growth in GDP just to absorb, to break even. This part of the populace is the traditional source of revolution and social change in China. It is the core of the makeup of the Maoist revolution and the subsequent social organization post Imperial and kleptocratic China. China is also a plutocracy which unlike democratic regimes the people have a very narrow and small list of specific folks to target and blame if things go astray. So China must produce, in the long run, growth of at least 7% or massive social unrest will result. Tienanmen Square was the last showing of this beast and the fact China completely embraced this proto-capitalism model shows both the need and the great fear underlying Chinese structure.

In the 1990s, China had to design a system that would gainfully incorporate well over 200 MM people in short order or it would slide into anarchy and terror and absolutism. They have succeeded.

But, the major problem, and also a major attribute for China, was the emergence of a hegemon power which allowed globalism to exist, not seen since either the Edwardian England or “The Twelve Caesars” in Rome. That power, the USA, allowed globalism by becoming the “buyer of last resort” and by evoking “soft power” via mercantilism versus hard power of the “boots on the ground” like Rome or England. Though certain key outposts were maintained with “boots on the ground” like Okinawa or Korea, these forces were more often than not welcomed or even insisted upon by the host countries. Global trade flourished where to gain entry of the system a country would ascribe to pax Americana and in return could be the mercantilist rather than in the time of Britain, the major power was the mercantilist. Currencies and command economies could be managed and applied which deliberately set terms of trade such that the USA was eager to move production to these foreign locales. The USA itself was moving to another phase of economic production of service and technology and also finance which was the hub administrating this globalism network of trade. In short, the USA to prosper deliberately allowed itself to be “used” in being the recipient of uneconomic terms of trade of mercantilist systems.

Japan prospered under this pax Americana system, so too did the “Tigers”, and then so did China, the largest client of the USA system.

China was certainly aware of this “deal” and must have felt that they could take advantage of the USA as long as required until China could produce internal terms of trade such that the exporting part of the economy would become complimentary and supportive to a vibrant near self sustaining domestic economy. But that has yet to occur and as long as tiered elitist system carries on (albeit one based on national merit testing) large swaths of China are basically welfare states which exchange and support has to be forthcoming from the export sector. The fact that there are over 250 MM productive workforce now in China was supposedly self evident that this shift from export trade to domestic economy was a given. And any suspicious fellow had to only go to Shang Hai or make the tour of the “100 Cities” to have all suspicions cast aside and an eager fan of China would emerge – often with the added insight as to newly discovered errors in the central hegemon, the USA. It has even gotten to the point where the obvious shift from the hegemon to just one sorry member in a multi-polar world had befallen the USA. But again, the story in the NY Times shows China is still riding the dragon as all mercantilists do and that their power and prestige and ability to function as a society is a function of the USA status. Ergo the shock in Chinese students finding they cannot get jobs and the correlation of near one with Chinese economy with developments in the USA.

Nial Ferguson is wrong, it is not Chimerica but rather Rome and Egypt, Athens and the Aeolian wheat growers in the Black Sea, the UK and India, and so on. What is different is none of those vassals to the hegemon had 1 billion people of which 250 MM are literate and technically adept. Whatever the form that China pursued, the threat to USA security was always apparent. A strategy to be able to defend the USA and utilize the Chinese presence in constructive ways insisted on China being a core focus of all USA foreign policy efforts.

Before being elected in 1968, Nixon made several tours of the world ostensibly as the spokesman for Pepsi-Cola. One such tour was in Germany where the elder statesman and leader Adenauer, the father of modern Germany, pleaded with Nixon that the USA must be mindful of the USSR successes in propaganda and pressure on Europe, that Europe was being ignored by the USA with their preoccupation with Vietnam and a history of China bashing. Adenauer suggested rapprochement with China to split the China-USSR axis and open a new front against the USSR. At the same time various leaders in Eastern Europe such as Romania’s Ceausescu also hinted that China may be an important counter to USSR power. Nixon went on to SE Asia and noted that the real heavy hand were not Maoist, but rather Neo-Stalinist with roots in Europe (Sorbonne) or Russia. Nixon also visited Chaing Kai-Shek in Formosa and when Chaing told Nixon the time was ripe to invade the mainland, he realized what a shaky and delusion ally Taiwan had become.

Then Nixon went through the process of leaving Viet Nam – which was really an evacuation - and it was important to at least have China standstill. In the crux of the Cultural Revolution Mao saw sense in this and he did.

The ability to work with China was a surprise and noted by the USA and in 1972 Nixon made his historical visit to Mao and the seeds of the partnership were laid.

From that point on China left the domain of the geo-political Kennan “containment” strategy which eventually destroyed the USSR, and was offered to join the pax Americana mercantilist system that Korea, Japan, Singapore, and even to some degree Indonesia was enjoying. The ravages of the Cultural Revolution taught China that the Jefferson/Trotsky periodic and constant revolution would not work given the size and unwieldiness of China. So trade and mercantilism was the answer. Tiananmen Sq clinched this as being the paradigm.

The USA had a choice of either continuing to contain China as they had the USSR and all the treasure that would require, or allow China access on disproportionate terms in China’s favor to the USA markets. The choice was to double the soldiers in Japan or in the indefensible Korea and add three more carrier task forces; or allows that part of growth required in China to maintain stability to be based upon selling into the USA markets. Basically it was (and still is) “guns or butter”. Unequal terms of trade were to be manageable as shown by the success in accommodating Japan and Korea and to some degree Germany in the same way. In the 1960s the USA was supposedly going down the tubes as German trade and German sound DM were obviously superior, and in the 1980s the same thought was applied to Japan. Germany was able to successfully raise productivity and allow the DM to float so that part of their trade surplus was not the results of manipulated currency but soundly based on equable terms of trade. Not only that German domestic demand increased substantially so that trade with the USA was not critical. Japan found that when limits of trade were reached and the USA was adversely affected to the point it was not longer tenable; the USA simply moved the Yen to sub 100 and eliminated the excess trade that was manipulated. Peaceful and close alignment allowed a managed response to this problem form Toyota plants in Georgia to Japan’s own domestic markets stressed, but still the “lost decade” that followed the currency change the USA insisted upon still showed the USA hegemonic position and power. An important and critical part of a weaker power having unequal advantageous terms of trade with a stronger power is the assumption of debt or assets in the end market assets, otherwise the mechanism which enable the mercantilist trade flow cannot be enabled – which is basically the Yen kept at levels cheaper than any “true” purchasing parity or real value vis a vis the dollar.

Now here is the rub and the key element to all the above and the main issue regarding the current economic crisis. That asset accumulated in the importing country’s currency has to be maintained at the purchased value otherwise it becomes impossible to maintain the currency level that allows the unequal terms of trade. In fact, in many ways, this asset does not exist but is the record of whatever economic fiction the exporting country applied to prompt the trade. Further most developing countries have an internal axis of fiction as well, or “trades of decline” as Jane Jacobs calls them where the currency generating areas of the economy have to send transfer payments or repatriations to the non-producing areas. Often those areas are also parts of the country where dissension and social pressure can evolve. So Japan had both the ever accumulating fiction of supposed wealth in US Treasuries, but if it were touched the fiction of the Japanese manipulated currency becomes apparent, and also large transfer payments were being made to non-productive areas of the country and sectors to maintain certain important cultural legacies or core support for the LDP party (rise farmers and rural elderly – Hokkaido). In the end Japan accepted their position and to maintain political power those in charge zombified the banks and the country “ate” the lost decade.

China is in the same status as Japan but perhaps in even more dire position.

The trillions of US Treasury are a brittle support edifice which if touched could uncover the true competiveness and status of China. This is perhaps why such deep concern is expressed in any loss that Chinese money management produces in dollar assets. Further more this asset creation that China required to balance the “fiction” in the terms of trade was massive and also occurred when the USA was not in a strong growth phase as Japan enjoyed in the 80s, and even in support during the 90s. USA had just entered a long war in the post 9/11 world as well as suffered wrenching re-organizations in corporate governance post Enron and Tyco and WorldCom, and was emerging from a market mania in dot com economy crashing. The absorption of the Chinese capacity for good destined to the USA market, realized through fictional pegs in the currency, is growth or is one side of a Pacioli identity which has to find another side. If the major cash flow realized destined to China has to be maintained in stable and unobtrusive US Treasuries, otherwise a “true” accounting occurs, then a proxy asset liability structure has to be developed in the USA.

And there you have it. Sub prime RMBS. I cannot think of any other market that might have occurred to fill that imbalance. But noting what has happened in the past, through a chain of causality, American financial institutions insisted that this time the assets would be AAA unlike times past when the investment was in EMD or other volatile assets. Not only this but to a lesser degree the whole world affiliated with the USA was allowing China to do this – and the whole world through various financial chains led back to the USA and then to RMBS. RMBS structures then established an absolutely standard bubble in the core asset – the USA home. Risk control was applied but based on data sets of past where such international flow did not exist and the regional makeup of mortgage banking provided a risk ameliorating profile which made the ratings agency and internal data reasonable in the support of the AAA rating. People were not fools but for not seeing how a market dominated by regional USA economy had become and integrated global market. There was to be no portfolio effect.

This also allows parameters as to the size of the USA problem – it is roughly in synch with the size of the Chinese (and to a lesser degree some other Asian exporters and oil producers) story.

All of this is good news and bad news. First perceived in this way – which is the correct and valid version of how we got here I feel – takes the average American person and society off the hook. We have a sub prime crisis because we did not want to risk putting young Americans in harms way on the Asian battlefield. And that remains the problem as there is still an excellent case to be made that to provide these imbalances to continue will allow a more secure and peaceful world. To eliminate these imbalances and insist on China (and others) to exist solely on the realities of their own domestic markets would lead to war as it is very unlikely that the current leadership of China will “take the fall” and fess up and admit they blew it in face of 200 MM very well educated and angry Chinese youth. Japan did take the fall, but we also cushioned the blow and worked closely with great respect with the Japanese nation. China will likely try and buy time and diversion by moving first on Taiwan and then perhaps India and then assist North Korea to be a great problem. If USA does not realize why this occurring we may respond with protecting Taiwan and at the very least a full war footing will be adopted. But that is if China responds as normal folks will. After Tiananmen, Chinese leadership actually reversed the direction of governance, the assassinated Hu Yaobang’s policy was instituted and Zhao Ziyang deposed. That steady and enlightened ability to move in such dramatic fashion to repair error has much to do why one should be hopeful. Also, despite Geithner’s jingoism on “manipulation” and the USA leadership inability to perceive the crisis as I outline above and instead pursue their own “blame game” and moralistic based crusades, despite this dismal start the USA may check up and realize what has happened and what could occur.

But still, the NY Times now “on any given Sunday” sickens me and frightens as to date I do not see these positive trends forthcoming.

Instead I see “all the family to dinner”

Saturday, January 24, 2009

The Hooey in Peak Oil

OK (Chart swiped from CIBC )

Here it is - someone has to explain this to me. Central part of "peak oil" is the graph above which shows the incremental cost of new oil.

Suddenly, out of the blue, incremental cost to make one more barrel of oil appear out of the ground moved, after decades, from sub $20 pre 2002 to just shy of $100? What happened in 2002, were the Saudi fields nukes? Did I miss that?

That's ridiculous. We can choose to make energy from bio-fuel or the $60 or so per barrel for Ft McMurry oil, but the least expensive incremental cost to make one more barrel of oil is still south of $20. And it will be so as as long as Russian and Middle East reserves are not depleted.

This chart above (er that part before 2002) also shows where oil is headed. Also shows the pain felt in many parts of Canada like Ft McMurry or Halifax yards servicing Hibernia....

Violence in Trade Data Shows Enormity of Crisis

Swiped the above from a terrific blog the economist Toma referenced: "Calculated Risk"
They were posted to outline the price of oil's impact on trade as well as to qualify Geirthner's China comments on trade.
What I find interesting is not in terms of trade and China - though China is about 1/2 of the above data and the interesting essay long question is what this change is doing to China, but more so that these pictures are a very clear view of what is happening to the US economy.
In the end of the Clinton era Japan hit a wall with little effect on us but for their mercantalistic trade impact. The first Iraqi war also had large impact as oil went through large gyrations. Trade moves can be explained by these exogenous factors to USA domestic economic waxing and waning.
This time around there are little in the way of exogenous factors.
Trade numbers have gone through these incredible shifts due to the developments in the USA domestic economy
This gives us an early read as to what is happening to USA consumption. Foreign imports have dropped at around a $600 billion annual rate in a shock move. The rate of droppage in US imports has dropped over 20% in a very short time span. And these are likely snapshots midstream of the total move that is occurring.
This translates to a drop in USA consumption of around 6% which implies the USA ha increased their savings rate from 0% to well over 5% in about 4 months. It also makes mincemeat of the NBER "declaration" that the recession started in 12/07 - the recession clearly started in July 08 or later. This is even more appalling considering the speed and violence of this wrenching move. The 12/07 start date helped provide some "same old, same old" calming in terms of a "normal" developing recession.
If one uses the trade data to provide a "seismic" measurement of the USA domestic economy, a picture of an incredibly violent crash in USA consumption/investment becomes apparent as well as the view that we are still midstream. Better analogy is we are in some tenuous shelf on a Thai beach on a recent Christmas and the first of three tsunami waves has just passed by.
The eventual rise in savings and drop in consumption looks like it will be well over 10% of GDP.
That will likely result in are touching or being in reach of touching 20% unemployment.
The only small but important "hope" in the above data picture is that the swiftness, size, and velocity of the move indicates that it is technical, meaning it is not form inherent problem or sea-change in the USA economic structure but - and I know it is a large "but" - for the $700 billion to $1 trillion foreign flows imbalances which insisted on the bogus AAA RMBS assets creation. This means that the start of this crisis and still likely the main problem is still a very enormous bank credit crash. Fix that with a Bagehot like action in total finality and then mend the drop in consumption and calm folks so they drop their savings rate and we can fix this with the same speed and violence with which it is occurring. But if we do not match tempo with tempo, then no fix will work and if anything a Keynesian "muddle" develops to augment the original problem.
These trade pictures above should make you pause long and hard and think.
If we do not provide the fix we are entering an economic setting which we have no experience of, even the 1930s.
These are very very calm and reasonable thoughts which make this all the more terrifying.
We have no time. We have perhaps already crossed the point of no return but I suspect we have a few more months. But the violence of this trade reversal data is amazing - like being in the lifeboat and seeing the fully lit Titanic upend and start the slide this is an amazing and singular thing to see and witness. Rather watching this given the political action and will shown to date, it is more like being on the Titanic stern and watching the slide into the water. We cannot let this get to the point where massive social unrest and societal pain on a global basis forces a solution as that is always the time of demagogic leadership and fanatical thesis.
Write a letter to your Congress, Senate, and our new President - or, go buy a gun as the poor and desperate will come calling.

Friday, January 23, 2009

A letter to a congressional staffer in charge of the economic issues

I just wrote this to a contact I have developed with my congressional representative office. The congressperson is a senior member of the appropriations committee.

I advise reading this - because it likely means you have interest or are practitioners in finance and have some pragmatic experience - to write your representative and stay at it.

This is becoming an incredibly dire national and global emergency.

My letter (and there have already been a few):


Once again I am not sleeping at night.

The current environment is as sweet as it could be to someone with my trade - ostensibly an expert in long term fixed income investments which is the key area as pension funds and investors set out to survive this crisis. So I should be happy. But a combination of both the pragmatic need to have a platform (which is at risk) to practice my trade along with a civic minded concern of the misery and extreme political pressures that may be forthcoming have returned me to despair.

The "American Recovery and Reinvestment Bill" looks like it will fail - not in passage but in meeting the intent.

Just, in robust fashion, consider that the amount that went to Appropriations for the $825 billion bill, as per Appropriations rules, was for $358 billion of spending, which is a good indication of the actual "meat" or true stimulus in the bill.

The rise in savings and drop in consumption that has either already arrived or is coming shortly is about $750 billion and if it is matched with only $358 billion then it will continue to rise to in excess of $1 trillion. That is standard econ 101 which all economists, right and left, agree upon.

If the increase in savings and drop in consumption goes to $1 trillion, then we are approaching a 10% excess in labor and capital investment and as the capital investment cannot be sold given the fact that little in liquidity or interest in buying, the adjustments will be made in labor. This implies a unemployment number in mid teens. A very persistent feed back loop develops at that point which is why unemployment went to mid 20% in the 1930s.

Current market prices are reflecting this as a new wave in bank failures seem to be upon us, international trading partners GDP is being reduced on a leveraged basis to decrease in USA demand, and the negative earnings resulting from excess capacity is forcing re-adjustment of prices in the stock market. The SP 500 stock market index has continued down from highs around Christmas,as the Obama-Biden Plan and now the "American Recovery and Reinvestment Bill" is causing dismay.

We are back to the edge where we are at high risk for an explosion in unemployment, corporate default, nationalization of the larger banks, bank holidays, and a stock market crash. Already massive damage has been done to retirement plans and pensions to the extent of never being able to repair, and another adjustment down will produce a chronic crisis in that area of our populace least able to protect themselves - the elderly. Migrations to more comfortable climes for retirement will cease and massive numbers of elderly in poverty will remain in XXXXXXXX.

As I have pointed out in the Fall, I am still seeing little if any signs of literacy of key economic concepts and the realization of the potential outcome in Congress - otherwise how did the "American Recovery and Reinvestment Bill" leave Appropriations? Why is there no terrified and shrill and even hysterical debate? I could be wrong but the potential outcomes I outline are in the realm of reasonable discussion and therefore responsible people should be extremely careful and diligent now. I do not see this occurring. I do not read about this occurring. I do not perceive the necessary responsible and civic change has occurred.

I think my insights are topical and correct, please put me to work. We are now all Keynesian and right left, Republican or Democrat, as in war time, these labels are not of issue. After the rescue and some normalcy returns we can all divide back to our various disciplines but for now the country requires steady civics.

I can also gather a very learned and credentialed small group for Congresswoman XXXX and for your education. Please relay this to the Congressperson and also please accept the market outcomes as they are developing and accept the information they are providing - the "American Recovery and Reinvestment Bill" is stillborn.

I see an obvious chain from the first week of January as the first draft of the "Obama-Biden Plan" was released to Romer's disastrous defense of the tax effect in the "O-B Plan" to the President's inaugural address and the development of the "American Recovery and Reinvestment Bill" - all have obvious economic flaws that will result in disaster. That is what the market is relaying to your office.


Oil Contango - Fed Funds Again

Another view on comparing the oil contango with Fed Funds path - how the market is pricing the Fed Funds change which will have equivalency to the market expectations for nominal GDP growth change. Think that all would agree oil shares much the same expectations - or it should.
The oil contango shows that the market feels strongly that growth will clearly be re-instated and that a completely successful reflation will occur as shown how future prices defy the cost of carry and trade steadily upwards. Given the obvious inventory of oil in both transport and also documented such as IEA PADD II etc etc, the contango can be read as only the most adamant and enthusiastic bullish future expectations of USA nominal GDP growth.
The CL contract in 12 months netted against the front CL contract:
But there is a diametrically opposed expectations in the Fed Funds market expectations. Fed Funds will over time have equivalency to nominal GDP. While there is a lot of noise in the first year at the market some robust insight can be had by looking at the future for Fed Funds one year forward versus the front Fed Funds contract. That difference will reflect the market expectations on change of nominal GDP. Looking at that chart, we can see how the crisis gobsmacked the market and expectations were for no growth for a year. Though noisy, some expectations of future growth expansion improved to the end of Oct , but then "something happened" and we have steadily deteriorated market expectations for the chance of reflation to this day.

The two schedules above both share that the most important factor is nominal growth in USA GDP. One is completely out of synch with the other. So one must ask which market is more efficient - most liquid and effective in relaying expectations. Obviously that is Fed Funds. Therefore the difference between the two markets expectations has to be inefficiencies in the less liquid oil markets - or put another way, oil is a manipulated inefficient market. The extreme moves in the contango around key settlements indicates that likely efficiency is about to return to the oil market and to force it inline with the macro USA key factors.

Thursday, January 22, 2009

What I Know and Believe

What I Know

A set of maxims.

1. There are two crisis occurring right now, one is a bank crisis and the other is a crash in future expectations.

2. The budgets/costs of the two crisis have to be differentiated and considered separately

3. The bank crisis is a classic Bagehot-Kindelberger bank crash where the inherent instability in open market financial money markets given excess growth and too rapid expansion of leverage results in sharp cusp like failure and a rush to hoard cash by banks as they cannot differentiate who might fail.

4. The academic literature on how to manage this crisis is deep and well studied, from Bagehot’s “Lombard Street” to the ex head of the Swedish Central Bank’s essays to Kindelberger to Minsky.

5. The methods to manage a bank crisis are of a very limited set but no one can find an example of a failure in policy once these remedies are applied.

6. The “cost” to repair and fix a banking crisis is really not a cost, but a certain amount the lender of last resort has to expand their balance sheet. The concentration of problematic assets of the system, apply punitive management changes of the problem banks, make creditors whole, and ruin equity holders or substantially reduce value so precedent is set.

7. Never can the lender of a last resort work on with the bank that is being rescued's executive post-rescue. They mist be removed in punitive fashion.

8. Total balance sheet expansion for our banking crisis was once about $750 billion but as contagion spread given the lack of a lender of last resort operation other assets failed such as derivatives based upon bank counterparty risk (AIG).

9. Now the required and inevitable lender of last resort operation is equivalent to the Federal Reserve balance sheet which basically has to be returned to the private sector banking system at some point – about 1 ¾ trillion.

10. This balance sheet expansion is not a net amount but by definition a gross number – net end csts will be about ¼ of whatever the required balance sheet expansion. (Based upon historical consideration of bank crisis last 50 years on global basis – literature is deep and the above isn’t debated.)

11. The NY Fed has effected the end results of a post lender of last resort operation as shown how solid and pre-crisis levels key money market relationships are – but unless we wish a command economy this has to be returned to balance sheets of private banks.

12. The other crisis, resulting from the banking crisis, is a classic Keynesian/Minsky implosion of demand which shocks capital to a large excess capacity or excess capital. The offset to this is a drop in consumption and a comparable rise in savings and drop in gross investment.

13. Profits are near impossible to maintain given the cost of the fixed capital investment and capacity cannot be liquidated – so most industry is thrown to a deficit

14. No investments are made as the expectation develop that this state will last long enough to assure negative return on investment.

15. A spiral develops in investment and drop in consumption and attempt to remove excess capacity and is characterized by deflation; no future expected return produces an excess return to the cost of capital.

16. The public sector must fill the void of the drop in consumption and investment to initially an amount equal to this drop and with utility such that a positive expected return to investment schedule – Keynes called in “rent” returns.

17. This is a real spend, a real cost, but the public sector will have the assets or investments resulting from this spend on the balance sheet and is an offset.

18. This amount is roughly equal to the increase in savings – which is going from 0% towards 7%, or at 7% about $1 trillion. However the unresolved bank crisis along with further cycles of the Fisher Debt Deflation Spiral means a meter is running and shortly will be well in excess of $1 trillion and likely is expanding at some power law and not linearly.

19. The amount of fiscal stimulus is at or over $1 trillion now but that is not to be a spot actual dollar spend, rather it has to be firmly in expectations and certitude that it will be spent has to develop. That means spend on non-abstract clear large projects assists in the speedy development of those expectations.

20. There is much truth to “only thing to fear is fear itself” as that captures the spiral of expectations in the future problem. The ability for the USA to easily produce such a fiscal stimulus is obvious and easily proven through history and experiences of other countries - mostly recent experiences

21. The bank crisis is fixed now as far as liquidity, but until a removal of toxic assets and freeing bank balance sheets so lending and then resulting multiplier effect occurs, it can only be stop-gap and maintain with by definition no growth.

22. The Federal Reserve has to conclude the Bagehot lender of last resort operation by removing problem assets and also, just as important, removing all executives of failed bank(s). Carping about executive pay is meaningless.

23. The fiscal stimulus is getting larger and larger and the political process must be able to manage the vast sum without either ending in total gridlock and stalemate or a kleptocracy (why World Bank fiscal stimulus and projects rarely produce growth in LDCs as corruption results) Also shows why FDR was so clever to realize an SEC was required. But we likely have passed the legislatures ability to implement and manage the large stimulus now required – it will be solely a executive task. Even there political capability is being swamped by the task.

24. But, fiscal stimulus will occur sooner or later – think on that why that is logical – standard Pacioli identity. Dual sided accounting. Otherwise means a organized democratic community which is well connected now will allow deflation and depression ongoing. I think not. Either enlightened political movement starts, or a demagogue/fascist captures imagination (Huey Long, LaGuardia, Hitler, Mussolini), or classic socialism seizes n behalf of the state the methods of production, or an external motive for the fiscal stimulus is found which is inevitable war which is only variable that can generate unity and the size of stimulus to “balance” the books. The right way to read WW II was it was caused by the inability f the USA to get past political hurtles and reflate in the 30s.

25. The world will discover that there is still only one power and it is the USA and since this discovery will be from their specific countries demise, extreme frustration and anger will develop. Leaders will try to divert that anger and frustration against the USA. Keep in mind this will be desperate times with unemployment leveraged to the hegemon’s experience.

26. The pressures which force the public to insist on the fiscal flow required will be urban revolution, anarchy, riots, crime waves, and intense immoral behaviour.

27. The misery in LDCs will be unfathomable

28. The concepts of green and global warming will be exposed for what they are – an attempt to make a supra-national revenue/tax flow to empower non-nation state organizations, to the demise of the hegemon. There will be an attempt to use green policies by foreign elements/leaders to divert internal pressure to the USA.

29. So so much misery and trauma and death and destruction could be averted by firm large and classic Keynesian stimulus by Obama’s administration in very short order.

30. In the age of Google so much literature and information can be acquired. There is no excuse for any civilized American adult, especially leaders, to not understand the above.

31. None of the above can be seen to be out of line with either liberal, socialistic, or conservative principles as the above are that aspects of economics that is fact and are the only remedies available and are applied by all forms of government in the end - be it Hitler, FDR, Stalin, Reagan, LBJ, or now Obama. How the government proceeds post-crisis is dependent on political philosophy. But for now, considering the risk and possible dire results, all parties and people should be united to implement the above. Later folks can have a nice long debate on the unwind.

My Response to DeLong's Yglesias-Barro Postings on Keynesian Fiscal Multiplier - Bigger Issues Involved

DeLong posted the following blog material on the fiscal "multiplier" from stimulus - an issue gaining notoriety since Romer's half-backed defense on the Obama-Biden Plan.

Delong posted (and I actually think he is complimenting Yglesias):

Matthew Yglesias vs. Robert Barro

One of these people is a tenured university professor. The other is a juicebox-drinking basement-dwelling bathrobe-clad weblogger.

Robert Barro writes:

Multipliers and Diminishing Returns: What do the data show about multipliers?... [T]he best evidence comes from large changes in military purchases.... The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists. World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports — personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses — there was a dampener, rather than a multiplier...

Matthew Yglesias responds:

I think this is running together two separate issues. One is “whether a large multiplier ever exists” and one is whether such multipliers suffer from diminishing returns. World War II spending was enormous relative to GDP. Wartime spending on that kind of scale goes way beyond the conversations we’re having right now about fiscal stimulus—the equivalent today would be something like a $5.2 trillion package rather than the $800 billion or so we’re talking about. And to get spending up to that level the government had to resort to quasi-forced savings (”war bonds”), rationing, etc.--deliberate efforts to direct production away from where demand was highest and toward the national objective of military production. The 0.8 multiplier is probably the result of diminishing returns. The question is whether you got a decent multiplier out of the first 5-10 percent of GDP you spend on stimulus. It shouldn’t surprise us if it turns out that defense spending eventually got somewhat higher than would be economically optimal in the middle of the largest war in history.

My comment on the above I left on DeLong's blog:

I think the multiplier issue is almost a red herring in regards to Keynesian measures required when savings rate soar (out of classic expectations or "forced" via war measures with lack of things to buy)and consumption dives. Obviously WW II spend "worked" - end of argument, and the size of fiscal stimulus FDR applied in peacetime did not do the trick, though important constitutional mandates were determined, rule of law via organizations like the SEC, and agencies to apply investments were initiated.

A far better example of Keynesian fiscal stimulus applied and the utility and "multiplier" it generated is the 1956 "Federal-Aid Highway Act of 1956" which created from scratch the Interstate Highway system. Avoiding for now chatting about cars and global warming - this was a massive undertaking which ended with a total $425 billion (2005 $) fiscal stimulus, unquestionable multiplier (most studies have it producing $1.5 and higher GDP per $1 spent)and had massive secondary and tertiary effects one cant account for such as auto industry growth to Howard Johnsons to...and so on. The project was solely conceptual in the start and certainly not "shovel ready".

Rather than worry about multiplier and whether or not it is "shovel ready", worry about making sure the project has utility and a long duration. Market pricing and the "rent" schedule will make for an almost immediate impact on GDP via first adjusting various market prices and then later with actual cash spend. The "shovel ready" is not required, only the certitude that the project will occur.

That's the trouble with abstracts or conceptual fiscal stimulus such as education or "green" technologies - the abstract nature will make for the GDP impact to not occur until actual cash flows are experienced .

So hard boundaried non-abstract projects which only a nation-state can budget for should be sought and declared. My call is the $600 billion high speed rail system nation wide. Or re do of the St Lawrence Seaway. Or rebuild every bridge over 20 years old (I am nervous driving over the Tappan Zee now). Or.. It has to be non-abstract and certain in public utility and it has to be not additive to existing programs and processes but be projects which the scope and size defy any budget unit but the federal.

The interesting question to ask is that if such projects are required, if we do not supply this fiscal spend in an obvious developing Fisher debt deflation spiral and if the USA as a power unit has any power or capability, that size of fiscal stimulus will occur. Sort of a weird supply side type thinking, voo doo I guess, but I think one can muse or even state that because FDR could not provide the fiscal stimulus outlined above, the fiscal stimulus did occur in a form that was politically applicable: war.

We will get our fiscal stimulus equal to the drop in consumption and investment and the rise in savings - one form or the other. I would prefer peace and the ability to drive over the Tappan Zee Bridge without thinking of the impact of water at such a height and the winter temperature of the Hudson.

Wednesday, January 21, 2009

SPX realized Vol (10 day) and VIX

Be careful wedding VIX with a directional bias in SPX.
By definition volatility can be bi-directional with those trading the gamma being long SPX options able to make money if the market moves up or down as they reset their deltas.
In fact, vol regimes are raised with a long term bull market, not bull, while short dated vol spikes up it seems only with a bear move given the impact of the correlation of the sum of the vol of all the underlying stocks in the index. This is how most think VIX will always behave.
But, while the VIX is trading down given the strong up move today, the vega of the underlying names along with the likely correlation staying unchanged or rising in the large bull move, and also given the reality of a large move in regards to delta hedging - all this makes for large loses in option trading today.
Also, while a bull market in the long run results in volatility rising in general, that has limits of being true from, say, low teens to high 20s but anything above 30 vol indicates stress, period. Stress from either hedgers not making money as the actual or realized volatility results in ill timed resetting of the delta exposure. Losses all around. Therefore while a bull market raises vol in general, once a certain level on vol is passed, increased vol reverts back to being a bearish indicator.
So, the VIX trades as most expect the VIX to move given the 30+ up move in SPX. But note how during this crisis how realized volatility - in this case the volatility the SPX showed in rolling 10 day periods - realized volatility was very prescient or at least concurrent with how the VIX ended trading.
I think for the up trade today and the drop in the VIX to give me comfort, I want to see it developing in a more steady fashion and showing a steady drop in realized volatility as well.
Do not think we are out of the woods yet by any means.

Inaugural Speech a Crisis

Getting a rebound day after, which may calm my concern, but I found the market verdict on Obama's inaugural very troubling. While not as severe, Obama has unusual similarity with FDR inaugural as the prime problem then as now was a bank credit crisis. Things have been learned in last 76 years and the monetary side of the fiscal-monetary measures has been implemented and has worked a shown by the return to normalcy for bank credit spreads in the money market tenor. But Bernanke, noting a near absence of coherent political and executive plan in the fiscal area has started to move down the yield curve and trying to evoke fixes in areas that in the end will only be fixed by appropriate fiscal measures. This is Bernanke's quantitative easing measures with program purchases of agency backed mortgages and now an intended program, TALF, in asset backed securities.

I could find only one solid Keynesian concept in the inaugural which addresses expectations and risk (or "rent" in Keynes words) schedules over time. When Obama said:

"We remain the most prosperous, powerful nation on Earth. Our workers are no less productive than when this crisis began. Our minds are no less inventive, our goods and services no less needed than they were last week or last month or last year. Our capacity remains undiminished. "

This is almost a direct quote from an essay Keynes wrote in the 30s found in "Essays of Persuasion" It indicated awareness that the crisis had nothing to do, in fact, with the justification or even reality of the fiscal actions to be taken, just that expectations have to be modified to a base schedule that can sustain growth. But that's all I could find. The rest of the inaugural was a hodge podge of shibboleths and wordsmith and a cynical lack of daring or courage resting solely on the historical significant event of being the first black President. In normal times that would have been sufficient to make the history books for all time - and it will. But in the midst of a once in a lifetime crisis, more courage and more daring and more dedication to showing resolve and the obvious, that a solution will occur with dispatch no matter what the cost in treasure, this was not forthcoming.

In March 1933 the SPX, after the immediate bank holiday solution after an extraordinary and immediate special session of congress called by FDR on his first day in office, showing resolve and definitive immediate action, rallied 22% in a few days - with a near immediate reversal of deflation and liquidity re-established in the banking system occuring. The stock market rallied the 22% almost immediately. These were problems that Hoover and most felt were intractable and just something that required fortitude and endurance which Americans have a history of accessing during tough times. FDR found that inhuman, unacceptable, and insisted on immediate action. Expectations which most academics thought were written in stone and would at minimum last a decade were reversed and shaped in one speech and with one day of policy choices. One day. "All we have to fear is fear itself". And FDR immediately demonstrated that was not a semantic phrase but that he enforced that philosophy immediately.

It is a serious and terrible error for Obama to take on what is basically a Hooverite train of thought, as ironic as that sounds. Paragraph after paragraph of text shows that Obama shares the standard view that we should be "afraid, be very afraid". Winter, woe, crisis, words have meaning as FDR showed and Obama's inaugural is a trail of tears. I was left with the idea that he was offering me the opportunity to show to all my good character but with near term results that I would not enjoy and basically suffer for the sake of my children. Just picture in whatever color or form your own representation of the schedule of expectation, of "rent" for the economy - I see this image as Obama spoke gremlin gleefully running down a structure indicating time slamming away at any positive outcome I could expect.

This inaugural speech, read without being aware this is the first black President and real historical significance - read with the idea that the speaker is a standard WASP very intelligent populist good looking male; read the text with that in mid as the speaker and you see not just a suave Jimmy Carter, but even at times Hoover.

Given the context this inaugural address is one of the most cynical and politically expedient and cowardly of any of the 44 addresses given.

With all the above in mind it is easy to see and understand why the Dow made the largest swoon in the history of data for when the leader of the USA provides his game plan.

Unless Obama reads stuff like this, accepts and understands the markets grading of his policy stance ( or lack there of), and makes corrections - he will have a four year term, Congress will come in Republican majority in 2010, the Senate and the Presidency Republican by 2012. The only administration to successfully apply Keynesian principles to date have been Republican - Eisenhower, Nixon, and Reagan. I thought of that as pictures of Obama were shown in the shadow of the Great Emancipator. Very ironic as perhaps Obama should have been running in the party of Lincoln, the Republicans.

SPX volatility surface certainly confirms the dim view I have of this inauguration:

Sunday, January 18, 2009

Grim thoughts: truly frightened

I guess I shouldn't read the NY Times this seriously and especially on Sundays now. Amongst all the Saint Obama (man, I really really hope he is anointed) walking (hope not slouching) to Bethlehem stories found article after article which outline that this is not some recession we are entering but without enlightened swift policy, this is it - the big one.

Mostly in NY City, the financial segment of the economy has lost 240,000 jobs over last 18 months - all at the highest percentile in income for the nation be it clerical or head of the shop.

Trade is down world wide with the best being the likely cooked books or at least rigged currency of China down YoY 2% and the rest of the world down well over 10% in exports YoY.

Then we read banks are not lending out TARP funds but hoarding. Do you expect bank executives acting on behalf of their shareholders, as they should and have to legally, would do anything else?

And so on.

Folks, none of this pattern was seen before 81, 87, 88-91, 94, 98, 00, 02 - be it technical like Russian collapse of 98 or the stock market crash or the agency mortgage backed crash of 94 or Long Term Credit collapse, or dot-com crash of 00 - never have we even come close to such devastating macro economic metrics. I also can not find them as I extend past my experience, into the 70s, or the mania crashes of the 60s, the late 50s Eisenhower recession that gave Kennedy his entre, or the Truman Korea recession.

There are only two times these numbers start shows some precedent and it is not even 29 - 30, but 33 to 36 and the numbers that prompted the Fed creation in 07, the crash of 1903.

And while there was some correlation amongst global economies - with 03 having more global wide impact than 33 - 36, the correlation between nations has never been higher.

This is a global calamity in the making.

All those who have some wisp or even a cable of importance in the line of development of economic policy should, like Dickens Christmas Carol, take a ride in past, present, and future worlds given our current Scrooge orientation.

It is crucial we take on some common reference points and crisis management behaviour:

1. The USA is the unipolar power or factor - or call it whatever you have to be ye French or Harvard grad;

2. All rests on the USA - we save the USA we save the world, the USA crashes and carries on as it is Global misery of something we have not seen but for the worst of WW II will occur.

3. Keynes - as he seems to be the only developed lexicon that is shared and understood - is our template of solution

4. A steady read of bank crisis similar to what the USA is going through required an average of 15% of GDP absorption of problematic assets (toxic assets - call it what you will) onto the national balance sheet or national agencies, and then result to either a 4% of GDP to 18% of GDP (Japan's zombie approach) all in final cost.

5. That the balance sheet required for the bank crisis resolution is not at all the same funds required for the Keynesian fiscal stimulus spend required.

6. The Keynesian fiscal stimulus will be equivalent to the drop in consumption which results from the increases savings from folks with their wits scared out of them. Figure out the change in savings rate and one has the size of the fiscal stimulus required. The USA entered this crisis with a problematic 0% savings rate.

7. All moralistic and judgemental themes and approaches that qualifies bands of the populace going into this crisis must be scrapped. It will only impede the solution if the starting point is about the lack of character or morals of "spenders" and equally bad no status should be assigned to "savers". In fact savers now are the dangerous element.

8. There is no generational assumption or passing on of burdens in the USA. Anything we do now will either provide a vital and useful context for future generations or will provide a crucible of pain and all of that rests on civic structure and organization and has nothing to do with debt. "You shall not crucify man upon a cross of gold" has much applicability now as when Jennings used this rallying cry. The USA, as far as a valuation of going concern has only two values - infinity or zero. It is a digital with nothing in between. There is no shades of gray or incremental movement in this. In the long run the USA will prevail and maintain seinorage and the question is how much misery and suffering domestic and international does the path entail.

9. And the fact the USA will maintain seinorage, of an infinite economic value spot and forward, is perhaps the most dangerous and important variable. This is because the core power of the USA will be maintained and those in political control of the USA power will in the end insist on a reflation. The reflation will occur one way or another. Water will find its level. Given all the above the leveling involves at some point a $2 trillion bank crisis solution with at least a $1 trillion Keynesian stimulus - a total of $3 trillion or over 20% of USA GDP. This is the most alarming and critical consideration. Realize this leveling of the waters will occur, one way or another.

Historically the USA has only been able to implement a fiscal spend and evolution of over 10% of GDP via war. No other motive has been able to overcome the political tensions and frictions. This explains why Mussolini and Hitler were able to move their countries out of the depression that for them started in the 20s - dictatorship of national socialism allowed the development of political will to allows such a stimulative spend over 10%. It explains why the common understanding that the Great Depression was not ended but for WW II.

Therefore, certainty can be applied with the thought that we either develop a new commonly shared lexicon and principles such that the democratic political debate can apply a budget with well over 10% deficit in any one year or we will have war.

The trade numbers in today's NY Times start to suggest the genesis of the tensions required to prompt either a global potential adversary attack us and allow for a righteous defense as in Pearl Harbor, or for us to cook up the shared righteous wrath to attack someone, anyone, so as to go out and spend $2 trillion dollars.

The choice is ours. I hope everyone adopts the above points as a starting point.

I also must include a disclaimer that some emotional alarmist feeling in the above that I might express is that eldest son is in the US Army and middle son wants to sign up next week.

Friday, January 16, 2009

SPX volatility surface does not look good (or does it?)

SPX volatility for 30 days out to 1 year is starting back to show stress as it did in November. Hindsight shows and given the persistence of volatility and its auto-regressiveheteroeskedastic nature (hah!), which is basically saying that what happens in past in vol land tends ot happen going forward and that volatility finds regimes and sticks to them, SPX volatility is starting to invert again showing greater immediate risk and more alarming, showing systemic risk the regime is rising form long dated volatility at sub 40s to just below 45.

We can have no recovery in the end without long dated SPX vol going firmly back through 30.

Also the twin peaks formed in November, which in one blurred vision might make the single peak depicted that volatility always does make if the crisis is over. This is showing the highs in SPX volatility in terms of regime levels and immediate risk are yet to come.

The only good explanation that can be made for this and accommodate an upside SPX move is if the general market risk has moved, being hedged and perhaps form macro point being underweight equity exposure, is that a sharp upside move would cause generally the most loss and damage. The week of the FDR inaugural address ("we have nothing to fear but fear itself") was the record move upwards for the SPX - 22% the day before and immediately after the one week bank holiday FDR declared. Obama repeat? If a very large upwards move in SPX occurs then SPX vol will peak and the single lone peak formation rule for volatility maintained.

Pelosi stimulus has done much to alleviate concerns

My count is the Pelosi stimulus plan is roughly $450 billion in actual spend over the next two years. If expectations can be firmly rooted in that it as good as money up front. I did not include any tax changes or transfer payments as they will just either reduce debt or increase savings.

Based upon my work below on Kalecki-Levy I find that $450 billion with savings going to 7% rate will result in SPX earnings of $58 which with a 14 multiple would be a 810 level in SPX.

Now I think the attention now goes to savings rate that develops from the crisis and using K-L the following table can be derived assuming the $450 bil of Pelosi does come in:

Savings Rate.......SPX Ern......Multiple.........SPX






Lets hope Obama does a good job alleviating fears and stirring up or maintaining animal spirits. But if Obama does a wonkish let deal with the facts speech a la Jimmy Carter - savings rates response could swamp any fiscal stimulus.

Basically any increase or decrease in savings rate of 1% results in a change in SPX earnings of $6, and any change in stimulus from the Pelosi current plan of $100 bil plus or minus results in an SPX earnings change of $4.

Thursday, January 15, 2009

Pelosi Plan resulting SPX Earnings Using Kalecki-Levy

Beats me why Microsoft objects morph to weird colors - but they do, so will proceed with the following graphs.
First is an update of the Kalecki - Levy identity from the Minsky guys using the following input:
Nominal GDP drops down to 3.5% (Goldman Sachs)
Savings up to 7%
Govt Investment up Pelosi's $197 billion
Import/Export -4%, improves as per numbers the other day
Results in following graph (sorry to blurry don't know how to transfer graphs form Excel to blog):

I calibrated SPX earnings to what the K-L identity has been last 20 years and come up with the green line above.
All the above result in a SPX earnings of $49.
With a 12 times P/E means SPX at 788.
To correct the SPX, we require a true additional fiscal spend/stimulus of an additional $650 billion which should result in an SPX earnings of $75 and assuming the multiple expands then with this happy development we get an SPX of 1200.
I think this goes far in explaining the rally since December and also how to consider the developments of the fiscal stimulus. Do not consider any transfer payments (unemployment etc) nor tax changes. Look only at actual increased spend of the government into the economy. Doesn't matter if it is shovel ready or not - it is the market expectations that this spend will occur which counts.
I worked out the following table:
........................................Stim.........Ern........Mult.......... SPX
Obama-Biden ..............50 bil ......$30..........10..............300
Pelosi ...........................187bil ......$49 ...........12 .............588
......................................300bil .....$54 ...........13 .............654
......................................600bil ......$63 ..........14 ............880
......................................900bil ......$75 ..........16 ...........1200
Hope this helps.

Oil and Nominal GDP: Contango

To carry on with what the relationship of Fed Funds expected to the oil contango, and ultimately to GDP, some simple arithmetic.

First note the 10 years interest rate swap trading 10 years forward chart below. For the last 30 years nominal GDP has a close relationship to this rate.

Oil is about 8% of GDP - in various forms.

Fed Funds over time should have equivalency to (and do) to nominal GDP - it is how the Fed controls the economy via monetarism and is a well understood identity by the likes of Friedman to neo-Keynesians.

If nominal Fed Funds expect some repair from this crisis, they should trend upwards and in fact they do as the following pattern shows - extracted from swaps and not Fed Funds futures:

The Fed Fund path has to eventually connect with the 10X10 to show the evolving Fed Funds to market long term expectations for nominal GDP.

Therefore the oil contango should have some relationship to the Fed Funds expected path.

Now the math - it is clear the Fed Funds path "only" returning to 1 1/2% shows that some long running drop in nominal GDP is expected. That long running drop can be estimated by seeing the 5 1/2% nominal GDP dropping to 3%, a drop in nominal GDP of 2 1/2 % per annum. That is a drop of $350 billion per annum in nominal GDP, or say about $3.25 trillion present value. If oil is about 8% of GDP then we should have a hit of about $28 billion per annum in demand for oil from the USA and a long term present value drop of about $250 billion to $325 billion.

Longer dated oil is trading at prices reached a year ago and if the market ideas as to growth expectations in relationship to oil ("peak oil") then obviously they have not even begun to price with the market expectations for the massive changes in nominal GDP long term expectations.

Further more, the rise in Fed Funds expected is more to do with the fact the market must price at some level from ZIRP to 3% over time, but as we are seeing that is really not a discrete steps curve but a massive step function - and even a step function that is oscillating from upside down to rightside up like some demonic animated Escher print. Most feel that the Fed Fund path should be much shallower and take a much longer time to get to the 3% nominal GDP.

Finally, one has to think of the "sizzle" to "peak oil" which was the Chinese inefficient use of energy along with the their 7% to 12% growth in nominal GDP. Supposedly the isolation from the USA the Chinese miracle was establishing would keep this major effect proofing "peak oil" intact. The recent decline in Chinese nominal GDP means that somewhere in there is a path similar to our Fed Funds path in terms of change if not more so as they prove to be a leveraged position on the USA economic conditions.

Then as we hear of 80MM barrels of oil roaming the ocean in Flying Dutchman like tankers, never to find shore or the contango trade is destroyed, and as PADD II overflows, and as refiners do all they can to cause roadblocks and bottlenecks - and given the above tectonic plat shifts in macro USA expectations......

Still believe in "peak oil"? If you do I got some already filled oil tankers to sell you....

We will likely see a handle of the teens on oil before this over.

Wednesday, January 14, 2009

How to Watch our Long Term Potential in GDP

One market to watch to qualify the "non-noisy" market expectations of how the Obama-Biden Plan is faring is to follow the 10 year interest rate swap level 10 years forward.

This is a good way to see what market expectations are for nominal GDP (versus real or inflation adjusted GDP).

It is very alarming as it shows that the USA has made a possibly permanent trend potential nominal GDP growth change from 5 1/2% to 3 to 3 1/2%. Assuming inflation corrects to 1 1/2% and Obama is successful in reflating - the deleveraging in financials will permanently lower productivity numbers and result in lower nominal trend GDP. Furthermore if we succeed in this ill thought of crusade against Mexican immigration, the population growth then drops to 1 1/2% form the effective 2%. So - take your pick, either inflation expectations, or population, or productivity make up the 3 1/2% nominal. The drop in nominal GDP to 3 1/2% is sufficient in its own right to justify a 850 SPX.

One more reason to be very keen to reflate, get this O-B Plan at least doubled in expectations of the real spend (not taxes which in a deflationary or no inflation environment just disappear into the "bizaro world" 4th dimension), and perhaps be friendly to those hard working Mexicans in the Hormel plants in MN.

Crude Contango versus Expected Fed Funds

The above sketches the market expectations for Fed Funds out to March 11 compared to the contango for oil.

Not to dive in about my usual spiel on how crude oil is a bubble that is in end game post crash, but even if I accept the "peak oil" fellows, it makes sense that before "peak oil" can kick in we have to return to a "normal" growth or eliminate the output gap in GDP.

Logic then is clear - Fed Funds reflect over time nominal GDP. Even 2 years forward Fed Funds show a nominal GDP expectations of about 2%, about 1 1/2% below GDP potential assuming a 1% to 2% inflation.

If the "peak oil" requires a return to trend growth, it is interesting to compare the contango so as to "calibrate" to the expected Fed Funds. This doesn't seem to work out. Though both schedules are sloped in the right manner, if the steepness of the oil contango is justified it has to match reasonable nominal GDP expectations repair, with a large part of the output gap eliminated and a return to "potential" trend nominal GDP. Even a quick view shows that compared to Fed Funds, oil contango should be much flatter. Further more, there are signs in long term markets - primarily the forward interest rate swaps and the the long dated interest rate swaps - that return to trend growth will be much slower than these Fed Funds expectations indicate, and the chance of Japanese long term stagnation is real.

Even if the "peak oil" argument holds it looks like the pricing of the oil contango has to adjust to both a longer time getting back to trend nominal GDP growth and that the trend nominal GDP growth or potential is now shifted down from 5% to 3%. If "peak oil" argument still holds it means the front crude price may not have completed the necessary adjustment and we could see a 20 handle and the contango must also flatten. All this and yet still maintain the "peak oil" thesis validity.

But an adverse technical situation may exist where some who reloaded trading positions for 2009, and with remaining legacy positions, which plan to take advantage of the contango by "rolling down" the term structure of oil, may have to be unwound in swift order if current pricing spot and forward do not match reasonable nominal GDP expectations. In that case not only does front oil drop more, but the contango might actually go to "backwardation", at odds with the Fed Funds term structure and cause even further pressure on the front oil.

Now if we enter a Japanese like "lost decade", even with "peak oil", much in oil pricing adjustment would occur. And if there is no such thing as "peak oil" just some theory chasing a market a la Malthus - then we have yet to see the completion of the oil crash and we will see sub $20 oil and even worse, a backwardation of oil. If the last 6 months didnt clip a hedge fund - this scenario likely would.

The following shows a regression of the one year oil contango versus the 10 year interest rate swap 10 years forward (a good quick way ot see what market expectations are for nominal GDP for the long run):

1/17/07 to 1/14/09

I think "peak oil" is hog wash - by the way.