Sunday, March 31, 2013

Darfur Helped Build a Simple Effective Way to Consider 10 Year US Treasurys Real Return and Price 10 Year US Treasurys

I was impressed with the heart wrenching and yet uplifting  60 Minutes story on the 'Lost Boys" of  Darfur.  It was a followup of the 12 young men who  received asylum in the USA after fleeing Eritrea for the Sudan a decade ago.  The Darfur calamity.

What amazes is that 12 years later after they were evacuated to the USA, despite how foreign in both terms of modernity and environment the USA was, almost all of the Darfur youth have thrived.

So I dug into population and immigration statistics to see what is going on now - first to defend an obvious view that the USA finest moments is when it becomes the 'Last Great Hope of Earth". So I wanted to show much greater immigration levels could take place that would be good for the USA economy, and also allow USA to reach even greater global altruism.

I found that despite the recent notion that the USA borders were "closed", immigration has soared in terms of the percentage makeup of the USA population growth.  I was  aware that a massive advantage the USA has over all OECD countries, and now China as well, is that we have had a population growth rate of around 1.25% over the long run, though it is declining.  With the Great Recession, the USA rate has dropped to .77% population growth, but that is still  very much higher than all of the other OECD countries, Russia, and China.

A surprise is that the population growth slowdown would be at  around   0.4%,  but for the surge in immigration that has taken place since about 2004.

In fact, immigration is now making over 1/3 of the USA population increase.

 Still it is obvious that the USA must increase immigration even more to allow the USA resume a 1.25% or better population growth rate.  That would be an approximately 2 million per annum increase  in immigration from approximately 1 million per annum now, to 3 million per annum total.

Why is population increase of importance, especially after the USA has suffered a severe solvency event and is still providing repair and with unemployment over 7%?

NGDP , or rather potential NGDP is a straight forward aggregation of the  USA native born population entering the workforce, the immigrants to the USA entering the work force, productivity and then inflation.

Immigration policy has been as effective - in forward space at least - as the Fed's QE - in providing remedy. And as native America birth death  rate decreases, immigration becomes vital so as to maintain the American current living standards.

Basically, over the last 60 years, population increase (a combination of immigration and native born) has formed  50% of real GDP,  (RGDP).

Rather than use trend GDP as per FRED etc, using RGDP composed of population increase equal weighted with productivity provides a better picture of potential.

It surprised me how robust this array was, especially when compared to realized RGDP.

Then I thought more utility from the array could be had if  the native born population increase is lagged by 18 years - a rough idea of how long after birth a contribution to the economy occurs,  and then lagging immigration increases by 7 years - keeping in mind the 60 minutes Darfur story and time it takes for an immigrant to become completely part of the US economy.  This lagged population increase with productivity resulted in a  potential GDP that was very robust when compared to other metrics, especially the risk free long rate.

Comparing this lagged population with productivity potential RGDP versus the realized RGDP shows the very large positive impact of the Reagan rationalization and reformatting of the USA economy, which I perceived to have been carried on by Clinton.  A very long and very successful growth period in the USA led to almost almost full GDP efficiency in terms of deploying all the potential. Then the Islamist war impacts, where the inefficiencies of war with a lower multiplier for public sector investment (bombs tanks and ships etc etc) along with waste, led to a falling behind  potential.  Later the solvency event clocks the USA, dropping it way beneath potential.

The usefulness of perceiving potential in this fashion versus than a CBO trend GDP, is that this potential can, or will, be closed via policy, especially when focused on immigration.  The USA has another 15% of real GDP growth to come based upon my RGDP.  And with the war inefficiencies being replaced with private sector commerce, that gain of 15% can happen rather quickly.

One can then consider the 10 year US Treasury.

It takes only common sense, and maybe a touch of Keynes, to realize that the US Treasury yield is a basket of Federal Funds rates over the tenor of that specific bond, or rather it is the expectations of those Federal Funds rates.  And the Federal Funds rate over the time of a complete business cycle, say 5 to 10 years, has to average out to NGDP.  For the last 30 years, since Volcker established the current monetary policy form of the Fed, the overshoot and undershoot has lessened.  The Great Moderation.   Another way to organize how to think on this is to consider the "Taylor Rule", not to figure out the "right" Fed Funds level, but rather to understand what are the weights of productivity and population of  a potential NGDP.

The  10 year US Treasury is showing the markets expectations for NGDP over the next 10 years, adjusted for the risk that perhaps, just perhaps, the Fed loses all reason and goes crazed, and for the positive convexity found in semi-annual coupon bond structures.  But in the  main 10 year pricing is expectations of NGDP, and the major pricing dynamics of the 10 year will be based upon the expectations changing for the general potential of NGDP.  Since I mentioned that we are considering a long enough time for at least a complete business cycle, that will mean with the modern Federal Reserve methodology,  Fed Funds will undershoot and overshoot NGDP, but will in the average, over that  tenor, be equivalent. Even if the total real return of the 10 year has to "catch up".

So, over time, the real total return of the 10 year US Treasury should approximate the all in increase in real GDP over the same time span - provided the time span is greater than a period that contains one complete business cycle.

And this is in fact what has taken place.

First, note how the adjustment by lagging the "coming on stream" of population growth makes for a more useful potential real GDP.  (Should become obvious why I am using real, as inflation has nothing to do with population or productivity.)  As said prior, one can see how the Reagan regime was a huge success.  Now for bonds, it can be seen that from early 1990s to just before the current crisis  - but for the stochastic properties in the convexity of the ten year -  the inflation impact ( or deflation), and the insurance like utility of a US Treasury longer tenor has swamped approximating RGDP.

Since I can expect maybe a slight increase in population impact to around 1%, and assuming productivity stays 1 1/4% to 1 1/2% - I can then explain some of the overshoot of US Treasurys.  But if RGDP potential stays around 2 1/2% , then over a 2 to 3 year periods a 60% hit has to be realized in 10 year US Treasurys real return.  That is back to back years of around -20% total real return.  Some of that can be inflation, of course. In short the overshoot the market priced into 10 year US Treasurys, reaching nadir in 1981, is to be repeated - and like 1981 onwards, will likely result in a 30 years of trending market - only this time a significant bear market for long maturity US Treasury.

Sunday, March 17, 2013

Cyprus: EZ's "Rogue's Island of Know Ye Men and Know Ye Measures"

In 1785 the tiny state - even then - Rhode Island was known by the rest of the 13 USA states as " Rogues' Island, the home of Know Ye men and Know Ye measures", a derisive phrase coined  for the Rhode Island's people tolerance of fast and loose speculation, pirates and smugglers.  The folks of that time most  like today's Russian oligarchs, arms smugglers, tax dodgers, money launderers, or drug lords, would flock to Rhode Island.   The "Know Ye" phrase came from the scam Rhode Islanders would play using local bank or state issued  paper money  to discharge debts in Rhode Island courts (the phrase "Know ye" was proclaimed by the judge administrating the debt dispute once the debtor presented the court with the deeply discounted paper money so to discharge a debt), effectively getting debts paid down for pennies on the dollar.  The state was infamous as a safe haven for pirates and smugglers, which in particular caused the Continental Congress great concern as tariffs were the revenue source for the new nation.   Fly by night bankers, speculators plunging into the ragged existing states debt - Massachusetts being a favorite state debt of speculators, driven to well under 20 cents on the dollar - and various other financial criminals settled in Rhode Island.   If there was a need back then to launder money - it would have been down in Rhode Island..

In short, the Rhode Island banks and financial system  was very much like today's Cyprus.

But  the ability of the 'Know ye" state to pursue financial  mischief ended in 1790 when Hamilton retired the state debt with the "Assumption of Debt", creating the US Treasury debt, eliminating speculation by providing collateral to exercise hard money seiniorage.  In the same year, the US Treasury under Hamilton also had the Continental Congress pass the "System of Cutters" Act, funding several "revenue" cutters to stop smuggling and enforce tariffs being the origins of the US Coast Guard.

These two actions - the "Assumption of Debt" and the "Revenue Cutter" Acts were the essential steps towards establishing  federalism in the USA, replacing the chaotic confederation that  enabled the criminality  in Rhode Island.

The mischief of the 'Know ye" state was one of the main motivations for the formation of the US Coast Guard and thereby start the process towards assured revenue for the federal government that allowed the conversion of state debt to the new federal debt, and define  federal prerogatives and the USA  national boundary which the 13 states lay within, rather than as a confederacy alongside.  

The Rhode Island fast furious banking ways were effectively outlawed by the creation the Hamiltonian federal monetary policy - and the newly created US Coast Guard was the implementation of eliminating the "tax avoidance" and "money laundering" of the age, by eliminating the Rhode Island smuggling and piracy.   

Rhode Island "Know ye" attributes and actions, via their elimination and remedy, were therefore  important positive  factor in the creation of a federal United States of America 

Just as Rhode Island "Know ye" contributed to the foundation and definition of the current USA federal system, Cyprus's remedy will have the same positive and beneficial impact on the Euro Zone at large, perhaps even being an important factor that in the ends with the creation of federal United States of Europe. That is if it is applied by the ECB.  

Cyprus is a near-criminal or criminal banking haven, a status that is well known to the point of a shared joke - just like the 1785 "Know ye" reputation of Rhode Island. Cyprus is the banking haven of choice for the Russian criminal oligarchy, arms traders, smugglers, and drug financiers.  Illegal activities around the world consider Cyprus first to launder funds, be they gamblers or drug lords or arms merchants.  It is  the rare locale where Middle East people  live in peace - that is if they were of  the criminal class.  

Cyprus is corrupting Europe. it is used as backdoor for the worst of the Russian criminal oligarch gain access to EU passports.

Cyprus is the EZ's  "Rogue's Island - the home of Know ye men and Know ye measures".

The need  for the current Cyprus bailout is the inevitable results of a lax confederate regulatory oversight , with a regional populace looking the other way so as to prosper, for a while at least, as a modern days "Rogue's Island".  The Cyprus stock market, such that it is, has been almost a 100% wipe out as all Cyprus listed companies become either corrupted or under the ax as the Cyprus banks their doors open like whorehouses.

The current bailout remedy proposed, will strengthen trans ECB dominion as its implementation defines ECB federal power and with ECB implementing regulatory oversight,  the EZ national borders are defined, just as the USA broders were defined by the creation of the US Coast Guard by Hamilton.   With Russian oligarchs fleeing with their deposits, a very important step in the "Monnet Process" of evolving towards  a United States of Europe occurs.  Hamilton defined the nature of the new USA federalism  with the conversion of "Rogue's Island" to a federal member state Rhode Island.    Draghi is doing the same with the conversion of Cyprus to becoming a financial federal member of the EZ.

This Cyprus event is all to the good, necessary, and will shortly be seen - if not already - as being a positive.

The Cyprus event has nothing to do with the string of crisis caused by the replacement of equalization payments required to cure intra-EZ trade imbalances with lending, as experienced in Greece and Portugal, and to some degree Italy, nor is it like the Irish and Spanish crisis caused by excess liquidity provided by the same imbalances.  The Cyprus event is singular as it is a regulatory action which in the end will be an important step in defining  a federal EZ.

Monday, March 11, 2013

A Word on Risk Free (USA)

A Word on Risk Free (USA)

 A mistake is to lump all fixed income together, perhaps separated by broad based quality identifiers - US treasuries are lumped in with investment grade US credit and sometimes with any credit that is investment grade, like emerging market debt or foreign denominated debt.  Duration is not considered with only, again, broad strokes used to differentiate cash and money markets and long term.

This common stance and approach to investing or even speculation will almost assure failure in making money or realizing objectives.

The most important factor to understand cold is that the US "full faith and credit" debt - and this even extends to receipts or contracts - is risk-free, with no gradients or waxing and waning of that quality.  US debt is also the only "risk-free" debt, with all other sovereign debt quality defined by how that country relates to the USA in a myriad of accounting identities and political relationships and specific domestic characteristics.  But I want to talk only on USA "risk-free" debt, for now.

USA "risk-free" is not based upon a collateral value or total net worth of the country or the annual flow of funds experienced.  Though all of these do contribute or allow the deciding factor that makes USA debt  "risk-free".  The underpinning of the risk-free status is solely political.  It is the the seiniorage capability of the USA and the "rule of law" allowing for long term commerce and savings without the risk of undue confiscation or expropriation - at least explicitly. The 'rule of law" is , of course. entrenched and provided by the the USA constitution - so in the end it is the nature and the dynamics of change of the US constitution which allow for the USA to achieve "risk free" status.

Now of course the ability of the USA to have designed, implemented, and maintained the USA constitution is the happy good fortune of the USA to be formed at the right time and at the right place, with additional good fortune added upon that.  The entire constitution was tested by the Civil War, and was not found wanting nor was its essence changed by the test, only elaborated with additional amendments. And then as globalization and interacting on an international basis become the means of growth, and not continental expansion, the interaction of the constitution on the international front became important as well.   Social welfare and other transfer payments and support prevent revolution or insurgency, so the constitution is not challenged by domestic status or change.  So that leaves the international constitutional interface - the challenges and enrichment  - that are now the major area that weakens or strengthens the constitution. That leaves us with the challenges to the constitution by international forces and dynamics as being the main challenge to the USA "risk free" status.

Therefore it is the international dialogue of conflict that the USA has, and has had since WW I, which define and maintain the USA "risk-free" status.

"Risk-free" status is absolute, there are no shades of gray or gradients.  No "really risk free" or "sorta risk free".  The USA is either risk free or it is not.  That is why it is specious for the credit rating agencies to even bother offering an opinion of the credit worthiness of US Treasurys.

So - for the last century - the most important factor for determining the US Treasury yield curve has - now swooping down to the base - been the ability to wage war, if need be, and to offer a defense or deterrent to those who may damage the efficacy of the US constitution.  This is what I think Lincoln was getting at when he said the USA, the Republic, the "the last great hope of Earth".

Words which are relevant for a stock broker trying to figure out an appropriate asset mix for a client's portfolio, or the most sophisticated hedge fund searching for arbitrage opportunities.

It is the constitution and resulting rule of law which allow for the seiniorage of the USA currency, which is the starting point of building the yield curve of US obligations - money being that obligation which has an instantaneous duration.

This means that politics is what defines the US Treasury 10 year rate, in the end, not demand and supply, how much debt there is how little, what China is buying or selling, or  the demographic dynamics of the USA.     So it is the consideration of politics, the leading edge being the dynamics of US foreign policy, especially conflict, that one begins and ends the consideration of the entire US Treasury yield curve.  And ground zero for that political consideration is the value of money, and the next most important rate which is the Fed Funds rate.

To say you think China holdings of US Treasurys has something to do with the pricing of US risk-free, or that the Fed has bought a trillion via QE and therefore shifting the demand supply curve - that approach shows a fundamental ignorance of the make up of the US Treasury market and how price is determined.

After one understands and accepts that the pricing of US Treasurys is political, solely, and that leads to an unqualified "risk-free" status, the US Treasury yield curve can then be priced.  That is next.