I’m thinking it’s about that time for portfolio managers to buy stocks and go play golf for a few years,
with the following very caveats.

1. A serious spike in crude oil/gasoline prices that undermines consumption
2. The euro zone could break down socially under the stress of continued austerity
3. Congress opting for ‘meaningful’ proactive deficit reduction

But apart from that it looks like relatively clear sailing to me

The Republicans are now softening on revenue increases to get past the fiscal cliff.

And in any case the fiscal cliff may already be up to 50% discounted, as business has slowed due to delayed contracts, etc. with top line growth still remaining modestly positive as the cyclical housing ‘recovery’ begins its multi year upward grind, providing a powerful ‘borrowing to spend’ force for growth. I call it a drop in ‘savings desires’ as borrowing is in fact ‘negative savings’.

This is fundamentally supported by continuing federal deficit spending that, while down from the peak, is still looking more than high enough to support a growing credit structure.

And the 4 years of ‘larger than ever’ federal deficits have added exactly (to the penny) that much in dollar net financial assets to the global economy, with much of that being added here domestically. This is evidenced by the full recoveries, and then some, of macro debt service ratios of all types. In short, ‘savings’ has been, for all practical purposes, more than sufficiently restored for a ‘normal’ recovery.

This kind of underlying strength will quickly cause the Fed to reevaluate policy as unemployment drops towards 7%, leading to a ‘normalization’ of policy, which means a fed funds rate at a ‘normal’ premium over ‘inflation’ for a ‘neutral monetary policy.’ In fact, as this happens, the higher rates from the Fed further support the expansion via the interest income channels.

The output gap is wide enough for this to go on for a long time without excess demand issues, again with the caveat of crude oil.

Growth has already caused the federal deficit to come in lower than expected, which is helping put off proactive deficit reduction efforts.

Yes, eventually, the automatic fiscal stabilizers will bring the deficit down too far for it to support the credit structure, and serve to end the cycle. But this is WAY down the road.

The first Obamaboom came from the ‘stimulus’ which wasn’t nothing, but was far too weak to remove the sudden drag on demand from the private sector credit contraction.

The ‘crime against humanity’ was not implementing the likes of my proposed ‘payroll tax holiday’ in mid 2008 to support demand at full employment levels at that time.

Instead, the govt allowed demand to collapse/output gap to widen. This did not have to happen. It was a total failure of govt.

Also, timing is also important, so mind the technicals!

51 Responses

      1. @WARREN MOSLER, Multinationals in the euro zone do OK, but for others times are very tough. Extra austerity everywhere. New Dutch govt just agreed to eur16bn austerity. Greece we could all witness yesterday again. Spain and Port do not reach targets etc, looks like more to come….. they simply do not see alternatives.

        What were the reactions to your presentation in Rome in this respect?

      2. Good from the large audiences, muted from most of the panel in Rome, but excellent from the Dean of the Sapienza economics department who is in full support.

  1. So, time to begin positioning for rise in interest rates? If so, how best to do this? Outright short Treasuries, which can be costly given negative carry? Or…. relative value? If rates begin to rise, will it be via bear flattening move in anticipation of Fed policy changes, or a bear steepening sell off?

      1. @jcmccutcheon,

        Could be. I am also thinking in terms of relative value. Sell 5yr Eurodollar futures bundle, which is synthetically like a 5yr zero coupon and receive fixed on 5yr swap as a deliverable swap future on CME. The trade has positive convexity and is biased to outperform in a bear flattening sell off.

      2. @Ed Rombach,

        Correction: The last sentence in my comment should read

        “The trade has positive convexity and is biased to outperform in a bear steepening sell off.

        Warren – To your question “the ed short would have negative convexity?” No, it would have positive convexity. The deliverable receive fixed interest rate swap would have positive convexity, not unlike a plain vanilla bond. The Eurodollar futures by definition have no convexity because each basis point = $25 per contract.

        So, in a rising rate environment, gains on the short 5yr Eurodollar futures bundle will tend to outperform losses on the 5yr receiver swap with bonus profit potential from a bear steepening sell off due to the extra weighting in the 5yr bundle.

        Alternatively, in a falling rate environment gains in the receiver swap will outpace losses in the short 5yr ED bundle, unless we get more curve flattening in the 2yr/3yr forward sector of the ED futures curve.

      3. sorry! I was thinking about another issue. I haven’t actually done this for maybe 15 years! 😉

        If I’m short ed and long a swap, if rates go lower, I pay the funds outright on the ed’s but have to pay interest on the funds i get with positive mark on the swap. So what we named a vmih- variation margin interest hedge- was needed, so we’d be short a few less ed’s for a given bond.

        to your point, in a falling rate environment, the value of a bp stays the same with the ed’s-$25- no convexity- but goes up with the bonds- positive convexity, and lower coupon bonds have more positive convexity than higher coupon bonds, etc.

      4. @Ed Rombach,

        “If I’m short ed and long a swap, if rates go lower, I pay the funds outright on the ed’s but have to pay interest on the funds i get with positive mark on the swap. So what we named a vmih- variation margin interest hedge- was needed, so we’d be short a few less ed’s for a given bond.”

        Warren – Yes. In the 1980s we thought of it as “tail” hedges of interest earnings on variation margin gains vs. interest expense on variation margin losses. But as time went on traders realized that these tail hedges were really nothing more than an attempt to construct a duration neutral hedge (DV.01). In any event it’s kind of a moot issue because ZIRP makes interest gains/losses on variation minimal. Moreover, both legs of the relative value trade I am recommending are futures positions with offsetting variation margin flows.

      5. yes,

        And yes, all the cash flows are just 0’s on the bonds.

        so you’re using swap futures?

        And looking fwd to getting some liquidity for you to trade for me!

    1. @Ed Rombach,

      Bear flattening is much more common than bear steepening. I think you would only have bear steepening if inflation becomes a problem (which I don’t expect), and which you would see first in the TIPS market.

      “lower coupon bonds have more positive convexity than higher coupon bonds, etc.”

      Actually, measured as convexity per year of duration, lower coupon bonds have lower convexity than higher coupon bonds. The higher overall convexity of low coupon bonds is due to their higher duration (convexity scales approximately as the square of duration).

      1. @ESM,

        Agreed. Under normal conditions it is much more common to see a bear flattening sell off in fixed income as market participants price in expected Fed rate hikes. Problem is that these are very far from normal times. I’m thinking of the devastating bear steepening sell off in 2003 when the Fed only cut FF by 25bp instead of the expected 50bp. The volatility was extreme at the long end of the curve. For example, QE1 & QE2 sell offs were bear steepeners, as I outline in this video I recorded when I was at Reuters.
        05/13/11 QE2 End Will Send Long-Bond Yields Down…. http://reut.rs/iSgCfl
        But, you may be right and anticipation of Fed rate hikes could result in a bear flattening sell off. If so, instead of selling a 5yr ED bundle against the 5yr receiver swap, it would be better to sell a duration weighted ED futures hedge that is more heavily weighted at the front end of the curve and more tapered at the longer maturities.

      2. @Ed Rombach,

        The steepening, and indeed the selloff itself, in June/July 2003 was driven by mortgage investors. Arbitrageurs who were getting killed on their negative convexity positions (long mortgage bonds, pay fixed on 7-10yr swaps) as interest rates fell through the spring basically had moved to a Texas hedge position (i.e. they actually underhedged so they were long duration). The combination of losing money on that mismatch during the selloff, as well as seeing their mortgage bonds lengthen dramatically, led to panic paying in the 7-10yr sector.

        You’re not going to see anything like that this time. The mortgage market is completely different now.

      3. @Ed Rombach,

        ESM – I agree with your analysis. The mortgage extension hedging (paying in swaps) was not unlike the portfolio insurance debacle in equities in the 1987 crash. Hedging the mortgage extension risk only accelerated the sell off thus increasing the need to hedge even more. Like spraying gasoline on a roaring fire.

  2. Isn’t the main problem that they have done nothing to change the financial system, and are intent on repeating exactly the same mistakes as before – i.e. growth based on rising asset prices and private debt?

    So eventually we’ll be right back in 2008.

  3. If Obama gets his grand bargain, then that will be $3.50 in net financial savings drained for each tax dollar cut. That seems like a big shock at a time when many have left the job market altogether. I don’t see how Europe does not keep getting worse.

    Not sure i am sold until seeing the details of any deal.

    1. @Mcwop, upon reading my post I am not clear on how O’s grand bargain actually works. A minimum it seems like either $2.50 in cuts for each dollar of increases, or cuts. So now to so sure on the hit to savings.

  4. Caveat 3 is closer to being the base case than a “caveat”. With the GOP now apparently willing to raise taxes, we may get even more deficit reduction than already feared. Details will matter a lot here.

    As far as oil goes, now that the election is over, Obama will not bend over backwards to postpone the bombing of Iran when their nuclear program gets too close for comfort.

    The Eurozone issue will continue to be a long, slow bleed. The ECB has come around for the most part, but the policy makers in individual countries still don’t understand the system, and further austerity is likely.

    1. @Erik V,

      Aren’t proposed deficit reduction on 10+ year budgets with the reduction in the later years, and current years will not change much if at all – deficits could even increase in current years? Plus they will assume high growth in future to make the numbers work, meaning relative to now even the plan cuts will not be as large as projected?

  5. Its weird that politicians really harp on the deficit and debt. Cutting taxes and spending should be really easy things to sell.

    1. @Broll The American,

      Completely right – it’s predominately because they misunderstand the Euro crisis so think that *suddenly* they might wake up and be Greece; as absurd as we all know that is. Joe Schmo on the street -Democrat or Republican- thinks the deficit will a) come out of his pocket (ironically) and; b)destroy the country if it isn’t reigned in …. So politicians play to those fears.

      If the Public understood modern money then the pressure would constantly be about upping the deficit – and the politicians would fall in line arguing about whether to cut taxes or hike spending; they are merely mirrors of the electorate.

  6. When you’ve figured out why it isn’t weird at all, you will have seen through the entire farce that is US politics. It took billions–billions–to put on the dramas to get these puppets elected and maintain the hologram; neither of them–the winner, in particular–is a billionaire.

    1. @Geoff,
      Well, Warren is suggesting rates go significantly higher from here (premium to inflation) so if he’s right you *definitely* don’t want to be long T-notes at 1.6%!!

      1. @Cesar, Right. Thanks, I didn’t catch that part about normalization of Fed policy the first time. But I think UE will have to drop well below 7% before the Fed starts to move. Not to mention the fact that they’ve said they’ll maintain the ZIRP until 2015, pretty much regardless of the circmstances.

  7. What if the Obama Administration puts the squeeze on coal and oil? It’s been said that it’s their intention?

      1. Yes, to some degree, if it causes a spike in prices.

        the caveat is a spike in energy prices which would shut down demand

        right now gasoline prices are down which is helping support demand

  8. Demographic developments in the US and in the rest of the world point to the fact that there won’t be any growth any more. In spite of MMT or MR.

    Housing recovery ? Don’t count on it !

      1. @WARREN MOSLER,

        thanks very much for your advice Mosler..
        in 3 years of trading I have understand (for me) only 1 thing: follow movement for some days/weeks.. over that period (with stocks&currency%commodity) I am not able to forecast.. for medium/long term I use fund of bond (Pimco&Templeton)..

        PS: I thing that PE, GDP, Book to Price Ratio, Demand, PRoduction => are fade => big affair banks can do all they want.. follow them.. go against them.. create a trend.. and create downturn from financial to real economy

  9. “And the 4 years of ‘larger than ever’ federal deficits have added exactly (to the penny) that much in dollar net financial assets to the global economy, with much of that being added here domestically.”

    From an output gap perspective, does it really matter that “much of” the financial assets are added here domestically? Aren’t they all added domestically, just some with foreign holders? The dollars are still generally just good in the U.S., no?

      1. @WARREN MOSLER, The dollar can trade all over the world for oil or other goods but its very last stop every night is at the Fed where it can earn interest. It’s also only accepted as a transactional currency because at some point there is something made or offered (service or entertainment) that the Chinese or Saudi’s want. Thus “good”.

      2. it can ‘trade’ or change hands but reserves remain data on the fed’s spread sheet.
        so if that’s what ‘good’ means they are always ‘good’

        what you then say is ‘good’ means it can buy something
        that’s the result of tax liabilities

      3. @Ivan, My point is that the economy doesn’t necessarily recognize if the saver is a Chinese national or a US Citizen holding private sector financial reserves. It’s only when the Chinese national purchases something for export that it becomes a real cost to the U.S. economy. Do I have this wrong?

      4. @Ivan,

        You’re not wrong Ivan. I never quite understood why people make a distinction between US holders of NFA and foreign holders. Perhaps it’s because the US government tries to trap its own residents by taxing them on their worldwide income, and by imposing an exit tax on citizens who renounce their citizenship.

        In any case, Bill Gates owns billions of dollars of dollar-denominated NFAs. So do Carlos Slim
        and Li Ka-Shing. The main difference is that when they spend billions of dollars on charitable endeavors abroad, only Bill Gates shares that expense with the US government via a charitable deduction on his income tax form.

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