Romney displays his complete ignorance about the global economy

I recently ran across a few headlines and news stories which claimed Romney had promised to stop borrowing from China. I had to read them a few times and then a few times again because, as I remembered, Romney claimed to know a little bit about economics and this was an egregiously incorrect statement, showing either a complete ignorance about the most basic aspects of the global economy, or a wish to exploit the fears of the Republican masses. Since I'd like to think he's not a total scum-bag, I'm going to assume it's the first.

The problem with this claim is that it claims that the US is dependent on the benevolence of Chinese creditors to fund its fiscal deficit. That's simply not true. Firstly, the accumulation of US obligations in Chinese balance sheets is a function of the Balance of Payments, not the US' fiscal balance. I'll quote Professor Michael Pettis here, as his explanation is more concise than mine,

...foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding. Capital account inflows must exactly match current account outflows.
...
The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall.
...
Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow.

As is obvious to anyone following the developments of the global economy over the last 10 years, the obvious scenario is the latter. The US Treasury doesn't need China's money, China needs US Treasuries as a way to warehouse its FX reserves in order to maintain its current account surplus. In fact, China reducing its holdings of US Treasuries would be net stimulative to the American economy as the US trade deficit with China means that, along with knicknacks and iPods, the US is also importing Chinese unemployment.

Unless the US Treasury starts emitting dim sums (borrowing in CNY or CNH), the US is not borrowing from China. This is not subject to discussion.

Things EFSF Will Not Fix

Expecting a bunch of bureaucrats to fix a decade's worth of accumulated imbalances in a matter of months with some alphabet soup ain't gonna work. What will work? Peripheral countries deflating with respect to core. Not only will it work, but it is the only thing that will work. Pictures follow. Toodles!

Cumulative Inflation relative to Germany. (i.e. Germany CPI would be a flat line at zero)

Balance of Trade (Exports-Imports) for GIIPS

GIIPS Balance of Trade as a % of GDP

Balance of Trade for selected European economies

Balance of Trade for selected European economies as a % of GDP

On Economic Data and Time Scales

I was looking at the excellent Bonddad blog today, and came across the post, "Uh oh: YoY gasoline usage down 5%, worst since October 2008."A small piece is quoted below.

US Gasoline demand

Something's happening here, but what it is ain't exactly clear. The most obvious candidates are:

1. demand destruction. But if so, why is consumer spending, as measured by the Gallup daily survey, holding up so well?
2. energy efficiency. But have we really bought so many hybrid vehicles to make that big a difference?
3. the weather. OK, we did have a strange Nor'easter that pummeled the northern and western suburbs of the Megalopolis, but that was one day only.
4. random stuff just happens. Always a possibility, but this seems unlikely given at least three weeks in a row of awful YoY comparisons.

 Now, I don't want to pick on Hale Stewart, the author, or his commentators, but I need to point something out here because this is a narrative I have heard many times in the last 3 weeks. Reduction in gasoline demand is not due to increased fuel efficiency. I don't doubt the fleet is getting more efficient, but this narrative completely ignores appropriate time periods and this is something I see quite often in the blogosphere. A reduction in demand due to fuel efficiency will be measured in decades, not months. If there is changes in the monthly numbers, it is either a different factor or noise, but the effect of increased fuel efficiency will not be measurable in the weekly data. Why? Because, at current sales rates and assuming no net growth in fleet, it would take roughly 23 years to turn over the US automotive fleet.

Auto sales as % of fleet, estimated fleet growth and replacement rates

Instead, I suggest we look for a more common-sense narrative and look at hotel occupancy, since Americans love to drive and, since we're talking gasoline sales, we need not worry about trucking.

Hotel Occupancy rate, via Calculated Risk

Hmmmmm. Notice anything? Like hotel occupancy and gasoline demand both coinciding in their drops?

Let's use some more common sense here guys and realize that different things happen in different time scales and if you are not paying attention to that, you are lying to yourself and making worse decisions as a result.

xoxo,

GossipGirl

UPDATE-1: This is not a criticism of Hale! This is a a comment regarding the four commentators that attributed the drop to fuel efficiency. This is a narrative I have heard from many people in the last 3 weeks and it is WRONG.

Buy Home, Sell Gold?

Presented without comment.

Hypothetical payment of a median-price new home purchased using a conventional 30-year mortgage

Hypothetical payment of a median-price new home purchased using a conventional 30-year mortgage as a % of median household income

Median-price of a new home expressed in troy oz of gold.

Muni Madness

Via FRED, the Bond Buyer Index GO 20y to maturity, mixed quality) spread to treasuries (weekly)

I've made no secret that I have been a heavy buyer of long-term municipal credit risk, taxable and non (via Build America Bonds) with short in treasuries of similar maturity to isolate the spread, looking for compression. But, please, take a look at the big 2008 spike. At these levels DV01s are big, so that widening can be really painful. Do yourself a favor and watch your risk levels. While there's reasons (scroll down to TOB section if you must) why I, personally, don't expect a 2008-like event, I am ready for it. This goes double if you think you are going to boost your positive carry and grab extra return from a wide discount in CEFs, as illustrated below.

XBBNX is NAV of BBN

Discount / premium of MQT via CEF Connect

UPDATE-1: Going back to 1953 using the monthly 20y treasury series with the long-term average series for the gap (pretty good fit, actually)

Build America, Young Man!

This is one of my favorite trades right now because I don't have a clear picture of where other things will go. The trade is simple: Buy BBN, sell TLT. In other words, buy the discount and credit risk and hedge your duration. By my calculation, the discount at the time of this writing (intra-day) is around 10.5% and, in my opinion, spreads in the Muni and BAB spaces are relatively attractive, considering credit risk, if you're not exposed to duration. BBN is a closed-end fund that holds Build America Bonds (basically taxable munis) with high credit ratings (3.6%AAA, 69.4% AA, 35.1% A). About 57% of the bonds are callable in 5-10y, which explains why, even with leverage (~30%) the daily NAV moves of late seem small compared to treasuries. The trade carries positive (~3% including borrow). If you have size, selling the ultra bond instead of TLT is easier and cheaper, and it's what I prefer to use. The risk with this trade is that spreads and discounts can always widen. In Nov-Dec '08 30% discounts to NAV were common and Munis took a beating vs treasuries. If you 're not levered, you can sit it out and make faces at your account balance until the dust settles. If you use too much leverage, your friendly margin clerk will probably liquidate you. Size accordingly.

Disclosure: I am currently long BBN, short TLT and short Dec '11 CME Ultra T-Bond contracts for myself and my clients.

Please remember, this is not a recommendation to buy or sell any securities. The information presented here is believed to be accurate as of the time of this writing but, hey, everyone fucks up, even me. This post is simply meant to be an illustration of one of the strategies I use in client accounts.

XBBNX = BBN Net-asset value.

X axis daily TLT change, Y axis BBN NAV change

Light Vehicle Sales and the NFP Report

I'm really dreading ADP/NFP week. It's my least-favorite week of the month. This month, I propose we all stop getting our collective panties in a bunch over a meaningless data-point that is subject to huge revisions and instead use a little common-sense and keep it simple.

You know what people are going to do when they get a job? Buy a car. Why do I think so? Because financing rates are low, deals are good, the fleet is old, and the sales have been depressed for three years. Don't believe me?

Red: SAAR Light-vehicle sales divided by the total population estimate
Green: Total non-farm private payroll divided by the total population estimate

Blue: SAAR Light-vehicle sales divided by the total population estimate (inverted scale)
Red: Civilian Unemployment Rate

The sewers I swim in

Boston sewer image from Liquid Assets

I've seen lots of arguments about why reducing the deficit right now would bring crisis to the economy. Most of them are very textbook Keynesian arguments arguing that at times of excess capacity, reducing deficit spending would just add headwinds to an already struggling economy. The other argument is that the US should take advantage of exceptionally low borrowing rates to invest in rapidly aging infrastructure and put Americans back to work using a sort of New Deal 2.0 scheme.

The first argument is a bird's eye solution to a ground-level problem. Yes, government spending would goose GDP, but is that spending creating wealth? Where is that "stimulus" going? Our goal, after all, is not to maximize GDP, but to maximize wealth. GDP is just a poor objective measure for a deeply subjective phenomenon and gaming our own framework won't help anyone, regardless of what numbers the BLS, BEA and FRB release over the upcoming months. And let's not forget that Washington has a very poor track record as an allocator of capital. I'm simply not comfortable leaving these decision up to the people that decided to try to reflate the bubble by pulling-forward demand, subsidizing toy arrows and foreign liquor and build useless airports. Just sayin'.

But does this mean we should address the crisis with full-throttle austerity? Not quite. As it was eloquently pointed out last Summer on interfluidity, austerity is stupid and deficits are dangerous. We can't make generalizations about debt, deficits or balanced budgets. Deficits and debt are neither good nor bad on their own. Leveraging up for wealth-creating projects is good, borrowing to throw money away shoveling sand from one pile to the other not so much. Washington is focusing on abstract goals like "putting real Americans to work." And one can't blame them because that's what people want, jobs. But "jobs" isn't something you can simply create from thin air, you can't just throw money at this problem and expect to fix it. "Jobs bills" and "improving America" are nebulous ideas, subject to interpretation without any objective way to measure success or failure, which is probably what Washington wants.

"Well, fine, but what do you suggest then?" you may be asking yourself. I just want to say one word to you. Just one word. Sewage. We've spent the better part of the last 10,000 years trying to secure sources of clean water and get rid of waste. Humanity has developed modern plumbing and sanitary sewers. We survived the Great Stink of 1858. We've battled epidemics of water-borne disease, droughts and floods.  I feel comfortable in making the broad statement that clean water is good and shitty water is bad. Therefore, one could expect that making something good out of something bad would be a positive thing, an improvement, a wealth-creating action. If you disagree, feel free to stop reading now.

All of which brings me back to our original topic, the deficit. We have swaths of unemployed persons and slack capacity in all aspects of construction, record-low financing rates, and an economy that uses fresh potable water faster than it replenishes it (including aquifer sources). Wouldn't it be great if we could put excess capacity to work creating an infrastructure that helps us achieve sustainability and conserve one of our most vital resources while financing it all at record-low rates? Well, we can, and it's called sewage treatment. It's the effective, efficient and inexpensive process of cleaning water.

The Deer Island Treatment Plant on the Boston Harbor provides primary and secondary treatment for the waste and storm water of the greater Boston area. It serves 43 communities, 2.5 million people and hundreds of thousands of businesses and it cost $3.8 billion to build. The entire MWRA had $176M of sewer-related operating expenses in FY2010 (pg 50). That works out to $70.40 per-person per-year. That figure includes not only the plant, but the entire sewer system as well as treatment of storm water and one of the most advanced plants in the country. DITP not only discharges water that is cleaner that the water it is being discharged into, but it efficiently decomposes organic waste using anaerobic digestion, reducing the volume of the sludge by 90% and using the resulting methane gas to help heat/power the plant. The dried, pelleted result of the digestion process is sold as Bay State Fertilizer (the heat naturally created by the digestion and drying process kills the harmful pathogens). So, for $70.40 per-person, per year, the MWRA cleans, on average, 360 million gallons of waste-water per-day and turns the organic water contained in it into energy and high-quality fertilizer, saving the city millions of dollars in sludge transportation and disposal fees, all while keeping the harbor clean. And while the $3.8 billion cost of construction may sound like a lot, consider that the plant had an initial 30-year expected life, meaning buying the plant on credit and amortizing it over 30 years (using the current 30y tsy rate of 4.12% as a proxy) would cost a only $7.36 per-person, per month. To put it all in perspective, including both amortization costs and operating costs, the cost per-thousand gallons of water treatment comes out to $1.48, or about the price of a medium-sized water bottle in a convenience store.

That's deficit spending I can get behind.

UPDATE-1: fixed an arithmetic oops and added reference to plant cost.
UPDATE-2: It was pointed out to me that the actual number of users serviced is 2.5 million, not 2 million. All numbers adjusted to reflect this. Link to source added as well.

Shut-up, CNBC: Carney on Muni bonds edition

Yesterday, Carney, when discussing risks to the Municipal markets said something I feel is inaccurate and deserves correction.

5. Information Cost is High. Muni issuers are not subject to the same disclosure requirements as corporate borrowers. The market is illiquid so pricing is opaque. The swaps market—the market for tradable credit protection—is thin and unreliable. This means that bond buyers may be taking on risks that they are not aware of. This is a recipe for panic once a triggering event occurs. 

First of all, CDS trading on a LOT of things is very thin. The municipal market is not a monolith, it is composed of thousands of issuers and so, yeah, swaps are probably pretty thin for many issuers. Just like bond and CDS mkts would be thin for most corporate issuers. Second of all, municipal market is dominated by retail, for obvious reasons. Joe Smith looking for safe tax-free bonds isn't exactly your average CDS trader.

Secondly, information is not that hard to come by if you know how to look and are not lazy. Anyone that's lending anyone money should do their homework, or at least pay an adviser or fund manager that has fiduciary duty to do it for them. MSRB is a wonderful resource, including a freely available trade history and, as Bond Girl has pointed out before, MSRB's EMMA allows you to find many issues' official disclosure documents.

Lastly, if you are the kind of investor that doesn't need an adviser or fund manager and is buying large amounts of municipal bonds, you can probably afford a subscription to The Bond Buyer and professional research from the rating agencies (ignore the rating and read the analyst's report).

6. Arbitrage Buying Leads to Bubbles. Much of the demand for muni bonds is not a function of credit analysis or a desire for exposure to the revenue streams of local governments. It is done for a technical, legal reason—to take advantage of the tax-free status of muni bond income. This creates an artificially high demand—a bubble—much like Basel accord capital requirements led banks to overinvest in mortgage bonds.

As Bond Girl wrote a few weeks ago, the last few years have seen some demand destruction, not only from a shift in investor's appetite for municipals relative to other securities, but by the departure of a number of leveraged actors that, through the use of short-term funding schemes created additional demand at the long ends of the curve. We're also seeing that "the muni market is transitioning from an interest rate space to a credit space." I can't go into it here, but you should really read Bond Girl's piece, it is excellently written and informative in a way no newspaper ever will be. But, getting back to my point, tax-free income doesn't necessarily increase demand.

Tax-free yield is attractive and investors are usually willing to take smaller yields for tax-free debt because it is still attractive in a taxable-equivalent basis. However, tax-free yields are only attractive to investors that benefit from preferential tax-treatment, limiting the universe of potential buyers--this is why the BAB program was introduced, to stabilize demand by introducing new participants. In my opinion, the tax-exempt yield of municipals actually hurts demand by restricting the universe of potential buyers. One only needs to look at the disparities between non-taxable TEY and BAB yields earlier in the year to see this at work.

The solution here, in my opinion, is for the federal government to refund issuers directly, like in the BAB program. Investors will receive higher yields that are equivalent on a taxable-equivalent basis and municipalities can offset the additional cost of debt service with refunds from the tax collectors paid for by the tax collected on the new, taxable issues. Otherwise, we risk a market where municipals can actually pay a premium, as they trade not only on their taxable-equivalent basis, but also on any extra risk or liquidity premium required by the restricted universe of buyers, increasing volatility and therefore the cost to issuers.

How China's Negative Real Rates Depress Consumption

If you've ever caught me ranting about China on twitter, you've seen me carry on about how negative real deposit rates are an implicit transfer of wealth from households to government. You may also recognize that point from Michael Pettis' China Financial Markets blog. In this post I'm going to try to explain how this transfer works. It's not complicated, but if you don't understand how developing economies differ from economies like that of the US it can be hard to see the mechanism at work.


The basics:

• Outside the upper-middle and upper classes, consumer credit is not easily available in developing economies. You can't just call Experian and check someone's FICO. Large amounts of the population is unbanked, underbanked or has no credit history at all.
• The deposit and lending rate (and therefore the spread between them) are set by the central government.
• Michael Pettis has estimated real deposit rates are suppressed by "at least 400-600 basis points" (China Financial Markets)

Negative real deposit rates are a transfer of wealth from depositors and creditors to debtors
Because of the limited access to credit that households have, households are the main source of deposits in the system. Like in other developing and under-banked economies with limited access to consumer credit, in China you need to save money until you have the full price to pay for X good (e.g. durables) which, when combined with inflation, forces the households to accept negative real rates. Accepting a 2% yield when there's 5% inflation may mean -3% real rate, but it's better than the -5% cash yields. Reasons for savings include emergencies, possible medical expenses, savings for a home, vehicle purchase or a child's education or every-day cash management. Remember, the rest of the world doesn't use their Capital One to pay for their groceries. With this kind of saving pattern, real rates have inverse effects on saving because, the more negative real rates are, the higher the savings must be to achieve a savings goal or maintain the real value of the savings balance. Without access to credit, negative real deposit rates force the household sector to save more. Money channeled towards savings by the household sector is money that is not spent on consumption. An approximation of total tax on households--and consumption--would be the product of the average daily balance of total deposits multiplied by times the gap between market and government-set rates multiplied by the percentage of household deposits in the system. That estimate excludes any effect from misallocation of resources by borrowers.


Who are the creditors? Who is receiving the transfer?
In April 2009, the Hong Kong Institute for Monetary Research published a paper which claims that state-owned enterprises (SOEs)--which account for about 37.6% of total value added in their respective industries and 25% of GDP--are only, or mostly, profitable due to a preferential cost of capital. According to the authors, "SOEs’ profits would have been entirely wiped out if SOEs were made to pay the same interest rates as otherwise equivalent private enterprises." How big is the problem? Well, "although SOEs’ contribution to the Chinese GDP was around 25%, they received about 65% of total loans."

Seeing as how a large portion of the SOE are involved in investment-related activities (in the GDP sense) and SOE's account for a majority of Chinese GDP the easy conclusion is that investment is being financed by taxing households through the banking sector. Net-winners? Anyone involved in that supply chain and the SOEs. So the transfer is moving from Households to government and business. Which businesses? Well, since, "about 41% of private enterprises have no access to credit and 56% have no access to bank credit," I'm going to guess big businesses.

Negative real rates impede a growth in household consumption by transferring wealth to government and business as long as households bear the cost of those negative real rates.

This leaves us with one way to increase consumption:

1. reduce the burden carried by households as a result of negative real rates.

And two possible ways of achieving that:

1. Raise real rates
2. Transfer some of the cost of negative real rates elsewhere

Barring a flood of foreign depositors itching to deposit funds into RMB-denominated accounts at negative real rates or holding RMB as FX reserves, option two means either government or business. Analyzing the effect to the SOEs is beyond the scope of this post, but since profits ultimately go back to the state, we can look at SOEs and government as one, and consider that subsidy as a tax. It's simply a way for the government to decide how citizens spend their own money. Unless the government stops trying to do that (fat chance), reduced subsidies to SOEs and government would just require more taxes/state-borrowing or less spending, of which the ultimate recipients are the household sector again.

Essentially, the other two beneficiaries of negative real rates, households and private industry with access to credit, are free-riding on this policy and benefiting from low-cost financing, creating a regressive re-distribution of household wealth. This is one of the many reasons we've seen restrictions, like higher down-payments, placed on mortgages of second and third home purchases.

Suggestions
The simplest fix to the problems caused by negative real rates (under-consumption, regressive redistribution, resource misallocation, asset-price inflation) is simply to raise real rates. Of course, raising real rates could cause a surge in NPLs from SOEs that wouldn't be profitable without the implicit subsidy. In the event of a SOE being rendered unprofitable by having to access capital at market rates, the implicit subsidy could simply be turned into an explicit one if the firm's activities were deemed important enough. Otherwise, the firm would go away or shrink, eliminating the dead-weight loss from misallocated resources. The banking system? The risk is already implicitly (and sometimes explicitly) socialized and the problem won't simply go away if Beijing keeps waiting.

Moving real interest rates up doesn't necessarily have to be contractionary for the economy. Sure, the loss of the implicit transfer from households to SOEs / Government would reduce investment capacity, but at the same time it would increase consumption capacity by an equal amount, although probably not the kind of consumption Beijing would prefer. Given the reduction in losses from negative real rates, households would be more able to absorb tax increases if Beijing wished to keep subsidizing investment.

Additionally, stepping closer towards market rates would allow the expansion of consumer credit. Widespread access to consumer credit wouldn't really co-exist well with real negative rates unless there was exterior financing, which would require major changes to the current account. Notwithstanding Q1 2010 numbers, I simply don't see consistent trade deficits for China in the horizon, so the next the easiest and healthiest road to increasing access to consumer credit is simply positive real rates.

Why increase access to consumer credit? In many ways--although not all--savings can be replaced by access to credit. Many people have savings so that they have enough purchasing capacity in short notice in case of an emergency. Credit can replace that cushion in many cases, reducing the need for short-term time or demand or deposits. Following this logic, giving someone access to credit allows them to spend deposits on consumption because the emergency purchasing power they needed is still there in the form of credit. Just this action, without any actual household borrowing, would shift some savings to consumption by reducing the quantity of household savings that need to be parked at deposit institutions.