Wednesday, 01 September 2010 10:27

The Great Global Macro Experiment, BoomBust Cycles, and the Refusal to See the Truth: Bubble Economics in the Mainstream Media

Back in September of 2007 when I was preparing to launch a hedge fund, I came up with this interesting name for a blog. It was BoomBustBlog. What made it interesting is that I can literally blog ad infinitum on the synthetically crafted booms and busts of the global economy, for the method of shepherding the economy in this day and age is actually predicated on the existence and/or creation of Booms and Busts. Of course, from my common sense perspective, one would think that the job of a central banker would be to ameliorate the effects of, and in time eliminate booms and busts... Apparently, that doesn't appear to be the flavor du jour. As a matter of fact, it appears as if central bankers are doing the exact opposite. Of course, attempting to cure a bust with a boom, or worse yet attempting to prevent a boom from busting with another boom is a recipe for disaster, and worse yet the probability of success is close to nil, yet central bankers try anyway. This leads to overt and explicit policy errors, which leads to outsized profit opportunities to those who pay attention. Enter "The Great Global Macro Experiment, Revisited", from which I will excerpt below. Please keep in mind that this article was written in October of 2008, and turned out to be quite prescient, I will annotate in bold parentheticals the portions of particularly prescient relevance. The original macro experiment piece was posted on my blog in September of 2007... For those that are interested, I plan on discussing this topic live on Bloomberg TV today: “Street Smart” with Matt Miller & Carol Massar at 3:30 pm.

As the US real estate market (residential, and soon commercial) is tanking (see BoomBustBlog.com’s answer to GGP’s latest press release and Another GGP update coming), the opaque derivative structures that allowed banks to write loans bigger than their balance sheets follow (see Is this the Breaking of the Bear? among many others). This will ripple throughout the world as speculative real estate and exotic financing vehicles follow the same paths in Europe (see the Pan-European Sovereign Debt Crisis series), Africa (reference Dubai's solvency issues), Asia (see Chubble (The Unmistakeable, Yet Thoroughly Argued Chinese Bubble), Unemployed/Deleveraging Shopaholics Pushing Retail Stocks & Other News and What Are the Odds That China Will Follow 1920’s US and 1980’s Japan?), and South America. Spain’s residential real estate market is currently on fire and 92% of the mortgages issued are ARMs, most of which are concentrated to the lower income buyers (see The Spanish Inquisition is About to Begin…“ and ). Sound familiar? Similar scenes in Brazil. UK residential prices have soared (see Osborne Seems to Have Read the BoomBustBlog UK Finances Analysis, His U.K. Deficit Cuts May Rattle Coalition as well as the near collapse of several large UK banks), Australia up nearly 3 times (relative) (see Australia: The Land Down Under(water in mortgage debt), China homebuilders and contractors or roaring, condos in Dubai everywhere… Add in the US exported structured products… Practically all of the popularized risky assets are destined to follow suit, not just real estate – expect pressure in the emerging market debt markets as a follow-through…

Understanding my proprietary investment style

reggieboombustcycles.png

My own, personal and discretionary investment style leverages long and short positions in any traditional or alternative asset class, in any instrument, in any market around the world with the goal of profiting from macroeconomic trends. Put most simply, I attempt to employ the tried and true adage: buy low and sell high – I simply aim to do it during all phases of the market cycle. The often used, but seldomly recognized as meaningless, investment style classifications of value investing, growth company investing, etc. are silly, to say the least. Everybody is a value investor. We all buy something with the understanding that we will be able to sell it for more, thus the implication that it is undervalued at the time of purchase. The reason why we feel we can sell it for more is the impetus behind these nonsensical monikers of value, growth, Amy, Cindy and Karen! At the end of the day, we all want to buy low and sell high. The key is, how do we successfully go about doing it.

Now, in reading the now historical missive above which references debacle after debacle that policy makers retort "were impossible to see coming" (yeah, uh huh!), it could conceivably be argued that a) I had a crystal ball, b) I'm just smart as hell, or c) I simply pay attention and adhere to basic math, i.e., 2 + 2 = 4, all day, everyday - you know, realism. I'll let you decide which answer is most appropriate. I go through this exercise because while reading through Bloomberg at 2 am in the morning (yeah, I know I should have better things to do,  but how else will this blog get written), I came across a statement from some professionals that reinforced my thesis that some investors literally cannot possibly fathom that we are still in a bubble despite 40% drops in commercial real estate prices. Take a look at the chart above, the cycle goes up and down, and has been doing so for centuries. Despite the fact that nothing has really changed for over a 1,000 years, it is amazing that so very few have learned their lesson. Or to put it another way, just because something is cheap doesn't mean it can't get a whole lot cheaper. Wait a minute, I've got another one... I fall out of a 10 story window, and drop 60 feet in a matter of seconds.... Does this really mean that my fall is over just because I fell 60 feet so fast, or do I really have another 100 feet to go, then a very hard impact before all is said and done???

Bloomberg writes: Real Estate Premium to U.S. Bonds Signal Time to Buy Property

Sept. 1 (Bloomberg) -- U.S. commercial real estate yields are near the highest level relative to Treasury bonds on record, a signal to some investors it’s time to buy property. Capitalization rates, a measure of real estate yields, averaged 7.22 percent in the second quarter, based on an index calculated by the National Council of Real Estate Investment Fiduciaries. That was 429 basis points, or 4.29 percentage points, higher than the yield on 10-year government bonds as of June 30, according to data compiled by Bloomberg. It’s about 475 basis points higher than Treasury yields as of yesterday.

That spread is near the record 539 basis points in the first quarter of 2009, when the U.S. was mired in the worst of the financial crisis and property prices sank. Risk-averse investors are seeking the highest-quality office towers, hotels and apartments as the gap widens, according to Nori Gerardo Lietz, partner and chief strategist for private real estate at Partners Group AG in San Francisco.

“The data indicate that real estate is poised for a rebound,” said Gerardo Lietz, who advises pension funds on property investments.

Well, I have several problems with the statement above. For one, it is very difficult to "time" real estate markets due to their illiquid nature and a lack of a crystal ball, but if one were a market timer the strategy above makes sense right? Actually, no it doesn't. For one, we are not in any better an economic or fundamental position now than we were in 2009, its just that the government and the fed have spent so many trillions of dollars to create the illusion that we are under the umbrella of attempting to reinflate the bubbles of 2000 to 2007. With that being said, of course spreads are similar, the situations are similar save the government has less ammunition to fight the battle this time around.




[caption id="" align="alignnone" width="640" caption="Chart sourced from CREconsole.com"][/caption]




The strategy above appears to be borne from the long only asset management mantra of always buying an asset. Sometimes its best just to say "No!". For instance, the story clearly states that spreads are almost as wide as they were in the first quarter of 2009, the height of the financial malaise. So, if one were to use the logic inherent and bought at those even wider blowout spreads (the argument for the thesis was stronger back then), take a look at what would  have happened to your hard earned (or your client's hard earned) money...




[caption id="attachment_3103" align="alignnone" width="624" caption="The Moodys/REAL commercial property index (CPPI) is a periodic same-property round-trip investment price change index of the U.S. commercial investment property market based on data from MIT Center for Real Estate industry partner Real Capital Analytics, Inc (RCA). The index has been developed with the objective of supporting the trading of commercial property price derivatives. The index is designed to track same-property realized round-trip price changes based purely on the documented prices in completed, contemporary property transactions. The index uses no appraisal valuations. The set of indices developed so far includes a national all-property index at the monthly frequency, national quarterly indices for each of the four major property type sectors (office, apartment, industrial, retail), selected annual-frequency indices for specific property sectors in specific metropolitan areas, and primary markets quarterly indices for the top 10 metropolitan areas in the major property types."][/caption]




The biggest hole (and there are a few) in this "spread" thesis is the gross reliance of the spread to Treasuries without recognition and appreciation that Treasuries themselves are most likely in a bubble. This is why it is best to take a truly fundamental look at your investments. Back to the story...

Some buyers already are acquiring buildings at lower cap rates, which move inversely to price. In June, a group of South Korean pension fund investors bought the 33-story Wells Fargo Building in San Francisco for $333 million from Principal Financial Group Inc. in one of the largest transactions in the second quarter, according to Real Capital Analytics Inc., a property research firm. The office tower sold at a cap rate of about 7 percent, said Goodwin Gaw, the developer who helped broker on the deal.

My question is, why not just wait until there is a discernible trend in the stability of CRE? Why must everyone rush in to be first? Do rental rates look to be going much higher in the near to medium term due to materially firmer business fundamentals or lessened supply? Do interest rates look to be dropping considerably in the near to medium term? Are the fundamentals of the renters firm and strong? How does supply vs demand look after rampant, bubblicious overbuilding (which is still going on, may I add)? How does the financing and credit landscape look? How about the credit metrics of existing buildings? Do we have low LTVs or are these things thoroughly underwater (see the Macerich excerpt below). Let's take a few pages out of my CRE 2010 Outlook report for subscribers (click here to subscribe). Be aware that this 47 page report was written nearly 10 months ago...



Are US Treasuries In A Bubble?

Well, if they are, not only does that debunk the "spread only" thesis to CRE investing but it will devastate those who employed said thesis when the bubble pops. As treasury yields spike, the cap rates on said buildings will have to spike to maintain said spread or the spread will have to lessen making the CRE that much more expensive relative to the safer treasuries. Either way, the CRE investor would have wished they waited! Let's take a look at the NYSE US 10 yr index...

Whoa!!! Looks pretty bubblicious to me! Herein lies the problem. I don't think that many investors truly understand the predicament that the US, much Europe and those big boys in Asia are in. Pray thee tell me, how is the US going to pay back its massive debt? Taking this from the beginning, many of us were told that the Federal Reserve's mandate was to management inflation and unemployment rates. I lost a lot of profit and messed up a 7 year record of investing in the 2nd quarter of 2009 when the federal reserve performed a stealth mandate change, which in essence was to reinflate and maintain the credit and risky asset bubbles of the new millenium. This bubble blowing has been funded by the tax payer through the US Treasury. I challenge anybody to prove that the Fed's objective has been anything but. The government and the CB has literally pulled out all stops to prevent the "Bust" portion of the Boom/Bust cycle. They have bought trillions in MBS, toxic assets directly off of private companies balance sheets, insured and indemnified private transaction, nationalized failed private financial institutions, purchased treasuries and MBS directly in a bid to artificially lower market interest rates -this is a move which is in and of itself by definition, unsustainable and guarantees a rate spike.

To make a long story short, nearly all of the biggest private sector problems have effectively been nationalized and made public sector problems without forcing the private sector to right its wrongs. Since nothing has really changed in the private sector and we are not marking bad assets to market but rather letting whatever we couldn't goose the government into buying and converting into treasuries remain as they were while cash generating from the faux recovery was paid out as bonuses - the banks still have a shit load of trash on their balance sheets amid a worsening macro environment, the most indebted government of our lifetime and crumbling fundamentals. I pray thee tell me, exactly how are rates not going to spike? US Treasures are the new CDOs, wherein back in 2007 private banks scooped the trash they couldn't convince suckers clients into buying directly, said trash was aggregated and repackaged with a AAA moniker and then sold to suckers clients. So, what is the difference between what Lehman, Goldman, Merrill and Bear Steans did and what out Central Bank is doing - that is picking up the garbage that nobody wants, recycling it into treasuries with a AAA moniker and then reselling them? The biggest difference is that one of the biggest suckers clients buying these repackaged toxic assets cum treasuries is the Federal Reserve, itself. Talk about a Ponzi scheme that is unsustainable. Again, how is it that treasuries are not in a bubble? How will rates stay low enough to justify buying CRE based upon the spread over treasuries at historic lows that are virtually guaranteed to go higher before the fundamentals of CRE improve significantly? I haven't even touched upon the situation of our friends over there in Europe  - see .Pan-European Sovereign Debt Crisis series, where several nations are skirting default or restructuring (de facto default, you don't get your money as promised) which will most likely cause some serious interest rate volatility, of which some banks are not prepared to withstand - See The Next Step in the Bank Implosion Cycle???). Since banks lend to CRE investors.... Oh well, back to the article...

Comparing Yields

Investors compare property yields with Treasuries to determine how much potential profit real estate offers relative to an investment that’s considered low-risk. The spread shrank to less than 80 basis points, the narrowest in 16 years, when commercial real estate prices peaked in 2007. Property values have dropped more than 40 percent since the October 2007 top of the market, according to Moody’s Investors Service.

The gap’s widening follows a plunge in bond yields after the global financial crisis spurred a flight to safety and the Federal Reserve slashed interest rates to a record low. Treasury bonds yesterday completed the biggest monthly rally since the end of 2008 amid signs economic growth is faltering, with the benchmark 10-year note yielding 2.47 percent.

“Property is attractively priced versus the fixed-income market,” said Ritson Ferguson, chief investment officer of ING Clarion Real Estate Securities in Radnor, Pennsylvania, which manages about $12 billion.

Yes, he's right. Then again, 2 day old oysters smell attractive versus 3 day old oysters as well. Does that mean that 2 day old oysters smell good? The primary mantra of investing should be return of capital over return on capital!

The wide spread carries a warning signal to some investors because the economy remains weak, hurting commercial rents and occupancy. To contact the reporter on this story: Hui-yong Yu in Seattle at This email address is being protected from spambots. You need JavaScript enabled to view it.

Those would be the more prudent investors they are referring to, at least in my oh so humble opinion.

The Amount of Underwater Properties is Nothing to Sneeze At

In December of 2009, I posted an article and accompanying research titled, “A Granular Look Into a $6 Billion REIT: Is This the Next GGP?” The following are excerpts from it:

The results of these activities have been congealed in our analysis of Macerich’s entire portfolio of properties (118+ properties), including wholly owned, joint ventures, new developments, unconsolidated and off balance sheet properties. Below is an excerpt of the full analysis that I am including in the updated Macerich forensic analysis. This sampling illustrates the damage done to equity upon the bursting of an credit binging bubble. Click any chart to enlarge (you may need to click the graphic again with your mouse to enlarge further).




image001.png

Notice the loan to value ratios of the properties acquired between 2002 and 2007. What you see is the result of the CMBS bubble, with LTVs as high as 158%. At least 17 of the properties listed above with LTV’s above 100% should (and probably will, in due time) be totally written off, for they have significant negative equity. We are talking about wiping out properties with an acquisition cost of nearly $3 BILLION, and we are just getting started for this ia very small sampling of the property analysis. There are dozens of additional properties with LTVs considerably above the high watermark for feasible refinancing, thus implying significant equity infusions needed to rollover debt and/or highly punitive refinancing rates. Now, if you recall my congratulatory post on Goldman Sachs (please see Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off), the WSJ reported that the market will now willingingly refinance mall portfolio properties 50% LTV, considerably down from the 70% LTV level that was seen in the heyday of this Asset Securitization Crisis. Even if we were to assume that we are still in the midst of the credit bubble and REITs can still refi at 70LTV (both assumptions patently wrong), rents, net operating income and cap rates have moved so far to the adverse direction that MAC STILL would not be able to rollover the debt in roughly 37 properties (31% of the portfolio) whose LTVs are above the 70% mark – and that’s assuming the credit bubble returns and banks go all out on risk and CMBS trading. Rather wishful thinking, I believe we can all agree.

For those of you who didn’t catch it in the table above, I’ll blow it up for you…

Notice anything familiar??? There is a very strong chance that every single property on the list detailed in the forensic reports will be taken over by the lenders, that’s a lot of properties. Subscribers should reference MAC Report Consolidated 051209 Retail MAC Report Consolidated 051209 Retail 2009-12-07 03:46:49 580.11 Kb , MAC Report Consolidated 051209 Professional MAC Report Consolidated 051209 Professional 2009-12-07 03:48:11 1.03 Mb, Click here to subscribe!

So, why has Macerich and the entire REIT sector defied gravity despite the fact they are getting foreclosed upon faster than a no-doc, subprime, NINJA loan candidate who just lost his minimum wage job amongst all of these “Green Shoots”??? Well, I took the time to answer that in explicit detail… I urge all to read The Conundrum of Commercial Real Estate Stocks: In a CRE “Near Depression”, Why Are REIT Shares Still So High and Which Ones to Short?

Now since the posting of the article above, Macerich as forced to disgorge several of those properties due to solvency issues. The math doesn't lie! Chances are there will be several more! Anyone who has an interest in the CRE space should download my 47 page outlook for the sector in 2010 (available to all paying subscribers of any level):  see Reggie Middleton’s CRE 2010 Overview CRE 2010 Overview 2009-12-15 02:39:04 2.72 Mb (42 pages). Now, I'm aware that viewpoints and statements may not win me many popularity contests in man professional circles (ie Even With Clawbacks, the House Always Wins in Private Equity Funds), but I aim to call it as I see it.

More on commercial real estate:

More on residential real estate:

Last modified on Wednesday, 01 September 2010 11:10

8 comments

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  • Comment Link Reggie Middleton Tuesday, 07 September 2010 14:22 posted by Reggie Middleton

    RE MBA_MSF_CFA:
    "I think I should have started by saying that allowing private demand to collapse and not have the government step in in some form to mitigate the effects of that would be disastrous, for Japan and the US."

    I'm in full agreement with this, but when the gov steps in the steps often have a steep cost hence the steps have to be worthwhile. Simply saving the very same establishment that imploded due to poor risk management and abject greed over prudence does nothing to solve the problem and only kicks the can down the road. Ask the Japanese what they have been up to for the last 20 years. In the saving of the financial system, certain asset classes and corporations should have been allowed to hit rock bottom in order to allow for a clearing of the chaff and proper price discovery. Where we disagree is the capability of sovereign governments. Without proper price discovery you are not going to get the full participation of the private sector in investment and that is a prerequisite for the proper functioning of capital markets. If the government had unlimited revenue capability then they can just print all of the money that is needed and simply buy up all the assets that don't have a private bid, thereby creating markets for them. Does that sound familiar?
    The only problem with that scenario is that having the government as bid and the only bid is not truly a market and eventually you will have a great unwind as market forces become too much for the government to bear, or (and probably AND) the government loses control of markets that it thought it once had control of, ex. Greenpsan and mortgage rates in the '90s.

    I have to go now, but I will address the rest of your comment later on.

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  • Comment Link MBA_MSF_CFA Tuesday, 07 September 2010 11:24 posted by MBA_MSF_CFA

    I think I should have started by saying that allowing private demand to collapse and not have the government step in in some form to mitigate the effects of that would be disastrous, for Japan and the US. I'm not as familiar with the Japanese culture but I wager it's just like here, no one wants to take that hard medicine and take a step backward to take two forward. We loved the boom times, we dont like the bust times and we blame government when they dont do something to stop the slide. We as a people don't reward politicians that would demand we take our medicines, so it's no wonder we have policies designed to keep stuff propped up. This is the context we must all accept when analyzing government activities.

    "I said the Fed contributed towards this, they are not the sole contributor. You agreed with this, as I feel you must as a prudent commentator. The sole reason for the Fed’s buying treasuries (and MBS) is to create a faux market in the and suppress rates. This rate suppression results in synthetic market rates, rates that are not sustainable. Even if they were sustainable, as we see in Japan, it will not fool market participants for everyone is free to see what the CB is doing. That is why assets that are academically quite sensitive to market rates (stocks and real estate) have tanked over 20 years as Japanese rates scrape rock bottom. What makes it worse, is that when (not if, but when) market forces take control of rates again and they spike higher, these assets (particularly real estate) will get hit even harder."

    Agreed on this but the artificial part still isn't correct. This is part and parcel with government operations, if they want rates low, they have the means to do so. If they want them high, they can get that too. There is no "market taking control" of the gov't rates. That can never happen if the government doesn't want it to. The gov't doesn't even have to issue debt if it didn't want to, it does so purely out of choice, not force. When they do allow the market to take control, it's only because the economy is humming along and they have no need to try to achieve a rate goal. The moment they want to take the reins back they can easily do so.

    We can disagree on whether what Japan has done and what the US is doing now i, which is hope that the quantitative easing will bide enough time for private demand to rebuild itself, is any good. I don't think we can disagree on what would happen if they abandoned those efforts. We'd see chaos in the streets, unemployment spike thru the roof, a further divide of the haves and have nots, and society would feel the impact of that for decades to come. There's a social impact here to just letting the markets act normally I don't think anyone has thought thru fully. The rub here is, those impacts last for decades to come, even further impacting society at large. Unfortunately, there probably isn't another WW2 or Internet on the near term horizon to give the economy another steroid shot.

    As for the CRE piece, while I would tend to agree with you, the timing is everything as you well know. They can and probably will goose this for much longer than anyone predicts so efforts to trade ahead of the impending crash are very dangerous. Folks have been predicting doom and gloom for Japan for 2 decades now and while they're not exactly growing like China YOY, they're not exactly crashing to the floor either. That chart you posted is exactly what the US is attempting to do, bring those markets down for a safe landing, not a crash. It took 15 plus years for the market to revert itself to the 1973 levels. I agree governments cannot goose asset prices forever over the medium to long term, they can and will ensure the prices dont fall thru the floor immediately. And they can do so by nationalizing these issues since they govt has an unlimited checkbook.

    So I agree with your basic thesis, but disagree with the research backing some of your analysis. There are fundamentals to the Treasury bubble and there will continue to be. Ignore them at your investing peril.

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  • Comment Link jon Monday, 06 September 2010 13:16 posted by jon

    The fed is never revenue constrained, interest rates look to be on the floor for sometime to come.

    Although the fed/Gov can fund it's obligations unless congress decideds not to , what they cannot fund is and what is harder for them to control if they have any control at all , is the houshold balance sheets which are more then likely bankrupt and a largest part of this economies current problem. Congress maybe better off setting off a bigger programe of public works and pay roll tax holidays, to speed up houshold balance sheet repair. I am not sure if congress understands that China does not fund the USA's borrowing and may start cost cutting programmes like in the UK.

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  • Comment Link Reggie Middleton Sunday, 05 September 2010 12:28 posted by Reggie Middleton

    You may have a point on Argentina.
    You totally failed to acknowledge the point of my article which is irrefutable that the government cannot manipulate the price of hard and risky ssets over the medium to long term. You use Japan as an example several times and I presented you with a chart that showed Japan's equity and land markets sinking over 20 years as BOJ tried to goose the economy through QE. As I stated before, sovereigns are not market gods, and the same thing will probably happen in the US. The theme in the article still stands, CRE does not look strong as an investment now, and the Fed's attempt to goose it through QE and suppressing rates will probably backfire. I would prefer rates to go up, driving down the price of CRE but allowing natural price discovery and the associated climbing of yields which will eventually call for an increasing in pricing to reach equilibrium. You can only have an asset yielding 16% for so long without other things moving in line.

    "Tsk tsk Reggie. Which superpower since the gold standard ended and we went to monopoly money has fallen due to purely fiscal circumstances? You can’t point to the ROmans or the English or any other superpower since we are under a completely different paradigm now. I know you know this.

    The demand will always be there, especially in times like this when inflation is negative!! Who wants sterile reserves earning nothing when you can at least get a guaranteed yield, even if it’s 1-2%? "

    Don't you see the error in this logic? Nothing has ever failed, until it has failed!!! Declaring that there will always be a demand for something because, up until now, there has always been a demand for it is circular reasoning.

    "“Governments are not “market gods” and they need access to foreign capital like everyone else. If the confidence in that government’s ability to service that access is faltering, bad things will happen.”

    Whoa whoa whoa whoa. Foreign capital? China owns Treasuries because of the trade imbalance, not because we need their money to fund the government. They get dollars for all the billions we spend in Walmart each year. They want to earn interest on it. This is done via Treasuries. Same for Japanese goods. Let’s also remember that a lot of Treasuries are owned by US citizens, either outright or via pensions or money market funds. "

    China buys treasuries because of the trade imbalance and we sell treasuries because we need the money. It is a symbiotic relationship, but you are discounting one side of the symbiosis.

    "No, the buying of Treasuries by everyone else has contributed to it. Sure the Fed is lapping them up, but so are all the major banks who have sterile reserves earning nothing due to govt spending. So are tons of people who see the private demand gap and want some return on their money. So are all the foreign countries with dollars earning nothing. The Fed buys them so all of those accounts(banks, foreign countries) held at the Fed have a savings account they can shift money into vs the sterile checking accounts they’re sitting in now. The Fed also buys them to keep rates low as you mention.They can do this as long as they want to achieve rate goals."

    I said the Fed contributed towards this, they are not the sole contributor. You agreed with this, as I feel you must as a prudent commentator. The sole reason for the Fed's buying treasuries (and MBS) is to create a faux market in the and suppress rates. This rate suppression results in synthetic market rates, rates that are not sustainable. Even if they were sustainable, as we see in Japan, it will not fool market participants for everyone is free to see what the CB is doing. That is why assets that are academically quite sensitive to market rates (stocks and real estate) have tanked over 20 years as Japanese rates scrape rock bottom. What makes it worse, is that when (not if, but when) market forces take control of rates again and they spike higher, these assets (particularly real estate) will get hit even harder.

    You make an eloquent argument, and I really like that on my site, but the fact of the matter is that the artificial suppression of treasury rates has created a bubble or close to one in that asset class and it is setting up CRE for a harder crash than we would have had if rates floated more naturally.

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  • Comment Link MBA_MSF_CFA Sunday, 05 September 2010 10:12 posted by MBA_MSF_CFA

    Not true, Argentina did not float its currency on the open market. It had it pegged to the USD. That's a completely different ballgame than a currency that allows the rate to float freely. Actually it was only when they ended that peg in 2002 that their crisis began to turn around!

    Yes the state to Eurozone comparison isn't exact, but my larger point still stands. States need to finance their spending in advance since they cannot issue currency nor control it. This is no different than Greece which owed debts in Euros yet could not influence nor issue Euros. They all share something, they are financially(revenue) constrained. A sovereign is not.

    "The demand will only be there if the percpetion that the US can service its debt as a superpower is there. Every empire had this mentality, until they fell!!!"

    Tsk tsk Reggie. Which superpower since the gold standard ended and we went to monopoly money has fallen due to purely fiscal circumstances? You can't point to the ROmans or the English or any other superpower since we are under a completely different paradigm now. I know you know this.

    The demand will always be there, especially in times like this when inflation is negative!! Who wants sterile reserves earning nothing when you can at least get a guaranteed yield, even if it's 1-2%?

    "Governments are not “market gods” and they need access to foreign capital like everyone else. If the confidence in that government’s ability to service that access is faltering, bad things will happen."

    Whoa whoa whoa whoa. Foreign capital? China owns Treasuries because of the trade imbalance, not because we need their money to fund the government. They get dollars for all the billions we spend in Walmart each year. They want to earn interest on it. This is done via Treasuries. Same for Japanese goods. Let's also remember that a lot of Treasuries are owned by US citizens, either outright or via pensions or money market funds.

    There will never be any lack of confidence in the government's ability to service the debt. Why should there be? Cash flow is king right? They can "print" at will and have the only computer allowed to credit bank accounts for US obligations.

    You're a hard data guy right? You use empirical data Why haven't the bond vigilantes made Japan bend over yet? Why is their 10 year so low? They got a 10 year headstart on us, I would have thought by now we'd see some evidence that the "lack of confidence" in Japan is impacting their ability to "fund themselves".

    "All I dud was illustrate the parabolic rise in treasuries that was not supported by the fundamentals. The buying of treasuries by the Fed has contributed to a bubble."

    No, the buying of Treasuries by everyone else has contributed to it. Sure the Fed is lapping them up, but so are all the major banks who have sterile reserves earning nothing due to govt spending. So are tons of people who see the private demand gap and want some return on their money. So are all the foreign countries with dollars earning nothing. The Fed buys them so all of those accounts(banks, foreign countries) held at the Fed have a savings account they can shift money into vs the sterile checking accounts they're sitting in now. The Fed also buys them to keep rates low as you mention.They can do this as long as they want to achieve rate goals.

    So yes, there's a "bubble" but the fundamentals support it. Market forces have little impact here, the rates are low because the government wants them low. So sure it's "artificial" if you still operate under the paradigm that the market Treasuries is similar to the market for stocks and other bonds where "confidence" means a whole lot. For a currency sovereign nation is doesn't and never will.

    While rates will rise eventually(can only go up from zero right?) you would have to time this perfectly to get it right because it remains to be seen how long this must continue to support the anemic growth of the economy. Einhorn from Greenlight made a huge bet on rates rising in Japan last year using the same arguments you are now:

    http://www.marketwatch.com/story/einhorn-bets-on-major-currency-death-spiral-2009-10-19

    He has 3-4 years left on those options. He bought them cheap but he'll wind up losing on them. His argument that the savers will become spenders is laughable because if that becomes the case, and the BOJ wants to keep rates low, they'll just buy them instead. Same here. Doesn't matter if regular folks lose confidence, or foreign nations, the Fed will buy them to keep them low if they think it's smart to do that, and why wouldn't you if you predict anemic growth for the next few years? Higher rates would kill any recovery, especially a tepid one.

    Currency sovereign governments are market gods when it comes to their own govt bond market.Once this is understood and accepted(which I hope and pray it will be after this is all said and done) there's lots of money to be made.

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  • Comment Link Reggie Middleton Saturday, 04 September 2010 13:04 posted by Reggie Middleton

    I was actually waiting for a reply like this. Let's take it step by step.

    Your comparison to Japan proves my point. A government cannot fight natural market cycles in a free market system. There is just not enough capital avialable. Japan employed QE 1.0. 2.0 up to v10 and although they were able to ignite GDP (which really didn't mean much) take a look at the asset prices that they were trying to inflate: http://boombustblog.com/images/stories/macro/thumbnails/thumb_japanese_land_vs_gdp.jpg
    Total, and absolute failure after DECADES of QE and stimulus. Yes, rates may remain low for some time, but that is not going to magically invert an asset cycle after a boom. Remember, this discussion is had in light of CRE prices.

    As for the US govt. it doesn't have to fund its spending in advance, but it does have ensure that the world and its creditors maintain the perception that it has the capability to service its debt. Mathematically, the ability to service the debt will not be there unless big changes are made. The only reason the US can pay the debt by pushing 1s and 0s behind a screen is because of global confidence in US financial fortitude. Without that confidence, all bets are off. This seems to be an aspect that many economists seem to miss.

    "Eurozone countries are more like US states. "
    I disagree. The states are:
    - geographically contiguous,
    - they all speak a common language
    - they all share a common federal government - the biggest point of them all
    - they all have a common federal legal system
    - they all participate in a common federal taxation system
    - and they have 200 years of experience in working and living together.

    The differences are many, and they are significant. The EU is only a few years old and it is obvious that many of the issues that make the US strong have not been thought out in Europe.

    "The answer to your first question is rather simple. They’ll pay back the debt by crediting accounts using #’s on a computer screen. That’s it. The demand for the debt will always be there as long as there is a trade deficit and as long as banks and foreign nations with surplus dollars want interest on the sterile reserves that result from govt spending."

    The demand will only be there if the percpetion that the US can service its debt as a superpower is there. Every empire had this mentality, until they fell!!!

    "You cannot analyze Treasuries using charts like they were stocks, they are completely different beasts."
    True, but I didn't do so. All I dud was illustrate the parabolic rise in treasuries that was not supported by the fundamentals. The buying of treasuries by the Fed has contributed to a bubble.

    "Well, managing deflation is part and parcel with managing inflation."
    Managing deflation is what you have to do when you failed to manage price inflation (a bubble) effectively.

    "Treasuries will always be repaid, with interest, and it’s never a concern that the US govt(or any other currency sovereign which owes “debt” in the currency it issues and controls) will be able to repay it. It’s a risk free rate for a reason. INsolvency is not a concern."

    So you'r saying that Argentenian bondholder got every dime they had contractually coming to them when comparing their situation after restructuring and before restructuring? Argentenia fits your description of a government that owed debt in a currency it issued and controlled.

    Governments are not "market gods" and they need access to foreign capital like everyone else. If the confidence in that government's ability to service that access is faltering, bad things will happen.

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  • Comment Link MBA_MSF_CFA Saturday, 04 September 2010 11:11 posted by MBA_MSF_CFA

    "I don’t think that many investors truly understand the predicament that the US, much Europe and those big boys in Asia are in. Pray thee tell me, how is the US going to pay back its massive debt?"

    "This bubble blowing has been funded by the tax payer through the US Treasury."

    Ahh Reggie, I generally love your work and willingness to think outside the box, but you show you definitely don't think outside the box when it comes to modern monetary operations. That second quote just proves you go along with the herd in thinking the US govt is just like you and I and needs to fund its spending in advance via income(taxes) and/or debt when nothing of the sort is required. Until you get out from underneath that paradigm, which hopefully will be proven to be false as a result of this "crisis", your analysis when it comes to sovereign government debt will continue to be off base.

    Also you cannot compare a currency sovereign by which I mean:
    - issues its own currency
    - owes "debts" in said currency
    - floats the currency freely on world markets

    to the Eurozone. It's just a false comparison and nowhere close to accurate. Eurozone countries are more like US states.

    The answer to your first question is rather simple. They'll pay back the debt by crediting accounts using #'s on a computer screen. That's it. The demand for the debt will always be there as long as there is a trade deficit and as long as banks and foreign nations with surplus dollars want interest on the sterile reserves that result from govt spending.

    Betting on rates rising anytime soon is a sure way to lose money. As long as the deficit spending continues and the govt chooses to match that dollar for dollar with debt, the rates will stay low. And deficit spending will be the ONLY way to keep the economy even remotely propped up with the private debt overhang killing demand from the private sector. Both parties know this, and no matter who's in power, you'll continue to see massive deficit spending.

    You cannot analyze Treasuries using charts like they were stocks, they are completely different beasts.

    " many of us were told that the Federal Reserve’s mandate was to management inflation and unemployment rates"

    Well, managing deflation is part and parcel with managing inflation. Inflation is years away from reappearing. Deflation is a more frightening scenario whcih is why they are trying to reinflate. As for unemployment rate, this really isn't the Fed's job. Only fiscal policy can guarantee unemployment rates. The spending has put a temporary cap on the rate but more will be needed to avoid it spiking even further.

    "So, what is the difference between what Lehman, Goldman, Merrill and Bear Steans did and what out Central Bank is doing – that is picking up the garbage that nobody wants, recycling it into treasuries with a AAA moniker and then reselling them?"

    Errrr, Reggie, the CDO's were ultimately backed by folks like you and I who had to possess the ability to repay the debt and interest. Only when that stopped did the CDO's become trash. Treasuries will always be repaid, with interest, and it's never a concern that the US govt(or any other currency sovereign which owes "debt" in the currency it issues and controls) will be able to repay it. It's a risk free rate for a reason. INsolvency is not a concern. Check Japan, which doesn't have a AAA rating, Debt to GDP ratio 2x as high as the US, and look at their 10 year rates.

    Love your contrarian bent, but you need to start moving some of that 'going against the grain' mentality to how government monetary operations actually work.

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