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Gold vs. US Treasuries

John Hempton writes:

We live in a strange world – the 10 year US Treasury is trading with a 2.63 percent yield.  The market is presuming that there will not be much inflation in those ten years.  However if there is deflation (as per Japan) then the 10 year will wind up being a very good investment (see my blog post on Japanese bond yields from the perspective of a Japanese household).

At the same time gold is appreciating very sharply – from $950 per oz to $1250 in the past year – and from $800 two years ago or $450 five years ago.  On the face of it the gold price is predicting inflation.

Try as I may – I can’t see any reason why both those prices are correct.  I have long held the view that prices are mostly sort-of-rational … [s]o either there is a theoretical way in which both these prices can be correct or even my weak version of the efficient market hypothesis is spectacularly wrong.

and then asks

My first question thus is can anyone tell me why these prices could possibly be consistent?  Is there a rational reason why the bond market is pricing low inflation and the gold market seemingly pricing high inflation?  Does anybody have the ingenious world view in which both these prices are correct?

Since Blogger rejected my comment over at John’s site as being too long, I may as well reproduce it here. I don’t know about “correct” and I’m no finance guy, so my first point is that  I have no freakin’ clue.  Nevertheless, here are five, somewhat contradictory ideas, three of which might fit in a weak EMH world …

Idea #1) Yes, yes, your whole post was predicated on some weak version of the EMH. However … Treasuries, despite what the arch-conservatives are saying, are unlikely to be in a bubble (see idea #4 below).  It might (and only might!) even be impossible for them to be in a bubble.  On the other hand, gold can experience a bubble (to the extent that you concede that bubbles can exist at all).  Just because it can doesn’t mean that it currently is in one, but if it is and treasuries are not, that would partially resolve your dilemma.

Idea #2) Gold, as a commodity, is a affected by global phenomena, whereas US treasuries, while obviously still influenced by global pressures, are more sensitive to the US economy than is gold.  This statement will become more true over time as the US economy shrinks as a share of global GDP.  Therefore, perhaps you should deduce that markets are predicting low inflation or deflation for America, but quite high inflation for the world as a whole.

Idea #3) Gold, as a commodity, partially co-moves with other commodities, many of which are seeing price increases because of real, observable events in their markets (Chinese construction, Russian drought, etc).  Perhaps it is being dragged up by those (this augments idea #2).

Idea #4) In the broad market for USD-denominated investment-grade bonds, there has, I believe, been a net contraction in supply despite the surge in US government borrowing.  This is the private-sector balance-sheet correction.  One might argue, from something of a monetarist point of view, that (disin|de)flation is occurring in the US precisely because the US government is not expanding its borrowing fast enough to replace the private-sector contraction.  I mentioned this briefly the other day.

Idea #5) Another non-EMH idea, I’m afraid:  Both the USD and gold enjoy safe-haven status.  An increase in generalised fear (Knightian uncertainty, unknown unknowns, etc) will shift out the demand for both at all price levels.  To the extent that such a dynamic exists, I suspect that it ebbs away only slowly and, while elevated, is susceptible to rapid increases in response to events that would, in normal times, not affect people so much.

Update 11 Oct 2010:

James Hamilton on essentially the same topic.

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The Australian Election (3 days past and the ball is still in the air)

[For any non-Australians, in the absence of Bryan Palmer and his once-magnificent-but-now-absent ozpolitics.info, John Hempton’s “guide to the Australian election for non-Australians” gives a fair overview]

[Update 25 Aug 2010: If you’re looking for reasons why the Labor Party did so poorly, I’ve had a go a listing them in my next post.]

A week and a half before the election, I noted (with no originality) that things weren’t looking good for Labor.  In the days immediately before, with the polls having started to improve again for Labor, I was predicting a narrow Labor win, possibly with the Greens taking the balance of power in the Senate (although I was skeptical on that front — I actually put the higher probability on the Coalition still having control in the upper house).  Perhaps I should have paid more attention to the polls!

As I type (AEC website updated at 24/08/2010 7:40:18 PM), the Australian Electoral Commission (the fully independent body that decides on electoral boundaries and conducts Australian elections) is estimating the results as:

  • 70 : Australian Labor Party
  • 72 : The Coalition (Liberal Party, Liberal National Party of Queensland, The Nationals, Country Liberals)
  • 1 : The Greens
  • 4 : Independent
  • 3 : Too close to call : Brisbane (QLD), Hasluck (WA) and Corangamite (VIC)

The ABC’s ever-superb Antony Green (a nerd’s nerd of the highest calibre) is currently making the following prediction for the final result:

  • 72 : Labor
  • 73 : Coalition
  • 1 : Greens
  • 4 : Independent

The four independents are Bob Katter, Tony Windsor and Rob Oakeshott (all ex-National Party) and Andrew Wilikie, an ex-Military and Intelligence official.

Tony Abbot has made a claim that since the Coalition got the most primary votes, they should be allowed to form government.  The counter argument is that in Australia’s system of preferential voting, to the extent that national vote tallies matter at all, it should be the two-party preferred total that counts, and on that basis Labor is in front (numbers here).

At first glance it would seem like the three ex-National Party independents will allow the Coalition to form a minority government, but it is not that simple.  For one thing, infrastructure in general, and telecommunications in particular, have long been issues of key concern to to National MPs.  Labor’s NBN plans would provide greatly improved services to those constituencies, while the Liberal’s policy would largely ignore them.  Farmers are not exactly enamoured of the mining industry, either, and so I suspect wouldn’t have the same opposition to the natural resource tax as the Liberal party.  Rob Oakeshott is also making noises along the lines of reforming parliamentary democracy as we know it in Australia:

Continuing his call to reinvent the parliamentary system, Mr Oakeshott said his preference was for a cross-party cabinet and indicated he may not support either side of politics if a cross-party cabinet could not be formed.

When asked if his fellow independents shared his view on “consensus politics” and his example of Kevin Rudd serving as foreign minister in an Abbott government or Malcolm Turnbull serving in a Gillard government – he said he would find out “in detail” today and how hard he would be pushing for the idea.
[…]
Looking ahead to today’s talks, Mr Oakeshott said “if we are just fluffing around, if we are just building a minority government with a bit of plus plus plus from the cross benches I’m not interested”.

“This is about trying to get to at least 76 and yes, if this doesn’t happen, if it doesn’t fly, if consensus can’t be reached we will go back to the position of three [independents] and Adam Bandt as well, making a decision on red team or blue team getting across the line in that context I’m not interested, I’m not going to play,” he said.

However, Mr Oakeshott would not rule out a cabinet position if consensus could be found.

Mr Oakeshott said elevating the role of committees, imposing deadlines on response times to recommendations and allowing private members bills to be brought to vote were critical issues for him.
[…]
Private members bills should be voted on and added he also wanted to see private members business “having some authority within the parliamentary time table”.

“If there is some sentiment for exploring creative options where this is about not political parties, not a red team or a blue team, this is about 150 members of parliament, building a majority with a focus on being able to get through some of the key national issues in this country, I’d be interested in having a conversation,” he said.

Mr Oakeshott called on the “traditional arch-rivals” to stop “pretending to be fighting to the death over ideology when they are actually more often than not in agreement on most issues”.

There is no love lost between the Coalition and Andrew Wilkie (who resigned from the Office of National Assessments in 2003 over (alleged) misrepresentations of the case for war in Iraq and Afghanistan), either, so they’re unlikely to be able to count on him.  But with Mr Wilkie’s strong stand against Pokies, he’s not likely to be all that keen on Labor, either.

Just to make things more interesting, even if Labor does form government, they won’t be able to pass any of their signature pieces of legislation for the better part of 12 months anyway, as even though the Coalition lost the balance of power in the Senate to the Greens, that won’t take effect until 1 July 2011.  If the Coalition forms government, you can therefore expect an absolute flurry of legislation between now and 30 June 2011 as they try to squeeze through everything they want before being forced to negotiate with the Greens in the Senate.

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Just a smidgen more on US healthcare reform

My previous comment on US healthcare reform, which was actually a comment on the current Australian system, got quite a few eyeballs thanks to John Hempton’s shout-out.  Anyway, I thought I’d highlight a couple of new developments for my little audience.

First, Republican Senator Olympia Snowe (of Maine), who sits on the Senate Finance Committee, has said that she will vote in favour of the suggested bill being proposed by that committee’s chairman, Max Baucus.  That is good for the Democrats as it will provide valuable political cover.  It’s no guarantee that she will vote in favour of whatever the Senate as a whole end up producing, or for whatever the Senate and House then negotiate as the final bill, but it’s still a significant move and the probability of her voting for those later versions has just increased.

Second, we have the fact that the healthcare insurance industry has recently done an about-face, from actively promoting reform to actively fighting against it.  Nate Silver points out why:

Take a look at what’s happened to the share prices of the six largest publicly-traded health insurance companies since Labor Day, which was about the point at which the Democrats appeared to regain their footing — at least up to a point — on health care.

Weighted for market capitalization, these insurance stocks have lost 11 percent of their value since Labor Day, wiping out about $10 billion in value. And that’s understating the case since the major indices have gained 5-8 percent over the same period — the insurance industry stocks are underperforming the market by just shy of 20 percent.

So why have they tanked in the stock market?  Nate suggests two reasons:

Firstly, the individual mandate has been weakened to the point where it’s arguably a tokenish provision. There are good, policy reasons to be worried about this, although the insurance lobby’s reasons for being opposed — they’ll have less guarantee of an incoming phalanx of high-margin customers — are not necessarily the same as the public’s at large. The second factor is that the Baucus bill in certain ways treats the insurers fairly harshly, both taxing them directly as well as levying a surcharge on high-cost insurance plans.

I’d also suggest that the compromise version of the public option (that it be in the bill, but with states able to opt out if they wish [Paul Krugman, Talking Points Memo]) will have scared the insurance companies and investors as well.

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The limits of shorting a stock

At the end of a brief post wrapped around this advertisment by the not-strictly-declared-bankrupt-yet-but-certainly-nationalised Kaupthing Bank, John Hempton observes:

I considered shorting Kaupthing several times – but did not (in part because of the cost and difficulty of borrowing the shares). Banks like Kaupthing might be insane criminal organisations – but they were also impossible to short because they might stay solvent longer than you… Three doublings and your short has become very painful – even if you are paid in the end. Add to that a 25 percentage point borrow cost for the shares and there was little chance of making money unless you shorted right at the end. Oh, and your profit (if any) was realised in Icelandic Krona – and they turned out to be worth much less than you would have hoped. It is hard to make money of this stuff – even when the end-outcome is obvious.

I do wonder how those three reasons — the market can stay insane longer than you can stay solvent, the cost of borrowing, and the fact that it was in a minor currency — rank and interact with each other for the market as a whole for short selling stock.  Given the involvement of Icelandic banks in the credit boom and — I assume — similar borrowing costs for shorting across “well developed” financial markets, the case of the Icelandic banks might arguably represent an opportunity to back out the scale of the minor-currency impediment.

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A description of Australia’s healthcare system

John Hempton has gotten to it before I did and written it far better than I would have anyway.  Have a read.  Although I agree that Australia’s system is much, much better than America’s current system or any of their proposed frameworks, I would add three negative comments about Australia’s system:

  • Medicare payments to GPs for a consultation by a patient are determined centrally (at the federal level) and have not increased with inflation.  At first that meant that GPs shortened each consultation to fit more people in per day, but in the long run served, I believe, to reduce the supply of GPs and as a result pushed people with minor ailments to hospital emergency rooms.
  • I don’t know if it is better or worse than other countries, but the administrative overhead in the state government health departments is surprisingly large, even to me.  I am led to believe that adminstrators and middle-managers exceed more than 50% of the staff of Queensland Health (and that does not include admin staff on the wards).
  • The federal-state funding arrangement in Australia is a real problem.  I don’t know whether the best policy is to put all health care in federal hands or to grant the states more revenue-raising posibilities, but something does need to happen.
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Demand for sex in Japan

Mentioning sex in a blog post is a great way to generate some interesting traffic.  The last time I filled some time writing about it (on the rise of public sexuality, the rationality of prostitution and the extent of human trafficking), I got hits via some very odd queries on Google.

Titillation aside,  prostitution is a tremendously interesting topic in economics .  As John Hempton discussed initially in July 2008 and more extensively in May 2009, the price of prostitution is enormously flexible, unlike prices (and wages) in most industries.  That means that when, as John discussed, a country is operating under a fixed exchange rate and only prices can adjust in response to a macroeconomic shock, the sex industry will almost certainly move both first and furthest.

But because prostitution has very flexible wages and prices, that also makes it a candidate proxy for estimating changes in the potential output of an economy — the output that would occur if all prices were perfectly flexible.  (Remember there are differences between potential and natural levels of output)

I mention this after reading that the Bank of Japan is conducting surveys to estimate changes in demand in the Japanese sex industry:

The survey of sex shops and restaurants was designed to better gauge demand for services, an area of the economy that’s becoming more important as exports slump. “Any study into services is most welcome,” said Martin Schulz, senior economist at Fujitsu Research Institute in Tokyo. “We’ve got hundreds of studies on exports and manufacturing. What’s needed is creative thinking on services and if that includes brothels, so be it.” … While services including restaurants and retailing make up about 60 percent of gross domestic product, Japan’s economy has risen and fallen with the strength of its exports.

(Hat tip:  Tyler Cowen).

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On the symmetry of employment contraction and recovery in US recessions

A couple of days ago I gave some graphs depicting movements in weekly hours worked per capita during US recessions since 1964.  Towards the end, I gave this graph:

Comparing US recessions in hours worked per capita, centred around their troughs

I thought it might be worthwhile to look at this idea further.  Here is the equivalent graph where movements in hours worked per capita are made relative to their actual troughs rather than their actual peaks:

Comparing US recessions in hours worked per capita, centred around and relative to their troughs

At a first glance, recoveries do appear to be somewhat symmetric to their corresponding contractions, although they do also appear to be a bit slower coming back up to falling down in the first place.

I then identified data pairs that are symmetric in time around each trough (e.g. 3 months before and after the trough) and put them in a scatter-plot:

Scatter plot of falls-to-come in weekly hours per capita against subsequent gains in recovery

Points along the 45-degree line here would represent recoveries that were perfectly symmetric with their preceding contraction.  Notice that for five of the six recessions shown, recoveries are in a fairly tight line below the 45-degree line.  By comparison, the recovery following the ’81-’82 recession was especially rapid – it came back up faster than it fell down.

Excluding the ’81-’82 recession on the basis that it’s recovery seems to have been driven by a separate process, a simple linear regression gives a remarkably good fit:

comparingrecessions_20090605_symmetry_scatter_excl_81-82

This is a very rough-and-ready analysis.  In particular, I’ve not allowed for any autoregressive component to employment growth during the recovery.  Nevertheless, it is suggestive.

There are more serious efforts in looking at this for the economy as a whole (rather than just hours worked).  James Hamilton is not convinced that it will occur this time.  The oddly rapid recovery in hours worked per capita following the ’81-’82 recession should give us reason to agree with Professor Hamilton, not disagree: it shows that the typical recovery is not guaranteed.  Look back at the scatter-plot of all the recessions.  Notice that the recovery following the ’69-’70 recession was actually quite slow.  It’s fitted line is y = 0.252 x.

For me, the big thing that makes me lean towards Professor Hamilton’s fears of a slower-than-typical recovery is the possibility of zombie banks, or as John Hempton argues, zombie borrowers.  Zombie borrowers should worry us because, if they exist, they are keeping hold of the capital that could (and should) be better placed elsewhere in the economy, which means that those more deserving would-be borrowers are not able to expand and employ more people.

As Hempton argues in the second of his posts, on this basis it is a Good Thing ™ that two of the three US car manufacturers have been forced into a bankruptcy-induced contraction.  Note that Ford only really managed to avoid the same fate by borrowing a huge amount just before the credit markets froze.  It probably needs (from the point of view of the economy as a whole) to follow the same process, whether inside or outside the courts.

But the car manufacturers are by no means the only candidates for the “zombie borrower” epithet.  The really big borrower behind all of the mess in the financial sector is the one at the bottom of all the “toxic” CDOs:  the underwater American households.

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How to value toxic assets (part 6)

Via Tyler Cowen, I am reminded (again) that I should really be reading Steve Waldman more often.  Like, all the time.  After reading John Hempton’s piece that I highlighted last time, Waldman writes, as an afterthought:

There’s another way to generate price transparency and liquidity for all the alphabet soup assets buried on bank balance sheets that would require no government lending or taxpayer risk-taking at all. Take all the ABS and CDOs and whatchamahaveyous, divvy all tranches into $100 par value claims, put all extant information about the securities on a website, give ’em a ticker symbol, and put ’em on an exchange. I know it’s out of fashion in a world ruined by hedge funds and 401-Ks and the unbearable orthodoxy of index investing. But I have a great deal of respect for that much maligned and nearly extinct species, the individual investor actively managing her own account. Individual investors screw up, but they are never too big to fail. When things go wrong, they take their lumps and move along. And despite everything the professionals tell you, a lot of smart and interested amateurs could build portfolios that match or beat the managers upon whose conflicted hands they have been persuaded to rely. Nothing generates a market price like a sea of independent minds making thousands of small trades, back and forth and back and forth.

I don’t really expect anybody to believe me, but I’ve been thinking something similar.

CDOs, CDOs-squared and all the rest are derrivatives that are traded over the counter; that is, they are traded entirely privately.  If bank B sells some to hedge fund Y, nobody else finds out any details of the trade or even that the trade took place.  The closest we come is that when bank B announces their quarterly accounts, we might realise that they off-loaded some assets.

On the more popularly known stock and bond markets, buyers publicly post their “bid” prices and sellers post their “ask” prices. When the prices meet, a trade occurs.[*1] Most details of the trade are then made public – the price(s), the volume, the particular details of the asset (ordinary shares in XXX, 2-year senior notes from XXX with an expiry of xx/xx/xxxx, etc) – everything except the identity of the buyer and seller. Those details then provide some information to everybody watching on how the buyer and seller value the asset. Other market players can then combine that with their own private valuations and update their own bid or ask prices accordingly. In short, the market aggregates information. [*2]

When assets are traded over the counter (OTC), each participant can only operate on their private valuation. There is no way for the market to aggregate information in that situation. Individual banks might still partially aggregate information by making a lot of trades with a lot of other institutions, since each time they trade they discover a bound on the valuation of the other party (an upper bound when you’re buying and the other party is selling, a lower bound when you’re selling and they’re buying).

To me, this is a huge failure of regulation. A market where information is not publicly and freely available is an inefficient market, and worse, one that expressly creates an incentive for market participants to confuse, conflate, bamboozle and then exploit the ignorant. Information is a true public good.

On that basis, here is my idea:

Introduce new regulation that every financial institution that wants to get support from the government must anonymously publish all details of every trade that they’re party to. The asset type, the quantity, the price, any time options on the deal, everything except the identity of the parties involved. Furthermore, the regulation would be retroactive for X months (say, two years, so that we get data that predates the crisis).  On top of that, the regulation would require that every future trade from everyone (whether they were receiving government assistance or not) would be subject to the same requirementes.  Then everything acts pretty much like the stock and bond markets.

The latest edition of The Economist has an article effectively questioning whether this is such a good idea.

[T]ransparency and liquidity are close relatives. One enemy of liquidity is “asymmetric information”. To illustrate this, look at a variation of the “Market for Lemons” identified by George Akerlof, a Nobel-prize-winning economist, in 1970. Suppose that a wine connoisseur and Joe Sixpack are haggling over the price of the 1998 Château Pétrus, which Joe recently inherited from his rich uncle. If Joe and the connoisseur only know that it is a red wine, they may strike a deal. They are equally uninformed. If vintage, region and grape are disclosed, Joe, fearing he will be taken for a ride, may refuse to sell. In financial markets, similarly, there are sophisticated and unsophisticated investors, and unless they have symmetrical information, liquidity can dry up. Unfortunately transparency may reduce liquidity. Symmetry, not the amount of information, matters.

I’m completely okay with this. Symmetric access to information and symmetric understanding of that information is the ideal. From the first paragraph and then the last paragraph :

… Not long ago the cheerleaders of opacity were the loudest. Without privacy, they argued, financial entrepreneurs would be unable to capture the full value of their trading strategies and other ingenious intellectual property. Forcing them to disclose information would impair their incentive to uncover and correct market inefficiencies, to the detriment of all …

Still, for all its difficulties, transparency is usually better than the alternative. The opaque innovations of the recent past, rather than eliminating market inefficiencies, unintentionally created systemic risks. The important point is that financial markets are not created equal: they may require different levels of disclosure. Liquidity in the stockmarket, for example, thrives on differences of opinion about the value of a firm; information fuels the debate. The money markets rely more on trust than transparency because transactions are so quick that there is little time to assess information. The problem with hedge funds is that a lack of information hinders outsiders’ ability to measure their contribution to systemic risk. A possible solution would be to impose delayed disclosure, which would allow the funds to profit from their strategies, provide data for experts to sift through, and allay fears about the legality of their activities. Transparency, like sunlight, needs to be looked at carefully.

This strikes me as being around the wrong way.  Money markets don’t rely on trust because their transactions are so fast; their transactions are so fast because they’re built on trust.  The scale of the crisis can be blamed, in no small measure, because of the breakdown in that trust.

I also do not buy the idea of opacity begetting market efficiency.  It makes no sense.  The only way that information disclosure can remove the incentive to “uncover and correct” inefficiencies in the market is if by making the information public you reduce the inefficiency.  I’m not suggesting that we force market participants to reveal what they discover before they get the chance to act on it.  I’m only suggesting that the details of their action should be public.

[*1] Okay, it’s not exactly like that, but it’s close enough.

[*2] Note that information aggregation does not necessarily imply that the Efficient Market Hypothesis (EMH), but the EMH requires information aggregation to work.

Other posts in this series:  1, 2, 3, 4, 5, [6].

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How to value toxic assets (part 5)

John Hempton has an excellent post on valuing the assets on banks’ balance sheets and whether banks are solvent.  He starts with a simple summary of where we are:

We have a lot of pools of bank assets (pools of loans) which have the following properties:
  • The assets sit on the bank’s balance sheet with a value of 90 – meaning they have either being marked down to 90 (say mark to mythical market or model) or they have 10 in provisions for losses against them.
  • The same assets when they run off might actually make 75 – meaning if you run them to maturity or default the bank will – discounted at a low rate – recover 75 cents in the dollar on value.

The banks are thus under-reserved on an “held to maturity” basis. Heavily under-reserved.

He then gives another explanation (on top of the putting-Humpty-Dumpty-back-together-again idea I mentioned previously) of why the market price is so far below the value that comes out of standard asset pricing:

Before you go any further you might wonder why it is possible that loans that will recover 75 trade at 50? Well its sort of obvious – in that I said that they recover 75 if the recoveries are discounted at a low rate. If I am going to buy such a loan I probably want 15% per annum return on equity.

The loan initially yielded say 5%. If I buy it at 50 I get a running yield of 10% – but say 15% of the loans are not actually paying that yield – so my running yield is 8.5%. I will get 75-80c on them in the end – and so there is another 25cents to be made – but that will be booked with an average duration of 5 years – so another 5% per year. At 50 cents in the dollar the yield to maturity on those bad assets is about 15% even though the assets are “bought cheap”. That is not enough for a hedge fund to be really interested – though if they could borrow to buy those assets they might be fun. The only problem is that the funding to buy the assets is either unavailable or if available with nasty covenants and a high price. Essentially the 75/50 difference is an artefact of the crisis and the unavailability of funding.

The difference between the yield to maturity value of a loan and its market value is extremely wide. The difference arises because you can’t eaily borrow to fund the loans – and my yield to maturity value is measured using traditional (low) costs of funds and market values loans based on their actual cost of funds (very high because of the crisis).

The rest of Hempton’s piece speaks about various definitions of solvency, whether (US) banks meet each of those definitions and points out the vagaries of the plan recently put forward by Geithner.  It’s all well worth reading.

One of the other important bits:

Few banks would meet capital adequacy standards. Given the penalty for even appearing as if there was a chance that you would not meet capital adequacy standards is death (see WaMu and Wachovia) and this is a self-assessed exam, banks can be expected not to tell the truth.

(It was Warren Buffett who first – at least to my hearing – described financial accounts as a self-assessed exam for which the penalty for failure is death. I think he was talking about insurance companies – but the idea is the same. Truth is not expected.)

Other posts in this series:  1, 2, 3, 4, [5], 6.