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Wednesday, March 19, 2008

And We Wait

Looking at CP short vs longer rates makes me think we've got a much larger problem waiting in the wings. If this doesn't even out a bit in the next few days, it's going to get ugly fast:
Term AA
1-day 2.50 3.38 2.66 3.40
7-day 2.32 3.20 2.31 3.22
15-day 2.12 3.13 2.44 2.92
30-day 2.08 3.13 2.40 2.81
60-day 1.94 2.89 2.47 2.79
90-day n.a. 2.78 2.41 2.58

There's a high risk premium now, which is pretty rational. Short money is too tight, though. Look at the difference between AA nonfinancial and AA financial. The market expects another 50 bps cut by summer, but it doesn't expect financial risk to diminish much or at all.

There are signs of trouble in commodities and in the Asian markets. Endeavour's losses stem from volatility in Japanese government bonds:
The fund suffered as the spread, or difference, between yields on Japanese 7- and 20-year bonds widened to 1.44 percentage points on March 17, the most in almost nine years.

``You've had a confluence of events that has led to extreme volatility and vast moves'' in Japanese government debt, said Matthews, 47, a former head of global fixed-income arbitrage at Salomon Smith Barney. ``The relative moves we've seen in Japan are not in the realm of anything we've ever seen for Japanese government bonds.''
The odd rate moves are blowing up various widely used hedging strategies which are inflicting some awful losses in various funds. I spoke to a financial advisor on Monday and he was completely spooked. There are two different types of investing in bonds. One is to buy for income. The other is to trade for price volatility. Both strategies really make money by using spread differences to finance the bonds. People hedge on both, but the most common hedges are now inflicting losses of their own as the relationships between yields on various types of investments move opposite to what the hedging model predicted.

Fed Funds rate is 2.25. Discount is 2.50. Look at treasury yield movements over the last week:
Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
03/11/08 1.82 1.48 1.64 1.67 1.74 1.93 2.61 3.04 3.60 4.48 4.53
03/12/08 1.68 1.48 1.56 1.58 1.63 1.81 2.49 2.93 3.49 4.35 4.40
03/13/08 1.56 1.35 1.50 1.54 1.63 1.84 2.53 2.99 3.56 4.42 4.47
03/14/08 1.20 1.18 1.32 1.37 1.47 1.65 2.37 2.84 3.44 4.30 4.35
03/17/08 1.16 1.11 1.31 1.32 1.35 1.52 2.23 2.71 3.34 4.24 4.29
03/18/08 0.71 0.92 1.32 1.40 1.58 1.74 2.42 2.88 3.48 4.30 4.35

Look at how short yields collapsed yesterday.

As of yesterday's close it did not appear that mortgage rates were going to be much affected by the Fed action. They may go higher on risk.

Commodities are falling fast.

I am not sure that most of the substitute strategies for hedging are going to work out any better in the long run. Volcker's comments last night seem dead on to me. Volcker was not in favor of dismantling the traditional restrictions on financials and banks in the first place. When he comments that the current situation is an inappropriate regulatory framework, he is obliquely referring to the fact that by dissembling Glass-Steagall (Congress) we introduced much larger potential risks into the financial sector. In order to compensate, we needed enhanced regulation on financials:
Rose: So the Federal Reserve should not be doing that, in your judgment. It’s not because it shouldn’t be done, it’s the role of the federal government.

Volcker: Absolutely. In this situation, they stepped in and nobody else was there to do it…They stepped into a vacuum, and I think quite appropriately, it’s a judgment they had to make. But is this what you want for the longstanding regulatory support system? My answer is no.

Rose: Somebody said to me that we entered a period in which they were worshiping mathematical models … And mathematical models had no business sense.

Volcker: The market was being run by mathematicians that didn’t know financial markets. And you keep hearing, you know, god, that event should only happen once every hundred years, according to my model. But those every hundred years events are coming along every two or three years, which should raise some questions.
Congress is still sitting around doing nothing. The regulatory structure is a creation of Congress, not the Presidency. Greenspan is still pushing the "no regulation" crap. I don't know how this will end. I think as long as the Fed chops the head off firms that become dangerous it will return a measure of sanity in the short term, but in the long term we need an enhanced regulatory framework or we will return to the boom-bust cycles of the 1800s, which were very painful and included one depression. Enhanced regulation requires money, which Congress must supply. As far as I can see, Congress intends to do nothing.

Blaming Congress (and by implication the Democratic leadership) is disingenuous in my opinion. The Democrats have 49 votes - far short of the 60 needed to avoid filibuster much less override a veto. With the GOP opposed to regulation of any kind and voting as a block, nothing can be done until November at the earliest and perhaps not then unless the Democrats win the necessary additional seats.

But you are correct in that we are in gridlock.

Blaming the GOP is disengenuous. You just threw down a bunch of Democratic talking points.

The gridlock can be broken by getting rid of do nothing Democrats. Chris Dodd has set a fine example by blocking all appointments to the Fed board so that they are now two short at a time when they need all the top people in place.
Jim, I am blaming Congress as an institution. Glass-Steagall's final repeal happened I believe in 1999. You can't just blame the GOP either, because there are some Dem luminaries pushing the banking free-for-all. And it was partly a Clinton creation.

Nor is it just Glass-Steagall. Look at the total mess that has resulted by Congress telling the Fed to regulate the mortgage industry on its own.

You can't simply assign this to one party or another. It's like SS. Everybody's got their fingers in the pot.

The recent failure to institute any meaningful regulation of hedge fund activities is clearly the fault of the Bush administration.

People complain about partisan quibbling, and sometimes it is truly counterproductive. But quite often the worst results occur when the current CW gets accepted by the leadership of both parties and is bipartisanly not examined for flaws.

Barney Frank's FHA proposal looks somewhat reasonable, but a much broader approach to financial regulation is needed.

Through the 90s and now most of the 2000s, we have had successive crops of financial types charged with overseeing the system who have refused to approach these risks. Now the Fed is trying to deal with them, and Volcker's right. It's not the optimal situation, but on the other hand the Fed can't just sit and watch the Great Crash of 2008 turn into the Great Depression of 2009.
This thing has been brewing for a generation or so. The Dems have aided and abetted, but the excuse for them is that their consultants said they had to follow the GOP lead or disappear. So 3 demerits go to the GOP for leading us into this mess and 1 to the Dems for not being an opposition party with principals. (any one that wants the Dems to get 2 demerits instead of one, I will not oppose, just that I give leaders extra credit when they mess things up)

This kinda of thing where a mess yields regulation which with the passing of the generation that dealt with the mess is deregulated resulting in a new mess has happened so frequently that some experts believe it is a cycle. While the names of the individuals have changed, the actors and their actions have not changed in a couple of hundred years. Money interested get greedy, buy government influence and things crash. The moneyed interest either though poverty or fear yield control of the government to reformers. The process starts again.
I actually much prefer to blame Alan Greenspan and his Ayn Rand style Libertarianism (sp?). Greenspan refused to see the need to regulate a "shadow" economy (that Doug Noland at PruBear has written about for years) and monitized reckless fiscal and military policies.

I suspect history will not be kind to Alan Greenspan.

So I'm back from my trip to London. Sure you all missed me.

Breakfast for 3 Monday morning, $160. That was for Toast, rolls, mineral water, tea and fruit.

Mrs. CF wanted to know if we had the truffle breakfast.
Lordy. I hope the fruit was good.

I wonder how much a cup of tea alone would have been?

I agree with Mrs. CF!!
In all fairness, the food was pretty tasty. This is even crazier the when I went to Japan in the mid 90's.

Too bad about the Paul Matthews guy. Seem to remember him being a thug back in the day at Salomon Brothers.
Wide miss again, NC Jim. Greenspan did nothing Randian or libertarian - they are different things - while Fed chair.

Did you catch the collapse in CP overnight? It was down in the mid to low 60's as I recall from this morning...

Is it all better or are folks who needed to roll CP able to go to the discount window now?
Greenspan actually induced the opposite of Randian economics while Fed Chair.
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