Worry, Be Happy

Bobby McFerrin was a sucker. Or at the very least, we know he wasn’t a trader. The title of his wretched 80’s ditty, Don’t Worry Be Happy, is the worst advice a trader could ever receive. Indeed, Macro Man is rarely happy unless he is worrying, and he rarely worries more than when he is in the midst of a purple patch.

So what worries Macro Man at the moment? The inevitable collapse of the subprime lending market? The next leg down in US housing, and the concomitant hit to consumer spending? Global imbalances (chuckle, chuckle)? A potential downgrade of (insert insanely crowded, crappy-fundamental emerging market or corporate credit here)? War with Iran?

Nah. All of those things are issues, but they are widely known and, in Macro Man’s view, widely discounted. Macro Man spends his weekends with Macro Boy setting up elaborate domino patterns, with each domino bearing the name of a different subprime lender, major bank, or emerging market country. They then tip the first domino over and watch the global financial system implode. Metaphorically speaking, of course.

No, what worries Macro Man is the stuff that either isn’t known or cannot be controlled. And as he has alluded in the past, he views inflation at the top of the list of potential roadblocks to continued risky-asset prosperity. And despite the presence of TIPS in the portfolio, recent signs are starting to trouble him.

Consider the price of gold. Since cratering in the first couple days of the year, it has rallied nearly $80 in more or less a straight line. It tried to sell off on Tuesday but came back uber-bid on Wednesday. Now, in the grand scheme of things, the rate of change has been fairly modest in comparison with the pace of the moves of the past couple of years (see below.) But in a sense, that is what’s troubling Macro Man. Last spring, gold shot through the roof and the Fed reacted fairly quickly (and painfully). This time around, the move has been more stealthy...which, in a sense, makes it more difficult to determine when exactly it becomes an issue.


To be sure, financial assets that have traditionally followed gold have lagged the move of the past couple of months. Macro Man’s Goldcorp position, for example, should be at $35, according to a relatively na├»ve overlay. Similarly, inflation breakevens appear 5-10 bps too low on the basis of where gold and oil (which appears to be breaking higher) currently reside.



What will it take to close the gap? Another 0.3% on core CPI? Signs of complacence from the Fed? Who knows. But if and when the gap closes, things will get interesting for risky assets, particularly if/when the Fed sits up and takes notice. A sure sign of the financial apocalypse (or at least the risky asset hiccup) will be when gold starts to melt down. The key is to be prepared, so that one can keep worrying but avoid panicking.

As such, Macro Man will apply a couple more hedges to his portfolio. He sells 100 TYH7 at 107-11, turning 40% of his TIPS position into a quasi-breakeven strategy. He also spends ~$150k premium on gold puts, buying 275 GCJ7 660 puts at $5.5 per. If the shakeout’s gonna come, he can only hope it comes before expiry.





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Anonymous
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February 23, 2007 at 3:32 PM ×

The rally in commodities recently seems to be a liquidity issue as all markets rally together .... something that worries me quite a bit .... the CRB equal-weighted index is at all-time highs and I am considering upping my energy exposure

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February 23, 2007 at 4:59 PM ×

The GG/gold "uncoupling" is quite notable. Could it be that they finally made Glamis' contribution to the gold operations more transparent and evident and that the final tally lagged the spin?

Just a thought. Nicely focussed blog, btw.

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Moldbug
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February 24, 2007 at 12:46 AM ×

Another fine and interesting post.

One point I find fascinating is the classification of gold as a risky asset, and the effect of any liquidity hiccup on it. There seem to be two very different schools of gold investing: the traditional goldbug world-is-going-to-end saga, and the Wall Street just-another-liquidity-inflated-commodity story.

In one of these stories, gold is the ultimate safe asset. In the other, it is the ultimate risky asset. Hmm.

It strikes me that there is a lot of logic behind both of these perspectives. I need not bore you with the goldbug story, you can get it anywhere. It is more than justified by a long historical view. And as for the commodity story, the behavior of gold in last May's yen crunch, where it correlated with crappy emerging-market bonds and such, seems to more than justify it. Hm, hm, hm.

If we return to fundamentals, we note that the price of gold is set by the same force as any other price, namely, supply and demand. Actually what we call the "price of gold" is not the price of gold - it is the price of unallocated claims to gold, which is not at all the same thing. Due to fractional-reserve banking in the bullion banks, it is by no means a negligible simplification to identify the one with the other. But still, the price of gold futures is set by the supply of and demand for gold futures, etc, etc.

So how will a liquidity crunch affect supply and demand in the gold markets? The answer has to depend on specifics.

To the extent that hedge funds have, say, borrowed yen to buy gold futures, or ETF shares, or whatever, a liquidity crunch that sends their yen running back to Japan will, ceteris paribus, decrease the price of gold.

To the extent that stock markets go south, bank solvency becomes questionable, emerging markets fumble, etc, etc, a lot of money will be looking for a new place to hide. To the extent that any of this cash finds its way into gold, it will - ceteris paribus - increase the price of gold.

And so on. The point is that all of these factors strike me as difficult to measure and demand a gut guess. If in a future post you want to expand on what your guess is and why, I'd be quite curious.

One point that I don't think can be disputed is that flows into the GLD ETF are a clear indicator of increase in investment demand for gold. If these continue to run at 30-50 tons per month, watch out. But of course, just as what goes up can come down, what goes in can come out.

For me the foundation of the gold case is that the global economy is increasingly dependent on politically driven credit expansion. It is very easy for me to see gold crashing in a liquidity crunch, and I think your April puts are a good buy. What I find hard to imagine is any situation in which the central banks choose to sustain and reinforce liquidation, rather than healing it with another massive wave of cash. But of course, the enemy always gets a vote...

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Banker
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February 24, 2007 at 12:32 PM ×

Great post.

I am still of the opinion that commodity prices go high (much higher) over the medium term (6-18 mths).

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Anonymous
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February 24, 2007 at 4:16 PM ×

Great subject, since I'm long GLD and cousins of GLD, and I don't like gold much. Long oil, too, and don't like it much either. Why?

Inflation, which one school of thought holds under-reported, which is partly a result of oil, and the cause of increase in GLD.

Is fear of liquidity crunch greater than fear of inflation? Isn't that the balance point of the see-saw? Wish I could have it both ways, but I'm a dinosaur. OldVet

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Macro Man
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February 25, 2007 at 6:26 PM ×

Hmmm. Some really interesting observations here.

I suppose my worldview on gold is bifurcated, in the sense that I reckon that long term trends in gold are probably driven by goldbug-y arguments vis-a-vis supply and demand, while short run trends are driven by liquidity/speculative supply and demand.

And to paraphrase moldbug, in one of these senses, gold is THE primary beneficiary of inflation; in another, it is one of many assets that are hurt by inflation (and any concomitant withdrawal of liquidity.) It is the latter that concerns me now.

Whether gold SHOULD be set up as a store of value ne plus ultra in a world of fiat currencies is a normative question that I won't go into now. I certainly have no beef with SOMETHING acting as a hard asset anchor.

As for Goldcorp, I think Charles Butler is right insofar as there are some Goldcorp-specific issues that have caused the lag. But obviously, one always has basis risk of this nature when one invests in a substitute rather than the actual commodity. Just look at USO, for example...

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Moldbug
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February 25, 2007 at 7:32 PM ×

MM,

I agree that normative views have no place in trading. I can't resist the normative observation, however, that a world in which traders tell us what they really think, without the helpful intermediation of the official clergy, is a new one and very much improved. Please keep up the good work.

My view is that the word "inflation" is responsible for most of this confusion.

I consider the money supply broadly defined as the difference between the current market price of all liabilities of officially protected institutions (banks and "agencies"), and the price these liabilities would command if this protection were withdrawn. Obviously this figure cannot be measured, but the definition remains useful. I call growth in this number "dilution."

I think this corresponds pretty well to the trader word "liquidity." That is, dilution is growth in liquidity (and antidilution is shrinkage in it).

"Inflation" in modern English is a statistic released by the BLS. The goal of this statistic is to measure and control the political impact of dilution. Because dilution gives people more money to spend, it tends to drive up prices. But many other forces tend to drive them up, down, around, etc. When you look at CPI inflation rather than dilution, you are throwing a lot of information into your equation that, for most purely financial purposes, has no reason to be there.

For example, one purely hypothetical way to think about money is to think in dilution-adjusted terms. Dilution-adjusted money can be defined in terms of a fraction of the money supply as above.

In dilution-adjusted money, the price of gold is falling, not rising, and it has been doing so for quite some time. If this trend ever ends, the world will look very different.

The business of Wall Street is mostly about finding a way to store constant dilution-adjusted money. For example, when you buy commodities futures, you are hoping that commodities prices will remain nearly constant in dilution-adjusted terms.

But the essential conundrum of this era is that the financial system is being managed by people who look at inflation, not dilution. Most of the financial excesses we associate with "inflation" are in fact the consequences of dilution. Because of an enormous explosion of productivity, the inflation thermometer is reading normal, while the signs of dilution dependency are everywhere.

The modelers who run the Fed do not understand this and show no signs of figuring it out.

The critical question - which Cassandra asked the other day over at RGE - is how, if the dilution spiral breaks past the productivity spiral and the inflation thermometer starts to move up, the Fed will respond. The world economy has an incredibly serious case of dilution dependency, and any attempt to go cold turkey will result in an unbelievable amount of pain.

Gold has no reason to be exempt from this pain. If Bernanke pulls a Volcker, the results for gold will be what they were in 1981. But in 1981, the global financial system was the very picture of rude good health compared to its status now. The entire Western political system does not strike me as having the legitimacy to impose the kind of recession that a new Volcker crunch would involve. But the lesson of that era has been so effectively absorbed in the monetary-wonk community that it is just as difficult for me to imagine the Fed pumping more and more liquidity into a stagflationary economy. At this point my crystal ball just goes dark... hm.

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Moldbug
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February 25, 2007 at 7:53 PM ×

Oh, and one other thing: I can't stress too much how important it is, in the age of weapons of mass financial destruction, for anyone holding gold to hold equity rather than liabilities.

By "equity" I mean owning physical gold or shares in an entity that owns physical gold, whether a gold mine or an ETF. By "liabilities" I mean a promise by someone to deliver gold - unallocated, futures, etc.

If you look at the contract you are buying when you buy Comex gold, for example, the exchange has the right to suspend delivery basically because a cow farted in India.

The existence of the ETFs, which are really modern-day recreations of the Bank of Amsterdam, makes this very, very dangerous. If Comex suspends delivery the ETF becomes the new price setter. The indicated price of gold futures and ETF shares will diverge, certainly in favor of the latter. Reversing this separation will be difficult if not impossible. The same will be true of unallocated gold if the solvency of the bullion banks becomes questionable.

I'm sure the built-in leverage of futures trading is still attractive for some reason. Perhaps it is cheaper to buy futures and pay the contango roll than to borrow dollars and leverage ETF shares. I don't think leverage and gold mix, but of course others may disagree. But I would think really, really hard about the probability of this kind of contingency before I bought any kind of gold future or unallocated gold. The whole point of precious metals is that they're cheap to store.

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Anonymous
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February 25, 2007 at 9:56 PM ×

Based on possibility of 1981-like gold chute, just put a stop under GLD , and everything else in my portfolio. Should have done it before but was only recently trading into area.

Fed has another option than interest rate tool, and that's mandatory banking reserve increases to cut down inflationary borrowing. They're already in gear with mortgage lending tightening rules. So it looks like interest rate rise (overt slam to equity markets) is going to be avoided if possible. Or should I say, reducing dilution by means other than interest rates.
OldVet

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Macro Man
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February 26, 2007 at 10:41 AM ×

The notion of monetary dilution is an interesting one. Most people acknowledge that some degree of dilution has occurred over the past several years, but differ as to the attribution.

While blaming the Fed is the easy route, particularly with the discontinuation of M3 publication, such explanations don't really resonate for me.

After all, monetary base growth is and has recently been very modest; at the end of the day, the monetary base is the only thing that the Fed can directly control.

For my money, not enough attention is paid to financial globalization. In my view, the primary source of dilution has been China, Saudi, et. al., who have shown a sustained appetite for public and private sector debt of Western countries at levels substanitally richer than those that would prevail were the price set exclusively by the private sector. I'm hoping to do a post on this later in the week.

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February 26, 2007 at 10:48 AM ×

Curious moldbug's mention of a certain lack of 'political legitimacy' of the governments of western countries. It is the enormous hidden cost of the under-negotiated end to the cold war, and the great underplayed story of the current paradise.

Knowing this, and working from the premise that financial markets will not be there, for those who have learned to count on them, when they are actually needed (any more than your local whore is at your bedside to help you through your testicular cancer operation), can anyone help but love gold?

The concept of 'dilution' is enchanting and clarifying. Can we add to that redefining 'assets' as what people change their money into (go into debt for) that gives them some acceptable status in the social order?

Hmm? Negative savings in the land of plenty. Gold.

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Moldbug
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February 26, 2007 at 6:02 PM ×

MM,

The historical pattern is that the "M's" (M1, M2...) are fighting the monetary last war, so to speak.

In the 19th century people argued over whether demand deposits should be considered part of the money supply. The Peel Act, for example, as recommended by Ricardo, limited the issuance of unbacked bank notes, but did nothing about demand deposits. Whoops.

There is a common pattern in all the definitions of money: they measure the price in present currency of liabilities of official institutions. Over time I suspect people will try to find some way to include derivatives in this figure. There is also the dimension of maturity - you can sum up all liabilities mature before time now+T, etc.

The problem is that the harder you work at this, the less the value it produces looks like a scalar, and the more it turns into just another garbage-out model. Ultimately there is no real way to measure dilution. But you can sure smell it...

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Macro Man
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February 26, 2007 at 8:29 PM ×

Yes, well I suppose dilution and its second cousin 'real economy' inflation fall into the bailiwick of Justice Potter Stewart: "I shall not today attempt further to define the kinds of material I understand to be embraced . . . but I know it when I see it . . . "

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Moldbug
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February 26, 2007 at 10:11 PM ×

If you know any top-notch computer programmers / software engineers, ask them what they think of (academic) computer scientists. Five to one the answer you get will be remarkably reminiscent of the way financial professionals - as I'm starting to see - look at economists.

There is no complete cure for this syndrome, but reading the Austrians certainly helps. A good overall treatise with minimal political bushwah is Rothbard's Man, Economy, and State.

What most people don't realize is that Austrian economics has nothing to do with model-oriented neoclassical macroeconomics. It is not even the same department - it does not ask the same questions and it does not use the same tools. Austrian economics is based entirely on clear thinking. Anyone intelligent can understand it.

(Mises and Rothbard were basically locked in the academic equivalent of broom closets for their entire careers. The Nobel went instead to Mises' second-rate student, Hayek.)

The trouble for modern readers is that although Mises at least was very engaged with the real world - he was sort of the Paul Volcker of post-Hapsburg Austria for a while - the real world as you read it in the Austrian School is the financial world of, say, 1912 (when Mises' _Theory of Money and Credit_ was published). A lot of work needs to be done in adapting this picture to what the world is now, and the more recent Austrians have not made remarkable progress in this.

But if you take the Austrian corpus with this grain of salt, I think it's a useful addition to anyone's mental toolbox. And chicks dig it, too.

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February 27, 2007 at 9:18 AM ×

Moldbug--

We were hoping that the economics team that put the political legitimacy ball into play were to run it a little further towards the requisite ten yards. (Slight, friendly nudge with the elbow from a fan...)

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