Wednesday, June 13, 2007

Science versus Myth

Well, the price action in bonds now officially qualifies as a rout. Contrary to popular expectations that things would settle down ahead of the US data dump starting today, 10 year bonds shed more than a point yesterday, taking yields through everyone’s obvious target of 5.25% (last year’s high.) Meanwhile, price action in short sterling is if possible even uglier. Implied rates on the Dec 08 contract have gone up 20 bps since Monday’s close- and that’s with lower than expected inflation and wage date released during that period. Ouch!

Global email boxes and Bloomberg message caches are now filled with missives purporting to explain the rationale for the rout. Mortgage convexity selling? The lack of indirect bidders at yesterday’s 10 year auction? Forced selling of unprofitable positions that have reached their ‘business risk’ stop loss? All of these have been offered as a possible explanation for the wretched price action in fixed income over the past few days.

And therein lies the problem. These analyses are long on explanation, but short on forecasts. Of course, this is nothing new in the realm of economics and strategy. If Macro Man had an email spam filter that rejected any variant of “here’s why this apparently bullish/bearish datapoint actually supports our bearish/bullish case”, then his Delete key wouldn’t be nearly as worn as is actually the case.

Richard Feynman once described science as saying “If I do this, what will happen?” and then finding out. Alas, much financial market analysis seems to focus on post hoc descriptions of what was done. As Macro Man’s Cockney friends would say, it’s all written by Harry Hindsight. Research from Frankie Foresight, meanwhile, appears to be in short supply.

Now, regular readers will know that Macro Man is of the view that FX reserve managers exert an enormous influence on global financial markets. Although never articulated here, a month ago Macro Man opined that the withdrawal of Voldemort, et al from allocating fresh funds to the US bond market would tack on 50-100 bps to ten year yields. Now, one can dispute this analysis, or one can believe it, but at least it yields a forecast of future events, and thus passes the bare minimum requirement for science (as opposed to reporting or creating myths.)

Of course, Macro Man then proceeded to ignore his own ‘forecast’ and buy bonds ahead of 5%. Why is that? Simply put, he felt (and indeed still feels to a degree) that there is insufficient evidence that the bond buyers of last resort (within current ranges) have departed the market, never to return. While CBs were clearly absent from yesterday’s auction, they are still accruing $ reserves at an extremely strong pace, and those funds need to be parked somewhere.

One hypothesis that Macro Man is toying with is that Voldemort and other CBs who are morphing into sovereign wealth funds will substantially and systematically shorten the duration of their fixed income investments so as to have a steady supply of funds in which to invest in risky assets. If this hypothesis is correct, it would represent a significant shift from past behaviour, in which these guys would simply buy the highest yielding part of the curve (thus exerting a significant flattening influence on global yield curves, exacerbating a trend already in place due to pension fund asset-liability management.)

It is the forecast that results from this analysis that is the most important part. If the hypothesis is correct (and Macro Man doesn’t know if it is or not), then we should see at least a partial unwinding, over an extended period of time, of the flattening of global yield curves. In other words, for a given level of rates, inflation, and economic activity, we should see yield curves steeper over the next two years than they have been over the last two years.

At this juncture, Macro Man doesn’t have sufficient data to make such a trade with the requisite degree of confidence. But the point he is trying to make is not that curves should steepen, or golly gee isn’t he clever for suggesting bond yields would rise. Quite the contrary- he is distinctly unclever for losing money while trying to step in front of the bear market train. No, the purpose of today’s post is to encourage readers to demand (or, if they are analysts, to write) research that is as scientific as possible- in other words, to contain not only a hypothesis/explanation, but also a forecast of what should or will occur if the hypothesis is correct. Research that merely explains what’s going on, or twists every data point to fit a preexisting forecast?

To quote Richard Feynman again, that’s nothing more than cargo cult science.

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8 comments:

Anonymous said...

re: always buy the highest yielding portion of the curve ....

maybe. but it seems to me, and I am not as close to the market as you, that some CBanks were buying the longer end of the Treasury curve last fall even though the curve was inverted.

China certainly seems to have taken on a bit of duration in the Agency MBS market over the past couple of years -- though it may have gone there b/c it couldn't get the yield it wanted in any part of the Treasury curve.

I obviously am struggling with the same issues you are -- namely, I still see lots of fuel (reserve growth in BRazil and Russia, growing Chinese current account surpluses/ reserves, ongoing korean and indian intervention, decent oil surpluses) for the central bank bid ...

bsetser

Macro Man said...

....and just like that, bonds deliver up a "**** you" rally on what was pretty darned hawkish data. Plenty of cargo cult stories as to why, but CB buying is prominent among them...

"Cassandra" said...

What about this:

When you ARE the market, the mark-to-market matters little unless you are excessively leveraged and being financed externally. You KNOW that the price of getting out (which one cant do in any event) will be horrendous, and is FAR AWAY from the current mark.

So if you know this, AND you know you are going to continue to pony-up the incremental dollar, (and re-invest your coupons) because there is little else you can do, why not extract a better yield? Let the market "state-change" - a non-reversionary move - to the next comfortable yield level. Walking away for however long it takes (a few days, a few weeks) will certainly accomplish this, emboldening the shorts who then will be forced to cover when you return, stabilizing yields at the new comfort zone.

It might even be easier and more efficient to cool things off in China by "letting" US rates rise, than by tinkering a few bp's with domestic rates, turnover taxes, or the margin requirement for stocks...

It's but a whimsical thought....

Macro Man said...

Perhaps you're right, C. The real Machiavellian explanation is that China let bonds go as a gentle warning against today's Teasury manipulation report and/or the Schumre legislation. Funnily enough, on the day that China is not named as a currency manipulator (yeah, right), they come back to hoover 10's. (And yes, I know this is a 'myth'.)

Macro Man said...

Oh, and Brad: lest you think my comments about cargo cult science were directed at you, you should know (if you didn't already) that I have the utmost respect for your work. Tracking CB reserve flows may be an inexact science>, but it is a science nonetheless.

"Cassandra" said...

The most important thing to remember about Machiavellian explanations is that we (the Royal "We") are still consulting Machiavelli after more than 500 years. Germane, indeed!!

Dale said...

Macro Man,

How do you know that the Chinese were hoovering the 10's today?

Dale C.

Macro Man said...

Dale, I don't "know" in the sense that I sold them the bonds myself. However, when five or six banks say that China is buying within a ten minute span, and yields mysteriously collpase, I am happy to conclude that where there is smoke, there is fire.