Wednesday, November 26, 2008

Ricardian Equivalence

Another day, another program....or, in the case of yesterday, two.

Yesterday's announcement of a new ABS lending program and, perhaps more importantly, direct Fed purchases of GSE paper, has been taken as a significant step. MBS spreads have cratered, swap spreads have come in, and markets appear to have concluded that this represents the next step in the Fed's quantitative easing (QE campaign.) After all, this program will take the Fed's balance sheet to $3 trillion...20% the size of US GDP.

As a consequence, the dollar came under pressure against a broad range of currencies as markets concluded that Helicopter Ben is taking his chopper for a spin with a fistful of benjamins.

Macro Man remains dubious that this is the appropriate conclusion. His view is that the actions of both the Fed and the Treasury, however ineptly communicated (here's lookin' at you, Hank!) simply represent the principle of Ricardian equivalence at work.

The past few decades, but particularly the past few years, have seem enormous rise in private sector leverage....both through traditional lending and derivatives contracts. The past couple of years have seen the total face amount of outstanding derivatives contracts increase at a run rate of $150 trillion dollars per year, according to the BIS.

And guess what? The value of that stuff has gone down. Financial institutions and private sector actors have learned the hard way that assets may come and go, but debt lasts forever. UBS estimates that banks need to raise an additional $1 trillion in capital to offset the amount of forthcoming losses and writedowns.

At the end of 2007, Citigroup had more than $2 trillion of assets on their balance sheet. That number will be a lot lower by the time all is said and done. Not that US banks have a monopoly on absurd leverage, of course; at the end of last year Deutsche Bank had over €2 trillion of assets- that's 80% of German GDP. Again, trends in that figure are only going one way moving forwards.

So in Macro Man's view, any dollars "created" by the Fed to expand its balance sheet (and let's not forget, they have yet to really crack out the printing presses by not sterilizing their asset purchases) will merely partially offset dollars lost through de-leveraging and the implosion of the shadow banking system, rather than finding their way into new the purchase of fresh turds.

The impact of these programs will, in Macro Man's view, only submarine the dollar once the crisis is resolved and domestic demand begins growing organically again. That seems likely to be several years away, for there is another kind of Ricardian equivalence at work- the ballooning of the US budget deficit should be offset by a sustained rise in the US private sector savings rate.
For now, of course, Macro Man has to scratch his head at some of the pricing out there. US sovereign CDS have ballooned out.....
...and are now trading merely a dozen bps below BNP! Are you kidding me? The US government (a flawed beast, to be sure, but the owner of a printing press for the current world reserve currency) a similar credit to a French bank? Puh-leeeez......the phrase "SocGen, 2007 risk management house of the year" keeps coming to mind....
Elsewhere, the Chinese have declared that they mean business by cutting rates a whopping 108 bps today. The knee-jerk reaction was a predictable rally in risk assets, though perhaps sensibly they have since given back those gains. While Chinese policy easing may eventually have an impact, let's not forget that a) credit is primarily allocated by executive diktat rather the interest rate mechanism b) these things work with a lag, and c) it's generally easier to slow your economy down than it is to speed it up again.

Anecdotes are circulating of mass plant closures in Guangdong...something does seem to be rotten in the state of PRC. One interesting tidbit to observe is the collapse in sour-grade Asian crude oil; the Indonesian Duri crude is now trading under $30!!! That would suggest very little demand indeed from Asian-based consumers of distillates....such as....oh....China.
Macro Man is kind of surprised at the number of punters he speaks to who kind of fancy a late year squeeze. He will concede that such a rally, if it happens, will have little to do with fundamentals and will instead be driven by positioning and momentum jockeys.

Who has't heard the stories of hedge funds and real money guys sitting on huge piles of cash in anticipation of year-end redemptions? And hey, with the Fed backstopping MBS and China doing its thing, surely the pain trade is stocks higher and underweights scrambling to cover?

Perhaps.....but then again, perhaps not. Macro Man's futures positioning indicator shows the highest net hot money longs in two years. This has been driven largely a a raft of short-covering amongst futures specs, taking speculative shorts in the e-minis to their lowest levels since early last year.
So maybe there will be a squeeze....then again, maybe not. At current pricing and market conditions, Macro Man just cannot see how there's a good trade there in either direction- so he's flat. His methodology has served him well this year, and he has little intention of becoming another footnote when the history of today's Ricardian equivalence is written.


Anonymous said...

What do you mean by "they have yet to really crack out the printing presses by not sterilizing their asset purchases"
How do they sterilize asset purchases?

Macro Man said...

They sell their existing stock of Treasuries (or the Treasury issues special financing bills)

Anonymous said...

they are deflating their debt.....only a question of time before others follow.

we are entering a new world, which is not priced in at all in the FX market. ALL ccys in G10 will devalue substantially and the only ones left standing are those with c/a surpluses, low inflation, somewhat high growth, low debt, i.e. good fundamentals......also metals will go a lot higher...

in fx be short G10, be long the good parts of EM versus short the bad parts of EM

Anonymous said...

I thought they have quit sterilizing recently? The SFP program was abandoned a couple of weeks ago..

Anonymous said...

Ricardian equivalence - the Benjamins being sprayed around will go to fill the hole created by deleveraging...Very good. But is this not just another way of saying the bail-out socialises the losses. The burden shifts to Joe six-pack et al, and his progeny. That must have a depressing effect long-term? If the losses were borne here and now by those who created them we might get over it and move on but what is happening drags out the problem - read Japan.

Anonymous said...

Anon 11.52,

Agreed on devaluation part, but see nor reason why metals and/or commodities go higher in a major serious global recession-depression environment.

Macro Man,

Simply brilliant observations again. Would you agree on most fiat currencies yet to price in 'a devaluation' scenario?


Sean Maher said...

Agree re China (but not rally potential) I've been a mega bear on the Chinese 'miracle' all year, and their latest wheeze to pour even more concrete into unproductive capital investment is repeating the failed Japanese model of the 1990's; the next shock will be the extent of China's slowdown and just how dubious official statistics will prove in hindsight. They certainly won't be buying many more Treasuries...

Anonymous said...

Ref: Indonesian Duri crude
Although Indonesia is an OPEC member, fact is that the country effectively has stopped exporting any crude due domestic demand higher (or equal) to its oil production.
Hence, I'm not sure Duri therefore is a good benchmark for China's oil demand/import.Better use Malaysia oil price(2008 771kbday output) or even China itself (2008 3,797kbday ouput!) ,which has now become an aggressive oil product exporter (eg:gasoline!)

Macro Man said...

Anon @ 12.12, while I agree this is socializing the risk, I have a different, perhaps elitist take on the usual "Joe Sixpack gets screwed" conclusion. The "rich" have a higher savings rate than middle quintiles, and bear a disproportionate tax burden...while income and wealth are concentrated in the top 5% of earners, the tax burden is even more concentrated among that same population. Moreover, while not many middle class Joes bought CDO turds, I wonder how many investment bank VPs lied on their subprime mortgage apps.

Anon @ 12.11, as far as I know they are still selling off treasury holdings, however.

Anon@ 12.22, I agree that all fiat currencies look like crap, which is another argument against the dollar bear trade...what are you going to buy against it? In a non-deflationary world, I suppose I could see the case for gold- but the difference between gold and currencies is that one is a physical asset that u have to pay cash (which, if the theory is right, will be in short supply) for, while the other can be don via forwards that entail no delivery whatsoever and much less upfront collateral.

The obviuous currency that should appreciate is, ironically, the RMB....all the more so if they are actually exporting petro products. The monthly trade numbers are reaching all time highs...and yet the RMB has ground to a halt- because Voldemort (PBOC) is still playing silly buggers and buying $ like it's going out of style.

And that, Sean, is why I think the bid for Treasuries will still be there.

Anonymous said...

The biggest contradiction i believe in markets currently is "equities are a sell, credit is a buy". I just don't see it at the macro level. Lets keep it simple - take any chart of credit spreads (investment grade or riskier) and they have a very decent relationship (VIX). Actually credit has led the way through this mess. How can credit spreads tighten, and equity volatility fall without causing a significant rally in equities (look at VIX vs SPX). Its a very meaningful upside risk, provided all the 'experts' are right on credit. I would play it through optionality. Selling limited downside (december08 put spread) to buy further dated upside in US or European major equity index looks like a good risk reward trade. Market feels binary at moment, i'm 60% for a market rally. 40% for a sell off. You can structure trade for zero outlay and contain your P&L loss on downside but very nice payoff on upside. Nothing happens, didn't cost you anything. Volatility term structure nicely inverted.

Anonymous said...

typo : take any chart of credit spreads (investment grade or riskier) and they have a very decent relationship with equity volatility(VIX). credit tightens, equity volatility declines, equity rally.

Anonymous said...

Just discovered this blog. Very interesting comments. My 2 cents the $ has been pricing in long term strong economy that turned out to be based on excessive credit. USA was not that great after all. While the US has to rebuild is balance sheet the Euro area has only to rebuild its P&L. In addition I dont see why you guys so negative on China it may turn out to be like Japan but only in 20 years when economic development is completed. This crisis is exactly what China needed capital will flow to long term growth and the only thing that was threatening China's growth ie natural resources, is now in their favor. The main thing to watch in China is social unrest and protectionism. But remember China is run by engineers and not politicians!!! So long term patterns in FX will resume $ portfolio allocation will start to decrease again the euro will gently rise and Asian and Brazilian currencies will raise. Hopefully Russia will start to become more understandable. the main beneficiaries will be BRICs equity markets. Try to run a DCF for a BRIC company with declining discount rates: cash-flows NPV just explodes.

MW said...

"the Indonesian Duri crude is now trading under $30!!! That would suggest very little demand indeed from Asian-based consumers of distillates....such as....oh....China."

If that's the case, why is the heat crack not lower?

Anonymous said...

Anon @ 2:20 PM,

Social systematic flaws and the technology are two major problems in China now. There are some serious challenges.


Although I agree with you on many issues, there is one exception: the infrastructure in China is not in excess but imbalance. In the inland crowded parts of China, the basic infrastructure is desperately in need.


I doubt the RMB appreciation is justified. Part of trade imbalance is caused by the trade restriction policies from U.S. and EU sides. Capital outflow would increase for the next 2 years IMO for China.

Anonymous said...

a) special financing bills are finished now and b) no more selling of treasuries either. if they didn't do these things a)the monetary base would not change b)their balance sheet wouldn't grow, which would not then be quantitative easing. this is the whole point - they've given up sterilising their injections of cash... they're "printing" new money to buy assets. this is what "helicopter ben" is all about.

Anonymous said...

happy gobble gobble!!

awesome mm post as usual!

TY new contract high! if american housing truly is the major problem, perhaps this shock and awe is the only way to get the mortgage rates down, they have refused to drop thus far...

An estimated 700 hedge funds may go out of business by the end of the year, an increase of 24 percent from 2007, according to Chicago-based Hedge Fund Research Inc...would think vicious tax loss selling is on deck to end the year, and with commercials short the SP and selling net -50k contracts of crude last weeks cot report, seems to support that view


Anonymous said...

Too many 'unreliable' data on China albeit agreeing on macro China potential on RMB revaluation.

While USD looks toast come this time next year given current bazooka lending process winds up, I honestly don't see how Euro would hold it's value.

On BRICs, I'd agree on their potential but who is gonna buy their exports while their local discretionary incomes are nowhere near the US, the EU, and Japan.

I see a prolonged recession but give credits to Barack for so far handling the formation of much needed powerful economical team, i.e. final appointment of Volcker.


Macro Man said...

Anon @ 3.15, OK , I see where they are no longer adding to the Treasury's deposit account in the FR point taken on the SFB's. I knew they had announced an intention to do so, but hadn't seen that they'd stopped already.

Regardless, all this "money printing" is being held as excess reserves in the federal reserve's not like it's currency in circulation.

Anonymous said...

How is the purchase of MBS and Agency debt not currency in circulation, Macro Man?
That’s freshly minted reserve’s going to anyone who owns those securities.

Macro Man said...

Currency in circulation on the Fed's balance sheet has barely the "printing press" isn't dropping benjamins on street corners. The point of today's piece is that the money going from the Fed's purchases will be retained on balance sheet to compensate for writedowns of turds and other future losses...rather than spent on financial assets.

Anonymous said...

@Anonymous 2:30 Pm

"But remember China is run by engineers and not politicians!!! "

That's the problem. This whole financial fiasco was engineered by the former engineers and mathematicians who were recruited by Wallstreet. Why will it be any different in China. In general, Engineers are too narrowly focused and do not have a broad view of all aspects of "living."

True innovation requires free thinkers; risk takers. Until China opens up its society and promotes ideas, then there can be no China century.

Anonymous said...

Yeah, I agree with you, ‘printed capital’ is merely replacing decimated capital.
Seems to me though that the program announced yesterday upped the ante, as the $600bn could be sprayed outside the banking system, to participants who may give it a little velocity; whether they choose to do so I don’t know.

Anonymous said...

@Anonymous 5:07 Pm

Although I am not engineer myself, this is one of the biggest jokes I heard today. Blaming engineers for their "narrowness, conservative lack of idea " just shows a surprising degree of ignorance and arrogrance. Where do you think those innovation and technologic progress come from? Who should be blamed for the current mess, the former engineer employees or their IVY-league big idea bosses? What contributed to the US century, money and warship, or philolsophers?

Anonymous said...

I think there is a very interesting debate developing in the FX world....none of the reserve ccys are attractive anymore in G10!!!

Now with all these pumping of liquidity and the devaluing of debts i cannot but think that one should have all of their savings in the undervalued Asian ccys mainly CNY.

BRL is interesting but much depends on commodities which i am not so sure how they can go higher...

thoughts welcome on any of the above

Anonymous said...


How can you believe the Treasury bid will still be there if china has already slowed treasury buying in the past 2 months or so and is already seling agencies. I would also like to hear your opinion on the cause of the recent treasury rally. How can you have lower CB demand, enormous new supply, the fed selling, and still get a rally? Regardless of China's bid, do you think treasuries are fairly priced here? It just seems odd to me that we have the ten year at 3% whilst the fed/treasury have all but promised future inflation. I can think of dozens of reasons why treasuries should go down from here but the only reason for a rally is a severe deflationary recession. I grant you the recession but the deflationary part is very unlikely. It just looks to me like the risk/reward on a treasury short is significantly skewed to the upside.

Anonymous said...

@ 10:09, I think this is the biggest Q in the mkts at mom, I've heard of a lot of receiving in the longer end from very insensitive players tied to mortgages (esp after yesterday's annoucement, 30s area) and general duration extension in a close to "zirp" world (10s out, Alphaville have some decent tidbits on this). Flight to quality players would have you believe that the only things worth owning require a govt guarantee and until the fear subsides they may be right. Nevertheless I do agree with you in thinking that actual deflation will not occur, but don't want to step in front of the steamroller just yet. Great post and great debate today.
Cheers, JL

JKH said...

Quite a few other comments on sterilization, but:

“Regardless, all this "money printing" is being held as excess reserves in the federal reserve system ... it's not like it's currency in circulation.”

This isn’t quite true.

Base money “held” as excess reserves has also been replicated as an increase in M1 deposit balances in the commercial banking system. It’s just as powerful as currency in circulation. It hasn’t been sterilized at all.

Moreover, currency in circulation is a red herring insofar as the identification of sterilization is concerned. CIC is determined as a function of private sector demand, to which central bank supply is a passive response. No central bank can goose system liquidity by forcing the public to hold more notes – it must work through bank reserves or government deposits as a required liability expansion.

Finally, government deposits at the Fed have been a form of sterilization to the degree they haven’t been used in disbursements to the commercial banking system. Now government deposits are being wound down, reserves will increase as an offset at least.

(Reserves decreased with yesterday’s report I think because FX swaps declined for the first time).

All this said, it becomes a question of judgement as to how much unsterilized balance sheet expansion is appropriate to offset deflationary forces in credit. And I agree with your direction there.