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February 20, 2007 (Caroline Baum - Bloomberg)
Maybe it was the repetition, the iteration of the same monetary policy testimony on back-to-back days last week, that did it, that left the words grating on my consciousness.
Here was Federal Reserve Chairman Ben Bernanke, one of the outstanding monetary economists of his time, talking about inflation as if it were the result of some pesky exogenous forces.
"A waning of temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation,'' Bernanke said in testimony delivered to the Senate Banking Committee on Feb. 14 and the House Financial Services Committee the following day.
What's more, the contribution "from rents and shelter costs should also fall back,'' he said.
There's a big difference between an inflation measure, which Bernanke was talking about, and the inflation process. Policy makers -- Bernanke, Alan Greenspan before him, the Fed governors and bank presidents -- talk about the effect oil prices or imputed rental costs have on inflation gauges, such as the consumer price index. That's not the same as the inflation process, which is always and everywhere a monetary phenomenon.
It may not sell in Zimbabwe, where anyone trying to explain the roots of inflation might be arrested on the spot. But in the U.S., with inflation running at about 2.5 percent, the public can handle the truth.
AntiSpin: Today our favorite Bloomberg columnist Caroline Baum rips Ben a new one for failing to play it straight with the public. We respectfully point out that Professor Ben's doing what every central banker does for a living, when he's not writing papers and suffering the indignity of explaining anything to anyone in Congress: lie. We covered the issue in The Fed: Dishonest or Incompetent? and found the Fed duly guilty of both. The iTulip Bible, J.K. Galbraith's galbraithmoney, instructs us to expect more of the same all the way to the bitter end of the terminal phase of the current debt cycle.
Chapter 9: The Price
Redefined definitions: panic, crisis, depression, recession, growth correction
Where economic misfortune is concerned, a word on nomenclature is necessary. In the course of his disastrous odyssey Pal Joey, the most inspired of John O'Hara's creations, finds himself singing in a Chicago crib strictly for cakes and coffee. He explains this misfortune by saying that the panic is still on. His term–archaic and thus slightly pretentious–reflects the unfailing O'Hara ear. During the last century and until 1907, the United States had panics. But, by 1907, the language was becoming, like so much else, the servant of economic interest. To minimize the shock to confidence, businessmen and bankers had started to explain that any current economic setback was not really a panic, only a crisis. They were undeterred by the use of this term in a much more ominious context–that of the ultimate capitalist crisis–by Marx. By the 1920's, however, the word crisis had also aquired the fearsome connotation of the event it described. Accordingly, men offered reassurance by explaining that it was not a crisis, only a depression. A very soft word. Then the Great Depression associated the most frightful of economic misfortunes with that term, and economic semanticists now explained that no depression was in prospect, at most only a recession. In the 1950s, when there was a modest setback, economists and public officials were united in denying that it was a recession–only a sidewise movement or a rolling readjustment. Mr. Herbert Stein, the amiable man whose difficult honour it was to serve as the economic voice of Richard Nixon, would have referred to the panic of 1893 as a "growth correction."
As the bubbles in debt-leveraged assets continue their collapse, starting with the sub-prime mortgage market, moving on to the prime market, eventually marking to market every crappy structured debt portfolio and suicide loan and crack-head credit derivative, the Fed will continue to frustrate anyone looking for an honest assessment. Redefined definitions: panic, crisis, depression, recession, growth correction
Where economic misfortune is concerned, a word on nomenclature is necessary. In the course of his disastrous odyssey Pal Joey, the most inspired of John O'Hara's creations, finds himself singing in a Chicago crib strictly for cakes and coffee. He explains this misfortune by saying that the panic is still on. His term–archaic and thus slightly pretentious–reflects the unfailing O'Hara ear. During the last century and until 1907, the United States had panics. But, by 1907, the language was becoming, like so much else, the servant of economic interest. To minimize the shock to confidence, businessmen and bankers had started to explain that any current economic setback was not really a panic, only a crisis. They were undeterred by the use of this term in a much more ominious context–that of the ultimate capitalist crisis–by Marx. By the 1920's, however, the word crisis had also aquired the fearsome connotation of the event it described. Accordingly, men offered reassurance by explaining that it was not a crisis, only a depression. A very soft word. Then the Great Depression associated the most frightful of economic misfortunes with that term, and economic semanticists now explained that no depression was in prospect, at most only a recession. In the 1950s, when there was a modest setback, economists and public officials were united in denying that it was a recession–only a sidewise movement or a rolling readjustment. Mr. Herbert Stein, the amiable man whose difficult honour it was to serve as the economic voice of Richard Nixon, would have referred to the panic of 1893 as a "growth correction."
Credit risk has been concentrated in the hands of investors who, after years of narrow credit spreads, have decided that if a junk bond or package of mortgage-related CDOs has a yield only a few points higher than a 10 year treasury bond, then, well, surely the market must be pricing the risk differential appropriately. No one bothered to tell them that they are the market.
Debt markets are expected to be more rational, disciplined, and transparent than equity markets. Equity markets are less refined but still respectable, with their earnings growth and contribution to productivity and jobs and so on, and infinitely more classy than the scrappy commodity markets, with their holes in the ground and pilings and smoke stacks. Each represents a level of abstraction removed from the political confluence of labor and capital. At such a distance from the holes in the ground and the houses made of wood, it's easy to be fooled and to fool oneself.
"If it walks like a low yield, low risk debt duck, and quacks like one, then if must be one," bond investors think. Really, what's the difference between a junk bond and a treasury bond? Ten points? Five? Two? Can irrational exuberance exist in the bond market? Beneath the veneer of abstract, classy finance lurks what flavor and degree of irrational thought process?
William J. Bernstein Credit Risk: How Much? When? wrote in 2000 for Efficient Frontier that the time to buy junk is when spreads are wide. Back in 2000, the junk-treasury spread looked like this:
The junk-treasury spread versus the forward five-year difference in returns between junk and treasuries looked like this:
Bernstein writes:
There's a pretty clear-cut relationship here: As expected, the higher the spread, the greater the advantage of bearing credit risk.
For a believer in efficient markets, these conclusions are profoundly disturbing, but not unprofitable. Although most of the time, it does not pay to take credit risk, there are periods when expected returns are too high to ignore. Yes, the devout efficient marketeer will point out that there's a reason why one does not often find $10 bills lying on the sidewalk, and that if this junk-bond opportunity were really a free lunch, it would have been arbitraged out long ago. However, there are limits to arbitrage. I ran smack into this limit at a conference of institutional fixed-income managers recently. It was easy to pick out the "spread investors" they were the ones with the deer-in-the-headlights stare and the portfolios suffering from the bond equivalent of irresistible-force-meets-immovable-object. I'm talking about huge mutual-fund-redemption demands running smack into illiquid, impossible-to-price securities. If you're a small investor with modest portfolio exposure to junk, say 1% to 2%, you can afford to wait a few years for prices to recover. These folks looked like they didn't even have a few weeks.
Belief in the efficient market theory does not relieve one of the duty to estimate asset-class returns. Because of the term structure of high-yield bonds, returns will tend to mean-revert more quickly, and more surely, than equity. Yes, there is risk. But when their long-term expected returns start approaching 5% over Treasuries (as they did not so long ago), it looks like a risk worth taking with a small corner of one's portfolio. One caveat: Because most of the return, similar to REITs, accrues as ordinary income, junk bonds are appropriate only for tax-sheltered accounts.
Are we market timing? I suppose. It's the lesser of two evils; I'd rather violate the efficient market hypothesis than ignore appealing expected returns with a relatively short time horizon.
By 2002, junk bonds were distressed, and many previously "A" rated junk bonds were selling for 40 cents on the dollar with a downgraded CCC rating. That will surely happen again, but with 70% of S&P companies' debt rated junk versus 30% in 1980, the stakes are so much higher today.For a believer in efficient markets, these conclusions are profoundly disturbing, but not unprofitable. Although most of the time, it does not pay to take credit risk, there are periods when expected returns are too high to ignore. Yes, the devout efficient marketeer will point out that there's a reason why one does not often find $10 bills lying on the sidewalk, and that if this junk-bond opportunity were really a free lunch, it would have been arbitraged out long ago. However, there are limits to arbitrage. I ran smack into this limit at a conference of institutional fixed-income managers recently. It was easy to pick out the "spread investors" they were the ones with the deer-in-the-headlights stare and the portfolios suffering from the bond equivalent of irresistible-force-meets-immovable-object. I'm talking about huge mutual-fund-redemption demands running smack into illiquid, impossible-to-price securities. If you're a small investor with modest portfolio exposure to junk, say 1% to 2%, you can afford to wait a few years for prices to recover. These folks looked like they didn't even have a few weeks.
Belief in the efficient market theory does not relieve one of the duty to estimate asset-class returns. Because of the term structure of high-yield bonds, returns will tend to mean-revert more quickly, and more surely, than equity. Yes, there is risk. But when their long-term expected returns start approaching 5% over Treasuries (as they did not so long ago), it looks like a risk worth taking with a small corner of one's portfolio. One caveat: Because most of the return, similar to REITs, accrues as ordinary income, junk bonds are appropriate only for tax-sheltered accounts.
Are we market timing? I suppose. It's the lesser of two evils; I'd rather violate the efficient market hypothesis than ignore appealing expected returns with a relatively short time horizon.
The end of the junk bond bubble has been called many times over the years, but I have resisted calling a top. So, today I do: it's a top.
"Because of the term structure of high-yield bonds, returns will tend to mean-revert more quickly, and more surely, than equity." Words to remember as the bond market soon grapples with the issue that Baum brings up today, the true inflation premium and its cause, the Fed itself. And when they finish pricing it in, Ben will wish he really was on the moon.
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