Morally Bankrupt

Romney displays his complete ignorance about the global economy

2012-01-10T22:01:00.000-05:00

I recently ran across a few headlines and news stories which claimed Romney had promised to stop borrowing from China. I had to read them a few times and then a few times again because, as I remembered, Romney claimed to know a little bit about economics and this was an egregiously incorrect statement, showing either a complete ignorance about the most basic aspects of the global economy, or a wish to exploit the fears of the Republican masses. Since I'd like to think he's not a total scum-bag, I'm going to assume it's the first.

The problem with this claim is that it claims that the US is dependent on the benevolence of Chinese creditors to fund its fiscal deficit. That's simply not true. Firstly, the accumulation of US obligations in Chinese balance sheets is a function of the Balance of Payments, not the US' fiscal balance. I'll quote Professor Michael Pettis here, as his explanation is more concise than mine,

...foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding. Capital account inflows must exactly match current account outflows.
...
The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall.
...
Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow.

As is obvious to anyone following the developments of the global economy over the last 10 years, the obvious scenario is the latter. The US Treasury doesn't need China's money, China needs US Treasuries as a way to warehouse its FX reserves in order to maintain its current account surplus. In fact, China reducing its holdings of US Treasuries would be net stimulative to the American economy as the US trade deficit with China means that, along with knicknacks and iPods, the US is also importing Chinese unemployment.

Unless the US Treasury starts emitting dim sums (borrowing in CNY or CNH), the US is not borrowing from China. This is not subject to discussion.

Things EFSF Will Not Fix

2011-11-03T17:57:00.001-04:00

Expecting a bunch of bureaucrats to fix a decade's worth of accumulated imbalances in a matter of months with some alphabet soup ain't gonna work. What will work? Peripheral countries deflating with respect to core. Not only will it work, but it is the only thing that will work. Pictures follow. Toodles!

Cumulative Inflation relative to Germany. (i.e. Germany CPI would be a flat line at zero)

Balance of Trade (Exports-Imports) for GIIPS

GIIPS Balance of Trade as a % of GDP

Balance of Trade for selected European economies

Balance of Trade for selected European economies as a % of GDP

On Economic Data and Time Scales

2011-11-03T14:24:00.000-04:00

I was looking at the excellent Bonddad blog today, and came across the post, "Uh oh: YoY gasoline usage down 5%, worst since October 2008."A small piece is quoted below.

US Gasoline demand

Something's happening here, but what it is ain't exactly clear. The most obvious candidates are:

1. demand destruction. But if so, why is consumer spending, as measured by the Gallup daily survey, holding up so well?
2. energy efficiency. But have we really bought so many hybrid vehicles to make that big a difference?
3. the weather. OK, we did have a strange Nor'easter that pummeled the northern and western suburbs of the Megalopolis, but that was one day only.
4. random stuff just happens. Always a possibility, but this seems unlikely given at least three weeks in a row of awful YoY comparisons.

Now, I don't want to pick on Hale Stewart, the author, or his commentators, but I need to point something out here because this is a narrative I have heard many times in the last 3 weeks. Reduction in gasoline demand is not due to increased fuel efficiency. I don't doubt the fleet is getting more efficient, but this narrative completely ignores appropriate time periods and this is something I see quite often in the blogosphere. A reduction in demand due to fuel efficiency will be measured in decades, not months. If there is changes in the monthly numbers, it is either a different factor or noise, but the effect of increased fuel efficiency will not be measurable in the weekly data. Why? Because, at current sales rates and assuming no net growth in fleet, it would take roughly 23 years to turn over the US automotive fleet.

Auto sales as % of fleet, estimated fleet growth and replacement rates

Instead, I suggest we look for a more common-sense narrative and look at hotel occupancy, since Americans love to drive and, since we're talking gasoline sales, we need not worry about trucking.

Hotel Occupancy rate, via Calculated Risk

Hmmmmm. Notice anything? Like hotel occupancy and gasoline demand both coinciding in their drops?

Let's use some more common sense here guys and realize that different things happen in different time scales and if you are not paying attention to that, you are lying to yourself and making worse decisions as a result.

xoxo,

GossipGirl

UPDATE-1: This is not a criticism of Hale! This is a a comment regarding the four commentators that attributed the drop to fuel efficiency. This is a narrative I have heard from many people in the last 3 weeks and it is WRONG.

Buy Home, Sell Gold?

2011-10-11T18:20:00.001-04:00

Presented without comment.

Hypothetical payment of a median-price new home purchased using a conventional 30-year mortgage

Hypothetical payment of a median-price new home purchased using a conventional 30-year mortgage as a % of median household income

Median-price of a new home expressed in troy oz of gold.

Muni Madness

2011-09-28T23:24:00.000-04:00

Via FRED, the Bond Buyer Index GO 20y to maturity, mixed quality) spread to treasuries (weekly)

I've made no secret that I have been a heavy buyer of long-term municipal credit risk, taxable and non (via Build America Bonds) with short in treasuries of similar maturity to isolate the spread, looking for compression. But, please, take a look at the big 2008 spike. At these levels DV01s are big, so that widening can be really painful. Do yourself a favor and watch your risk levels. While there's reasons (scroll down to TOB section if you must) why I, personally, don't expect a 2008-like event, I am ready for it. This goes double if you think you are going to boost your positive carry and grab extra return from a wide discount in CEFs, as illustrated below.

XBBNX is NAV of BBN

Discount / premium of MQT via CEF Connect

UPDATE-1: Going back to 1953 using the monthly 20y treasury series with the long-term average series for the gap (pretty good fit, actually)

Build America, Young Man!

2011-09-06T11:33:00.000-04:00

This is one of my favorite trades right now because I don't have a clear picture of where other things will go. The trade is simple: Buy BBN, sell TLT. In other words, buy the discount and credit risk and hedge your duration. By my calculation, the discount at the time of this writing (intra-day) is around 10.5% and, in my opinion, spreads in the Muni and BAB spaces are relatively attractive, considering credit risk, if you're not exposed to duration. BBN is a closed-end fund that holds Build America Bonds (basically taxable munis) with high credit ratings (3.6%AAA, 69.4% AA, 35.1% A). About 57% of the bonds are callable in 5-10y, which explains why, even with leverage (~30%) the daily NAV moves of late seem small compared to treasuries. The trade carries positive (~3% including borrow). If you have size, selling the ultra bond instead of TLT is easier and cheaper, and it's what I prefer to use. The risk with this trade is that spreads and discounts can always widen. In Nov-Dec '08 30% discounts to NAV were common and Munis took a beating vs treasuries. If you 're not levered, you can sit it out and make faces at your account balance until the dust settles. If you use too much leverage, your friendly margin clerk will probably liquidate you. Size accordingly.

Disclosure: I am currently long BBN, short TLT and short Dec '11 CME Ultra T-Bond contracts for myself and my clients.

Please remember, this is not a recommendation to buy or sell any securities. The information presented here is believed to be accurate as of the time of this writing but, hey, everyone fucks up, even me. This post is simply meant to be an illustration of one of the strategies I use in client accounts.

XBBNX = BBN Net-asset value.

X axis daily TLT change, Y axis BBN NAV change

Light Vehicle Sales and the NFP Report

2011-08-23T00:28:00.000-04:00

I'm really dreading ADP/NFP week. It's my least-favorite week of the month. This month, I propose we all stop getting our collective panties in a bunch over a meaningless data-point that is subject to huge revisions and instead use a little common-sense and keep it simple.

You know what people are going to do when they get a job? Buy a car. Why do I think so? Because financing rates are low, deals are good, the fleet is old, and the sales have been depressed for three years. Don't believe me?

Red: SAAR Light-vehicle sales divided by the total population estimate
Green: Total non-farm private payroll divided by the total population estimate

Blue: SAAR Light-vehicle sales divided by the total population estimate (inverted scale)
Red: Civilian Unemployment Rate

The sewers I swim in

2011-07-31T14:26:00.005-04:00

Boston sewer image from Liquid Assets

I've seen lots of arguments about why reducing the deficit right now would bring crisis to the economy. Most of them are very textbook Keynesian arguments arguing that at times of excess capacity, reducing deficit spending would just add headwinds to an already struggling economy. The other argument is that the US should take advantage of exceptionally low borrowing rates to invest in rapidly aging infrastructure and put Americans back to work using a sort of New Deal 2.0 scheme.

The first argument is a bird's eye solution to a ground-level problem. Yes, government spending would goose GDP, but is that spending creating wealth? Where is that "stimulus" going? Our goal, after all, is not to maximize GDP, but to maximize wealth. GDP is just a poor objective measure for a deeply subjective phenomenon and gaming our own framework won't help anyone, regardless of what numbers the BLS, BEA and FRB release over the upcoming months. And let's not forget that Washington has a very poor track record as an allocator of capital. I'm simply not comfortable leaving these decision up to the people that decided to try to reflate the bubble by pulling-forward demand, subsidizing toy arrows and foreign liquor and build useless airports. Just sayin'.

But does this mean we should address the crisis with full-throttle austerity? Not quite. As it was eloquently pointed out last Summer on interfluidity, austerity is stupid and deficits are dangerous. We can't make generalizations about debt, deficits or balanced budgets. Deficits and debt are neither good nor bad on their own. Leveraging up for wealth-creating projects is good, borrowing to throw money away shoveling sand from one pile to the other not so much. Washington is focusing on abstract goals like "putting real Americans to work." And one can't blame them because that's what people want, jobs. But "jobs" isn't something you can simply create from thin air, you can't just throw money at this problem and expect to fix it. "Jobs bills" and "improving America" are nebulous ideas, subject to interpretation without any objective way to measure success or failure, which is probably what Washington wants.

"Well, fine, but what do you suggest then?" you may be asking yourself. I just want to say one word to you. Just one word. Sewage. We've spent the better part of the last 10,000 years trying to secure sources of clean water and get rid of waste. Humanity has developed modern plumbing and sanitary sewers. We survived the Great Stink of 1858. We've battled epidemics of water-borne disease, droughts and floods. I feel comfortable in making the broad statement that clean water is good and shitty water is bad. Therefore, one could expect that making something good out of something bad would be a positive thing, an improvement, a wealth-creating action. If you disagree, feel free to stop reading now.

All of which brings me back to our original topic, the deficit. We have swaths of unemployed persons and slack capacity in all aspects of construction, record-low financing rates, and an economy that uses fresh potable water faster than it replenishes it (including aquifer sources). Wouldn't it be great if we could put excess capacity to work creating an infrastructure that helps us achieve sustainability and conserve one of our most vital resources while financing it all at record-low rates? Well, we can, and it's called sewage treatment. It's the effective, efficient and inexpensive process of cleaning water.

The Deer Island Treatment Plant on the Boston Harbor provides primary and secondary treatment for the waste and storm water of the greater Boston area. It serves 43 communities, 2.5 million people and hundreds of thousands of businesses and it cost $3.8 billion to build. The entire MWRA had $176M of sewer-related operating expenses in FY2010 (pg 50). That works out to $70.40 per-person per-year. That figure includes not only the plant, but the entire sewer system as well as treatment of storm water and one of the most advanced plants in the country. DITP not only discharges water that is cleaner that the water it is being discharged into, but it efficiently decomposes organic waste using anaerobic digestion, reducing the volume of the sludge by 90% and using the resulting methane gas to help heat/power the plant. The dried, pelleted result of the digestion process is sold as Bay State Fertilizer (the heat naturally created by the digestion and drying process kills the harmful pathogens). So, for $70.40 per-person, per year, the MWRA cleans, on average, 360 million gallons of waste-water per-day and turns the organic water contained in it into energy and high-quality fertilizer, saving the city millions of dollars in sludge transportation and disposal fees, all while keeping the harbor clean. And while the $3.8 billion cost of construction may sound like a lot, consider that the plant had an initial 30-year expected life, meaning buying the plant on credit and amortizing it over 30 years (using the current 30y tsy rate of 4.12% as a proxy) would cost a only $7.36 per-person, per month. To put it all in perspective, including both amortization costs and operating costs, the cost per-thousand gallons of water treatment comes out to $1.48, or about the price of a medium-sized water bottle in a convenience store.

That's deficit spending I can get behind.

UPDATE-1: fixed an arithmetic oops and added reference to plant cost.
UPDATE-2: It was pointed out to me that the actual number of users serviced is 2.5 million, not 2 million. All numbers adjusted to reflect this. Link to source added as well.

Shut-up, CNBC: Carney on Muni bonds edition

2011-04-19T12:08:00.001-04:00

Yesterday, Carney, when discussing risks to the Municipal markets said something I feel is inaccurate and deserves correction.

5. Information Cost is High. Muni issuers are not subject to the same disclosure requirements as corporate borrowers. The market is illiquid so pricing is opaque. The swaps market—the market for tradable credit protection—is thin and unreliable. This means that bond buyers may be taking on risks that they are not aware of. This is a recipe for panic once a triggering event occurs.

First of all, CDS trading on a LOT of things is very thin. The municipal market is not a monolith, it is composed of thousands of issuers and so, yeah, swaps are probably pretty thin for many issuers. Just like bond and CDS mkts would be thin for most corporate issuers. Second of all, municipal market is dominated by retail, for obvious reasons. Joe Smith looking for safe tax-free bonds isn't exactly your average CDS trader.

Secondly, information is not that hard to come by if you know how to look and are not lazy. Anyone that's lending anyone money should do their homework, or at least pay an adviser or fund manager that has fiduciary duty to do it for them. MSRB is a wonderful resource, including a freely available trade history and, as Bond Girl has pointed out before, MSRB's EMMA allows you to find many issues' official disclosure documents.

Lastly, if you are the kind of investor that doesn't need an adviser or fund manager and is buying large amounts of municipal bonds, you can probably afford a subscription to The Bond Buyer and professional research from the rating agencies (ignore the rating and read the analyst's report).

6. Arbitrage Buying Leads to Bubbles. Much of the demand for muni bonds is not a function of credit analysis or a desire for exposure to the revenue streams of local governments. It is done for a technical, legal reason—to take advantage of the tax-free status of muni bond income. This creates an artificially high demand—a bubble—much like Basel accord capital requirements led banks to overinvest in mortgage bonds.

As Bond Girl wrote a few weeks ago, the last few years have seen some demand destruction, not only from a shift in investor's appetite for municipals relative to other securities, but by the departure of a number of leveraged actors that, through the use of short-term funding schemes created additional demand at the long ends of the curve. We're also seeing that "the muni market is transitioning from an interest rate space to a credit space." I can't go into it here, but you should really read Bond Girl's piece, it is excellently written and informative in a way no newspaper ever will be. But, getting back to my point, tax-free income doesn't necessarily increase demand.

Tax-free yield is attractive and investors are usually willing to take smaller yields for tax-free debt because it is still attractive in a taxable-equivalent basis. However, tax-free yields are only attractive to investors that benefit from preferential tax-treatment, limiting the universe of potential buyers--this is why the BAB program was introduced, to stabilize demand by introducing new participants. In my opinion, the tax-exempt yield of municipals actually hurts demand by restricting the universe of potential buyers. One only needs to look at the disparities between non-taxable TEY and BAB yields earlier in the year to see this at work.

The solution here, in my opinion, is for the federal government to refund issuers directly, like in the BAB program. Investors will receive higher yields that are equivalent on a taxable-equivalent basis and municipalities can offset the additional cost of debt service with refunds from the tax collectors paid for by the tax collected on the new, taxable issues. Otherwise, we risk a market where municipals can actually pay a premium, as they trade not only on their taxable-equivalent basis, but also on any extra risk or liquidity premium required by the restricted universe of buyers, increasing volatility and therefore the cost to issuers.

How China's Negative Real Rates Depress Consumption

2011-04-11T08:30:00.046-04:00

If you've ever caught me ranting about China on twitter, you've seen me carry on about how negative real deposit rates are an implicit transfer of wealth from households to government. You may also recognize that point from Michael Pettis' China Financial Markets blog. In this post I'm going to try to explain how this transfer works. It's not complicated, but if you don't understand how developing economies differ from economies like that of the US it can be hard to see the mechanism at work.

The basics:

Outside the upper-middle and upper classes, consumer credit is not easily available in developing economies. You can't just call Experian and check someone's FICO. Large amounts of the population is unbanked, underbanked or has no credit history at all.
The deposit and lending rate (and therefore the spread between them) are set by the central government.
Michael Pettis has estimated real deposit rates are suppressed by "at least 400-600 basis points" (China Financial Markets)

Negative real deposit rates are a transfer of wealth from depositors and creditors to debtors
Because of the limited access to credit that households have, households are the main source of deposits in the system. Like in other developing and under-banked economies with limited access to consumer credit, in China you need to save money until you have the full price to pay for X good (e.g. durables) which, when combined with inflation, forces the households to accept negative real rates. Accepting a 2% yield when there's 5% inflation may mean -3% real rate, but it's better than the -5% cash yields. Reasons for savings include emergencies, possible medical expenses, savings for a home, vehicle purchase or a child's education or every-day cash management. Remember, the rest of the world doesn't use their Capital One to pay for their groceries. With this kind of saving pattern, real rates have inverse effects on saving because, the more negative real rates are, the higher the savings must be to achieve a savings goal or maintain the real value of the savings balance. Without access to credit, negative real deposit rates force the household sector to save more. Money channeled towards savings by the household sector is money that is not spent on consumption. An approximation of total tax on households--and consumption--would be the product of the average daily balance of total deposits multiplied by times the gap between market and government-set rates multiplied by the percentage of household deposits in the system. That estimate excludes any effect from misallocation of resources by borrowers.

Who are the creditors? Who is receiving the transfer?
In April 2009, the Hong Kong Institute for Monetary Research published a paper which claims that state-owned enterprises (SOEs)--which account for about 37.6% of total value added in their respective industries and 25% of GDP--are only, or mostly, profitable due to a preferential cost of capital. According to the authors, "SOEs’ profits would have been entirely wiped out if SOEs were made to pay the same interest rates as otherwise equivalent private enterprises." How big is the problem? Well, "although SOEs’ contribution to the Chinese GDP was around 25%, they received about 65% of total loans."

Seeing as how a large portion of the SOE are involved in investment-related activities (in the GDP sense) and SOE's account for a majority of Chinese GDP the easy conclusion is that investment is being financed by taxing households through the banking sector. Net-winners? Anyone involved in that supply chain and the SOEs. So the transfer is moving from Households to government and business. Which businesses? Well, since, "about 41% of private enterprises have no access to credit and 56% have no access to bank credit," I'm going to guess big businesses.

Negative real rates impede a growth in household consumption by transferring wealth to government and business as long as households bear the cost of those negative real rates.

This leaves us with one way to increase consumption:

reduce the burden carried by households as a result of negative real rates.

And two possible ways of achieving that:

Raise real rates
Transfer some of the cost of negative real rates elsewhere

Barring a flood of foreign depositors itching to deposit funds into RMB-denominated accounts at negative real rates or holding RMB as FX reserves, option two means either government or business. Analyzing the effect to the SOEs is beyond the scope of this post, but since profits ultimately go back to the state, we can look at SOEs and government as one, and consider that subsidy as a tax. It's simply a way for the government to decide how citizens spend their own money. Unless the government stops trying to do that (fat chance), reduced subsidies to SOEs and government would just require more taxes/state-borrowing or less spending, of which the ultimate recipients are the household sector again.

Essentially, the other two beneficiaries of negative real rates, households and private industry with access to credit, are free-riding on this policy and benefiting from low-cost financing, creating a regressive re-distribution of household wealth. This is one of the many reasons we've seen restrictions, like higher down-payments, placed on mortgages of second and third home purchases.

Suggestions
The simplest fix to the problems caused by negative real rates (under-consumption, regressive redistribution, resource misallocation, asset-price inflation) is simply to raise real rates. Of course, raising real rates could cause a surge in NPLs from SOEs that wouldn't be profitable without the implicit subsidy. In the event of a SOE being rendered unprofitable by having to access capital at market rates, the implicit subsidy could simply be turned into an explicit one if the firm's activities were deemed important enough. Otherwise, the firm would go away or shrink, eliminating the dead-weight loss from misallocated resources. The banking system? The risk is already implicitly (and sometimes explicitly) socialized and the problem won't simply go away if Beijing keeps waiting.

Moving real interest rates up doesn't necessarily have to be contractionary for the economy. Sure, the loss of the implicit transfer from households to SOEs / Government would reduce investment capacity, but at the same time it would increase consumption capacity by an equal amount, although probably not the kind of consumption Beijing would prefer. Given the reduction in losses from negative real rates, households would be more able to absorb tax increases if Beijing wished to keep subsidizing investment.

Additionally, stepping closer towards market rates would allow the expansion of consumer credit. Widespread access to consumer credit wouldn't really co-exist well with real negative rates unless there was exterior financing, which would require major changes to the current account. Notwithstanding Q1 2010 numbers, I simply don't see consistent trade deficits for China in the horizon, so the next the easiest and healthiest road to increasing access to consumer credit is simply positive real rates.

Why increase access to consumer credit? In many ways--although not all--savings can be replaced by access to credit. Many people have savings so that they have enough purchasing capacity in short notice in case of an emergency. Credit can replace that cushion in many cases, reducing the need for short-term time or demand or deposits. Following this logic, giving someone access to credit allows them to spend deposits on consumption because the emergency purchasing power they needed is still there in the form of credit. Just this action, without any actual household borrowing, would shift some savings to consumption by reducing the quantity of household savings that need to be parked at deposit institutions.

ESM / EFSF: An Inverted Capital Structure

2011-03-22T12:50:00.001-04:00

I've been meaning to write about this for quite some time, but it's been really hard to have the time to sit down and do it. I've let perfect be the enemy of good and so here I'll try to lay out a rough sketch of what I think are some of the possible risks of the EFSF / ESM.

From Reuters:

The euro zone's permanent bailout fund, the European Stability Mechanism ... which will have an effective lending capacity of 500 billion euros, will be backed by 80 billion euros of paid-in capital and 620 billion euros of callable capital ... It will offer loans at funding costs plus 200 basis points for loans up to three years and plus another 100 basis points for loans longer than three years.

What you are seeing here is what Michael Pettis described as an "inverted" capital structure in his excellent book, The Volatility Machine. What that means is that there is positive correlation between the need for funds, the cost of funds and the credit quality of the facility. This is problematic because it could cause reflexive price action in the bonds of the aid recipients, lowering the value of the EFSF holdings and furthermore deteriorating its perceived credit quality. This is also sometimes referred to as "wrong-way risk" when talking about CCPs. In other words, "the risk that different risk factors be correlated in the most harmful direction." AKA a vicious cycle.

Here's some numbers from the June 7, 2010 EFSF execution agreement. They represent the subscription amount and percentage to the EFSF. The EFSF is just a legal entity where various countries contribute capital and become equity holders (with unlimited liability). The contributed capital and proceeds from bond issuance are used to make loans to countries that need aid. The bonds are guaranteed by the full faith and credit of the EFSF, the EFSF equity holders (EUM member states), the EU, and have the EFSF holdings as collateral. The table below is a breakdown of the contributed capital so far. Issued debt is to be overcollateralized at a rate of no less than 120% by AAA Holdings and AAA guarantees. There is also to be a cash reserve that equals the NPV of the margin of the EFSF loan and service fee. The EFSF is available to all EMU member states.

ECB Member State	Capital subscription	Contribution Key %
Kingdom of Belgium	2.4256	3,475494866853410%
Federal Republic of Germany	18.9373	27,134106588911300%
Ireland	1.1107	1,591454546757130%
Kingdom of Spain	8.3040	11,898297070560200%
French Republic	14.2212	20,376693436879900%
Italian Republic	12.4966	17,905618879089900%
Republic of Cyprus	0.1369	0,196155692312101%
Grand Duchy of Luxembourg	0.1747	0,250317015682425%
Republic of Malta	0.0632	0,090555440132394%
Kingdom of the Netherlands	3.9882	5,714449467342010%
Republic of Austria	1.9417	2,782143957358700%
Portuguese Republic	1.7504	2,508041810249100%
Republic of Slovenia	0.3288	0,471117542967267%
Slovak Republic	0.6934	0,993530730819656%
Republic of Finland	1.2539	1,796637126297610%
Hellenic Republic	1.9649	2,815385827787050%
Total	67.8266	100,000000000000000%

Where is the risk? Well, the risk here is that everyone is guaranteeing everyone. So, if Ireland Portugal and Greece need aid, their guarantee is pretty much worthless, and they are now users of the fund. If another state were to need aid, another piece of the guarantee would become worthless and need for funds would increase. This would increase the cost of funds, which would be passed on to aid receivers. Unless the states receiving aid are running a budget surplus, this would translate to increasing borrowing needs to cover additional debt service costs, furthermore deteriorating their quality.

Of course, losing Portugal's guarantee is unlikely to be disastrous, but if Belgium and Spain were to find themselves in trouble too, that would put additional pressure on the remaining members, affecting their own credit quality. While it might be no more than an inconvenience to Germany or France, it could adversely affect smaller economies. It could, in essence, leave France Germany and Italy holding the collective bag. I have no clue as to the probability of this happening, but the risk is present and shouldn't just be ignored. If we were to think of bonds as way deep out-of-the-money options (this model goes beyond of the scope of this post), you would notice that you are basically short a lot of gamma here. As the situation deteriorates, the speed at which it deteriorates increases. Of course there is the possibility that it will all work out, which is what the EU is banking on.

I'm not going to get into the gritty part of of this until I have more time, but I think the best way to think about it is as a highly-levered, short way-out-of-the-money put on the EU sovereigns. The probability of going into moneyness might be remote, but the damage in that case would be catastrophic. Buy the paper at your own risk.

Economic Implications of the Japanese Earthquake & Tsunami

2011-03-13T20:59:00.003-04:00

I'd like to start this post by point out I am not a macroeconomist. I did obtain a B.S. in Economics from Northeastern University, but my transcript is anything but impressive. Please question everything I say here and if you see any flaws in my logic be sure to point them out to me in the comments.

The first reaction I saw in the twitter finance / economics crowd was that, while the destruction was very tragic, reconstruction would act as Keynesian stimulus, possibly helping the economy. Some even joked that the combination of increased demand and stimulus in ZIR environment could cause hyper-inflation. So, let's try to step through this piece by piece:

There was massive destruction of the capital stock of Japan. This helps nobody, we are all collectively poorer as a result. There is simply less goods in the world now than there was a week ago. The same can be said for wars. The economic damage to Japan is likely humongous, but that's partly because Japan is a very wealthy country.

Replacement of the damaged capital stock will likely take years, but certain things will be replaced quicker than others, like insured cars, homes, household staples and durables. This sudden replacement will goose demand in the short term, providing stimulus to the economy, putting people to work and utilizing capacity.

A large part of the money for cleanup, reconstruction and replacement will come from exposed insurers and re-insurers. These companies will pay out claims from their assets. Some of the claims will be paid out from their most liquid assets, like cash and cash-equivalents or highly liquid instruments, including but not limited to, sovereign paper. If there is need for additional liquidity to pay out claims, other assets will have to be liquidated. I am no insurance expert, but common sense would dictate that insurers would be likely to liquidate the most liquid and least risky assets first, and then gradually adjust their risk and liquidity exposure in order to avoid paying too much for liquidity or having to take unfavorable bids (I started writing this before the TSE opened, but as of now the JPYUSD has already hit 80.80 and the Nikkei was almost 200pts down).

The initial move up in the Yen is hardly surprising. However, repatriated currency and any carry unwind help support JGBs, especially the front of the curve. Additional liquidity provided by BoJ does the same (Y7T and counting). As supply is set to increase there will be a firm bid for safe haven assets. Risk assets will have it more difficult, especially until losses are sorted out, especially financials.

Overall, this will essentially be bearish for JGBs in the long term. The economy's Supply capacity was just reduced (S curve moves left) and demand is about to be goosed (D curve moves right). Because of increased demand and reduced supply, I'd expect to see price increases. I'm not talking about price gouging, but pricing power is moving to suppliers, both of goods and of labor. Whether this will be enough to shock the country out of the deflationary trap remains to be seen, though. If it does succeed, the natural thing to expect would be a gradual uptick in nominal rates, which would be bearish for JGBs in Yen terms. The currency is a different matter.

At first, as we are seeing already, JPY is going to be strong. JPY is a flight-to-quality currency and a carry funding currency. Any unwind of carry will come with demand for Yen and supply of the carry currency, putting upward pressure in the Yen. The carry trade is so big that there's no way in hell BoJ can do anything about it. After this, though. I see a bearish path for the JPY. What you are going to inevitably end up with is an increasingly indebted country and a reduced capital stock. Best case scenario the crisis kickstarts the economy and deflation ends, but--again, in the long term--inflation will be bearish for the currency from a PPP standpoint.

PS: anyone telling you that the flight-to-quality is going to lower exports is in the wrong time frame. Techinically, yeah, a strong JPY would hurt exporters, but there's about to be such a HUGE boost to internal demand, that it ain't no thang.

For those of you that like to play, here's some long ideas. (no short ideas because if you short disaster victims you're a real asshole)
Managed timber; Durables and materials retailers; Equipment sales and leases; Construction; Auto dealerships; furniture retailers; electronics (TVs, computers, etc retailers). Basically go long the people who are going to sell the stuff that needs to be replaced and were either undamaged or probably protected by insurance. Also, anyone that rents out heavy machinery.

Technically speaking: A setup for selling $PG Feb 18 2011 62.50 PUTs

2011-01-27T10:12:00.000-05:00

Watch the next few hours in $PG trading. The Feb 18 62.50 PUTs sold at this morning for up to $0.40. If we see the day turning for the worst, I'd say this would be a nice trade if you are looking for some delta-positive exposure. Will PG fall and hit it's trendline again? Maybe, but the general updraft is powerful and I wouldn't put my money on the short side. Plus, we have GDP numbers tomorrow and, uncharacteristically, I'll take the over on the 3.5 estimate. If you are expecting GDP numbers to disappoint, you might want to wait.

Disclosure: No position yet, but if I can get a good price, I'm looking to sell those PUTs.

Just a small note on $NFLX and growth rates

2011-01-26T21:12:00.000-05:00

According to the U.S. Census Bureau, the average household size is 2.6 people and the total US population is about 312,000,000, which gives us an approximate 120,000,000 households. If Netflix (NFLX) has 20,000,000 subscribers that is one-sixth of the households in the US. One-sixth might not seem like much, but take in mind only about 58% of American households get cable and Canada only has like 13M households.

According to this Arstechnica post, the U.S. has about a 60% broadband penetration rate. According to PEW Internet, this is closer to 66%. That gives us a total target market of 79.2 million households for "watch instantly", of which Netflix already captures 25%. While broadband penetration is likely to continue increasing, and so is the population, I would think that eventually their growth is becoming seriously limited in the U.S. While netflix does have some tailwinds in it's favor--like computer processing power getting cheaper and cheaper every year--barring signs of international expansion (outside of it's recent entrance into Canada), it seems to me like the growth rates like we've seen in the past will soon be history.

Let's look at what ValueLine has to say on growth rates:

OK, so revenues can grow from increasing prices, buuuuut, I feel like everyone I know with Netflix is actually downgrading it since "watch instantly" is generally good enough and the whole mail thing for newer titles just does not appeal to the instant gratification we want. We can just rent it from iTunes!

But, seriously, assuming no further price hikes and stable revenue-per-subscriber, we are talking about a tripling in the subscriber base to 60M. You may be thinking that's totally doable, but take in mind iTunes and Hulu are becoming real competitors, oh, and there's also that Cable TV thing...

I mean, if you want to buy the stock, whatever, I don't care, just keep in mind that fantastical growth rates are not going to continue forever, at least not without international expansion. If you are buying NFLX betting pretty soon people in Europe, and Australia are all going to be watching Netflix, that's cool, just remember that outside of the rich first world, demand is likely to be very limited. Oh, remember that even if competitors eat Netflix's dust, you can bet your ass content providers will keep on trying to squeeze every dime they can out of Netflix, so keep an eye out for some compression in that net margin.

I mean NFLX is cool, it's one of my favorite services and I've been a paying member since it's first year of existence, but at the end of the day, it's just a content delivery method. Just like Hulu or cable or the FiOS TV service. The comparative advantage in the company lies in their recommendations and ratings database. Right now, they are using it as a way of keeping people from switching--nobody wants to lose all their ratings--but that's not a good long-term strategy. That data is a marketing and targeted recommendation wet dream and I'd love to see them find a way to monetize that. Amazon and Apple seem like the perfect candidates for that, as they would get the biggest benefit out of being able to deliver higher-quality targeted recommendations, but they are also competitors in the space, so I foresee no friendly cooperation in that space. If , however, Netflix suffers a sharp correction, I wouldn't at all be surprised to see an acquisition taking place.

Unemployed workers with no unemployment insurance

2011-01-19T11:06:00.001-05:00

Click image for hi-res version

Blue is percentage workers receiving unemployment benefits and red is the national civilian unemployment rate. Green line is the percentage of unemployed workers minus the percentage of workers receiving unemployment benefits (red - blue).

This crisis that looks like that crisis

2010-12-25T16:11:00.002-05:00

I was spending my morning reading when I came across the following passage. See if you can guess what countries it is referring to and then scroll down to the bottom (after the jump) to see the answer.

The [debtors] argued that the collapse was proof enough ... that for them to pay the amount owed was impossible. The [creditors], by contrast, saw the collapse as the evidence of capital flight ... How could it claim to be bankrupt when so many rich [debtors] seemed to be wandering around Europe? ...

Y took the approach that the simple and direct approach would not work. The total figure owed, $xyz billion, was too politically charged a number, particularly in [creditor A]. Tampering with it would inevitably lead to confrontation To challenge [creditor A] at this stage of the negotiations would bog them down in the sort of wrangling that has produced no results ... Instead, Y proposed that the committee focus on the very limited but achievable goal of reducing the amount [debtor] would have to pay in the immediate future to a more manageable level.

The committee would jettison the whole concept of "capacity to pay," he argued. It was impossible to know what this number was. Too many imponderables entered into the calculation, involving such questions as: How much could taxes be raised without triggering mass protest? How tightly could imports be squeezed without precipitating a collapse in production? How far could wages be reduced without provoking labor unrest? No one could agree on the answers to such cosmic questions. ...

In it's place, Y proposed an alternative criterion: the [debtor] public should be required to shoulder the same tax burden as [creditor] taxpayers. [Creditors] had to tap their tax revenues to pay interest on their own debts. [Debtors] had [devalued] away its internal public debt--the [debtor], therefore, had a natural surplus from which they could afford to pay their debt.

The passage is from Liaquat Ahmed's excellent book, Lords of Finance, and refers to the reparations owed by Germany to France and Britain after World War I. The "collapse" mentioned in the first line refers to the collapse of the Reichsmark during German hyperinflation in the early 1920s. Feel free to draw similarities to your favorite over-indebted contemporary nation, may it be the Southern European nations that struggle with constant tax evasion, or maybe Ireland with a corporate tax rate much below it's EU member state neighbors. I wouldn't be surprised to expect any further aid to Ireland from the EFSF / IMF / EFSM alphabet soup to come along with significant pressure to increase the corporate tax level.

5 Unlikely and unexpected events that you should consider in 2011

2010-12-24T17:40:00.001-05:00

I saw a few lists making the rounds of low-probability events that are generally unexpected as predictions of potential 2011 surprises. Here is my list of potential 2011 surprises:

Increasing reserve requirements in China, in conjunction with excess lending in the last year and lower balances amongst household depositors as a result of negative real rates and increasing inflation expectations result in a sharp rise in interest rates as demand for credit increases and cheap deposits are scarce. Credit becomes difficult to obtain, causing the expansion to slow significantly.
Credit crisis in Brazil. Attempts at controlling inflation by Dima Rousseff's new government lead to tightening and in the process expose massive overallocation of credit by the banking sector. Increasing rates make certain parties unable to refinance without sacrificing profitability or at all and a trigger wave of defaults as a result, particularly in consumer credit. Uncertainty spreads to other LatAm countries leading to significant losses in dollar and local currency-denominated debt.
Q4 2010 Retail sales disappoint as increasing volumes are more than offset by margin compression as a result of online competition leading to very low net-income. Poor retail earnings releases kill sentiment and start a snowball that leads to a 20% sell-off in the S&P. Aggregate S&P earnings still increase, but PE compression stays and the S&P ends 2011 at 1150.
Lackluster global growth lead to Aussie property market weakness. EU banks dump Aussie MBS at steep losses to limit exposure, leading to continued weakness in the European banking sector and a new wave of Gov guarantees, further stressing sovereigns.
An EU member state defaults after receiving aid from the EFSF. Resulting haircut severly impairs EFSF capital base. Member states, under obligation to make EFSF bondholders whole, suffer rating downgrades as a result of the liability (France, Italy, Spain, Netherlands, Belgium) excluding Germany. The EFSF becomes uneconomical and is abandoned as the German public protests about the risk risking becoming a guarantor to an increasing number of EU member states.

Please understand this is all wild, wild speculation of technically possible yet very unlikely events. In particular #4 and #5. These things might happen, but they could take multiple years to play out.

Someone at the BoJ doesn't quite grasp supply and demand

2010-12-21T02:06:00.000-05:00

From Bloomberg:

Bank of Japan Pledges to Steadily Buy More Assets"...The BOJ’s purchases of real-estate investment trusts and exchange traded funds have bolstered stock prices, a sign the stimulus has supported sentiment even as global growth slows."

Uhm. I guess it's nice they are at least buying some hard-assets instead of government paper as far as the Yen is concerned, but someone ought to tell the peeps at the BoJ that if you have a stable, aging (and soon to be declining) population while you forbid foreigners from buying real-estate, chances are you are not going to have much luck supporting real-estate prices. Especially not when interest rates are already at record lows. It's that supply and demand thing you can learn from Mankiw's book.

My suggestion? Start letting immigrants in. Seriously.

Just for fun: 2011 Predictions

2010-12-19T14:06:00.002-05:00

Well, Bespoke got a cute little round-table thing going on and they forgot to consult me. It's OK, I'm used to it.

We'll review these again next year, along with a review of other people's too and see if the "wisdom of crowds" is for real. I suspect most of us will do no better than a dart-board.

Fed funds: Flat. Benny Bernanny wouldn't dare and he'll err in the inflation side, just like the King of Knifecrime Island did. I truly believe he cares more about achieving full-employment than price stability and he his hell-bent on weakening the dollar, supporting asset prices and holding short-term real rates negative at all costs.
Dollar: Mixed, but generally flat. General downtrend with high spikes up if Portugal is forced to go to the EFSF or if haircuts for Euro debt happen, although I doubt that will happen. I haven't had a chance to update the maturity schedule for the PIIGS because, being unemployed, I can't afford decent health insurance, much less Bloomberg, but I'll try to sneak in somewhere when I get back home--currently on vacation
Long bond: Up. Right now I think it's oversold, but I could see it oscillating in this space, although I think the downtrend in interest rates is going to keep going (thank Europe!). The 2-30 curve is already at historical wides and I really don't see it getting much wider, especially because I think recovery hopes are a dash too high. In August I bet a trader at my old job that by next August we'd see the 2-30 spread around 200bp. In retrospect, that was too aggressive.
Munis: Definitely up. Conviction buy. In fact, if you follow me on twitter, you would have seen me ranting all last week about buying Munis and selling Tsys if you wanted to hedge the curve. Default fears are way overdone and I think that they are definitely undervalued on a relative basis. My preferred play here is lightly levered CEFs selling at a discount.
S&P: Up. I got my money on a range bound market with an upwards trend. Slower earnings growth. The story here is going to be multiples. I wouldn't be surprised to see PEG compression. So I think companies will be in better shape, but I think valuation won't keep up. Overall I like corp bonds, convertibles and HY (although I think upside here is limited). I think "Wall of Maturity" fears are way over-done. Best places to play are are CEFs with 20-40% of leverage and selling at decent discounts (> 7%). Good opportunities to trade in and out.
Light Vehicle Sales: 13.5M total, but steady and steep uptrend in SAAR. (Previously)
Euro crisis: Mostly unch. I expect upward creep on spreads. I think that the catalyst for Portugal to go to the EFSF is going to be really high rates on a refinance, not high rates on current-year deficit financing. 2012 is when I see that happening, the fund-raising necessary in 2011 is limited enough that Portugal could probably stomach the pain, so if they go to the EFSF it will be because of political pressure from peers to stop contagion fears and volatility, not market pressure. I think Italy is going to see the biggest widening (in % terms), followed by Spain. If Portugal front-loads and can pull-off a successful auction in Q1, I doubt anything drastic will happen.
UK: There is so much sad face to be had there. I expect continued weakness in the Sterling vs Euro combined with high inflation and a limited recovery. The VAT rise is fucking asinine. The only thing Brits are getting for Christmas is lowered standards of living. Banking exposure to Ireland is big and they still have their own housing issue to deal with. I see little probability of a recovery in UK housing and in fact expect significant further weakening. I wouldn't be surprised by additional write-downs, buuuut there is an upside. Banks that have deposits (liabilities) in Sterling and hold assets with Euro exposure will benefit from said weakness as losses in Euro denominated assets are partially offset by movement in the Sterling. I suspect this is deliberate.
Spain: Increase in spreads, banking problems no EFSF assistance necessary, but expect the FORB to get plenty of use.
Latin America: Continued boom. Inflation leading to central bank tightening will be a theme, at least in Brazil. Argentina up (PEOPLE ARE RETARDED!!!!). Increasing interest rates risk attracting more hot money and further aggravating the situation. Brazil's bond-tax was a great idea, in my opinion, I hope to see it elsewhere. I think the Automotive recovery will be a nice tailwind for Mexico. (I'll update with production graphs when I'm back home)
International Economics: I expect capital controls to be a continuing theme, particularly in the form of taxes similar to Brazil's. It makes perfect sense to me, curbing funding local assets with foreign liabilities and vice-versa will increase currency stability by creating "speed-humps" for capital and limiting the volatility caused by hot money flows.
China: Pettis already did it, so I'm not going to bother. My only prediction is continued inflation. Just look at the money supply growth. You can also look at all those Chinese IPOs happening recently. If that's not hot money, I don't know what is. Expect price inflation to lead to wage inflation which will lead to some exporters and manufacturing moving inland, South and possibly abroad. This is a good thing. Expansion outside of the currently-urbanized centers could maintain investment expenditure high, which would be good for nat. resource producers. The whole issue of Yuan appreciation might go away as a consequence of price inflation.
Housing: Mixed. Suburban McMansions down, multi-family up. Expect people to avoid big suburban houses in gated communities with expensive fees. Foreclosures will keep putting downward pressure on prices and there will be a lack of demand as people look for smaller, cheaper housing. Community Association fees got to outrageous levels and the upkeep on big houses is likely to be a deterrent to people in debt, or getting out of debt. Apartment rents up. I think a solid investment would be non-luxury condos to rent out. In South Florida, you could can definitely find properties that have positive carry. (rent > taxes + mortgage + fees).

We'll see how I fare next year!

Shut-up, TNR: Lady Liberty is a perky-titted, skinny chick with hairless labia

2010-12-17T21:27:00.000-05:00

Outraged over their privacy being violated, The New Republic publishes a cover of an x-rayed Lady Liberty to show how our precious freedoms are being taken away. Normally, I'd be OK with their sensationalist outrage, buuuuut I was put on this earth to rain on your collective parades.

Not to get all Steinem/Levy on you, but I'm just kind of wondering, was it really necessary to use a skinny perky-titted model for this shoot? Also, I guess you can't blame TNR editors for not knowing much about physics, but I'd like to bring up the issue of hair. Normally, you can't see hair in x-ray images, but this image clearly shows Lady Liberty's nice 'do. Curiously, though, that's the only place where the Lady has hair. So, I'm left wondering whether seeing Lady Liberty go bald was so heinous that it had to be stopped, or whether outlined labia were acceptable for a magazine cover but pubic hair wasn't. Seriously guys, fuck you.

In response to the Athens riots

2010-12-16T21:59:00.001-05:00

Unrestrained idealism, explosive temperament and no much to lose will get you that way. I don’t know if its better but its definitely sexier than polite complaints uttered quietly about the state of things. - Srta. Batsouli

China Money Supply: October 2010

2010-12-07T09:06:00.002-05:00

To see the latest data please see the label Chinese Money Supply

I was going to stop publishing these, but after looking at the blogger statistics, I noticed they were the most popular recurring item in terms of pageviews, so I decided to update them again. As always, the data is released in an unpredictable schedule--often late--so I can't predict when the next update will be.

You might notice that I changed the scale of the nominal graph to a log scale. It made sense. The only reason I hadn't done it before was because the formatting was poor, but I finally gave in and decided function was more important than form in this case.

Light-Vehicle Sales: Population-Adjusted November 2010 Sales

2010-12-07T08:53:00.002-05:00

Monthly sales per thousand people at the SAAR rate. This is done by people and not number of drivers because statistics on licensed drivers are only released every two years. A fair estimation, for the present year, is about 68% of the total population (~88% of 16+ people are drivers and ~78% of the population is aged 16+). This figure has held fairly steady since 1990, before then drivers as a percentage of the population were as low as 50%. It is my opinion that the downtrend in the number of sales per thousand people ist he result of lengthening replacement cycles and a slowdown in the growth-rate of new drivers.

For more on driver demographics and trends in sales please see the Auto Sales Special Report posted in late October.

Don't dump your moral problems on the legal system!

2010-12-04T16:53:00.000-05:00

I came across this blog post about Four Loko today on Modeling Behavior, where Adam succinctly summed it up:

This is because while the regulation is ostensibly about caffeinated beer, as Robin Hanson argues, it’s actually about regulating a “particular vaguely-imagined classes of people”. Politicians want to regulate Four Loko drinkers, not caffeinated beer.

So yeah, kids are drinking Four Loko and getting pretty drunk and caffeinated. When I was 22 we used to do these things called Jagger bombs where we gulped down a shot of Jaggermesiter and a half red bull in like 2 seconds. Other times we simply drank a 20oz Rockstar and then took a couple of shots of cheap vodka before going out. Really, it's no different.

People like getting fucked up, they really do. The problem of substance use is a purely moral one, and it's mind-numbing that this country still insists on trying to use the legislative system to tackle moral issues. I mean, people are free to try to legislate things they find unsightly away. People are also free to make the retirement age 40 and provide free housing for everyone. Neither is going to work.

This is one of the reasons I would support legalization of all drugs. I don't want kids hooked on heroin any more than the next person, but I think using legal prohibition to control that is largely an exercise in futility. Some drug being legal will not automatically mean that people are going to run into the pharmacies in droves to buy it. Alcohol is legal and you don't see people--other than college students--stumbling around drunk all day and night. Your coworkers probably don't show-up to the office after downing half a pint of vodka, either. And seriously, I doubt the productivity lost to new cases of intoxication will even compare to the productivity lost to gossip websites and online shopping.

Yes, drugs can be addictive and all that, but that's what education and medical treatment is for. To be honest, I don't really think that legislators are really so concerned about the people's safety, I think they are really just afraid that someone, somewhere, is getting fucked-up and enjoying it. Especially if that someone is young, poor or brown.

Treasuries as volatile as stocks!

2010-11-14T12:56:00.002-05:00

The NYT has a story about how long-term treasurys are sensitive to changes in yield. Socking, I know.

“There could be near-equity-like volatility” coming for these bonds, warned Joseph H. Davis, chief economist and head of the investment strategy group at the Vanguard Group.
...
The Vanguard Long-Term Treasury fund, for example, has lost around 8 percent of its value in just the last two and a half months

and,

In the first six months of 2009, the average long-term government bond fund lost 23 percent of its value, only to climb around 14 percent in the subsequent four months, slump 8 percent in the next six months, and soar 26 percent between April and August of this year.

I applaud Mr. Lim for his mention of duration in the article, it's nice to see a journalist not treating his/her readers like idiots, but I wish he would have gone the extra mile and mentioned convexity. By bringing down long-term yields, the Fed was the one that increased volatility in bond prices by increasing duration. Just like the decline in long-term yields has created great gains for bond holders, it is putting them at great risk. To see why, look at the graph below.

Image borrowed from thismatter.com

As you can see, the line turns nearly vertical as yields approach zero. This is the same effect that you see in the graphs displayed in the housing affordability posts. The slope of that line is the sensitivity of interest rates, in fact, the slope of the tangent is the duration that Mr Lim mentions. What I wish he had mentioned, however, was that that volatility is natural at rates this low. Changes in yield have not really been violent, but these instruments are very sensitive to yield levels. in the future, it will not be ticks up in yield that are at fault for making bond investors lose money, it will be the Fed for bringing down far rates to such low levels, and investors for not doing their homework.

Of course, investors need not lose money even if yields move up. Mr. Lim accurately explained how coupon payments may make-up for loss in bond price, but he forgot one more thing, the yield curve. With a positively-sloped yield curve, the value of a bond naturally increases as time passes because the rate on near-term securities is lower than those on longer-term securities. In other words, if the 30-yr rate is 6% and the 20-yr rate is 5%, then an investor could absorb a 1% rise in the 20-yr rate over 10 years without having to absorb a loss on the price of his/her bonds. This may do little for investors in the 30-yr bond, but when you consider the gap between the 3 and 7 is 126bp, you see how that positive slope can provide a little cushion to bond holders. In the mean time, though, investors looking for low volatility are cordially invited to invest in one of the safest assets out there, cash and cash equivalents.