November 27, 2004

Nouriel Roubini Tries to Read Tim Geithner's Mind

Nouriel writes:

Nouriel Roubini's Global Economics Blog: Systemic Risk Concerns: NY Fed vs. IMF. Is the Fund behind the Curve?: Tim Geithner - NY Fed President and formerly Under Secretary for International Affairs at the US Treasury and head of the IMF's PDR department - has warned again this week about hedge funds and systemic risk.... [T]his is the third time since March that he has spoken on the subject....

[T]he NY Fed is the institutional guardian of the stability of the US, and possibly the world, financial system. So, his recent rebuke of financial instititutions for their lax standards in prime brokerage activities with hedge funds is timely and well appropriate.... Private reactions of market participants were very defensive after Geithner's speech this week. Some bankers claimed that they knew that their competitors were lax with hedge funds but, God forbids!, their institution is not. Hedge fund managers got nervous that this may be a prelude to some further indirect regulation, even if Geithner was careful to rule that out for the time being....

[T]he NY Fed is not the only official institution concerned about systemic risk: so are the BIS, the Financial Stability Forum and the Bank of England. The only dissonant cord in this official sector concern about systemic risk is the IMF's ICM (International Capital Market) department....

History suggest that systemic crisis events occur when four different factors join to create a perfect storm: 1. Excessive liquidity and easy monetary conditions; 2. Excessive leverage and less cautious risk assessment and management by financial institutions; 3. Economic or political surprises; 4. Concentrations of risk among a few institutions.... We certainly are coming out of a period of excessively easy liquidity with short rates near bottom in US, Europe and Japan. Even at 2% the Fed Funds rate is still negative in real terms.... [E]very indicator of leverage suggests that all sorts of financial institutions are chasing for yield, not just hedge funds but also traditional commercial and investment banks.... [R]isks are highly concentrated in a small number of institutions, as Tim Geithner worried in March speech.

What about surprises? The Fed... is moving cautiously. But Fed policy may still surprise. Asset markets are now pricing a very gradual increase in the Fed Funds rate. But suppose an oil shock or inflation... were to lead the Fed to tighten faster... a rout in the bond market could occur as in the bond market mini-crisis of the summer of 2004. Which other surprises could occur?... the price of oil... another major terrorist attack... a Chinese slowdown that is faster than expected... a major hedge fund or financial institution going belly up and having greater systemic effects than predicted... the continued US current account deficit and reckless US fiscal deficit leading to a sharp fall in the value of the US dollar that causes a spike in US long term interest rates.... trouble with the GSEs and mortgage hedging....

In my not too well informed judgment, at least, the big systemic vulnerability is that bond and currency markets do not seem to be pricing the full distribution of future possibilities. The most likely and central-case scenario for 2010, in my macroeconomic view, is one of medium-run equilibrium. Such a scenario sees:

  1. A U.S. trade account near balance as foreign investors on net decide that they have a large enough share of their wealth invested in the U.S., and a stable U.S. current account deficit with net foreign assets growing at the rate of U.S. national product.

  2. Consequently, a trade-weighted value of the dollar consistent with roughly balanced trade--that is, a trade-weighted value of the dollar 30% or more below what it is right now.

  3. Some recovery of wages to their trend as the economy approaches closer to full employment, hence lower profits--and lower retained earnings to finance investment.

  4. Continued large and growing federal budget deficits.

  5. A great reduction in capital inflows and continued high budget deficits together diminish the supply of savings flowing into the financial markets, and a reduction in retained earnings increases firms' demand for outside capital. The implication is long-term interest rates in 2010 that are not low but high--supply and demand, you know.

This is the most likely future that I see: the central case. And the markets are not pricing it. The foreign exchange markets are not registering the likely large decline in the trade-weighted dollar out there in the medium-run future. The bond markets are not registering the likely large fall in long bond prices as insufficient savings supply runs into expanded investment demand.

I think I understand why the foreign exchange markets are not yet pricing the big dollar decline to come. As long as central banks are large actors in the market, the big foreign-exchange bets against the dollar undertaken by private businesses that are needed to drive the dollar down to medium-run equilibrium are very risky indeed. It's better for large private players (or they think it's better) to wait until it's clear that central banks are about to start dumping their dollar reserves for euros, yen, and renminbi before dumping their own dollar-denominated assets for euros, yen, and renminbi. Central banks are, after all, governments--and so private businesses think that it will be easy to anticipate what they are about to do and to front-run them when it's about to happen. Prematurely betting against the dollar takes on lots of risk for no real significant gain. That, at least, is how I think the big private players in foreign exchange are thinking.

I don't, however, understand the bond market. Do they expect the wage share to stay this low forever, and corporate profits are retained earnings to be abundant? Do they expect the capital inflow to continue forever? Do they expect the Bush administration to get serious about balancing the budget? None of these seem plausible as expectations, as modal scenarios, as central cases. But then why isn't the long bond market already pricing the supply-and-demand for loanable funds imbalance that seems inevitable in medium-run equilibrium? It's a mystery.

Perhaps it's as simple as this: in the 23 years since 1981, Ten-Year Treasury positions have yielded capital gains in 17 out of the 23 years averaging more than six percent per year. Those who are by nature likely to be short the long bond have presumably lost heavily over the past quarter century, and are no longer a significant part of the market. We may have selected for a group of long-bond traders and speculators who are powerfully overoptimistic, because optimism has been powerfully rewarded over the past quarter century.

If so, then Tim Geithner is very right to impose a very high degree of surveillance. What other overoptimistic bets have these people made--especially considering that the market has been selecting not just for optimists, but (with the exception of 1994) optimists who are willing to take on substantial leverage?

Posted by DeLong at November 27, 2004 06:30 PM | TrackBack
Comments

The other issue raised in Roubini's commentary is why the IMF would choose to downplay these risk factors even as the NY Fed is willing to speak up about it -- and with the oracle being someone who is ex-IMF. It seems that Roubini does not have much confidence in the capital markets people at the IMF to speak their mind on this one.

Posted by: P O'Neill at November 27, 2004 06:50 PM

John Bogel of Vanguard sent investors a letter in the fall of 1993, telling them the bull market in bonds that began in 1990 was coming to an end. The Federal reserve had taken the funds rate to 3% and kept it there for more than a year to insure banks time to build back earnings. Now, bank earnings were excellent and it was obvious that the Fed would begin to raise rates. Vanguard investors had about 6 weeks to consider the warning before long bonds peaked in December. The Fed began to raise rates in February. Despite the obvious signs of a change in policy, despite John Bogel and Vanguard, the bond market sold off rather violently. there were derivative positions that had been marketed to institutional managers that resulted in large losses when losses should have been impossible for an intelligent investor. Heck, we knew what was coming.

This bond market has puzzled me for months. Why would any investor buy a long term Treasury note at 4.1 or 4.2%? What sought of positions could there be to unwind if rates were to even mildy spike? Could any manager think it makes sense to buy derivates against long bonds? Huh?

Posted by: anne at November 27, 2004 07:01 PM

Well, I sort of know the sought is not sort, but that is what Thanksgiving does to me. Do not notice the other 2 invented words; they were obviously written by someone else. I could even blame my nibbly parrotlet :)

Posted by: anne at November 27, 2004 07:16 PM

Looking forward to 2010, I agree with Brad that the 10 yr yield of 4.2% is ridiculously low given the likely central scenario.

However, if you are an Asian central bank you need a place to park your dollars. Hence treasurys are overbought and overpriced (yield is too low).

WSJ: "... Market participants said these institutions (Asian central banks) rushed into the market as the 10-year yield approached 4.25% and put a lid on the selloff by buying government securities in large amounts, with bids Friday estimated at around $1 billion."

http://infoproc.blogspot.com/2004/11/where-would-we-be-without-them.html

As far as US traders are concerned, there is a lot of carry trade going on: leverage up at low interest rates, buy 10yrs for the yield. Continue until burned - no one is looking forward to 2010.

Posted by: steve at November 27, 2004 08:19 PM

Brad: "I don't, however, understand the bond market."

What's not to understand? When the short-term rate has been kept so low for so long, the distortions just ripple through the entire markets. Virtually every assets are over-priced because investors have been "stretching for yields". Can you name any asset class that is reasonably priced right now? The real rate on inflation index bonds is around 1.5, compared to the historical average real return of 2.5 on bonds; Stocks aren't exactly cheap; real estates? You tell me. Early in the year, when commodities prices went up, there were reports that hedge funds rashing into the market, pushing the prices higher. Same story for oil. Now it's gold, euro, Chinese yuan ... If you are a bond fund manager, your choices are park the money in short-term bonds which gaurantees a loss (CPI inflation this year looks to be between 3 and 3.5) or take some risk by putting money in long-term bonds and hoping you can get out before everyone else (or at least before those Asian central banks). Is it a surprise that you choose the latter?

It is funny that the Fed is worrying about the systemic risk -- they are the root cause of the risk, if you ask me.

Posted by: pat at November 27, 2004 10:25 PM


I'm also stunned by the failure of the markets to price in what seems certain to happen. One factor is that a lot of participants seem to operate portfolio weighting rules that rely implicitly on some sort of efficient market hypothesis, and adjust these only slowly, even when holding an asset like US Treasury bonds is obviously a bad idea.

Posted by: John at November 27, 2004 10:29 PM

Would you like to own any other assets rather than long term treasury bonds?
1. Foreign exporters (oil, ore, oats, or autos) that will stop exporting to the US if the dollar collapses?
2. US equities, bonds, or real estate, that will collapse in foreign currency value if the dollar collapses?
3. Foreign commercial real estate that is just as overpriced as ours in the OECD countries?
4. Foreign residential real estate that is just as overpriced as ours, and where moving your retirement location to the US is always possible?
5. Foreign real estate that is more reasonably priced, if not as politically safe, in nonOECD countries?
With the possible exception of tungsten billets, I don't really know anything that I would be willing to invest in at today's prices. I mean, why not just buy six months worth of household goods at Sam's Club, an equivalent amount of physical foreign currency, and hope for the best?

Posted by: wkwillis at November 27, 2004 10:42 PM

Would you like to own any other assets rather than long term treasury bonds?
1. Foreign exporters (oil, ore, oats, or autos) that will stop exporting to the US if the dollar collapses?
2. US equities, bonds, or real estate, that will collapse in foreign currency value if the dollar collapses?
3. Foreign commercial real estate that is just as overpriced as ours in the OECD countries?
4. Foreign residential real estate that is just as overpriced as ours, and where moving your retirement location to the US is always possible?
5. Foreign real estate that is more reasonably priced, if not as politically safe, in nonOECD countries?
With the possible exception of tungsten billets, I don't really know anything that I would be willing to invest in at today's prices. I mean, why not just buy six months worth of household goods at Sam's Club, an equivalent amount of physical foreign currency, and hope for the best?

Posted by: wkwillis at November 27, 2004 10:48 PM

Brad: I don't, however, understand the bond market.

What's not to understand? When the short-term rate has been kept so low for so long, the distortions ripple through the entire market. Almost all asset prices are boosted as investors "stretching for yields". Can you name an asset class that is reasonably priced right now? If you are a manager of a US bond fund, you have basically two choices: either invest in short-term bonds and gaurantee yourself a sure loss (CPI inflation looks like to be 3-3.5% this year), or invest in longer-term bonds and hope you can get out before Asian cental banks. Is it such a surprise that the latter is chosen?

It's funny that the Fed now is worrying about systemic risk -- they created this risk in the first place.

Posted by: pat at November 27, 2004 10:49 PM

Interest rates depend both on supply and on demand. Perhaps what the market is saying is that rates can't rise very much without suppressing demand from non-governmental sectors so much as to substantially offset the effects of the Bush deficits. Or, perhaps, that the Chinese and Japanese authorities don't care about potential losses in value of their dollar reserves. Japan's government routinely engages in horrendous malinvestments (http://202.221.217.59/print/news/nn03-2004/nn20040310a1.htm, http://www.mof.go.jp/english/zaito/zaito2002e-exv/21.pdf , http://www.mof.go.jp/zaito/English/Za2003-02-08.html). In WWII, Japan's elite were willing to fight to the last bamboo-spear-armed schoolgirl to maintain the status quo. Why would their lineal descendants not be willing today to fight to the last yen of her retirement savings? Note that much of China's trade surplus with the US is in fact an indirect addition to the Japanese trade surplus (overall, China has no significant trade surplus, because its trade with non-US partners is in deficit).

If rates go up very much, the music's going to stop, and all around the world, many of the mighty will fall. China's real estate bubble will pop. Japan's deflation will reaccelerate. Our real estate, hedge fund, and consumer financing games will end.

The unsustainable is likely to be sustained quite a bit longer.

A report earlier this year said that the Bank of Japan had authorization to use about one trillion dollars* to intervene against a rise in the yen. That's a lot of supply.

(*On top of the hundreds of billions already expended.)

Posted by: jm at November 27, 2004 11:29 PM

The last time there was a problem in bonds, in 1994, it turned out that some of the people you would least expect took a bath. Orange County, for one. Goldman Sachs, who you would think were too sophisticated for that sort of thing, for another. Who really knows this time? It looks like the Asian central banks will be holding the bag, but probably there are others. We'll have to wait and see.

Posted by: Andrew Boucher at November 27, 2004 11:46 PM

A trade balance near zero and approaching full employment by 2010 as the most likely scenario? I think the bond market aren't the only optimists out there.

Posted by: Tim H. at November 28, 2004 07:36 AM

When you will be hung in the morning it seems foolish not to party all night long.

Posted by: dilbert dogbert at November 28, 2004 07:49 AM

4. Continued large and growing federal budget deficits.

But Brad, the President has decreed these deficits will just .... disappear! Surely you don't believe Dear Leader is arithmetic-challenged, do you?

Posted by: derrrida derider at November 28, 2004 05:37 PM

4. Continued large and growing federal budget deficits.

But Brad, the President has decreed these deficits will just .... disappear! Surely you don't believe Dear Leader is arithmetic-challenged, do you?

Posted by: derrrida derider at November 28, 2004 05:39 PM

The reality about the US current account deficit for the rest of the world: reducing it means that US exports will have to increase much more rapidly than imports.

In other words, other countries collectively will have to absorb more US goods and services while exporting relatively less to the US.

Posted by: bakho at November 28, 2004 09:30 PM

"In other words, other countries collectively will have to absorb more US goods and services while exporting relatively less to the US."

uhhhhh, what US goods? do we even make ANYTHING anymore?

we have already been hollowed out. the cliff is mighty steep from this point regarding the CAD.

Posted by: sampo at November 29, 2004 12:11 AM

Personally, I think that the rates are unrealistically low because of the anticipated privatization of social security.

Investing in "long term treasury notes" will be one of the "approved" strategies for "private accounts", and "smart investors" are counting on the same 59 million americans who were stupid enough to vote for Bush to be stupid enough to buy long term Treasury bonds at relatively low interest rates....

Posted by: p. lukasiak at November 29, 2004 03:49 AM

I too would like to know what we export that is going to increase by 200-300 billion in the next few years.

Posted by: Tim H. at November 29, 2004 05:06 AM

Is asset mispricing really a form of systemic risk? Doesn't a sudden change in the price of a broadly held asset constitute a surprise, rather than a manifestation of systemic risk?

I understand that cascading non-payment could result from a sudden lack of liquidity, but that is not an inevitable result of a sudden change in asset price. The LTCM melt-down, for instance, involved lenders to LTCM holding large chunks of the same asset that LTCM had suddenly, temporarily, devalued. Banks became risk averse just when LTCM needed them to take risk to make sure payments continued to be made. The change in asset price was the surprise, the threat of sudden illiquidity in the bond market resulted from lenders to a leveraged bond holder also holding bonds. Am I missing the forest for the trees here?

Posted by: kharris at November 29, 2004 05:45 AM

Tim asked: "I too would like to know what we export that is going to increase by 200-300 billion in the next few years."

No single product, I think. But there are a few areas that in combination are potentially eligible for export at that level. Note I don't think they'll be successful - or rather, I hope they don't reach those levels that fast given the necessary change in the economy, but they do have some potential.

I'll direct attention first to agriculture, and particularly those products which are subsidized. They're subsidized because they "cost too much" to export. Drop the dollar and their trade viability goes up.

Our automotive industry has taken hit after hit - we import a LOT more than we export. US Trucks in particular are popular exports, but their price makes them displays of conspicuous consumption. Egos being what they are, a drop in the dollar means that for a few years that industry would make interesting gains, possibly carrying a number of other cars as they become economically viable (though still for upper level customers).

I'm constantly surprised when I look at export stats for the 874 SITC (Measuring/Checking/Analysing Instruments) - it's a HUGE export line. It implies to me that we make a lot of somewhat peculiar narrow-focus systems that the rest of the world doesn't make but does want. As the dollar drops, these industries might be able to expand their lines to things the rest of the world makes (at this time) for less than we do.

I do not think we can make "200-300 billion" in gains swiftly, but I do think the potential is there to catch up as long as any change is gradual instead of a crash. Of course, the fear is the crash.

Posted by: Kirk Spencer at November 29, 2004 07:03 AM

kharris: Is asset mispricing really a form of systemic risk? Doesn't a sudden change in the price of a broadly held asset constitute a surprise, rather than a manifestation of systemic risk?

OF course you are right. I guess what I was saying was that the fed has created an environment that is more conducive to systemic risk, because when many assets are grossly over-priced, it is more likely that no one will be the courter party when people finally want to unload the inflated assets as everyone wants to reduce their positions in those assets -- which will lead to the dryup in liquidity as we observed in the fall of 1998.

Posted by: pat at November 29, 2004 07:47 AM

The beginning year of the bear market in stocks, 2000, saw a steady incready in the prices of drug and medical equipment company stocks. Energy stocks, real estate investment trusts, and many value stocks had fine to moderate gains in 2000. Though 2001 and 2002 were tougher years for stocks, there were still many issues that help up well through the bear market.

The point is that there was a severe decline in price of severely inflated stocks, but many stocks were not. Stocks like Microsoft and Intel and Cisco easily distorted capitalization weighted indexes. Was there asset inflation in 2000? Selectively, yes.

Similarly there is likely selective asset inflation now in real estate, and in bonds. But, that does not mean we must expect a broad selling of bonds or real estate if interest rates continue to rise gently.

Posted by: anne at November 29, 2004 09:00 AM

"But then why isn't the long bond market already pricing the supply-and-demand for loanable funds imbalance that seems inevitable in medium-run equilibrium."

More interestingly, if Brad's argument is sound, why aren't speculators arbitraging the bond market's foolishness?

If we wanted to place bets that the bond market is nuts, how would we do it? That might answer the above questions about where to put large amounts of money. Put it down on big bets against the bond market.

Posted by: John Faughnan at November 29, 2004 09:28 AM

We began the secular bull market in bonds in December 1981, and prices peaked in June 2003. The decline in prices since June 2003 has been decidedly mild, almost certainly because there has been ample demand for bonds by government institutions at prices that seem very high to any sensible private investor. If as seems likely the demand for bonds from public institutions falls, we can look forward to a continued increases in long term interest rates unless the economy were to markedly weaken. Even if the economy were to weaken long term interest rates might climb if food and energy price increases hold. So, I suppose the 21 year bull market in bonds is over.

Posted by: anne at November 29, 2004 09:49 AM

The only way round the argument that public institution purchases of Treasuries are supporting bond prices, is to believe that labor costs are going to rise at subdued rates for many years to come. Labor costs are the primary product component costs. Possibly globalization and the emergence of China and India as prime high value labor suppliers have limited and will limit labor costs increases for quite a while.

Posted by: anne at November 29, 2004 12:01 PM

Investors Business Daily (11/29) has an interesting graph showing that the "internal finance gap" (cash flow minus plant & equipment expenditures) has been positive for the last year, for the first time on record (going back to at least 1970.) To the extent that this is sustained, it may imply a reduced demand for new investments via either bond market or new equity offerings.

Posted by: David Foster at November 29, 2004 01:04 PM

Investors Business Daily (11/29) has an interesting graph showing that the "internal finance gap" (cash flow minus plant & equipment expenditures) has been positive for the last year, for the first time on record (going back to at least 1970.) To the extent that this is sustained, it may imply a reduced demand for new investments via either bond market or new equity offerings.

Posted by: David Foster at November 29, 2004 01:10 PM

Investors Business Daily (11/29) has an interesting graph showing that the "internal finance gap" (cash flow minus plant & equipment expenditures) has been positive for the last year, for the first time on record (going back to at least 1970.) To the extent that this is sustained, it may imply a reduced demand for new investments via either bond market or new equity offerings.

Posted by: David Foster at November 29, 2004 01:10 PM
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