Tuesday, January 18, 2022

Most Money Managers Don't Understand How Money Works

I have been an avid reader of Barron's for years, and always look forward to the annual Barron's Roundtable at the beginning of every new year.

This past weekend, Barron's published part 1 of the series, which includes more of a macro outlook than individual stock selection.

The members of the Roundtable are typically titans of the financial industry, including legendary value investor Mario Gabelli.

I was disappointed when, upon reading this year's discussion, the very first thing discussed by the first panelist was US government debt hysteria and misinformation. Unfortunately, this seems to be endemic to the finance profession.

Scott Black, founder of Delphi Management in Boston who is also an art collector, leads off the discussion, and as mentioned almost immediately expresses misleading and false statements related to the US government's "debt" (emphasis added):

"At the time of the financial crisis, the Fed’s balance sheet was about $850 billion. Today, it is $8.8 trillion. The national debt has surged to $29 trillion, and the debt-to-GDP ratio is close to 1.3 times, both all-time highs. The Fed was reluctant to raise interest rates sooner because it feared killing economic growth.

Also, higher rates raise the interest expense on the national debt. Every one-percentage-point increase in rates adds about $290 billion of federal interest expense, so the Fed had an incentive to cap rates at today’s very low level. Given the current rate of inflation, the 10-year Treasury theoretically should yield closer to 3.5%-4%, not 1.8%. That would add $580 billion of interest costs to the budget, and the country would have no money left for discretionary spending. So, the underpinnings of the economy are pretty good, but high inflation doesn’t bode well for the market."

First, Mr. Black correctly notes the current levels of national debt and its ratio to GDP. However, what he conveniently ignores is the fact that the US Treasury's "debt" is an asset for everyone in the non-government sectors, including US households, businesses, municipalities, and foreign countries. A subtle rephrasing of his statement reads as follows: "US Treasury securities held by US households, businesses, municipalities, and foreigners have surged to $29 trillion, and the asset-to-GDP ratio is close to 1.3 times, both all-time highs." Doesn't sound nearly as scary, huh?

The same applies to interest "expense" on the national "debt." Remember: one person's expense is another's income, and one person's debt is another's asset. Higher interest expense on the national debt = higher interest income on the non-government sectors' assets.

The point about what the 10-year Treasury "should yield" is an example of the extreme hubris and arrogance that permeates this industry. The 10-year Treasury should yield whatever the correct yield is for optimal economic output for all citizens of the United States. Some MMT economists have argued the "natural" rate of government debt is 0%; positive rates are a subsidy for wealthy folks, whereas negative rates are a de facto wealth tax. The Fed has a dual mandate that is equal by law, which is stable prices and maximum employment. How would taking rates so the 10-year yields 3.5-4% (as Mr. Black proposes) achieve either of those goals? How does raising the cost of funding bring prices down, and combat unemployment and labor force participation rates that are still at worse levels than they were pre-pandemic? If anything, we are still a long, long way away from full employment, and rates should logically fall until we get there.

Finally, the comment on the US having "no money left" if rates were to go up is just absolute nonsense. The United States government cannot involuntarily "run out" of dollars, just like a scorekeeper cannot "run out" of points to assign in a basketball game. The US government creates new dollars by telling the Fed to credit banks' reserve accounts, then the banks use those reserves to purchase the government's debt. The idea that the US government has to "borrow" money from the private sector to fund itself is ludicrous. It is the other way around - the private sector needs dollars from the government so it can pay taxes, fees, fines, and other obligations the government imposes on it. Further, the US government is the monopoly supplier of dollars globally. It is a price-maker, not a price-taker. It dictates what rate it pays on its own currency-denominated "debt," and the private sector takes it. It has unlimited capacity to create new dollars to fund new debt purchases, and is also the buyer of last resort. As a monopolist price-maker, the government determines what interest rate it pays on its liabilities, whether the private sector likes it or not.

Mr. Black later says, "I would avoid fixed income like the plague." Likewise, panelist Sonal Desai says, "I’m the token fixed-income person on the panel, and I would argue that fixed income is one of the least attractive areas to invest in this year." Sounds like fixed income is pretty hated. As I write this, Treasury yields are spiking (albeit the long end of the curve is flattening), with the 10yr hitting a 2-year high. I believe this will prove to have been an attractive buying opportunity, particularly on the long end, as the Fed's rate hikes will tighten financial conditions, raising the cost of funding for borrowers right as the economy is starting to slow, increasing the risk for a recession.  Indeed, today's Empire Manufacturing Survey reported an astonishing 33pt drop m/m to -0.7. This follows disappointing retail sales in December and the second lowest Michigan Consumer Sentiment survey reading in a decade (November 2021 was the worst). Because Treasuries carry zero credit risk, an are assigned special legal denominations as type 1 HQLA, they essentially serve as a liquidity buffer during periods of stress, despite low nominal rates. Holders of US Treasury securities get paid a "liquidity premium" during periods of stress. Part of this is related to the shift from unsecured bank lending to secured lending in "alternative" credit markets, which requires pre-existing collateral; Treasuries effectively function as "base money" for alternative credit markets. They are effectively cash instruments with a positive carry.

Desai further adds:

"My last point is that we have had more than a decade of low market volatility, largely because of the large amount of liquidity in the financial system. We are at the start of a multiyear period, if not a decade, in which the markets will have to learn to reprice risk, because the consequence of a decade’s worth of extremely easy central-bank policy has been the distortion of prices and the mispricing of risk. The coming period is going to be a difficult one. I anticipate a rocky multiyear adjustment period resulting from the combination of high valuations and the unwinding of central banks’ easy money that has distorted risk assessment and capital allocation in markets for over a decade."

Again, the hubris in these statements is remarkable. Markets haven't been pricing risk? The 2014-2015 bear market in HY/distressed debt was absolutely brutal. According to law firm Haynes and Boone, LLP, there were a total of 572 oil & gas, oilfield services, and midstream bankruptcies in the six years ended in June 2021. Multiple mentions of central banks "distorting prices;" what makes central banks' actions over the last decade tantamount to asset price "distortion?" As argued in a previous post from January 11, QE has historically preceded a rise in rates, at least on the long end. Or, said differently, the Fed's QE announcements have always come after yields have already fallen. It's puzzling why these basic facts are continuously ignored by the financial media and Wall Street. The narrative is always: the Fed is "distorting asset prices."

Of course, only the Federal Reserve chairs over the last decade have engaged in this "distortion." Not Paul Volcker and his interest rate hike shenanigans.

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