No. of Recommendations: 23
”…Not to be absolutely certain is, I think, one of the essential things in rationality…”---Bertrand Russell

Dear settled Fools:

Begin sojourn:

The orange glow of campfire light deepen the solemn faces of the Lenni-Lenape sachims. Each understood the gravity of the situation. Each had heard the rumors. Settlers in the north had made treaties with some tribes to war on others. Settlers in the south were completely hostile and had starved to death rather than accept help. Now, they had to put aside petty differences and stand together, else all might be lost. For several days they debated one question: how could they and the strangers coexist peacefully?

Tamanend brought this evening’s discussion to order. “Brothers! It seems to me that the best idea we have is to let the strangers settle on Manahatta. The island is self-sufficient. It will generously provide them with everything a people need. Manahatta protects us from them. It’s surrounded by rivers and not easily traveled by going north. This way we can share the land, keep the peace, and have a natural boundary between us.”

Wompsikuk followed. “I agree. It’s a very good place but we don’t make much use of it. It’s just too much trouble to get to. We have plenty in every direction from this very spot. If the settlers are content to stay there, it’s good for everyone. As for myself, I’ve no intention to swim across a river as wide as a lake for want of an apple!” His remarks drew laughter. He added, “Even if it’s a big apple!”

Paukunawan was more serious. “We shouldn’t be too glib about this. I’ve been to their village. These people must have never seen a forest before! They were awed by a small waterfall. I wanted to show them around the surrounding woods but they were frightened of becoming lost! They think this is some kind of promised paradise! They’re like children! We must handle this carefully.”

Wonkussis took his side. “Paukunawan is correct! We can’t simply shrug our shoulders and say ‘who cares, go ahead’. If they already believe this is a ‘promised place’ and we agree to a one time trade, they might then think they actually own the place! We must be clear: the land can be shared, but not possessed!” There was a somber rumble of agreement. He continued: “It just occurred to me that we don’t even know if they have anything of value! What could they possibly have that’s equal to Manahatta?”

Paukunawan answered. “I’ve seen what they have. It isn’t much. They’re good at smelting metal and making tools. We can certainly use that! They tend to wear a lot of clothing and then lots of jewelry on top of it. I did notice one curious thing. Whenever I tried to take a close look their jewelry, they became very agitated. One actually slapped my hand away! They will trade, though. A settler was anxious to give me this in exchange for an old, worn-out beaver pelt.” He held up a large gold coin. “That old rag was more useful to me than this silly thing. It’s called a 'Guilder' .”

Wompsikuk chimed in, “You fool! He had no use for it either!” The council’s laughter seemed to fan the flames.

Tamanend seized on the thought. “Well that’s it then! If they prize their jewelry above all else, then that’s what we should insist on! No doubt, metal tools will certainly be useful, but let’s all understand something now. To us it’ll be a bunch of trinkets, but to them, from their point of view, it’s a very great fortune to pay!” It’s risky, I know. But our purpose is to impress upon them the worth of this place!

Clapping hands mixed with the crackling campfire.

Wonkussis put forward a strategy. “We mustn’t take them for granted. Let’s assume that they know how trading is. Paukunawan said they like pelts; we’ll bring a few along. We’ll talk a bit. Make sure we understand each other. We’ll draw a map for them and point out the good places to farm or hunt or fish. That’ll catch their interest. Now, if they try to palm off a box full of those guilders, we’ll turn it down and pretend to be disappointed. We’ll give them the pelts as a gift and start to leave. As we do we’ll casually show interest in what they’re wearing! If they take the bait, we’ll insist on tools and as much of that jewelry as we can squeeze out of them!”

After a few silent moments the sachims stood, one at a time.

Tamanend concluded the meeting. “It’s settled then. We’ll meet back here tomorrow morning. Be dressed for business. We’ll go down to the village and have a talk with that Peter Minuit fellow.”

It is late evening, 23 May 1626. Although history will record the next day’s legendary transaction as folly, it might have actually have begun as a brilliant attempt to inflate the price of the asset needed to manage a habitat.

End Sojourn.

Can rational market behavior create a wildly speculative bubble? Do such bubbles remain hidden, as does a forest for the trees? Are recent Fed statements designed to deflate an unseen bubble?

Here’s an excerpt from the San Francisco Fed’s 26-7-2007 Economic Letter: ”…[the] so-called "rational bubble" models say that investors are fully cognizant of an asset's fundamental value, but nevertheless they may be willing to pay more than this amount. This can occur if expectations of future price appreciation are large enough to satisfy the rational investor's required rate of return. To sustain a rational bubble, the stock price must grow faster than dividends (or cash flows) in perpetuity. ..”--- Senior Economist Kevin Lansing

Note two key words:’Expectations’ and ’Rational’ A little background is needed.

Expectation Model: Suppose Las Vegas hotel room availability is low and advanced booking prices are high. Travel agents reason that the vacationer’s ultimate goal is to gamble. That being so, vacationers will seek out the best hotel bargain for gambling. Travel agents will anticipate room price increases, say in Atlantic City. So they will advance book more rooms there and fewer in Vegas. In doing so room prices in Atlantic City begin to increase. Vacationers notice price increases and hurry to book rooms. Ultimately, travel agents will realize a better return by substituting locations. Yield arbitrageurs behave similarly. They’ll leverage the higher price security and obtain better priced substitute security. Their objective is to arbitrage for consistent portfolio yield based on the predictability of non-arbitrage trading. Arbitrageurs don’t chase trends. Arbitrageurs are rational traders.

Preferred Habitat Model: Some vacationers will always have a preference for a particular resort. Thus demand for Las Vegas hotel rooms is always present no matter what the availability. Price variations in Las Vegas stay in Las Vegas and have no effect on Atlantic City prices. Thus there are no substitutes for the lack of supply in Vegas. It’s similar in the bond market. For example, money market and pension funds ‘inhabit’ preferred maturity sectors. They will take advantage of asset mispricing in their own ‘habitat’. Habitat traders act as ‘equalizers’ in their own sector.

In reality, arbitrage traders and preferred habitat traders coexist. When yields are very high, habitat traders dominate; when yields are very low arbitrage traders dominate. Otherwise, arbitrage and habitat traders compete, creating an efficient market.

Arbitrageurs trade across maturities and assets. Habitat traders don’t. Near zero rates make arbitrageurs dominant. Having a nearly explicit guarantee of low rates is tantamount to guaranteeing future expectations, minimizing arbitrage risk. However, the supply of any asset is limited. Not that it matters to arbitrageurs. They make money on mispricing. But supply does matter to technical traders. Technical traders are defined as ”naïve” traders. Diminishing supply drives prices and they’ll participate with the trend, creating more arbitrage opportunities in the process.

Thus a possible explanation as to why every asset class all relentlessly trended up, all at the same time: The Fed reduced the supply of Treasuries driving yields down. Habitat trading was suppressed. Arbitrageurs dominated. The risk in shorting treasuries to leverage capital was minimized. Arbitrageurs use leverage to substitute better yielding assets. Number crunching technical traders caught the noise created by the arbitrageurs and followed the trends. The increase in market participators created more arbitrage opportunities. Lastly, the expectation of future price appreciation was so strong it created demand for cheap capital outside of the financial sector, further fueling the trend:

”…Why pay a dividend in the 3% to 5% range, when you can issue bonds at 2% or less and buy back those shares? …”

”…According to TrimTabs, companies have spent $290.7 billion this year on buybacks…Which are aimed at decreasing the amount of available shares—or float—thus driving up stock prices…”---CNBC

Low interest margin further fueled technical trading, thus creating more arbitrage opportunities, creating more technical trading and so on and so on. It’s a self-fulfilling prophecy; an expectation feedback loop:

What it all amounts to is that the bull has been chasing his own tail, confidently expecting to catch it!

This is not to say that markets are behaving irrationally. The markets are behaving exactly the way they should given the underlying conditions. So too dividend-paying-share-repurchasing corporations. It’s the rational thing to do. Unfortunately, all this hasn’t helped the larger economy all that much. In fact, it seems that the larger economy has been slowly recovering on its own! It isn’t as much the Fed's fault, as much as it is the ”transmission mechanism” for moving liquidity. Like water, capital will flow along the path of least resistance. Fed liquidity has been irrigating upstream fields with better yields and lower risk. It’s best summed up by economist David Malpass in a WSJ op-ed. He makes two important points:

First: ”…Growth in the current recovery only rose above 4% once, in the fourth quarter of 2011, and averaged just 2% per year in its first four years versus 5% in the same period of the 1980s recovery, 3.2% in the 1990s recovery and 2.9% in the 2000s recovery. The underperformance over the past four years translates into more than three million jobs that should have been created but weren't, an economic disaster that lowered real median incomes by 5%...”

And second: ”…The Fed's intention is that the low bond rates it provides…will spill over to big corporations and banks, who in turn will help the little guy. This trickle-down monetary policy has contributed to very fast growth in corporate profits, part of the explanation for the record stock market, but also to weak GDP growth and declining middle-class incomes. The extra credit the Fed channeled to government and big corporations meant less credit elsewhere in the economy, a contractionary influence since most new jobs come from small businesses…”---WSJ

If the Fed has perceived a ‘rational market’ bubble and simultaneously concludes that economic data does not warrant a change in policy, then the Fed faces quite a ‘conundrum’. They must deflate the bubble without affecting the larger economy. It recent weeks, Fed chiefs have been publically vocal with differing opinion. It has sent ‘mixed signals’ to the market. It’s no secret that top Fed officials have differing opinions, but is it possible they’ve agreed to be publically and adamantly vocal about it? It just might be.

Creating ‘mixed signals’, about the future supply of the most foundational asset, US Treasury Bonds, absolutely forces arbitrageurs to alter their future expectations and unwind positions. Technical traders will detect the reversals and selling picks up momentum:

”…the Bank of America-Merrill Lynch Corporate index posting its biggest monthly loss since the height of the credit crisis…. Investment-grade trading volumes rose 17.8 percent from $11.8 billion…and surpassed the previous record of $13.4 billion in May 2009,….[as] concern mounts that prices for government debt will fall if the Fed begins to slow its $85 billion of monthly bond purchases, investors are rushing to sell notes that are most-sensitive to moves in Treasury yields…”---Bloomberg

”… One strong signal of a change in trend has been the rotation out of interest-rate sensitive stocks, which has coincided with a rise in U.S. Treasury bond yields, Dickson said. Those stocks had been among the biggest gainers in this year's rally …”---Reuters

But how is an unseen bubble seen? Perhaps the demand for yield has created some structural dangers to the economy. For examples:

Distortions in the housing market:

The reemergence of structured collateralized debt and structured collateralized debt swaps:
”…Citigroup offered one synthetic CDO trade to hedge funds this year that pooled credit swaps…. “Investors are in a desperate search for yield,” said David Knutson, a credit analyst... “CDO products offer incremental yield”… As the Federal Reserve holds its benchmark interest rate near zero…, investors including pension funds and hedge funds are again seeking out more structured debt or derivatives that offer greater yields than the bonds or loans underlying them…---Bloomberg”

Banks moving away from the fundamental business of lending: ”…The banking sector is becoming a greater force in the U.S. municipal bond market….holdings of municipal bonds reached a record $374.2 billion in the first quarter of 2013….Part of the reason for the banks' ascendancy is the increasing attractiveness of highly rated tax-exempt municipal bonds when compared to U.S. Treasury bonds…"Banks will buy the high-quality municipals instead of Treasuries and they'll get the tax-exempt income"…”---Reuters

Let me reiterate the last line from the quote by SF Fed economist Lansing: ”…[a rational bubble may] occur if expectations of future price appreciation are large enough to satisfy the rational investor's required rate of return …” .

This is precisely what has been happening. Enormous amounts of liquidity have been pushing the envelope in a desperate search for yield. If the larger economy has improved, it seems to have done so without that river of Fed liquidity. If so, then it no longer makes sense to hold rates near the zero bound.

This great experiment might have led to the discovery that interest rates held too close to zero is counterproductive. That would then imply that there must be an optimal target rate that will benefit the larger economy and peg markets to expectations based on fundamentals.

As it stands now, the Fed might be successful holding asset markets in check by creating uncertainty. However, the balance will be delicate, and as the Lenni-Lanape discovered 387 years ago, it’s best to be prepared for those unexpected exogenous events.

Your drum beating Fool,

Note-1: Here’s a link to the Kansas City Fed, and the paper by Taeyoung Doh. It’s interesting reading and will clue you into the thinking behind the actions:

Note-2: The following article (link) is somewhat dated, but here’s an excellent example of what arbitrage traders look for. It specifically refers to the trader’s expectations. A “Butterfly Spread” is also the name of an arbitrage trading strategy. : Butterfly spreads may either be credit or debit. In a credit spread the trader shorts the higher price body and uses the credit to go long the wings. Conversely, in a debit spread, the trader shorts the wings and applies the credit to the body.

Note-3: There’s a lot of literature on Rational and Naïve market models, or Rational vs. Irrational bubbles and various forms of market expectation theories. You don’t have to know the math as much as the basic concept. If you do know the math, these theories boil down to martingale models vs. predictive models, like trend analysis.

Note-4: Most market watchers seem to focus on the ‘primary’ US Treasury’ market. True, the Fed has been ‘buying in bulk’ from the supply issued by the Treasury. But what about the secondary markets? The secondary market offers a great deal more flexibility for all bond traders. For example, traders who need a 10 year note at a particular yield can substitute a 30 bond, with 10 years remaining to maturity. Both habitat and arbitrage traders will compete for such issues creating market efficiency. Hence, small changes in expectations can have far reaching effects.

Note-5: Tamanend means ‘the affable one’. He must have been the ‘secretary of state’ of the Lenni-Lenape, in his day and won the favor and trust of the European settlers. He was best known for negotiating a long held peace with William Penn’s English Colony which became modern day Pennsylvania. The other Sachims are fictitious. I could not find any reference that noted the names of the Sachims who, in actual fact, had no intention of trading away Manhattan Island. The agreed 'rent' was for goods worth an estimated 60 Dutch Guilders, about $1000 in today’s money and never intended to be a sale.

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