Author Archive for Cullen Roche

“Do you Want to be Right or do you Want to Make Money?”

I can’t remember the first time I saw the quote in the title of this post (maybe this Barry Ritholtz post), but it always stuck out to me. I will never forget the emotion I had following the financial crisis – that gripping fear. I went about 6 months in late 2008 and early 2009 without doing anything in the markets. I was paralyzed with fear. At points it was the right emotion, but as it ceased to wane I realized that the fear was no longer a productive part of my life. And as the markets and the economy healed in late 2009 I made a promise to myself that I would never let fear dictate my life the way it had in 2009.

In my book I describe fear as “the most destructive emotion”. Fearful people are easily manipulated, don’t take the right risks, easily fall in line with conventional thinking and never experience their full capabilities because they let their own emotions hold them back. And while this emotion is destructive in our personal lives, it can be even more destructive in our portfolios.

I’ll never forget 2009 because it was the year where I vowed to start thinking objectively rather than emotionally. This was the period when I began to obsess over the specific operations of the monetary system. It was when I realized that I needed to understand the world for what it is rather than what my emotions want it to be. That was the only way I could make objective decisions about the future.

As someone who writes a moderately popular website I’ve had to resist the urge of alarmist and “eye catching” commentary. I know exactly what works in the field of finance. If you want to have a wildly popular website you write about the following topics consistently:

  • The Federal Reserve is a big scam out of screw us all.
  • Government debt and spending will be the end of us all.
  • The next big market crash is always right around the corner.
  • High inflation is going to destroy the financial world.
  • Gold is the best thing since, well, anything, ever.

The reason those topics garner so much attention is because they feed on people’s emotions. They feed on people’s fear. Of course, most of the articles about those topics are totally misleading. And I hurt my own popularity by not writing about them. In fact, I tend to write about incredibly boring stuff and often say precisely the opposite of the aforementioned topics.  It’s amazing any of you are even reading anything I write. But the objective and pragmatic view is usually a boring view. It doesn’t reside in extremes. It resides somewhere in the middle. The beauty is, I’ve noticed that a more objective and practical approach leads to far better results.  And ultimately, that’s what we’re all after. Someone who sells you fear is trying to separate you from your savings by selling you a scary story. And fear will always end up being “right” at some point because the markets are always in flux.  But that won’t necessarily help you make money.

It took me a long time to overcome my behavioral biases and stop viewing the world through a fear based lens. It took me even longer to develop my understandings of the monetary system and the financial system. But there’s no looking back for me. Irrational optimism and irrational pessimism are emotions that are no longer part of the way I live my life. Living on the extremes of your emotions creates too much risk in too many different ways. And in this business you can’t afford to let your emotional extremes get the best of you.

Rail Traffic Trends Hanging Strong Despite Oil Collapse

Oil prices are collapsing, but trends in rail traffic are hanging in there.  The latest weekly reading on rail traffic came in at 4.5% on a year over year basis and brought the 12 week moving average down to 3.6%.  That’s the lowest reading since March of this year, but still solidly growing.  It will be interesting to see how things pan out in the coming weeks/months, but for now this indicator appears to be hanging in there.



Quick Thoughts on the Fed Statement

Not much to say here following the latest Fed statement. They dropped “considerable time” and added that they will remain “patient”. I don’t even know what that means, but the parsing of words here is a bit overdone in my opinion. The key point at present is not in the statement’s specific terminology, but the broader macro events. And at present the Federal Reserve and other Central Banks are seeing a few things:

  • Very tepid global growth & declining growth in many international markets.
  • High risk of deflation in Europe.
  • Growing risk of contagion from the collapse in oil prices and the Russian economy.
  • Low wage growth and downside risks increasing in the US economy.
  • Increasing risk of banking system defaults due to oil and foreign exposure.
  • An economy that is still healing from the impact of the financial crisis.

Given all of this there is simply no way that Central Banks can consider tightening. Frankly, I am shocked by how shocked people are about this report. This announcement was a total no-brainer given recent events. So, the bottom line is:

  • The Fed is on hold at least until Q3 next year.
  • In Q4 2015 and Q1 2016 the inflation comps will get rather low which will make the Fed much more skittish.
  • I still think there is a high risk that we will be at 0% interest rates when we enter the next recession.
  • Therefore, QE is the likely policy tool of choice. Any dovish statement should be interpreted as a move towards an increasing probability of balance sheet expansion.

Chart of the Day: Hello Deflation?

I mentioned earlier this week that the inflation threat is totally off the table in the near-term thanks to the collapse in oil prices.  And we now have a great idea of just how much the decline in oil prices is impacting prices. The PriceStats Daily Developed Markets Index follows prices in the USA, Canada, Japan, Australia, the United Kingdom and Europe.  And it’s telling us a very grim story (via Josh Zumbrun at WSJ):


My guess is we’ll see a snap back at some point in late 2015 as the year over year comps become very low, but for the near-term there is very clearly no threat of inflation.  And that means that any Fed tightening is going to be put on the back burner.


Here’s another view of this that might be helpful in terms of putting this in some historical perspective. The 10 year break-even rate which shows inflation expectations has now declined to levels that we haven’t seen since 2010:



History is an Outline, not a Blueprint of the Future

One of the most important points I stress in my book is the importance of thinking about market environments as their own unique set of circumstances. In the world of finance and economics it’s always convenient to look at the past and draw conclusions about the future. We’re seeing this quite a bit in the current environment where Russia appears to be undergoing a currency crisis and many people are drawing their conclusions based on the 1998 experience. And while there are many similarities (falling oil prices, collapsing exchange rate, etc) there are also many differences (floating exchange rates, significant foreign reserve positions, etc).

The important point is that this cycle is not like the 1998 cycle. It’s different and it has its own unique causes and effects. Yet we see this sort of historical backtesting in all corners of the finance and econ world. It’s so convenient to extrapolate the past into the future in your portfolio construction or your economic forecasting because that makes us feel confident about our projections. But the reality is that no one really knows precisely how the future will play out and the future is certain to be different than the past to some degree. The best we can do is study the history, view it as an outline, understand the current environment and monetary system for what it is and put together the best blueprint of the future that we can.

So yes, it’s important to arm yourself for the future by studying the past, but we must also understand that our necessary forecasting of the future relies on more than understanding market history.


Can a Central Bank Always Create Inflation?

Ambrose Evans-Pritchard got a Paul Krugman lashing over the weekend thanks to some comments about the power of Central Banks when the economy is stuck at the zero lower bound.  Evans-Pritchard had argued that increasing the money supply is still a relevant strategy for increasing inflation and Paul Krugman didn’t agree based on the evidence of the last 5 years which has put king sized holes in the idea that “money printing” QE can create inflation.

Ambrose responded today making some rather strong claims that I don’t think are exactly right. This isn’t the first time I’ve been critical of his commentary. Back in 2009 Ambrose wrote a piece about a potential bubble in US government bonds and I responded with a lengthy piece citing the many reasons why I didn’t think US Interest rates would rise, why bonds weren’t in a bubble, why there was no risk of US solvency, why we weren’t like Greece, why there was no hyperinflation coming and why high inflation certainly wasn’t coming. All of this led me to believe that there was most certainly not a bond bubble in US government bonds and that view has been undeniably correct.

It’s important to be precise in these discussions because the details are what help us understand cause and effect. I start from a very in-depth understanding of the monetary system and its institutions and apply specific monetary environments to my thinking. It’s by no means perfect, but it’s generated some fairly good results over the last 5 years.

Anyhow, Ambrose says in his piece:

“Central banks can always create inflation if they try hard enough. As Milton Friedman said, they can print bundles of notes and drop from them helicopters. The modern variant might be a $100,000 electronic transfer into the bank account of every citizen. That would most assuredly create inflation.”

Central Banks are not omnipotent independent entities.  They are essentially just normal banks with loose legal constraints and a central infrastructure. But they are still constrained by the laws in the system in which they operate. For instance, the Federal Reserve is not legally allowed to just transfer $100,000 in the bank account of every citizen. The Fed must operate within the laws that constrain their actions as outlined in the Federal Reserve Act. And the Fed “transfers” money into private bank accounts by buying other private sector assets. This is the key weakness in QE’s inflationary transmission mechanism. As I’ve described tirelessly, QE swaps private sector financial assets. It does not create more net financial assets. It’s madness to think that swapping a checking account for a savings account will lead to higher inflation. So Ambrose is not describing a realistic transmission mechanism.

Ambrose then goes on to argue that monetary policy that “finances” the deficit could be inflationary. I don’t necessarily disagree with this, but that is not monetary policy. The size of the Federal deficit is not determined by the Federal Reserve so they can “finance” the deficit as much as they want, but they are merely playing second fiddle to the US Congress.  Again, the Fed is not the institution in control there.

He later argues that the key to QE being inflationary is to buy assets from non-banks.  That’s been happening in droves in the USA with no inflationary effects. Again, this was a mere asset swap of privately held T-bonds for deposits with the banks acting as middlemen. I described this in some detail here. But he goes on to say:

“The relevant monetarist prescription is to buy assets from non-banks. The authorities do not have to purchase state bonds (though to do so is convenient, politically neutral, and easily reversible). They could equally create and inject money by buying land, or herds of Texas Longhorn cattle. Central banks can buy anything they want, and it should be obvious that the effects of buying cattle do not work through the rate of interest.”

Again, the Federal Reserve has no authority to purchase cattle or land. But yes, if they did this would most certainly be inflationary. I’ve referred to this idea as “Roche’s Bags-O-Dirt” in the past. That is, if the Fed could buy worthless bags of dirt from the private sector at $100,000 a pop that would most certainly cause inflation for obvious reasons. But again, we have to understand the world for what it is and not what our monetary theories want it to be. And buying bags of dirt, cattle or land just isn’t on the legally mandated list of assets that the Fed can (or will) buy.

If we fail to understand our monetary system for what it is, as opposed to what economic myths say it is, then we come to all sorts of generalized, vague and erroneous conclusions. Of course, all Central Banks are somewhat different in how they’re structured and so the details matter in terms of how powerful they really are within a certain economy, country and legal structure, but in the developed world economies there are important constraints on these entities that limit exactly how powerful they are.  I hate to pile on here, but I think Krugman is generally right – given the limited policy tools that Central Banks have and their unwillingness to utilize more controversial tools I just don’t see how there’s a currently relevant transmission mechanism by which Central Banks can be relied upon to carry the policy burden.  So while economic theory is correct that a Central Bank can always create inflation, the reality is generally much more complex.



Three Things I Think I Think

There’s a lot going on.  Too much to write about in one post so here’s a fresh installment of three things I think I think:

1) Bigger Scare: Oil or Greece?

Oil prices are off about -45% from their June highs.  It’s an alarming drop to say the least. While it’s a welcome decline to US consumers who are now paying significantly lower energy bills it’s unclear what exactly is driving the decline and whether it’s a sign of something nasty in the global economy.  My best guess is that there’s a bit of everything going on here. That is, we’re seeing the supply build up finally take its toll on prices and OPEC is unwilling to support prices given that they can afford not to (the Saudis, for instance, produce oil at a significantly lower cost than most of their competitors). But we’re also seeing some signs of weak demand in the price. The big worry is that this is a sign that China and Europe are even weaker than we think.

And that brings me to my biggest concern. As I’ve stated previously, I still think the biggest threat to the current economic environment is Europe. In the last few weeks we’ve seen a sharp move higher in Greek bond yields. While this is just some repositioning in bonds due to political uncertainty, it’s a big potential risk in the coming years. The European Monetary Union is NOT fixed and the critical flaw in the system remains in place. Europe won’t see a stable monetary system until this is resolved and that means that high peripheral debt and unemployment are very likely in the coming years. That creates huge political uncertainty. At what point do Greek citizens or German citizens just get fed up with what is clearly an unworkable system? The worst case scenario is a form of restructuring that create all sorts of near-term uncertainty.

While the decline in oil looks frightening the rise in Greek bond yields is a reminder of an even larger potential disruption to the global financial system.


2)  The looming deflationary & disinflationary threat

Disinflation was the main theme in 2014 as investors realized that QE just doesn’t cause high inflation. And that trend is likely to continue into 2015 thanks in large part to the collapse in oil prices. We are likely to see very low levels of inflation in 2015 thanks to this decline. That’s a good thing in that it’s a sign that costs will remain low, but it’s a bad sign because it also means demand is too low.

This decline in energy prices will give Central Banks even more wriggle room than they already have and increases the odds of intervention in 2015. I still do not think that tightening of any form is on the table in 2015. At least not in the first half of the year. More importantly, Central Banks are likely to grow increasingly concerned about the ripple effect from the fall in energy prices. With high yield bonds spiking we’re likely to see a growing number of defaults in many high yield issues. Bank exposure to the energy sector is not crippling like the mortgage crisis, but it is larger than many might think. This all adds up to Central Banks that will likely lean heavier on the easing side than the tightening side.

So, the disinflation is likely here to stay. Will it turn into a full blown debt deflation? Hard to say without a major set of defaults either at the sovereign level (Russia, Greece, etc) or a wave of defaults that Central Banks don’t foresee. For now this looks like a disinflationary event with some risk of a deflationary tail risk.


3) About those 2015 Year-end forecasts

Business Insider had a good piece over the weekend on the 2015 forecasts from Wall Street’s biggest analysts. Barrons also discussed the forecasts citing the lack of a single bear. But the real question is whether anyone should care?

In my view, no one knows where the price of stocks will be in 12 months. It’s a silly game to try to guess where the price of such a dynamic market will rest in such a short period of time. And we have to recognize that most analysts are pretty smart – that is, they know there’s about a 70-80% chance that stocks tend to rise in any given year so most of these analysts are just playing smart odds. Bearishness in the equity markets can be career suicide for most analysts at a big bank even though the media makes rock stars out of bears who regularly scream “fire” in the crowded theater of the markets.

Besides, most Wall Street analysts are perennial bulls because their firms rely on being perennial bulls. These are firms that make money by ensuring that people are being actively involved in the markets. It doesn’t help their business model to move people into cash or scare investors away from acting. They sell products for which they want there to be rabid demand. And these analysts help to foster the environment which feeds that demand. Every investor should realize this before reading a forecast from any big Wall Street firm.  So do yourself a favor and ignore the myth that anyone has a crystal ball about where markets will be in 12 days, 12 weeks or 12 months.

Answering Common Questions (i.e., Rude Emails) About the National Debt

I sent this email in response to someone who sent me a not-so-friendly email about the national debt and my response to Stephen Moore’s article from last week.  I thought that republishing it might be illuminating for others since these are very common concerns and I seem to regularly receive emails like this from people who have serious concerns over the national debt:

Hi (redacted),

Not sure why the tone of your email is so visceral and personal? Anyhow…Let me see if I can answer your questions in a friendly manner:

How is the (national) debt going to ever be paid down?

Actually, the debt will NEVER get paid down. Saying that the govt has to “pay back its debt” is like saying that the private sector must pay back its debt.  This is true at the micro level, but false in the aggregate. Debt is someone else’s asset.  So, to “pay back” the national debt is to reduce non-government’s assets by that much. In a credit based monetary system there is no such thing as aggregate debt repayment. In the long-term, debt is pretty much always expanding.  And as our population grows we have, at least to some degree, growing needs for government (more policeman, firefighters, etc). So it’s not surprising that our debt has grown over long periods of time. 

For some perspective on this consider the US government’s history with debt.  Since 1776 we have been in debt almost the entirety of our existence. There was a brief debt repayment in 1835, but the US economy slipped into a depression in 1837 and we quickly went back into debt as tax receipts collapsed. So, we have pretty much been in debt for 230+ years. 

This is neither good nor bad necessarily. It really depends on what the debt is being used for. Is it contributing positively to our lives or is it contributing negatively to our lives?  Is it contributing to high inflation and is it reducing our living standards?  I would agree with many Conservatives that the US govt is issuing debt on many unproductive activities, which is a bit disconcerting. But I would stop worrying about repaying the national debt. It won’t happen mainly because, in the aggregate, debt repayment is actually impossible/unsustainable.

The deficit keeps increasing, and we can’t pay the interest without more debt.

The interest burden in the USA is actually declining as a % of GDP.  We pay about $250B in debt service every year. The Federal govt could actually reduce this substantially by reducing the maturity on their debt. They have complete control over their interest costs if they so desire. So this too is not a realistic concern.  


How are we going to fund all the social spending?

The same way we always have. We will tax and issue bonds. The question is not about whether the govt can “print money” from thin air to funds its operations, but whether this will cause disastrous inflation.   (The government doesn’t actually “print money” in any realistic sense so please read more here for details). 

What are you going to do, when interest rates rise?

I am going to get in a bunker and prepare for the long dirt nap.  Just kidding. The Fed likely won’t raise interest rates until the economy has gotten substantially stronger. And if the economy is getting stronger then stocks are likely performing well and offsetting any downside in bonds. But as I said above, there is no ironclad law that forces the US govt to raise interest rates. Just look at Japan where interest rates have been zero for two decades. A government that is sovereign in its currency, has no foreign denominated debt and a central bank that can issue its own currency does not have to worry about someone else telling them that they need to raise their interest costs. This interest cost is not controlled by “the market”.  It is controlled by the monopoly supplier of reserves to the banking system (the central bank) and the Treasury which dictates the average outstanding maturity of the liabilities it issues. 

None of this means your concerns are totally unwarranted. I also have my concerns about government spending, efficiency, etc. But I wouldn’t get too bogged down in narratives about “repaying” the national debt and the burden of interest costs.  Those ideas are mostly trotted out by people who are trying to scare you into believing their political narrative.

I hope that all makes sense. If you have some more questions feel free to ask. Just leave the personal stuff out of it. Unless it’s funny. I don’t mind personal insults if they’re funny.