Q&A – THE ANSWERS

Thanks again for another set of good questions. I’ll do my best to answer them all….

Delta Financial: Here’s mine. Do negative real rates matter?
If so, does the commodity based paradigm of generating capital from savings and allowing the market to determine rates based on the mix of money supply and money demand not make considerably more sense than this dodgy paradigm of a board of governors figuring the world out on behalf of the rest of us?

CR: The primary channel through which monetary policy works is credit channels. So setting rates low when growth is low will theoretically spark borrowing, investment, reduce saving/increase spending, etc. The answer is really – it depends. Negative real rates have not had a massive impact on the economy in the last few years, but as regulars well know that’s largely due to the balance sheet recession in which monetary policy has had a muted impact due to a lack of demand for credit.

The second part of your question is more one of policy. Should the government set rates? Personally, I think policy of this sort can be beneficial. Letting the market dictate the terms, is in my opinion, a lot like sending a car down a steep road without brakes or a gas pedal. Public policy can and does allow us to step on the brakes and the gas when needed (though granted, too much and too little at times).

Gray Matter: What does the concept of modern monetary theory mean for us today in practical terms? Is it possible to tie the “funny money” status of sovereign currencies, bonds, etc to Argentina’s alleged seizure of YPF which has REPSOL screaming bloody murder for $10B?

CR: First, I don’t speak for MMT since I am not an MMTer. I helped start MMR specifically because of our many disagreements. Anyhow, the fact that the USA is an autonomous issuer of a fiat currency has little to do with being a coercive or authoritarian figure in that society. If we want a very large and involved government then we can vote for that. If we want a very small government then that too is consistent with this form of currency issuer. But there’s nothing in this idea that requires the currency issuer to be authoritarian. In fact, the existence of private banks as money issuers disperses the power of money creation away from government so you could argue that the current structure of our monetary system is actually designed to avoid this sort of authoritarian approach that you seem to fear.

internationalmonetary: Should we have a separation of powers in the monetary and executive departments of the government? In other words do you believe we should separate the central bank from the government? It seems like MMT treats the monetary and executive department as one.

CR: Again, I am an MMRist, not an MMTer. The differences have become distinct (see here for details). In this regard though, both MMR and MMT treat the central bank as part of the government. In my opinion, you don’t need to believe in the ideas of MMR or MMT to understand this. You just need to look at how the Fed operates. I often call the Fed and Tsy two pockets in the same pair of pants. That’s because they are. The Fed and Tsy are in constant communication with one another and constantly need to coordinate their actions so as to maintain a smoothly functioning monetary system. The idea of the Fed operating without knowing what is going on at the government level or at Tsy is unfathomable. So while the current political arrangement has the Fed being “independent” there is really nothing independent about their actions. To me, this isn’t some special MMR or MMT insight. It just is what it is.

Jussi: These keeps me awake during nights:

1. Why the govts keep issuing long term bonds, does it make the economy more pro-cyclical or counter-cyclical? I can see arguments both ways.

2. Do we need govt debt at all, is it just disturbing the allocation of resources? What would be the best way to arrange the medium of exchange in theory?

CR: 1. Govt spending can be both pro-cyclical and counter-cyclical so I don’t think there’s really a black and white answer for you on the bond issuance question.

2. Gosh, I wish I knew what the optimal structure of the monetary system was! I’m more of a specialist in what IS and not necessarily what COULD be. The govt technically does not need to issue debt, but there are arguments for and against this. To be perfectly honest with you, I have not devoted enough time to considering the optimal monetary system so I don’t think I quite feel comfortable discussing even preliminary thoughts I’ve had on the matter….Give me 30 more years and I’ll probably spout off at some point.

InvestorX: Please compare your macro view of how the economy works to that of Ray Dalio’s “machine”.

CR: Dalio’s a genius and I often cite him here. We both often describe the monetary system as a machine. This is a really useful way to think of the monetary system because, it is, after all, a system. And this system has many moving parts that all come together to achieve some particular outcome. If you don’t understand how all the pieces of the system work then you can’t be expected to understand how it will operate in certain environments. I think Dalio does a better job than just about anyone doing this, but in my humble opinion, he does misinterpret the way an autonomous currency issuer functions in this system. We’ve heard him discuss the problem of the national debt and a potential insolvency in the USA so it’s clear he’s not approaching the view of the machine in the same manner that I am. This is not surprising given the fact that MMR is a far from a mainstream perspective…..

Puzzled: I stumbled across a post in which “CP” argued back and forth with Scott Fullwiler about “S-I”

http://pragcap.com/what-happens-when-the-government-tightens-its-belt-part-2

CR: This is incredibly wonkish, but no one has covered these discussions more thoroughly than JKH over at the MMR website. Rather than do his work an injustice I’ll just point you to his brilliant work on this. See here.

Q: Can you tell us how you learned to program and build your quantitative skills and algos? A CFA here that is just trying to improve through the self-taught route. I don’t want the secret sauce of the mulit-strat, just the path for knowledge.

CR: I would by no means call myself a programmer. But I built a rather basic automated trading system using simple Excel spreadsheets through the Interactive Brokers platform. This allowed me to apply my data to an automated approach. IB’s system is really dynamic and the automation just takes the human element out of it, however, any trading system you have should be able to be overridden by human interaction. Unfortunately, in order to describe how I built this I’d have to show you point by point, but I figured it all out by googling and watching youtube videos so you can probably find more info online. IB has a superb automated trading platform if you are willing to take the time to connect the dots. It was a real pain, but if don’t have the discipline to control the system on your own then sometimes it’s best to execute through the robots….My approach is not high frequency or terribly active though so it’s not as involved as most trading algos are. In fact, a HFT or math guy might not even call my approach a true algo. But I approach a lot of this through a simple idea – “keep it simple stupid”….

In Accounting: I’d love to hear your thoughts on the HSBC risk-on risk-off piece.

http://www.research.hsbc.com/midas/Res/RDV?p=pdf&ao=20&key=qZ08fgma7C&n=327415.PDF

If you believe the above, how have you adapted your multi-strategy approach to maintain diversification?

CR: My approach is multi-strategy because I believe diversifying across strategies is the optimal form of diversification. The problem is finding the good strategies. So I actually think my approach is diversified even though it’s not the traditional form of diversification that most investors think of when they think of diversification. Unfortunately, I don’t disclose much about exactly how I approach all of this because the strategies I use are essentially the culmination of my life’s work, but I did provide a broad overview here.

hfm: It seems when market goes against your algo signal, you try to average in. So you do not cut loss?

CR: I never pick tops and bottoms. So I always average into every position I establish. It’s not “doubling down” in the traditional sense because I have a pre-established position size set at the max amount. So, if one strategy has a 30% max allocation in the overall portfolio of strategies, I might establish 10% of a position for XYZ strategy at $10, 10% more at $9 and 10% more at $8. The position then has a $9 cost basis with a full 30% allocation. From there it’s all about following the strategy as pre-established. You sell or cover when your strategy tells you to. Not when you get “squeezed” or get scared out of the position. Each strategy has sets of rules that are not to be violated. I have overridden my algo output just twice in the last 5 years. Once in late 2008 and once last year during the Euro scare. Last year’s override proved to be a big mistake since it called the market bottom nearly to the day. Stick to your discipline….That’s the lesson.

jford: What are your sell rules?

CR: I have a lot of different rules depending on the strategy. How about this? I’ll compile my favorite rules for an upcoming article….

Tom Reilly: Cullen, How does a person know in advance if the FED is going to increase the monetary base for the coming two weeks, month? Do they pre list their operations somewhere that helps someone know in advance an increase or decrease is coming for the coming two weeks.

CR: The Fed is pretty transparent about the size of their balance sheet. You just need to follow the operations as described by the NY Fed. Here’s a schedule, for instance of remaining $600B in operation twist.

Ville: You seem to be quite a liberal fellow. What are your thoughts about legalizing drugs. Obviously it would be a massive income transfer from organized crime organizations to state.

CR: I’m actually pretty centrist. I tend to be more fiscally conservative and socially liberal. On this particular issue I tend to fall into the camp that says drugs don’t kill people, people kill people. Alcohol, for instance, is a terrible drug. But it’s a drug I use fairly often. In moderation of course. Any drug that is abused can kill you. Whether it’s Tylenol, alcohol or LSD. That said, I personally have no problem with the government enforcing laws against certain drugs that are proven to be very dangerous, but I can’t tell you where exactly I draw the line on that. I am not a doctor and don’t know enough about each type of drug to decide where that line can or should be drawn…..

VB: With all of the trouble in Europe, why has the euro held up so strong against the Dollar? Do you think this will continue?

CR: Currency valuation is all about relative values. The Euro has held up because, even with the troubles in Europe, it is a very strong economic region. Much stronger than many alternatives. So a lot of this question depends on what you mean by the Euro being “held up”. Held up against what? The USD? The Yen? The Hungarian Forint? The Euro area as a whole is the largest economic region in the world. This is why I keep saying that if they could get their act together and politically unite (a tall task I know!) they have the potential to become a really powerful and unique currency union.

troll: You constantly state that banks don’t lend reserves.
Does this mean that the cash (i.e. reserve notes) that I take out of an ATM are not considered reserves – or is it considered reserves until I withdraw it – or is it considered reserves after I withdraw it? OR does this mean that reserve notes have nothing to do with reserves?

CR: Reserves are essentially required cash held on “reserve” at regional Fed banks. In the USA the reserve requirement is 10% so banks must keep 10% on “reserve” at all times. If a bank has a deposit then it must keep 10% of that on “reserve” at the Fed.

eludog: Do you believe the stock and commodity markets are manipulated?

CR: This depends on what you mean by “manipulated”? Does the government alter prices of things denominated in its currency? YES. They’re in the business of manipulating prices. The Fed is ALWAYS manipulating the Fed Funds Rate higher than it otherwise would be. If the Fed didn’t manipulate interest rates excess reserves in the banking system would result in a permanent 0% overnight rate. So the Fed has to always manipulate rates UP in order to control monetary policy. The Federal government is further manipulating prices by constantly running budget deficits. Now, as the currency issuer, this manipulation is necessary to some degree though not always efficient or productive. But yes, any autonomous issuer of a fiat currency is essentially always in the business of manipulating its currency and therefore manipulating the price of all things denominated in that currency….Then again, the banks as money issuers are also in the business of influencing the price of money and market prices. So it all depends on what you mean by “manipulating”. I can manipulate prices, but I am a small fish in a big pond. Goldman Sachs and the Federal government, on the other hand, are big fish in a big pond….So I guess you could say that we are all kind of in the business of manipulating prices to where we want them to be. And the bigger the fish the bigger the wave….

Ben: Cullen, What are your thoughts on Reuters’ recent interview with Buba’s Weidmann?

http://www.reuters.com/article/2012/04/18/us-ecb-weidmann-idUSBRE83H0EH20120418

CR: Weidman is towing the party line in Germany. The fact is, Spain is part of an unworkable currency system. The current system is like the USA where the states receive no federal aid (the US Federal govt accounts for about 20% of all state spending currently). Like Europe, there’s no currency rebalancing among states in the USA, but they don’t need it since trade imbalances are offset by fiscal aid. This doesn’t exist in Europe. Instead, the countries are being told they must fix their problems on their own. But they can’t rebalance trade through currency devaluation and they can’t take on more debt because, as currency users, there is a limit to amount their debt accumulation. So it’s full US of Europe or bust. Germany’s gonna have to write the check or take it on the chin when Spain decides to leave to bring back their own currency. There’s no other way out….

Ted: Any thoughts on the increasing student loan debt burden on younger people and the potential for this to act as a drag on the economy going forward?

CR: It’s certainly a worry, but nothing of the magnitude that we saw with the housing crisis for instance. Don’t quote me on these figures, but a quick google search shows that there is about $1T in student loan debt outstanding and $14T in mortgage debt outstanding. So the student loan problem is roughly 1/14th the size of the recent housing debt crisis. Nothing to scoff at, but not the ticking time bomb that housing was in 2006….So it’s a big concern and a potentially disastrous trend if it grows larger, but it’s not going to crash the global economy like the housing bust did.

Paul: In Europe, the ECB can write check, but choses not to, partially due to a perception that peripheral institutions are inefficient and extractive. Therefore, the bond vigilantes are in charge.

In the US, “there are no bond vigilantes”, but we could chose to change that. Do you think this is a likely scenario (i.e., sufficiently likely to be worth considering or even hedging against)? Are there any “canaries in the coal mine” that you monitor regarding this scenario?

CR: To me, it’s all about maintaining faith in debt payments. So, if the USA starts to decide not to pay interest on US Treasuries then bond markets will panic and yields will rise. That’s basically what we keep seeing in Europe. When the ECB says they’re not going to backstop the sovereigns the yields spike. It would be like California nearing default and the US government allowing the 8th largest economy in the world to default. That would be madness. The Federal government would write California a check just like they do every single year (just like they do for all 50 states). It’s not in the interest of our union to allow massive economies within the union to begin defaulting. After all, the states are part of the government. But Europe doesn’t have this unity. There is no political unity and no monetary unity in this regard. So you have Germany saying they don’t want to write the check. Okay, then kick the others out of your monetary union rather than holding them hostage in an unworkable currency system…..The USA made a commitment to sustain our monetary union through being a UNITED STATES OF AMERICA. Europe wants the benefits of a currency union without the political baggage that comes along with it. But that’s not how it works.

James: Cullen, I currently work in internet advertising but am considering a switch to a career in finance. I am enthralled by the daily discussion (mostly via twitter) on the nature of money, the world economy and markets, but am not so sure I want to dedicate my full attention to the task of modelling future market values to determine whether current market prices are high/low. Could you provide thoughts on how you decided on a career in finance?

CR: Career advice is tough because we’re each different. I have always been fascinated by markets, money and the social aspects of it all. To me, it’s like one big puzzle and as a natural puzzle solver I feel incomplete not having finished the puzzle (which probably means I’ll always feel incomplete). I was never drawn to finance for the money and I think that’s the pitfall that most people fall into. They chase something not understanding what money is. But they assume that if they can accumulate enough money then their life will be great. But this confuses money and wealth. Real wealth is not having piles of money. Real wealth is being healthy, having great friends, finding love, finding peace, finding wisdom or whatever it is that you might define under the broad realm of things that make you “happy”. Money might help you in some of these aspects, but it won’t fulfill them. So my advice to you would be to find something that really interests you. But no matter what you line of work you go into understand that your monetary rewards might not directly correlate to your actual wealth as a human being. If you go into finance you should go into the industry with the intent that you want to provide a worthwhile service to others. Not that you just want to make a boatload of money for yourself thinking that this will solve all of life’s problems. If you you do something that interests you and you go into it with the right intentions then it’s hard to say you’re doing the wrong thing….It might sound cliche, but I really believe it’s true.

Rich: since the Chinese fix the Renminbi to the dollar (they’ve expanded the trading range…still not a full float, though)…and since the Fed is a currency issuer, doesn’t that mean the Fed is also an implicit issuer of Renminbi also…(only indirectly, of course) ???

In other words, are the Chinese by fixing their currency also compromising their currency autonomy…?

CR: Yes, pegging one’s currency is a way of compromising monetary sovereignty. The risk is that you become dependent entirely on the ability to obtain that currency in order to fix the peg. We’ve seen this historically and how badly it can end. Examples like Argentina and Russia come to mind.

hangemhi: +1 and I’d add other currency pairs especially USD vs. Yen and AUS. Also curious for your thoughts on Gold.

Where can I find up to date stats on deficit spending and private sector debt (expansion or contraction)? Combined this would be NFA’s, correct? Or do you not consider private debt NFA’s?

When these two are combined I would think growth or contraction would lead to overall economic growth or contraction (obviously depending on where the money is going to, but for now I’m just looking for the numbers). And then, if you have thoughts on how quickly growth (or contraction) in NFA’s show up in GDP, jobs, etc.

(and I still don’t see a subscribe button for comments that you had a month or two ago)

CR: The best place for this data is the Fed’s Flow of Funds and the NIPA tables. That’s where I compile it all.

Private debt is not NFA’s. Private debt always nets to zero. It has an asset and a liability.

I’ll look into the subscribe button. I haven’t had much time to work on the website’s layout lately….

Colin: Individual Euro countries are not currency issuers, but some entity (the ECB?) must issue Euros. How does this process occur (eg differ from the US federal government ‘spending USD’s into existence’)?

CR: I would recommend reading this post/series at Concerted Action for a comprehensive overview of the Euro system.

Exertia: Just like most of us hit pragcap.com for our daily fix, what are some of your daily websites / iPad apps?

Also, what have been some of the books / authors / thinkers / doers who have influenced you the most?

CR: I read a lot of bank research. The blogs I follow are the standard big blogs that most of us probably read. I don’t have any great secrets here. You can find my list of most influential market practitioners and analysts here. One of these days I’ll compile a comprehensive list of book/authors/thinkers/doers who I have been highly influenced by.

Paul: Can you comment on the practical viability of a US state using its taxation power to become a de facto currency issuer? For example, could my home state of CA pay for services using coupons good for extinguishing CA tax liability eliminating the solvency constraint? Where do you see this falling down in practice (or not … it’d be great to stop the tired “tax increase vs. spending cuts” debate around here)?

CR: States are currency users. They can create money in the form of debt, but cannot create net new financial assets like the federal govt can.

Joe: As I recall you’re not a fan of Shiller’s 10 year PE Ratio. I like it, because it’s a simple way for an unsophisticated investor (such as myself) to know where the market stands in terms of valuation.

1) In short, why do you dislike Shiller’s 10 year PE Ratio?

2) The 10 year PE Ratio currently stands at 22.98 (*), which is somewhat high. Is it possible the ratio is unfairly skewed due to abnormally low profits following the very unusual recession we had recently? Or are the abnormally low profits balanced out by abnormally high profits?

CR: I really don’t find a lot of value in PE ratios. They’re essentially a guess based on the market’s perception of current price divided by either a rear view mirror figure or a future guess by analysts. The result is something that adds little value. The CS PE just stretches the ratio out over a longer time horizon which adds some perspective, but is virtually useless for a market timer and void for a buy and holder who doesn’t care about market value to begin with. So I just don’t know how to embed these kinds of indicators into an actionable strategy….Maybe someone else has a better answer here….

jt26: What’s your current thinking on NGDP targeting?

CR: I see things differently here than the Market Monetarists do. They think the Fed can influence the market just by promising to implement QE. But I don’t see the mechanism by which this changes fundamentals. My preferred approach for NGDP Targeting would be for the Fed to set the price of bonds or to actually buy back assets that in what would essentially result in a form of fiscal policy. David Beckworth recently wrote about an interesting proposal on using the platinum coin idea first proposed by my MMR colleague Carlos Mucha.

Jonathan: What are your favorite technical indicators or combination of, for entry and exits in equities and for currency/commodities?(if applicable).

CR: I don’t really use technical indicators in any sort of specific manner for buy/sell strategies. I vaguely follow things like moving averages, % bullish, breadth, etc, but these indicators don’t decide my outlook necessarily. I generally use technical analysis as a complement to fundamental analysis and to gauge the big picture of underlying market trends. On its own I have never found that TA can be used to sustain high risk adjusted returns, but that’s just me.

WGO: When the Fed buys foreign debt are they “printing money”?

CR: The Fed supplies dollars to foreign governments through swap lines. Unless I’ve missed something, the Fed has not been buying foreign denominated debt….

Lance: Do you really believe that:

A) Your proprietary stuff is so good that:

B) So many people would use it to line their pockets that:

C) The number of followers would thus reduce your “edge” (assuming of course that you actually have one that is sustainable) by any really measurable (i.e. meaningful) degree?

The man behind the curtain retains his aura as long as he never steps in front of the curtain, yes?

Me? I just don’t believe in anyone’s “track record” unless I can audit the same.

CR: The results of my macro approach here at Pragcap speak for themself. Regulars who have followed my macro calls and real-time trading calls have seen my results as they’ve played out. Some of these have been broad macro calls and others have been specific market calls (like my March 2009 buy call or my pre-flash crash short call). I am certainly not arrogant enough to claim that I am never wrong (I am wrong a lot), but I understand how the machine works and I’ve generated audited returns as follows since I began keeping an audited track record:

2006: 41.99%

2007: 26.01%

2008: 18.07%

2009: 6.5%

2010: 3.17%

2011: 6.96%

Avg: 16.3%

Since I am not running my partnership this year I can disclose this info. As you can see, I’ve beat the market in many years and underperformed the market in many years. But I’ve generated steady high risk adjusted returns throughout a pretty tough cycle using a multi-strategy approach. Do I have some holy grail? No. But do I understand how the machine works, know how to manage risk and understand how to generate decent absolute returns? I think so. I’m not some man behind a curtain though. I don’t have a crystal ball. I am just another guy who’s done pretty good running a small investment partnership who happens to have amassed a decent understanding of the monetary system and the investment world and how it’s all interconnected. But I’ve got nothing to hide here so I am not some man behind a curtain. If you think my comprehensive understanding of the system is inferior then that’s fine. I don’t ask anyone to pay for the content here.

John: Banks dont lend reserves? Who told you this? They lend reserves in various ways, otherwise what would the point of having reserves be?

CR: Banks don’t lend reserves. The money multiplier is a myth. See here. Banks use reserves for settlement of payments and to meet reserve requirements.

Sam: How do garden variety open market operations work in a world where banks aren’t reserve-constrained? What is the MMR/MMT conception of open market operations and why they affect interest rates in ways that QE doesn’t appear to?

CR: OMO’s always work through the central bank exchanging assets with the private sector. MMR and MMT know that monetary policy is always about price and not quantity. So the reason why the Fed can set the overnight rate is because they set the specific price and not quantity. QE is implemented differently. They are setting quantity and not naming price. If they wanted to they could set the price of long bonds. This is why I’ve said QE doesn’t really work. Because it doesn’t actually set the price….

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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