Tuesday, September 19, 2017

Things Don't Always Work Out the Way They Ought To!

Remember back when the Fed started creating money like mad and sending it by the billions to the banks, in return for their holdings in treasury bonds and mortgage backed securities? For many legitimate analysts and too many illegitimate fear-mongers/gold purveyors this was a phenomenon that was certain to bring on rampant inflation and mass financial destruction. After all, the production of "paper money" at a pace far exceeding the production of goods and services had to push the prices of goods and services to the moon, right?

Well, that's not how things happened to have turned out -- at least not yet. In fact, the Fed's been begging for a little inflation so it can begin unwinding its monstrous balance sheet consisting of all those debt securities it bought from the banks. 

As regular readers know, we're seeing signs of inflation brewing below the surface that we believe will likely, well, surface in the not too distant future. 

The announcement following Wednesday's wrap up of the Fed's two-day policy meeting is likely to include language somewhat sympathetic (but muted with some compensatory soft commentary) to our view, along with a plan that will have the Fed reinvesting a few billion less of its balance sheet's interest and principal payments in the months to come.

Backing up a step: So why no inflation? Well, while the great Milton Friedman indeed said "inflation is always and everywhere a monetary phenomenon", there's more to the equation than simply money creation. The money has to go chasing stuff to push stuff prices higher. In fancy econ-speak they call it the "velocity of money", which is the rate in which money is exchanged for stuff within the economy. And there's where the Fed officials were really really smart. By simultaneously raising bank reserve requirements and paying interest on the excess, they, in effect, kept all that money from pushing into the system and pushing prices higher. And being such a massive buyer of bonds, they inspired the rest of the world to do the same, which, in the process, sent interest rates to history-of-the-world lows. Genius!

Today's message was inspired by a chapter in Sebastian Mallaby's fascinating accounting of the hedge fund industry titled More Money Than God, where he chronicles the amazing history of Renaissance Technologies -- a phenomenally successful hedge fund (averaged 39% per year between 1989 and 2006). Jim Simons, the fund's founder (retired in 2009), hired only non-economist, non-financial industry, mathematicians and scientists. He had absolutely no use for economic or market theory and conjecture. He was interested in the data and the data only. Otherwise, his investors may have fallen prey to the trading decisions of ideologues who allocated assets based on how they thought things ought to be, as opposed to how things actually were. Like the folks who -- back in March 2009 -- bought gold (up 42% since) and shunned stocks (up 270% since [S&P 500 Index]), because all that money creation ought to create runaway inflation and/or, again, mass financial destruction:
....the crucial early years at Renaissance were largely shaped by established cryptographers and translation programmers—experts who specialized in distinguishing fake ghosts from real ones. Robert Mercer echoes some of Wepsic’s wariness about false correlations: “If somebody came with a theory about how the phases of Venus influence markets, we would want a lot of evidence.” But he adds that “some signals that make no intuitive sense do indeed work.” Indeed, it is the nonintuitive signals that often prove the most lucrative for Renaissance. “The signals that we have been trading without interruption for fifteen years make no sense,” Mercer explains. “Otherwise someone else would have found them.”

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