One Hedge Fund CIO Is Shocked To Learn The Fed's Model Ignores "The Only Two Things That Matter"

Some Sunday thoughts from the CIO of One River Asset Management, whose latest Weekend Notes starts off in traditional Eric Peters style, namely a mockery of the Fed...

Wait, that’s not even part of your model?” asked the private sector, imagining itself in the presence of the Fed.


“You seriously don’t even consider the crushing weight of the pension avalanche that is bearing down on us?” And the governors shrugged.


“You don’t even take into consideration what’s happening in China?” Silence. “Do you even understand today’s world? You’re all so old, you’re from a different time.” They returned to their spreadsheets, moving dots around, what fun.


Pensions and China are the only two things that matter!” Silence. 


“Let me get this straight,” said the private sector, collecting its composure. “You’ve got this thing called China, and you don’t understand that?” The governors nodded.


“And you’ve got this other thing which is my pension liability, and you’re not modelling that?” Each nodded.


“And I’m supposed to have confidence in Fed policies?” asked the private sector. The governors put down their crayons, lifted their dot plots, displaying them proudly.


And the private sector quietly started selling its assets to buy Amazon stock, which has none of these problems.

... Continues with some additional thoughts on credit math...

“Look at it this way,” said the CIO. “If default risks are remote, and there’s a 3% return available in an asset class, investors will borrow money to buy those assets and arbitrage that 3% away.” Most assets in today’s world have an expected return of 3% or less, even negative.


“It should be obvious, but at this point in the cycle, with expected forward returns so low, you’re a complete prisoner to the cost of capital.” Early in a cycle that’s not the story. The arb between the cost of capital and expected returns is wider. Naturally, volatility is higher too. 


“Credit spreads reflect the cost of capital in an economy,” continued the same CIO. “And they are reflexive; meaning tighter spreads beget tighter spreads and vice versa.”


When spreads tighten dramatically, and remain there, you can be sure the arbitrage players drive asset prices higher, lowering the expected future returns. At that point, even a modest widening of spreads closes the arbitrage, and leaves asset prices with a shortage of buyers. “You don’t need yield curves to invert to spark a cycle. You just need rates to move high enough to kill the arb."


“Let’s say the average US corporate borrows at 150-200bps over 5yr Treasury yields,” explained the CIO. “Now imagine 5yr Treasuries are 2%.”


So the average corporation borrows at 3.50%-4.00%. “Now let’s say US nominal GDP is 3.5%.” Why would corporations borrow?


“Now, let’s imagine that people rightly assume that defaults will rise. Credit spreads can quickly rise to 400bps.” Which lifts the cost of borrowing to 6% (5yr Treasuries plus 400bps). The arb reverses. “That’s why default cycles are so dangerous for highly leveraged economies.”

... and ends with the topic least understood by the Fed, reflexivity:

“When employment cycles turn, they do so violently,” said the historian.


“The same is true of credit default cycles.” Our economic system is highly integrated. One man’s liability is another’s asset. One CFO’s payable is another’s receivable. It’s a global Ponzi scheme that works wonderfully until it doesn’t.


“One default ripples through the system - by definition – causing another default, and so on. Nothing exists in isolation. This is why credit cycles turn violently. And they feed back into the employment cycles, amplifying those too.” Reflexively.


johngaltfla BuddhistAescetic (not verified) Sun, 07/23/2017 - 17:28 Permalink

The funny thing is anyone has read Danielle DiMartino Booth's excellent book, Fed Up, one would discover the most obvious and terrifying fact of them all:The models are antiquated, fail to accept revisions with any regularity, and the economists on staff often use formulae which is dated theory and disproven by reality over 20 years ago.In other words America we are living in one giant shit sandwich economy and real soon, we're all going to have to take a bite of it.

In reply to by BuddhistAescetic (not verified)

Anteater Sun, 07/23/2017 - 16:12 Permalink

Come next April 15th, you will still need to pony up 1/3rd of your income:10% to the King, 10% to the Pope and 10% to the Sherif evictor/collector.The Fed is the adult in the room, compared to NYC bankbroker fraudsters.The Fed is the only thing that kept what's happening now, from happeningin 2008, when nobody was financially or emotionally ready for a holocaust.If you're not ready now, then you haven't been paying attention, have you? "You're gonna need a first-born child collateralized loan from all the winning!" Don the Con

gmak Anteater Sun, 07/23/2017 - 16:42 Permalink

Nobody expects the Financial Inquisition. But you know what? It's better to take the hit in the beginning than decades later. It would have been much better to let the system clear itself out and reset in 2000 - never mind 2008.   The FED will be the main driver responsible for the big crash coming. It's ludicrous to think that somehow GDP will grow (with shrinking population) at a rate to justify 8% expected future gains.  [Oh noes, say TPTB. Let the terrorists in to distract them all]

In reply to by Anteater

Creative_Destruct gmak Sun, 07/23/2017 - 18:10 Permalink

Exactly. Should have let the small economic "forrest fires" (small recessions, downturns) naturally clear out the flammable brush and dead wood.NO money pumping!!!We have not done that in, well, FOREVER.The economic underbrush and deadwood now accounts for more burnable mass than the viable economic "trees."And the inevitable (sooner or later) economic firestorm will be EPIC.We're just waitin' for the spark...

In reply to by gmak

NickyGall Sun, 07/23/2017 - 16:15 Permalink

Here is an article that looks at what governments will have to do to reduce the pension shortfall:… 
/* Style Definitions */
{mso-style-name:"Table Normal";
mso-padding-alt:0cm 5.4pt 0cm 5.4pt;
The looming pension issue is far from clear and, as the years pass and increasing numbers of baby boomers retire at the same time as the workforce shrinks, the pension funding issue will become increasingly difficult to resolve.

abgary1 Sun, 07/23/2017 - 16:51 Permalink

How is this any different than the neo-classical economists ignoring money and banking in their models?It's no wonder that the world is financially fucked!

CHoward Sun, 07/23/2017 - 17:13 Permalink

"They returned to their spreadsheets, moving dots around, what fun. The governors put down their crayons, lifted their dot plots, displaying them proudly." Hilarious!  

gdpetti Rick Cerone Sun, 07/23/2017 - 18:40 Permalink

You're talking about the 'sheep', right? to put in it biblical terms? We all start off as 'sheep', the quest is 'waking up' and seeing the BS all around us here in Purgatory... then see the need to choose sides in the battle.... see the Choice, make the Choice, empower that Choice.... that is the game. All of that 'flesh and blood' is the battleground... and it's always  messy.

In reply to by Rick Cerone

artichoke Sun, 07/23/2017 - 19:04 Permalink

I don't think the Fed should be taking away the punchbowl right now, but they're probably trying to make things hard for Trump.  If they tighten now, it could have an adverse effect in 2020 when he's running for reelection.  They want that.But on the other hand the article's argument has a problem too.  Do we really want the Fed trying to do fundamental economic analysis?  That failed when Ray Fair tried to build big macro models.  I am not sure we're any more able to do it now, although granted we do have better data mining methods and infinitely more compute power.

Centerist Sun, 07/23/2017 - 19:41 Permalink

The Fed issues capricious statements that correlate with nothing of substance in the real world.  On one day, they'll say that there is evidence of growth in [fill in the blank] and that they anticipate a need to raise interest rates by .00001 basis points at some point in the next 15-20 years.  On the very next day, they'll say that [fill in the blank] is stagnating/showing signs of contraction and that interest rates will need to remain steady for the foreseeable future.Those knuckleheads are shaking a magic 8-Ball every day and saying whatever appears in the window when they look at it.  They are officially of no further use and have proven why central planning will always fail.

platyops Sun, 07/23/2017 - 21:16 Permalink

America has been living off the profits of WWll. When we won that war, it in effect wiped out all competion.The 50's were wonderful. But now in 2017 we have lot's of cheap labor in poor countires. There are no jobs for the average American that pay a good wage. Not everyone can be a success any more in America.

roddy6667 platyops Mon, 07/24/2017 - 21:20 Permalink

Most people don't realize how WWII catapaulted America into the Number One position. The rest of the world had to rebuild their infrastructure. America got rich off that rebuilding. However, as soon as they had factories running again, they started making cheaper goods that were good quality. The first wave was the invasion of the Japanese cars in the Sixties. It hasn't stopped since then. America peaked financially back somewhere back in the mid-Sixties. Since then, it has been living on credit, borrowing from future generations. This was done on a Federal, state, and municipal, and personal  level. Now the repayment of debt is baked into the price of goods and services in the US, making it too expensive to compete worldwide. It's like a couple with a six-figure income that has two mortages, two car loans, massive credit card debt, college loans, and high property taxes. They don't have much left after they make all those debt payments. 

In reply to by platyops

Iskiab Mon, 07/24/2017 - 00:03 Permalink

The fed should be abolished. It doesn't matter if their models are junk, it's their purpose that's garbage.

Free markets and democracy work because it's constant revolution, that's the philosophy behind the constitution. Trying to manage the unmanageable just leads to further problems down the road.

When they bailed out the banks and started QE it was, arguably, well intentioned, but now it's created another problem. It bailed out failed businesses that should have folded, and kept assets in failing businesses that should have been reallocated. If the fed had just left it alone there would have been some chaos yes, but the us would have come out of it stronger.

Another BS thing the fed is doing is tightening 'in anticipation' of the job market tightening. No wonder wages haven't gone up in so long, the fed is trying to tighten before that stage in the recovery and skip it by raising interest rates and causing a recession.

JailBanksters Mon, 07/24/2017 - 00:16 Permalink

And all this time I thought the FEDS only model was to transfer all the wealth from the Goyim to the Jews.But that's not happening at all is it. And I'll bet Jon Corzine, Bernie Madoff would agree to that.

Charvo Mon, 07/24/2017 - 01:34 Permalink

When I think of the Fed, I think of 2 Feds.  One would be the Obama Fed which is the current one.  Then there's the Trump Fed coming next year.  Why wouldn't this Fed want to max out the rate hikes now?  Everyone knows Gary Cohn is going to be a dove.  That's not even a question.  It's a fact.  This is why the market is anticipating dollar destruction coming next year.  Big money is moving into different currencies besides the dollar.  I think Yellen and the current Fed will be hawkish with their statements this week.  Look at the dollar index.  It's tanking.  A dovish statement would send the euro to 1.20 in a heartbeat.

what happened Mon, 07/24/2017 - 09:30 Permalink

During the impending pension crisis, you will see citizen against citizen.  Those who have funded their 401K and are now asked to pay more taxes to fund pensions.  Some pensions are over 300,000 per year.  We need to take a look at excessive pensions.  I have seen teachers try to wrestle funds from the special education department, DCF turn their back on children so a profit is made on them, aggressive ticketing by police to make up revenue.  It is a bigger problem because those in state and federal government all get pensions and a comprehensive health package.  Non government employees will have their backs broken in taxes, the disabled will lose their benefits, the poor will be further marginalized and the rich will be called upon for more.