Streetwise Professor

August 3, 2015

Adding to Atlas’s Burden: The EPA’s CO2 Rule

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 6:41 pm

Acting under the aegis of its most malign agency, the EPA, in its unbending effort to hamstring the US economy, the Obama administration today released its long dreaded CO2 rule. The Rule mandates a 32 percent decrease in CO2 emissions by 2030. This outcome will be achieved by a dramatic reduction in the use of coal powered generation, and its replacement by renewables.

The administration touts its generosity by pointing out that compliance with the Rule has been extended by 2 years.

Great. We get screwed in 7 years, instead of just 5. Gee. Thanks. How thoughtful. You really shouldn’t have.

The Rule is tarted up with a cost-benefit analysis which purports to show massive benefits and modest costs. The benefit is in the form of improved health, in particular through the reduction in respiratory ailments.

But every step of this analysis is literally incredible. Consider the steps. First is an estimate of how the regulation affects climate. The second is an estimate of how climate affects health. The third is an estimate of the value of these health benefits. None of these calculations is remotely plausible, or even is it plausible that they can be made realistically, given the incredible complexity of climate and health.

And note the bait and switch here. The Rule is touted as a solution to the Phenomenon Once Known As Global Warming. But the Rule itself admits that the effect on temperature will be point zero one eight degrees centigrade by 2100. This is effectively zero, meaning that the “Climate Change” benefit of the Rule is zero.

The health benefits come from reductions in particulates from coal generating plants. So why not regulate particulates specifically?

This all points out that cost benefit analysis for large federal rules is basically Kabuki theater. Some laws require this analysis, but since courts give so much deference (under Chevron) to agencies, that this analysis is not subject to any serious scrutiny. Consequently, the process is ritual, not a serious check on agency discretion.

The Rule is grotesquely inefficient even if you believe this Making Shit Up And Calling it Science!® “cost-benefit analysis.” An efficient rule would achieve its results at lowest cost. But the command-and-control EPA rule does not do this.

Originally, the Rule was expected to lead to a substitution of natural gas for coal. But we can’t have that, can we, given that natural gas is a fossil fuel (even if Nancy Pelosi doesn’t think so)? So the current rule encourages the use of renewables.

The economics of renewables (especially wind) are atrocious. They are intermittent and diffuse. Intermittency strains reliability, and requires maintaining backup generation. Germany (and other countries, including Spain) have gone all in on renewables, and it has been a disaster. Energiewende has saddled Germany with high costs and lower quality power that has imposed great costs on German manufacturing. (Fluctuations in wind and sunlight induce fluctuations in frequency that wreak havoc with precision manufacturing processes.) California is already on the verge of reliability problems when the sun sets during winter months due to a sudden drop in solar generation (aka the swan problem) that requires a sudden ramp up of conventional generation: but the supply of solar during daylight hours undermines the economics of conventional generation. Wind power in Texas is leading to frequent bouts of negative prices which reduce the profitability of conventional generation necessary to maintain reliability.

The Rule acknowledges reliability issues, but the response is totally inadequate:

[T]he rule requires states to address reliability in their state plans. The final rule also provides a “reliability safety valve” to address any reliability challenges that arise on a case-by-case basis.

That’s just great. EPA says: “Yeah, we know renewables create reliability issues. Not our problem! You figure it out, states.” Note that this is problematic because the electrical grid is interconnected, meaning that retiring a coal plant in one state can have serious effects on reliability in numerous other states. So how do individual state plans efficiently address these inherently interstate issues? And as for the “safety valve”, the case-by-case analysis is likely to be cumbersome and costly.

Let’s get down to cases. By its own calculations, the proposed Rule will have a risible effect on global temperature. Therefore, there is no cost benefit justification for the control of CO2 per se, the ostensible purpose of the rule. If there are substantial benefits from reducing particulate emissions, then tax these emissions at a rate commensurate with these costs and let utilities and others find the most economical way of complying.

But that’s not the point, is it? Obama and the EPA don’t want efficiency. They have an intense ideological animus against fossil fuels, and a romantic attachment to renewables: many of the Democrats’ largest donors are have a strong investment in renewables. Pigouvian approaches would likely result in the failure to litter the landscape with bird blending windmills and massive solar panels, so they prefer command and control approaches instead.

And did I mention that Obama insinuated that if you oppose the Rule you are racist?

This new Rule is a piece with the last 6 plus years of grotesquely inefficient legislation and regulations. Frankendodd. Obamacare. Net Neutrality. Each of these add huge amounts of new weight that the Atlas of the American economy must bear. An economy subjected to such burdens will survive, but it will not thrive. The EPA’s new Rule will provide no meaningful benefit, and any benefits that it does generate will be gained at excessive cost. But that is the Obama way. That is the leftist way.

 

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August 2, 2015

They Are Spinning in Valhalla

Filed under: History — The Professor @ 3:56 pm

In June I visited Stockholm, and was able to fit in a trip to the Swedish history museum. I was quite interested in viewing the Viking exhibit, but was rather aghast when I did. First, the signage disclaimed any Swedish responsibility for the Vikings: “Vikings were not Swedes.” Whatever. Second, another sign claimed  “the Vikings were peaceful.” I’m sure the monks at Lindisfarme and myriad other English monastaries, the inhabitants of any navigable river from the Baltic to the Mediterranean, etc., would beg to differ. And those Sagas. So peaceful! But the best was what a tourguide said: “The Vikings were inclusive people who treated everyone equally.” Sure they were! Talk about anachronism. Who knew the Vikings (who weren’t Swedes!) personified postmodern Swedish values. (But if they did, why the haste to deny that Vikings were Swedes? A little cognitive dissonance?)

To put an exclamation point on how far the people who reside in the country now called Sweden have changed since the 8th century, consider this: “Nine ways to become a truly Swedish man.” At least those 9 ways don’t involve peeing while sitting, which is a subject of raging debate in Germany. So there’s that.

Thank God-or would it be Odin?-that my ancestors got on the boat in the mid-19th century. And if the Swedes are denying they are Vikings, I’m pretty sure the residents of Valhalla are now willing to agree.

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July 30, 2015

Perfidious America: The Allegedly Anti-ISIS Turkish Campaign is Objectively Pro-ISIS.

Filed under: History,Military,Politics — The Professor @ 1:42 pm

Last week the administration breathlessly announced that it had secured Turkey’s participation in the anti-ISIS campaign. This would entail Turkish airstrikes against ISIS positions, and Turkey granting the US use of Incirlik and other airbases for strike and drone aircraft. The straw that supposedly broke the camel’s back was an ISIS suicide bombing of a Kurdish protest on the Turkey-Syria border (by people wanting to cross to Kobane to help in reconstruction) and the subsequent killing of two Turkish policemen by Kurds who blamed Turkey for the bombing.

With great fanfare, Turkey launched an airstrike against ISIS. And then it has spent the last week bombing the snot out of Kurdish PKK positions in Iraq. If Turkey has engaged in further attacks against ISIS, I haven’t seen it reported, whereas there Turkey has attacked Kurdish positions on a daily basis. Nor do I believe that an extensive campaign would be possible without close coordination between the US and Turkey to avoid fratricide, mid-air collisions, etc., if their forces are operating in the same airspace against the same targets. And as I discuss below, it is unlikely such coordination is occurring.

In sum, under the pretext of attacking ISIS Turkey is attacking its real enemy, the Kurds, who happen to be the only effective ground force against ISIS, and who in addition to pushing them out of Kobane have been taking territory from ISIS and pushing it back towards Raqqa. Indeed, the Kurds have pushed ISIS away from virtually all of the Syria-Turkey border. But in addition to inflicting damage on the Kurds, the Turkish attacks will also no doubt divert Kurdish resources into a renewed war against Turkey, thereby further diminishing pressure on ISIS.

Put differently, the allegedly anti-ISIS Turkish campaign is objectively pro-ISIS.

This is not surprising, because Turkey has always perceived the Kurds-especially the PKK-as a true enemy, and has hardly been stalwart anti-ISIS. Indeed, there is much circumstantial evidence that elements in Turkey support ISIS. Turkey did precious little to seal the border with Syria, thereby allowing ISIS to move men from Turkey into Syria. Furthermore, most of ISIS’s oil is sold in Turkey. Turkey says that the PKK are atheist Marxists, but it is more accurate to say that the real beef is that they are not Sunni Islamists like Erdogan, which means that he has more affinity on sectarian grounds for ISIS than he does the Kurds.

Today Egypt went even further, explicitly accusing Turkey of supporting ISIS fighters in the Sinai.

But it gets better! The supposed deal between the US and Turkey for the use of airbases is only a verbal understanding. And we know about the reliability of verbal understandings in that part of the world, don’t we?  (This is why I doubt there is any serious coordination between US and Turkish air forces, and why I believe that there is no serious Turkish action against ISIS.)

Further, no formal deal is expected for weeks:

But the Pentagon said it will take “weeks” before U.S. airstrikes are launched from Turkish soil, as officials are still working out final arrangements. Pentagon spokesman Navy Capt. Jeff Davis told reporters Monday that several bases were being looked at to house U.S. aircraft for missions against the Islamic State.

My guess is that “weeks” will turn into “never.” Erdogan, engaged in an intense domestic political battle following his bruising electoral defeat (to which a Kurdish party greatly contributed) is waging war on the PKK both because he hates them and because it plays well domestically, thereby boosting his position in coalition negotiations or a snap election. He will string out negotiations with the US until he accomplishes his political objectives, and then his enthusiasm for letting the US use Turkish bases will evaporate. Erdogan dangled supporting the US against ISIS to get a US (and NATO) green light to attack the Kurds: he will take the latter and renege on the former.

Even if, against my strong expectation, Turkey does permit US use of its bases, this will matter militarily only if the airpower supports and is coordinated with a strong ground force. At present, the only real ground force is Kurdish, and (a) Turkey is attacking the Kurds and (b) do you really think Erdogan is going to permit the use of the bases in a way that strengthens the Kurds? This is all so farcical.

This is not the first time the US has betrayed the Kurds: it has been a habit for going on 30 years. But this most recent action, betraying them again in the name of fighting ISIS, when in fact this betrayal will undermine the anti-ISIS campaign, is the most shameful of all.

Turkey has been opposed to US interests since Erdogan’s assumption of power. It has thwarted us at every turn. Only a fool would believe Erdogan (one of the leaders whom Obama said he got on best with-ha!) has changed his tune. I will certainly not discount the possibility that Obama and Kerry are fools of the first order, but I think it is more likely that this is a truly cynical ploy, with Obama pretending to have achieved a great diplomatic victory that advances the campaign against ISIS, when in fact it does nothing of the sort (and indeed is likely to do the exact opposite).

Idiocy or perfidy. Hell of a choice.

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July 22, 2015

Glimpses of Military Discontent

Filed under: Military,Politics — The Professor @ 7:58 pm

I have long been certain that there is seething discontent within the Pentagon, directed squarely at Obama. The past several days have made this abundantly clear.

The most brutal takedown was by retiring Army Chief of Staff General Ray Odierno. This certified warrior squarely blames Obama’s Iraq bugout for the rise of Isis. Further, he pointed out Iran’s malign role in the Middle East. He agreed that Iran, and the truly evil Qasem Soleimani in particular (who was un-sanctioned as a result of the Iran deal), were responsible for the bulk of American deaths in Iraq in 2007-2009.

Further, two generals (including the nominee to be Odierno’s replacement) and the Secretary of the Air Force gave testimony before the Senate which squarely undercuts Obama policy. Each identified Russia as the US’s primary threat: one referred to it as an “existential” threat. As if to emphasize that this was off-message, spokesnimrod Josh Earnest said that no one on Obama’s national security staff believes this. This is no doubt true. So much the worse for them.

One of the generals (Milley, I believe) supported arming Ukraine. The testimony also indicated that deploying tactical air controllers to Iraq was advisable. Also not on the Obama agenda.

And note: these are the people that Obama has selected for the top positions in the military. Just think of what those who couldn’t make it through the political filter are saying and thinking.

I am not saying that there is a crisis in civil-military relations under Obama, but it is pretty clear that these relations are in the worst shape in modern memory. What Odierno and the others are saying is likely just a pale shadow of the extreme discontent in the military at their commander in chief.

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Vlad’s Pivot to Oblivion

Filed under: China,Commodities,Economics,Energy,Politics,Russia — The Professor @ 7:09 pm

This story is a Sino-Russian twofer:

The contract between Russia and China for gas supplied via the western route known as Power of Siberia-2 is being delayed indefinitely, Vedomosti cited Russian officials. They say China is reviewing its energy needs due to the economic slowdown.

The demand growth for gas in China is slowing, at the same time access to liquefied natural gas (LNG) is becoming more available in the country, for example from Australia, due to the fall in oil prices, Sberbank CIB analyst Valery Nesterov told Vedomosti on Wednesday.

Repeat after me: Gazprom finalizes about one out of a hundred of the vapor deals it announces. This is especially true where China is involved.

There are three basic problems. First, the pipeline is expensive, primarily because the Russians insist on building it. After all, how else could they tunnel out money? And if they can’t tunnel out money, what the hell is Gazprom good for?

“Gazprom offers CNPC a high price, explaining this by the high cost of the Power of Siberia – 2 construction. China is ready to build the pipeline at a cheaper cost and at public tender, so its companies could participate and for the construction price to be transparent,” the president of the Russia-China analytical center Sergei Sanakoyev said.

Second, the pipeline would go to the western part of China, which is convenient for Gazprom, but it isn’t where China needs the gas.

Third, China doesn’t need as much gas period, because (a) new (LNG) supply is coming on line in Australia, and (b) despite the happy talk of official statistics, every indication is that the Chinese economy is slowing:

The demand growth for gas in China is slowing, at the same time access to liquefied natural gas (LNG) is becoming more available in the country, for example from Australia, due to the fall in oil prices, Sberbank CIB analyst Valery Nesterov told Vedomosti on Wednesday.

So how’s that pivot to Asia working out, Vladimir? Timing is everything in life, and Putin is counting on China precisely when China has its own issues to deal with. If China was continuing to power forward, Putin’s pivot would have turned him into China’s pilot fish. Now even being a pilot fish looks out of reach.

To all those who hyperventilated at the announcements of huge Sino-Russian gas deals: when will you people learn to discount virtually anything Gazprom says down to just above zero? That’s especially true when there was a huge political reason for Putin to hype such a deal. I guess suckers never learn.

The second part of the twofer here is the further evidence it provides of China’s economic troubles. Look at the commodity carnage going around: oil, copper, iron ore, gold, platinum, you name it are in the dumper. China put them there. This is just another pixel in the image.

 

 

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July 21, 2015

The Fifth Year of the Frankendodd Life Sentence

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 7:52 pm

Today is Frankendodd’s fifth birthday. Hardly time for celebration. It is probably more appropriate to say that this is the fifth year in the Frankendodd life sentence.

So where do we stand?

The clearing mandate is in force, and a large fraction of derivatives, especially interest rate and credit index derivatives are cleared. This was intended to reduce systemic risk, and as I’ve written since before the law was passed and signed, this was a chimerical goal. Indeed, in my view the systemic risk effects of the mandate are at best a push (merely shifting around the source of systemic risk), and at worse the net effects of the mandate are negative.

Belatedly regulators are coming around to the recognition of the risks posed by CCPs. They understand that CCPs have concentrated risk, and hence the failure of one of these entities would be catastrophic. So there is a frenzy of activity to try to make CCPs less likely to fail, and to ensure their rapid recovery in the event of problems. Janet Yellen has spoken on the subject, as has the head of the Office of Financial Research, Robert Dudley of the NY Fed, and numerous European regulators. Efforts are underway in the US, Europe, and Asia to increase CCP resources, and craft recovery and resolution procedures.

This is an improvement, I guess, over the KoolAid quaffing enthusiasm for the curative effects of CCPs that virtually all regulators indulged in post-crisis. But it distinctly reminds me of people madly sewing parachutes after the rather dodgy plane has taken off.

Further, these efforts miss a very major point. The main source of systemic risk from the clearing mandate derives from the huge liquidity strains that clearing (notably variation margin on a rigid time schedule) will create when the market is stressed. There has been some attention to ensuring CCPs have access to liquidity in the event of a default, but that’s not the real issue either. The real issue is funding large margin calls during a crisis.

Moreover, as I’ve also discussed, efforts to make CCPs more resilient can increase pressures elsewhere in the financial system (the “levee effect.”) Relatedly, regulators have not fully come to grips with the redistributive aspects of clearing–including in particular how netting, which they adore, can just relocate systemic risks.

I therefore stand by my prediction that a regulation-inflated clearing system will the source of the next systemic crisis.

Moving on, I called the SEF mandate the worst of Dodd-Frank. In the US, the majority of swap trades are done on SEFs, though mainly through RFQs rather than the central limit order books that Barney and Co. dreamed about in 2010.

There was never a remotely plausible systemic risk reducing rationale for the SEF mandate. Hence, if SEFs are inefficient ways to execute transactions, the mandate is all pain, no gain. As an indication of that this is indeed the case, note that virtually all European banks and end users stopped trading Euro-denominated swaps with US counterparties exactly when the mandate kicked in. The swaps mandate was too onerous, and anyone who could escape it did.

In a piece in Risk, I referred to the Made Available to Trade part of the SEF mandate the worst of the worst of Dodd-Frank. It made no sense to force all market participants to trade a particular kind of swap on SEFs just because one SEF decided to list it. Apparently that realization is slowly sinking in. The CFTC recently held a meeting on the MAT issue, and it seems as if there is a good chance that the CFTC will eventually determine what has to be traded on SEFs.

It is an indication of my loathing for MAT as it currently exists that I consider that an improvement.

Still moving on, Frankendodd was intended to reduce concentration and interconnectedness in the financial system. The actual result cannot really be called a mere unintended consequence: it was the exact opposite of the intended effect. Completely predictably (and predicted) the huge regulatory overhead increased concentration rather than reduced it. This is particularly true with respect to clearing. Gary Gensler’s dream of letting a thousand clearing firms bloom has turned into a nightmare, in which the clearing business is concentrated in a handful of big financial institutions, exacerbating too big to fail problems. And clearing has turned out to be the Mother of All Interconnections, because every big financial institution is connected to all big CCPs, and because pretty much everyone has to funnel the bulk of their derivatives trades through clearinghouses.

I could go on. Let me just re-iterate another risk of Frankendodd: standardization–the regulators’ fetish–is  a major source of systemic risk. Monocultures are particularly vulnerable to catastrophic failure, and the international regulatory standardization that was birthed in Pittsburg in 2009, and enacted in Frankendodd and MiFID and Emir, has created a regulatory monoculture. Some are grasping the implications of this. But too few, and not the right people.

I’ve focused here on the sins of commission. But there are also the sins of omission. Frankendodd did nothing about the Fannie and Freddie monster, which is coming back from the dead. F&F was a real systemic risk, but the same political dynamic that fed it in the 1990s and pre-2008 is at work again. Get ready for a repeat.

Frankendodd should have just focused on raising capital requirements for banks and other financial institutions with liquidity and maturity mismatches, and driven a stake through Fannie and Freddie. Instead, it sought to impose a detailed engineered solution on an emergent order. This inevitably ends badly.

So maybe it would be more accurate to say that we’re in our fifth year on death row. Someday the warden will come knocking.

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Perhaps There is an Alternate Universe Where This All Makes Sense

Filed under: History,Military,Politics — The Professor @ 6:45 pm

The US has entered into  deal with Iran that will unfreeze $100 to $15o billion in assets, and which will also unleash an investment bonanza in the country going forward. (With unseemly haste, the German vice chancellor has already run to Tehran to rekindle economic ties.) Iran is a longtime supporter of Hezbollah and the Syrian government, and all sentient beings (and by saying this I understand I exclude John Kerry and Barack Obama) realize that Iran will spend some of this windfall on Hezbollah, Syria, and other equally charming organizations and countries. Indeed, Iran has made plain that it will do so:

In relevant remarks on Monday, renowned political analyst Dr. Mohammad Marandi said that Iranian Foreign Minister Mohammad Javad Zarif told him in Vienna last week that Iran would continue to supply arms to the regional nations even under a final nuclear deal.

“When we were in Vienna, the Arab reporters asked me if Iran would continue arms aids to its regional allies under the final deal, and when I asked Mr. Zarif, the Iranian foreign minister, the question, he told me that Iran would continue the arms supply policy,” Marandi, a Tehran University Professor, said.

“Mr. Zarif told me that Iran would continue its arms aid to the regional nations and he told me that it would be in violation of the UN Security Council resolution (that was adopted earlier today), but it would not be in opposition to the agreement (also known as the Comprehensive Joint Plan of Action),” he reiterated adding that Zarif had not asked him to remain unnamed when reflecting the answer to the reporters.

Simultaneously, however, the US is sanctioning Hezbollah officials for their involvement in the Syrian bloodbath:

The U.S. government on Tuesday imposed sanctions on three leaders of the militant group Hezbollah and a businessman in Lebanon, saying they were key players in the group’s military operations in Syria.

The sanctions were imposed by the U.S. Treasury Department.

“The United States will continue to aggressively target (Hezbollah) for its terrorist activities worldwide as well as its ongoing support to (Syrian President Bashar al-) Assad’s ruthless military campaign in Syria,” said Adam Szubin, the Treasury Department’s acting under secretary for terrorism and financial intelligence.

Jesus H. Christ: Who is the biggest supporter of “Assad’s ruthless military campaign in Syria”? Iran! So we are freeing billions to a country that will use it to support Assad’s butchery but we are sanctioning Hezbollah (which is pretty much a wholly-owned Iranian subsidiary) because it supports Assad’s butchery.

You cannot make up this stuff. It is impossible.

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July 18, 2015

Nothing Says Panic Quite Like Three TARPs

Filed under: China,Economics,Energy,Politics,Regulation — The Professor @ 3:41 pm

The invaluable Christopher Balding has been tracking closely the massive financial support the Chinese government has been injecting into the banking system, the shadow banking system, local governments, and the stock market. In a blog post earlier this week, he estimated that this support totaled at least $692 billion, rising to $933 billion if the Reserve Ratio cut is counted as a subsidy to the banking system.

These funds went to the local government bond program I wrote about in June, an  investment in pension funds, PBOC 6 month loans to banks, and PBOC loans to the Chinese Securities Financing Corporation, which in turn will lend these funds to buy stock on margin.

But it’s hard to keep up! Christopher kindly shared with me his most recent calculation, which shows that the Chinese government keeps pumping in the money, most notably an additional $200 billion in loans to intermediaries who will use these funds for margin lending, and a rumored (but not yet confirmed) $160 billion in additional support for provincial municipal bonds. This brings the total to $1.3 trillion.

In RMB, that totals over 8 trillion (with a “t”, boys and girls). To Sinofy Evertt Dirksen: A trillion here and a trillion there, and pretty soon you are talking real money.

Another metric: $1.3 trillion is approximately three TARPs. Maybe we should start using that as a new unit of measurement, as in, “Chinese authorities intervened in the market and banking system today, providing an additional .5 TARPs in state funding.”

Yet another metric: $1.3 trillion is almost exactly $1000 per Chinese citizen. TARP was about $1500 per American. But China’s per capita GDP is (depending on whether you use exchange rates or PPP) about 1/5th or 1/7th of US GDP per capita. Thus, a low middle income country is spending roughly 3 to 5 times more per person as a percentage of per capita income than the high income US did. (Given that Chinese GDP is likely overstated-another issue that Christopher has analyzed in detail-the true multiples are even higher.)

Such massive spending-arguably the most gargantuan stimulus package ever-is not the sign of a confident leadership. It is a clear sign of panic.

Remember the extreme panic in DC and Wall Street in the post-Lehman period that culminated with TARP? Even in that hysterical environment, people questioned the need for and advisability of TARP. But in the end panic won out. That is the only reason TARP passed: people were scared stiff at what would happen if it didn’t.

Now think of how panicked the Chinese must be to implement measures that dwarf TARP. That’s what economists call revealed preference. Or, in this instance, revealed panic.

This gives the lie to official statistics, which showed a (patently unbelievable even absent this massive stimulus) .1 percentage point decline in the growth rate. Also giving the lie to the official statistics is the collapse in China-driven commodity prices, notably iron ore and coal, and oil as well. The slowdown in commodity economies further discredits the official Chinese data.

The Chinese stock market is getting most of the attention. This is the drunk-looking-under-the-streetlamp-for-his-keys phenomenon. The stock market is visible, and people can relate to it: this is why the government is using massive carrots (notably the support for margin lending) and even bigger sticks to try to arrest the decline. This would suppress the most visible manifestation of crisis. But the real dangers are lurking out of sight, in the leveraged sector (most notably the rats’ nest of non-bank lenders, but the banks are concealing a lot too), SOEs, and a real economy whose performance is masked by dodgy official statistics.

I’ve long referred to China as the Michael Jackson Economy, kept going by intense dosages of economic/financial drugs, cosmetic surgeries, and stimulants. The Chinese authorities are now administering the biggest dosages ever. This is an indication that the patient is doing quite badly. Further, although such actions may delay the inevitable, they make the end all the more horrific.

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July 15, 2015

The Joint Report on the Treasury Spike: Unanswered Questions, and You Can’t Stand in the Same River Twice

Filed under: Derivatives,Economics,HFT,Regulation — The Professor @ 11:39 am

The Treasury, Fed (Board of Governors and NYFed), SEC, and CFTC released a joint report on the short-lived spike in Treasury prices on 15 October, 2014. The report does a credible job laying out what happened, based on a deep dive into the high frequency data. But it does not answer the most interesting questions.

One thing of note, which shouldn’t really need mentioning, but does, is the report’s documentation of the diversity of algorithmic/high frequency trading carried out by what the report refers to as PTFs, or proprietary trading firms. This diversity is illustrated by the fact that these firms were both the largest passive suppliers of liquidity and the largest aggressive takers of liquidity during the October “event.” Indeed, the report documents the diversity within individual PTFs: there was considerable “self-trading,” whereby a particular PTF was on both sides of a trade. Meaning presumably that these PTFs had both aggressive and passive algos working simultaneously. So talking about “HFT” as some single, homogeneous thing is radically oversimplistic and misleading.

But let’s cut to the chase: Whodunnit? The report’s answer?: It’s complicated. The report says there was no single cause (e.g., a fat finger problem or whale trader).

This should not be surprising. In emergent orders, which financial markets are, large changes can occur in response to small (and indeed, very small) shocks: these systems can go non-linear. Complex feedbacks make attribution of cause impossible.  Although there is much chin-pulling (both in the report, and more generally) about the impact of technology and changes in market structure, the fundamental sources of feedback, and the types of participants in the ecosystem, are largely independent of technology.

Insofar as the events of 15 October are concerned, the report documents a substantial decline in market depth on both the futures market, and the main cash Treasury platforms (BrokerTec and eSpeed) in the hour following the release of the retail sales report. The decline in depth was due to PTFs reducing the size (but not the price) of their limit orders, and banks/dealers widening their quotes. Then, starting about 0930, there was a substantial order imbalance to the buy side on the futures: this initial order imbalance was driven primarily by banks/dealers. About 3 minutes later, aggressive PTFs kicked in on the buy side on both futures and the cash platforms.  Buying pressure peaked around 0939, and then both aggressive PTFs and the banks/dealers switched to the sell side. Prices rose when aggressors bought, and fell when they sold.

None of this is particularly surprising, but the report begs the most important questions. In particular, what caused the acute decline in depth in the hour leading up to the big price movement, and what triggered the surge in buy orders?

The first conjecture that comes to mind is related to informed trading and adverse selection. For some reason, PTFs (or more accurately, their algos) in particular apparently detected an increase in the toxicity of order flow, or observed some other information that implied that adverse selection risk was increasing, and they reduced their quote sizes to reduce the risk of being picked off.

Did order flow become more toxic in the roughly hour-long period following the release of the retail number? The report does not investigate that issue, which is unfortunate. Since liquidity declines were also marked in the minutes before the Flash Crash, it is imperative to have a better understanding of what drives these declines. There are metrics of toxicity (i.e., order flow informativeness). Liquidity suppliers (including HFT) monitor it in real time.  Understanding these events requires an analysis of whether variations in toxicity drive variations in liquidity, and in particular marked declines in depth.

Private information could also explain a surge in order imbalances. Those with private information would be the aggressors on the side of the net imbalance. In this case, the first indication of an imbalance is in the futures, and comes from the banks and asset managers. PTF net buying kicks in a few minutes later, suggesting they were extracting information from the banks’ and asset managers’ trading.

This raises the question: what was the private information, and what was the source of that information?

One problem with the asymmetric information story is the rapid reversal of the price movement. Informed trades have persistent effects. I’ve even seen in the data from some episodes that arguably manipulative (and hence uninformed) trades that could not be identified as such had persistent price impacts. So did new information arrive that led the buyers to start selling?

A potentially more problematic explanation of events (and I am just throwing out a hypothesis here) is that increased order flow toxicity due to informed trading eroded liquidity, and this created the conditions in which pernicious algorithms could thrive. For instance, momentum triggering (and momentum following) algorithms could have a bigger impact when the market lacks depth, as then smallish imbalances can move prices substantially, which then triggers trend following. When prices get sufficiently out of line, these algos might turn off or switch directions, or other contrarian algorithms might kick in.

These questions cannot be answered without knowing the algorithms, on both the passive and aggressive sides. What information did they have, and how did they react to it? Right now, we are just seeing their shadows. To understand the full chronology here–the decline in depth/liquidity, the surge in order imbalances from banks/dealers around 0930, the following surge in aggressive PTF buying, and the reversal in signed net order flow–it is necessary to understand in detail the entire algo ecosystem. We obviously don’t understand it, and likely never will.

Even if it was possible to go back and get a granular understanding of the algorithms and their interactions, this would be of limited utility going forward because the emergent ecosystem evolves continuously and rapidly. Indeed, no doubt the PTFs and banks carried out their own forensic analyses of the events of 15 October, and changed their algorithms accordingly. This means that even if we knew the  causal connections and feedbacks that produced the abrupt movement and reversal in Treasury prices, that knowledge will not really permit anticipation of future episodes, as the event itself will have changed the system, its connections, and its feedbacks. Further, independent of the effect of 15 October, the system will have evolved in the past 9 months. Given the dependence of the behavior of such systems on their very fine details, the system will behave differently today than it did then.

In sum, the joint report provides some useful information on what happened on 15 October, 2014, but it leaves the most important questions unanswered. What’s more, the answers regarding this one event would likely be only modestly informative going forward because that very event likely caused the system to change. Pace Heraclitus, when it comes to financial markets, “You cannot step twice into the same river; for other waters are continually flowing in.”

 

 

 

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July 13, 2015

Chronicles of Hillary, Book the First: Kabuki, Not Conviction

Filed under: Commodities,Economics,Politics — The Professor @ 7:16 pm

This is, alas, likely to be a long running saga, hence the title: if we are lucky, the chronicles will end no later than 16 months from now. We can only hope.

Today Hillary gave a Big Speech on the economy. She channeled her inner Elizabeth Warren, and blasted Wall Street, big banks, hedge funds, short-termism and other easy targets.

You knew it was Kabuki, not conviction, from the very first: Hillary was introduced for her bankster bashing speech by leading bankster Lloyd Blankstein of Goldman Sachs. If Blankfein was truly threatened by Hillary, he wouldn’t have been embracing her, literally.

And of course, for all of Hillary’s leftist red meat, she has long been quite intimate with Wall Street. She has long milked The Street for campaign contributions and other boodle like it was a prize holstein. Most notably, Hillary was a very solicitous junior senator from NY, and in exchange for very generous financial support, she did Wall Street’s bidding. No Warren-esque rhetoric then, in those halcyon pre-Crisis years.

Further, Hillary has personal experience with hedge funds. Her son-in-law (about whom she presumably corresponded on her secret server in now-deleted emails) runs a hedge fund. More tellingly, Hillary held a million dollar investment in a hedge fund which just so happened to short medical stocks while she was on the campaign trail blasting the pharmaceutical industry and promising thoroughgoing health care reform. In other words, Hillary was an investor in hedge funds before she was against them.

Hillary declaimed today against Too Big to Fail. I guess I will have to give her a pass on this: her experience  is with small, crooked, insolvent ditchwater S&Ls in Dogpatch, not big banks in Gotham.

 

And insofar as short-termism is concerned, who can forget the Miracle of the Cattle Futures, in which Hillary turned some short-term profits totaling around $100 grand, based (in her telling) on her discerning reading of the WSJ? Which has always had crappy commodities coverage.

Hillary, in other words, is wildly implausible as an anti-Wall Street crusader. It is transparently the case that this is something that polls well, especially among Democratic primary voters, so she will play that part.

Hillary’s complementary theme is that she will fight for middle America. Yet more kabuki. You know Hillary detests her middle class upbringing in Park Ridge, IL, and has spent her entire life distancing herself from it. The years in Arkansas were like purgatory. Whenever Hillary subjects herself to the actual presence of middle class Americans, it is plainly evident that she would much rather be undergoing a root canal, but for the fact that a root canal won’t advance her vaulting political ambitions. The trials she endures!

Insofar as policy is concerned, Hillary served up a dog’s breakfast of tedious progressive proposals. The most amusing of these was a swipe at Uber and Airbnb, further evidence that alleged progressives are actually the enemies of disruptive technologies that undermine (politically-connected) incumbents: they are the party of stasis, not progress. (The losers from Uber are not working stiff cabbies, who make their reservation wage, but the owners of government-rationed taxi medallions.) She also paid obeisance to the sacred cow of “infrastructure,” advocating the creation of an infrastructure bank (which would direct resources to the politically connected rather than the economically productive). She also had a flashback to the 60s-70s infatuation with corporate profit sharing, which she said her administration would “encourage.” If profit sharing is indeed mutually beneficial, Hillary’s encouragement is hardly needed. If it isn’t, such encouragement would be detrimental.

All in all, a paint-by-progressive-numbers performance intended to shore up her left flank. It was classic Hillary-banal, and as authentic as Velveeta.

And just think, we have at least a year to put up with the tripe. Just pray its not 5 plus-or 9 plus-years.

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