Tails of the unexpected
Must read paper on risk, nerds and the unexpected tails. Great insights by BOE’s Andrew Haldane.
For almost a century, the world of economics and finance has been dominated by randomness. Much of modern economic theory describes behaviour by a random walk, whether financial behaviour such as asset prices (Cochrane (2001)) or economic behaviour such as consumption (Hall (1978)). Much of modern econometric theory is likewise underpinned by the assumption of randomness in variables and estimated error terms (Hayashi (2000)). But as Nassim Taleb reminded us, it is possible to be Fooled by Randomness (Taleb (2001)). For Taleb, the origin of this mistake was the ubiquity in economics and finance of a particular way of describing the distribution of possible real world outcomes. For non-nerds, this distribution is often called the bell-curve. For nerds, it is the normal distribution. For nerds who like to show-off, the distribution is Gaussian. The normal distribution provides a beguilingly simple description of the world. Outcomes lie symmetrically around the mean, with a probability that steadily decays. It is well-known that repeated games of chance deliver random outcomes in line with this distribution: tosses of a fair coin, sampling of coloured balls from a jam-jar, bets on a lottery number, games of paper/scissors/stone. Or have you been fooled by randomness? Continue reading
Spain needs more than (a small) bank bail out
As we wrote earlier today, six months ago, one year ago etc, Spain is in much deeper problems than people realize. The (insufficient) bail out today is just another desperate PR trick by the politicians. Spain needs more than a small bail out. Remember, the unemployment is hitting new highs, and there is a lost generation (youth unemployment is currently at 55%). The real problems need to be adressed in order to fix Europe. The real fix won’t involve the EFSF, ESM, LTRO not the (in)famous FBRO. Sorry Spain, you can’t fool investors like Don Quijote fooled Sancho Panza with promises of wealth. Some takes via NYT.
The answer, of course, is everybody. In fact, the whole story is starting to feel like a comedy routine: yet again the economy slides, unemployment soars, banks get into trouble, governments rush to the rescue — but somehow it’s only the banks that get rescued, not the unemployed.
Just to be clear, Spanish banks did indeed need a bailout. Spain was clearly on the edge of a “doom loop” — a well-understood process in which concern about banks’ solvency forces the banks to sell assets, which drives down the prices of those assets, which makes people even more worried about solvency. Governments can stop such doom loops with an infusion of cash; in this case, however, the Spanish government’s own solvency is in question, so the cash had to come from a broader European fund. (Full article here).
Spain’s Santa Bail Out
Guest post by Peter Tchir of TF Market Advisors.
It seems like it would be easier to find an adult who believes in Santa Claus than one who believe the events in Spain over the weekend accomplish anything. It is actually very hard to find a positive article, yet most seem to take worst case scenarios and take that as the likely outcome. Some seem to even rely on combining worst case scenarios that are actually mutually exclusive.
One and Done or More to Come
Before focusing on the issues directly surrounding this weekend’s announcements, it is important to put this event in the proper context. Even if the Spanish situation was resolved by this action the markets were be at serious risk of fading hard. There are too many problems in the world – Grexit, recession in Europe, declining economies in the U.S. and China, etc. If nothing is done that helps those situations, then the rally will be fairly short lived. Fixing Spanish banks is a bit like drowning one lawyer – a good start. Signs that this is another haphazard deal to delay the inevitable will cause the market to sell-off. Signs that the EU is truly working hard to make this deal have the least impact on Spain and signs that other policy shifts and money printing programs are in the pipeline will add to the rally.
Given how much doubt there is that anything else is about to be done, the element of positive surprises seems high, and quite possibly the central bankers and policy makers took note of the Economist’s cover this weekend, because it is a pretty accurate portrayal. With either get large intervention, largely in the form of money printing, to help the economies, or we don’t and the economies drag down. Longer term would we be better off dealing with short term pain to reduce the complexity of the situation and weed out bad companies and industries? Probably, but time and again we have seen the aversion to that, and the only time they let it happen with Lehman made them even more convinced to avoid doing it again (in spite of belief of many that more Lehmans would have been better).
The St. Louis Financial Stress Index and Market Risk
Guest post by Vix and more.
Determining the risk in the financial markets should get easier with more data, more measures and more experience navigating crisis environments, right? Not so fast.
Right now, for instance, the CBOE Volatility Index (yes, the VIX does have a formal name) is just a shade above its lifetime average, yet the yield on the 10-Year U.S. Treasury Note is just a week away from its all-time low. Granted the Fed has been distorting interest rates with Operation Twist and other policy initiatives, but it has only been in the last month or so that yields have dipped below 1.7%.
One broad-based tool for measuring risk in the financial markets and related institutions is the St. Louis Fed’s Financial Stress Index (which I refer to as the STLFSI), which has 18 component measures that include a variety of interest rate and yield spread data, as well as the VIX, measures of bond volatility and other data that are correlated with market stress.
This week’s chart of the week below shows the movements in the STLFSI and the VIX since the beginning of 2007. Note that for most of 2012 the VIX has been indicating much less risk and uncertainty than the STLFSI. Only since the middle of May have I observed the VIX rise to a relative level that is consistent with the STLFSI. As of last week, for instance the STLFSI was at the 79th percentile of its lifetime range, while the VIX was in its 82ndpercentile. For the record, the divergence was widest in the middle of March, when the STLFSI had a 68th percentile reading, yet the VIX was mired in the 23rd percentile. Financial historians might also be interested to know that the mid-March divergence was the largest since August 2008…
Rajoy’s claim for fame
Spain’s Rajoy pulls the magic move over the weekend by requesting the bail out (more to come according to The Trader). Discounting this as massively good news could prove rather dangerous. The Spanish economy is in a much bigger mess than only needing 100 billion Euros. The zombie urbanizaciones won’t be helped much by this small bail out. In order to fill up those + 1 million empty properties, prices need to come down much more, and that won’t be met by the 100 billion bail out. For now, enjoy the Risk On mood credited to Rajoy. From El Pais.
After being widely criticized for failing to appear in public on the day that Spain accepted a European Union bailout for its debt-ridden banking sector, Prime Minister Mariano Rajoy improvised a brief press conference on Sunday to explain the financial rescue package before flying off to Poland for the Euro 2012 soccer match between Spain and Italy.
In his first solo address to the media since he was elected last November, the always-cautious Popular Party (PP) leader took care to avoid using the word bailout, and instead talked about “a loan” and even “yesterday’s event” to describe the agreement with the Eurogroup of financial ministers to prepare a bailout to clean up Spain’s financial sector.
Long Term Budget
CBO’s long term projections.
Source; CBO.
“Sleepwalking Toward a Precipice”- Europe and China
Let’s look beyond Spain’s ability of asking for a bail out of the banks. Guest post by Craven Brothers. Simply must see presentation.
Our latest outlook series details structural (i.e., long term) problems in the world’s largest economies that were “unmasked” by the credit crisis and Great Recession. This year’s multi-part discussion seeks to look beyond debt and deleveraging (see last year’s “The Age of Deleveraging”: Our Observations and Outlook), to assess the myriad influencers of growth, and thus market prospects going forward.
Part I of our Sleepwalking Toward a Precipice series focused on structural issues in the United States.
In Part II, we discuss structural problems in Europe and China, a variety of unknowns that could impact growth and markets going forward, and central bank rule.
In an upcoming final installment, we discuss our investing approach given the “double-wide” possibilities for global growth and markets over the next decade. We hope you enjoy and please email or call with any questions.
News That Matters
Ft.com
Mariano Rajoy, Spain’s embattled prime minister, on Sunday attempted to portray his country’s decision to seek as much as €100bn in European Union rescue funds for troubled domestic banks as a victory, saying his government’s budget prudence prevented a full-scale bailout that would have forced him to surrender sovereignty to Brussels. Spain has now became the fourth and largest eurozone economy to seek an international bailout. But Mr Rajoy, who had resisted any outside EU assistance since his centre-right government was voted into office in December, insisted the agreed loan from EU funds was solely to recapitalise banks. However, because Spain was able to take advantage of new provisions in the eurozone’s €440bn rescue system, it will avoid the kind of intrusive inspection of government books that came along with Irish, Greek and Portuguese bailouts. http://www.ft.com/intl/cms/s/0/4599be98-b2ed-11e1-83a9-00144feabdc0.html#axzz1xSNLBdRq
Alexis Tsipras, leader of Greece’s leftwing Syriza coalition, seized on news of the Spanish bailout to bolster his position ahead of next week’s crucial general election, which may determine whether the country stays in the euro. “The developments in Spain confirm the position we adopted from the start – that the crisis is a pan-European problem, and the way it has been handled so far has been socially catastrophic and completely ineffectual,” Mr Tsipras, who opposes the bailouts, told a newspaper. http://www.ft.com/intl/cms/s/0/c8e85ba6-b31a-11e1-83a9-00144feabdc0.html#axzz1xSNLBdRq
François Hollande was in sight of an all-important parliamentary majority following the first round of National Assembly elections on Sunday, vital to entrenching the authority of France’s new Socialist president a month after he was elected. If confirmed in the decisive second round next Sunday, Mr Hollande will be able to start implementing his growth plans, rejecting at least part of the austerity drive installed by his predecessor. http://www.ft.com/intl/cms/s/0/92dc223e-b317-11e1-83a9-00144feabdc0.html#axzz1xSNLBdRq
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