Yield Curve Flattening

A good man pays his debt
But you ain't paid yours yet
--Heart

The yield curve is a plot of yields at various Treasury bond durations. When times are good, people generally like to see a 'steep' yield curve, meaning that there is a significant positive difference between short and long rates. This permits an attractive 'carry trade' where investors can borrow short duration and buy long duration.

In tough times, the yield curve 'flattens,' meaning that there is less difference between short and long rates. In an economy that depends on borrowing and leverage as ours does, this is an unwelcome event.

Presently, the yield curve is flattening. Much of this has been Fed induced as QE buys in long bonds, forcing their yields lower. Difference between 5 and 30 year Treasury yields is back to early 2009 levels and only 50 bips from 2008 lows.

Harbinger of coming problems? Not sure, but is seems likely that carry trades will come under increased stress.

Paper Wealth

An angel's smile is what you sell
You promise me heaven
Then put me through hell
--Bon Jovi

As the SPX marks new highs, many people are breathing a sigh of relief. Not only have they recovered losses associated with the credit market meltdown, but in many cases their account statements indicate that they are wealthier than ever.

However, the numbers on those statements reflect wealth only to the extent that financial securities can be converted into liquid assets that can buy real resources.

People tend to assume that such a conversion is straightforward. Simply sell stocks, bonds, et al to get liquid.

Maybe so. But if lots of people simultaneously decide to seek liquidity, then today's account statement numbers do not reflect wealth levels.

They reflect ignorance and overconfidence.

Affiliation, Groupthink, and Discrimination

Can you imagine no love, pride, deep fried chicken
Your best friend always sticking up for you
Even when I know you're wrong
--Train

Thomas Jefferson said that he sought kept his affiliations to a minimum in order to preserve independent thought. He understood that belonging to groups invites groupthink and clouds judgment.

Social identity theory posits that people join groups to enhance self-esteem. As they do so, individuals begin to assume characteristics thought to belong to the group.

To advance self-esteem, however, people must believe that they belong to the 'right' group. They will defend their group against perceived threats from outsiders. Group members will go also along with what the collective wants even if they personally believe it to be wrong. Failure to do so would constitute admission that their affiliation is a mistake.

A consequence of affiliation is inherent tendency to discriminate. Outsiders are apt to be seen as inferior in some way. Discrimination enhances self-esteem to be gained from joining groups.

Because he thought this was not a worthy route to self-esteem and sound judgment, Jefferson sought to be as group-free as possible.

Freedom of Choice

"A king may move a man. A father may claim a son. But remember that, even when those who move you be kings or men of great power, your soul is in your keeping alone. When you stand before God you cannot say 'but I was told by others to do thus' or that 'virtue was not convenient at the time.' This will not suffice. Remember that."
--King Baldwin IV (Kingdom of Heaven)

One characteristic that separates us from the rest of the animal kingdom is freedom of choice. Unlike Pavlov's dog, we can decide how to respond to a stimulus. We can override limbic reflex and choose differently.

This means that no matter how bad or high pressure things get, we control our response. Others cannot move us unless we let them. When we stand accountable before the Creator we will not be able to claim temporary insanity, or that social pressure was too much, or that orders were merely being followed, or that we were ignorant, or that good ends justified evil means.

But I gave you capacity for reason and choice, He will say, to choose between right and wrong, between peace and aggression. Why did you not use it?

Little Joe

And when the night is cold and dark
You can see, you can see light
'Cause no one can take away your right
To fight and to never surrender
--Corey Hart

Thoroughly enjoyed listening to Joe Morgan the other night as he joined the Reds TV broadcast crew for a few innings. Morgan was my favorite player on the Big Red Machine. On a team loaded with superstars, Little Joe made the machine tick. He put it all together during the magical 1975 and 76 World Series years, earning back-to-back MVP awards.

Morgan was testimony to the truth that size was not a prerequisite for performance excellence. Despite his small stature, he hit for power as well as average. Watching countless BP sessions, I recall watching him stroke ball after ball against or over the right field fence at Riverfront. Long, smooth stroke, quick hands.

Morgan was also quick afoot, but not blazing fast. He learned how to channel his quickness into base stealing skill and Gold Glove defense.

Joe Morgan possessed superior attitude. He stepped on the field to play hard and to win.

In his on-air conversation the other night, Morgan demonstrated that he has not lost that attitude. When asked about what the Reds needed to do to break out of this bad losing streak, Morgan said that players have step up and do it. "You need to figure out a way. You need to will it. If what you're doing isn't working, you have to find another way. But you keep trying until you are successful."

You need to will it. That's the lesson of Joe Morgan.

Malignant Body Politic

"I hate to tell you this, but it's a bankrupt business model. It won't work. It's systemic, malignant...and it's global. Like cancer."
--Gordon Gekko (Wall Street: Money Never Sleeps)

Jacob Hornberger proposes three malignant tumors infecting the American body politic:

Regulated society. Slowest growing of the three tumors, regulations manipulate and control people's otherwise peaceful behavior. Because people can learn how to cope with its debilitating effects, regulation impoverishes and destroys over long periods of time.

Welfare state. Socialist programs such as Social Security and Medicare start out slowly but its aggressiveness accelerates over time to reach a size that can take society down quickly. As the tumor grows, resources required to feed it require borrowing and debt. When the debt becomes too large to pay back, money is debased to extend the tumor's life. A chaos endpoint is only a matter of time.

Warfare state. In JH's view, this is the worst tumor of all. This cancer generates forces that convince people that the warfare state is necessary to preserve life and liberty. Even though the tumor is destroying society, people feel that they have to embrace militarism in order to protect against external dangers that the tumor itself produces.

Like personal medical situations, when diagnosed with these cancers, society collectively goes into denial. People become angry and refuse to believe that they are sick, arguing that these three pathologies are actually healthy and life-nurturing attachments to society.

As every cancer patient learns, however, denial of reality does not change reality. The diagnosed are facing immenent death.

Unnatural

"I know the vibration was not normal."
--Jack Godell (The China Syndrome)

Jeff Cooper poses a question that I've been asking myself for some time: "Does this look and feel like a natural market to you?"

My answer: "No way."

Forced price action. Futures led. Declining volume. Automated. Agenda driven. The action feels manipulated. Manipulated by non-economic buyers.

A manipulation that can last only so long.

position in SPX

Busily Unaware

"Look at these people. Wandering around with absolutely no idea what's about to happen."
--Peter Sullivan (Margin Call)

As people become busier and more involved in minutae of life, awareness of trending danger drops. Threat builds unsensed. It is not until harm is imminent that people wake up.

Being busy, therefore, can be distracting. It lowers one's guard.

Aggressors can use this to their advantage.

Induction Errors

Right behind you, I see the millions
On you, I see the glory
From you, I get opinions
From you, I get the story
--The Who

Inductive reasoning is the process of reaching conclusions or generalizing from specific observations. For example, one might observe increasing temperature trends in the midst of industrial activity and conclude that industrial activity increases temperature.

Induction is particularly useful in the early stages of seeking truth. A phenomenon is observed, and induction initiates the sense-making process.

However, induction is prone to error. Spurious correlations can be confused with cause-and-effect. Small sample size of individual observations may lead to sweeping generalizations that do not hold across entire populations.

Cognitive biases can exacerbate induction errors. The availability heuristic favors data that are readily accessible. For example, we are prone to rely on recent experiences and observations when seeking inductive conclusions. Essentially, convenience samples form the basis for conclusions.

Confirmation bias, a.k.a. selective reasoning, also taints inductive processes. People are prone to seek out cases or evidence that confirm our points of view while discounting or completely dismissing conflicting evidence. Confirmation bias impairs critical thinking as it discourages search for informed alternatives.

To manage potential for error, induction seemingly needs to be complemented by deductive processes that spark minds to test inductive premises for validity. By doing so, perhaps fast and slow thinking can be coordinated and managed.

Central Bank Distortions

Look at the faces
Listen to the bells
It's hard to believe
We need a place called hell
--INXS

Good list (sourced from Fred Hickey) on the bottom of this post of problems/distortions created by the Fed and other central banks:

Fostered widespread moral hazard

Encouraged formation of asset bubbles that eventually pop

Skewed wealth inequality far beyond natural levels

Severely penalized retirees on fixed incomes via financial repression

Encouraged spending/discouraged saving

Funded massive government spending by monetizing debt

Lengthened recessions and reduced job creation

The Fed and other central banks have also sewn seeds for massive consumer price inflation in the future.