Triffin’s Paradox v Today

Interesting article by my friend David Kotok to share hereunder:

The Triffin Dilemma & Gold
September 30, 2012

“This tension – the Triffin dilemma – was linked to the specific modalities of the gold-exchange standard in 1960, when his Gold and the dollar crisis was first published. Today we are in a much more flexible system, where the demand for global liquidity can be more easily accommodated. But even if the mechanics have changed, the dilemma is still valid if we capture its essence and formulate it in broader terms, as I will do in the first part of my comments today. In second place, I will briefly recall how the dilemma came into being and was addressed in Triffin’s times. This will allow me to better identify the main differences and similarities compared with our times, which will lead me to conclude that it is indeed correct to talk about a ‘Triffin dilemma revisited’. Finally, I will look ahead and ask whether and how it is possible to escape the dilemma today.”


Source:  Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB, at the Conference on the International Monetary System: sustainability and reform proposals, marking the 100th anniversary of Robert Triffin (1911-1993), at the Triffin International Foundation, Brussels, 3 October 2011.   See: .  The link does not always open; so, you may have to go to the ECB website and separately pull up the Bini Smaghi speech.


Robert Triffin saw the inherently destabilizing effects that originate from global reserve currency status.  He perceived the tensions between short-term and long-term effects, in terms of trade deficits.  He never imagined that the tension would be exacerbated by extraordinary monetary policy of the type we see implemented by central banks today.


Triffin’s observations were made in the 1960s.  He saw how gold rose to trade at $40 per ounce after the official $35 price gave way to the incipient anti-dollar pressure of the ’60s.  By the 1970s, the Bretton Woods fixed currency exchange regime had collapsed.  The gold exchange standard ceased when President Nixon revalued the dollar to $42 per ounce of gold and then closed the “gold window” by stopping the exchange of gold for dollars.  In its official accounting, the US Treasury still values its gold hoard in Fort Knox at $42 per ounce.  The Federal Reserve’s gold certificates are similarly valued.


Until his death in 1993, Triffin watched the trade deficit grow and the reserve currency status of the US dollar slowly erode.  His warnings about the Triffin dilemma were unheeded by policy makers.  The speculation around Triffin’s work was about how the US dollar’s world reserve currency status would evolve (unwind) and what the catalyst would be for its demise.  Second-derivative questions were about whether the unwinding would be orderly or violent.  Lastly, there was speculation about what would replace the dollar.  Many proposals about a global central bank and a global reserve were offered.  None have materialized in any serious way.


Fast forward to today.


The dollar maintains its reserve currency status because it is the least worst of the major four currencies – the US dollar, the British pound, the Japanese yen, and the euro.  All four of these currencies are now suffering the effects of a stimulative, expansive, and QE-oriented monetary policy.


We must now add the Swiss franc as a major currency, since Switzerland and its central bank are embarked on a policy course of fixing the exchange rate between the franc and the euro at 1.2 to 1.  Hence the Swiss National Bank becomes an extension of the European Central Bank, and therefore its monetary policy is necessarily linked to that of the eurozone.  For the balance sheets of the five central banks associated with these currencies, see


When you add up these currencies and the others that are linked to them, you conclude that about 80% of the world’s capital markets are tied to one of them.  All of the major four are in QE of one sort or another.  All four are maintaining a shorter-term interest rate near zero, which explains the reduction of volatility in the shorter-term rate structure.  If all currencies yield about the same and are likely to continue doing so for a while, it becomes hard to distinguish a relative value among them; hence, volatility falls.


The other currencies of the world may have value-adding characteristics.  We see that in places like Canada, Sweden, and New Zealand.  But the capital-market size of those currencies, or even of a basket of them, is not sufficient to replace the dollar as the major reserve currency.  Thus the dollar wins as the least worst of the big guys.


Fear of dollar debasement is, however, well-founded.  The United States continues to run federal budget deficits at high percentages of GDP.  The US central bank has a policy of QE and has committed itself to an extension of the period during which it will preserve this expansive policy.  That timeframe is now estimated to be at least three years.  The central bank has specifically said it wants more inflation.  The real interest rates in US-dollar-denominated Treasury debt are negative.  This is a recipe for a weaker dollar.  The only reason that the dollar is not much weaker is that the other major central banks are engaged in similar policies.


Enter gold.


Gold is not money when it comes to functioning as a medium of exchange.  We live in a fiat currency world where money is printed (electronically) by central banks.  We pay each other in currency, not gold.  The US dollar and euro are the two giants when it comes to payments.


We do not use gold as a unit of account.  We measure prices in dollars, not ounces of gold.  True, other countries measure their prices and settle their payments in currency like yuan, krona, or rand.  But the world’s transactions are still largely executed in dollars, priced in dollars, and paid in dollars.  Modern currency hedging allows this practice to continue without much risk to the specific agent making or receiving the payment.


Gold comes into play when we focus on the store of value characteristic of money.  The world’s distrust of fiat currencies is rising.  Given the policies in place, one would expect that to be the case.  One investor, or one agent, at a time decides to reallocate a portion of wealth to gold.  That agent also looks at the central banks of the world and sees them buying gold to add to their reserves.  He doesn’t see much institutional selling of gold.  Individual investors now have vehicles like the exchange-traded products (ETFs and ETNs), which allow them to participate in this reallocation process.


When an investor buys a gold ETF, like GLD or IAU, he may be thinking only of a speculative trade.  But given the size of the total gold holdings in ETFs and their turnover, it appears that a growing number of investors are adding to a personal hoard of gold ETFs as a way to store value in other than a domestic currency.  Physically backed gold ETPs now exceed 2500 tonnes (source: Barclays) and are steadily growing.  That makes the ETF universe one of the largest gold hoards in the world.  Very few countries hold more than 2500 tonnes of gold.


Cumberland recognizes this trend and believes it may persist as long as the central banks continue their present policies.  Our internal modeling of changes in velocity (GDP divided by M2) suggests that the gold price will move much higher, when measured in the various currencies engaged in QE.  Remember, gold is a long-duration asset, and the central banks are buying long duration from the market.  A “deep-pockets,” persistent buyer is likely to drive the price higher.


Cumberland’s Global Multi-Asset Class portfolios hold gold and are routinely rebalanced to maintain the internally determined weight.  Relative to the size of gold in a global allocation, we consider these gold positions to be overweight.


Triffin’s paradox did not focus on QE and its effects on reserve reallocation.  Triffin did not have to consider a central bank policy of buying long duration from the market.  Triffin’s writings disparaged gold as a reserve and also opposed floating exchange rates.  Professor Triffin did not foresee the present-day construction.

Today, we have floating exchange rates, gold as reserves, and central banks using QE to buy long duration.  One can only speculate what Triffin would write today.  Meanwhile, gold prices seem to be headed higher.


David R. Kotok, Chairman and Chief Investment Officer


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QE Infinity v Stock Market

For US stock market investors, these facts lead to only one conclusion: the bias has to be toward fully diversified investing in US stocks.-so said David Kotok:

QE Infinity and US Stock Market
September 23, 2012


“QE3+ is an operation analogous to walking a tightrope over Niagara Falls. Success will be exhilarating, but failure will be ugly.” (John H. Makin. “The Fed Takes a Gamble.” American Enterprise Institute for Public Policy Research. September 2012.)


The last two weeks have been remarkable in this new era of central banking. Developments continue.


The latest move to withdraw more duration from the market is coming from the Bank of Japan (BOJ). The recently announced additional program by the BOJ includes a fifty-percent allocation to the purchase of ten-year Japanese government bonds. The other fifty percent will buy shorter-term government securities. Thus, the BOJ is applying half of its additional QE stimulus to extracting long duration from the government bond market, denominated in Japanese yen.


In the US, we see the continuing evolution of QE3. The Federal Reserve is now increasing the outright purchase of longer-duration, federally backed mortgage securities. This is an extension of Operation Twist, whereby the Fed replaced short-term Treasury bills with longer-term Treasury notes and bonds.


In the US, the amount of long duration extracted from the market is now estimated to rise to about $85 billion per month. In other words, approximately $1 trillion of long-duration US government securities will be purchased annually. By many estimates, that figure exceeds the amount of new, long-duration US government securities being created.


The deficit of the US is financed by a combination of short-duration and long-duration instruments. Thus, the emphasis on long duration may mean that the total purchased could exceed the amount of actual new issuance of long-duration Treasuries. At the same time, the mortgage finance agencies, Fanny Mae and Freddie Mac, are limited in the amounts of credit they can extend. By some estimates, the Federal Reserve is in the process of becoming the largest government-sponsored enterprise involved in the financing of American housing.


Whether all of this is good or bad, we do not know. The extraction from the market of long duration in this amount could lead to a very bullish outlook for the US stock market. We think that is now the case and will remain the case as long as the Fed policy continues in this direction.


Assume that the short-term interest rate is going to be near zero for the next five to ten years. Assume that the long-term interest rate, defined by the ten-year Treasury note, is going to be in the vicinity of two percent for the next five to ten years. What would you then use as an equity-risk premium so you could calculate the value of the US stock market? Let’s run some numbers to try to predict where the market is headed.


A traditional equity-risk premium calculation would be 300 basis points over the riskless rate. If you apply the calculation to the short-term interest rate, the equity-risk premium would suggest (by traditional standards) an extraordinary price earnings multiple, because the benchmark short-term riskless rate is near zero. If you apply a more conservative approach and use the ten-year yield and a two percent estimate, you will derive an equity-risk premium comparative interest rate of about five percent. That is two percent on the riskless piece plus three percent on the equity risk premium, for a total of five. This calculation leads you to the basic conclusion that the stock market is priced properly and at an equilibrium level at twenty times earnings. Twenty times earnings is not excessive under this set of assumptions. The market would be neither cheap nor richly priced.


Apply the twenty multiple to the earnings estimates that we have for 2013. Many estimates, which suggest that the US economy will slow down and flirt with recession in 2013, center at about $95 for the S&P 500 Index. Their range may be $90 low, high nineties high. Use $95 for this purpose. Estimates that are derived from the assumption that the US economy will continue with slow growth, a low rate of inflation, and a gradual but consistent recovery lead to an earnings estimate of about $105 for 2013. The wide range could be $90 low and $110 high, for an average of about $100.


For the purpose of this counting exercise, I am going to use $90. Ninety times a PE of 20, which we derive from an equity-risk premium of 300 basis points over the ten-year Treasury yield, gives us an $1800 price target on the S&P 500 Index. That is the pricing of the stock market today, if the lower earnings number and a slower-growing economy are assumed and interest rates (as determined by the Federal Reserve in its current policy mode) remain stable. The Fed has essentially said it will hold these interest rates for a long period of time; and the slow-growth economic assumptions, outlined in deriving the value of the stock market, are consistent with the interest rates being so low for so long. Under these assumptions, 1800 on the S&P 500 Index is a fair price today.


On previous occasions, we have written that our price target for the S&P 500 Index was 2000 by the end of this decade. Given the above assumptions, the policy broadcast by the Federal Reserve, and the elements that are in place to achieve it, we are raising that estimate. We think it is quite possible that the S&P 500 Index could be closer to 2300, 2400, or 2500 by the end of this decade. As long as Fed policy stays in its present mode, a little more inflation and a little pick-up in the growth rate during the course of the decade will let us easily achieve these numbers.


Will the Fed stay in its present mode for that long? No one knows. Given the current concentration of intensity, effort, and communication on the employment situation in the US, you can easily guess that it will take four to seven years to achieve an unemployment rate low enough to warrant the Fed changing its policy stance. One Fed president has now called for continuation of this policy until the unemployment rate is 5.5 percent. Another Fed president has repeatedly called for this policy to continue until the unemployment rate falls below seven percent. The unemployment rate in the US today is above eight percent. Other employment statistics reveal that the employment situation in the US is not healthy and is not getting better very fast. For US stock market investors, these facts lead to only one conclusion: the bias has to be toward fully diversified investing in US stocks.


Under the rationale that we will continue seeing the interest rates that we are accustomed to for a number of years, and that the policy will persist until the Fed can say it has achieved the goals established in its mandate to restore a baseline of full employment in the US, Cumberland Advisors’ accounts will remain positioned as described in this commentary.



David R. Kotok, Chairman and Chief Investment Officer


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IS one of the issues of GIC as my friend David Kotok shares with us:

Ghana, Healthcare Delivery, and Sustainable Philanthropy
September 20, 2012


Michael McNiven is a senior vice-president and portfolio manager. His bio may be found at  His email address is


As many of our readers know, Cumberland Advisors is a proud sponsor of the Global Interdependence Center (GIC –, the not-for-profit organization headquartered in the Federal Reserve Building in Philadelphia.  GIC is a neutral convener of dialogue around the world on global trade, economics, finance and markets, and other important issues related to world citizenship.


Last week we had the opportunity to attend GIC’s conference in Accra, Ghana in partnership with Sanford Health, the largest rural healthcare provider in the US, with headquarters in Sioux Falls, South Dakota.  Sanford Health is a not-for-profit system that operates over 37 hospitals, clinics, and services in the North Dakota, South Dakota, western Minnesota, northwest Iowa, and northeast Nebraska geographical area.  Sanford Health has also launched its Sanford World Clinics effort, to provide primary-care services in multiple locations around the globe.


Issues of health and wellness can be profound and truly impactful to individuals and nations.  The conference was specifically focused on the issue of providing a sustainable model for permanent healthcare infrastructure.  The intent of the organizers and the participants was to discuss specific and real methods for alleviating human suffering, to improve the human condition, and to do good in the world.  Featured speakers at the conference included representatives from the Ghana Ministry of Health (, the Ghana National Health Insurance Scheme (NHIS –, the Women’s World Health Initiative (WWHI – focuses on maternal health, with emphasis in Senegal;, USAID in Ghana (, DocuTap (a provider of electronic medical records (, and Sanford Health (  Attendees included GIC members, American Chamber of Commerce in Ghana personnel, local business owners, church officials, and other Ghanaian citizens and organizations interested in healthcare issues.  We encourage readers to explore these organizations’ websites to see the interesting and varied work they do.


The dialogue was vigorous as various approaches and topics were explored.  It was clear that a need exists to regularly convene such dialogues among the stakeholders, both regionally and beyond.  Providing sustainable healthcare and building permanent infrastructure are fraught with potential complications, particularly and most importantly the specific health needs of the people being served, with challenges arising from the mixing of cultural expectations and norms, differing standards, differing models of delivery, the resources available, the openness of officials to new participants, the political and legal stability of the nations involved, and of course the actual issues on the ground.


As in politics in general, healthcare delivery around the world is local, local, local.  This presents a challenge to anybody seeking to provide a model of sustainable healthcare delivery.  The facts are that this is really hard to do in a way that is both effective and replicable; hence, the need for a venue and a host to facilitate a healthy exchange of ideas.  In many ways, the conference turned into a working session, as the participants and attendees questioned and sought to understand and resolve concerns.


The tour portion prior to the conference focused on the Sanford World Clinics initiative as it relates to a hub and spoke network of ten primary-care clinics being built in Ghana (see and, specific to Ghana, The Cape Coast clinic began operation at the beginning of the year, with other clinics in Mankessim, Adenta, Kojokrom, and Kasoa to open in the next several months.


The tour began by driving to the Mankessim facility, which is still under construction.  It will be an outpost of positivity and newness amid a backdrop of somewhat rough conditions. The participants then continued on to Cape Coast to view the hub facility that is functioning and seeing patients.  It was wonderful to see the innovations, modern-looking pharmacy, people waiting to see the doctor, and electronic records systems.  The clinic itself is a “light on the hill”: well-painted, clean, and inviting.  The clinic sees about 1400 patients per week, adults as well as children. A majority of the patients are presenting with malaria and are being treated.  These are real people, with real and treatable maladies, receiving appropriate care.


The memorable moment for me at the Cape Coast clinic was gazing into the male recovery room.  There was a small boy getting a drip IV who was shaking under his sheet, obviously in discomfort.  It is a very simple, mundane, and profound thing to offer a basic human remedy to another.  That quiet little miracle of health and life is all that really matters.  Basic access to care for that young boy, who might otherwise have gone untreated (with the attendant mortality considerations that would follow), is a miracle in its plainness and simplicity.  To the degree that others in various parts of the world do not have access to treatable maladies, this is part of the human tragedy.


Many good things came from this mixing of people—hosts, speakers and attendees—and the conference certainly could be viewed as a resounding success.  What a fantastic opportunity to make a meaningful difference in individual lives – doing the right things, hopefully in the right ways, for the right reasons.  For people who think often and long about how to make the world a better place and help people to flourish in both theory and practice, this conference on tangible healthcare infrastructure and delivery seemed particularly noble.  Practical and consistent application of good intentions is where the rubber meets the road; and the convening of the conference, with the working clinics as a tangible product for investigation, provides hope.  Of course, sustainability is the key and the Holy Grail.  Having interesting discussions and also seeing people on the ground meeting the practical needs of patients who come in the door was truly invigorating.  It was inspirational to see the opportunities, challenges, and complexities that might present themselves going forward in these endeavors.


A hearty thanks to the Global Interdependence Center and Sanford Health for convening and hosting such a worthwhile event.



Michael McNiven, Senior Vice President and Portfolio Manager

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“I know it when I see it”

 This phrase became even more popular because of its well-known quotation in Goldfinger, when M  asks Bond: “What do you know about gold?” and Bond replies with  “I know it when I see it.”
So said Bob, too!


We’ll Know It When We See It!
September 17, 2012

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at  He may be reached at

Because of its scope and aggressiveness, the FOMC’s open-ended MBS purchase program caught many by surprise, including us.  The Committee not only extended its forward guidance with respect to the time period during which it intended to keep rates low, it also initiated $40 billion per month in new mortgage-backed securities purchases.  To be sure, Chairman Bernanke did indicate at his press conference that when Operation Twist was concluded in December, the Committee would revisit its entire set of asset purchase programs.  But he also unambiguously left open the possibilities for an extension of Operation Twist and more Treasury purchases.  This suggestion alone will result in lots of market and pundit chatter as the December FOMC approaches.  The FOMC’s decisions have drawn the headlines and attention of the press and commentators.  But it is also worthwhile to delve deeper into the details of the projections materials that were released following the meeting.


Perhaps the most interesting detail is contained in what we call the dot chart, which shows the assumed Federal Funds rate by each FOMC participant for each year. FOMC participants submit their forecasts with embedded rate assumptions prior to the FOMC meeting, and those assumptions reflect what they believe to be “appropriate” policy.  After each meeting, participants are given the opportunity to revisit their projections and assumptions.  However, since only a couple of hours elapse between the end of the formal FOMC meeting and the release of the projections materials at the Chairman’s press briefing, it is not likely that significant changes can be or are made.  In addition, because we are now in a regime of quantitative easing, it isn’t known what assumptions have been made in the forecasts concerning the volume, composition, or timing of Fed asset purchases.  This is particularly critical now that the FOMC has made a significant change in its program and it is unclear whether the released forecasts include the likely effects of that program.  Here is one opportunity for more Fed transparency, and the reason this issue is important will become clearer in a few more lines.


Now, back to the dot charts.  The striking thing is that, when compared with the June projection in Chart 1 (, by September Chart 2 ( more of the Committee have fallen into line and appear to be very similar in their policy views. In June three participants assumed a movement of rates from the current policy.  For 2013, a total of six (or three more participants) were assuming a movement in rates away from the 0-.25 basis point range; and by 2014, thirteen participants had abandoned that low rate-range policy.  However, in the most recent September projection materials, only three months removed from June, just one participant assumed a rate movement in 2012 (most likely this was President Lacker).  Only four assumed a rate move in 2013, as compared with six in June; and by 2014, only six assumed a different rate from current policy, as compared with 13 in June.


Clearly, views of FOMC participants have changed significantly, and one wonders what kinds of information triggered the tipping point.  The economy is continuing to grow, jobs are being added, and housing appears to have stabilized.  And the Beige Book, which supposedly accounts for information that postdates the macroeconomic data, fails to reveal a significant decline in economic activity, region by region.  The reported noted that “… economic activity continued to expand gradually in July and early August across most regions and sectors.” Nine of the twelve districts in fact reported “modest” or “moderate” growth.  Retail activity had increased and real estate markets had improved, while employment was either steady or “growing only slightly.”


The clues to the Committee’s thinking, of course, are in the statement and were explained by Chairman Bernanke in his press briefing.  The Committee has become impatient with the slow pace of the recovery and lack of improvement in the unemployment rate.  In the face of a benign inflation situation, it concluded that action was needed and could be provided with little or no inflation risk.  The key phrase here is in the Chairman’s line “… if we do not see substantial improvement in the outlook for the labor market, we will continue the MBS purchase program, undertake additional asset purchases, and employ our policy tools as appropriate until we do so.”


Reporters at the press conference astutely pressed the Chairman repeatedly both on what the Committee would have to see specifically in the data and on whether the policy change signaled an increased tolerance on the part of the Committee for inflation.  On both issues the Chairman bobbed and weaved without providing anything other than “We’ll know it when we see it.”  He talked in generalities about “… broad-based growth in jobs and economic activity that generally signal sustained improvement in labor market conditions and declining unemployment.”  No hints were provided as to how rapid growth would have to be, or for how long, to meet the Committee’s definition of “broad-based,”  nor did the Chairman clarify how the Committee would determine whether observed improvement could be “sustained” or not.  The effect of this kind of vague language will likely come back to haunt the Committee when the economy improves and markets and investors are faced with the challenge of determining when and how to change investment strategies.  Clearly, market euphoria over this most recent policy move is not based upon either economic or company fundamentals, and this should be worrisome.


The issue of “when and how” becomes even more significant when one looks at the forecasts that are contained in the projections materials released by the Committee.  The September forecasts for 2012-2015 and the intermediate term are compared with previous forecasts in Charts 3-4.  The central tendency for GDP growth in 2012 moved down from a range of 1.9-2.4% to 1.7-2%, a slowing not necessarily reflected in the Beige Book.  There were virtually no changes for the years 2013-2014, which had moved up to 2.5-3% for 2013 and up to 3.0-3.8% for 2014. Moreover, the first forecast for 2015 has a range nearly identical to that for 2014.  Keep in mind that, because there were essentially no changes between June and September in the growth forecast ranges for 2013 or 2014, and there is no difference for 2015, one wonders how to think about the assumed impacts of the asset purchase program.  Either the purchases have not been vectored into the forecasts, in which case the projections are essentially useless, or they have been.  If the latter, then the FOMC’s own forecasts suggest there will be no substantial impact of the programs on growth through 2015.


As for unemployment Chart 4, no change was predicted for 2012, virtually no change for 2013, and only modest improvement for 2014.  Given the growth projections and the lack of improvement in the unemployment rate for 2014, the sudden improvement in the range for 2015 is puzzling indeed.  The central tendency range for 2015 dropped significantly to 6.0-6.8%.


Here is why that forecast is puzzling.  On average, we estimate that an economy growing at the rate of, say, 3% will create 161 thousand jobs a month, plus or minus 50 thousand (with 95% confidence).  This means that it would take about 29 months on average just to replace the remaining jobs that were lost in the recent recession.  Given the conservative position on hiring that businesses have assumed coming out of this recession, the average of 161 thousand jobs created per month is probably optimistic, even with growth at the high end of the FOMC’s assumed range.  Additionally, considering that it takes about 150 thousand jobs per month just to absorb new entrants into the labor market, let alone allow for the re-entry of discouraged workers, it stretches credibility to believe that the pace of job creation implied by the GDP growth forecasts can lead to the significant drop in the central tendency for the 2015 unemployment rate in the projections.


In short, the Committee’s decision to embark upon further stimulus programs raises important questions about the usefulness of its projections materials and how changes in quantitative easing policies figure into those projections.  The concerns from a policy and markets perspective are the Committee’s views on what the incremental effects of its policy decisions are on the real economy and how and when it will decide that it is time to unwind the period of extreme policy accommodation.  Certainly, the materials provided imply a long period of sustained asset acquisitions and a further substantial increase in the Fed’s balance sheet.  This expansion will only exacerbate the Fed’s exit problem, and to the extent that it experiences capital losses on asset sales, those losses will accrue to the taxpayer through reduced remittances to the Treasury, and increase the deficit.

Bob Eisenbeis, Chief Monetary Economist

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Job 1:21

 This is an eye-opener on Duration from my friend David Kotok:

 “The Bible says ……..”
September 16, 2012


“The Lord giveth and the Lord taketh away, blessed be the name of the Lord.”  Job 1:21


The Federal Reserve (Chairman Bernanke) sent the message of giving at the Jackson Hole conference on Labor Day weekend.  Many, including us, read it as a statement that Operation Twist would continue and may be extended.  Many, including us, concluded that the forecast period of low rates would be lengthened to 2015.  At the FOMC, Bernanke gave us both.


After Jackson Hole, we did not expect the additional and open-ended, long duration, new asset purchase program to run at $40 billion a month.  Some call this QE3.  Others call it QE infinity.  My colleague, Bob Eisenbeis, is writing about our reasons and our assessment in detail.


Needless to say, we were wrong about QE infinity.  The Fed has now monumentally changed the game.  The eventual (very long term) outcomes are unpredictable.  We can assert, guess, estimate, calculate, infer but we cannot be certain of the final outcomes or their timing.


We do know that the Fed is committed to expand its balance sheet to an unprecedented size.  We will track that weekly at  And we do know that the acquisition of securities in the mortgage area will expand coincident with the Fed also rolling over its existing portfolio.  Simultaneously, the Fed will continue twisting its portfolio to longer duration holdings.


So here is what we think this implies for markets.


The Fed is now extracting more and more duration from the market.  It may be more than the federal government creates.  That means the market price of duration will rise from this additional demand if all things are held equal.  But in a global world where the world’s reserve currency is in rapid new money creation, all things are not equal.  There are sellers of duration who want to disgorge their US dollar holdings into the Fed’s bid.


Ok, that is the technical definition.  Let’s translate this into English.


A quick definition of duration is needed.  Duration is a technical term.  It measures the sensitivity of the price of an asset to changes in interest rates.  It is commonly thought of in terms of years.  For example: a single US treasury bill that matures in one year, with no intervening interest payments is considered to have a duration of 1.  A zero coupon, 30 year, US Treasury strip has a duration of 30.  A 30-year treasury bond with semi-annual coupon payments and a final 30-year maturity has a duration which is calculated as a weighted and discounted series of values of all the payments over the entire 30-year period.  The approximate duration of that instrument is about 13.  I hope that was understandable.  I tried.


The Fed is enlarging the duration of its balance sheet and thereby altering the market’s clearing mechanism.  Thus, long duration asset prices are expected to rise.  That means US treasury bond yields are expected to fall.  But global sellers may have other things in mind.  They now suspect the US dollar will weaken and therefore they want to exit their holdings.  When they do that, the yields on those instruments will rise and the prices fall if the global sellers sell more in a given period than the Fed is buying.  This is the tradeoff we cannot estimate.  Only time will tell.


So the volatility in the bond market is rising and will continue to do so.  That is what happens when you mess around with duration.


Stocks are a very long duration, variable rate, asset class.  They also have the ability to adjust to the inflationary outcomes that this extraordinary Fed policy can deliver.  American stocks can state their foreign earnings in US dollar terms.  Therefore a weakening US dollar means they will report higher earnings.  Thus stocks get a double kick from this policy.  They benefit from the weak dollar earnings translation and they benefit from the Fed duration switch.


That explains the market’s reaction to the Fed’s announcement.  US long treasury yields rose, not fell.  Stocks rose.


We can affirm this reaction by digging into the market.


The cap-weighted S&P 500 average was up 4.49% from Labor Day weekend until the September 14 close.  The top 100 are found in an ETF; its symbol is OEF.  It was up 4.30%.  Remember, it is the larger companies that get the biggest kick from the weaker dollar.  So we would expect OEF to trade closely with SPY (the symbol for the S&P 500).  It did.


Contrast that with RWL.  It is the symbol for the revenue-weighted S&P 500.  These are same stocks but with a different weighting method.  If the Fed’s policy is expected to result in more inflation, there will be a greater impact on the revenue side, with top-line growth.  We should see that expectation show up in the market, where we track revenue weightings vs. cap weightings.  It did.  RWL was up 5.13% vs. SPY up 4.49%.  Note also that risk-taking is broadening in the stock market.  We see that by examining RSP.  It is the equal-weighted version of the 500 Index.  It was up 5.61%.


Let me be very clear.  I disagree with this Fed policy move.  It was not my first choice.  I think the Fed is now playing with fire.  But our job is to manage portfolios and not to make policy.  If the Fed is now in QE infinity and if the Fed is now buying duration from the market at a rate faster than the market is creating it, then we want to be on the bullish side of that trade.  Our US stock accounts are nearly fully invested.  Our bond accounts are avoiding the longer-term treasuries and are using them as hedging vehicles.  Our international accounts have been realigned accordingly.


The Bible says that Job was tested to his limits.  In the next few years the financial and investing world will be tested, too.


The central bank giveth and the central bank can taketh away.



David R. Kotok, Chairman and Chief Investment Officer


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Dance with Fire

 Received from my friend David Kotok – an interesting fire-dance!


ECB, OMT: Nuances and Fireflies
September 8, 2012

Outright Monetary Transactions (OMT) is the name of the newest program launched by the European Central Bank (ECB).   If you haven’t read about it, if you don’t care about it, don’t waste any more time reading this commentary.


Nuance 1.  The ECB now views sovereign debt instruments with three years left to maturity as cash equivalents.  There is a reason behind this strange definition; we discuss it in Nuance number 2.  Under OMT, a promise to pay you in euro banknotes three years from now is viewed as the same as the banknote today.  The adjusting process is the nominal interest rate on the seasoned and market-trading note.  That interest rate will be manipulated by the ECB to something lower than market forces would set.  That manipulation will be performed by the central bank issuer of the banknotes.  Technically, it will be implemented by the 17 national central banks (NCB) that make up the euro system.   The nuance is in the direct admission of this concept.  By declaring this policy Mario Draghi has moved the policy needle to the extreme left.  The ECB will disregard the creditworthiness of the sovereign issuer.  The ECB standard is already down to a BBB-level rating.  The ECB has bent its rules many times.   Investors must ask how this latest move ratchets up moral hazard.  They must guess when and where the presumed increase in moral hazard risk will evidence itself.


Nuance 2.  The ECB publicly commits to a parity claim with the private creditors.  Here the ECB is admitting that the previous assertion of a senior claim in the case of the Greek default created unintended negative consequences which the ECB must now repair.  In the case of Greece, the collective action clause retroactively changed the terms of a sovereign bond of Greece.  The CAC was used to “stiff” the private-sector holders of Greek debt.  Prior to that arrangement, the ECB had manipulated its creditor position to a senior status.  The result was to widen the spreads on Spanish, Portuguese, and other weaker eurozone credits.  Market agents concluded that the European powers would stiff them again if things deteriorated.  With this OMT action of denying seniority, the ECB is trying to cure a “Fool me once, fool me twice” folly.  An additional nuance here is that the forthcoming ESM rules state that, starting January 1, 2013, all eurozone sovereign debt issued with greater than one-year maturity will have identical collective action clauses.  Thus the ECB is positioning in advance of that rule and trying to manipulate the specific market in advance of the ESM.  That leads to nuance number 3.


Nuance 3.  “Conditionality” is the new buzzword.  It has replaced the previous ECB construct used with Greece.  Greece deteriorated ahead of changes in ECB policy actions.  In each tragic step of Greek restatement, credit downgrade, spread widening, etc., the ECB acted after the fact.  It kept amending the rules to permit Greece more time for misbehavior.  The cost of this moral hazard increase has been severe.  ECB policy-making was backward-looking.  With conditionality, the ECB will require a country to request assistance and thereupon submit to review, supervision, and agreed-upon austerity measures.  The ECB says its purchases of weaker-credit, 3-year-maturity debt will occur only after the sovereign has requested help.  This, too, is a new form of central banking.  It changes the rules.  Sovereigns now need to determine if they are going to submit to conditions that are externally imposed.  They will try to pre-negotiate the outcome.  Spain is the candidate under scrutiny now.  Investors need to determine how they will position on this uncertainty.  Does the promise of ECB intervention keep Spanish rates lower than they would otherwise be, thus enabling Spain to avoid conditionality?  Or defer it?  We shall see.   Is there a future unintended consequence that is going to result in a market shock?  An example is Spain waiting too long to make adjustments and reforms, then encountering an accelerating downward spiral in its economy.  Note that Spanish banks have been bleeding from capital flight.  The Spanish central bank is now using Emergency Liquidity Assistance (ELA) to prevent bank failures.  That happened and continues to happen in Greece.  We shall see.


Nuance 4.  The Bundesbank publicly dissented to the new ECB program.  Its president, Jens Weidmann, declared the ECB move “tantamount to financing governments by printing banknotes.”  Germany has only one vote in the ECB governing council decision, but note that Germany is the largest “capital key” in the eurozone.  It is 27% of the weight and therefore incurs 27% of the cost of any failed ECB action.  France is second at 20%, Italy third at 18%, and Spain fourth at 12%.  Also note that as a country gets into trouble and “requests” help, its share of the capital exposure to EFSF and ESM guarantees is reduced to zero.  That is consistent.  How can a Greece, which cannot pay, guarantee anything?  So far Greece, Ireland, and Portugal are on this “zero” list.  That leaves the other 14 eurozone members more exposed.  The recalculation to date has raised Germany to 29%, while Spain is up to 12.75%.  If Spain requests aid and drops to zero, the recalculation among the remaining 13 eurozone states will be large.  Weidmann is rightfully worried.


Where does this lead?


We have labeled the European sovereign debt saga a “dance of the fireflies.”  Why?  Fireflies dance in the dark.  They create a mosaic, an appearance.  Turn on the headlights and they stop.  The image you then see is much clearer.  Turn off the headlights and they resume their alluring but unpredictable dance.  Headlights are the metaphor for unencumbered market forces.


In Europe, we continue to witness this game of lights on and lights off.  We watch moral hazard increase with each action.  And we watch economies shrinking as countries avoid reforms, defer the reduction of expenditures, and impose higher taxes.  The politicians are doing the reverse of what is needed to contain the crisis.   Until they emphasize growth in the private sector, this downward spiral will continue.  Europe is in recession, and it is getting worse.


The newest ECB program is another “can kick.”  It may buy some time.  It uses monetary policy to address fiscal problems.  It may delude markets, as it did in the short-covering rally.  The OMT lacks headlights that could be turned on to achieve clarity.  That is revealed on close examination of the nuances.  Jens Weidmann is correct.


In a recent (August 15, 2012) Cato working paper entitled “World Hyperinflations,” co-authors Steve Hanke and Nicholas Krus document 56 episodes of monetary policy running amuck.  The first was in France in 1795-6.  Germany was 1922-3.  Greece was 1941-5.  About 40% of the episodes were in Europe.


Jens Weidmann knows his history.


David R. Kotok, Chairman and Chief Investment Officer


From my friend David Kotok:

More Stimulus?
September 4, 2012


Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at  He may be reached at



Saturday’s WSJ banner headline trumpeted “Fed Sets Stage for Stimulus,” and this wishful thinking has been widely expressed by other analysts, most of whom are Wall Street economists who were not invited to the Jackson Hole summit.  A careful reading of the WSJ article, however, shows it to be inconsistent with the headline.  Only the first three paragraphs of the article are devoted to a description of Bernanke’s defense of the use of unconventional monetary policies, and there is no mention that he hinted of a policy move.  Most of the article sets out the arguments and beliefs, both within the Fed and outside, that those unconventional policies have sowed the seeds of future inflation, failed to deliver the desired improvement in economic growth, and hurt the value of the dollar.  So what did Bernanke actually do?


Bernanke did exactly what any central banker in his position should have done, especially one who is running out of options.  He provided a balanced discussion and defense of the policies put in place from late 2007 to the present. The speech provides no hint of future policy moves and simply reiterates the points made in Fed policy-maker speeches and FOMC statements, that is, the Fed is watching incoming data and will act if necessary.


Others have already commented and dissected the speech ad nauseum. Simply put, Bernanke did several things.  He described the policies put in place.  He detailed the portfolio-balance theory behind the FOMC’s attempt to lower interest rates.  There was no discussion of who holds those securities or what their alternative investments might be.  Pension funds, for example, are major holders of Treasuries but can’t make loans to small businesses or consumers.  Bernanke also cited evidence of how rates did decline.


He defended his belief in the efficacy of the unconventional policies. But most importantly, he not only discussed the risks inherent in those policies, which were discounted, but also pointed out the difficulties in demonstrating the links between those policies and their effects on growth and employment.  The only evidence cited here were Fed counterfactual simulations, showing that real growth is 3 percentage points above what it otherwise would have been and that 2 million more people are employed.


So what about that research?  The estimates are based on a Fed paper by Chung et. al. (Hess Chung, Jean-Philippe Laforte, David Reifschneider and John C. Williams, “Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?” Federal Reserve Bank of San Francisco Working Paper 2011-01, January, 2011,  That very long paper is a complex, academic, econometric exercise that precisely lays out all the simplifying assumptions behind the simulation models employed and details some of the confidence intervals around the forecasts.  The caveats read like the lists of possible side effects in the disclosures for over-the-counter and prescription drugs.  Whether those assumptions are appropriate or realistic is left to the reader to decide.


For our purposes here, the main model results cited by Bernanke on the effectiveness of policy rely upon the authors’ use of the Board’s FRB US large macro model.  The model’s reported confidence intervals don’t give us much comfort in the counterfactual employment and growth results cited by Bernanke.  First, as the authors carefully point out, the data and structure of the model do not include events like those we experienced in recent years, and the authors’ out-of-sample forecast comparisons of the predictions of the model with actual performance during the crisis are dismal.  Actual results lie outside the 95% confidence intervals for growth and unemployment predicted by the model.  And consider those confidence intervals and how wide they are.  For example, the 95% long-sample confidence interval for the output gap (the difference between actual economic growth and potential growth, a key variable in the structure of the model) is -4.8 to 4.9, and for unemployment it is 2.3 to 7.8.  This means that one can place little comfort in the counterfactual point estimates in the paper, or those cited by Bernanke for growth and employment.  The associated confidence intervals for those counterfactuals aren’t reported; but they have to be huge, given the uncertainty in the model’s parameters and its performance.


Putting all these criticisms aside, but recognizing the dilemma any central banker in Bernanke’s position would face, what else could he have done?  What follows are three talking points that Bernanke could have used that are equally consistent with the empirical evidence, research, and discussions within the Federal Reserve that have been revealed in the FOMC minutes and in policy makers’ speeches. Of course, Bernanke would never have used them, but the reader may judge how such statements might be received by markets, politicians, or the general public.


Point 1.  Bernanke could have said, “We have been exploring other tools available to us and, as detailed in the last set of FOMC minutes, no new options are under consideration at this time other than those we have detailed in previous speeches and that have appeared in the minutes.  About the only policy move we haven’t made is to change the interest rate paid on reserves.  We could reduce that to zero or even begin charging banks for holding reserves at the Fed.  But this would mean that we would have to be prepared to act preemptively to raise that rate once bank lending took off, to avoid future inflation.  Unless some of us have some additional ideas, what you see is what we have.  Our choices are either to put in place another round of quantitative easing to satisfy the markets or to stand pat.  The former risks revealing that our policies haven’t been particularly effective and that future actions are likely to be even less so, especially if some of the FOMC members believe that quantitative easing is resulting in diminishing returns.  Standing pat for now, on the other hand, preserves the perception that we can and will do more.  Let us just hope we don’t have to do more.”


Point 2.  “The Fed’s portfolio has increased by some 1.969 trillion dollars since the end of August 2007.  We estimate that 2 million jobs were created as a result of these unconventional policies and the accompanying drop in interest rates.  Thus, this puts the cost of each job created at 980 thousand dollars, in terms of our willingness to expand the Fed’s portfolio by that amount. At that rate, to completely regain the 8 million jobs that were lost during the crisis we would have to expand our portfolio by an additional 7.84 trillion dollars.  These numbers say that we are way behind the curve, and were we to publicize this, there would be hearings on why we hadn’t done more long ago.”


Point 3. “We are confident that we can execute an effective exit strategy from the current policies.  In June of 2011 we detailed our then most current thinking as to how to proceed, which involved a gradualist combination of a change in communications policy, an increase in the target Fed Funds rate from the current 0-0.25 basis points, a cessation of the rolling over of maturing securities, and then possible sales of securities from the portfolio.  This should work, provided existing bond holders don’t decide to liquidate their low-yielding bond portfolios to avoid the inevitable capital losses that will occur.  If we are wrong about our assumptions concerning investor behavior, we are in for a big interest-rate shock and will find ourselves chasing the market when it comes to setting the Federal Funds rate, and will face dysfunctional markets that will make the 2007-08 period look mild.”


Given the alternatives available to Bernanke and the FOMC, at Cumberland we view the most likely scenario for the near term to be one of watchful waiting rather than one of more aggressive actions called for by many.  If the Fed is actually or nearly out of options, then responding to short-term market demands for more quantitative easing seems like a very risky strategy, with the only payoff being requests for more and more.



Bob Eisenbeis, Chief Monetary Economist


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