1 June 2007

Calvin on bond prices

It may be of some value – for serious players here - to stop arguing around quite different sets of factors that can cause the movements in bond prices as if there were only one set of variables to look at.

The bond price (interest rate) equation is a differential equation with multiple variables.

One analogy might be to consider a large body of water such as a big lake or a small sea: the total volume of water in the lake might increase, in which case the waves upon the shore beat more vigorously compared to when the total water body was less.

Or, the speed of the tide might merely be at its peak (although the total water body volume remains the same) so that the waves upon the shore beat AS VIGOROUSLY AS THE CASE ABOVE. In other words, there might be two completely different causes of the same wave force or wave rate outcome.

Thus it is possible for interest rates pressure to decline because of lack of demand for cash (low velocity circulation), or for interest rates pressure to decline because of rapidly decreasing total volume of cash.

And, the equation can get much more complex still.

In theory it is possible for a low relative force (pressure) over a time series distribution - of demands for cash – to be exhibited as high nominal interest rates where the economy is not smoothly or perfectly distributed. This would be the situation in which there is a strong and clear disparity between the risk models for credit, of say a monopoly in a business sector, compared to another sector in which there is high competition. Applied interest rates at which the monopoly would consider borrowing money would be totally different to the interest rates at which the competitive businesses would be prepared to take up credit.

Demand for money is not completely symmetrical in respect to risk factors across an entire economy, nor is it totally homogeneous with regard to pure demand in any case.

The total average of all the prices of money throughout an entire economy might come out as a particular figure – and mostly this is expressed as the catchall benchmark prime rate or the benchmark average on Ten Year Government Bonds – but this in itself can hide the asymmetrical topology of credit transactions in an economy. Hence the very reason there is such a thing as capital formation policy led by Central Banks, or fiscal policy led by political government ideologies that people vote about at main elections.

My personal view of the current situation tends towards the idea that there is a very large body of ‘water' (liquidity, or money!) on issue as currency and as government obligations on financial paper, and, that there is a highly controlled set of channels into which this money is helped to ‘run.' Quite obviously, one of these channels is mortgage lending (real estate). Here, there is a rapidly declining total volume of liquidity (falling real estate prices, rising defaults) paired with a very high supply of real estate ‘stock' (properties). On the other hand, there is an extremely low supply of companies in the general equities market with high earnings, paired with a relatively very high historical participation rate of share buyers whether through 401k plans or direct share buying and especially, through virtually globally incoming foreign demand and derivatives.

Risk of liquidity loss and loss of substantial capital value when investing in real estate may well be very high at present, whereas risk of total capital loss in the share market assuming an investor is trying to control their TRADING profits via hedged derivatives only, might be relatively small. The whole big difference between real estate and the share market is namely that it is possible to trade an entire company ‘brick by brick' as it were in ‘shares,' whereas it is impossible to trade a house mortgage brick by brick.

When assuming or trying to assume that major realized losses in real estate will necessarily translate into losses in the general share market Indexes because of the need to liquidate positions held in order to get cash or to pay for debts, it is important to consider if or whether credit channeled into the real estate market happened in quite the same way as money was channeled into the rising prices of equities.

General retail banks and mortgage providers were the sources of the real estate credit boom, whereas investment banks, who were also issuers and ultimately free-carried shareholders of shares were the source of the share market boom. Moreover, the building boom carried with it the seeds of an upside in velocity flows of money in sectors such as building materials and transport. The ultimate owners of shares are the investment bank issuers themselves, whereas the ultimate owners of real estate stock will be the mortgages. These mortgages need to foreclose to gain control of the asset base as fully owned capital; until they do that they only ‘own' the credit contracts (in o0ther words they are ledger short cash). The investment banks do not need to do anything to own their capital base and they are not ledger short cash because in theory, if they were prudent, they would not have been lending cash out in order for the market to buy their shares.

Investment banks indeed should have been the recipients of the cash value of the helocs from mortgage providers.

It is unlikely, in my view, that the major equities Indexes can fall substantially at this stage if this assumption were to be based only on the negative effects of the real estate crash currently being experienced.

Because of this differential equation spoken of at the beginning of this essay, it is unlikely, in my view, that there should be an equities market crash because of sudden hitherto unforeseen fluctuations in interest rates springing from a platform of around 5% ANNUAL at the benchmark. This is a relatively LOW rate of interest if it is used to take short-term hedged derivative positions in equities.

However it is absolutely possible for there to be a huge equities market crash. And, there is no question in my mind that it is possible to accurately pinpoint when this is to occur. The whole point about being a professional bear, is about being correct about when to put your shorts in. And that aspect of the differential equation comes under the Time component, and also whether you think the absolute Volume of realizable Money is vastly in, or out of kilter with the market value of equities, or whether you think the Velocity of the available Volume is vastly higher, or lower, than would substantiate and support equity prices.

Calvin J. Bear

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