Crude Contango versus Expected Fed Funds

The above sketches the market expectations for Fed Funds out to March 11 compared to the contango for oil.

Not to dive in about my usual spiel on how crude oil is a bubble that is in end game post crash, but even if I accept the "peak oil" fellows, it makes sense that before "peak oil" can kick in we have to return to a "normal" growth or eliminate the output gap in GDP.

Logic then is clear - Fed Funds reflect over time nominal GDP. Even 2 years forward Fed Funds show a nominal GDP expectations of about 2%, about 1 1/2% below GDP potential assuming a 1% to 2% inflation.

If the "peak oil" requires a return to trend growth, it is interesting to compare the contango so as to "calibrate" to the expected Fed Funds. This doesn't seem to work out. Though both schedules are sloped in the right manner, if the steepness of the oil contango is justified it has to match reasonable nominal GDP expectations repair, with a large part of the output gap eliminated and a return to "potential" trend nominal GDP. Even a quick view shows that compared to Fed Funds, oil contango should be much flatter. Further more, there are signs in long term markets - primarily the forward interest rate swaps and the the long dated interest rate swaps - that return to trend growth will be much slower than these Fed Funds expectations indicate, and the chance of Japanese long term stagnation is real.

Even if the "peak oil" argument holds it looks like the pricing of the oil contango has to adjust to both a longer time getting back to trend nominal GDP growth and that the trend nominal GDP growth or potential is now shifted down from 5% to 3%. If "peak oil" argument still holds it means the front crude price may not have completed the necessary adjustment and we could see a 20 handle and the contango must also flatten. All this and yet still maintain the "peak oil" thesis validity.

But an adverse technical situation may exist where some who reloaded trading positions for 2009, and with remaining legacy positions, which plan to take advantage of the contango by "rolling down" the term structure of oil, may have to be unwound in swift order if current pricing spot and forward do not match reasonable nominal GDP expectations. In that case not only does front oil drop more, but the contango might actually go to "backwardation", at odds with the Fed Funds term structure and cause even further pressure on the front oil.

Now if we enter a Japanese like "lost decade", even with "peak oil", much in oil pricing adjustment would occur. And if there is no such thing as "peak oil" just some theory chasing a market a la Malthus - then we have yet to see the completion of the oil crash and we will see sub $20 oil and even worse, a backwardation of oil. If the last 6 months didnt clip a hedge fund - this scenario likely would.

The following shows a regression of the one year oil contango versus the 10 year interest rate swap 10 years forward (a good quick way ot see what market expectations are for nominal GDP for the long run):

1/17/07 to 1/14/09

I think "peak oil" is hog wash - by the way.

Thinking on Oil Prices; Thinking of Norwegian Blues

The total lunacy and brilliance of Monty Python's "Dead Parrot " skit will be watched a century from now and is perfect to think upon when looking at the following price graph on the front oil contract:

Oil is just pining for the fjords!

http://www.youtube.com/watch?v=e6Lq771TVm4

Putin must be a bit stunned: Nat Gas Markets

In a sign of how Russia is about to join Venezuela as a peer rather than a mentor, Nether land "virtual hub" natgas prices since September 08:

Putin has got to be concerned that his cutting of natural gas to Ukraine didn't even register on European markets.

The Progress So Far: Fed Completely Successful (so far) Bank Credit Crisis Over

The Crisis of 08 is still, form my perspective a classic Banking Crisis with the epicenter being the credit quality and ability to lend of the USA banks. The trigger was the large amount of non-agency scrutinized mortgages which triggered in an absolutely classic fashion a crash in bank credit.

So far this is the domain of the problem and one should not infer a moralistic viewpoint on spending or savings patterns of the USA or the worthiness of the USA market and capitalistic system beyond technical observations on how could the mortgage debacle triggered such a massive crash. All the other headlines such as AIG, autos, home prices, and employment are symptoms of the technical problem - a classic failure in the USA banking system.

There is a good chance, though I don't know yet if it is over 50% probability, that the fiscal remedies applied to fix a bank crisis and public policy fail, or are ill thought out. That certainly seems to be the case with the bizarre tax-centric fiscal stimulus Obama-Biden is proposing now. Then this technical issue of being a bank credit crisis could develop into a systemic crash as we had in the Great Depression. Given good policy and given this is a massive and powerful -still technical - problem, the recovery could be an extremely violent V shape full recovery in asset prices. Of course asset prices are now at levels with that in mind which is why the SPX has not made levels as we saw in the lows of 1933 and 1933. But if those levels develop the technical problem would have become systemic and then a V shape recovery would be very difficult. That development would have SPX trading with little liquidity with little daily volatility at around 200 to 300 and the large lurches down - jumps in vol parlance - would price to what appears to be an incredible 50 to 70 long term volatility and the VIX touching well over 150. That is basically a complete market failure and trading opportunity would be little and pain much.

In that state, to paraphrase Keynes, we are all dead - bull and bear alike. Jesse Livermore wrote the book on speculative trading http://en.wikipedia.org/wiki/Jesse_Lauriston_Livermore and it should be kept in mind that he could not survive the depression and blew his brains out in the mens room of Delmonicos in 1940. We go to this state it is ridiculous to anticipate any trade opportunity. Dave Schulman was a great trader and survivor and partner to John Mulheren - he went through the 70s as an equity trader. I asked him about those times and he said the salary was the benefits and a place to hang out and after a few minutes in the morning everyone would settle down to play poker for the rest of the day. There was no trading. This is "only" the 1970s.

So all focus should be on keeping this a technical crisis and avoid at all costs a systemic failure.

Being a bank credit crisis what to watch as far as tracking progress and the maintaining of that progress to date.

Basically everything that can be done form a Friedman monetarist point of view has been done. Bernanke went to Congress with Paulson in September, warned our elected representatives what the score was and he was insulted and chastised with comments that one of the world's leading academic in depression economics would have thought inane and showing that Congress was a totally ineffective and unreliable avenue to meet this crisis. But for when summoned we never saw Bernanke again in front of Congress and then he faded quickly to Fed-speak, letting Paulson and his mini-me "Kash-and-Kari" to babble away and present a helter skelter policy answer.

Bernanke then steadily implemented the largest Central Bank operation since Bagehot wrote "Lombard Street" in the 1870s.

The progress of the Federal Reserve can be observed here: http://www.federalreserve.gov/releases/h41/ the H.4.1 "Factors Affecting Reserve Balances" which shows the following incredible "quantum physics" like developments. Compare the summation of the total liability of the Federal Reserve balance sheet (capital and A/L) on August 7 2008 versus the latest Jan 8 2009.

Capital and Assets and Liabilities Fed Res

August 7, 2008 $902,471,000,000

January 8, 2009 $2,141,053,000,000

First, as indicated by current money market relationships (which I give below) any Jim Grant or standard gold bug talk or USA falling apart like the USSR is obviously complete rubbish to anyone with even a moments thought on the above numbers. The August numbers were already at levels folks thought stressed and ready to crush the Fed with Maiden Lane on the balance sheet. Then looked what Bernanke did which resulted risk pricing leaving the market and basically a complete cure in money markets by taking almost the entire USA money market and putting it on the Federal Reserve balance sheet. At least to this level of stress all doubts or silly talk about demise of the USA should be laid to rest. And this "proof" is the core of any development of a bullish stance.

The spread between Fed Funds and LIBOR (rate banks led to each other) , and how it developed through the crisis and how it repaired contains most of the story, especially if the market expectations of this spread in the forward markets is looked at. In the following it is the spread as traded for the next 2 years:

The frightening data point is the 300 basis points reached in October which showed the market was pricing for a complete failure of the USA banking system resulting in either a nationalization or a bank holiday. Now the spread of 18 basis points (.0018%) indicates complete repair and confidence this Fed Reserve fix will be robust and last. Watch this spread before you start really betting on gold or other weak-USA trades.

Many in the market catch some of this change by watching the 2 year interest rate swap spread:

But this does not depict the dynamics occurring in the immediate short end and in Fed Funds.

As this bank credit crash was occurring, the most alarming pricing which actually did, for a few weeks lent credence to the most dire predictions of a depression and end of pax Americana was the risk premia in the risk-free curve. One way to observe it is ot look where the 3 months LIBOR rate is in Chicago 7 years in the future and subtract that rate from the same 8 years in the future:

This tracks from 12 to 20 basis points which can be an off the cuff risk premia measure showing the markets idea as to the risk of the Federal Reserve able to control inflation and deliver growth. I would certainly buy gold if this was seen to shoot up to 30 or 50 basis points. But the spread collapsed top where during the grimmest days of November, the absence of fiscal partnership to the monetary fix the Federal Reserve was providing indicated the development of systemic economic failure and the negative spread of -2 to -10 shows the market was starting to price for deflation 7 years plus forward. Think on that for a bit. But we are back form the brink and it looks like some normal expectations of risk has re-appeared.

So the technical issues have been pretty well all cleaned up as far as what happens with a bank crisis.

But to prevent this from becoming systemic, a fiscal stimulus policy has to be forthcoming which is in size equal to any jump increase in savings (which will be a drop in consumption as it occurs) along with offsetting the large drop in corporate investment (cap x) which will also be occurring. If the market starts to doubt the ability of the incoming administration to effect such a policy, the market will first discount secondary assets to bank credit - the SPX and credit spreads. But if Obama does not respond then - say with SPX making new lows - and rewrite the plan to provide adequate stimulus, then the containment shell the Fed Reserve will start to crack and if the above relationships return to October/November levels, don't buy gold but go buy arms, 2 years of dehydrated food, some good mountain bikes for you and your family, penicillin, and fish hooks (fishermen never starve).

SPX Volatility Implied Surface and Realized: Concern Over Obama-Biden Plan

The last several months of the Credit Crash of 08 has been noted mostly through the shared pain of the daily movements of the SPX.

10 day realized volatility in the SPX - average daily move in the SPX for 10 days expressed in units of one standard deviation - "realized vol":

Since most of the pressure and drama since August has been on the downside, the volatility realized tracks the market to a great degree. This along with some technical consideration of the correlation of the stock moves making up the SPX, is the reason most folks look at high volatility as a sign of a bear market - and that usually is the case in the short volatility measures.

And since the SPX is the the broad market index most closely aligned with the USA GDP waxing and waning - or rather the "gap" that current growth realized in excess or less than the growth than the GDP can reach without starting inflationary pressure - it is reasonable to look at volatility as the "canary in the coal mine" in regards to how GDP is doing.

Market makers and position takers on the option markets seldom take a view on options in terms of the direction of the SPX, and carry various hedges to offset their risk. Therefore there is a usual and dependable relationship between the above "realized volatility" above and the "implicit volatility" that, as named, is implicit in the option price. Further more their is a relationship between short term volatility explicit and implicit and longer periods of volatility which is a function of time - in fact it is the square root of time - which I wont get into here as it is the concept that is the core of much of Einsteins work and allowed Black, Scholes, and Merton to win their Nobel.

But it means we can watch developments in volatility and then reasonably expect it to "expand" or "scale" along time at certain levels and also relate, for SPX, to the economy and between option trading (implicit volatility) and price moves in SPX (explicit or realized volatility).

Volatility also has strong tendencies or is "persistent" such that basic shapes in the movement of volatility can provide a weak prescience of the future. Volatility is therefore the most important market level to watch and understand as it is the only technical trading pattern that will provide a dependable prescient development. (This is the basis of various complex works called ARCH and GARCH).

Basically persistence means that given the above connections, SPX volatility viewed in implicit (forward, ex ante) space as well as realized volatility (ex post) to justify or verify the moves in implicit volatility, and given the all important macro economic considerations that now dominate everything, all will give you a brief head start on trading or at least allow one to control risk in terms of whether or not "is it safe yet".

Past market moves during duress is a good starting point. First look at the 70s with long term realized volatility (120 days) showing a typical pattern which is the basis of "persistence" academic theory:

A core aspect of the persistence characteristics of volatility is that it will, in the end, never describe a multi peaked pattern but will always depict, in the end, a single peak. That means it is very dumb to apply standard technical and trend analysis on volatility. What one does it determine the "regime", the long term riskiness or volatility in the market and then watch for the volatility realized, and implicit to fill in a single peak. The closer one gets to the market in terms of shorter periods of realized volatility considered and in short dated options, the more messy this gets and the less obvious the development of this single peak can be. This is why folks do apply technical analysis to the short dated VIX and live to tell the tail, but they are always at risk for a regime shift or a snap back to the regime due to persistence such that the larger moves will be jumps.

The current pattern of realized 120 day of realized SPX volatility:

If this doesn't give you pause for concern, I don't know what would. As far as volatility in any strategic consideration goes, is like catching a falling knife. Potential for large gains but only a hint of a peak being described.

Option markets are being more constructive in general and there is solid academic literature which provides over time and in longer dated volatility markets, and given all the connectivity noted above, the implicit volatility of the SPX is prescient and will lead realized volatility.

The SPX volatility market at various dates shows this messiness in the short end but longer dated volatility expected perhaps has made a turn:

And the daily SPX moves over time to "justify" the above vol markets:

But, one should keep in mind the long dated realized volatility and relate it to the pattern that did fill out in the 70s. Long dated realized SPX will in the end define a single peak. Market is still on hold and all is bet on the Obama-Biden Plan being sufficient and that Keynesian principles do work.

Nothing else matters.

Kalecki - Levy Analysis onCorp Profits and Obama Biden Plan

The good folks at Levy Economic Institute are the keepers of the flame for the Minskian economic analysis. Minsky has regained popularity this year as Bill Gross used the phrase (think it was one of his bond guys which brought it to his attention) "Minsky moment", as in 2007 to 2008 crisis was the USA experiencing a Minsky moment.

A lot of folks started glomming onto the Levy Economic Institute http://www.levy.org/ website to get on board.

To date the doom and gloom folks had been applying Minsky to show we were "gonna get it and get it good", applying the key "instability" thesis of Minsky - noting the three phases of economic dynamics from "hedge" to "speculative" to "ponzi" stages - with of course us always being in the "ponzi" stage and going to hell. Well, in finally happened and in this light Minsky guys flying high.

But I came across Minsky when I got to know Jack Nash in the last 80s, trying to get a berth as his bond guy. That didn't happen as the psyche tests Jack applied indicated I was "too nice a guy" - a problem many will testify I worked hard to remedy over the years since. But Jack seemed to like me and I guess to mollify me he gave me a book written by his partner Leo Levy's father Jerome Levy on how American corporate profits were determined by an analysis of public sector deficit/surplus, private sector savings, trade, and corporate investments - the "Kalecki-Levy Formula". Jack said this is how Odyssey made their money, so I sat up and paid attention.

So over the years I have used and read with great interest all the Levy Institute stuff not to be a prophet of doom but to make some money as per Jack. This was perhaps the using Minskian ideas for the "dark side" but it sure worked for me. I found a major flaw is that those who use

Minskian analysis is that the "instability" aspect of Minsky's work was thought to indicate that of

course we were "gonna get it and get it good". Minsky clearly takes a more balanced approach and rather than portray "instability" as proof modern capitalism is flawed, he cheerfully said it was a natural state of democratic liberal capitalistic systems and was a function that showed the danger but also in Schumpeter like way was an engine of great achievement.

The core function that is used throughout the Minskian models is Kalecki-Levy formula (K-L)- a fascinating story is how two geniuses - one making buttons ad the other a major socialistic European economists both arrived at the derivation and identified the importance of corporate profits in the analysis of Western capitalistic economies. Jerome Levy derived the formula to try and manage his inherited "notions" business through the turbulent first half of the 20th C while Kalecki was part of the academic economic criticism of the American capitalistic structure.

It makes perfect sense that profit dynamics would be a key driver of capitalistic economies - but even to this day it seems only those Keynesian economics with a Minskian bend hold it front and center.

The K-L formula in essence, taken from this paper:

http://129.3.20.41/eps/mac/papers/0004/0004056.pdf Profits: The Views of...Kalecki...Levy" 2000 from the Levy Institute :

Corp Profits after-tax = Corp Investment + Private Sector Investment + Net Trade + Actual Deficit Spend - Savings

Minskians use this identity to map out both the instability implicit (volatility) in the economy but also once corporate profits are identified by the more easily predicted public sector flows, prescience can be provided for GDP and thereby equity markets. Ergo why Jack Nash claimed this is how they made all their money.

It can bring insight in considering major watershed events and qualify public response. Application of the Kalecki Levy is the best way I know of to figure out what the SPX will do in 2009 given the Obama-Biden Plan.

Based upon this use of K-L, I was dismayed to find the O-B Plan intends to use a large chunk of the deficit spend in the form of tax cuts. The K-L identity will only count actual deficit spend and assume tax cuts or changes are just part of savings.

My simple table of a K-L breakdown if the O-B as written is what we get:

Notice the disastrous plunge in corporate profit and the move to 7% to 8% savings rate such an environment would bring. This would likely be commensurate with an SPX earnings below $40. The graph of this disaster is:

And the likely results in GDP and investment and Profits in nominal dollars:

I think I have gotten all the identities basically right. Obama Biden as written suggest we enter a depression.

Now, what amount of fiscal stimulus is required - and again I mean actual public sector spend, not counting tax adjustments as spend - to maintain 4th Q 2007 corporate profits. I assume savings continues upwards but not as much as some reduction of fear will result, though I assume corporate investments do not change.

The table:

This graphs out to a slowdown in GDP as savings still increase but not as much as with the O-B Plan as written and with the savings increase and corporate drop in investments offset by fiscal stimulus spend:

And the nominal dollar results that likely results with this true spend increase of $1.2 trillion in fiscal stimulus. Corporate gross investments still drops sharply but the fiscal stimulus is enough to keep corporate profit intact and also maintain GDP:

This would have the recession behind us and SPX earnings for 2009 be in excess of $70. Unemployment would start to improve by second quarter and likely back towards 6% by this time next year.

Romer's "The Job Impact...." Important

http://otrans.3cdn.net/45593e8ecbd339d074_l3m6bt1te.pdf

http://tinyurl.com/89wwxv

Christina Romer released a defense of the Obama Biden Plan (OB) this Saturday AM. It is a must read. I am personally confused as she has now claimed that the OB as written will provide 3.6MM jobs by 12/10.

Yet she also acknowledges the large difference in tax credits/cuts on GDP growth versus direct public sector spend/investment with a schedule showing tax credits/cuts expand to a multiplier effect or increase in GDP per dollar of .99 while spend or investment form public sector has a obvious multiplier that expands to 1.57 by the second year.

I find it confusing that the effective jobs added keeps expanding as the incoming admin discusses OB and also how this is possible given the non-existent money multiplier for OB.
Romer also provides a very comforting pic which shows unemployment with and without the OB:

This graph is not the rough, but I think correct view, I hold that if nothing is done unemployment certainly exceeds 10%.