Thursday, March 5, 2015


One thing that bugs me to no end is the generic assumption that we can tease out tons of information from prices, this is probably mostly a rant piece so feel free to ignore (all zero people that read this blog).

Point 1.  You can only figure out default probability by comparing interest rates to some neutral asset.  Say, for example, you wanted to guess at the implied default rate of a bond put up to build a new casino in Vegas.  You take that bond and subtract out the interest rate for a T-Bill of similar maturity and you have a decent idea of what that bonds default rate is relative to the T-Bill.  This ONLY works because you are assuming the failure of 1 hotel in Vegas doesn't cause a noticeable change in the probability of default of the US.  Duh.  Everyone knows this.  Except tons of people don't follow this advice when discussing the default rate of T-Bills.  I have read, in various comments and blog posts, probably dozens of different times some variation of "the market doesn't seem worried about a US default seeing as they are only demanding x% interest rates to compensate".  So here is the question- what would you want to hold if there was a default in Treasuries?  Cash?  Where are we putting trillions of dollars in cash, because the US banking system is backed both explicitly and implicitly by US bonds.  If there was a default the FDIC would not be able to cover any substantial failures without turning to the treasury who wouldn't be able to borrow. 

Point 2.  A market price only tells you about what market participants think.  The TIPS spread only tells you about inflation expectations of people that actively buy treasuries, and who think that TIPS are an excellent way to play high inflation expectations.  If Gold cranks generally aren't buying TIPS when they think inflation is around the corner, they buy gold.  It doesn't matter if you think they are nuts or not, if you call you position "market monetarism" but exclude portions of people you disagree with, guess what- you should be dropping the "market" portion of your name.