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Analyzing the QE Meltdown, Ex-Ante


Correlation does not imply causation.

MINYANVILLE ORIGINAL Last week I attended an investment conference in Memphis hosted by FTN Financial that catered to its vast depository institution clientele. The overriding theme of the presentations was how to manage your bank's portfolio in this low interest rate environment. I didn't agree with everything I heard, but overall, it was a very value-added experience.

After a night of sucking down beer and Rendezvous ribs, FTN's interest rate strategist Jim Vogel delivered a presentation titled Understanding Low Interest Rates, Supply and Demand for Credit in the US.

For the most part, it was the same story we've all heard about the debt bubble. Vogel goes through the basics of how we got to this point of low interest rates and then addresses whether this is a cyclical change or a structural one.
  • Real interest rates should be negative to reflect aversion to economic leverage and poor risk-adjusted results on other asset classes. Real rates follow debt demand, and the Fed isn't spurring appetites for new loans.
While I didn't disagree with his point of view and analysis of the deleveraging cycle, I jotted in my notes confirmation bias. He basically gave the room of bankers a good excuse for owning and buying the negative coupons his firm has been selling them because the market was rational.

This was an exercise in ex post analysis. Vogel's conclusion was based on what had already happened. Like in the bullet above, explaining the demand for negative coupons was based on the results of returns on other assets. Right, but that's after the fact.

As an investor, I don't want to know why something is priced the way it is today. I want to know what is going to change price in the future. You can't define the risk/reward of buying and holding an asset based on what has caused the price you are paying; you have to define it by what variables will drive the price going forward. In order to anticipate price, you have to identify what risks are not currently discounted but what could be discounted.

Wall Street and Fed policymakers can't handle this concept, and that is why they are prone to blowing up your portfolio. Their models are a function of ex post analysis. They extrapolate data that has already been reported into the future based on past trends or similar past relationships. However, one of the biggest mistakes investors make is interpreting cause and effect in the market. It's easy to draw correlations to explain market behavior, but just because something appears to be related or was in the past does not mean that it is or will be in the future. Correlation does not imply causation.
No positions in stocks mentioned.
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