LIBOR is not a free lunch

The latest banking scandal has some people yawning, some yapping, some yelling. Overall, there seems to be a clear lack of outrage except among those who have an incentive to find a reason to be outraged. What to think? Frankly, this case smells. All the telltales indicate that this is a false scandal. LIBOR is an interest rate derived from information volunteered by various banks periodically. What do the banks get for their effort? Nothing, really. The information they supply costs them time and effort, and they get nothing in return.

LIBOR is a free lunch, an attempt to concoct an important benchmark interest rate from voluntary statements  of a few banks. What incentive do they have to tell the truth? Apparently, the incentive is jail time if they lie, and nothing if they don't. So for the bankers, it is a negative sum game. Is it any wonder that Libor Case Documents Show Timid Regulators? The regulators must have been wondering whether it was an April Fools joke. You can imagine them talking to the walls, as though the pranksters were hidden nearby: "Okay, okay, come on out guys! What's the catch? Tell me what the joke is!"

Since there is no way to predict the outcome of the investigations underway, and there is little reason for those of us who are not LIBOR experts to suddenly learn a bunch about what it is and how it works, our net investment thesis is something between short everything having to do with banks and governments and I don't care and I am going to ignore the whole thing. You could make a case that random and capricious prosecution of impolite behavior (certainly Barclay's attempted "manipulation" of LIBOR at least qualifies as impoliteness) indicates that those in the know among regulators of the financial industry are short the banks and intend for other investors to sell out at the bottom.

It could be foolish to expect that LIBOR will last much longer. Do we need a benchmark rate built on the assumption of a free handout of information?

Eliot Spitzer writes in Larry Kudlow Says the Libor Conspiracy Has No Victims. That’s Grotesquely Wrong (sorry, I misplaced the URL) that there is massive harm done in this case. People are quite astute at perceiving damage to themselves done by others. Some are astoundingly good at it, spotting eleven out of every three cases of negligence or inconvenience that occur. The remedy will be an unexpected consequence:  LIBOR will go away, and we all--Spitzer, you, me, and all the other people who have mortgages and car loans--will have to rely on much fuzzier (and more expensive) estimates of short-term borrowing costs.

'Twist'counting the Future

Today's Wall Street Journal Cynthia Lin writes Debt Does a 'Reverse Twist'. Fed Chairman Ben Bernanke explained earlier this month that the Fed's goal with Operation Twist was to narrow the gap between short term and long term interest rates, bringing long rates down by about 0.2%, thereby giving a boost to business by reducing long-term borrowing costs. As Lin points out, however, long-term rates have risen 45 basis points (an increment of 0.45%) rather than fallen.

So what is going on? Let's go back to basics. Interest rates exist because people prefer present consumption over future consumption. We don't live forever, so if you wait too long you might not get to enjoy the benefits of that dollar. So, you'd rather have a dollar today, say, than two dollars ten years from now. The greater your uncertainty about your future, the higher the interest rate you need to receive to compensate for the risk you are taking of dying before you get your money back.

The credit markets are saying that either inflation will increase or that uncertainty has increased. I see both happening. The spread between 2-year and 10-year rates has increased as well, indicating that the market is anticipating a stronger economy looking forward. A stronger economy will increase inflation pressures, so bond markets need more yield to be persuaded to hold debt.

Although it is tempting to think the Fed had something to do with the reverse twist effect, I don't see any reason for assigning causation there. The Fed was attempting to flatten the yield curve, which in my opinion, if it had happened, would be more likely to reflect contractionary tendencies already occurring in the market. Instead, the market has done what it wanted to, regardless of the Fed's plans. If the Fed has had any role, it could be said that tending to depress the markets in the short term (with a flatter yield curve) would then set up the economy for an inflationary bounce back later.

So far, the moves are slight. Some of the experts Lin quotes are convinced that 2-year Treasuries will eventually rally from here, sending yields as low as 1.5%. My contention is that Operation Twist would have triggered a move in that direction if such events were going in that direction, and therefore that Treasury yields will rise.

PIMCO has had a rough year because it bet heavily against Treasuries in March, around the time that market expectations and economic activity was peaking. Since April, equities have fallen, bond yields have fallen, and bond prices risen as the markets digest Greece's slow, agonizing fall into default. I think PIMCO mistimed its bet, but mainly it was too early. 2012 could see very significant inflation as pent-up demand and economic activity roar back to life.

I am not predicting that any gains in equities or general economic activity will be sustained. It will be characterized more by fits and starts of high demand, accompanied by shortages of raw materials, high oil prices, and inflationary pressures.

The mood in markets is fairly gloomy. Articles are beginning to appear saying that both bulls and bears see stocks as highly priced. With so much pessimism already in the market, the most contrary event would be a sudden rise in stock prices.

Another factor: If the Fed were to err and cause deflation or inflation, which event would be excusable? Before you answer, consider that general inflation would hit the housing market and increase prices. That wouldn't be so bad, would it? The Fed would get a lot more sympathy for "accidentally" causing inflation than it would for a deflation. Housing would recover, homeowners would be above water again, and new buyers would view the housing market with a differnt perspective. Clearly, Bernanke's incentives are to create a little inflation. Even better, if he does so in 2012, and the resulting economic boost occurs as would be expected, then he tends to cause his boss to be re-elected President. (Now that's never happened before, right?)

All in all, I look for increases in 2-year and 10-year yields that will anticipate and maybe keep pace with inflation occurring in 2012 and 2013. It isn't too late to sell your 2-year Treasuries, as some stocks will do much better than Treasures of any duration in the coming 12 to 18 months.