Alex — I want to ask your thoughts about long bond yields, if you are willing to share. Specifically, I wonder how US long term interest rates can remain as low as they are now, without triggering a complete collapse of the pension system (actual pensions and insurance co annuities). Pensions assume 6-7%, while long bonds pay half as much? No way. Some tax increases might happen, but convexity makes tax hike math impossible… How do you see this ending?

The assumption of 6-7% risk with low risk is not realistic and the pension system will have to adjust. I don’t think this concern has any mechanism of actually affecting the rates. 

As the United States has current account deficit, i.e. relies on foreign investment to fund its debt, lower rates are beneficial for the nation as whole.

Greece and China: Crisis doesn’t happen on schedule.

It has been a fun weekend. Between the escalation of Greek crisis and the surprise liquidity measures in China, it was as if the market never closed.

When considering market significance of a geopolitical event, it is important to distinguish between

  • The actual economic effect
  • The immediate impact on market players

In the case of the on-going Greek debt crisis and the potential so-called “Grexit”, remember that Greek economy commands only about 2% of the Eurozone GDP. Whether Greece muddles through or exits, the long-term economic impact should be moderate.

Two points that have been made by multiple people:

  • Greece exit might create a blueprint for an exit by other countries on the periphery, such as Portugal or even Spain.
  • Eurozone might be actually economically better off and the euro incrementally stronger without Greece.

What concerns me now though, is whether whatever happens in Greece may trigger a market panic or even a new crisis. There I encounter the “positioning” conundrum.

Paradoxically, it is easier to describe what would happen to the  markets in the aftermath of a completely unanticipated and destructive event such as 9/11. We would expect a sharp equities sell-off, a flight to U.S. Treasuries and to defensive currencies such as dollar, swiss franc, and yen. The reason is that if market players are not positioned for this particular event, it is easy to guess what they would do.

But when an event was in the making for five years, the prediction is much harder. The “buy the rumor, sell the fact” paradigm comes into play. If we assume that most of speculative money was already positioned defensively with respect to Greece, any resolution may come as a relief.

But let’s go to the next level. If the speculators anticipate the post-resolution relief rally in Greek bonds and stocks, they may actually not be positoned defensively.

You know that I know that you know…

A parallel begs to be drawn with the Russian crisis of 1998. Russia didn’t default exactly overnight. But market players were anticipating either default or devaluation of ruble, not both. Caught by surprise, over-leveraged hedge funds folded like dominos, liquidating all positions, good or bad. Everything, from swap spreads to implied equity vol to municipal bonds went into a crisis mode.

So the question we have to ask ourselves is not just what exactly going to happen to Greece, but how is the “fast money” positioned.

Greek banks are not opening on Monday.

Stock market is likely not opening.

Virtually nothing should surprise us on Monday morning. Not a huge market commotion, not a relief rally,  and not even business as usual.

Generally I am a fan of the concept that “crisis doesn’t happen on schedule”. We have learned it after the Y2K. And we knew in advance, about all the deadline for Greece and the dates for Brussels summit. 

As I write this on sunday afternoon in California, the euro is down moderately (1.5-2%) and US Bonds are rallying quite a bit. My usual intuition would be not to get overexcited and stay with my core positions without adding anything. Which happen to short euro and long bonds as all my readers know.

If anything my bias would have been to expect for things to calm down and pull back to normal on Monday.

However, for me China is the enormous extra variable in this equation. I have tweeted earlier that extraordinary measures taken by the PBOC over this weekend indicate to me that might more problems there than it looks from the outside. Indeed, the correction in the stock indices like SHCOMP which are still tremendously up on the year is hardly a disaster by itself. But the aggressive central bank’s response may instill further doubt rather than inspire confidence.

But beware of contagion! Risk aversion in Europe may spill into Asia and converse. And when it comes to positioning in China  – I have a feeling – the majority market players expect the government to be able to back-stop any crisis.

This type of confidence has been a path to disaster over and over again in the course of history.

My readers know me as a general global growth and economy bull. I don’t cry “crisis” often. But the confluence of events over last few days is making me view risks as highly elevated.

China: You have to know the rules to play the game.

Here’s the deal: I am a trader, not an economist. I have no qualifications that would allow me to dig up any data that others don’t have or create innovative econometric models. What I am good at (I think) is coming up with trading strategies given an economic paradigm.

The USA has been my bread-and-butter for many years. Some find it challenging to operate in such transparent and well-researched market; they bemoan the lack of informational advantage. I am very happy with the lack of informational disadvantage. When it comes any broad domestic market, I can rely on widely available research to formulate my strategies. In fact, I don’t even have to read in-depth any particular research – a mere osmosis gives me sufficient idea of what is going in the United States. Following any given researcher closely accords more of this person’s opinions and little in a way of informational advantage.

This way of thinking has been leaving me in the dust when it came to China. The future of this country is one of the largest (if not THE largest) variables which will affect the course of global economy. And I have been at a loss of how to formulate a China strategy for over a decade. Any trade I could conceive of left me at a huge informational disadvantage.

The problem is dual. Any official statistic coming out of China is unreliable. But even if I had the correct numbers, I wouldn’t know how to interpret them: Chinese party-controlled society needn’t obey the same causality laws as a true free market economy.

The hodge-podge of conflicting opinions on social media was very confusing and I have been having hard time distinguishing between biases (including my own) and hard facts.

It was like playing poker without knowing the hand rankings.

This is why, I have so much looked forward to a comprehensive modern book on Chinese economics. Yes, modern. I didn’t need a review of the Ming Dynasty politics, but a systematic professional presentation on what is going on now.

John Mauldin and Worth Wray, the creators of the anthology A Great Leap Forward? didn’t disappoint. The editors, as well as their contributors, are not afraid to state their opinions, but what distinguishes this book is the intellectual discipline of separating those opinions from facts.

The anthology engages China sceptics and optimists to deliver every point of view to a reader.

China bears tend to focus on ballooning credit growth problem, mounting inefficiencies, and pressures on the RMB carry trade. Meanwhile, the bulls talk about the unique positioning of China, its potential to technologically leapfrog the West, and the government being on the right track to conducting the necessary reforms.

Yet the book’s discourse on China cannot be characterized as simply a battle between two opposing camps. The interaction of economic and geopolitical scenarios creates a non-linear set of outcomes. The contributors all realize the underlying uncertainty, but they assign different probabilities to various possible paths for China.

The styles of chapters are as diverse as opinions: some are very technical and some read like excerpts from a geopolitical thriller. Fortunately for a non-professional reader, the editors present a summary for every chapter, which allows one to decide where to focus their attention.

There was a bit of tough love for me. l did not finish this book with a clear plan or strategy imposed, rather I was given the facts and arguments and will have to come up with my own decisions. It is more daunting, but in the end, this is the way I prefer it.

Those who follow me may have noticed that my tendency is to side with China sceptics. I do have three inherent biases:

  • I am sceptic of any government being able to retain control, as they manage economic transitions.
  • I have very low respect for Communist ideology and the ability of Party to control corruption.
  • I have observed Chinese historical tendency to self-destruct each time they have risen to dominance.
  • A Great Leap Forward helped me to see past those biases and remember that

    • On one hand, the current positioning of China is truly unique and unprecedented.
    • On the other hand, there are examples of authoritarians rulers successfully implementing economic reforms (Pinochet’s Chile and Peter the Great’s Russia come to mind).

    The next step is to parse what I’ve read, discover undeniable common threads, and to find asymmetric macro bets.

    For example, the opinions on the imminent RMB devaluation range from near certainty to very low likelihood. But this is where I can get useful takeaways.

    Assume I believe the estimate of a China optimist and relative RMB bull that chances for this year are:

  • 75% no deval
  • 15% small deval
  • 10% large deval
  • An economist in my place would say “my forecast is no deval”. But as a trader I say “there might be limited downside, positive expectation bets on deval”.

    Or, when a contributors thinks that in the event of continued dollar appreciation RMB will deval slightly against the dollar, but perform well against other currencies, I say “Aha, I can have a low risk bet on strong dollar via shorting RMB”.

    So, I am still leaning toward the sceptics, not because I am certain they are right, but because they offer positive expectation bets that can have an additional benefit of protecting portfolios in the event of China-induced global slowdown.

    A Great Leap Forward is a must read for anyone whose financial fortunes are in any way linked to China (which is by now almost anyone).