Keep Testing Self-Driving Cars, Even if They Kill People

If March 18 was a typical day on America’s roadways, about 90 people lost their lives in car accidents during that 24-hour span.

Unless you were unfortunate enough to know one of them, you probably didn’t hear about the vast majority of those crashes. But you’ve probably heard about the accident that killed Elaine Hertzberg, a 49-year-old Arizona woman who was struck and killed by an autonomous Uber vehicle undergoing testing in Tempe. Video of the incident released by police shows that Hertzberg was crossing the street outside of designated crosswalks, and that neither the self-driving car nor the human back-up driver stationed in it had time to detect Herzberg before the collision took place. Police determined that the pedestrian was at fault.

It was an unfortunate accident, the kind that unfortunately happens every day on roads all over America. The fact that the vehicle was a self-driving car has made the accident a national news story, but policy makers should try not to overreact. Self-driving cars have an incredible potential to save lives, and officials should not put that prospect at risk.

Already, Arizona Gov. Doug Ducey, a Republican, has suspended Uber’s self-driving car testing privileges in his state, citing concerns about public safety. That move is a “a major step back from his embrace of self-driving vehicles,” notes Melissa Daniels of the Associated Press. Ducey had previously welcomed autonomous driving tests to the state after they were subjected to strict regulation in California.

Meanwhile, four state senators introduced a bill this week to ban autonomous vehicles from being tested in Minnesota. “Arizona confirmed my concerns,” state Sen. Jim Abeler (R-Anoka) told Minnesota Public Radio. “I’ve been hearing about this and am very worried about it. And very frankly the idea of driving home while you ride in the back seat is just a recipe for trouble.”

Want to hear an even bigger recipe for trouble? Driving home while he rides in the driver’s seat.

To err is human, and human error is the cause of 90 percent of car crashes. “We should be concerned about automated vehicles,” University of South Carolina law professor Bryant Walker Smith told the Associated Press in 2016. “But we should be terrified about today’s drivers.”

If driverless cars can amass a better safety record than that, they will literally save lives. Unfortunately, those futures lives saved are invisible relative to lives lost in the present, which have significantly more weight for governors, legislators, and regulators.

In aggregate, car accidents are a massive public health problem. And I don’t just mean the deaths they case. Americans spend $230 billion annually to cover the costs of accidents, accounting for approximately 2 to 3 percent of the country’s GDP.

Driverless cars will not be perfect. Certainly, they won’t be perfect when human beings are darting out into traffic on dimly lit streets where there’s no crosswalk, as Hertzberg apparently did. But we shouldn’t expect perfection. If they can be better than human drivers—and that’s a low bar—then they should continue to be tested and developed. They will only get better.

And even if you’re skeptical of the assumption that computers can drive better than human beings, the only way to find out for sure is to allow more testing. As Megan McArdle of The Washington Post points out, Americans drove 3.2 trillion miles in 2016, with a 1.18 fatalities for every 100 million miles driven. How far have driverless cars driven since they began being tested? Fewer than 100 million miles. It sounds like a lot, but it’s a very small sample size. To get a better perspective, we need a bigger sample.

Prior to the accident earlier this month, Arizonans seemed willing to give autonomous vehicles that chance. A February poll sponsored by the Consumer Choice Center found that 51 percent of Arizonans favored testing self-driving cars in the state, while 42 percent were opposed. Residents aged 18 to 44 were far more likely to support self-driving cars than older residents were.

Those feelings may shift in the wake of Hertzberg’s death, but officials should keep the long-term perspective in mind.

As Reason‘s Ron Bailey wrote in a prescient July 2016 article, driverless cars have the power to make us richer, less stressed, more independent, and safer. “Unless,” he added, “lawmakers and regulators manage to screw everything up.”

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Report: FBI Officials Dragged Feet Breaking into Terrorist’s Phone to Try to Force Apple to Weaken Encryption

Syed Farook and Tashfeen MalikRemember when the FBI went before a judge to demand that Apple break its own encryption and force access into a terrorist’s iPhone? A newly released report from the Justice Department suggests that the bureau may have deliberately avoided alternative solutions in order to go to court and create a precedent.

The case involved a locked work iPhone in the possession of Syed Farook, one of the terrorists responsible for killing 14 people at a San Bernardino Christmas party in 2015. When the FBI asked Apple to help them break into the phone, Apple refused, arguing that doing so would render all their customers vulnerable to intrusion. The bureau eventually gained access with the assistance of a third-party contractor.

Cybersecurity and privacy experts speculated that the FBI was deliberately trying to create a precedent for forcing tech companies to weaken their encryption on demand. An inquiry by the Office of the Inspector General for the Department of Justice should fuel those concerns further.

The purpose of the Justice Department’s investigation was to determine whether then–FBI Director James Comey spoke accurately in February 2016, when he testified before Congress that the FBI was unable to unlock Farook’s phone. The report concludes that Comey was telling the truth at the time. But it also highlights a fair amount of foot-dragging. (The FBI waited til mid-February before looking for outside assistance in unlocking the phone.) The chief of the cryptographic unit, it concludes, did not want a third-party solution. The chief wanted to use the case to force Apple’s compliance:

[Executive Assistant Director Amy Hess] became concerned that the [Cryptographic and Electronic Analysis Unit] Chief did not seem to want to find a technical solution, and that perhaps he knew of a solution but remained silent in order to pursue his own agenda of obtaining a favorable court ruling against Apple. According to EAD Hess, the problem with the Farook iPhone encryption was the “poster child” for the Going Dark challenge.

“Going Dark” is law enforcement jargon used to describe their inability to bypass encryption and cybersecurity tools to engage in surveillance or access data of targets of investigation.

The chief apparently became frustrated when the third-party solution undercut the legal challenge, reportedly asking another official: “Why did you do that for?”

Apple was put under enormous political pressure to comply with the FBI. Donald Trump, then still a presidential candidate, called for a boycott on Apple. Other GOP candidates demanded that Apple cooperate with the feds. Sens. Dianne Feinstein (D-Calif.) and Richard Burr (R–N.C.) crafted terrible legislation that would require tech companies to follow the feds’ demands that they weaken their cybersecurity. The bill failed, fortunately.

During that whole public fight, some FBI officials were deliberately trying to fail. All to sell a narrative that they had no choice but to make Apple weaken its own security—and yours as well.

Read the inspector general report here.

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Is The Fed Paniccing? Yield Curve Tumbles To Fresh 11-Year Lows

Despite the stock market’s Amazon-bounce gains, US Treasury yields are lower and the yield curve flatter once again – tumbling to its flattest since Oct 2007.

Deja vu all over again…

10Y Yields are holding below 2.80%…

 

And the yield curve has crashed to fresh flats not seen since Oct 2007…

 

The entire curve is rolling over…

As a reminder, Bloomberg notes that according to the minutes of the Federal Open Market Committee’s Jan. 30-31 meeting, the most recent for which minutes are available, showed that some policy makers thought it important “to monitor the effects of policy firming on the slope of the yield curve,” noting the strong association between curve inversions and recessions.

Which confirms what The San Francisco Fed warned…  about the flattening of the yield curve…

“[it] is a strikingly accurate predictor of future economic activity.

Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve.

Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession.”

Furthermore, as the two Fed authors explain below, the recent decline in the Treasury curve is sending recession probabilities notably higher.

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Killing Ride-Sharing Is Not the Solution to America’s Transportation Blues

Uber has come under fire everything from its safety record to its disruptive effect on transit agencies. But those sins don’t even scratch the surface, Steven Hill writes in The New York Times. The ride-sharing service is rotten to the core, he says, thanks to “a business model that harms drivers, and the environment, and drains away passengers and revenue from public transportation.”

According to Hill, Uber is waging a “predatory price war” aimed at achieving a “transportation monopoly.” It’s shutting out the competition—in this case, saintly public transportation agencies—by charging artificially low fares. In the process, the company is worsening traffic congestion and harming the planet. Only by using regulation to forcibly dismantle Uber’s business model can we write these wrongs and get riders back on buses and trains where they belong.

Or so says Hill. He leaves a few things out.

For starters, for all that he writes about Uber’s low fares, Hill spills not a drop of ink on the fact that those public transportation services are themselves subsidized up to their eyeballs. Unlike Uber, whose losses are covered by shareholders voluntarily sinking cash into the company, transit subsidies come straight from taxpayers, whether they ride it or not.

I am aware of no transit agency in the United States that turns a profit. Few are even able to cover half of their operating expenses with traditional farebox revenue.

Take New York’s Metropolitan Transit Authority (MTA), which runs the city’s buses and subway system. It’s the most heavily used transit system in the country, and it services America’s most densely populated major city, yet it covers only 40 percent of its operating expenses through with farebox revenue.

Hill mentions a colleague who expresses a preference for a $5 Uber ride over a $2.25 bus ride. Hill asks his friend whether he’d make the same choice if that Uber ride was an unsubsidized $10. Given that MTA’s bus service covers less than a quarter of its operating expenses with ticket sales, perhaps Hill should have asked his colleague whether he would prefer a $10 Uber ride or a $10 ride on the bus.

This example is telling in more ways than one. The fact that Uber rides—whatever their level of subsidy—are still more expensive than public transit suggests that price is not the only thing encouraging people to make the switch. Uber and other ride-hailing services offer added comfort while traveling, plus the convenience of being taken directly from point A to point B at a time of your choosing.

It also includes the numerous downsides of America’s public transit systems. Ridership on New York’s public transit systems dipped last year for the first time since 2009. In other words, ridership managed to grow for the first six years that Uber was operating in the city. That it fell in 2017 has at least as much to do with the failings of public transportation as it does with the benefits of Uber. 2017, recall, was the year of the New York subway’s “summer of hell,” which saw track fires, derailments, claustrophobic waits aboard broken trains, sewage spewing from station ceilings, and an on-time arrival rate of 65 percent.

Since then things have gotten worse. The New York Times reported this month that on-time arrivals now average 58 percent. Some lines are performing even worse, with less than 40 percent of trains arriving on time. The fact that ride-hailing companies are giving travelers an alternative to this dismal service is a positive development.

It is of course true that when more people ditching public transit for ride-sharing services, more cars are on the road, increasing congestion. But time spent in traffic is just another cost riders should be free to shoulder or shrug off, depending what works for them. For many New Yorkers, the 15 percent decrease in traffic speeds is still not enough to get them back on the subway.

That’s not to say that policy makers can’t do anything about congestion. Gov. Andrew Cuomo’s Fix New York panel has recommended a $11 charge for any vehicles entering lower Manhattan. This kind of “cordon pricing” is not a terrible idea and is already in place in cities as diverse as London, Stockholm, and Singapore. A better idea might be congestion pricing, where a variable toll is charged to drivers entering the city depending on the number of vehicles on the road. Virginia is trying this out on badly congested stretches of Interstate 66 on the approach to Washington D.C.

The revenue from these fares can then be spent on adding lane-miles to highways or subsidizing bus and transit service.

Hill, by contrast, recommends capping the number of ride-sharing cars, prohibiting “subsidized fares,” regulating Uber like taxis, collecting drivers’ contact information so that it can be handed over to union activists, and forcing the company to pay drivers more.

You’ll note that these ideas have little to do with combating the supposedly negative consequences of Uber and Lyft, or even with improving public transit so that more people will consider it a viable option. They’re all designed to limit transportation options that Americans have been freely choosing.

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Nasdaq Scrambles Green As White House Down-Plays Amazon Focus

Nasdaq has managed to scramble back into the green for the day, led by Amazon’s rebound following a White House statement that “there are no specific policy changes regarding Amazon right now, but always looking at different options.”

Nasdaq is green…

 

One wonders if someone told Trump that “Amazon is the market” and he realized he needs to back off…

As goes Amazon, so goes ‘Murica!

 

Nasdaq also seemed to reject going red for the year…

 

Once again the S&P 500 found support around its 200DMA…

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15 Years Of War: To Whose Benefit?

Authored by Charles Hugh Smith via OfTwoMinds blog,

As for Iraq, the implicit gain was supposed to be access to Iraqi oil.

Setting aside the 12 years of “no fly zone” air combat operations above Iraq from 1991 to 2003, the U.S. has been at war for almost 17 years in Afghanistan and 15 years in Iraq. (If the word “war” is too upsetting, then substitute “continuing combat operations”.)

Since the burdens and costs of these combat operations are borne solely by the volunteers of the U.S. Armed Forces, the American populace pays little to no attention to the wars unless a household has a family member in uniform who is in theatre.

Permanent combat operations are now a barely audible background noise in America, something we’ve habituated to: the human costs are invisible to the vast majority of residents, and the financial costs are buried in the ever-expanding mountain of national debt. What’s another borrowed trillion dollars on top of the $21 trillion pile?

But a nation continually waging war should ask: to whose benefit? (cui bono) As near as I can make out, the nation has received near-zero benefit from combat operations in Afghanistan, one of the most corrupt nations on Earth where most of the billions of dollars “invested” have been squandered or stolen by the kleptocrats the U.S. has supported.

What did the nation gain for the tragic loss of lives and crippling wounds suffered by our personnel and Afghan civilians?

As for Iraq, the implicit gain was supposed to be access to Iraqi oil. As near as I can make out, the U.S. imports about 600,000 barrels of oil per day from Iraq, a relatively modest percentage of our total oil consumption of 19.7 million barrels a day.

(Note that the U.S. was importing around 700,000 barrels a day from Iraq before Operation Iraqi Freedom was launched in March 2003–and imports from Iraq declined as a result of the war. So what was the energy-security gain from launching the war?)

Meanwhile, Iraq exports over 2 million barrels a day to China and India, where the presumed benefit to the U.S. is that U.S. corporations can continue to produce shoddy goods using low-cost Asian labor that are exported to U.S. consumers, thereby enabling U.S. corporations to reap $2.3 trillion in profits every year.

(Before China joined the World Trade Organization (WTO), U.S. corporate profits were around $700 billion–less than one-third the current gargantuan sum. Isn’t this suggestive of the immense profits gained by offshoring production to Asia and reducing the quality of the goods being manufactured?)

Since “energy security”, i.e. access to oil, was the implicit reason for going to war, let’s ask: were all the sacrifices of lives and limbs and the direct costs of roughly $1 trillion worth the roughly $200 billion in oil that the U.S. has imported from Iraq– and if history is any guide, could have imported without going to war at all?

It’s far easier to blunder into war than it is to blunder out of war. But hey, it’s certainly been profitable for a few at the top of the financial heap.


*  *  *

My new book Money and Work Unchained is $9.95 for the Kindle ebook and $20 for the print edition. Read the first section for free in PDF format. If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com.

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University Cites Eminent Domain to Kick Students Off Property

In a repressive double play, the Rensselaer Polytechnic Institute has both censored student speech and tried to justify its clampdown with an absurd interpretation of eminent domain law.

In Februrary, security guards at the New York college removed two students from a public sidewalk outside a hockey game for passing out buttons and fliers that criticized the university. The students were supporting the “Renew Rensselaer” campaign, an alumni group that seeks to expose adminstrative abuses of powers. When the students pointed out that they had a right to be on public property, the guards suggested that the school controlled the property through eminent domain.

This drew the attention of the Foundation for Individual Rights in Education (FIRE), which had already sent the school three letters about its restrictive approach to students’ free expression. In its fourth letter, FIRE explained that the guards’ argument was “as preposterous as it is legally incomprehensible. Eminent domain is the practice of a public body condemning and seizing real property for a public purpose, not a private institution requisitioning public lands for its own purpose.”

While the institute has not responded to FIRE’s letter, school official Richie Hunter did speak with The Washington Free Beacon about the case. She would not answer questions about the university’s odd interpretation of eminent domain. Instead she suggested that the student handbook gave the school authority to quell the protest. Because these students failed to get prior authorization, Hunter says the school was justified in removing them from the sidewalk.

One of the students who was thrown off the sidewalk later emailed Hunter, asking her to clarify what part of the student handbook she referenced. In response, she cited a section called “Use of Institute Buildings and Facilities”—a segment clearly designed to cover private property—and stated: “Activities which groups wish to promote a cause, event, etc. must work either through the Union, Dean of Students Office, or the appropriate location supervisor to receive permission.” The sidewalk in question, again, is public property.

Students at Rensselaer have been involved in an ongoing battle with the administration concerning who controls the student union. The university guarantees that it “shall not impede or obstruct students in the exercise of their fundamental rights as citizens” and that “students and student groups shall be free to examine and discuss all questions of interest to them and to express opinions publicly and privately,” but it has rejected the student body’s request to protest and it has charged a student with “operating an illegal business” to prevent him from handing out information. Videos of the administration tearing down fliers and a recording of guards ordering students not to post literature have been posted online.

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Macquarie: “This Is The End Of The Liberal Order… But At Least No Wars Yet”

One week after Council on Foreign Relations president Richard Haass wrote an op-ed in which he waved farewell to the world he helped create, saying “Goodbye, Liberal World Order.” Then overnight, one of Wall Street’s most original, if underappreciated analysts, Macquarie’s Victor Shvets, gave his own unique take on this increasingly sensitive topic, injecting a dose of his unique pragmatism, in a note that one could say has a silver lining based on the title: “The end of liberal order: De-globalization drift; but no wars, yet.” Unfortunately, in a world in which almost every analyst sounds increasingly as skeptical as this website has been for the past 9 years, that’s as far as the optimism goes, as the following note reveals.

* * *

The end of liberal order: De-globalization drift; but no wars, yet

Investors continue to search for order; there is none

Investors seem to be striving to find order and pattern in a world that has neither. It is only human to search for patterns as without some order, there are no investment strategies. Instead, it becomes a world dominated by noise. Whether it is Trump tariffs, CBs (incessant debate – ‘too dovish or too hawkish?’) or Facebook and the role of social media, investors embark on a fairly meaningless task of calculating likely damages while trying to rationalize these actions within confines of conventional economic theory (trade is good; lack of it is bad). As a result, there is a growing chorus of shrill voices about onset of trade wars and/or need for deep regulatory changes. Similarly, any widening of spreads (however small) is almost immediately interpreted as the onset of major liquidity contraction. In a modern world of signals, noise & AIdriven re-pricing, reality is just ‘fake news’ (or basically facts you don’t like).

De-globalization is a fact of life; both trade & capital

Amongst all the noise, it is still useful to examine the latest trade news with some degree of realism. First, de-globalization has been a fact of life for more than a decade. There are already ~50,000 cases outstanding with WTO, with members introducing various anti-dumping duties & non-tariff measures. This is more than double the case load of ’08, and it is bound to grow exponentially; the US is not even the greatest offender. The liberal trade order had died at least a decade ago. Second, global economy is no longer driven by conventional trade, with elasticity close to one (trade to incremental GDP) vs. ~2x in ‘80s-90s.

There are many reasons for such erosion, but atrophy of supply chains and dominance of technology in trade flows are the key. Third, CBs interference with exchange & interest rates to constrain capital markets is also likely to become ever more pronounced. Neither Japan nor China have a yield curve, why should the US have one? The same applies to constraints on cross-border capital flows. The essence of liberal order was not freedom of shipping but freedom of capital.

The public demands protection from ravages of globalization and wants to see a shift of returns from capital to labour. Investors now reside in essentially a zero-sum world. This explains unorthodox political and electoral outcomes and it seems inevitable that politics would deliver what public demands, one step at a time. Having said that, there is a huge difference between an inexorable slide towards de-globalization and an outright trade war. The former is inevitable, the latter is unlikely, at least for a while; corporate lobbying and desire to avoid the most extreme outcomes is likely to prevent a trade war on a broad waterfront (just see how China has thus far avoided targeting industries that make America Great – soybeans & planes).

Not an anomaly; an integral part of investment landscape

De-globalization and constraints on capital flows are now not anomalies, but are an integral part of the new  investment climate. It implies that it is no longer possible to assess what is ‘safe’. Aggressive public sector & technological disruptions blur lines between ‘safe’, ‘value’, ‘cyclicals’ etc. It explains why value fails to perform or why even disruptions prevent staples from outperforming. It also makes assessment of trade vulnerability hard; Korea, Japan or Taiwan export radically different products vs. Thai or Mal. The former have low substitution & high value while latter is commoditized, facing disintegrating supply chains.

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Bezos Battered : $13 Billion Net Worth Loss As Amazon Crashes

Amazon shares are down 7% today and almost 11% in the last two days, breaking below its 50DMA, amid a broad tech unwind contagion and growing concerns about government crackdowns from “obsessed” Trump.

Bloodbath…

 

The reason is that according to Axios, it is not Facebook that Trump wants to go after, but rather Amazon: “He’s obsessed with Amazon,” a source said. “Obsessed.” According to the anonymous sources, Trump has allegedly talked about changing Amazon’s tax treatment because he’s worried about mom-and-pop retailers being put out of business.

A source who’s spoken to POTUS: “He’s wondered aloud if there may be any way to go after Amazon with antitrust or competition law.”

Trump’s deep-seated antipathy toward Amazon surfaces when discussing tax policy and antitrust cases. The president would love to clip CEO Jeff Bezos’ wings. But he doesn’t have a plan to make that happen.

Behind the president’s thinking: Trump’s wealthy friends tell him Amazon is destroying their businesses. His real estate buddies tell him — and he agrees — that Amazon is killing shopping malls and brick-and-mortar retailers.

  • Trump tells people Amazon has gotten a free ride from taxpayers and cushy treatment from the U.S. Postal Service.
  • “The whole post office thing, that’s very much a perception he has,” another source said. “It’s been explained to him in multiple meetings that his perception is inaccurate and that the post office actually makes a ton of money from Amazon.”
  • Axios’ Ina Fried notes: The Postal Service actually added delivery on Sunday in some cities because Amazon made it worthwhile.
  • Trump also pays close attention to the Amazon founder’s ownership of The Washington Post, which the president views as Bezos’ political weapon.

To be sure, speculation like this is hardly new, and reemerges periodically, although today it comes at a sensitive time for the tech sector, and Amazon in particular. As Stifel analyst Scott Devitt pointed out today, Amazon’s shares are sinking after an earlier Axios report suggested that President Trump may not like the company, yet “we already know this based on numerous tweets on the topic by the president.”

And all that means that Jeff Bezos has lost over $13 billion in net worth in the last two days.

Bezos lost $4.6bn yesterday and today’s drop is almost double that – the biggest two-day crash in the stock in four years…

 

Still, at least he has his dog…

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The Mind Blowing Concept Of “Risk-Free-ier

Authored by Michael Lebowitz via RealInvestmentAdvice.com,

  • The Earth is flat

  • Cigarettes are healthy

  • Leeches are the cure for everything

  • The universe revolves around the Earth

  • California is an island

  • Red wine is healthy, unhealthy, healthy…

Facts are essential as they offer humans a sense of stability in a chaotic world. For instance, we find comfort in the “fact” that the life-sustaining sun will continue to shine for billions of years. If there were serious doubts about this fact, our lives would be very different today.

In this article, we debunk a “fact” that serves as the foundation for the pricing of all financial assets. It was not that long ago that people who thought the earth round were labeled delirious madmen. Today, questioning the “risk-free” status of U.S. Treasury securities (UST), as we do, will lead many financial professionals to decry our prudence as foolish irrationality. That said, we would rather assess the situation objectively than get caught “swimming naked when the tide goes out”.

Mesofacts

In a must-read article entitled, My Leitner-esque Moment, Kevin Muir of The Macro Tourist blog broaches the topic of sovereign debt risk and, in what must be a moment of temporary insanity, questions the so-called “risk-free” status of UST.

Sovereign debt risk exists and said bonds default from time to time. Despite history and facts, associating the word “risk” with UST is for some reason blasphemous amongst financial professionals. The yields of UST are treated by all investors, even those nay-sayers like Muir and ourselves, to be the risk-free rate. This argument does not refer to the risk of changing yields but more importantly to that of credit risk.

All financial and investment models and theories assume that UST have no credit risk which, by definition, implies zero chance of default. What in this world has no risk? If you can name something, congratulations, we cannot.

For background, consider that sovereign debt defaults have been commonplace among big and small countries. The graph below shows the frequency by country since 1800.

Graph Courtesy Carmen Reinhart and Kenneth Rogoff

Go back further in time, and almost all nations can be added to that list. The United States stands alone as an economic and military powerhouse that has never defaulted. (It is important to note that many people, ourselves included, believe the U.S. defaulted when it went off the gold standard.)

Despite America’s perfect credit record thus far, it would be false to assume that UST are “risk-free”. This type of fact, assumed by the masses, is what Samuel Arbesman, the author of The Half-Life of Facts, calls a mesofact. A mesofact, unlike the known effect of gravity, is not a fact of the natural order destined to last for eons. Nor will it have a very short existence, like the fact that the sun is currently shining on my garden.  Essentially, a mesofact is one that has temporary permanence.

We refuse to debate whether UST are risk-free as we patently know that cannot be true. Instead, we consider the mindset of a bond trader and describe the ways we might measure U.S. credit risk.

The Mindset of a Bond Trader

“This next part of my post might be difficult to accept. Many will simply write off the theory as the ravings of a lunatic.”

Kevin Muir’s quote precedes a discussion about whether or not a U.S. corporate bond can trade at a yield below that of a similar maturity UST.

Can a corporate bond be even less risky than “risk-free”? The concept of “risk-free’ier” is mind-bending.

Fresh out of college, on day one on a trading desk, a bond market trainee is taught the practical (non-academic) concept of spreads. Unlike stocks, which trade at a dollar price and are not easily comparable to the price of other stocks or indices, all bonds trade at a yield spread to some benchmark, usually UST. Frequently, in fact, the dollar price of a bond is not even computed until after a trade is consummated.

To better describe this pricing methodology let’s relate it to the solar system. Bonds closest to the sun (UST) are the highest rated. As one travels away from our starting point, and the distance between planets and the sun increases, the perceived credit risk and therefore the yield spread over “risk free” Treasuries increases. In the fixed income universe, AAA-rated corporate and municipal bonds tend to trade with the tightest (or smallest) spread to comparable maturity UST as they have lowest default probability. Traveling further out the credit curve toward lower-rated bonds, the spread increases as default risk increases and the certainty of repayment decreases. The graph below shows the gyrations of various corporate bond indexes aggregated by credit ratings and their spread to UST over time.

Data Courtesy: St. Louis Federal Reserve (FRED)

In bond trader parlance, one would say the up and down movements of the lines above represent tightening (spread is declining) or widening (spread is increasing) relative to Treasuries. The graph below takes the orbit, or the percentage spread between BBB-rated corporate bonds and UST from 1997 to today, and plots it in a circular format to help further highlight this concept. (The orbit-like axis markers (0-8) are the percentage spread between BBB bonds and UST).

Data Courtesy: St. Louis Federal Reserve (FRED)

Back to the solar system. If we told you that, over the last few years, Mercury was tracking progressively closer to the sun, you would likely assume the orbit of Mercury is changing. Although inconceivable based on current scientific knowledge, what if it was determined that Mercury’s orbit was unchanged and the altered distance was due to the re-positioning of the sun? Similarly, what if the spreads of non-Treasury bonds were not 100% reflective of the factors that determine the yield for each security but also a change in the perceived risk in the benchmark itself?

Altered State

The U.S. Treasury Department is expected to issue over $1 trillion of debt in each of the next four years. This is additive to the $21 trillion debt load that is currently outstanding and must be refunded when bonds mature. Even more troubling, the growth rate of forecasted debt issuance is almost twice the size of the Congressional Budget Office’s (CBO) most optimistic economic growth forecast. As we have argued on many occasions, such a divergence between the debt burden and the means to service and payoff the debt cannot continue indefinitely. Deficits and debt do matter, and given this unsustainable situation, there is inherent credit risk in UST despite what finance professionals may tell you.

Ironically, there are currently two popular ways to measure the credit risk of the risk-free security, and neither of them currently reflect the absence of risk. The two commonly followed gauges are the credit ratings assigned to UST via the credit rating agencies and Credit Default Swaps (CDS) traded in public markets. Currently two of the three major credit rating agencies (Moody’s and Fitch) assign the highest credit rating of AAA to the debt of the United States. S&P rates them at a less than perfect AA+. Credit default swaps (CDS) are derivative contracts that enable an investor to buy insurance on the default risk of a debt issuer. If the issuer defaults, the insurance holder is made financially whole. The CDS of the United States currently trades at 27.5 basis points, which implies the odds of default are about 1.50-2.00%

A Third Way to Measure Default Risk

As Kevin Muir implies in his article, there is a third way to evaluate credit risk. Kevin wonders about the implications of a corporate bond trading at a lower yield than a U.S. Treasury of comparable maturity. We take that thought a step further. Could the spread between corporate bonds and UST, even though they are currently positive, be expressing heightened credit concerns for Treasury securities as opposed to less default risk for corporations?

What if the spread of AAA rated corporate bonds to UST were to tighten by ten basis points over the next month? Bond traders will robotically claim the spread tightening is a function of increased demand, reduced supply and/or a better economic outlook for the bond issuer. Given current circumstances, is it unreasonable to suggest that the yield on the corporate bond was unaffected and the yield on the U.S. Treasury increased due to credit concerns? Might it be possible the Sun has, against all conceivable logic, moved?

This concept is extremely hard to grasp, especially for those of us with decades of experience trading bonds. There are many instances in finance where a large majority of participants are gripped by muscle memory and habit. They are wed to the idea that the future credit history of the U.S. will be what it has been in the past. If we are to be successful investors over the long run, especially at crucial turning points, we must fight false assumptions, bad habits and challenge the durability of even the most basic “facts”.

Summary

Debunked facts are not only common but reflect a healthy progression of human knowledge. Such advancement, otherwise known as innovation and productivity, has led the human race to longer life spans, improved technologies, and greater economic well-being.

The fields of finance and economics, unlike most sciences, do not always seem to ascribe to the notion of incremental learning. Those in the financial community tend to repeat the same errors of the past. Just the past 100 years provides ample evidence of this through multiple boom-bust periods in which those Ph.D.’s from the best universities made the same critical mistakes. As such, the “growth” of logic and critical thinking in economics tends to be more cyclical than incremental. Mesofacts are presumed permanent, effectively stifling progress.

“I find it funny that the most vocal critics about the spiraling upward out-of-control government debt are often those investors’ most likely advocating positions in long-dated sovereign bonds as a place to hide. The surprise of this cycle will be that risk-free sovereign bonds provide no safety against the next crisis, but will instead themselves be the source of the instability. Think about hedging against the unthinkable happening.” – Kevin Muir

We concur with Kevin. No one has a crystal ball with the mystical ability to know when the imbalance of debt will overwhelm the nation’s ability to pay for it.  We would argue that the United States is well beyond that point of no return and the missing piece of the puzzle is the point at which investors realize that fact. One glance at recent patterns of buyers of UST argues that some of our largest foreign sponsors may be asking these very same questions. That said, all investors should recognize that U.S. Treasury debt does indeed have credit risk and that risk is growing.

We intend to persuade you to think about things in ways that few do. In doing so, you will be able to rise above the large majority of investors that get caught in the sinkhole of cyclical thinking. Compounding your wealth depends on it.

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