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Wednesday, November 26, 2014

The Days of Green Eyed Men

Common Knowledge is a slippery concept that been bugging me for a while. If something that everybody knows is not worth knowing, then what is the point of learning from wisdom of the past? If people learn from history, why are they constantly repeating old mistakes? If human nature never changes, how do I judge progress? The more I think and read about these topics, the more I get confused...

The theory and application of Common Knowledge is a relatively new field of philosophy, only about as old as I am. Wiki has a pretty good summary here (link) with following well known example:
On an island, there are k people who have blue eyes, and the rest of the people have green eyes. At the start of the puzzle, no one on the island ever knows their own eye color. By rule, if a person on the island ever discovers they have blue eyes, that person must leave the island at dawn the next day. On the island, each person knows every other person's eye color, there are no reflective surfaces, and there is no discussion of eye color.

At some point, a missionary comes to the island, calls together all the people on the island, and makes the following public announcement: "At least one of you has blue eyes". The missionary, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that he is truthful, and thus it becomes common knowledge that there is at least one islander who has blue eyes. The problem: assuming all persons on the island are completely logical and that this too is common knowledge, what is the eventual outcome?

The answer is that, on the k-th dawn after the announcement, all the blue-eyed people will leave the island.
 I am a market practitioner, so pure philosophical problems interest me somewhat intellectually, but only to a point where I ask: "Whats the use?" Specifically in financial speculation, 'common knowledge' is misleading and can not be relied upon most of the time.

Federal Reserve (aka The Fed), is sort of 'public' outfit, entrusted to run Treasury Bonds of US... I know, I know... you can spare me a lecture about dual mandate this, and financial stability that... None of it is possible or feasible, at least not in the way they do it for a past few years. Besides, there is very little that monetary policy can influence in general - there is iron-clad statistic showing little or no correlation, but nobody cares to research. Then there is QE, that suppose to influence stock market somehow, while nobody paying attention to the fact that QE is directed towards bonds and not connected to SandPee in any shape or form.  The same nonsense being repeated on Tee-Vee for years became sort of reality, and conditioned investor psychology no doubt ... but I digress.

QE 1 was a bit different animal, but here is what simply happens.
When Fed buying Treasury and Mortgage Bonds on (not very) open market, newly minted cash flows from US Treasury - thru The Fed - to The Banks, to pay for bonds that Banks bought with (non-cash) funds, borrowed ... from The Fed. No new money is effectively created (note - I am not talking about inflation, as prices do spiral out of control, however it has nothing to do with QE). Treasury department just works as a low cost printer and intermediary clerk - small fish. Banks earn a risk-free spread, according to age old banking model "3-6-3 or better" (old joke: borrow at 3%, lend at 6%, hit the golf course by 3pm). Now The Fed returns cash to Treasury and keeps free Bonds to maturity, while receiving their own interest rate. Although it looks like just transferring money from left pocket to right one (I thought so too), its actually a very profitable enterprise. In fact (its a public record, but ones again - nobody bothers to look), The Fed has been kicking hundreds of billions dollars of profit upstairs to US Gov, after paying 6% vig (ahem, statutory dividend) to member banks.

Technically,  The Fed is the biggest and (quite possibly) the most successful bond fund in the World.
Observe 10 year note yield chart attached below. (For uninitiated, yield is an inversion of price. When interest that bond pays is rising - the price of same bond goes down, but when interest or yield plummets - bond prices go bonkers to upside).
Evidently, they've been riding this bull train since at-least 2008 and probably much longer than that, with QE (and especially QE3) as a perfect example of 'how to buy the dip'.
I took a liberty to throw in a crayon, projecting 1% 10-year note yield sometime in a year or two, based on rhythm of the chart and slope of blue channel. Not saying it will happen like that or at all, don't care to make predictions either. As a matter of fact, I was short treasuries last year, and long for most of this year (I trade 30-year bond - its a big boys game), without relying on any kind of crack-pot theories or cockamamie squiggly lines on a chart.
I have Gravitsapa for that... err, what are you using for intergalactic travel...?

So next time, when someone tells me that Fed governors is just a bunch of academics with no real world experience - I am going to spit into that person's left eye; and if they yell that "they know nothing" (extra Jim Cramer) - I'm gonna bitch slap them too.

The point of this exercise is this:
What I think is a common knowledge, may not be common at all...
O, and I think - my wife is THAT fucking MISSIONARY

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