coercion leads to cleaner signals

Why would a surge in mergers and acquisitions (M&A) activity not necessarily signal an economic recovery?

- In every transaction, there is a buyer and a seller. Assuming that neither side is under any coercion, the expectations regarding the future value of the company in question should diverge. In other words, an increase in M&A activity may contain the same signals as a surge in initial public offerings (IPOs) does.

Companies are not apples. They are complicated entities. (Let's ignore the irrelevant fact that the biological complexity of an apple probably surpasses the organizational complexity of any company.) That is essentially why buying and selling companies is more sensitive to information asymmetries than trading apples. If sellers (e.g. previous owners or founders of the company) are more informed than the buyers, then there are grounds for being suspicious that the current rally in valuations is unjustified.

- A peak in the number of sales of distressed companies may signal a trough in the economy. Note that this type of M&A activity differs from the one mentioned above. Here the equity holders, who have the informational edge, usually get wiped out. The new owners of the company (e.g. Debt holders), who are less informed than the original equity holders, are forced into an untimely sale due to lack of coordination, liquidity needs etc. The presence of coercion renders the signals remitted by these transactions more trustworthy.

Those signals could be any of the following: Credit markets have thawed / Risk appetite has returned back to the equity markets / Separation of good from the bad is setting clean grounds for a new sustainable economic revival.

oil vs other commodities

Historically commodities have demonstrated a remarkable tendecy to move along with crude oil prices. What is the explanation for this baffling correlation?

1) Finding causal links between the factors that influence a certain commodity's price and the factors that determine oil price can be a mind-bending exercise. Often these factors are not clear. Even if they are clear, there are hundreds of direct and indirect ways in which they can interact.

For example, the main inputs for steel are electricity, coking coal and iron ore. The latter two represent a massive fraction of the sea-borne dry-bulk trade. Hence their prices are inevitably affected by changes in fuel prices which are in turn affected by changes in crude oil prices. More over, the majority of electricity in steel-producing countries is generated by thermal power plants. Therefore steel prices are also sensitive to changes in thermal coal prices. However it is rather hard to find any concrete links between (locally-mined) thermal coal prices and crude oil prices. (Note that there is very little substitution between the two commodities.)

2) The correlation may be a spurious one that emerges from regressing one non-stationary time series onto another. (See this paper for technical details.)

3) There may be a tenuous link through the expectations (e.g.signalling) channel. Crude oil prices keep track of the global economic growth prospects. Their recovery sends a bullish signal to every other market where the aggregate supply can not adjust as quickly as the aggregate demand.

4) The correlation may be due to a third causal factor that simultaneously influences prices of both oil products and other commodities. Instead of looking for causal arrows that point from oil to another commodity (or vice versa), we should perhaps be searching for a third factor that spits out arrows towards these two commodities. (For example, as people get wealthier, they buy more cars and thereby consume more gasoline. Gasoline is distilled from crude oil and cars are made of steel. Hence a speculative housing bubble that lifts the overall wealth can lead to greater demand for both iron ore and crude oil.)

5) Perhaps the correlation is simply a monetary phenomenon. Markets may be pricing everything in energy units and not in US Dollars. The correlation ensures that the relative price relationships between the commodities remain in tact.

contracts and benchmarks

If the price on your purchasing (or supply) contract will be floating according to a formula that depends on a "benchmark", you should pay special attention to the following points:

1) There are liquid futures markets for several commodities. Benchmarks that are based on such markets are by definition "forward-looking." This is ideally what you want. At the beginning of each quarter, the price on your contract will be reset by factoring in price expectations for the next quarter.

Unfortunately, there is not a deep (i.e. hard-to-manipulate) futures market for every single commodity. For example, in the ferro-chrome business, the quarterly price that is collectively declared by major South African producers is often taken as the "forward-looking" indicator.

If your contract involves such a benchmark, then make sure that your counter party can not collude with the major producers who set the benchmark. It is not difficult to imagine cases where the major producers get side payments from your counter party for declaring a price that is favorable for him.

Often the physical markets have an air of competitiveness about them, but the reality can be quite different. So be inquisitive and gather some intelligence on your counter party's relationships.

Note that if the major suppliers have made a substantial switch to the spot markets, their price declarations will not have any binding effects even for their own future transactions. Especially in extremely volatile price environments, do not be surprised if nobody takes the "benchmark" seriously.

2) Sometimes (especially in very non-transparent markets) there may be no "forward-looking" benchmarks available. In that case you will have to rely on "backward-looking" indexes. The most frequently-used indexes are the ones published by leading commercial journals.

The intelligence that these indexes rely on is often quite shaky. Prices of past-transcations are pulled straight from the voluntary questionnaires that are sent to major commodity firms. These firms have all sorts of reasons to supply false data. (In fact, after tying the price formula on your purchasing contract to the journal's index, even you will be tempted to transmit false information by deflating the prices achieved on your recent spot deals.)

Indexes are open to manipulation even if the journal manages to collect data that is reliable on average. So make sure that your counter party does not have any "sweet" connections at the journal's headquarters. Note that these connections do not have to be at the top-level. Low-ranking officers are usually more open to cooperation. (These guys are easier to impress and manipulate. They are less experienced. They have less to lose. They also have more need for side payments and other "goodies".)

3) Of course, the silliest thing to do is to base your contract on a benchmark that is "technically" very easy to manipulate. Resetting the price on your annual contract according to the December 31st closing price of a derivatives market is not a good idea. Your counter party may step in just before the market closes, place a massive order and push the price towards the direction that is favorable for him. He may lose some money on the derivative transactions, but these losses will be easily offset by the annual gains he will be making on the physical contract that he signed with you.

4) If the contract stipulates delivery of a tonnage that is quite substantial in comparison with the size of the total market, then the contract will inevitably affect the benchmark it is based on. (Assume that the prices are temporarily down for some unclear reason. If this movement takes place in a fashion that affects the benchmark, then your contract will reinforce it and stretch its lifetime.) There is one simple way of preventing this endogenous interaction from happening: Do not disclose the price formula to the public.

turkish mortgage market

Apparently, Turkish banks have already started to issue fixed-rate mortgages with maturities that extend to 15 years. Competition is forcing them to offer lower rates and longer maturities. But can any one of them actually manage the risks entailed by holding such long-term, Turkish lira-denominated instruments?

Probably not. The average maturity length of Turkish banks' liabilities has historically been very short. Even if the liquidity of secondary markets improves in near future, these mortgages will still stay in hands which can not properly manage the associated risks. In fact, there is no natural holder of these instruments because there are no Turkish counter parts for the large Western private pension funds and college endowment funds which are financed by long-term minded investors.

Moreover, the spectrum of maturities available in the government and corporate bond markets is not suitable for the management of such long duration risks. (In other words, banks can not use these markets to align their net duration exposures with the duration of their liabilities.)

I guess that these mortgages will be kindly handed to the Turkish government once an unanticipated spike in inflation forces banks to roll-over their liabilities at punishingly higher rates.

Governments have always been the ultimate risk managers.(Check out this book which is currently on my reading list.) Development of "sophisticated" mathematical risk management techniques will not change this fact.

types of efficiencies

Nature seems to be optimizing at several levels. For example,

1) Particles minimize energy consumption.
2) Organisms minimize calorific consumption.
3) Companies minimize costs.

But why?

3) Shareholders press for higher returns. Cutting costs increase competitiveness and chances of survival.
2) Managing net calorific intake increases the possibility of successful reproduction by increasing resistance to environmental shocks.
1) No idea. In biology and economics, efficiency emerges out of the system constraints. However, in physics, it is just part of the system constraints.

There may be selectionary evolutionary pressures at work in physics too.

The organisms that we see around are good at minimizing calorific costs. Why? Because if they were not, they would not have survived until now and therefore would not be observable by us. Particles we see around are good at minimizing energy costs. Why? Because if they were not, the resulting physics would not exhibit the properties that render our presence possible, and therefore would not be observable by us. (See: Anthropic Principle and Cosmological Natural Selection)

Note that the discovery of such "environmental" constraints for physics may be outside our experimental reach. Let's just keep this discourse quiet so that we will not raise Karl Popper from his grave with our non-falsifiable conjectures.

Wittgenstein would have also shuddered at the thought of physics taking place in some environment. Physics is by definition all encompassing. Regularities in physics are not by-product of anything else. They can only be self-induced. In particular, they can not arise due to a competition in a greater realm.

Although it is silly, let's imagine that there indeed is a "greater realm". Then you can iterate the same question: "Why are the rules of competition between different physics the way they are? Is this set of rules also a result of some competition?" To answer such questions, you will inevitably end up conjuring competitions inside competitions inside competitions... realms inside realms inside realms... Ad infinitum!

In short, our speculation does not even make logical sense. Hence it would have been crossed out by Wittgenstein before it even reaches Popper.

In fact, calling the behaviour of a particle "efficient" is misleading. A particle is not making calculations within the theoretical framework we subscribe to nature. It is just being a particle. That is all. What we are observing is not efficiency but simply regularity, and our theoretical framework makes this regularity look like efficiency.


Update (August 2010)

I have just discovered that the questions posed above have first been considered in the 18th century:

In 1748 Maupertuis showed that Newton's laws of motion could be derived by the application of a teleological principle. It is possible to define a mathematical quantity, the action, which involves the product of mass, velocity, and distance travelled by bodies. Maupertuis's Principle, which we now call the Principle of Least Action, was that

If there occurs some change in Nature, the amount of action necessary for this change must be as small as possible.

This elegant idea turns out to be equivalent to the Newtonian laws of motion (although it is more powerful in the sense that it can be used to derive the equations of motion in other areas of physics once the appropriate action is identified.) But, unlike the formulation of Newton, it is teleological. It says that, of all the paths that could be taken by a body moving from A to B, it actually takes that path for which the associated action is a minimum. This path is therefore determined by both the initial and the final states. Maupertuis attached great metaphysical significance to this result, regarding it as a "proof of existence of Him who governs the world". Formerly, arguments of the sort that we lived in the "best of all possible worlds" were open to the objection that we did not know any other worlds with which to draw such a comparison, but Maupertuis claimed that the other worlds were those in which motion occurred with non-minimal action. Our world was optimal in this well-defined sense, and moreover there existed a teleological aspect to the laws of Nature (in fact, some nineteenth-century commentators interpreted the existence of fossils as relics of the still-born worlds of non-minimal action.)

Barrow - Universe That Discovered Itself (Pages 88-89)

a coding theorem and genetics

Here is a nice result from an information theory book:

(A code is uniquely decipherable if every finite sequence of code characters corresponds to at most one message. If no code word is a prefix of another code word then the code is also called instantaneous. Although a uniquely decipherable code is not necessarily instantaneous, the existence of such a code implies the existence of an instantaneous one.)

Let's try to apply this theorem to genetics...

The genetic code alphabet consists of only four letter: A,C,G,U. Therefore we have D=4 in the above formula.

We need to assign a code word to each of 20 existing amino acids: Alanine, Arginine, Asparagine, Aspartic Acid, Cysteine, Glutamic Acid, Glutamine, Glycine, Histidine, Isoleucine, Leucine, Lysine, Methionine, Phenylalanine, Proline, Serine, Threonine, Tryptophan, Tyrosine, Valine. Therefore we have M=20 in the above formula.

In vertebrates the relative observed frequencies of the above amino acids are respectively 7.4, 4.2, 4.4, 5.9, 3.3, 5.8, 3.7, 7.4, 2.9, 3.8, 7.6, 7.2, 1.8, 4.0, 5.0, 8.1, 6.2, 1.3, 3.3 and 6.8 percent. (Note that these numbers sum up to 100.) In other words, 7.4 percent of the amino acids needed for the next typical protein synthesis will be Alanine. 4.2% of them will be Arginine, 4.4% will be Asparagine etc. This vector of percentages will be our probability variables "p_i". (e.g. x_2=Arginine and p_2=0,042)

Let's enforce the additional requirement that the length of each code-word is equal. In other words, for all "i" we set "n_i" equal to some "n". (There may be some structural justifications for this extra assumption. I will not make any speculations though since my knowledge of molecular biology is close to nil.)

After inserting the numbers into their appropriate places, the theorem reveals that the lower bound for the probability-weighted average of code-word lengths is 2.1. Since we set all "n_i" equal to "n", the probability-weighted average is simply "n". Note that code-word length "n" has to be an integer. Hence what noiseless coding theorem tells us is that the minimum value "n" can assume is 3.

Guess the actual word-length that occurs in genetics! It is 3. If there was a single more letter in the code alphabet, then "n" could be 2! (Due to the anti-parallel structure of DNA the alphabet size has to remain even. Therefore I should have probably written "If there were two more letters...".) However, with only four letters, the word-length can not theoretically be pushed below 3.

Given the size of the alphabet, nature is as efficient as it can theoretically get. It even opportunistically exploits the difference between 2.1 and 3 by assigning more than a single codon (namely a three letter code) to some of the amino acids. The number of code-representations belonging to each amino acid is repectively 4, 6, 2, 2, 2, 2, 2, 4, 2, 3, 6, 2, 1, 2, 4, 6, 4, 1, 2 and 4.

There are some suggestions that the genetic code has evolved in an error-minimizing fashion. When a single-nucleotide mutation transforms UUU into UUC, tRNA still codes for Phenylalanine. Hence, in some sense, greater number of representations entails less sensitivity to mutations and operational errors during the decoding process.

When you compare the number of representations against the observed frequency of occurrence, the following pattern emerges:

Note that if you exclude the outlier Arginine, then the correlation becomes 0.78. Here are two possible explanations of this high correlation:

1) Assuming that the observed frequency distribution is a reliable indicator of the relative importance of each amino acid, the high correlation ensures that the formation of important amino acids is less affected by mutations and decoding mistakes.

2) Amino acids whose production is more resistant to random shocks (e.g. mutations and decoding mistakes) will sooner or later overpopulate the weaker ones.

Notice the striking similarity with the following graph:

Here expected frequency depicts the relative frequency of amino acids that one would get by a random, serially independent juxtaposition of the available bases (A,C,G,U) in the DNA. For example, since Glutamine is coded by CAA and CAG, its expected frequency in the metabolism is W*[(C%*A%*A%)+(C%*A%*G%)] where X% is the frequency of base X in the DNA and W (larger than 1) is a factor that corrects the addition for the presence of stop codons in the DNA.

If you exclude the outlier Arginine, then correlation in the above graph becomes 0.89. In other words, the observed frequency is remarkably in line with what would have happened if the transcription mechanism lacked any structure and acted randomly on DNA.

Two cases come to my mind:

1) What happens if the number of codons coding amino acid X increases (decreases) and if none of A%,C%,G% and U% change? Each of the 64 (=4*4*4) mathematically possible codons are either assigned to an amino acid or to a "stop" signal. Therefore, as the number of codons that code X increases (decreases), the number of codons assigned to some other amino acids needs to decrease (increase). The expected frequency of X will increase (decrease) while that of others will decrease (increase).

2) What happens if A%,C%,G% or U% change due to mass mutation and the code remains the same? Then the whole expected frequency distribution will change accordingly.

If the second graph depicts a causal relationship, then in each of the two cases above, observed frequencies will soon align themselves with the new expected frequencies. What happens if this development endangers the stability and survival of the metabolism? Will any dynamic mechanisms kick in and undo part of the mass mutation or switch the code-words around so that the expected frequencies remain as before?

One final question: What is wrong with Arginine?

ship brokering

I sometimes wonder why independent ship brokering companies exist at all. Ship owners and cargo providers could come together and establish a centralized forum where all the relevant information (e.g. ship positions, availability dates, cargo positions and destinations) is uploaded and continuously updated. But neither party is interested in the idea of introducing such absolute transparency into the market. In fact, each party thinks he is better off under the status quo regime.

This sounds logically impossible. How can both parties be better off at the same time? For example, using the centralized forum, they could (in principle) agree on the same freight rate and split the brokerage fees.

Nevertheless the status quo persists. Why?

1) Perhaps brokering companies are way too entrenched and powerful to be entirely removed from the system.

2) Ship owners and cargo providers are unable to discover what their losses/gains would be under a centralized forum scheme. Perhaps they are prevented from doing so by their own employees or brokers who subtly manipulate their information channels.

Example: Brokers may be supplying false information.

Example: Assume that the ship owner is a large public company whose shareholders can not keep track of the daily business affairs. The employees receive fixed salaries. Therefore their financial wellbeing is not correlated with the freight rates. In particular they will lose nothing by making favors to brokers who take them out to fancy dinners. Employees will do their best so that the shareholders will not be able figure out the suspiciously low freight rates at which their ships are being rent out. (Remember that the shareholders only look at the aggregate quarterly figures...)

2) Thinking of ship owners as a single class may be misleading. Say there are 10 ships owned by 10 different ship owners and 10 cargos owned by 10 different cargo providers. Assuming that there are no idle ships lying around, at any point in time there will be 10 outstanding brokered transactions. The number of parties (ship owners or cargo providers) who could have obtained a better deal through a centralized forum is at least 10. (It is probably strictly greater than 10 since brokerage fees usually steal profits from both sides.) Say 7 ship owners and 4 cargo providers would have been better off with a centralized forum. (Here we implicitly assume that, at the end of each brokered transaction, parties can figure out how the deal would have unfolded through such a forum.) In other words, if there was a democratic council composed of ship owners, then 70% of the members would have voted to circumvent the brokering companies and establish a centralized forum. On the other hand, a democratic council composed of cargo providers would have voted in favor of the status quo regime. Assuming that each council holds equal power in shaping the future of the freight markets, nothing will be done and the status quo will persist.

3) Incorporating a time dimension to the above analysis yields some more insights. Say there are 10 discrete time periods. At the end of each period ships deliver their cargos and 10 new voyage contracts get brokered. Let S=(8,10,10,9,9,2,3,2,2,5) be the vector that represents the number of ship owners who would have been better off with a centralized forum. (e.g. This number is 8 at time 1, and 9 at time 4.) Let C=(2,5,3,2,8,8,7,9,8,10) be the corresponding vector for cargo providers. During the first 5 periods, ship owners are pissed off at the brokers and are willing to overthrow the status quo regime. During the first 4 periods, they complain about the situation and seek cooperation from cargo providers for changing the market structure. Cargo providers are pretty happy with the status quo and therefore turn down ship owners’ offers until period 5 during which 8 of them become worse off due to a major change in market dynamics.

(For example, this change may be due to a sudden spike in the fuzziness of the market information that cargo providers receive through means other than their brokers. In that case the independent brokers can demand above-normal brokerage fees by claiming that the markets are very tough at the moment and there are not many available ships around. The cargo providers will not be able to verify these claims due to the fuzziness. They will probably go ahead and trust their brokers who helped them close the nice deals during the first 4 time periods.)

Now cargo providers will change their minds and decide to cooperate with the ship owners for the establishment of a centralized forum. Planning starts but the project never takes off. After period 5, tides change. Now ship owners feel better off with the current regime and defect from the project. Note that, across the 10 time periods, the average number of ship owners who would have been better off with a centralized forum is 6 (=(8+10+10+9+9+2+3+2+2+5)/10). The corresponding average for the cargo providers is also 6. Assuming that the underlying markets dynamics are not expected to change, does this imply that the ship owners will make the statistical inference that the current regime will not be in their favor in the future? No.

a) Ship owners will probably behave myopically with respect to time. Example: During the time period from 10 to 15, they may again start to feel that they are better off under the current regime. The feeling may be strong enough to make them shelve the plans of establishing a centralized forum.

b) Moreover, the identities of these 6 losers will change over time. Therefore it will be difficult to get a democratic “over-throw the status quo” vote out of the ship owners’ council. (Example: If ship owner X becomes a loser for three consecutive time periods, then other ship owners may believe that X will be among the 6 losers during the next period too. This belief may be ungrounded since the underlying dynamics may be totally random. In other words losing three times in a row may be just due to bad luck.)

4) Brokers may be performing important services other than simply bringing the two parties together. In other words clients may be enjoying non-monetary gains that could not be possibly provided by a centralized forum. For example, ship owners could be assigning a positive value to the market tips they receive from their brokers. Reliable gossips about the financial situations of various cargo providers (e.g. commodity traders) may help the ship owners by facilitating counter-party risk evaluations.

5) Absolute transparency in the shipping market may have indirect, harmful commercial consequences for ship owners or cargo providers. For example, a commodity trader may not want to post cargos to an open forum since that would amount to disclosing all its trades to public. Strategically and selectively disclosing such information may be beneficial for the trader. However a wholesale disclosure will probably not be in his favor.

Post Script 1:

You can generalize the above analysis to any type of brokerage institution. (e.g. Stock brokers, real estate brokers, marriage brokers, recruitment brokers…)

Post Script 2:

Through a centralized forum, information flows as follows:

(green=ship owner, red=cargo supplier, dark blue=forum)

Note the following two properties of the graph:

1)Every node is only two steps away from each other. In other words information flows lightning fast.

2)There is no single node (or a group of nodes) that is separated from the rest of the graph. This implies that every single information reaches to every single node.

Due to brokers' efforts, the actual freight markets are pretty connected as well. However the information flows slower:

(Light blue=broker)

free floating tankers

Supply/demand dynamics play an important role in the determination of stock prices. That is why you can not simply go ahead and buy a large stake in a public company at its prevailing market capitalization. The price reflects the beliefs of the current market participants and your entrance will change the dynamics of the game.

For instance, the way you enter the market will make a significant difference. There are two important points to consider here:

1) It is usually not a good idea to reveal your identity early on. If the market thinks you are more informed about the value of the stock than they are, then they will be more hesitant to sell at the prevailing prices.

2) Large orders suck liquidity out of the market and cause big ripples in prices. (Price may shoot up even before the execution of the large order due to information spillover and front-running.)

Therefore it is usually a good idea to hide your intention of acquiring the company by executing small orders through various different intermediaries. (Note that there are existing laws that will force you to reveal your position after gathering X percentage of the available shares.)

Is there an exact definition of what constitutes a "large" order? No. There are two importanat parameters here.

1) First is the percentage of shares that is free floating. For example, some shares are held by institutions on a long term basis and are not available for spot trading. Unless those institutions are willing to engage in a block trade with you, the only shares you can demand are those that are free floating (i.e. changing hands in the spot market). Let's assume that you want to buy 1% of the total number of outstanding shares. In other words, if the total number is 1000, your order will be for 10 shares. Now assume that the percentage of free floating shares is only 20. Although your order looks small compared to the total number shares, it demands 5% of the number of shares that are available.

2) Will that 5% move the market price? That depends on how much liquidity you will be sucking out of the market. If trading volumes are low and bid/ask spreads are high, then you are more likely to cause a ripple.

The concept of free floating is relevant to commodity markets as well. Let's consider an example. What will happen to tanker freight charges if the world seaborne crude oil trade slows down 1% in terms of tonnage? For the sake of simplicity we can disregard the size segregation in the tanker market. Moreover, since it is pretty easy to move ships across continents, we can assume that the geographical effect of the slowdown will be arbitraged away and the freight rates will go down globally.

Here the important parameter is the percentage of ships on the spot market which is the arena where freight rates get determined. Each big oil company has its own tanker fleet which is usually supplemented by some ships on long-term time charter. If these ships are all occupied (or if none of them are available around the port where the cargo needs to be picked up from), then the company will hire a tanker in the spot market. And when the company needs less ships, it will pay less visits to the spot market.

This is where an analogy with stock markets can help us. One can think of the freight charge as the stock price and the percentage of ships on spot market as the percentage of shares floating. As pointed out in the analysis above, 1% contraction in the global demand can have the effect of 5% contraction on freight charges if percentage of ships on spot market is 20.

steepening yield curve

Why is the yield curve of US government bonds steepening? Does the movement signal an end to the current recession? Perhaps. Unfortunately there is no way to be sure.

The spread between the long-term and the short-term yields may widen due to several reasons:

(Here bonds should be understood as "US government bonds".)

-Investor start to shun the long-term bonds for their greater sensitivity to interest rate fluctuations.

-Investors switch to the short-term bonds for the greater liquidity their markets enjoy.

-Investors predict that US will run into fiscal problems and funding difficulties in the future, and this will lead to higher future short-term interest rates in the bonds market.

-Investors believe that inflation rate will increase in the future. Therefore they demand higher future short-term interest rates in order to attain the same inflation-adjusted rate of return.

-Investors think that FED believes that inflation rate will increase above the targeted level. (If so, FED will take action and employ monetary policies to increase the future short-term interest rates.)

-FED decides to to pursue a less aggressive monetary policy and tones down its current quantitative easing program. It starts focusing solely on the short-end of the yield curve and removes the artificial ceiling from the long-term yields. (In other words it continues buying short-term bonds and stops purchasing long-term ones.)

-Foreign investors worry about a future devaluation of dollar. (If so, they will ask for deeper discounts while buying US bonds. This is due to the fact that they will presumably convert the money back to their respective home currencies after selling the bonds.)

-Investors believe that the global supply in the government bond markets will increase and US will face stiff competition against other nations. Therefore, in order to attract the desired number of investors, US will have to offer higher short-term interest rates in the future.

-A syncronized sell-off depresses long-term bond prices. (For example, investors may be adjusting their portfolio in order to get more commodities and stock market exposure. Also there may be a movement towards non-dollar denominated markets.)

-Dynamic hedging of mortgage convexity risk may be amplifying the fluctuations in the long-term bond prices. (As mortgage backed securities move into the hands of sophisticated investors and active hedgers, this activity increases.) In other words, higher interest rates on long-term bonds may be a consequence of higher interest rates on callable fixed rate mortgages.

-Investors think that the economy will revert back to positive growth in the near future. (If so, FED will respond by tightening the money supply and increasing the short-term interest rates. Remember that FED aims at sustainable growth with low inflation. It will interfere and calm down the "animal spirits" if growth gets out of control.)

liquidity and deflation

During times of crisis and loss of confidence, people hoard liquid items such as gold, silver, cash and government bonds. These items are of two uses:

- They are non-perishable and hence can be used to transfer wealth into the future.

- They are extremely easy to exchange into other goods.

Hence low bond yields and deflation are consequences of the same phenomenon. As liquidity becomes more desirable, bonds become more expensive in terms of dollars and dollars become more expensive in terms of less liquid items such as cars/houses/food etc.