What Can Field of Dreams Teach Us About Corn and Trading Macro?

Last night I wasted Field of Dreams with the kids. Plenty of complaints before the start. One wanted to watch Avengers, another didn’t want to watch a sports movie. The other one was opposed to the entire endeavor. 

They came around pretty quick. But here was my big takeaway: I’m on the verge of becoming a naturalized citizen in the commodity world--I couldn’t stop thinking about how all the farmers were appalled and outraged when Kevin Costner dug up his corn to build the baseball field. And then there was the clearly disastrous financial implications, where this decision put his farm on the verge of bankruptcy. 

I had questions. 1) how much corn did he dig up? 2) how much revenue did he forego, in absolute terms and relative to the size of the farm? 3) Given a few assumptions, was this really a farm-wrecking decision, or was this Hollywood stuff? 

In 1987 many farms in Iowa were between 250-500 acres, and this same data shows a husband/wife team could have eked out a living managing such farm. Let's assume this was a 250 acre farm.

The average value per acre in Iowa was $875 in 1987, around the depth of the US farm crisis. A 250-acre farm could have been had for around $220,000. Lets call it $280k with a modest farm house on the property. Putting say, $60k down on such a property was certainly within reach for a college educated, dual income couple in their mid-30s that has been working and saving for 10-15 years.

The average farm price for corn in 1987 was $1.89/bushel. And one might expect an acre of corn to yield around 120 bushels of corn.  

So 250 acres of corn, yielding 120 bushels nets you 30,000 bushels of corn. Lets say Kevin Costner is a particularly crafty basis trader and he gets $2/bushel for his corn. He grosses $60,000.  The 1987 census report above suggests such a farm might generate $20-$30k in net income--enough to live on if you’re into the lifestyle--but there were many farms during that time that were losing money.  Bankruptcy was certainly on the mind of every US farmer in the mid-late 80s. 

Now, what about this baseball field? A major league baseball field is around 2.5 acres. 

But with foul territory and some residual space for bleachers, you’re probably looking at another acre. But no more than 4.5 acres total, even if you add in a few parking spaces. 

Let's say Kevin Costner dug up four acres of corn. That’s less than $1000 in foregone revenue in the year he dug it up (it probably had some residual silage value!) and in the new crop year when Shoeless Joe finally showed up. 

So our hero gave up $1000 out of $60,000 in revenue, and maybe $30,000 in net income. Let’s add on another $1000 for the infield dirt, the grass he planted, and the backstop fence.  Despite the gossiping and murmuring of the other farmers and their wives, he certainly could have billed it as a community service--and heck, even written it off on his taxes--since presumably he didn’t just let the field sit there..he let the local farm-kid teams play on it while he was waiting for whatever was supposed to happen. 

An aggressive financial decision, but one easily justified by hearing a voice say, “If you build it, he will come.” 

Kevin Costner made one crazy, totally unjustifiable decision: he lit the field!! 

This, is what would have bankrupted his farm. This is the decision that would have had his smarmy brother-in-law questioning his sanity.  Lighting the field today would easily get you into six digits, and would certainly have been out of reach for a financially strapped family farmer in the midst of an agricultural crisis.

Sure, it made for the coolest scene in the movie. 

But completely implausible.  

Here’s a few light-hearted takeaways for market analysis: 

Question assumptions. We all have a cognitive bias to buy into what we’re being told. It’s called “Truth Default Theory”. It’s what makes movies work….but it often turns into a trap in markets. 

Sometimes the trade is not where you think. Everyone jumped on Kevin Costner for digging up his corn--but it was the lights that were financially reckless. 

Everyone loves a story.  Many trades are long on “story” because stories sell. You’re not going to get your boss to buy into upsizing your trade because of your spreadsheet. You need a story.

But….every story needs data.  Stories without data are just that, Hollywood stories. A good story combined with solid data can go a long way. 

But most important:

Be open to changing your mind.  I didn’t mention this above, but the key point of the movie is when the fussy pants brother-in-law has his epiphany. This was a man that was deep into his own trade to buy Kevin’s farm. But he changed his mind. That this was done only with divine intervention is irrelevant! Too often we get wedded to ideas and refuse to accept the metal cost of accepting that we were wrong and changing course. 

Love your ideas, but don’t be afraid to set them free. 

@EMInflationista

Curve Flattening and Monetary Policy Effectiveness: Is This Time Different?

No doubt you’ve read something about the flattening of the yield curve. You may have even heard it inverted. I can always tell when an arcane financial concepts hit the mainstream by when my relatives ask me about it.  I’ve gotten that one a few times lately. 

But let's take that question at face value. Let’s put aside curve inversion for a moment.  What does a *flattening* yield curve mean for monetary policy and the economy? 

Mohamed got me thinking about that question this afternoon: 

The biggest story in financial markets over the past year is not the inversion of the US yield curve, but the bull flattening of the bund curve: here is a chart of Germany 5y/30y slope vs. assets on the ECB balance sheet:  

The end of the ECB’s asset purchase program coincided quite closely with a slowdown in global growth that resulted in the bull flattening of the 5y/30y bund curve. What does that mean? Slowing growth--but also little optimism for a pickup in growth or inflation in the future. Combine that with the factors Mohamed mentioned and you have the recipe for a very big bull flattening. 

Fast forward to the next ECB meeting. How should monetary policy react? Traditionally, as growth slows monetary policy eases, either through rate cuts, or more recently, asset purchases. You can see that clearly in the chart above in 2015 and heck, right through to 2017. 

The flattening in 2014 and again in 2016 both reversed out quite nicely--the first time the result of increased QE from the ECB, and the second time after global growth recovered from the nadir of China growth fears and low oil prices in early 2016. 

Where does that leave the ECB today? In a heap of trouble. They need to steepen the curve. 

Among the myriad problems in Europe are their banks. The flat curves, low growth, and regulatory constraints have strangled big European banks. Look at this chart of return on equity in European banks vs. US banks: 

Sources: Bloomberg, Federal Reserve Bank of St. Louis (FRED)

A flat curve means that banks can’t borrow low (from depositors) and lend high (to borrowers). They have to rely on credit spreads or simply do nothing at all and make money off fees. When banks can’t make money on lending, credit growth suffers. A similar chart of US vs. European credit growth would show a similar dissonance between the US and Europe. 

The ECB must find a way to steepen yield curves. How can they do it? Easing monetary policy *must* be a signal for higher growth and inflation, otherwise it is ineffective and most likely counterproductive. If the ECB believes further easing won’t steepen yield curves, they should say so explicitly and tell the government this is their problem now. 

That would lead to an easing of fiscal policy--via issuing more long end bonds. That would give  Mohamed the supply he so desperately wants for his friends at Allianz. 

Now, let's contrast the situation in Europe with what we see in the US.

By way of example, look what happened back in 2007: when the Fed started cutting rates, the 5/30y UST spread started to steepen--as one would expect if monetary stimulus coinciding with the end of the business cycle leads to higher growth in the future (the vertical line coincides with the first cut from the Fed). 

Throughout 2008, the curve stayed steep...going over 200bps in mid 2009. The first round of QE 

Steepened the curve even more: 5y/30y spread topped out at over 250bps in 2010. 

That was very supportive for credit growth--which is one of monetary policy’s core transmission mechanisms. 

Now, looking at the situation today: here is the same chart, 5y/30y ust spread and the fed funds rate.

This time, the curve FLATTENED when the Fed started cutting rates. 

The market is telling the fed and the ECB that they don’t believe the traditional monetary policy transmission mechanisms work anymore. 

Do you believe the market has that right? The market opportunity is clear---bet on further flattening and stagnation if monetary policy is broken--bet on steepening if you think a combination of normal business cycle re-ignition and Fed and ECB easing can sort this out and  return growth to trend. 

My take: I think the market has gotten way out ahead of itself and is trading on 1) fear and 2) momentum. Real money guys benchmarked to indexes--who happen to be getting eaten alive by passive indexation--caught on to the rally in the front end, but have reacted by buying long end duration and convexity. They are going to stay long until proven otherwise. Nobody wants to be left behind in the great bond rally of 2019. 

Now, put on your behavioral finance hat. If you have skin in the game, ask yourself or your colleagues these types of questions:

• What is the probability the US and/or European governments pass fiscal stimulus packages of at least 2%/GDP per annum? 
• What is the probability that US and European monetary policy will prove ineffective over the next year--as demonstrated by a 5/30y curves in US and Germany flatter 1 year from now vs. where they are today? 
• How much of this is Soros-esque reflexivity, reflecting the “fear of fear itself” and a self-fulfilling prophecy of lower long-term interest rates? If you buy into that--what evidence can you bring to the table? 
• Curves have re-steepened in the past--prove to me why this time is different.

These are the type of questions that can get us past rank speculation and productive discussions about what is baked into the markets and how we can exploit that to generate alpha.

skewrisk@gmail.com
@EMinflationista