Day: October 7, 2008

Setting a New Speed Record for Being Wrong

Setting a New Speed Record for Being Wrong

Okay, so 16 minutes after my last post, Ben Bernanke says he will consider more rate cuts.? Nice, and toss in the commentary that sound like the Fed is taking signals from the TIPS market on inflation, as well as the commentary in the minutes that some members were leaning toward cuts in the Fed funds rate.

The key here is how much of the loosening they allow to work its way into the banking system, versus how much they put into the intervention programs.? So far, it hasn’t been much.

Bound for the Zero Bound, or, Will They Accept Dollars in Exchange for Helicopter Fuel?

Bound for the Zero Bound, or, Will They Accept Dollars in Exchange for Helicopter Fuel?

These are the times that try my soul as a portfolio manager.? During crises, I am forced to make tradeoffs of the short-, intermediate-, and long-terms.

  • Short-term: technical oversold/overbought-ness.
  • Intermediate-term: valuation levels.
  • Long-term: what industries benefit from economic change?

This is a difficult balancing act.? What makes matters more complex here is trying to understand what impact the actions of the Fed/Treasury are likely to have on the Dollar.? I hope to have another post up on the balance sheet of the Fed, for now, here’s the graph that Ron Smith called “the hockey stick.”

As I note in the graph above, the changes are even larger than the change in the weekly average figures.? Now, this isn’t presently going to be inflationary, because the Fed is (sort of) acting as an agent for the US Treasury in bailing out lending markets.? The US Treasury creates T-bills or notes, gives them to the Fed, and the Fed uses them as collateral in their collateralized lending programs.

The difficulty comes here: it’s easy to create these programs, but hard to shut them down.? Now the Fed will buy commercial paper.? Talk about unbacked paper money, CP is unsecured by any assets of the company receiving the loan.? jck at Alea rightly calls this not-so-wee beastie the Super-SIV.? As I commented there:

  • # 1 David Merkel Says:
    I think you pegged it calling it the Super-SIV. As I commented in late 2007 as the Fed began this series of interventions in lending markets, it is easier to start these actions than to complete them. It is hard to estimate all of the consequences.Just as I think George Bush, Jr., started to go wrong when he concluded that he had found his mission (fight terrorism, without boundaries), Ben Bernanke faces a similar problem (do whatever it takes to stop the Second Great Depression, without boundaries).

    History is being made here, and it will be volatile?

    And jck responded:

  • # 2 jck Says:
    one thing we know for sure, is that the policy of ?promoting? liquidity appears to have backfired, no reasonable person would claim that markets are functioning better now than when they started?in fact some people would say they are a lot worse.
    as you say David, very hard to get out of this, I don?t expect to see a normal Fed balance sheet, i.e treasuries_t-bills in my lifetime.
    I will pop in for a comment on your euro piece a bit later?busy???
  • The question is: what are the endgames for these programs… TAF, CPFF. PDCF, TSLF, TARP, the bailouts of Bear and AIG, etc?? Once a market gets a taste of cheap credit, it is difficult to get them to give it up; they begin to depend on it.

    And there are more demands for use of the credit of the US Government.? Bill Gross wants Fed funds at 1%, and wants the Fed to guarantee that institutional transactions clear.? Sounds simple, but the devil is in the details.? The essentially means that the Fed takes short term risk of financial firms failing while securities are in the course of settlement.? The losses could be significant in a crisis, but so could the calming effect.

    The Treasury/Fed hopes that if they can calm the markets, eliminating fear of cascading defaults, eventually the markets will regain a tolerance for risk, and they can slowly eliminate the new lending programs.? My sense is that is the Japanese solution, and we are still waiting after two decades to see if it works.? Other “solutions” include:

    • Inflating away the value of the promises made. (I.e., monetizing some of the T-securities that have been printed and given to the Fed.)
    • Increasing taxation to pay for the credit losses from the bailouts.
    • Creating a two-tier currency system, where foreign lenders get paid back in a cheaper currency, but domestic lenders don’t get so badly affected.
    • Or, a combination of the above four.? Like jazz, I think policymakers are making it up as they go along, and will use a wide variety of solutions.

    And, all of this hinges on the willingness of those who buy Treasury and Agency securities to continue to do so.? On the bright side, the disarray in Europe is making the US Dollar and Japanese Yen more attractive, giving the US the opportunity to issue more debt at a time when it will be needed for the TARP.

    I come down on the side of an eventual inflation, monetizing the debts of the US Treasury, though that is a minority opinion at present.? It certainly isn’t showing in the TIPS market.? Take a look at one of Greenspan’s favorite graphs, five year inflation, five years forward:

    After six years of stability in this statistic, expected inflation has gone over Niagra in a barrel.? Call me a nut, but I like TIPS even more here.? Very cheap inflation insurance, which I think we will need when this comes into its endgame.

    Most of the pressure is toward a lower Fed funds target rate, but given that the Fed has sterilized their prior cuts, I don’t see what great good it will do.? It just gets us closer to the zero bound, after which, Japanese quantitative easing exists, and the infamous helicopters of Friedman and Bernanke.? As it stands now, I don’t put much credibility in a Fed funds rate cut.? The Fed seems committed to using its balance sheet to intervene in lending markets, not the more traditional stimulus of the economy as done in the past.

    Truth, I am not sure where this ends, but from my recent discussions with Ron Smith and Dr. Jeff Miller, the solutions aren’t easy or pretty.? The time to have acted was 5-15 years ago, and we don’t have a wayback machine.

    You’re Owed Euros

    You’re Owed Euros

    The Euro has been falling recently versus the Dollar.? Why?? There have been many theories proposed, but I want to offer my own theory this evening.? Fiat currencies are political creatures, and are only as strong as the political entity issuing the fiat currency (fiat — it’s currency because we say that it is).

    The intersection of politics and economics is tricky.? Currencies, and confidence in currencies are ephemeral.? I look at the Eurozone and ask a simple question: who stands behind the Euro?? Who will lay out tax revenues to support it in a crisis?? Who will be the lender of last resort?

    Much as I did not like the bailout plan because I think there were many better plans to pursue, nonetheless, the US has the benefit that the US Treasury and Federal Reserve are acting like one unit.? In the Eurozone, there is no central taxation, regulatory banking, or police authority; there is no lender of last resort.? Individual governments or “coalitions of the willing” may bail out financial companies, but there are no guarantees because the ECB and European Parliament are toothless.? If the same conditions existed in the US, regional Federal Reserve Banks would do the bailouts, and not the Central Bank.

    When I was on “The Ron Smith Show” two weeks ago (sorry, no podcast), I commented that the credit crisis was a global phenomenon, and the European banks were more levered than US banks, though with less credit stress as a percentage of assets.? I pointed out that there is no lender of last resort, and that many countries have different goals for currency policy, and bank regulation.? I also noted that the criticisms of American finance were valid, but applied to Continental Europe as well.

    At present, those Europeans that dissed Anglo-American finance have egg on their faces (including the lady who shares my surname).? With the competitive rush in Europe to guarantee bank deposits, even Germany switched its policy and guaranteed deposits.? That hasn’t happened in the US yet, but I wouldn’t rule it out.

    It is possible that the current crisis could destroy the Euro, and possibly the EU.? I think of the Confederation, where the economic pressure became so great that an extra-constitutional coup took place to create the Constitution, and implicitly, the fiat Dollar that we live with to this day.? WIthout political unity, fiat currencies have short shelf-lives.? Alternatively, the crisis could create a Federal Europe where the central government has significant powers to the degree that France in the Eurozone would be similar to Texas in the US.? I don’t see that as likely; there is not the same degree of trust across the Eurozone as there is in the US.

    What’s my upshot here?? Extreme volatility does not favor the Euro; it calls their system into question.? Better to be in the Dollar, or better yet, the Yen, Swiss Franc, or Norwegian Kronor.? Carry trades are play on low volatility; when volatility rises, the low interest rate currencies tend to do well because the ability to hedge bad currency outcomes is diminished, and carry trades collapse.

    That’s where we are now.? Neither the US nor Europe should gloat over the other’s bad providence.? They have their own unique weaknesses.