Category: Fed Policy

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A Bonus from MoneySense Magazine

Posted on by David Merkel

For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.? In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.? Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.? Fortunately, the piece I wrote was generic, and can benefit investors anywhere.

Notes on Stocks and the Fed

On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.? It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.? This wasn’t just true of the US, but of most global equity markets.

So, if we are going down further, the market will have to rest a while.? That said, valuations are more compelling than they were, especially compared to Treasuries.? Compared to BBB corporate yields, they are still attractive.? I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.

One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.

Fed Cuts 75 Basis Points, More to Come

Fed Cuts 75 Basis Points, More to Come

Posted on by David Merkel

It just shows how high the pressure on the FOMC is, if they have to peremptorily act one week ahead of their regularly scheduled meeting.? Again, one week doesn’t matter much in terms of actual policy impact.

Yet, they may do more at their meeting.? Though I called for a 3.00% Fed funds rate in 2008, I wasn’t thinking of the beginning of the year… more like the middle-to-end.? Now it seems to be a first quarter phenomenon.? And, as I have said since the beginning of this move, given that the FOMC has been willing to use crude policy tools like the Fed funds rate to try to reflate areas where credit stress is high, they will overshoot.? The lags in the action of monetary policy versus the immediacy of political pressure forces the overshoot.

My questions: how low do we go with the Fed funds rate, and how much will price inflation run in the process?

Deflation or Inflation? Why Choose?

Deflation or Inflation? Why Choose?

Posted on by David Merkel

Some of the commentary regarding inflation and deflation misses the point.? We are presently faced with both rising consumer price inflation and asset deflation.? Not a fun combination, to say the least.? It puts the FOMC into a real box.? To borrow an analogy from the Bible, Greenspan ate sour grapes, and Bernanke’s teeth are set on edge.

So what does the FOMC do in such a situation?? We don’t have that much history to work with, but during the ’70s, the FOMC generally loosened.? Fixed income portfolios should tilt toward shorter duration, even though you are losing income, and away from the dollar.? It is probably still too early to begin taking a lot of additional credit risk, but the bet is getting more attractive by the day.

Now, there are a number of commentators that can’t wait one week, and say the FOMC should act now.? The economy is not like someone that you have to take to the emergency ward; one week makes little difference, and the FOMC will do better work if they are meeting each other face-to-face under normal meeting conditions, than over a conference call.

Given the present equity market distress, should we assume that the FOMC will do more than 50 basis points in January? Had you asked me last week, I would have said “no.”? The political pressure is a lot higher now, so I would say yes, they will do more.? It won’t help the areas under credit stress, but it will make it look like they are serious about “fixing the economy.”

We could see a move of either 75 or 100 basis points.? I debate internally how good Fed funds futures are in abnormal environments like this.? Under Greenspan, I sometimes felt that monetary policy had been privatized, and whatever the futures market said, the FOMC would do that.? I don’t know if Bernanke has the same faith that futures traders know what the right monetary policy is.? If I were a Fed Governor, I certainly would not have that confidence.? Once the yield curve gets to a certain slope, the recovery will come in time.? Making the curve steeper won’t make it any faster.

People are impatient, and their complaining causes the FOMC to overshoot on policy decisions.? The lag that monetary policy has is significant, and the FOMC in recent years has made it even slower through their policies of incrementalism.

There are several possibilities here for the FOMC action:

  1. They hold firm, and don’t lower much (50 bp), because price inflation is a concern.
  2. They take the judgment of the futures traders, and move a full 100 bp.? Or, they conclude that asset deflation is a bigger risk, and decide to make a bold statement.? After all, isn’t Bernanke the guy who never wants to see the Great Depression recur, and loose monetary policy can prevent that?? (I don’t think that’s right, but…)
  3. They split the difference, make bows to both camps in their language, and do a 75 bp cut.

The last of those seems most likely to me.? I have said in the past that the FOMC is:

  • Being politically forced to loosen more than they would like, and
  • Dragging their heels in the process.

That’s why I think we end up on the low end of where Fed funds futures will likely point tomorrow.? 75 basis points does not trip off the tongue, but will be a compromise position in the minds of Federal Reserve Governors who are puzzled at the present situation.? Because of political pressure, they know that they have to move big, but consumer price inflation will make them less aggressive.

Score One Success for the Federal Reserve

Score One Success for the Federal Reserve

Posted on by David Merkel

I’ll give the Federal Reserve this, their TAF program has succeeded in bringing down US Dollar LIBOR rates relative to Treasuries and Fed funds.? I did not doubt that they could succeed at doing this; my main concern is what happens when they stop doing this.? Flooding the short end of the yield curve with liquidity has overwhelmed those seeking permanent liquidity cheaply, by offering large amounts of temporary liquidity cheaply, and saying that the program could become a regular part of the Fed’s policy tools.

So, the most recent auction priced out at 3.95%, well below the Fed Funds target of 4.25%, and below where Fed Funds have averaged recently, which is around 4.15%.? Why borrow at Fed funds if the TAF is available?? The TAF can accept a wider array of credit instruments as well.? Why even give a second thought to the discount window at 4.75%, if the same collateral can be financed by the TAF?? Granted, the rate was above the expected fed funds rate for the next month, but using that as a guideline is tantamount to surrendering control of the money supply to the Fed Funds futures market.

Looks like a win for the Fed, at least in the short run.? The long run could be a different story.? The old rule of Walter Bagehot was for the central bank to unlimitedly lend against secure assets at a penalty rate in a crisis.? In this case, it is lending against less than top-quality assets at what is a bargain rate.? In the long run, that is a recipe for monetary and price inflation.? Though longer-dated TIPS don’t reflect that future consumer price inflation, I expect that they eventually will.

The Fed, Financial Guarantors, and Housing

The Fed, Financial Guarantors, and Housing

Posted on by David Merkel

This post will be a little more disjointed than others. One housekeeping note before I start: I’m behind on my e-mail. I will catch up on it next week, DV.

Fed and Federal Government Policy

I don’t know; it seems like there are rumblings that the Fed will imminently take action, and that does not resonate with me. You can also read the stuff from Doug Kass at RealMoney, or consider the rebirth of the Plunge Protection Team. We are not so far from the next Fed meeting that waiting would make that much of a difference, particularly since the Fed tipped its hand when Bernanke spoke recently. There is a decent-sized cut coming, and the Treasury yield curve reflects it.

Now, I have my doubts as to the long-term efficacy of unusual measures from the Fed or the Treasury. You can’t get something by government fiat. Even a Fed Governor thinks we expect too much from the Fed, a sentiment with which I heartily agree, even though the Fed is partially responsible for creating that illusion. If the Fed took more of a “we do our best, but our powers are not that large in the long run” approach, market players might not give them so much credence.

Now, I’m not going so far as Anna Schwartz, who thinks the current Fed isn’t up to the task. That may or may not be true; what is hard to dispute is that Alan Greenspan dealt the existing FOMC a bad hand from a prior monetary policy that too easily responded to minor crises, rather than letting the economy take some pain. Moderate recessions are good for the economy; save the heroics for depression-like conditions.

Financial Guarantors

I may fail at it, but I try to be honest and self-critical here at my blog. For example, I did not suggest that Warren Buffett would buy Ambac, but I was misinterpreted as saying so. Now that Ajit Jain says that Berky might buy into one of the financial guarantors, I am not going to say that I predicted that, because I didn’t. It would be amusing if Buffett announced his new entry into the financial guaranty space to drive their prices down so he could buy a stake cheaper, but that is not his style. He values his reputation. That said, the NY regulator may not have thought enough steps ahead in pushing for Berky to set up a new guarantor. Good for new issues; perhaps not as good for old ones at legacy carriers.

Now, I admire Marty Whitman and Aldo Zucaro, but so far, their forays into the mortgage guaranty space have not worked out. I’m not counting them out, but it still may be early for that trade. Maybe we should wait for one of the companies to fail. The remaining companies should do well, once capacity drops out.

As for MBIA, they cut their dividend, which to me indicates a lower future level of profitability. Then they raise $1 Billion through surplus notes at their operating subsidiary, and pay 14% to do that. That has to be a record spread for a new-issue nominally AA-rated bond. Personally, I think I would pass on the notes, except for a flip. I would rather hold the common. Scenarios that would kill the common would most likely also kill the surplus notes. The common has more upside potential.

Residential Real Estate

I am fascinated by the willingness of some of the courts to insist on strict standards before they allow lenders to foreclose. Examples:

In general, I think there are legitimate flaws in the documentation that got ignored before the number of attempted foreclosures became so large. This is pointing out some stresses in the system. When this is done, securitization will not vanish; it will just be better managed.

Now as a final note, it is somewhat shameful that banks can’t follow FAS 114. The calculations aren’t hard; they just don’t want to recognize losses that they should recognize. That’s the real issue, so FASB and Congress should not give in here.

Politics and the Fed

Politics and the Fed

Posted on by David Merkel

I do not share the view that the Fed is above politics.? The Fed was created by politicians.? They appoint/approve many of its governors.? They set the rules for what the Fed is authorized to do, whether the Fed follows that or not.? The politicians can change the rules if they want.

Beyond that, there is the formal and informal lobbying from businessmen, bankers, and speculators, who might implicitly argue for preservation of purchasing power, or stimulation of the economy.

There is also the interaction of the Fed with the Department of the Treasury.?? So, from all of this, I view the Fed as an implicitly political institution, which is why my analyses of the Fed stem largely from the economics of the situation, but do not end there.? I engage in “game theory” analyses of prospective Fed actions, asking myself how different scenarios would be received politically.? The Fed lives to protect itself.

So, when I read articles that suggest an apolitical Fed, I come to two possible conclusions:

  • The truth is being stretched, and what you hear serves a political goal, or,
  • The Fed governor speaking does not care about reappointment.

Politics abhors idealists, outside of semi-revolutionary moments.? Being the art of the possible, politics favors compromisers.? As I see it here, the Fed is under a lot of political pressure to stimulate the economy, and not under a lot of pressure to restrain inflation.? Should it surprise us if the Fed continues to loosen, perhaps aggressively?

Why Do I Follow M3?

Why Do I Follow M3?

Posted on by David Merkel

I like the no-nonsense attitudes of some bloggers. Dr. Jeff would be one of them. In response to my piece Looking Beyond the Three Percent Horizon he posed the following question:

David –
I understand that the Fed discontinued M3 and that you have a good proxy. My question is, ?Why??

In my research on money supply measures, I have been asking economists what they are trying to measure and why. So far, none has had any reason to track M3. I?ll get around to my reasons for this in a future post, but before doing so, I am curious about why you think this is important. The same question might be asked of MZM.

Thanks,

Jeff

I do have a reason to track M3, so maybe this will help Dr. Jeff.? At RealMoney, as M3 was eliminated, I made the following post:


 David Merkel
Taking a Substitute for Vitamin M3
3/14/2006 3:26 PM EST

If you’re not into monetary policy, you can skip this. Within the month, the Federal Reserve will stop publishing M3. Now, I think M3 is quite useful as a gauge of how much banks are levering themselves up in terms of credit creation, versus the Fed expanding its monetary base. I have good news for those anticipating withdrawal symptoms when M3 goes away: The Federal Reserve’s H.8 report contains a series (line 16 on page 2 – NSA) for total assets of all of the banks in the US. The correlation between that and M3 is higher than 95%, and the relative percentage moves are very similar. And, from a theoretical standpoint, it measures the same thing, except that it is an asset measure, and that M3 incorporated repos and eurodollars, which I think are off the balance sheet for accounting purposes, but should be considered for economic purposes.

But it’s a good substitute… unless Rep. Ron Paul’s bill to require the calculation of M3 passes, this series will do.

Position: none

My reason for wanting an M3 measure is that the process of intermediated credit creation is important.? As we go down the monetary aggregates, from cash, to the monetary base,? to M1, M2, and MZM, we get further away from cash, and closer to credit.? At one point in time, the Fed had a measure called L for total liquidity, which was broader than M3.? In a credit-driven economy like ours, measuring the differences between various types of credit creation can give signals as to how the banks are faring, and how well aggregate demand will do in the intermediate term.? That’s why I look at M3; it helps me to see how much the banks are stretching their balance sheets compared to how much the Fed is stretching its balance sheet.? There are limits to how much independent stretching the banks can do, in the absence of aid from the Fed.

Perhaps I’m just a wonk here, but the willingness of banks to extend credit in our economy is important, and M3 was better correlated with that than most other monetary measures.? That’s why I went in search of an M3 proxy.

Fifteen Points on Credit Where Credit Ain’t Due

Fifteen Points on Credit Where Credit Ain’t Due

Posted on by David Merkel

I’ve wanted to do a post on credit for a while, but I’ve just had too many things to think about. Well, here goes:

1) From the “We Keep Him in a Bubble” file there is James Glassman with his prediction that Spring 2008 would bring the end of the housing troubles. Why does this guy still get air time? Why wasn’t Dow 36,000 enough? There are too many vacant homes to reconcile, there is no way for Spring 2008 to be it….

2) For an excellent summary of where we are in housing, Calculated Risk has this review piece.

3) Not all defaults are subprime. They are happening with Option ARMs, and even prime loans where they had to get Private Mortgage Insurance.

4) Is the subprime mortgage bust bigger or smaller, or similar to the size of the the S&L crisis? I’ll go with bigger. I don’t buy DeKaser’s smaller argument because securitization has provided more credit to small and medium sized businesses. I do think Portfolio.com is on the right track by looking at the amount of the housing price rise that has happened.

5) Personally, I find it delicious that the banks get stuck footing the bill in particularly bad foreclosure situations. So much for structural complexity in lending.

6) Americans are the most overhoused people in the world. No one else gets as much space, or stores as much stuff, broadly speaking. This book review of “House Lust,” will take you through the whole matter, in probably too much detail. (And yes, my house is large also, but I have ten people here… Americans can be unusual in other ways too; as a culture, we are more optimistic about children.)
7) From Calculated Risk, a tale of why lenders tend to forbear with marginal borrowers that are having difficulties with their current loans. One thing they don’t mention, the Residential MBS market does not have special servicers like the Commercial MBS does. When a loan gets into trouble, the CMBS special servicer gets paid adequately, but the ordinary RMBS servicer does not, particularly when lots of loans are in trouble. It is a weakness in the RMBS system.

8 ) As the TED spread declines, market players begin to relax about liquidity. But what of solvency? As losses are realized by banks, some will have to shore up their capital positions, and to do that, they will have to ratchet back lending.

9) How similar is the US today to Japan back in the early ’90s? There are some similarities, given the property bubbles in both places, and the interest rates that get lower and lower, but there are differences — a healthier banking system in the US, and a more market-oriented economy here as well. A depression is possible in the US, but I would not assume it at present.

10) Is the US consumer spent-up? Could be. Consider this article on auto loans as well. Personally, I am surprised at the degree to which lenders will make consumer loans with inadequate security, but that is just a normal aspect of American life today. For now.

11) What of corporate bonds? It certainly seems like junk bonds will be seeing more defaults in 2008. (Here also.) This shouldn’t surprise us, because the credit quality was low and the volume of high yield bond issues was high 2004-2006. It takes a little while for bad debt to season, and we should see the results in 2008.

12) When I did my “Fed model” I used BBB corporate yields as my comparison to earnings yields on equities. Given the backup in credit spreads, my Fed model is not nearly as favorable as those using Treasuries. But those looking only at credit spreads get the wrong result also. With Treasury yields so low, most high quality bonds are not attractive now.

13) On the bleak side, I tend to agree with Naked Capitalism and the FT that there is a transfer of power going on in the world, away from the US, and toward China and the Middle East. Power follows capital flows, and they are funding the US at present. They will own more and more of US businesses over time. They increasingly won’t be satisfied by owning our debts.

14) I found this piece from Credit Slips to be educational. There are certain types of income that can’t be garnished; nonetheless, garnishing happens. The only way to protect yourself is to fight back, and that article highlights how it is done.

15) Finally, credit at its most basic level. Credit is trust; trust that repayment plus interest will occur. Who do you trust? Personally, I found the discussion following Barry’s post to be depressing, because so many commenters were cynical. here was my comment:

Capitalism is based on trust. Without trust, capitalism will slowly cease to exist. Yes, there will be barter-type transactions, but any complex long-term transaction or relationship is based on trust. Any multi-party transaction requires trust, because multiple parties can gang up on the weak one.

Even representative government requires trust. Now, that trust is often abused, but who wants to get rid of representative government?

There is a lot more trust within our society than most of us imagine. Woe betide us if trust drops to a minimum level.

Estragon (thank you) agreed with me at the end, but it is fascinating to consider the implications of a society where trust is declining. Ultimately, it means that credit will be declining.

Looking Beyond the Three Percent Horizon

Looking Beyond the Three Percent Horizon

Posted on by David Merkel

Give the Fed some credit. Not literally, of course. Isn’t it their job to give us credit?

I haven’t talked a lot about Fed policy in a while, so I thought it was time to do an update. Five months have passed since my 3% sometime in 2008 call was made, and now it is becoming the received orthodoxy. That’s why I have to ask what is wrong with it, or better, what is the next phase beyond it?

Truly, I don’t know for sure, but I will offer out my thinking process. We are seeing rising unemployment and inflation at the same time. The bond market is rallying, anticipating falling Fed funds rates, but not forecasting rising inflation rates. (Buy TIPs!) In the spirit of watch what they do not what they say, let’s review the relevant Fed data.

We are in a period of asset deflation and consumer price inflation, so this is a difficult period to negotiate through. You can listen to facile comments from PIMCO; everyone is focused on economic weakness, and few are focused on rising inflation.

I think we get to a 3% Fed funds rate, but we don’t get much below it, because by that time, a 3% Fed funds rate will imply a negative real interest rate on the short end. Congress will have an implied inflationary bias, because the complaints will come more from asset deflation. They will kick nudge the Fed that way to the extent that they can.

The TED spread is not as wide as it once was, but it is still in a historically high range. Anything above 60 basis points implies stress. To reduce this the Fed has set up an auction facility, called the TAF. The TAF has been expanded, which allows for a greater variety of securities to be lent against. That’s the real novelty of the TAF. Not new liquidity but new collateral. That said, even the discount window is getting greater use. As a result, the Commercial Paper market is showing some life, even for asset backed commercial paper.

So, liquidity is increasing on the short end, to the point where a 1/4% cut in Fed funds has for practical purposes already happened. A formal 1/4% cut at the next FOMC meeting would do little except ratify what has already been done. Now there is weakness in the job market, and the PMI is signaling some weakness as well. The yield curve has moved down, particularly on the short end, to reflect expectations of more cuts from the Fed.

But TIPS yields are quiet, at least for now, and viewing the Fed as quasi-politicians, whose main goal in life is to avoid political pain, the path of least resistance is to loosen policy further. Fed funds futures and options are indicating the most likely outcome in on January 30th is a 50 basis point loosening. Ordinarily, because of the “gradualist” culture that has built up inside the Fed, I am reluctant to argue for loosenings other than 25 basis points. I think at this point, I have to argue for 50 basis points, but with the usual squishy language that pays heed to all potential threats, effectively saying, “But no more after this! Conditions are balanced!” We know better, though. The only real question is when rising consumer price inflation or a deteriorating Dollar (think of 1986) will be a sufficient counterweight to economic weakness.

The US Dollar is weak here, and that reflects the judgment of many actors as to the value of what they get paid back will be. My guess is that foreign investors sense that inflation is higher in the US than is stated in the Government’s statistics. Too many dollar claims (internal and external) chasing too few goods that they want to buy. What will dollar-denominated bonds be worth at maturity? (Judging by current yields, quite valuable for now.) And will the US Government allow significant US companies to be owned by the Chinese, or by Arabs? How free market is the US really? Will foreign governments stop policies that disfavor the purchase of US goods? Perhaps once they import enough inflation, they will.

With gold, crude oil, and a host of agricultural prices high, and with structural reasons for them to remain high, the FOMC won’t feel too happy as they cut rates. But cut they will, and then we get to see where the excess liquidity flows. Some will bail out banks, which will invest in safe instruments in areas of the economy not under threat. Loans in or near default will not be affected. Well, more on that later. Tonight’s post will be on credit issues.

In closing, a return to the problem that I posed at the beginning: So what’s wrong with the 3% Fed funds forecast, or better, what is the next phase beyond it? It could go several ways:

  1. Rising price inflation and a deteriorating dollar lead to an end to the cycle, and the Fed funds rate either stops falling, or has to rise to squeeze out inflation.
  2. Continuing asset deflation, and declining but still positive economic growth (as the government measures it) leads the Fed to continue to loosen, or stand pat in the face of rising consumer price inflation.
  3. Liquidity difficulties in the banking system morph into solvency difficulties, leading pseudo-M3 and credit to contract (after all the banks are doing the heavy lifting here, not the Fed) and the Fed starts to loosen aggressively.
  4. We get a “bolt for the blue” leading to something not currently predictable, but which leaves policymakers in a bind.
  5. We muddle along, get to something near a 3% Fed funds rate, and continue to muddle (think of 1992-1993).


Personally, I favor scenario 2. And, for those that like to invest, TIPS are reasonably priced. Insurance against scenario 2 is inexpensive, and relatively high quality. But be wary, because particularly in a Presidential election year, there could be significant surprises (part of scenario 4).

Long VIPSX

Two Final Notes in 2007

Two Final Notes in 2007

Posted on by David Merkel
  1. When I was seven years old, my parents gave me a colorful wind-up alarm clock. I thought it was beautiful. They taught me how to wind it up each evening so that I would wake up to go off to first grade. Being a boy, after a while, I wondered how tight I could wind it, but there seemed to be a limit to that. One night, I found I could wind it one “click” tighter than usual. A week or so later, another “click” tighter. After some time, I wound it one click to many, and I heard a snap, after which the clock rapidly moved in reverse for about 30 seconds, and then moved no more. I was heartbroken, because I really liked the clock. Perhaps its “death” was not in vain, because it is a great analogy for a full swing of the credit cycle. The spread tightening in the bull phase of the cycle is initially relatively rapid, and gives way to smaller bits of incremental tightening, until it is too much, or an exogenous force acts on it. Eventually, when cash flow proves insufficient for debt service, the credit cycle turns, and the move to spread widening is rapid. Once spreads get really wide, the cycle can resume when those with strong balance sheets can tuck bonds away and realize a modest return in the worst scenario, if they just buy-and-hold. Though it did not happen for me, it would be the equivalent of buying the little kid a new clock. Then the cycle begins again.
  2. Economically, Japan has had a lost decade. It is beginning to verge on two decades. During this time, interest rates have been low, and growth has not been forthcoming. The main reason why low rates did little to stimulate the economy is that the banks were impaired, and could not lend. The secondary reason was demographic; equity markets tend to do well when there are more savers versus spenders. For Japan, that peaked in the early 90s. For the US, that will peak in the early teens. Now, it is possible that the more market-oriented culture of the US has reacted to this factor faster than Japan would, thus the relatively stagnant equity market in the 2000s in the US. This is also a cautionary note to those that thing that lower short-term rates will benefit the US markets; after all, what good have they done for Japan?

Thanks to all my readers, and especially my commenters. You make the blog worthwhile to me. I hope to better for all of you in 2008. Happy New Year to all of my readers, whether here, or at other sites that use my posts. May God bless you richly in 2008.

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