I’m swamped with putting the finishing touches on my talk for the Society of Actuaries, so this post will be brief.? When it’s done, I’ll be posting it here for all of my readers.? When the transcript gets published, I’ll post that as well, but that takes a while.
A few observations, some of them obvious, because we’re at an interesting juncture in the markets now:
The equity markets are near new highs.? Who’da thunk it?
Equity implied volatilities have returned to a semi-normal state, and corporate credit spreads have tightened, but lagged.
Fixed income implied volatilities look high.
Fed policy, if LIBOR, narrow money, or the monetary base is the measure, hasn’t worked that well.
Fed policy, if the stock market or total bank liabilities is the measure (credit expansion), has worked pretty well.
The dollar has bounced, but I would expect it to retrace the losses.
We’re experiencing a small period of macroeconomic quiet amid the start of earnings season.? Earnings season should be good overall, with weakness in housing-related areas, and strength in export-related areas.
Banks should be able to end the logjam in the LBO debt markets.? The cost is feasible.
Residential real estate prices are still weakening, and provide most of the drag on the US banking system and economy.
Inflation is rising with many of our trading partners; the US may begin absorbing some of it.
Our trading partners are going to have to choose between controlling their interest rates, and following US policy, or letting their exchange rates rise further.
In this environment, I am trimming my equity portfolio slowly as positions hit the upper end of their trading bands.? 20% of the portfolio is within 5% of the upper rebalance point.? Almost nothing is within 10% of my lower rebalance point, so I’m not likely to add anytime soon.
1) In an open economy, you can control your exchange rate or your interest rates, but not both.? The first time I learned that was late 1986, when the Dollar crashed, then the bond market crashed (May 1987), then the stock market crashed(October 1987).? This article from Morgan Stanley goes over the same idea.? Pay attention to the investment? implications at the end, though Hong Kong may have already rallied enough.
For a more bearish view, many Asian economies are facing the choice of slowing their economies, or importing inflation from the US. My sense is that we are in an uptrend for inflation globally.? Few central banks are truly pursuing sound currencies.
2)? Europe is no monolith here.? Managing the ECB is some trick, because money is political, and there is monetary union without political union.? The Swiss Central Bank continues to tighten, while the Bank of England effectively loosens, because of the recent panic there, involving Northern Rock.
3) One of my favorite observations about technical analysis is that slow moves tend to persist, while fast moves tend to mean-revert.? Well, the US dollar is having a grinding, slow adjustment downward. ? To me, that is just another indicator that the decline will persist.
4) Will the Saudis drop the dollar peg?? Maybe.? Given the current inflation rate there, I would suspect that they, and other Persian Gulf nations, will move to a currency basket approach that has a high US Dollar weighting.? That will allow themselves the flexibility to make further adjustments that allows them to arrest inflation.? That will lead to further declines in the dollar against other currencies.
5) What makes a currency attractive?? GDP growth and high real (inflation-adjusted) interest rates.? The US has neither of those now.
6) An old dear friend of mine, Roy Hallowell, had two merciful rules: a) We all make mistakes.? We ALL make mistakes. b) Most of them are like the rest of them.? Such is Goldman Sachs Global Alpha.? They played too much on the carry trade and got burned, among other bad trades.
8)? Given the fall in the implied volatility of the yen, the yen carry trade is coming back.? The carry trade works best when implied volatilities are low, because the cost of protection against adverse moves is modest.? But, if low interest currencies persist in tightening, the carry trade could be a bad bet.? My thought : Japan is not tightening anytime soon, and? the carry trade continues there.? Switzerland goes the other way.
The Chinese banking system still can’t stand on its own.? It’s not as bad as it was, but it still needs more of a capital cushion to be more certain of survival.
They have punished over 3000 government officials for illegal land transfers.? And we complain about eminent domain.? On the bright side, perhaps the Chinese government finally realizes that property rights are necessary to a healthy economy.
1) Fed chatter has gotten a little quieter, so maybe it is time for an update.? Let me begin by saying in an era of detailed press releases from the Fed, many analysts spend more time parsing phrases than looking at the quantitative guts of monetary policy.? This article from Mish, which cites this article from Gary North is close to my views, in that they are looking at what is happening to the critical variables of the money supply.
2) For another example, Look at the discount window.? That has faded as a factor over the past two weeks.? You have to dig into Dow Jones Newswires just to hear about this.? The discount window is back to being a non-entity.
3) Review his book.? Cite his article.? Though I think the FOMC will loosen more, I agree that it should not be loosening.? The Fed will overstimulate healthy areas of the economy, while sick areas get little additional credit; that’s how fiat monetary policy works.? (Maybe I should review James Grant’s The Trouble With Prosperity?)
4)? I may not vote for him, but I like Ron Paul.? He is one of the few economically literate members of Congress. Thus I enjoyed his question to Ben Bernanke.? I favor a sound dollar, and risk in our system.? It keeps us honest.? Without that, risk taking gets out of control.
5) Now, onto the chattering Fed Governors.? Consider Donald Kohn, a genuinely bright guy trying to spin the idea that the Fed is not to blame for residential real estate speculation.? He argues that much of the speculation occurred while the FOMC was tightening.? Sorry, but the speculation only cut of when the FOMC got rates above a threshold that deterred speculation because positive carry from borrowing to buy real estate disappeared, which finally happened in September of 2005, when the FOMC was still tightening.
Or, consider Fed Governor Frederic Mishkin, who thinks that troubles in the economy from housing can be ameliorated by proactive FOMC policy.? If his view is dominating the Fed, then my prediction of 3% fed funds sometime in 2008 is reasonable.
But no review of Fed Governor chatter would be complete without the obligatory, “Don’t expect more rate cuts.”? They don’t want their policy moves to be impotent, so they verbally lean against what they are planning on doing.? This maximizes surprise, which adds punch to policy moves.
6)? Consider foreign central banks for a moment.? I’ll probably write more about this tomorrow, but a loosening Fed presents them with a problem.? Do they let their currencies appreciate, slowing economic growth, or do they import inflation from the US by cutting rates in tandem?? Tough decision, but I would take the growth slowdown.
8) Now the CP market is returning to health; almost all of the questionable CP has been refinanced by other means.? Now, money market funds are better off than they were one month ago, but all of the issues are not through yet.? Some money market funds contain commercial paper financing subprime CDOs.? Now, the odds are that the big fund sponsors would never let the ir funds break the buck.? They would eat the loss.? That’s not a certainty though so be aware.
9) This article is the one place where the Fed lists most of the Large Complex Banking Organizations [LCBOs — pages 32-33].? Some suggest that this is the “too big to fail list,” though by now, it is quite dated.? On the bright side, it correlates highly with asset size, so maybe a list of the 20 largest bank holding companies in the US would serve as well.
10) We end with Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”? My way of saying it is that trying to control a system changes the system.? The application here is that when the Fed tries to affect the shape of the yield curve by FOMC policy, it eventually stops working.
With the US Dollar Index taking out an all time low previously set in 1992, I thought I would take this moment to discuss my thoughts about where the dollar is going, and what we might see along the way. If the dollar gets much lower against the major currencies of our world, I would expect to see some currency intervention to try to raise the value of the US dollar.
There are rules to effective currency interventions. There may be more than four, but here are the four that I know.
Do the intervention on a day when the economic releases favor a stronger US Dollar.
Do the intervention when traders are overconfident, and pressing their bearish dollar bets too aggressively. Catch them leaning the wrong way.
Don’t do it alone. You will fail. You must get the central banks of most of your major trading partners to go along to create an impression of unanimity.
Do it BIG. This is not a time to hold back; either do it BIG, or don’t do it at all. You want the currency traders to wish they had never taken up the profession.
You want to have at least three of these in play for an effective intervention. You want to create a genuine panic that feeds on itself, leading everyone to readjust their positions on the US Dollar, pushing it up, and winning the psychological battle against a lower US Dollar.
Easy, right? Well, no. In the short run, interventions work if done properly. They don’t solve the macroeconomic problems underlying the weak Dollar, though, and so toward the end of the shock move upward in the Dollar, I would be inclined to buy more foreign bond exposure. Why?
During the intervention, the participating central banks suck in US Dollars, and pump out their local currencies. In the case of the Fed, they sell foreign currencies and buy US Dollars. Most of these central banks have all of the US Dollar assets that they want already, and they understand the fundamental situation regarding the US Dollar. So, like OPEC in their ineffective days, where they would announce production cuts, and then everyone cheats, in this case, the Central Banks do the intervention, but then quietly recycle the US Dollar assets that they never really wanted to hold.
That leads to a slow retest of the levels that the intervention happened at, and eventually, breaking through the level, at which point, the Central Banks can try again, or give up.? Eventually the response is a “give up,” after which, the US Dollar slowly overshoots and then finds a new temporary equilibrium level, and the rest of the world adjusts to it.
I’m leaving out a lot here.? The internal political pressures to keep the Dollar from falling.? The effects on export industries.? The slowly growing willingness to buy US Goods and services.? Rising interest rates in the US.? Rising inflation abroad.? And more.
The investment implication is this, though.? Until an intervention happens, the path of the US Dollar is down.? After it happens, the path of the US Dollar is down, until a new equilibrium is found.? Economies are bigger than governments, and in the long run, governments can’t affect exchange rates.
Just stay on your toes, and be ready to buy non-Dollar assets after the coming currency intervention.
Implied volatilities have fallen below long-run averages for equity indexes.
The equity market is within spitting distance of a new high.
The Fed is loosening (will they do more?)
The discount window is largely vacant.
Away from real estate, and real estate finance, things seem pretty chipper.
The yield curve is normalizing.
Inflation as measured by the government is low.
Long term interest rates are low, for investment grade borrowers.
Commercial paper problems are gone.
LBO debt difficulties will be solved soon, through a combination of losses to the banks, and canceled deals.
Or maybe not:
Inflation is rising globally.
The dollar is weak.
US inflation should start to rise as a result.
Housing prices are weak and getting weaker.? Default and delinquency statistics are rising.
The CDO [Collateralized Debt Obligation] problems are still not solved.
Defaults should begin to increase significantly on single-B and CCC-rated corporate debts in 2008.
The TED [Treasury-Eurodollar] spread is still in a panic-type range.
I’m seeing more of my stocks get closer to the upper end of my rebalancing range.? I will begin reducing exposure if the market run persists.? I’m not crazy about the market here, but I am not making any aggressive moves.
Though I don’t agree with all of his theories, John Hussman did an excellent job describing how little the recent Fed loosening has done for monetary policy. There still has not been a permanent injection of liquidity since May 3rd. The monetary base is flat. The real changes in monetary policy have come through additional leverage at the banks. That comes through explicit policy waivers, policy changes (e.g., permitted collateral at the discount window, removal of stigma), and the “wink, wink, naughty boy” returning to bank exams.
That reflects in the monetary aggregates. M2 and MZM both have moved up smartly since the beginning of the temporary loosening, as have total bank liabilities, which is a good proxy for M3. That said, because LIBOR is high relative to Fed funds, it is less good of a proxy, because banks are less willing to lend unsecured to each other in the Eurodollar markets.
Think of it this way, US Dollar LIBOR has only incorporated 16 basis points of the 50 basis point rate cut, measured from the equilibrium level that existed previous to the latest crisis in 2007. During the rate rise, they moved pretty much in lock-step.
So, things are a little better on the liquidity front in the short-run, but not much better. If the banks begin to become more conservative, just for survival reasons (i.e., more leverage is permitted, but they don’t want to use it), the small effects of regulatory easing will be erased.
Position: none, but while I wrote this, my youngest boy (10) came up to me, and asked me to explain what the stock market was like during 9/11, and during the Great Depression. It is very rewarding to be with my family during the day.
After this, Dr. Jeff Miller of A Dash of Insight pinged me asking me to clarify a little.? My response went like this:
You’re right, I need to be plainer about where I agree with him, and disagree with him, and I’ll probably put that into a post tonight at my blog.? Oddly, his models, from what I can gather, work off of some sort of cash flow yield for valuation, and even have a “don’t fight the Fed” component to them, in addition to momentum.? The reason this is weird, is that from those simple measures, he should be far more bullish, but he is not.? My suspicion is that he assumes that profit margins will mean revert, which they will, but maybe that will happen a lot more slowly than many anticipate.
As for his theory on the Fed, he is off.? The Fed has real impact on the economy through its effect on short term rates, admittedly with a lag, and they can’t fix inverted situations, no matter how low rates go (like Japan).? They affect bank leverage quite a bit, and though not cost-less, it has a real impact on the economy, with less of a lag, unless they go too far.
In essence, Hussman got the data right, and part of the interpretation, but missed increased leverage at the banks, which so long as it is sustainable, will stimulate economic activity.? He also missed that “Don’t fight the Fed” generally works.? I understand his valuation arguments, but he needs to get more sophisticated, and look at relative valuations of stocks to bonds.? Stocks are quite attractive on a relative basis, at least for now.
Monetary policy and its effects are complex, and non-nuanced explanations do a disservice to readers, particularly when the investment prescription is too simplistic.? At present, the Fed has done little to increase the money supply directly, but has encouraged the banks to lend more.? If the banks can tolerate that, then good.? If not, then watch out, because the banks are integral to our credit-based economy.
There is a misunderstanding about contrarianism, that somehow if a lot of people think something, it must be wrong, so take the other side of the trade.? We can make an exception here for some financial journalists, because they are often late to catch onto a story, and thus, the magazine cover indicator often works.
My point here is that intelligent contrarianism does not work off of what market players think, but how much they have invested relative to their investment policy limits, and the capital that they have available to carry the trade.? When there are many investors that have gone maximum long on a given company, that is a situation to either avoid or short, because unless new longs show up, the current longs have no more buying power — it is a crowded trade.
I saw this with housing in 2005, as I wrote a piece on residential real estate that proved prescient.? It drew a lot of controversy, but my point was plain.? Where would additional buying power come from?? In September of 2005, I concluded that we were at the inflection point.? One of my theories about inflection points is that there is no good numerical signal of an inflection point, but qualitative chatter undergoes a shift at the inflection points.? In that case, I had a series of googlebots trawling the web for real estate related chatter.? The tone shifted in September/October of 2005, but it was largely missed by the media and the markets.
Though I have nothing written on the web on the Internet Bubble, the qualitative chatter change that happened in March of 2000 was commentary from a variety of companies that had relied on vendor financing were turned down by their vendors.? That was new, and it indicated a scarcity of cash.? My rule of thumb on bubbles is that they are primarily financing phenomena; bubbles pop when cash flow proves insufficient to finance them.
Now, with both the residential real estate and internet bubbles, there were a bunch of naysayers prior to the bubbles.? Most were way too early.? Keynes observed something to the effect that markets can remain irrational longer than an investor can remain solvent.? Risk control is a key here, as well as cash flow analysis. When does the financing fall apart?? What will the inflection point, with all of its fog, look like?? Where is the weak spot in the financing chain?
Those naysayers were an inadequate reason to take a contrarian position; many of them didn’t have a dog in the fight, aside from intellectual bragging rights.? Rather, the contrarian position was to ask what side had overcommitted relative to their ability to carry the positions, and the ability of others to get financing to buy them out.
Where I differ with many permabears is that I am usually unwilling to extend my logic to second order effects.? Just because one area of the economy is falling apart, doesn’t mean that a related area will of necessity get blasted.? There are dampening effects to almost any economic phenomena, such that you don’t get cascading effects where failure in one area leads to failure in others, leading to a failure of the system as a whole.? The exception is of course the great depression, and that was a situation where the whole economy was overlevered.? We’re not there today, yet…
Okay, one semi-practical application, and then this article ends.? I get a certain amount of pushback for being bearish on the US Dollar.? I’ve been bearish on the US Dollar since mid-2002, when I saw that our monetary and fiscal policy were shifting to aggressive levels of debasement stimulus.? Today I heard someone dismiss further US dollar weakness because “everyone knows that.”? Well, if everyone knows that, tell it to the foreign investors who are stuffed to the gills with US dollar claims (bonds), such that their economies are beginning to suffer higher inflation.? I see a continued crowded trade here, and I am waiting to see where the pain points are, such that foreign central banks begin to intervene to prop up the dollar.? It hasn’t happened yet, and we are within 20 basis points of taking out the all time low in the dollar index, set back in 1992.
My broad market portfolio trailed the market a little today. I’ve been a little out of favor over the past three months; I’m not worried, because this happens every now and then. That said, we are coming up on another portfolio rebalancing, where I will swap out 2-3 stocks, and swap in 2-3 others. Watch for that in the next few weeks.
Every group in the S&P 1500 was up today. I can’t remember when I have seen breadth like that before. Financials and Energy led the pace. Names like Deerfield Triarc flew on the Fed cut. They will benefit from cheaper repo rates, and the excess liquidity injected the system should eventually ease repo collateral terms.
If the US dollar LIBOR fix at 6AM (Eastern) tomorrow follows the move in the US futures markets today, then we should see LIBOR drop by 27 basis points or so. Given the smaller move down in T-bill yields, 14 basis points, that would leave the TED spread at 132 basis points, which is still quite high, and higher than the 10-year swap spread. (LIBOR would still be higher than the 10 year swap yield.) This indicates that there is still a lack of confidence among banks to lend to each other on an unsecured basis. Things are better than they were two weeks ago, but still not good.
The short term crunch from the rollover of CP, especially ABCP is largely over. The good programs have refinanced, the bad programs have found new ways to finance their assets, or have sold them, or used backup guarantors, etc.
Watch the slope of the yield curve. It is my contention that the slope of the yield curve changes relatively consistently through loosening and tightening cycles. In the last tightening cycle, the curve flattened dramatically through the cycle, making the word “conundrum” popular. This is only one day, but the yield curve slope, measured by the difference in yields between 10-year and 2-year Treasuries, widened 10 basis points today. (The curve pivoted around the 7-year today.) If I were managing bonds at present, I would be giving up yield at present by selling my speculative long bond positions that served me well over the past few months in my model portfolio. I would be upping my yen and Swiss Franc positions.
We learned some new things about the FOMC today: a) They don’t talk their book publicly, so don’t take their public comments too seriously. b) They are willing to risk more inflation for the sake of the non-bank financial system (which is under threat), or economic growth (which may not be under threat). c) They are flagging the Fed funds rate changes any more by letting rates drift nearer the new target in the days before the meeting. d) Beyond that, we really can’t say yet whether this is a “one and done” or not yet. We just don’t have enough data. e) The FOMC really isn’t interested in transparency.
It would be historically unusual for this to be a “one and done.” Fed loosenings are like potato chips. It’s hard to stop at one. Just as there is a delay in the body saying, “that’s enough,” with the potato chips, the in the economy in reacting to monetary policy is slow as well, often leading policy to overshoot, as the FOMC reacts to political complaints to do more because things aren’t immediately getting better. It’s hard to sit in front of the short-term oriented Congress, or listen to the manic media, and say, “But the FOMC has done enough for the economy. It doesn’t look good now, but in 18 months, our policy will take effect and things will be better. Just trust us and wait.” That will not fly rhetorically; it will take a strong-headed man to not overshoot policy. On that Bernanke is an unknown.
To me, it’s a fair assumption then that this cut will not be the last. Investment implications: in fixed income stay in the short to intermediate range, and remain high quality. Buy some TIPS, and have some foreign bonds as well. I like the Yen, Canadian Dollar, and the Swiss Franc. In equities, think of high quality sectors that can use cheap short-term credit, and sectors that benefit from inflation and a weaker dollar. So, what do I like? High quality insurers, mortgage REITs that have survived, (maybe trust banks?), basic materials, energy, goods transportation, staples, some areas in healthcare and (yes) information technology (if I can find any more cheap names there that I like).
Well, that’s what I get for putting forth my guess.? The FOMC statement is here, and will get hyper-interpreted.? I don’t think it says anything significant.? When the minutes come out on October 9th, there should be greater clarity.? Until then, the market will have some bumps and jumps as Fed Governors give speeches.
As I have said before, my view on the FOMC has gone cloudy.? That said, I’ll put forth my best guess for you what the FOMC will do and say today.? I think the FOMC will ease the Fed funds target 25 basis points, or maybe a little more, but not 50 basis points.? (Stuck my neck out there, hope I don’t get chopped.)? Here’s why:
Not all lending crises are over, but the crisis in the CP market largely is over.? There was some paper that had to be taken back by the banks, and some that had to be rolled over at relatively high rates, but the refinancing of the bulk of short term credit is done for now.
Total bank liabilities are growing smartly since the change in the discount window, leverage changes, and temporary liquidity adjustments took effect.? Little effect on the Fed’s monetary base, M1, MZM, or M2 yet.? This is just a bank leverage thing.
The NY Fed Open Markets desk continues to be sloppy on the upside.? Over the last four days, three times Fed funds finished over 5.25%, with the close yesterday at 5.4325%.? This is not what you would expect to see from a Fed that expects to loosen aggressively.
The discount window finally got good demand last week.? With that strategy seeming to work, the FOMC has less pressure to cut the funds rate.? Might they cut the discount rate more than the funds rate?? Yes. because seeming success often breeds more of the same.
Business conditions aren’t that bad nationally yet.? Real estate is a drag, and will get worse, but it is not an immediately obvious reason to loosen.
A 25 basis point move validates the temporary policy move of the Fed, and does not change policy, beyond making the more semi-permanent.
There are more hawks with votes on the FOMC now, and Bernanke is not pushing to get his way, the way that Greenspan did.
Beyond that, we have the language of the statement, where the FOMC will attempt to sound a balanced view between the risks of inflation and economic weakness.? After the announcement, I expect the stock market to fall back and then rally modestly.? Bonds won’t do much.
That’s my view, though I must state that this is not one of my more strongly held views.? I am still gathering data on the current Fed, because they are so new to their roles in loosening environment.
