Look at the H.4.1 report.? We may have finally hit the panic phase of monetary policy, where the Fed increases the monetary base dramatically.? They are pumping the “high-powered” money into loans:
$20 billion for Primary credit
$80 billion for Primary dealer and other broker-dealer credit
$70 billion for Asset-backed commercial paper money market mutual fund liquidity facility
$40 billion for Other credit extensions
$80 billion for Other Federal Reserve assets
-$20 billion netting out other entries
Making it an increase of roughly $270 billion from last week’s average to Wednesday’s daily balance.? Astounding.
In general, the increases are not being pumped into the banks, but into specialized programs to add liquidity to the lending markets.? Now, I’ve written about this before, but it bears repeating.? What happens if the Fed takes losses on lending programs.? It reduces the seniorage profits that they pay to the Treasury, which means the Treasury has to tax or borrow that much more.? The Fed isn’t magic; it’s a quasi-extension of the US Government in a fiat currency environment.? It’s balance sheet is tied to the US Treasury.
Yves Smith at Naked Capitalism is correct.? The US is no longer a AAA credit, particularly if you measure in terms of future purchasing power of US dollars.? I’ve felt that for years, though, with all of the unfunded future promises that the US Government has made with Medicare, Social Security, etc.? The credit of the US Government hinges on foreign creditors (like OPEC and China) to keep it going.? What will they offer them? The national parks? 🙁
I try to be an optimistic guy and hope for the best.? But the current actions of the government are making me think about a massive re-alignment of my portfolio… and I never do things like that.? But, if the government is ramming through desperate measures, maybe I should too.
The markets are manic.? It is rare that we have so many large moves in a short time.? Consider these graphs:
Gold is rising since the bailout announcement.
So are crude oil prices.
And the US Dollar falls.
Swap spreads rise.
And mortgage rates rise also.
Forces larger than the US government are acting on the world economy, leading to a partial repudiation of the US Dollar by some foreign entities.? This leads to higher implied volatility in the equity markets, and higher credit and swap spreads.? Commodity prices rise also. Would you want to own the securities of a country that overpromised what it would deliver in terms of debt repayment?
I think not, and the present economic environment is decidedly hostile to fixed US Dollar denominated assets.? Play in the US dollar with care… the short trade has much to commend it in the intermediate term, though the short term is cloudy.? Also, be careful on the long end of the US fixed income market… it could deliver some significant negative surprises.
There are irregular miracles from God, the Creator of all, but there is no magic.? The US government can step forward and say, “We guarantee the liabilities of Fannie and Freddie, and take control of the companies.”? But who guarantees the US government?? In the economic world, there is always a cost for every action.
Yes, the US government will continue to borrow from the Saudis and their allies, who appreciate our military actions constraining their Shi’ite adversaries, and supporting their own regimes.? China wants to continue to “grow,” and they don’t care if they are paid back in “funny money” for now, buying Treasury securities with excess dollars.
The US Dollar rallied today, even as the government absorbed liabilities that are uncertain as to size, even though I think the eventual cost will be less than $200 billion.
Who doesn’t want to be guaranteed by the government?? The auto companies are in line, can I get in line too?? I could do amazing things with a $50 billion credit line from the government.? I would assemble a small empire of undervalued companies with earnings yields higher than what I would have to pay Uncle Sam in interest.
My point is this: when you take into account the structural deficit, funding for the wars, social security currently on the balance sheet (but not its increase in liabilities), Fannie and Freddie, and future demands for bailouts of homeowners and auto companies, where does the bailout stop?? Where does the willingness of foreigners to buy Treasury debt end?
I don’t know, and this is the biggest question facing the global debt markets now.? A century from now, a fellow resembling James Grant will write several popular books explaining the decadence of the era, and how the US squandered its leading position in the world by borrowing too much.
So, call me skeptical of the US Dollar and Treasury rallies today.? Those should reverse soon.
Today’s FOMC meeting is largely a done deal.? No moves, but sound hawkish.? Personally, if I were in their shoes, I would move the Fed Funds target to 2.05%, just enough to weird the markets out, but not enough to do any real damage to those who rely on Fed Funds.? Creating uncertainty through breaking the convention on quarter percent moves would be good for the market, because market players have gained a false confidence over what the Fed can and can’t do.
The thing is, the Fed is boxed in, like many other central banks.? A combination of rising consumer prices, rising unemployment, and a weak financial sector will compel them to stay on the sidelines for now.
Now, as for Saturday’s post, I received a number of responses asking me to explain my views.? Here goes:
1) I’m not a gold bug; I have no investments in gold, or metals generally at present.? Any liking that I have for a gold standard is that it gets the government out of the business of manipulating the economy through manipulating the money supply.? Currency boards, pushed by my old professor, Dr. Steven Hanke, are another good idea.
2) Where am I on inflation/deflation?? We are experiencing goods and services price inflation, asset deflation, and a monetary system where the Fed is not increasing the monetary base, but the banks are expanding their liability structures over the last year, but that may have finally peaked.? Consider this graph:
There is a limit to how large the liabilities of the banking system can get relative to the Fed’s stock of high-powered money.? We reached that limit in the first four months of 2008, and now banks seem to be focusing on survival.
It is very hard to reflate bubbles — you can’t build an economy on sectors that are credit impaired, which makes me think that the housing stimulus ideas will likely fail.
3) The Fed is in a box.? They have no good policy options now.? They are stuck between rising (or at least high) inflation, rising unemployment, and the banks are not strong.? Fortunately the US Dollar has been showing a little more strength, but that’s probably anticipating the hawkish tone of today’s announcement.? If the statement is insufficiently hawkish, I would expect the US Dollar to weaken.
4) I expect goods inflation to persist in a moderate way over the intermediate-term, unless the main US Dollar pegs are broken (Gulf States, China).? Presently, we import a little of the inflation that the rest of the world is experiencing mainly through energy, and energy related commodities, like fertilizer.
5) Globalization does restrain wage growth on the low end.? On the high end, it is likely a benefit, and in the middle, probably neutral.? Those who benefit the most are those who are able to use relatively cheap labor for unskilled tasks.? But technological change also affects job prospects in different industries.? My view on steel is that the industry shrank mainly due to technological improvements at the lower cost mini-mills.
6) As for the GSEs, banks, and the investment banks, the Fed would be challenged to raise rates much.? At present, the positively sloped yield curve is allowing some banks to repair by borrowing short and lending long.? That is a good trade for now, but will be prone to trouble if the Fed ever concludes that it has to shift to fighting inflation, and not just put on a rhetorical show.
7) Finally, we have some degree of restiveness among the hawks on the FOMC.? I would expect two (or so) dissents favoring tightening today, but now with the current cast of ten (counting Elizabeth Duke, a banker), but if we get four, which is not impossible, I think it would unnerve the markets.? Mishkin is leaving at the end of August, and the custom is that he attends but does not vote at his last meeting.? (For more on FOMC dissents, I have this article.)
Well, let’s see what the FOMC has to say.? After all, at present, they are all talk.
From 1995 to about 2004, I would imagine Federal Reserve Governors sitting around over dinner the night before the FOMC meeting, and because the mainstream view of monetarism hadn’t been discredited yet, and saying something to the effect of: “What would it take to create inflation? How fast could we move up the monetary aggregates and not get inflation?? We run a stimulative policy far more often than theory would demand, and we don’t get significant inflation.? We’re heroes! What a free lunch!”
(Note: the S&P 500 would look much more impressive if dividends were included.)? I’m not crazy about the way the CPI is calculated, for reasons listed in this article.? But there is a reason behind the lack of goods price inflation for that era.? The money wasn’t going into goods, it was going into assets, like stocks, bonds, venture capital, homes, etc.? There were too many dollars chasing too few assets.? Asset values inflated in the 80s and early 90s, leading to the “lost decade” 1998-2008, where the market went nowhere.
Part of that problem is that the ratio of savers to consumers was topping out 1998-2008, and the Baby Boomers as a whole were a lazy cohort with respect to saving money.
That’s the prologue, my real puzzle is similar to what I posited above.? Dick Cheney has reportedly said, “Reagan proved that deficits don’t matter.”? Well, Reagan had the luxury of running the largest peacetime deficits we have seen, but at least it eventually bore the fruit of the “peace dividend,” that Clinton got to harvest.
I can see some leading officials at the Treasury having dinner together, and they about the budget deficit, and they say this: “How much money can we borrow from abroad?? We keep running larger and larger deficits, and the foreigners keep taking the paper down even as the US Dollar falls. That is great for us politically, because export industries get stimulated, and no one cares about imports (buy American), except crude oil.? There don’t seem to be any limits here.? What a great boon it is to be the world’s reserve currency!”
Yes, it is good to be King.? But, kings topple when they cannot control the amount they extract from their subjects.? I wrote a piece for RealMoney on how central banks would diversify out of the Dollar.? My main point was that those with the least to lose would do so first, and those with the most to lose would do so last.? I commented that diversification out of the Dollar would be “Led by smaller central banks, such as Singapore, Russia, or India.”
Well, India revalued the Rupee up since then, and Russia has diversified away from Dollars.? Singapore?? Their Dollar has had a significant rally against the US Dollar.
But other revaluations have not occurred yet.? The Gulf states, except Kuwait, have maintained their Dollar peg.? China is running a dirty crawling peg, rather than revalue its currency upward by 20%.
As a result, there has been no discipline, no constraint to the level of borrowing by the US Government.? They will borrow even more in future years.? Is there a time where they will find a lack of willingness of lend in Dollars to the US Government and other Dollar-denominated debt and force US interest rates up?? I think so, and it will happen by the time the demographic wave crests around 2015, give or take a few years.? At that point, future dissaving will overwhelm asset markets, as they anticipate the cash needs of the Baby Boomers as they retire.
Inflation is returning to the US, and will return in greater measure when foreign central banks diversify away from the US Dollar.? Until then, they will import inflation from the US, as they send us goods, and we send them paper.
Our position is precarious, and makes us reliant on the kindness of strangers, who might for economic or political reasons decide that the Dollar is not worth investing in.? Like any writedown, they would admit the loss that they knew was there, and move on.
In the long run, that is why I think the path of the Dollar is down, even though I think it could rally in the short run.? We are absorbing too much of the world’s goods and providing too little in return.
I am overweight financials, but I don’t own any banks, or entities where the primary business is credit risk.? I own a bunch of insurers, because they are cheap.? The first one to report came Monday after the close, Reinsurance Group of America.? They beat handily on both earnings and revenues.? They are the only pure play life reinsurer remaining.? Competition is reduced because Scottish Re is for all practical purposes dead.? They make their money primarily off of mortality, charging more to reinsure lives than they expect to pay in death claims.
This is a nice niche business, and a quality competitor in the space — well-respected by all.? And, you can buy it for less than book value.? Well, at least you could prior to the close on Monday.
Here are the financial stocks in my portfolio at present:
Safety Insurance? (Massachusetts personal lines)
Lincoln National (Life, Annuities, Investments)
Assurant (Niche lines — best run insurer in the US)
Hartford (Life, Annuities, Investments, Personal lines, Commercial Lines, Specialty Lines)
RGA (Life reinsurance)
Universal American Holdings (Senior Health Insurance — HMO, Medicare, etc.)
MetLife (Life, Annuities, Investments, Personal lines)
National Atlantic (waiting for the deal to close)
Now, I do have my worries here:
Even though asset portfolios are relatively high quality, they still take a decent amount of investment-grade credit risk, and even squeaky-clean portfolios like the one Safety has are exposed to Fannie and Freddie, unlikely as they are to default on senior obligations.
Those that are in the variable annuity and variable life businesses might have to take some writedowns if the market falls another 10% or so.? For those in investment businesses, fees from assets under management will decline.
Pricing is weak in most P&C lines.
Away from that, though, the companies are cheap, and I have a reasonable expectation of significant book value growth at all of them.? Also, a number of the names benefit from the drop in the dollar — Assurant, MetLife, Hartford, and RGA.
One final note before I close: diversification is important.? I have Charlotte Russe in the portfolio, and it got whacked 20%+ yesterday.? Yet, my portfolio was ahead of the S&P 500 in spite of it.? If Charlotte Russe falls another 5% or so, i will buy some more.? There is no debt, earnings are unlikely to drop much (young women will likely continue to buy trendy clothes), and there are significant assets here.? I don’t expect a quick snapback, but as with all of my assets, I expect to have something better 3 years from now, at least relative to the market.
Full disclosure: long SAFT LNC AIZ HIG RGA UAM MET NAHC CHIC
I haven’t written about the Fed much recently, largely because little has changed.? The Fed is frozen in its position.? Can’t raise rates because the banking system is on edge (and now the Fed informally cares for the systemic risk created by the investment banks).? Can’t raise rates because labor unemployment is rising.? Can’t lower rates because inflation is moving up.? Can’t lower rates because the dollar will dive.? What a pickle!
This is my monetary aggregates graph over the last year.? Growth of the monetary base is anemic, but that is intentional.? Rather than let the monetary base grow through the purchase of Treasuries, the Fed is using its balance sheet to add liquidity to certain money markets.? When was the last time the Fed did a purchase of Treasuries?? 5/3/07.? I think this is the longest period in the Fed’s history without a purchase of Treasuries, and I have written the Fed to ask, but alas, no answer.? For comparison purposes, there is a tool at the NY Fed website that allow you to look at permanent open market operations after August 25, 2005.? How many purchases of Treasuries during the tightening/flat period from 8/25/05 to 5/3/07?? Fifty-nine.? Fifty-nine during a predominantly tightening period, and not one during a loosening period?
I point this out because the Fed is behaving very differently under Bernanke than any Fed Chair since the Great Depression.? Part of it is the situation in the capital markets.? Leverage got too high among a number of big capital markets players, and the SEC didn’t do diddly.
But under this new arrangement, liquidity goes out to the capital markets through the Fed’s new programs, but not out (at least not directly) to the commercial banking system and the general economy.? The balance sheets of some financial entities get relief, but not much stimulus makes it into the general economy.? What liquidity that is created gets extinguished by the Fed, because they sell/lend Treasuries to fund their lending programs.
It’s an inflationary world, and one of the reasons that the US is not feeling it as bad is that we are the world’s reserve currency.? So long as China and OPEC keep buying US debts, the game can go on, but woe betide us if the music stops.
At present, Fed funds futures indicate a Fed that is frozen.? No more moves in 2008.? Using my “pain model” for the Fed (the Fed acts to minimize its political pain), I would concur.? When you don’t know what will work, doing nothing seems like a great plan.
A great plan for now, that is.? My guess is that the Fed can’t be out of step with the rest of the world for too long, and in 2009, they will begin tightening, even if the economy and the banks are weak.
My, but haven’t we had interesting times in the short end of the yield curve lately. Have a look at this graph:
This covers the period from the final aggressive 75 basis point move by the FOMC, where there were expectations of a 1% fed funds rate by year end 2008, to now, where the rate at year end is between 2.5-3.0%.? Now look at this chart, which summarizes the yield curve moves:
The graphs and numbers tell a story.? My four datapoints represent:
3/17 – The sharpest point in the loosening cycle, prior to going to 2.25%.
4/25 – Anticipation of the end of the loosening cycle.
6/6 – FOMC jawboning that we must support the dollar and fight inflation.
6/12 – Now.
Let’s describe the moves, period by period.? In Period 1, the transition was from maximum FOMC accomodation to the end of the loosening cycle.? What happened?? Investors required more yield to invest for two years versus cash instruments, because they concluded that short rates would not go near record low levels.? The long end of the curve flattened, because inflation expectations were under control.
In period 2, things were quiet.? Three month rates rose to reflect the new consensus that the FOMC was on hold after the 4/30 meeting for the foreseeable future.? The rest of the curve did nothing.
In period 3, members of the FOMC began beating the inflation drum, particularly the hawks, including Plosser, Lacker, Fisher, and Bernanke.? The belly of the curve (twos to fives) rises the most, anticipating tightening moves by the FOMC, leading the long end to flatten, and the short end to steepen.? This implies that inflation will remain under control in the long run, an idea borne out by the TIPS market, where you can buy 20+ year inflation protection at a real yield of 2.3% — a pretty good bargain for investors that must own Treasuries and other high quality debt.
I’ll give the FOMC this.? In the last four trading days, they helped create the biggest move in the 2-year note yield that we have seen in a long time.? They managed to push up 30-year mortgage yields around 35 basis points, close to the move in the 10-year note.
Now, (to the FOMC) is that what you wanted?? Go ahead.? Start tightening monetary policy in August or September.? See what that does to the investment and commercial banks.? See how that affects weakening employment.? Do it during an election year, when politicians in 2009 might say, “Central bank independence hasn’t helped the nation.? Let’s clip the wings of the Fed.”
I see the FOMC tightening, and then abandoning the tightening early, and reverting to a weak policy, accepting more inflation for the sake of growth in the real economy, and leniency to banks that are facing tough market conditions.
The last few months have seen a change in expectations of FOMC policy. The next expected move is a tightening, while some incremental loosening was expected 2-3 months ago.
One of the reasons for this is that the Fed has managed to calm the short term lending markets. They have also managed to defuse a possible crisis among derivative books by bailing out Bear Stearns with the aid of JP Morgan. Also, GDP growth hasn’t gone negative yet, at least the way the Government calculates it. As a result, Ben Bernanke feels that the risk of a substantial downturn has receded, and so, the next focus of the FOMC will be inflation.
Now, I don’t think the answer for the Fed is that simple. That said, there are many that would welcome a tighter FOMC policy.
China is importing our lax monetary policy, and they are unsuccessfully trying to fight the implications of the policy, because they won’t raise their exchange rate. They will have to eventually, perhaps after the Olympics, but a tighter US monetary policy relieves some of their stress.
Europe would welcome a tighter US monetary policy, because it would relieve pressure on the rising Euro. As it is, the ECB with its single mandate is moving to fight inflation. Even the Bank of England is not loosening aggressively, and their housing problems may be proportionately greater than those in the US.
The Gulf States would like a stronger US Dollar to help arrest the inflation that they are importing.
Savers in the US might like higher rates.
But the trouble is that there are still weak spots that might cause the Fed, which has a dual/triple mandate to not tighten monetary policy. (Dual — inflation and unemployment. Triple — financial system solvency, inflation and unemployment.)
The Fed is not out of the woods yet on real estate related credit. I commented many times at RealMoney that Home Equity Lending would be a big problem, back in 2006. I also warned on option ARMs. Well, both are looming problems now.
I still expect residential real estate prices to fall further.
The correction in commercial real estate prices has only begun.
Also, investment banks are still delevering and taking writeoffs. Lehman is the most recent poster child there, but other investment banks could still be affected.
Beyond that, we have defaults rising in speculative grade credit, which will do damage directly, and through the CDOs that they are in.
I think the Fed has less freedom to act than is commonly believed. As Yves Smith has commented at his blog, the Fed may have painted itself into a corner. I think the risks from inflation, unemployment, and financial system weakness are fairly well balanced. As it stands, the Fed has adopted the following policy:
Don’t let the monetary base grow. Sterilize all new lending programs.
Allow the banks freedom to expand their lendings; informally relax regulations for now.
Bail out any significant systemic risks.
Work out kinks in the short term lending markets through new programs.
The Fed may make some of those new programs permanent, but then they will need to find a new policy equilibrium involving greater tightness elsewhere in their policy tools. They will also need to decide what to do regarding investment bank leverage, both direct and synthetic. They will also have to figure out what comes first if there is a broader banking solvency crisis, and/or significant shrinkage of real GDP with a rise in unemployment.
It is my guess that Dr. Bernanke is talking a good game today, but that the Fed’s policies will be loose toward inflation, should systemic risk or unemployment prove to be more difficult problems than currently advertised today. They are not out of the woods yet.
What can a possible crisis in Vietnam tell us about the US Dollar? Or rumors of currency stress in in nations in the Persian Gulf? That loose US monetary policy is rippling out, and affecting the countries with fixed (or dirty-fixed) exchange rates. These countries face a challenge — float their currencies, or revalue the significantly higher, and send their export economies into the cellar, or, keep importing inflation from the US.
Inflation is a global problem today, and many countries are ignoring it, because in the short run, economic growth is better. Because the US Dollar is the global reserve currency, it can get away with a lot of excess borrowing, given that there aren’t any countries capable of taking the place of the US as the reserve currency, yet.
