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HomeBernanke Conundrum
Posted by Larry Doyle on June 8th, 2009 7:27 AM |
Overnight markets indicate that Treasury prices are lower and interest rates subsequently higher (remember the inverse relationship between bond prices and interest rates). 2yr Treasury notes are trading at 1.33% and 10yr Treasury notes are trading at 3.85% (both are .03% higher from Friday’s close).
If interest rates are higher, clearly that move must be an indication that economic activity is improving and equity markets should be higher overnight, correct? In “normal” economic times, perhaps that line of reasoning would hold water, but in the Uncle Sam economy, we need to go deeper.
Equity futures indicate our stock markets will open lower by approximately 1%. What’s going on? Welcome to the Bernanke conundrum! What is the riddle wrapped inside our economic enigma? How can Fed chair Ben Bernanke nurse our economy back to health while at the same time maintaining the necessary fiscal independence, integrity, and discipline of robust Fed policy?
Big Ben has used aggressive measures to backstop a wide swath of our markets. In the process, he has created a fair amount of stability but with an effective government guarantee “insurance” policy as the cost of stability. Some of these policies have lessened in size as certain sectors have normalized. However, the major Fed programs remain in place. What are these?
1. quantitative easing: commitment to buy $1.3 trillion in total of Treasury and mortgage-backed securities in an attempt to keep these rates down. Then why are rates rising? More on this in a second.
2. commitment to provide necessary liquidity as needed to support the “wards of the state” including Freddie Mac, Fannie Mae, GM, AIG, Citigroup.
These programs in conjunction with the massive deficit spending programs undertaken by the Obama administration have ballooned our expected funding needs in calendar 2009 to upwards of $3 trillion, a fourfold increase over prior years.
In my opinion, interest rates are moving up much less on any real signs of economic improvement than on these funding needs and very real signs of a monetary printing press malfunction. What’s that? With the Fed Funds rate at 0-.25%, the Fed is literally flooding the economy with cash. Where is that cash going? Is it flowing through to the economy? Not really.
The cash is pouring into the banking system to cushion and support financial institutions from the ongoing losses connected to rising defaults on credit cards, residential mortgages, commercial real estate, and corporate loans.
The market is now very clearly sending a signal to Bernanke, Geithner, Obama and team that if they want to continue their programs as designed (and they do and will), the price, that is the rate of interest, is going up. Why?
The market is very concerned that the flood of liquidity will lead to inflation if not rampant inflation and potentially hyperinflation. How does Bernanke head that off?
Withdraw the very liquidity that he has found so necessary to pour into the financial system. How does he do that?Two ways.
1. increase the Fed Funds rate: that is, make borrowing more expensive.
2. reverse the quantitative easing program so that the Fed actually sells Treasury and mortgage-backed securities into the market and takes liquidity out in the process. What are the impacts of both those maneuvers? Higher interest rates.
In fact, interest rates are moving higher already in anticipation of Bernanke being forced to make these moves. Can Bernanke “thread this needle?” What will happen if interest rates move higher?
Slow the economy, especially housing given higher mortgage rates, and lower earnings especially for financial institutions. To wit, our equity markets are lower overnight.
Nobody said this was going to be easy.
LD
Front End Springs a Leak
Posted by Larry Doyle on June 5th, 2009 4:57 PM |
In a manner of speaking, the management of our economy has been nothing short of a major overhaul of a tired old ship. When the tide went out, the base of our ship was exposed as being filled with holes.
Little did we know at the time, but through many of those holes a number of “pirates” were running off with a whole lot of booty. In the process, many market participants riding along on the main deck were thrown overboard by the economic storm that hit our economy and markets over the last two years.
We do not have the luxury of bringing our ship into port for an overhaul. We have had to continue to sail this ship while trying to repair it. In that spirit, by necessity we have had to add significant ballast (liquidity) in our hull. In so doing, we need to recognize that the ballast can itself be inflammatory if the engine generates a spark.
In purely economic terms, this morning’s non-farm payroll number of -345k jobs was a hint of a spark. While various sectors of the market gyrated today, the front end of our ship, that is the front end of our yield curve, sprung a serious leak. How so? Interest rates on short term Treasury notes increased a DRAMATIC 35 basis points. Why?
Traders are already pricing in an expectation that the Federal Reserve will be forced to increase the Fed Funds rate prior to any hint of inflation or even the expectation of inflation gains a foothold. Bloomberg sheds color on this likelihood, Traders Begin to Speculate Fed Will Need to Tighten:
Traders are beginning to price in expectations the Federal Reserve will raise interest rates this year as the recession shows signs of abating.
Federal-funds futures contracts on the Chicago Board of Trade show a 70 percent probability the central bank will lift its target rate for overnight bank borrowing to at least 0.5 percent by November after a report today showed the U.S. economy shed the fewest jobs in May in eight months. Rate-increase odds were 27 percent yesterday.
The Fed cut the target rate to the record low range of zero to 0.25 percent in December as the economy lapsed into the worst recession in decades. President Barack Obama and Fed Chairman Ben S. Bernanke have committed $12.8 trillion to thaw frozen credit markets and ramped up government spending to revive growth. The Fed last raised borrowing costs in June 2006, when policy makers pushed the rate to 5.25 percent.
Fed governors and Fed chair Bernanke now face a serious quandary. Economic data will remain decidedly weak. Unemployment will continue to increase. Consumers are going to remain strapped. Corporations will face challenges. Municipalities will encounter an ongoing decline in tax revenues. Nobody is going to truly feel like the economy is improving to the point that the Fed should even think about increasing interest rates. Then why is the market starting to price that reality into the market? Let’s go back into the hull.
The bowels of our ship are flush with liquidity and given any sort of traction in the economy, the velocity and growth in the money supply will drive inflation.
What is Big Ben and team to do? The market is raising interest rates on him rather than his raising interest rates on the market. In the process, a very fragile economy will now be forced to deal with higher interest costs along with anemic growth.
What do I see on our economic horizon? In my opinion, today’s price action took us in the direction of the island known as Stagflation.
Please share your thoughts and comments.
LD
Inflation, Deflation, or Stagflation?
Posted by Larry Doyle on June 1st, 2009 11:06 AM |
I am an eternal optimist and, as such, I never want to see people’s spirits waver. I encourage people not to allow the current economy to “deflate” their hopes for better days. By the same token, I am a pragmatist and caution people not to view the recent bounce in our equity markets as reason for an overly “inflated” sense of optimism. In this same spirit, though, we need sufficient optimism along with practical analysis to avoid the perils of “stagflation.” Let me expound.
The debate between analysts touting prospects for inflation versus deflation is ongoing. Those concerned with deflation highlight increasing levels of unemployment pressuring wages, falling asset valuations, and slack consumer demand. Those concerned with inflation point toward the unprecedented levels of liquidity injected into our system via all of the government programs. The inflation hawks maintain the economy merely needs a small spark and inflation will spread in an uncontrollable arson-like fashion.
I actually believe there is a very real chance we get developments from both camps leading to the scourge known as stagflation. How may this play out?
Many respected analysts are promoting the concept of a new “normal” economy. This scenario entails an economy operating with enormous government deficits, an elevated level of unemployment, and little to no shadow banking system (securitization of loans and other assets).
In this new “normal” economy, GDP may only eke out small positive growth given these heightened pressures. Pimco’s Mohamed El-Erian writes of A New Normal:
This reflects a growing realization that some of the recent abrupt changes to markets, households, institutions, and government policies are unlikely to be reversed in the next few years. Global growth will be subdued for a while and unemployment high; a heavy hand of government will be evident in several sectors; the core of the global system will be less cohesive and, with the magnet of the Anglo-Saxon model in retreat, finance will no longer be accorded a preeminent role in post-industrial economies. Moreover, the balance of risk will tilt over time toward higher sovereign risk, growing inflationary expectations and stagflation.
Even as we come out of this recession, our economy will run increased risks of slipping into another recession given the lack of cushion provided by a strong consumer, the burdens of heavy government debts, and inability to easily access credit.
El-Erian adds:
For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector. (As one of our speakers put it, we have transitioned from a world where the private sector provided public goods to one where the public sector provides private goods.) It is also a world in which central banks and treasuries will find it difficult to undo smoothly some of the recent emergency steps. This is particularly consequential in countries, such as the U.K. and U.S., where many short-term policy imperatives materially conflict with medium-term ones.
As our global economy transitions to this new “normal,” I believe the likelihood of stagflation is quite high. For those who recall the perils of our economy in the early 1980s, stagflation is not a pretty picture. How does one manage investments and personal finances in an environment of stagflation?
Let’s deal with the component parts. Given sluggish growth, limited credit, and lessened opportunities, it is of paramount importance to cut expenses and minimize debt as much as possible. Servicing debt will be an ongoing challenge and increasingly problematic. Be proactive at this point in time in adjusting your finances to this reality.
Where will the inflation come from and how does one address it? In my opinion, the inflation “train” will arrive sooner than we think. Some of the savviest investors, including Financial Pacific Advisors’ Bob Rodriguez and noted Black Swan author Nassim Nicholas Taleb, are already positioning themselves for it. (The WSJ reports, Black Swan Fund Makes a Big Bet on Inflation).
How can people protect themselves from the inflation monster? Increase exposure to the following:
– precious metals and commodities
– critical infrastructure (power plants, agriculture, water, transportation)
– necessary life items (drugs, medicines, food)
– stronger and more fiscally prudent foreign markets
Decrease exposure if not get outright short
– longer maturity (5yr and and longer) Treasury bonds
This stagflation story will have many chapters and I will be writing extensively on it. Please share your thoughts, opinions, and recollections of the early 80s economy so we can all move forward most effectively in navigating the economic landscape.
LD
The Wheels Have Come Off Barack’s Bond Bus
Posted by Larry Doyle on May 27th, 2009 5:56 PM |
Despite what market analysts, media mavens, and government officials may assert, from an investment standpoint, the price action in the bond market can only be defined as “THEY’VE LOST CONTROL!!”
Who’s they? Bernanke, Geithner, Summers, Obama, and team. How so? The weight of the massive deficit spending along with the embedded costs of the Fed’s quantitative easing program are pressuring the bond market and driving interest rates dramatically higher. (10yr U.S. Treasury moved higher by almost 20 basis points today to 3.75%, a full 55 basis points higher over the last week. This is an ENORMOUS move.)
The knock on effect is increased anxiety in the equity markets (down 2% today) and a highly likely further slowing in the economy. I am not surprised. Given the programs and approach put forth by Obama, along with the economic turmoil, there was little doubt we would experience very high levels of deficit spending. Prior to the inauguration (January 4th to be precise), I surmised:
I also believe that despite the Fed and Treasury purchasing government and mortgage debt, these rates will end up much higher at the end of this year than they are now simply due to the growing deficit. A move higher in these rates will potentially cause further anguish within the equity markets.
I have tried to proactively highlight why I thought the government bond bubble was bursting (Is The Government Bond Bubble Getting Ready To Burst?) and just yesterday broached the negative impact on interest rates of all the mortgage refinancing activity (Mortgage Refi Activity Is Driving Rates Higher).
For those involved in trading or investing, successful calls are measured by direction, magnitude, and time. This call on rates has been a fairly patient development, but given the dramatic shift higher in rates over the last week, the implications of this move can now be embraced. Those implications include a revaluation of the equity markets (lower) and the economy (forestalled recovery). Beware of people who discount this move in interest rates. The fact is it has more to run. In my opinion, the move higher in rates is not only a reflection of the supply of bonds (both government and mortgage) but also an indication of further deterioration in our currency precipitating inflation.
Can the Federal Reserve do anything to defend the currency? Increase short term interest rates. Does anybody think our economy can afford an increase in short term rates at this juncture? NO WAY! There truly is very little the Fed or Treasury can do at this juncture. Thus, in my opinion, they’ve truly lost control as “the wheels have come off the bus.” Welcome to the Brave New World of the Uncle Sam economy 2009.
LD
What Does A Declining Dollar Mean?
Posted by Larry Doyle on May 22nd, 2009 11:21 AM |
On the heels of comments yesterday by Bill Gross of Pimco that the implied AAA credit rating of the United States will eventually be downgraded, our dollar is being hit hard again today. Let’s address some questions about a weaker dollar:
1. What are the implications of a weaker dollar?
– more expensive to travel overseas
– higher inflation here at home
– perceived greater risk of holding the currency and dollar denominated assets
– given the greater perceived risk, investors will demand a higher rate of return. In other words, interest rates will head up (and are currently, especially longer maturities).
2. What are the risks?
– significant exit of foreign capital from our market. Can you imagine the conversations going on around the world, but especially in China and Japan the two largest foreign holders of our debt?
– as our economy is forced to pay higher rates to attract capital, the economy slows as the cost of debt service increases.
3. Are there benefits?
– in a perverse way, I think our political leaders actually want a somewhat weaker dollar. Why?
– A weakened dollar will help domestic production of goods relative to our continued reliance on imports.
– generating some inflation is a de facto means of devaluing our outstandng massive amount of debt. Whomever is in debt currently can actually pay back those debts in future dollars that are worth less.
– however, having the dollar decline in value marginally is akin to getting a little bit pregnant.
4. How do you stem the decline in the value of the dollar?
– increase short term interest rates, that is, the Federal Funds Rate (currently sitting at 0-.25%) will have to go higher. What does that mean? Higher rates lead to a slowing economy. Although given the current economic turmoil, the Fed may have to increase the Fed Funds rate even sooner than they desire and we could suffer through a nasty bout of STAGFLATION.
Playing with the valuation of the currency and not defending it is a VERY dangerous game.
LD
Increasing Inflation or Playing With Fire
Posted by Larry Doyle on May 19th, 2009 4:09 PM |
There is a reason parents tell their children not to play with matches. Small campfires can take down an entire forest. In similar fashion, heightened levels of inflation also have the potential to explode in a ball of fire. Are our central bankers playing this 
game as a means of addressing our massive government and non-governmental debt burden? In my opinion, they most definitely are rubbing those sticks together mighty hard.
I have highlighted three means for central bankers to address excessive debt: default, restructure, devalue. Individuals and corporations are increasingly defaulting and will default at an increasing rate as evidenced by my post earlier this morning highlighting the surge in delinquencies. Individuals and corporations are looking to renegotiate and restructure debt burdens wherever possible. Our government is restructuring debt through the legislative process and not always consistent with generally accepted market and legal principles. Despite words to the contrary, I am convinced that Ben Bernanke and Tim Geithner are on course to devalue our debt, as well, via a promotion and acceptance of higher inflation.
I was somewhat surprised to read that two economists whom I highly respect are encouraging Bernanke specifically to raise the inflation target. Greg Mankiw, an Economics professor at Harvard, shied away from providing an actual inflation target but did offer that Bernanke should work towards a “significant” level of inflation. Kenneth Rogoff, also a Harvard professor and former chief economist at the IMF, believes Bernanke should target an inflation rate of 6%.
Rogoff and Mankiw are both highly regarded. In my opinion, they are calling for higher inflation because they are clearly concerned that the mix of stimulus programs (monetary, fiscal, and budgetary) will not be sufficient to jumpstart our economy. (more…)
What is Going on with LIBOR?
Posted by Larry Doyle on May 15th, 2009 12:47 PM |
Libor (London Interbank Overnight Rate), the cost of borrowing U.S. dollars in the overnight market, is plummeting. What is driving this move and what does it mean? A number of people in global finance are asking that very question. Let me offer my opinion.
After Lehman failed in September 2008, confidence in banks declined precipitously, counterparty risk soared, and Libor screamed higher as well. 3 month Libor topped out at close to 5%. Historically, Libor is just marginally higher than the Fed Funds rate which is currently between 0-.25%.
Today 3 month Libor is approximately .8%. This move lower is a clear sign of increased confidence in the banking system, isn’t it? In my opinion, this move in rates is a reflection of the following:
1. a realization that global governments will not allow major money center banks to fail.
2. a reflection of the massive increase in dollars in the system associated with all of the liquidity injected via Uncle Sam’s programs.
Has the drop in Libor coincided with an improvement in the credit markets? No. Despite what pundits would tell you, credit spreads remain at elevated levels. In fact, on an inflation adjusted basis, rates are at the highest levels since the early 1980s.
Why aren’t banks lending as much? Lack of confidence in the economy along with enormous embedded losses in their current book of loans. Those losses are real and will be rising. The elusiveness of bank credit is highlighted in a McClatchy article, Businesses Struggle as Bank Loans Remain Elusive, in the Newsworthy section of Sense on Cents.
Thus, if a drop in Libor is not a reflection of improved credit conditions, what does it mean?
In my opinion, it is a precursor to a drop in the value of the dollar. Why?
Very simply, too many greenbacks floating around. A decline in the value of the dollar is inflationary. Both core rates of producer prices and consumer prices reported this week were higher than expected. I’ll be watching.
Maybe a drop in Libor isn’t such a great development after all.
LD
Federal Reserve Statement July 15, 2009
Posted by Larry Doyle on July 15th, 2009 3:50 PM |
The minutes of the Federal Reserve Open Market Committee meeting from June 23-24 were just released. Let’s not take anything on face value, so bring some tools as we review and continue navigating our economic landscape.
For the diehards in the audience, here are the actual minutes, including voting results, for your reading pleasure.
For those who may choose a synopsis complete with graphics, I submit the Fed’s Summary of Economic Projections.
What do we learn? For those not familiar with Fed policy and procedures, the target goals of the Federal Reserve are maximum employment and stable prices. Where do Fed governors think the economy stands now and where are we headed? They measure our economic health in terms of output growth, that is GDP (gross domestic product), unemployment, and inflation.
Output Growth Projections
Unemployment
Inflation
Overall, I read this sumamry as an admission by Fed governors that the economy has currently achieved a degree of stability with risks still skewed toward slower growth. In regard to unemployment, it is likely we will have a protracted level of heightened unemployment for a sustained period. On the inflation front, we have some concerns about increasing inflation although it is not imminent.
Over and above these consensus opinions, it is notable that the range of opinions amongst Fed governors is extremely wide. That to me spells real uncertainty as well.
On the topic of the Fed’s balance sheet, the governors do not believe they will need to implement more quantitative easing.
Taken in totality, our economic patient is certainly not dead nor a vegetable. That is the good news. However, in reading these minutes, the patient’s quality of life remains in serious question.
LD
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