Category Archives: Federal Reserve

A Market Correction is up to the Fed

Since I turned cautious on stocks in early May, the market has been treading water with minimal volatility. If the year ended today, the S&P 500’s intra-year decline of 4% would be the 2nd smallest in 35 years.

S7P 500 Intra-Year Declines

This would be highly unusual for a year in which corporate earnings estimates have been slashed and economic growth has disappointed. Moreover, we have seen significant deterioration in the market’s breadth with the utilities and transports both having already corrected 15%.

I believe one reason that the major averages are holding up is that expectations of Fed rate hikes have been pushed back.

Economists Fed Rate Hike Forecasts

Coming into 2015, economists were projecting the first Fed funds rate increase to take place in June — now they believe it will occur in September. Market participants, on the other hand, are betting on December as seen in Fed funds futures pricing. By pushing out expectations of rate increases, the Fed has in effect eased.

However, I believe there is a reasonable chance the Fed could move in September. Fed chair Janet Yellen has repeatedly said that the Fed will not wait for inflation to hit its target. All that is needed is confidence that inflation is moving towards its target. If job growth continues at its recent pace, then it will be hard for the Fed to justify emergency level rates with unemployment approaching 5%.

Therefore, the July and August inflation and jobs data will be worth paying attention to. 200,000+ monthly job growth with rising inflation will cause the Fed to move in September. Since this is not currently priced into the markets, a major stock market correction could ensue. However, weak economic numbers could lead to a Fed on hold and a continuation of the recent choppiness or a slight move higher.

Nevertheless, the 4% year to date correction in the S&P 500 seems too mild to me, and I will wait patiently for more of a pullback.

 

“Deflation: Making Sure ‘It’ Doesn’t Happen Here” by Ben Bernanke

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Remarks by Governor Ben S. Bernanke
Before the National Economists Club, Washington, D.C.
November 21, 2002

I have previously stated my concern with the challenges facing the banking system and the likelihood of its deflationary collapse in the absence of any government intervention. This might actually be the best medicine for the long term health of the economy, but I will have to expand on this point in another post. What matters for investors is that the government will indeed intervene more forcefully, though the scope and effects of its actions are not clear.

I have positioned my portfolio to capitalize on increasing market fear of deflation, but I recognize that the government might be able to eventually print enough money to create inflation and preserve the current financial system; and perhaps print so much money to produce hyper-inflation.

So to get a better sense of how scared the Fed is of deflation and to anticipate its future policies, I thought it would be worthwhile to examine a popular speech made by Bernanke in which he suggests how the US can overcome deflation. This speech was made in 2002 when the US was in recession and consumer prices as measured by the CPI were barely increasing causing many to worry about the onset of deflation.

The following is my outline of Bernanke’s speech:

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Deflation: Making Sure “It” Doesn’t Happen Here

  • The chance of significant deflation in the US is extremely small.
  • US economy is resilient and has the structural ability to withstand such shocks.
    • Flexible and efficient markets for labor and capital, an entrepreneurial tradition, ability to cope with technological change.
    • Strong financial system.
  • Federal Reserve has sufficient powers to preserve price stability.


Deflation: Its Causes and Effects

  • Deflation is defined as a general decline in prices.
  • Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.
  • Deflation is in almost all cases a side effect of a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.
  • Deflation of sufficient magnitude would lead to nominal interest rates of zero; and the real interest rate would equal the expected rate of deflation.
    • Fed would be unable to utilize its traditional method of stimulating economic activity by lowering short term interest rates


Preventing Deflation

  • Maintain an inflation buffer zone of 1-3% during normal times.
  • Ensure financial stability in the economy.
    • Smoothly functioning capital markets.
    • Well capitalized banking system.
    • At times of extreme threat, Fed should stand ready to use discount window and other tools.
  • When economic fundamentals deteriorate and inflation is already low, Fed should aggressively cut rates.


Curing Deflation

  • Lower medium- and long-term interest rates.
    • Commit to holding the overnight rate at zero for a specified time period.
    • Enforce ceilings for yields on longer-maturity Treasury debt.
    • Purchase agency debt.
    • Offer fixed-term loans to banks at low or zero interest while accepting a wide range of private assets (corporate bonds, bank loans, mortgages) as collateral
  • Purchase foreign government debt and reduce the value of the dollar in relation to foreign currencies, though this would not be a desirable way to fight domestic deflation.


Fiscal Policy

  • A money-financed tax cut would stimulate consumption and investment.
  • Increase government spending and acquire real or financial assets; the additional debt issued should be purchased by the Fed with newly created money.


Japan

  • Why Japan has not ended its deflation?
    • Problems in the banking sector have muted the effects of monetary policies and the heavy overhang of government debt has made officials reluctant to pursue aggressive fiscal policies; the US does not share these problems.
    • Necessary economic reforms have been avoided by policymakers for fear of the large costs imposed on the economy in the short run.
  • Japan’s deflation problem is real and serious; but political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has.

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My belief is that money supply growth that until now has been fueled by bank credit is now moderating. Commodities are now sharply correcting because of a stronger dollar and demand destruction. Therefore, consumer prices should follow asset prices and begin falling. This would lead to the “deflation” environment that Bernanke is afraid of.

Bernanke is certainly acting preemptively as the CPI falls within the buffer zone of 1-3% from its current rate of 3.7%. In the meantime, I expect he will continue to provide liquidity to the financial sector recognizing that it’s health is important for creating inflation. The TAF, TSLF, and PDCF programs are going to remain in place for a very long time. These programs help banks with short-term funding problems, but they don’t address the solvency issue the banking system is facing. This is why the TARP was implemented. It pumps capital into banks so that they don’t fail.

I expect the Fed to cut rates until they get closer to zero and signal its intention to keep them low for a long time. But a low Fed funds rate won’t translate into higher bank lending because financial institutions are hoarding capital to restore their balance sheets, consumers are already highly indebted, and businesses will not borrow money and invest in an environment of lower consumer spending. This is very similar to the situation Japan faced in the ’90s.

The Fed has recently recognized the ineffectiveness of further lowering its short-term interest rates. Soon, Bernanke’s suggestion of manipulating medium-  and long-term interest rates will be carried out. The Fed will likely purchase longer-maturity Treasury and agency debt with newly printed money in a much more aggressive fashion. Simultaneously, the government will sharply increase its spending in such areas as infrastructure which create jobs. It will also begin purchasing real and financial assets such as real estate, stocks, and bonds. All of this will be financed by selling Treasuries to the Fed which will finance the purchase, again, with newly printed money.

This period of money printing will need to be closely monitored by investors since it will determine whether the rate of inflation will accelerate. But, in my opinion, we are several quarters away from this. Only once the excess capacities of several sectors of the economy are adjusted to meet demand will the Fed’s money printing start to affect prices… but this will take time.

Buying November ‘09 Fed Funds Futures

Last Friday I purchased fed funds futures contracts for November 2009 at 98.25. I went long fed funds futures earlier this year and closed the position in September with a huge gain. In retrospect, I could have made even more if I held on to the position, but I didn’t anticipate the Federal Reserve slashing the overnight rate by 100 basis points in October.

If I would have known in advance that October would be the ninth worst month in stock market history, the CRB index would register its largest monthly decline on record, and the US dollar would attain its biggest monthly gain against a basket of currencies in more than 17 years then, of course, I would have predicted the Fed’s policy decisions. But October was an unusual month to say the least.

What I find strange is that the market is pricing in only another 25 basis points cut by the next FOMC meeting on December 16th, after which the Fed is expected to embark on a tightening campaign next year by such an extent that the overnight rate would reach 1.75% by November.

I think only two conditions would necessitate such a policy response: (1) the US economy soon begins to stage a rapid recovery or (2) confidence in the US dollar is shaken and its value plummets. The first condition is highly unlikely, in my opinion, given that the US consumer is early in the process of decreasing consumption and increasing savings in order to repair his balance sheet from the damage done by declining real estate and equity values.

As for the possibility of a dollar crisis, I certainly expect one at some point in the future, but not in the next 12 months. The US dollar is the world’s reserve currency and in a period of de-leveraging, it will be in great demand. Only if the Fed prints money in a far more rapid fashion would confidence in the US dollar be shaken, and even then the Fed would have first resorted to a zero interest rate policy (ZIRP) for a period of time before attempting such a risky action.

During the last recession, the Fed began easing in January 2001 and didn’t raise rates until June 2004 or 41 months later. In the current cycle, the Fed first cut rates in September of last year or 14 months ago. If the Fed emulates its policy actions from the previous downturn then rates won’t increase until February 2011. I don’t know if the Fed will wait that long before it begins to hike rates, but given that the current recession will be far more severe than the previous recession, I am confident that there won’t be a hike in 2009.

Lowering of the fed funds rate helps the two groups most affected by the current crisis: banks and consumers. Banks benefit because their business is based on borrowing short and lending long, so their net interest margin will expand. Consumers benefit because many adjustable rate mortgages and loans are based on the banks’ prime rate which is influenced by the overnight rate. Therefore, there is a lot of incentive for the Fed to implement ZIRP.

However, I don’t think it will be enough to offer much of a stimulus for the economy because banks are barely solvent and don’t want to lend in order to preserve capital. And consumers have too much debt relative to the total value of their assets to want to borrow more. Therefore, credit growth, which factored in each time in the past as the Fed cut rates to pull the economy out of a recession has disappeared. Once the Fed cuts rates close to zero, it will realize that additional actions will be required.

Japan held rates at zero for nearly six years in its decade-long struggle against deflation. When that was not enough it resorted to “quantitative easing”, a technical term for what amounts to printing money on huge scale. I expect the Fed to follow the same game plan. Though it has already started to print money via its normal open market operations, I expect more aggressive money printing through unconventional means when it realizes ZIRP is not making much a difference.

The following table lists the profits or losses I would incur under various fed funds rates for each November 2009 contract that I buy at a price of 98.25:

Fed Fund Futures Risk/Reward

My intention is to hold the contracts until they rise to at least 99.50 (i.e. the market prices in a 0.50% fed funds rate or lower) so that I can make a profit of more than $5,000 per contract. This would be a spectacular return since the Chicago Board of Trade requires a maintenance margin of only $1,200 per contract.

Buying Fed Funds Futures

Today I purchased the 30 day federal funds futures contract for February trading on the Chicago Board of Trade for 97.17 meaning that I do not believe that the Federal Reserve will increase the fed funds rate above 2.83% by February. The market has priced in a hike of at least 83 basis points within the next 8 months due to Bernanke’s and other committee members’ recent speeches expressing concern for the weakening dollar and rising inflation. The fear is that the Fed will follow up its hawkish talk with aggressive monetary tightening.

I think the market, which gives the Fed far more credibility than it deserves, has been hoodwinked by Bernanke and co. in the Fed’s attempt to manage inflation expectations. It is actually quite clear that the Fed will not significantly tighten anytime in the near future if we consider two facts.

First, the Fed is a private entity owned by all of the chartered banks of the US. Although congressional oversight and statute can alter the Fed’s responsibilities and control, currrently it does have the authority to act independently without prior approval from the President or Congress. Thus, while the government’s hope is that the Fed will act to promote economic growth, a sound currency, and a stable banking system — its greatest incentive is to act in the interests of its shareholders (i.e. banks).

Second, the balance sheets of banks are rapidly deteriorating as what was once thought to be an exclusively subprime problem, is now beginning to be recognized as a widespread underpricing of risk that has also affected prime real estate mortgages, commercial real estate mortgages, consumer loans, corporate credit, municipal bonds, and derivatives. US banks alone have written off a couple of hundred billions of dollars worth of subprime mortgages and writedowns related to other assets are only beginning. With only $1.2 trillion of capital within the entire US banking system, a huge flood of bank failures is looking increasingly likely.

If these two facts are put together — a Fed that acts primarily in the interest of banks and a continued deterioration in bank balance sheets — then the Fed will continue to promote an easy monetary policy. Indeed, a low Fed funds rate will promote a steep yield curve which should provide some relief to banks who are in the business of borrowing short and lending long.

That said, if oil prices begin to rise parabolically and/or the US dollar depreciates rapidly, it would not surprise me to see the Fed hike by 25 basis points to persuade the markets that it is about to embark on a tightening mission. However, the 83 basis points increase in the Fed funds rate that the futures market is pricing in by February, in my view, has a very small chance of becoming reality.

Don’t Worry Mr. Market! More Rate Cuts Are on the Way

As expected the Fed reduced by 25 basis points the funds rate to 4.25% and the discount rate to 4.75%. The stock market tumbled immediately after the announcement because there was hope that the discount rate would be cut by 50 basis points. Moreover, investors seemed to be concerned that the FOMC statement didn’t signal additional future rate cuts.

For example, Jim Cramer vented his disapproval saying, “a simple 25 basis points more would have made a tremendous difference for the economy’s psyche. It would have showed the Fed is on the case.” Although the Fed’s policy decision disappointed Cramer and the market, I believe many more rate cuts will be delivered next year – more than investors are expecting – though some would argue that it would be too late.

Currently, the futures market is pricing in a Fed funds rate of 3.25% by December 2008. I am willing to take the under on that bet. With eight FOMC meetings scheduled for 2008, I think it’s likely that we will see a two handle on the funds rate at some point next year. Let me explain.

I will concede the Fed is very concerned about inflation: they have expressed this whenever a microphone is put in front of one of its members. And it is why they didn’t deliver a 50 basis points cut yesterday. They are concerned because I am sure that they are not foolish enough to believe the CPI — after all, former Fed governor, Alan Greenspan, played a major role in its dubious construction.

But in the their view, high inflation is not necessarily problematic as long as long-term inflation expectations don’t rise. That is, if people don’t doubt the dollar’s purpose as a store of wealth, the Fed can print a lot of money and stimulate the economy. This makes managing inflation expectations critical, especially in the current environment of slowing economic growth where money printing would be useful. Thus, the rationale behind all the hawkish talk about inflation, while in practice they cut rates.

So although the Fed would rather not ease monetary policy, a weakening economy is forcing them to do just that. And the economic picture is going to get bleaker. Residential real estate, with high inventory levels and home affordability declining, will continue to suffer falling prices. This will exert a drag on consumer spending, which amounts to 70% of GDP, and therefore on the economy. Lower rates won’t lead to greater corporate spending either. Business investments have been sub-par even when the economy was strong, so it is unlikely to pick up in pace as the economy weakens.

In the last recession, the Fed had to reduce the funds rate to 1% to stimulate growth. That was a capital spending led recession. This recession is being led by real estate investment and consumer spending which are more meaningful to the economy. It would therefore be unlikely that a downturn can be overcome this time around with an easier monetary policy than implemented during the previous, more mild recession.

Now while I think the Fed will bring down rates more than consensus expectation, I am not suggesting this is the right thing to do. Actually, if I had my way the Federal Reserve would be abolished, but that’s a topic for another time. My belief is that an accommodative monetary policy is the wrong approach to dealing with the current economic problems — akin to giving more heroin to a heroin addict.

The money supply, as measured by M3, is growing at 16% annually: inflation is clearly a big threat to the economy, though its impact may take a while to be felt. The Fed, with the urging of Wall Street and Capitol Hill, will continue to lower rates which would help dealing with the near-term credit crunch, but will make the eventual day of reckoning more painful.

The US economy has a fundamental and serious structural problem: too much debt. That is, the greatest challenge the economy faces is servicing the existing debt, not access to additional debt. The cure for this is to let the market work by forcing bankruptcies and having the debt written off. A deflationary recession would ensue marked by declining corporate profits, job losses, and falling asset prices. Although this would be a harsh experience for most Americans, eventually the economy will be cleansed of distortions and it can get back to robust growth. Wouldn’t be nice to attain a 7-8% long-term growth rate rather than the 3-4% that we yearn for now?

However, the loose money stance the Fed has adopted actually makes the problem of excessive debt worse by encouraging more borrowing. Perhaps if the Fed prints enough money the debt will become worthless. In any case, the result will be that the economy should avert a severe deflationary recession in the short-run, but there won’t be smooth sailing either. As discussed before, home prices will be declining for a very long time, providing a substantial drag on consumer spending.

The excessive money creation stimulated by the Fed will rather spill into consumer prices, particularly food and energy. Thus, stagflation will be the likely result. Eventually inflation expectations will start to rise, and if Fed monetary policy isn’t altered, inflation will reach excessive levels — dare I call it hyper-inflation — and the whole monetary system will collapse leading to the deflationary depression that we are trying to avoid. I can’t put a timetable on this, but it’s a textbook pattern that has been played out frequently in history. I hope to expand on this point in a later blog post. So how does one protect oneself from all of this? My choice is gold.

The Fed Yields to Wall Street

With yesterday’s announcement of a 50 basis points cut to the federal funds rate, the Fed has officially shifted their expansionary monetary policies to high gear. Their previous move was a hike to 5.25% on June 29th of last year. A month later, when the market was debating whether the next Fed action would be a cut or hike, I stuck my neck out and guessed that an interest rate reduction would be more likely given the drag that the troubled real estate sector would exert on the rest of the economy.

I was wrong about the timing of the cut to the benchmark rate, expecting it to take place much sooner in response to a weakening economy. But the effects from falling home prices and plummeting housing starts have taken a little longer than I thought to filter through the economy. I still expect the economy to stumble into a recession and the Fed to respond with many more rate cuts.

Will it work to keep the recession brief? I am not sure. But I am quite sure that the Fed’s expansionary monetary policies will shake confidence in the US dollar, lead to higher commodity prices, stimulate consumer price inflation, and cause the gold price to exceed $1000 in the not too distant future.

I realize that many people will counter my argument by pointing out that Alan Greenspan printed as much money as all the other Fed governors combined, yet inflationary pressures remained subdued for most of his 19-year term. But that period was marked by the fall of communism and the rise of capitalism across the third world, which allowed production to be shifted to lower cost regions. However, as the recent rise in prices of imports from China indicates, the effect of globalization is receding.

The irony in all of this is that the Fed’s willingness to lower rates and sacrifice the dollar in exchange for economic growth does not address the underlying problem of excessive credit creation, but actually makes it worse by creating a bubble in some other asset class. Perhaps the next bubble will be in gold and commodities.

Can the Fed Save Housing?

Yesterday the market got a lift from the FOMC statement which was interpreted to indicate that the Fed no longer held a tightening bias, setting the stage for a possible rate cut later this year. The expectation is that Fed easing will help the troubled housing sector by making it easier for people who are struggling to meet their mortgage payments to refinance at lower interest rates.

I can’t see how lower interest rates can save the housing market. First, the rise in defaults on subprime mortgages have prompted all the major lenders to tighten lending standards. As this graph shows, the last time lending standards were substantially tightened was in 1990 and 1991, which were terrible years for housing. Despite lower costs for mortgages, tighter lending standards may make getting a mortgage approved more difficult.

Second, inventories are at record levels and may continue to rise due to a large number of homes currently in the foreclosures process. In order for housing activity to recover, the large supply of homes on the market needs to be reduced. Even if lower interest rates were to increase demand, it could take a while for this inventory to be worked down.

And third, stagnant prices over the last year may have shaken investor confidence. Speculators, who were a significant source of demand for homes during the last few years, are not likely to be persuaded by Fed rate cuts to jump back in. More likely, they will wait until there is clear evidence that home prices have recovered before jumping back in with both feet.

The Fed was unable to save the internet/telecom sector in 2001. However, that monetary easing did spark a boom in the housing sector. It is possible that Fed easing will again help fuel a bubble in another sector of the economy. But housing can’t be revived so quickly.

The Fed Can’t Save the Economy

An excerpt of a column from today’s WSJ, Not Too Fast, Not Too Slow caught my attention:

“But last week, at least, investors looked past that kind of worry. Widely followed Wall Street economists were telling clients that even a significant economic weakening might actually be good for stocks.

“If we could have a hard landing but not a recession, I think that would be a favorable outcome for the financial markets,” says economist Ed Hyman of New York research and brokerage house International Strategy & Investment. Should the Fed start to worry that it has slowed the economy too much, Mr. Hyman says, then it would have to cut rates sharply. Investors would welcome the rate decline as a boost to growth, consumer spending, the housing market and profits.

What Mr. Hyman and many economists fail to realize is that if we get a hard landing we are also going to see corporate profits take a hit. And as far as I know, profits are much more important to share prices than the Fed funds rate. Besides, the last time the Fed cut rates the stock market continued to fall.

Mr. Hyman also states, “History tells me that a significant weakening in the economy and a crisis-induced reversal of Fed policy could make this stock market move up dramatically.” But the same column looks back at history and sees something else:

“Trouble is, although they get talked about a lot, soft landings rarely happen. Going just far enough but not too far — and doing so during an election year and amid conflicting economic signals — is one of the hardest things for monetary-policy makers to do. They almost never have succeeded.

Since the mid-1970s, almost every time the Fed has pushed rates higher, it has created a recession, a bear market or both. The notable exception came in 1994 and 1995, when the Fed raised rates without causing either, but did blow up the bond market and tank the Mexican peso. It looked as if the Fed might achieve another soft landing in the late 1990s, but then came the tech wreck and a deep bear market.”

As the economy continues to slow, I actually expect the market to rally higher in the short-term based on this misguided thinking that the Fed can save the economy by lowering rates. But any rally will be short-lived and would make an excellent shorting opportunity.

Next Fed Move Will Be a Cut

My belief is the Fed has ended its current rate hike campaign and will begin cutting rates sometime this year or early next year. James B. Stewart of SmartMoney.com points out that history supports my belief:

History may also be instructive. With all this talk of a pause, I was curious to see just when the Fed last paused in a rate-raising campaign, in the sense that it stopped increasing rates for one or more meetings, and then resumed. I looked at every Fed rate decision since 1914, and guess what? The Fed has never paused in a campaign to raise rates. Sometimes it has held rates constant for several meetings, but the next move has always been a cut. Pauses aren’t unheard of — they occurred three times, in 1999, 1994 and 1988. But these all happened in periods of declining rates.

As the pop of the housing bubble trickles through the economy, expect weaker economic numbers to be revealed over the coming months. Then the current talk of a rate hike will give way to talk of a rate cut.