Many Fed watchers and other assorted punditry have focused recently on how the Fed is exiting from the temporary liquidity facilities and how it is going to go about draining liquidity from the system when it is time to do so. For example, there has been much attention focused on the Desk’s testing of large-scale reverse repos and the question of whether this indicates a hike in rates (or otherwise tightening of monetary policy) is near. This is well and good, but it seems less attention has been paid, at least from the point of view of public statements from the Fed, to the market effects of the unwind of the Fed’s massive balance sheet position.
I want to bring to your attention several excerpts from a very important recent speech by Brian Sack, who manages the System Open Market Account (SOMA) at the NY Fed (in market parlance, he ‘heads the Desk’ with a capital “D”). Ordinarily, I need to significantly annotate speeches from Fed officials in order to mark-them-to-market with respect to reality. With Mr. Sack’s speech, I don’t really need to do that very much and it is a delight.
As an aside, I think Sack is a big upgrade over the prior manager of SOMA, Bill Dudley, who now runs the whole NY Fed. He is more of a theoretician, and I initially had concerns that he may not be as adroit a manager of markets as is required, but he has done a great job during a time when Desk operations were being conducted in totally new ways. I don’t applaud many public servants, and Mr. Sack and I have disagreed in the past on some economic questions of importance, but he deserves laurels for his work to date.
So without further detour, here are some choice quotes from Mr. Sack’s December 2, 2009 speech at the Money Marketeers club of NYU, entitled “The Fed’s Expanded Balance Sheet” and available in full here.
He begins by talking about the Fed’s program of purchasing $300bln of Treasuries, $175bln of agency debt securities, and $1.25 trillion of MBS, and discusses some of the side effects:
“With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.”
It is fantastic to see a Fed official actually understand and admit that they are somewhat responsible for bidding up equities, even when they’re not bidding on equities. And his explanation of why it happens is clear and concise. Bravo!
“One key issue in this regard is whether the market effects mentioned before arise from stock or flow effects. The portfolio balance effects discussed earlier would presumably be associated with changes in the expected stock of assets held by the public. Under this view, even an abrupt end to the Fed’s purchases, if fully anticipated, would not cause an adverse market response, as it would not represent a discrete jump in the outstanding stock of securities held by the public. However, we want to allow for the possibility that the flow of asset purchases, or the ongoing presence of the Fed as a significant buyer, may also be relevant for market pricing. In that case, the end of the Fed’s purchases could cause an increase in longer-term interest rates, at least temporarily until the market has had more of an opportunity to adjust to the Fed’s absence.”
When have you even seen any other Fed official make such an important distinction, and raise such an important question?
“Related to this discussion, it is useful to note that exiting from LSAPs can involve a tension that is absent in the Fed’s liquidity facilities discussed earlier. The liquidity facilities were established in response to considerable market strains that had caused the price of term liquidity to skyrocket. In responding, the Fed could be confident that it was pushing market rates toward levels that would be considered normal over the intermediate term. LSAPs, in contrast, could in practice push risk premiums below the levels that would be sustainable over the medium term. Doing so could still be an optimal approach, in terms of achieving macroeconomic outcomes, even if it requires that market pricing will eventually have to reverse.”
Better yet, when have you heard a Fed official note that what they are doing might actually have a deleterious effect if taken too far?
I am clearly taking snippets from throughout the speech, so I apologize if they don’t segue well. He next starts talking about tools under consideration, in particular the paying of interest on reserves.
“In that regard, it is useful to consider what these tools can achieve and what they cannot. As noted earlier, draining reserves with these tools could help to improve our control of short-term interest rates, which is the critical issue for ensuring that policymakers can tighten financial conditions when necessary. However, draining reserves with these tools does not undo the portfolio balance effects of the LSAPs. These operations would basically substitute one short-term, risk-free asset for another—replacing what is in effect an overnight loan to the Federal Reserve (reserves) with another short-term loan to the Fed (a reverse repo or term deposit). It is hard to believe that the willingness of an investor to hold risky assets or of a bank to make risky loans would be affected in any meaningful way by this substitution between such similar assets.
“A key issue here is whether reserves have some special importance for the availability of credit. Some market observers have a very reserve-focused perspective on the transmission mechanism of monetary policy, arguing that high reserve balances inevitably lead to rapid credit expansion. Under that view, the large-scale asset purchases provide stimulus to the economy primarily by supplying reserves to the banking system, in which case the stimulative effects could be unwound by draining the reserves using any of the tools available. My own perspective differs. In my view, the effects of the asset purchases arise primarily from the removal of duration and prepayment risk from the markets, based on the portfolio-balance effects discussed earlier. Those effects would not be unwound by draining reserves with reverse repos or term deposits.”
I have a modest issue here. If the Fed can push markets up by buying lots of risky securities and then essentially immunize it by paying interest on balances at the Fed or doing reverse repos with no effect on the portfolio balance effects, then why shouldn’t they do that constantly? It seems like a free lunch. Of course, it’s not – by buying risky assets, and not selling them out, the Fed (and by extension, taxpayers via the budget) is collectivizing the risk. I would have liked to see a nod in this direction, or some indication that merely holding these risky assets at the Fed in run-off mode creates other imbalances.
“An alternative approach would be to reverse a portion of the portfolio-balance effects through asset sales. Asset sales would put the portfolio risk back into the market at a faster pace than redemptions alone, forcing risk premiums to adjust more quickly in order to entice investors to hold that risk. The result would be to put upward pressure on Treasury yields and MBS rates independent of any changes in the expected path of short-term interest rates, so that less of the burden of financial tightening would fall on the short-term interest rate.”
Also, I would add, it should reverse earlier effects and cause other risk assets to fall. But it is the result that gets the Fed back to where it began most effectively, and gets risk back in the market where it is supposed to be more quickly. By not selling the assets, the Fed is creating a market shortage of risky assets and driving up the price of risky assets above where it would be if all risks had a market price. Mr. Sack mentions this earlier, but neglects to mention that this statement defines the word “bubble.” The Fed is, in no uncertain terms, helping to inflate another bubble. The only way to avoid this is to sell the assets into the market as soon as is practicable. But they have to choose between pain now and deferred pain from a later bursting of this next bubble. Since Volcker, no Fed and no Administration has chosen current pain and I am not convinced they will have the guts to do so.
But these are excellent questions and an excellent discussion of them by Mr. Sack. As readers will know, I have been a critic of the Federal Reserve for a long time, in particular its Chairmen (see the tab at the top of this page? Buy my book! Buy my book!). And I think the very structure of the Fed and its conflicting mandates makes its usefulness as an institution not a completely slam-dunk case. But I will give credit where credit is due. I figured the Fed would miss some of the really important big-picture issues about the way the end game of this crisis should be played. This seems reasonable, since they missed some of the important big-picture issues about the way it began. I still believe they will be late in tightening and that we will have some measure of inflation before they can rein it in, just because there are lots of reasons to be slow and few reasons to be fast (not to mention, I doubt they are looking at inflation ex-Shelter). But I am less concerned today that they will completely lose control of the situation, and it is because of guys like Brian Sack.
At the end of the day, inflation is partly a global process and effective central banking at the Fed can’t prevent other central banks from screwing up. Additionally, the part of inflation that is idiosyncratic to the US and comes as a result of dollar depreciation isn’t the Fed’s fault, but will eventually be laid at the door of the people trying to finance the huge deficits. But, while I am no fan of Ben Bernanke, I will say that this Fed is definitely improving its marks this semester.
Okay, let’s say this plainly: anyone who thought that the bailout of Fannie and Freddie would stop at the cap the Treasury originally put on them, that after pouring $111bln into them the government would just walk away and let them fail if losses were greater than that, was living in a fantasy world to begin with. From the moment of the original bailout, it was clear that whether the institutions were going to be phased out or sized up, they weren’t going to be allowed to default.
It was also clear that since FNM and FRE issued some enormous one-year obligations when they regained access to the credit markets, the first real concerns would come when those debts were being rolled over along with the loads of other debt that the GSEs typically need to roll. We’re what, 15 months or so from the bailout, so the timing isn’t particularly shocking. A trifle later than I expected, actually.
That’s why it is all the more amazing that Secretary Geithner’s Treasury waited until Christmas Eve, late in the day, to announce that the government’s support for FNM and FRE would be henceforth uncapped (which is as close to an explicit guarantee as you can get – in theory the Treasury didn’t say they would cover any debt, just that they could cover any debt). Currently, the government has committed up to $200bln per entity (double the original commitment), and has injected about a quarter of that amount…so uncapping it is probably irrelevant. So why do it on one of the least-watched news days of the year? It just smells funny.
What is more important, actually is that the Treasury also softened the requirement that the GSEs start shrinking their mortgage portfolios next year by 10% per year (the 10% in 2010 now applies to $900 bln per entity rather than their actual portfolios of around $800bln each, so voila! they’re already there). This is a concern because these enterprises are much much much too big to fail and their subsidized existence skews the functioning of the mortgage marketplace. They need to be dramatically reduced in size, and backing away from that commitment only one year after it was made looks to me like the first step to removing that requirement altogether. And that would be a bad thing.
All of this needed to be done by year-end or the Treasury would lose their authority to make these changes without Congressional approval, but…there are a lot of other days that would have made the announcement seem less cloak-and-daggerish. What is it they always say on “Law & Order”? Something about the perp displaying a “consciousness of guilt?”
Credit should be given to David Kotok at Cumberland Advisors for actually being around to read the Treasury’s release and to write a post on Christmas Day to make sure this didn’t completely slip under the radar.
The bond market appears ready for a trend; unfortunately historically the trends in rates early in the year tend to be bearish ones.
I don’t want to read too much into price action the last week or two of the year, but bonds sold off on yesterday’s very strong Existing Home Sales data, and did next to nothing on the very weak New Home Sales data. New Home Sales fell 11.3% from last month’s number, which itself was revised downward. The net result was that Sales were expected to be 438K this month (annualized) versus 430K last month; the actual print was 355k plus a -30k revision.
Of course, New Home Sales is a much smaller part of total home sales than are Existing Home Sales, and so in the grand scheme of things are less important economically. However, from a prognosticator’s standpoint right now we think we know the following: New Home Sales have been goosed recently by government incentives, so all else equal are higher than they would otherwise be, while the turnover of Existing Homes is flattered by distressed sales of bank REO property and other sellers who have been waiting to sell into any reasonable bid. So there is a plausible explanation for some of the strength in EHS, but the weakness in NHS is a bit of a conundrum and a worry.
I showed one chart yesterday. Let’s put them side-by-side:
Well, something is going on here. The degree of decline didn’t really worry me, but the fact that one series has launched and one has languished is a real pickle.
I think we will have to look beyond home sales to figure out what is happening to the economy!
This gets to the heart of the bigger matter: with the degree of government intervention in autos, housing, capital asset markets, and money & banking, it is more difficult than ever to find unpolluted series. The economy is recovering. But is it an organic and self-sustaining recovery? It doesn’t seem to be, at present. Can it become one? This is the $64,000 question, and I don’t know the answer yet. But I am skeptical.
What is Brad Childress, the coach of the Minnesota Vikings, thinking?
It’s a remarkable story this week…in a one-point ballgame, in the third quarter, the coach tells quarterback Brett Favre that it might be better for his long-term health if he takes a seat for the rest of the game, because he’s getting crushed by the defense.
Keep in mind this is Brett Favre, who holds a significant edge in the longest streak of consecutive games in NFL history: 285, equivalent to almost 18 NFL seasons. Odds are good that he has been sacked a few times before and he has a pretty good streak of getting back up. I can imagine the conversation went something like this…
Childress: “You’re getting kinda beat up. Don’t you want to come out?”
Favre: “I think I’m okay. I didn’t even notice the last three.”
Childress: “If you came out now, you’d have some time to get Christmas shopping done. How in the world can you find the time? Go ahead, have a seat.”
Favre: “I want to play. I’m fine. You’re paying me a lot of money to sit.”
Childress: “Let someone else play. Come on, be fair. Tavaris Jackson’s mom is in the stands. Be cool.”
The only thing I can think of in Childress’ defense is the new NFL rules on concussions. For those of you who aren’t fully aware of these rules, essentially they say that if you take a rap on the noggin and tests show you can’t do nonparametric estimation for semimartingale stochastic differential equations in your head, then you can’t play until you can prove you have the power to lift an apple using only telekinesis. If that explanation confuses you, then hit the showers: you have a concussion.
But sitting the NFL’s all-time tough guy at quarterback because he’s getting dropped faster than GM’s market share? That seems to me to be a bad coaching move. As Will Rogers once said, you “dance with the one that brung ya.”
So…then why did I become a secular bond market bear in November 2008 after watching a bull market in bonds basically for my entire career? For years, I scoffed at people who saw the big turn in interest rates, and didn’t respect the dominant trend of our era: the gradual disinflation caused initially by tight money and encouraged later, ironically, by loose credit and suffocating financial and operating leverage. The big trend, which is still technically in force, is illustrated below in a chart I have shown many, many times:
There is not yet any technical reason to suspect that the grand disinflation is over. But to my mind, the writing is on the wall and it’s time to pull the quarterback. Things are not working as they used to.
The big supporting factors of the Great Disinflation in my view were the spread of globalization, a general trend of governmental deregulation of business, consumer and producer over-leveraging, maturation and synchronization of central bank policies, and (possibly, although the data is pretty sketchy on this and it doesn’t explain why less-connected countries also disinflated) the significant labor-saving developments associated with computerization.
And that is why it is time to be skeptical about the secular bull market in bonds. Globalization seems to have gone as far as it is going to go anytime soon, although I would be loathe to bet that way (it might just be the depression that is giving rise to xenophobia and populist protectionist policies). Government over the last decade has begun to get more intrusive rather than less so. Producers and consumers are starting to de-lever, sometimes gradually and sometimes suddenly (through the bankruptcy code). Central banks are synchronized, but have added too much liquidity worldwide so the synchronization is a negative at the moment. And to be honest, Excel 2007 keeps corrupting my spreadsheets so I’m not convinced the microchip will save us.
That doesn’t mean that the next 25bps are to higher rates necessarily; inflation derivatives markets imply 2010 inflation is expected to clock in at only 0.9% before rising gently thereafter, and this agrees with other models of core inflation I look at. However, as noted here the underlying inflationary trend (ex-Shelter) may already be established. The undertow may be pretty strong already, and to my mind the big picture contributors to the long decline in inflation and rates are turning around. I am not presently a fan of nominal bonds. It is time that old soldier takes a seat.
Today, the Existing Home Sales data was very strong, almost stupidly so, with the annualized sales pace clocking in at 6.54mm units/yr. That’s faster than all of 2008 and 11 of the 12 months in 2007. The price index is now tickling the underside of 0% for the year, threatening to show real stability.
The skeptic in me has trouble believing that the housing market is actually repairing itself faster than it broke down, and faster than the bubble built in the first place. Obviously, some of this is pent-up supply hitting the market now that prices have stabilized, and I wouldn’t expect these turnover levels to be sustained even with support from the government tax breaks etc. But at this level, they don’t have to be sustained for a very long time to clear a bunch of the deadwood that is overhanging the housing market.
What that will probably mean, though, is that we’re going to see credit contracting more quickly as folks who have technically had credit (because the bank didn’t care to seize the house) lose it. There is still a huge mess to clean up here, and we’ve not even addressed the commercial real estate market yet. But things have stopped getting worse, at least for Christmas.
Don’t downplay the importance of the yield curve shape in helping to heal things, either. Traditionally, banks have healed themselves by borrowing short and lending long when the Fed has engineered low short-term rates. In this particular episode, that would not be nearly enough, but as we have seen recently banks are also raising tens of billions of equity capital from credulous investors who can’t do math. The finance industry is healing more rapidly than I ever expected, too.
And that means: if these trends continue, it means that just like in 2002-3 we never let the economic rinse cycle complete. If (and it remains a big if) the expansion is already under way and if it is robust, then I fear it is setting us up for another, worse, debacle. I shudder to think of it, but it boggles the mind to think that the horribly bloated financial dinosaurs that were the biggest targets in this debacle might be “allowed” to succeed and thrive.
I am not sold on that yet, but I am open to the possibility.
I have a very simple chart to show today, but first I want to give my award.
Of course, by now you know that Time Magazine awarded Chairman Ben Bernanke its “Person of the Year” award, which in the past has been given to such luminaries as Chiang Kai-Shek (1937), Hitler (1938), and Stalin twice (1939, 1942), as well as to some people who didn’t manage to kill or impoverish millions. With that history, it would have been understandable if Dr. Bernanke was loathe to accept the honor, but the Nobel Peace Prize had already been awarded so…
And, in an act of inspired comedic timing, the AP announced that its Athlete of the Decade is…Tiger Woods. I am not sure what the selection criteria here is but it appears to be purely statistical. Check that, since Tiger Woods’ other hobby seems to be generating quite a raft of statistics as well…let’s say…gee, this is hard to write but you know what I mean. His formal job.
So, since the bar has been placed extremely low with awards this year, I decided to award one myself. And so, the inaugural E-piphany Investor of the Century Award goes to … Bernie Madoff. I decided to honor Mr. Madoff because his track record was par excellence, at least if you ignore that last little bit. Basically the same standard as the AP is applying in the Tiger case. Congratulations, Prisoner #61727-054A. Your $10,000 prize (less, of course, a 10% management fee deducted annually) will be waiting for you in 150 years.
Now for a more-scary picture.
When the deficits began exploding last year the Treasury issuance calendar grew concomitantly crowded. Issue sizes increased sharply; the Treasury even brought back the 3y and 7y securities. Clearly, the government needs to raise money wherever and however it can. Except that there’s one exception.
Treasury doesn’t seem to want to increase the size or number of TIPS auctions. They replaced the 20y TIPS with a 30y TIPS, and increased issue sizes very marginally, but the changes were very slight compared with the wholesale re-jiggering of the nominal Treasury auction calendar.
The result is that the proportion of outstanding debt that is represented by inflation-linked issuance has declined in the last year, as shown in the chart below.
I need to make clear a couple of caveats about the chart. First, the denominator here is total federal debt (Source: Treasury Bureau of Public Debt); if it were only marketable debt then the ratio would be higher but the chart would have the same slope. More importantly, I am using market value for TIPS (Source: Barclays Capital) and the Treasury’s numbers are face value. I could have shown face: face, but that ignores the accretion of the TIPS. The change in market rates, which affects the market value, is important but I had to choose one or the other. Finally, the Barclays index excludes maturities under 1 year, which biases the ratio lower. In other words, I didn’t spend all of Saturday putting this chart together in the cleanest way.
With all that said, the chart makes the salient point: what is of interest is not the level of TIPS issuance relative to other Treasury debt, but the relative change in the level. That is, the Treasury is de-emphasizing TIPS by neglecting their issuance. This is a really peculiar time to be neglecting inflation-indexed bond issuance, when the risks are as great as they have ever been that the government might see some benefit to monetizing the debt. I would argue that, instead, if the powers that be wanted to increase confidence among their debt holders (many of them not dollar-based) that they have no such intention, they should be increasing the issuance of TIPS. Even if it was just a smokescreen, it’s a cheap way to convince people to buy all of the nominal debt at attractive levels!
The Treasury will respond that there just isn’t enough demand for TIPS. Baloney. There are enormous non-domestic holders of Treasury debt who would buy anything offered, I suspect. With TIPS yields at strikingly low levels, it is hard to imagine that there isn’t enough interest to raise a bit more through the TIPS program.
I still think that an inflation-indexed perpetuity would be a great idea. Unless, of course, you are planning to monetize the debt.
Don’t listen to what the Man of the Year says; watch what his colleagues on Capitol Hill do and I think you may find some cause to be concerned.
The CPI release right now is like a coded message…or perhaps a better analogy is George Orwell’s Animal Farm. You can read the report on two levels: on one level, it’s an interesting little story. In the case of CPI, the pleasant story is that inflation remains low and tame, with core CPI printing 1.7% year-on-year, right in the middle of the Fed’s comfort zone and enough off the lows that deflation fears can be quelled.
But of course in Animal Farm there is a deeper meaning, and so too must we dig a little deeper into the CPI report these days. The reason there is some necessary digging is that a large portion of CPI (and especially core CPI) is Shelter: rents, owner’s equivalent rent, and lodging away from home (hotels). Ordinarily, this is a pretty stable part of the series, especially since 1983 when the Bureau of Labor Statistics (BLS) adopted a “rental equivalence method” to evaluate the cost of living in a home.
But right now, we are coming off a bubble and the deflating price of housing is weighing down overall inflation. Thus, if we want to get a true picture of how the prices of goods are responding to the extraordinary global monetary stimulus, we need to abstract from the Shelter component. We need to look at CPI ex-Shelter.
This is no mean feat, because the BLS doesn’t calculate CPI ex-Shelter. We need to do it ourselves.
When you do that, you get a fascinating story. What we see (Chart, source Enduring Investments and used with permission) is that Core CPI ex-Shelter is rising and has been rising quite steadily for some time. Core CPI ex-Shelter rose 2.756% over the last 12 months, the highest rate since November 1995; over the last 6 months the pace has been 2.92% and over the last 3 months, 3.30%.
To me, that chart looks like a very important bottom was established in 2003, and inflation has been accelerating ever since in fits and starts. And it looks as if there’s a chance it might be “breaking out,” to go all technical on ya’.
In the latest month, Shelter fell a seasonally-adjusted -0.224%, the largest single-month decline since the BLS adopted the rental equivalence method in 1983. And that’s what held down, continues to hold down, core CPI.
On which series should the Fed focus? The Fed is clearly trying to dampen the disaster in housing, and perhaps has succeeded. But the cost is becoming clear: most of the economy is inflating, 10% unemployment or not.
Interestingly, this same chart helps take some of the blame off the Fed for causing the housing bubble. Ex-housing, prices really were close to deflation in 2003. If most of the economy was nearly deflating, then the Fed’s aggressive easing back then may have been appropriate – and the bubble, which was already underway, may be more due to changes in incentives/bullying proffered by Congress to the GSEs (Fannie and Freddie) and other things. I’m not an apologist for the Fed, and it was probably pure luck, but Greenspan may have been concerned about deflation for a good reason.
PPI is not a particularly useful indicator, at least compared to the tremendous weight that market participants often place on its release. Today, the market managed to avoid getting excited about a higher-than-expected rise in PPI and core PPI, which is normally the proper response. It turns out that PPI doesn’t tell us much of anything that CPI does not tell us with a whole lot less noise. Over time, PPI might be useful as a measure of pricing pressures in competitive industries, as when compared to CPI it should indicate whether margins are increasing or decreasing. But that’s a pretty weak reason to tune in at 8:30ET on PPI day.
Today, there were other data to get more excited about and so PPI was properly overshadowed. It was interesting that the Empire Manufacturing index didn’t just decline, but plummeted (to 2.55 from 23.51, versus expectations for a near-unchanged print), and the NAHB Housing Market Index declined to 16 rather than rising to 18 from last month’s 17. On the other hand, Industrial Production was stronger-than-expected, and that let to Capacity Utilization coming in higher-than-expected. That sounds like a wash: Empire and NAHB weaker, Cap U stronger. However, Empire and NAHB were December numbers, and the Industrial Production data from November. There’s no reason to let that alarm you yet, unless you’re predisposed to that kind of thing.
However, from a trading perspective the PPI may actually matter if you believe in inefficient markets (which I do). This is because tomorrow’s CPI is going to show a rise in the year-on-year headline inflation to a positive level, somewhere around 1.8%, from last month’s -0.2% year-on-year. That’s not really super significant, and it certainly is no surprise; it happens because last year’s plunge in prices after Lehman is rolling out of the data. But what it does, following today’s PPI print, is create the illusion that inflation is suddenly accelerating. That will scare the commonfolk.
Inflation is beginning to rise, if you abstract from the aftermath of the housing bubble. Core CPI is forecast to come in around 1.8%, up from 1.7% in October; but core ex-Shelter will probably reach the highest level since 1995. So inflation is rising…but not yet exploding, which is what you would perceive if you look naively at the PPI figures today and the CPI figures tomorrow.