The Coming Week: Fed, Employment Report, Asia

This is going to be a big week.  And it comes on the heels of another weekend bank-failure announcement, and as we absorb the Geithner testimony and the discussion draft hearing in front of Barney Franks’ House Financial Services Committee.  

Ours views of this Geithner-designed proposal are harsh and already known to readers. It has the makings of another PPIP-type fiasco; but in this case the damage could be lasting, since it involves a government super-regulator structure and not just a single program.  This is a mix of politics and money and power at its worst.

It seems as if criticism is mounting from all sides, labor and business, left and right, Democrat and Republican.  Geithner really hurt himself when he danced around the direct questions pertaining to “secret lists.”  Mr. Secretary: when you were asked if there were going to be secret lists, why didn’t you just say yes?  By not answering the questions directly you opened yourself up to an entire scrutiny of the flaws in the bill and lost your already damaged credibility.  As for secret lists, it is time for the federal government to stop.  Make rating scores public.  Stop mouthing the word transparency while practicing opacity.  That may restore the term moral hazard back into usage, in place of what we have witnessed.  Kevin Ferry aptly described the current condition as “moral swamp.”

The first question for this week is easy.  Will the Fed signal a policy change in the text of the release at the end of its meeting?  If yes, what will it be?  If no, will there be any revelation of the internal disagreements within the Fed?  All eyes will be focused on this event at 2:15 PM, Wednesday, November 4.

There is real and serious division within the Fed.  The regional Federal Reserve Bank presidents are being marginalized.  They know it and do not like it.  They are a lot closer to the real economy than the ivory-tower, Washington-based board.  The Geithner proposal draft only exacerbates this marginalizing of the FOMC members who are presidents and not governors. 

Among the Board of Governors a threesome of Chairman Bernanke, Vice-Chairman Kohn, and Governor Tarullo appear to be the new inner core.  Tarullo seems to have replaced Governor Warsh, who held this insider’s insider position last year while Tim Geithner was still at the Federal Reserve Bank of New York.  David Wessel’s book In Fed We Trust provides insight into this threesome and how it operates.

We wish Wessel had been less polite.  For example, he didn’t stress how the Fed has interpreted the requirements for “sunshine” in its deliberations.  Here is why it hasn’t: There are supposed to be seven governors.  We have written and spoken about that repeatedly.  Politics have held the number to five seated governors for over three years.  Obama has continued this policy of holding the Fed captive.  Senator Christopher Dodd was the point man on this in his capacity of chair of the Senate Banking Committee. 

When you have seven governors, a normal decision is made with four votes of the board.  And an emergency power invocation is made with five.  But when you have only five, the designed supermajority rule becomes a unanimity rule.  So we now have and have had a situation where any governor holds a veto.  Today, Obama appointee Tarullo holds a veto in his hand, as does every other governor.  If Tarullo disagrees with Bernanke, Kohn, Warsh, and Duke, he can stop them from any Fed emergency action.  Notice how the emergency actions have receded from prominence since Tarullo became a governor.

The key here is in the interpretation of the sunshine requirement.  The Fed is taking the position that when three governors are together, it does not constitute a “meeting,” because the sunshine meeting rule is set for seven governors, not five.  Therefore, Bernanke is acting as if four are required to convene a meeting.  Wessel has described the use of this stratagem during the crisis decision making.  Is this the same Fed that wants to sponsor transparency? 

When markets do not trust the central bank, they can be very punishing.  These market-driven actions occur at the margin.  They are not recorded in public pronouncements.  They appear in transactions.  That is one of the reasons the US dollar has been chronically weak.  The actors in world finance do not trust the United States.  Who can blame them after what we have delivered to the world during the last two years.

There are other reasons for dollar weakness, too.  Here is a short list: massive issuance of federal debt, dramatic and expansive federal spending programs, Obama policies that will hurt productivity, layers of government regulation on top of what is already in the pipeline, forthcoming tax increases that will ultimately take the top US personal-income bracket to somewhere between the rate in Denmark and that in Sweden.  Denmark and Sweden rank number one and two among the most highly taxed and socially managed people and economies in the world.  The US will be vying for the top position in 2011 if all the present offerings are enacted into law.

Back to the rest of this week. 

Friday’s unemployment report may reveal an unemployment rate at or even above 10%.  Whether the number is 9.9 or 10.1 is not the issue.  The key is that chronic and very high unemployment is going to be with us for a very long time.  The U-6, or underemployment rate, is likely to be 18%.  The rate for married men with spouses present will be around 8%.  Jason Benderly taught me about the importance of this one.  Other record unemployment rates will occur for teenagers, those with lower levels of education, and those with disabilities.  The last one will be extraordinarily high.  The unemployment rate for those with all types of disabilities will top 70%.  For those with cognitive disabilities, the unemployment rate will approach 90%.  Does anyone really expect the Fed to raise interest rates in the face of these numbers?  I don’t.

Remember, the Fed has never raised interest rates coming out of a recession before the unemployment rate peaked and clearly marked that peaking with at least five or six months of improvement.  Even if this coming report is going to mark the peak, history shows that the Fed would not make its first move until next summer.  We do not expect a rate increase, but let’s assume it for the point we wish to make.  We repeat: even if this report marks the peak, history shows that the Fed may be facing its first move next summer.  Does anyone believe that this politically influenced and politically threatened Fed will raise rates next summer, when the unemployment rate is still in the 9%-plus range and it is an election year?  We don’t.

So, the Fed is expected to hold the target short-term policy interest rate to ¼ of 1% for some additional and prolonged time.  We have written on how a very low shorter-term policy rate anchors all rates because of the use of forward rates in the managing of debt.  Experience shows that the top yield on the 10-year Treasury note is likely to be limited to about 3-¾% to 4% as long as the Fed is holding the short-term rate near zero.  We also know from Japan and elsewhere, including the US, that the bottom of the 10-year note yield range could be as low as 2%, or even lower if deflationary psychology creeps back into expectations. 

We conclude that a range of 3% to 4% defines the yield on the 10-year Treasury note for the foreseeable future.  For markets this means tax-free Munis are still a desirable asset class, since they contain a great deal of the “tax arbitrage" and since future tax rates are likely to be higher than present ones.  We also like the Build America Bonds, since they tier in an alignment with tax-free Muni rates.  BABs are taxable municipal securities that came into existence in 2009 under a special new Obama administration program.  We believe they are a terrific bargain for the investor who uses them properly in portfolio constructions. 

As for US stocks, we believe the American market will be higher by next spring.  We are targeting a range for the S&P 500 of 1200 to 1300 and believe that the index will fully close the “Lehman gap” created by the waterfall selling after Lehman Brothers failed.  We are nearly fully invested and expect to use any weakness in November to deploy any cash residual in accounts. 

In the international arena we have taken some of the stellar profits in emerging markets.  Some of these positions have nearly doubled.  Presently the international accounts are holding a cash reserve of nearly 13%.  We expect to deploy those funds in weakness as the long-awaited correction in these extended markets unfolds.  

At the end of this coming week we will leave for a three-country Asian trip.  Tokyo comes first, then Hanoi, and lastly Singapore.  An exciting GIC delegation trip is ahead.  Details on Hanoi and Singapore may be found at  Our meetings include central bankers, finance ministries, and stock exchanges, as well as various investors and banking and academic professionals.  Private roundtable discussions will round out the information gathering.  The GIC is honored to have Philly Fed President Charles Plosser join the delegation and speak in Singapore, and Philly Fed First VP Bill Stone with us in Vietnam. 

We will try to write impressions during the trip if time permits and if jet lag doesn’t suppress the flow of words.  Fortunately, email and phone work on our 3G BlackBerry in all three countries.    That has been my experience in the past in Singapore.  Last time in Narita Airport, I had to borrow a Japanese keyboard; that required lots of help from the Japan Airlines business center.  We expect to do better this time.

End of the Carnival in Brazil?

The Brazilian stock market has sizzled this year.  The 116% gain in the MSCI Index for Brazil is second only to that for Russia, which recovered from a very severe fall. Foreign investors have been flocking to the BM&FBOVESPA, Brazil’s multi-asset exchange in Sao Paulo, and to the Brazilian currency, the real, which has advanced by some 36% against the US dollar this year. Investors have been attracted by the excellent economic prospects for the largest economy in Latin America, whose exports have been powered by the renewed strong growth in China and other Asian markets. Looking ahead, the prospect that Brazil will become a major exporter of oil and the selection of Rio for the Summer Olympics have given additional boosts to market sentiment.

This bright outlook suddenly turned cloudier last week when the Brazilian government imposed a 2% tax on portfolio investment inflows in an attempt to ease upward pressure on the real and avoid the development of a bubble in the stock market.  The immediate reaction was as expected. The iShares MSCI Brazil ETF, EWZ, fell 3.4% the next day.  The Wisdom Tree Dreyfus Brazilian currency ETF, BZF, was off a more modest 2.2%. Commentators wondered if Brazil had seriously harmed its reputation in the eyes of foreign investors.

Developments in the following days were also predictable to anyone familiar with the experience of applying such measures in an attempt to curb currency and equity-market appreciation that is driven by strong economic fundamentals. By the end of last week the equity market, as measured by EWZ, had recovered a third of the ground lost in the first day after the tax was imposed, and the currency ETF, EWZ, had fully made up for the loss earlier in the week. Investors appeared to be taking the tax in stride.

This writer spent 27 years at the OECD, overseeing, inter alia, the decades-long process of eliminating exchange controls and other restrictions on capital flows among the advanced economies that are members of that organization. That experience, together with the IMF’s experience with developing countries’ capital controls, revealed that such administrative measures rarely have much impact on exchange rates.  Indeed, Brazil’s recent experience gives reason to be skeptical.  Last year Brazil imposed a 1.5% tax on fixed-income inflows, and the effect on the currency’s appreciation was short-lived. That tax was lifted when the global financial crisis hit.  This time the tax is at 2%, and equity portfolio flows are included.

It is understandable that the Brazilian government is concerned about the continued strength of the real and the accelerating volume of portfolio inflows, which they rightly consider too much of a good thing.  But it is very risky to attempt to fine-tune global investors’ attitudes. Any measure that gives the impression that foreign investment is not welcome could have a greater-than-intended effect. For many years the Brazilian stock market had great difficulty getting Brazilian firms to list in Sao Paulo. New York was a more favorable place to raise capital. Following important, hard-won market and corporate-governance reforms, the Brazilian market has strengthened its reputation over the past 10 years, and equity issuance has been surging. This may now be at risk. Moreover, most major Brazilian firms have ADRs in New York, and there is a real risk that trading flows will shift to New York. We are concerned that if the authorities find the currency continuing to rise, they may take additional, more aggressive action, and the carnival really would stop.

It is too early to determine how this will play out.  So far this week (through October 28) Brazil has joined in a global equity-market retreat, particularly in emerging markets. The Brazilian ETF, EWZ, dropped 9.9% since the end of last week. This exceeds the 7.4% drop in the emerging-market benchmark ETF, EEM. That difference may reflect a reduced appetite for Brazilian equities, which would be a marked change from the outperformance of Brazil in recent months. The Brazilian currency ETF, BZF, declined 3.4% in the last three days, but again, this occurred in a period of most currencies losing ground against the US dollar.

At Cumberland Advisors we did not want to risk losing the substantial gains this year from positions in EWZ, recognizing that after a 116% rise, a market correction was probably overdue in any event.  Accordingly, we sold off our positions in EWZ and booked our profits.  When the smoke eventually clears, if the Brazilian authorities have avoided taking further actions against foreign capital and the market is recovering, we will likely decide to reenter this market and participate in the anticipated strong growth of the Brazilian economy. But for the time being we are content to watch developments from the sidelines.

Fed Independence: R.I.P.?

It’s now official.  The proposed legislation to reform America’s financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors.  If this becomes law, it will be a sad day for the independence of America’s central bank.

The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly.  The governors of the Federal Reserve Board are also appointed by the President.  Both cabinet officers and Federal Reserve governors are confirmed by the US Senate.  There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period.

The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled.  Instead, we have been governed by the present five member politically configured board. 

The original seven governor construction was designed to insulate them from political pressure for very good reasons.  Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies.  The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone.  When central banks are under political influence you can get fire or you can get ice. 

In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations.  There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan.  But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis. 

In the United Kingdom, the Bank of England now has to comply with procedures that involve the written reporting of monetary policy decisions to the Parliament.  Previous politics empowered the Financial Services Authority whose purpose was to supervise financial institutions and prevent a crisis.  One need only witness the current financial turmoil in the UK to ascertain how the introduction of politics has caused problems between the Bank of England and the Financial Services Authority.

Only one of the G-4 central banks avoids direct political influence.  That is the European Central Bank, whose policymakers are protected by a treaty.  The unanimous consent of 27 countries is required before the central bank’s independence can be threatened.  Readers must note that 90% of the world’s $82 trillion of debt is denominated in one of these G-4 currencies.  Three of the four are under some form of political  hammer.  That explains the euro’s ascendancy and also why there is increased pressure on the US dollar. 

History shows that, over time, politics tends to favor easier monetary policy and lower interest rates than would otherwise be required.  Thus inflation-prone tendencies are more likely to be the outcome of political intervention in monetary affairs of the US. 

In the US we are experimenting with a massive issuance of federal debt.  We now measure that additional debt in the trillions each and every year.  And we are now trying to intensify and formalize the political intervention into the governing body responsible for the value of the US dollar.  At the same time, this legislative initiative concentrates unprecedented power in the executive branch and in the hands of the Secretary of the Treasury. 

If this becomes law, will global financial markets reprice the US currency to reflect this new asymmetrical policy threat?  Will this risk premium result in higher interest rates, where deregulated markets can set them?  Will there be a currency crisis?  Will politics that create class warfare with “too big to fail” also, by implication, create an under class of “too small to survive?”  

I do not want to personalize my criticism of this law to Treasury Secretary Geithner.  His record in the New York Fed and since he became Treasury Secretary is controversial.  But I ask one question.  PPIP was his idea.  It is an obvious failure.  With a concentration of power in his hands, would it have been funded with a trillion dollars instead of falling victim to an independent market analysis of its flaws?

Memorializing executive power in the hands of one individual is fraught with danger.  Think not only of Geithner.  Would you have wanted to empower Paulson, Snow, O’Neill, Miller or Connally or others?  Readers who want to take the time may wish to reflect on the evidence of history as it relates to our various Treasury Secretaries.

If any readers support this law change they may act accordingly with their Congressmen.  In my case, I have already spoken personally to the Member of Congress I know well and asked him to oppose this destruction of the balance of power envisioned in our constitutional framework

$80 Oil…..

The $80 oil price is starting to worry me a little.  Translate it into gasoline and you get somewhere around $2.50 per gallon or a little higher, depending on where in the US you fill up your tank.  Add to that a little cold weather and expanding crack spreads in refineries, and the price will edge toward $3.  

History-derived economic models show that the US consumer starts to change behavior as the price of gas approaches $3, and then goes into a more pronounced state of shock when it ranges higher, in the $3 to $4 corridor.  The reaction is to cut spending and retrench if the consumer thinks the price is going to stay at the new higher level for a while.  When the consumer thinks the price will not stay higher, he keeps on spending and buying on credit. 


That history is derived, and has been modeled, from a time period when household balance sheets were relatively solid and when credit was flowing easily and when the unemployment rate was close to 5%, not 10%.  So that is why I am starting to worry.

There are no solid models of rising gas prices that I can find which give good estimates of what happens to consumers when the unemployment rate is 10% instead of 5% and when many household balance sheets are wrecked, and when the credit mechanism is damaged.  

SO –

The issue now is what gasoline price change it takes to impact consumer’s behavior.  Does the price have to go as high as previously to hurt?  Some retail experts I consulted say yes and that there will be no change in the relationship.  Others disagree and say there is a new lower level, but they have insufficient experience to estimate what it is. 

SO –

We asked some fellow economists if they thought the relationship was linear or something else.  There was consistent disagreement.  Five two-handed economists had ten opinions.  Some said yes to linear and others said no.  Most thought that the impact of a change in gas price is much more severe in the current environment.  No one said it was milder. 

SO –

If a rising gas price is going to crunch the consumer more than normally, the fragile economic recovery may be about to be derailed.  Remember that every penny on the gasoline price acts as a $1-billion direct tax on the consumer.  This rule-of-thumb estimate is used to guess at the normal effect.  But if this time is not normal and if the effect is magnified and more severe, who knows what the new rule of thumb should be?  We don’t.


We worry that this issue is not being discussed by the policy makers, who are still wringing their hands over inflation fear.  And we see an energy policy coming from the Obama administration that will only serve to raise the price of gasoline and tax the extraction industries.  That explains why the drill rig count is down even as the oil price is going up. 

Energy and oil may be the next “sleeper” to awaken and jolt markets.  However, we think it is more likely to slow down the fragile recovery.  When it does, oil and gasoline demand will shrink, not grow.  That will put downward pressure on the oil price, even if the dollar is weak.  This will be even more pronounced if the dollar rallies 

Oil is now $80.  We may just see $60 sooner than we see $100.  I will take the “under” on this trade as long as there is no outbreak of war in the Middle East, no rumbling from Russia, and I will hope there is no tax policy in the US that hits the energy consumer in the middle of a recession that features a 10% unemployment rate.  We already have a no-exploration policy in all but four of these United States. 

The first two risks are geopolitical.  The last one is just political, no “geo” needed.  As my friend Loren Scott likes to say in his speeches, “All the oil in America is in four states: Texas, Louisiana, Mississippi and Alabama, and the dipsticks are in Washington.” 

The Muni Market a Year (and change) After the Lehman Failure(What a Long Strange Trip It’s Been)

John Mousseau is a portfolio manager and heads the tax-free Muni section of Cumberland. He is a member of the Management Committee of Cumberland Advisors. His bio is found at His email is

A year ago the failure of Lehman Brothers (which we believe was avoidable, with responsive Federal Reserve action) sent the tax-free bond market into a world that was unrecognizable to most market participants. We thought it would be instructive to see where the market has come during the year and posit where we think the municipal bond market is heading.

Source: Bloomberg

Here is the AAA tax-free yield curve the Friday before Lehman Brothers failed last year (white line), in the middle of the hedge-fund meltdown in October (red), at the end of the year (yellow), and now (green). The market has gone from a total meltdown with little liquidity to long-term tax-free yields that have not been this low since 1967. A quick roadmap of the plunge into the abyss and climb back out is in order.

By the time Lehman Brothers failed, the municipal market had been buffeted by illiquidity, a downgrade of most of the bond insurers, and what (in retrospect) was a mild blowup of municipal hedge funds in February of 2008.

October 2008 (early)

Hedge Fund Blowup 2: With short-term markets in disarray in the wake of Lehman Brothers, muni hedge funds (who take advantage of the traditionally steep tax-free yield curve, with borrowed money in a high degree of leverage) again saw large call on their money by their lenders. Unmitigated selling in a market with almost no buyers and no Wall Street bids causes yields to rise over 100 basis points in a week.

October 2008 (third week): With the unprecedented rise in yields, buyers emerge voraciously and yields drop almost 150 basis points the following week – a roller coaster such as the muni market has never seen.

November 2008: The Fed begins to buy longer-dated Treasury and agency securities in an effort to bring down longer-maturity yields, with the goal of “dragging” other non-Treasury yields (munis, corporates, and mortgages) along with it. Initially this just causes the gulf between Treasury and muni yields to widen even more.

December 2008: Credit concerns hit the high-yield muni market and there are forced liquidations at a number of high-yield funds. Because they’re unloading the highest “quality” they can to raise funds, this forced selling brings all high-grade muni yields higher. Recognition of this cheapness rallies the market back somewhat towards year end.

January-April 2009: There is a “calming” effect on the municipal bond market. The market is learning to live without the overwhelming presence of bond insurance. With the exception of FSA and Assured Guaranty (now merged) and Berkshire Hathaway (Warren Buffet’s muni insurer, which in fact has not insured very much) all the other insurers have stopped being a force in the market. Bonds with these other insurers are all trading to the underlying ratings. Thus, in many cases, bonds with poor or no underlying ratings trade (when they trade at all) like junk bonds.

However, for the first time in years, municipal bond funds are seeing inflows. Equity markets continue to slump until March, but the forcing down of long-term yields by the Fed is starting to pay off, as yields on other instruments, including munis, corporates, and mortgages, continue to fall, from 6% down to 5.25% for long-dated tax-free bonds. It was the unfreezing of the debt markets that allowed equities to start improving in March.

May-July 2009: The stimulus program has helped munis on two fronts. So far the smaller effect is the allowing of banks to buy up to 2% of their net assets in munis issued this year and next AND write off the interest costs for carrying munis. Banks lost most of their ability to deduct 80% of their carrying costs with the Tax Act of 1986. This certainly spurs on demand for new issues.

The second effect is from the Build America Bonds (BABs) program. This allows issuers to issue bonds (for new projects) in the taxable bond market and receive a 35% interest subsidy from the federal government. Build America Bonds (BABs) come into the taxable bond market. A product of the federal stimulus plan, BABs are allowing municipal issuers to sell TAXABLE municipal bonds for which the Federal Government is subsidizing 35% of the interest costs. BABs have been coming (at least initially) at very generous spreads over US Treasuries. Taxable buyers such as pension funds, endowments, and charitable foundations have all flocked to own BABs, as the yields have been higher than high-grade corporates but with a perceived (and real) higher credit quality due to the resources of municipalities versus those of corporations. It has also been great for the issuers, as their true cost of issuance has been much less than it would have been in the equity market.

A quick example is illustrative. In mid-April, the University of Virginia came to market with a 250mm BABs deal with a 6.20 yield. This was attractive to buyers, especially since the 30-year Treasury was a 3.75% at the time. University of Virginia is also an AAA issuer on its own, without any credit enhancement (a rarity among colleges). The cost to the university was not 6.20% but an effective 4.03% after deducting the 35% subsidy of the federal government. At the time the tax-free market for the university would have been effectively 5% (which means that less gilt-edged credits were yielding decently more than that). The tax-free market views this transaction and realizes there is no incentive for issuers to come to the tax-free market as long as they are saving a full 1% or more by issuing their debt as BABs. Thus tax-free supply starts to fall and, more importantly, PERCEIVED future supply also drops. This begins the drive towards lower tax-free yields as buyers begin to scramble.

August-September 2009: The BABs phenomenon continues and accelerates greatly in September. Tax-free yields cruise through 5% and keep dropping lower. AAA yields start to approach 4% in the long end – levels not seen since the Johnson administration. The driver for this has been the dropping of spreads on BABs deals. The same UVA deal that came at a 6.20 (or 245 basis points over long Treasuries) is now yielding approximately 5.055, or 100 basis points over Treasuries. Thus, the BABs after-subsidy rate has been dropping and tax-free bonds have been rushing downward in an attempt to keep up. At the same time, municipal bond funds (both general and high-yield) are seeing fund inflows on a scale they have not seen since 1993. Not only has this driven yields lower, but credit spreads, or the difference in yields between bonds of similar maturities but different ratings, has been narrowing as investors search for incremental yield.

October 2009: The muni market hits its first bump of 2009 as yields on AAA paper approach 4-4.25%. Though still “cheap” relative to US Treasuries, the low nominal yields have caused sticker shock among retail investors. This backup has returned some value to the muni market.

Where do we go from here?

Cumberland is beginning to get somewhat more defensive on the tax-free municipal bond market. This is a recognition that the market has run a long way from the days of last year’s fourth quarter, when there were few buyers at any level. We favor premium bond structures where we can obtain what we think are favorable prices. This is because of the fact that the tax-free municipal market and the US Treasury market have moved closer together, setting up the possibility of advance refunding of older, higher-coupon bonds by issuers. This provides present-value savings to issuers and lowers long-term debt-service costs. We do think that a more defensive posture will pay off as we move into the latter part of 2009 and 2010.

Will the Europeans Be Eating Our Lunch?

The converse of the title above was asked by Business Week when the former socialist government in France introduced the 35-hour week.  As an American living in Paris at the time, this writer agreed that France and much of the rest of the Eurozone appeared likely to fall increasingly behind the US in the competition for global markets.  Several recent developments in Europe and policy trends in the US, however, cause us to question that view. The US risks losing its competitive edge as Europe adopts more business-friendly policies, while Congress appears headed in the opposite direction.

Two notable developments were in the tax area.  At the end of last month, French President Sarkozy, in a move described as a “competitiveness shock,” announced scrapping of the “taxe professionnelle,” which was a local business tax levied on fixed investment. This move to give a 12-billion-euro tax cut to business comes despite the fact that France has one of the highest structural deficits in the eurozone.  This is only one of a growing number of economic reforms under Sarkozy.  The 35-hour week has essentially been buried.

In neighboring Germany, the largest economy in Europe, the new center-right government is also moving towards business tax reductions as well as pro-business bureaucratic reforms. Also, while it may well prove necessary to increase social security contributions, any such increase will fall totally on taxpayers, not on employers.  Of course, in both countries the reform process has much further to go, but the direction is clear.  Governments in both countries are seeking to improve the international competitiveness of their businesses in order to encourage investment and job creation. We look in vain for similar action in Washington, or even recognition of the fact that US companies face some of the highest taxes in the group of advanced economies.

The other notable development was in the trade area.  On October 15th, the European Union and South Korea signed a landmark free-trade agreement covering the approximately US$90 billion of trade between the 27-member EU and South Korea, which is projected to increase by some 20% as a result of the deal.  South Korea committed to eliminate 99% of its tariffs over a three-year period and a number of its non-tariff trade barriers, as well as to liberalize its telecommunications, environmental, legal, financial, and shipping sectors. The EU will eliminate 96% of their tariffs. The deal still has to be ratified by the 27 member states and the European Parliament, as well as the South Korean Parliament.

The previous administration in the US reached a very similar agreement with South Korea in 2008 – indeed, it appears that our negotiators did much of the heavy-lifting in preparing for such a deal with Korea.  Very unfortunately, our Congress in its wisdom has yet to ratify the deal. While the Obama administration has said it will push for ratification, the President has expressed his lack of enthusiasm for free-trade agreements. He has expressed concern that the pending U.S -Korean deal could have an adverse effect on our auto industry.  Now it is European auto manufacturers that should find increased opportunities in the Korean market. One can only hope that the specter of European companies gaining a competitive advantage over US firms in trade with this important Asian economy will wake Washington up.

We recognize that taxation and trade are only two of the numerous factors affecting the international competitiveness of US companies.  Our more flexible labor markets, for example, will likely prove to be an important advantage as the respective economies emerge from the recession.  US firms have had much greater leeway to cut back on labor costs than has been the case in the EU, and far more than in Japan. This will have a strong positive effect on productivity in the near term. Nevertheless, we are concerned to see opposing policy trends in Europe and the US that will have important market implications if not reversed.

The effects of these policy trends on the relative ability of U.S., European and Korean firms to compete in global markets will come into play in the medium and long term. We have been adding recently to our European positions in our international ETF portfolios.  Recovery in Europe progresses, but it still appears to be lagging the U.S. economy. In the case of Korea we are slightly underweight as the Korean won has been the strongest currency in emerging Asia – which hurts exports.

We use the iShares MSCI South Korea Index ETF, EWY, to obtain exposure to the Korean market.  So far this year, this index is up a healthy 63.3%, only slightly below the MSCI Emerging Market increase of 70.4%.  However, this month Korea is off by a little over 1% whereas the Emerging Markets as a whole are up a further 5.7%.  This pull-back in Korean equities may be short-lived. We are paying particular attention to Korea’s technology exports as information technology accounts for 29% of the EWY ETF. The Korean firm Samsung alone accounts for 21.3%. As the global economic recovery gathers pace, technology exports will likely accelerate.

Some Observations about Spot Interest Rates and Forward Interest Rates with help from Jason Benderly, Jim Bianco, Ned Davis & Howard Simons

“What’s going to happen to interest rates when the inflation comes?”  This is a recurring question in our quarterly client review meetings. 

In a normal cycle one can make some reasonable projections about the changes in interest rates when the economy bottoms.  The usual sequence is that the Fed first allows the economic recovery to gain traction and then eventually starts to tighten policy by raising the short-term interest rate.  Other rates also rise, first in anticipation of Fed action and then as the Fed persists.  At some point the Fed reaches a level which slows the inflation tendency of the economy.  The yield curve flattens and longer-term rates stop rising, even as short-term rates continue to do so.  In extreme cases the short-term rate is pushed above the long-term rate.

 We are not in a normal cycle.

The operation of interest rates and Fed policy is quite different this time, as the Fed is engaged in quantitative easing; there is no serious inflation, there is huge federal debt issuance and the policy-prescribed interest rate is effectively near zero.  Traditional dynamics of monetary policy don’t work.  There are many reasons why this is true, and we will discuss them in future Commentaries.  Japan is an example of how this zero-rate status with no inflation and huge deficits can persist for a very long time. 

The reason traditional policy may not fully apply to the United States, is because it is the world’s biggest provider of a reserve currency.  But some of the reasons do apply, in part, and are at work today.  That is why the long-term Treasury yield remains quite low and why those who keep sounding warnings about much higher interest rates have been frustrated by the markets.

A zero short-term policy rate is anchoring the entire Treasury yield curve.   Benderly Economics recently reviewed the last 50 years of history and noted that “10 year yields have never moved more than 350 basis points above the Fed Funds rate.”  Today the Fed Funds rate is targeted between zero and 25 basis points (one quarter of one percent).  True to history, the 10-yr Treasury yield seems contained to an upper rate of 3.75%.  That level has defined the top of a trading range; the bottom is defined as much lower.

Large deficits do not seem to matter much to the market’s setting of interest rates.  This is and has been true in Japan and seems to be the case in the US.  We all know that the government is borrowing trillions and will likely continue to do so for years and years.  In spite of this information, the Treasury bond rate remains low. 

Of course, a 3.75% 10-year rate and a zero short-term rate mean the yield curve is very steep.  A steep curve allows the projection of forward rates, which quickly come into play in bond portfolio management.  One of the great pieces of research work on forward rates and forward rate ratios is done by Howard Simons and Jim Bianco.  We pay close attention to their commentaries every time they release them. 

Forward rates allow a portfolio manager to make choices.  Here is a simple example.  Let’s say the very short-term rate is zero; the one-year rate is 1%, and the two-year rate is 2%.  An investor can have absolute liquidity and earn nothing.  Or she can tie up her money for one year and earn 1%.  If she chooses the 2% rate for two years, she is implicitly betting that the one-year rate will be 3% or lower one year from now.  Let’s ignore compounding and use just simple annual rates for this example; we will explain how we reach the conclusion.  

The investor with the two-year time horizon can be guaranteed the 2% rate for the entire two years right now.  If he chooses the one-year 1% rate instead, he is now betting that the second year will yield a higher rate, such that his total over the two years exceeds what he can get as a guaranteed result right now.  In this case a 1% for the first year and a 3% for the second year would equal the 2% for the entire period of two years. 

The investor who thought that rates in year two would be much higher than 3% would choose the one-year option.  The investor who thought the second-year rate would be lower than 3% would choose the two-year option.  The investor who didn’t know what to do would choose the overnight rate of zero and defer the decision.  Change the numbers slightly and you have the decision tree that every investor is wrestling with today.

The same logic applies when you compare the 10-year rate with the 5-year rate or many other combinations of forward rates.  The process of forward rate adjustment is dynamic and ongoing which is why the movement of any rate impacts all rates. It is the forward rates that function to limit the steepness of the yield curve in times when the central bank’s policy is setting the shortest rate at zero.

There are many models used to forecast what the 10-year Treasury yield SHOULD BE.  Each has strengths and weaknesses.  Most practitioners have their favorites.  But all of us know that no model works perfectly.  If there were a perfect model and I knew it, I wouldn’t be writing this Commentary or sweating out these portfolio-management decisions. 

A review of most of the models would suggest that the 10-year Treasury yield SHOULD BE about 3% on the low end, if the models are based on assumptions of some continuing economic weakness.  The upper level of the SHOULD BE range is about 4.5%, based upon assumptions that the economy will be recovering on a sustained path and that some little bits of inflation will eventually emerge.  If you average out the various models, the 10-year Treasury yield should be between 3.25% and 4%, or right about where it is now at 3.4%. 

We like Ned Davis’ model, which uses four factors and creates a “fair value” of 4.27% today.  This model allows the user to modify the assumptions about the direction of the factors.  Ned admits that the present trends suggest his fair-value computation could soon be deriving a lower yield.  That is our view, too.  Ned’s model is not widely known, so it doesn’t suffer from a Goodhart’s Law effect.  And it is tested by a nearly a half-century of data and has worked well in both high- and low-inflation-rate regimes and in both high- and low-interest-rate environments. 

We get similar results when we apply our own internal and proprietary models.  They are based on inflation-adjusted holding returns and use year-over-year computations to eliminate seasonality.

One cause of concern was recently noted by Howard Simons as he discussed China’s currency peg to the US dollar and how a floating yuan would cause US rates to face large upward pressure.  Howard is on to something and demonstrates it well by comparing the euro vs. the dollar and how the China policy works with each one. 

To this point, at Cumberland we do not expect the Chinese to engage in any policy that is not in their longer-term self-interest.  Orderly markets and economic growth by selling stuff to the world are at the top of their agenda.  China employs 50 million people making low-cost items to sell to Americans and Europeans.  As long as that drives their policy they will continue to manage their currency such that they stay competitive as to price.  That means their reserves will continue to grow, because they will have to keep managing their currency exchange rate against the dollar.

At Cumberland we have maintained long duration in our bond accounts for a considerable period, and clients have benefitted by this approach.  We emphasized “spread product” over Treasury bonds and watched spreads narrow to the benefit of clients.  We continue to do that today. 

We expect to gradually reposition duration to a more neutral point over the coming months.  We are not ready to go to very short duration.  We do not see rates abruptly going higher.  That is out in the future and not at hand today.  We cannot say if significantly higher rates are a year away or three years away or five years away but we can say they are not destined to arrive real soon.  For now, the Fed will remain at zero and forward rates will continue their role as anchorage of the entire yield curve.  For the present time our duration shift in portfolios will be gradual. 

One duration target change is working its way into the strategy and portfolios.  We believe it is the beginning of the time period to start moving from long to neutral.  It is way too soon to get fully defensive in fear of abruptly rising rates.  It still pays to select certain spread product over Treasury bonds.  And in some cases it makes sense to hedge bond portfolios to dampen the volatility. 

We will make changes in this strategy in response to any event-driven input or when our preferred models suggest it is time to do so.  For now we expect the short-term rate to remain near zero for a while longer and the 10-year Treasury yield to be limited by the upper bounds we discussed earlier in this Commentary. 

Oh, Those Financials!

Oh, financials, financials, financials.  Here we go again.  JPMorgan Chase reports quarterly profits on Wednesday; Citi announces a quarterly loss on Thursday, Bank of America delivers its results (no one knows if loss or profit) on Friday.  The parade will continue right through Halloween.

Cumberland does not use single stocks in its US equity account management.  So while we are keenly focused on these reports, we’ll review some of the applicable ETFs instead. 

Since March 9 the big bank ETF that tracks the KBW Bank Index has delivered a total return of 145%.  The three banks reporting this week constitute 25% of the weight of the exchange-traded fund (ETF) that mirrors that index.  Its symbol is KBE.  These big banks are deemed “too big to fail” and have benefitted greatly by obtaining the federal government’s direct support and guarantees.  That subsidy will be revealed in their positive surprises to earnings reports

Contrast KBE with KRE.  It is the exchange-traded fund composed of regional banks that have not been deemed “too big to fail” by the Washington-based troika of Treasury, Fed, and White House/Congress.  Many regional banks are small enough to be resolved by the FDIC, and many suffer from a greater concentration of deteriorating commercial loans than their larger brethren.  Their status is reflected in the performance of their stocks.  KRE has had a total return of only 49% since March 9.  It has actually lagged the performance of the S&P 500 index, represented by the “Spider.”  SPY has had a total return since March 9 of 59%.

Other broad-based ETFs that hold the three large banks include XLF.  It is the widely followed exchange-traded fund composed of the financial stocks in the Standard & Poor’s 500 financial-sector index.  XLF’s total return since March 9 is 146%.  The three reporting banks make up 27% of the weight.

Contrast XLF with IYF; this ETF tracks the Dow Jones financial-sector index.  The three banks are 22% of the weight.  Since March 9, IYF has delivered a total return of 122%.  Clearly, the heavier the weight of the “too big to fail” banks, the better the ETF has done.  Markets are very rational here.  They like subsidized businesses that are not going to fail.  There’s nothing better in the short term than a government guaranteed profit. Markets ignore the long-term negative implications of the government bailout policy; that will come into focus down the road.

For all the attention given to the banks, the real sleeper in the financial group has been the insurers.  KIE is the exchange-traded fund that tracks the insurance index.  MetLife, Chubb, Travelers, and Aflac are the four largest weights and constitute 27%.  These are not on the government’s “too big to fail” list of 19 firms.  They suffered with all insurance stocks in the post Lehman-AIG market cascade last year.  They have outperformed the banks on the way back.  KIE has a total return of 153% since March 9.

We also need to comment on KCE.  It is the ETF that comprises the capital market firms.  Lehman was once a prominent member.  Goldman Sachs is now the largest weight at 10%.  Other large weights include State Street Bank, Morgan Stanley, and Charles Schwab.  KCE has a total return since March 9 of 107%.

Since October 1, KIE has been the leader among the specialty financial index ETFs.  KCE is second, KBE is third, and KRE is lagging in fourth place.  All are up.  At Cumberland we have been repositioning the financial sector for several months.  Our two overweight financial ETFs are KIE and KCE.  

Our rationale is simple.  Insurers have a long way to go and were unduly hurt when AIG imploded.  That created a buying opportunity.  We have recently positioned KCE and expect it to do well; we replaced KBE with it.  In a capital-constrained world, the firms that can provide capital to those who need it have very welcome market skills; they will profit.  We expect KCE to be an outperforming ETF. 

It will be an interesting week as the three banks start the season of financial reporting.  As for us, these two ETFs of insurance and capital-market firms represent our choices.  

One last note is offered to those who are playing with leveraged financials like FAS.  There are costs involved in using this leverage, and there are tracking-error issues.  Think of yourself as trading in a margin account with high leverage and imperfect execution.  Then act accordingly and with your eyes wide open.

Investing in a Weak-Dollar Global Economy

Last weekend, in the margins of the G-7 meeting in Istanbul, Treasury Secretary Tim Geithner told reporters that it is “very important” to have a strong dollar and that the US will do “everything necessary” to maintain confidence in the dollar  He acknowledged that this meant getting the US budget deficit under control.  These words are what one expects from a US Treasury Secretary and did not have a noticeable effect on the greenback’s continued swoon.

Monday, October 5, the US dollar was undermined by two developments. The first was the unexpected move by the Reserve Bank of Australia to increase its policy interest rate by 25 basis points to 3.25%. The already strong Australian dollar soared. This signaled the start of a global tightening cycle, as exit strategies start to be implemented.  The first to move will be those where the recession has been mildest and/or the recovery is strongest.  The US will not be quick to follow.  Indeed, the US monetary authorities have given strong indications of their intention to hold short-term rates to close to zero for an extended time.

The Australian rate increase served to underline the continuing interest-rate disadvantage of holding the US dollar. The greenback has reportedly become the currency of choice, replacing the yen, for the so-called “carry trade” (borrowing in a low-interest-rate currency in order to invest in a high-interest-rate currency).

The second blow to the dollar came from unconfirmed reports of a secret meeting between officials of oil-exporting and oil-consuming countries (the Gulf states, China, Russia, Japan, and France) to discuss replacing the US dollar with a currency basket in the oil trade. The official denials following the reports in the press were expected but not completely convincing.  Such rumors are increasingly common when the dollar is weak. Nevertheless, any such move to replace the dollar with a currency basket could not be implemented rapidly. There are considerable practical problems with such an alternative, and no other currency can match the depth and liquidity of the dollar markets. Nor would these countries wish to take actions that would undermine the value of their very substantial US dollar holdings.

Another development that could be contributing to the heavily bearish dollar sentiment was revealed in the latest (2009-Q2) report of the IMF on the “Composition of Official Foreign Exchange Reserves.”  These data implied that central banks are becoming increasingly reluctant to further accumulate US dollars and are slowly shifting to other G-10 currencies.  Central banks are very unlikely to make any drastic changes in this regard, as that would impact seriously on the value of their existing dollar reserves.  However, any evidence that central banks are becoming increasingly averse to holding the US dollar is a negative for the market.

An important structural factor underlying the dollar’s weakness is the massive US budget deficit and liquidity injections by the Fed that could well lead eventually to inflation problems, unless policy makers can manage to move the economy to a more balanced and sustainable track. We do not see inflation becoming a problem in the US for a considerable period, but this concern does appear to be one of the factors weakening the dollar.  Probably of more immediate importance is a cyclical factor, the growing appetite for risk on the part of investors as the recovery in the global economy becomes more evident. Flows to the US dollar (short-term Treasuries) as the only place to hide at the height of the financial crisis are being unwound. 

We do not see an early reversal of these factors.  Direct intervention in the exchange market by the US Treasury is very unlikely, and the Fed is not likely to advance its timetable for beginning to raise short-term interest rates in order to support the dollar. Fed Reserve Chairman Ben Bernanke’s statement that the Fed will ease monetary policy when the economic outlook shows sufficient improvement appears to behind the covering of some short dollar positions on Friday, October 9th.  This followed the fall of the currency to a 14-month low on Wednesday. The statement of the obvious did not imply an early rate rise to support the dollar.  There also was some intervention Thursday by a number of Asian central banks (South Korea, Taiwan, Thailand, Indonesia, and Hong Kong).  This move appears to have been motivated by a concern that the appreciation of their currencies is making their exports increasingly uncompetitive, particularly in comparison with the Chinese renminbi, which has been pegged to the dollar since July of 2008. Such intervention may slow the appreciation of these currencies somewhat, but no one thinks this can reverse the dollar’s decline. Intervention by the European Central Bank or the Bank of Japan potentially could have a greater impact, but neither seems likely to intervene as long as the currency markets remain “orderly.”

At Cumberland Advisors, we have positioned our international portfolios for a continuation of US dollar weakness.  In our Global Multi-Asset Class ETF portfolio, we have long positions in the currencies of two major commodity-producing countries, the Australian and Canadian dollars. More importantly, the portfolio is underweight US, UK, and Japan equity ETFs and overweight Australia, Canada, Euro zone, and emerging-market equity ETFs.  It is noteworthy how much US dollar-denominated returns from international investments have been helped this year by the dollar’s decline.  For example, the benchmark equity index for advanced-economy markets outside of North America, the MSCI EAFE Index, is up year-to-date by over 24% in US dollar terms, some 50% more than the 16% increase in local-currency terms.  Of course, this effect will reverse when the US dollar eventually recovers.  We will be looking carefully for advance indications that the greenback’s decline has come to an end. We fear that wait could be a long one.

Ed Yardeni on Policy

Note to readers:  Ed Yardeni opened his daily missive today with the text below.  We requested permission to reproduce it here and thank Ed for giving us the same.   Ed has written it better than my draft so I scrapped mine and am pleased to be able to share his words with our readers.   Full story at

“Why are so many members of Congress supporting and pushing for so many policies that make no sense? The Employee Free Choice Act won’t give workers more free choice. The economic stimulus bill passed in February isn’t reviving employment. Healthcare reform may soon cover all Americans with health insurance, but there will be less care for those who are currently covered, and it will drive up the overall cost of healthcare. Cap-and-Trade won’t stop the accumulation of greenhouse gases. Pushing for these half-baked measures at this time, and all at the same time, makes even less sense if the goal is to get the US economy out of recession.

However, doing what’s best for the economy and the general public doesn’t seem to be the goal of our leaders in Washington. Rahm Emanuel, the White House Chief of Staff, said as much earlier this year when he said, “Never let a serious crisis go to waste. What I mean by that is it’s an opportunity to do things you couldn’t do before.” Could the corollary be: “Keep the crisis going for as long as possible until you get everything on your wish list?”

I can’t believe that’s the game plan of any of our fine leaders. They are all among the best and the brightest in our country. Surely they know that the policies they are promoting make no sense. How can any of them say with a straight face that the so-called “public option” will increase competition in the health insurance industry? Why not just deregulate the industry if the goal is to increase competition? If the public option makes sense for healthcare, why not do it in every industry? Why not have a public option in the auto or banking industry. OK, bad examples, but you get my drift.

So how can we make sense of all the nonsense? The nonsense all makes lots of sense once we recognize that parochial special interest groups have seized our government. There are no special interest groups pushing for taxpayers, consumers, or entrepreneurs. These people are all too busy to organize politically to protect their interests. The people who attended the Tea Parties on April 15 could only stay for an hour during their lunch break before going back to work. has a revealing website which tracks the top 100 all-time political donors from 1989-2010 (linked below). There are several unions on the list. The most successful unions represent state and local employees. They have lots of members and have won extremely generous benefits for themselves, at the expense of taxpayers, who don’t enjoy the same benefits from their employers in the private sector. Second on the donors list is the American Federation of State, County, & Municipal Employees. Seventh and 15th are the National Education Association and the American Federation of Teachers.

Unions in private industries haven’t fared as well as those in the public sector. What do they want? More members. That’s why unions such as the Teamsters Union (11th) and the AFL-CIO (31st) support the Employee Free Choice Act. The Service Employees International Union (9th) is a big supporter of the Democrats and is pushing hard for ObamaCare. (It has also had strong ties to ACORN.) This union represents lots of health care workers. As municipal workers have shown, it is easier to get what you want when you are negotiating with politicians than with company managements.

Number 4 on the top donor list is Goldman Sachs. What do they want? Whatever they can get! Right now, they are all for Cap-and-Trade. At least that is the conclusion of Matt Taibbi’s over-the-top diatribe against Goldman in the 7/2 Rolling Stone. He ends his article with the following accusation: “And instead of credit derivatives or oil futures or mortgage-backed CDOs, the new game in town, the next bubble, is in carbon credits–a booming trillion-dollar market that barely even exists yet, but will if the Democratic Party that it gave $4,452,585 to in the last election manages to push into existence a groundbreaking new commodities bubble, disguised as an "environmental plan," called cap-and-trade. The new carbon-credit market is a virtual repeat of the commodities-market casino that’s been kind to Goldman, except it has one delicious new wrinkle: If the plan goes forward as expected, the rise in prices will be government-mandated. Goldman won’t even have to rig the game. It will be rigged in advance.”

There are plenty of other companies in the top donor list. Number 1 is AT&T, followed by Goldman (4th), Citigroup (13th), Altria (19th), UPS (21st), Microsoft (26th), Time Warner (27th), JP Morgan (28th), Morgan-Stanley (30th), Lockheed (32nd), Verizon (33rd), FedEx (34th), GE (35th), and Bank of America (40th). What do these companies want? Mostly to be left alone. In “Money for Nothing,” Fred McChesney ably describes a model of “rent extraction,” the political process of paying politicians off so that they don’t hurt your business. It’s the political protection racket.

In “The Logic of Collective Action” and “The Rise and Decline of Nations” Mancur Olson observed that as nations prosper, narrow special interest groups proliferate. They favor policies that redistribute national income in their favor, even though they didn’t earn it. These policies harm economic growth, but since the costs are diffused throughout the whole population, there will be little public resistance to them. Hence as time goes on, and these distributional coalitions accumulate in greater and greater numbers, the nation burdened by them will fall into economic decline. Does this sound familiar?

Of course, special interest groups have always been a major part of the American political process. Indeed, the Founding Fathers wrote the Constitution mostly with the aim of subjecting “factions” to a system of checks and balances. The system seems to be breaking down. This is evidenced by the ballooning of the structural federal deficit. Without a balanced-budget amendment, the special interest groups have gone on an unprecedented spending spree. They figure they can all get what they want by voting for each other’s 1000-page appropriations bills. What about the Bond Vigilantes? Why aren’t they protecting the rights of their constituency? They’ve been silenced by the Fed, which is giving them the choice of buying more bonds or earning zero in the money markets.”

We thank Ed for giving us permission to share this essay with our readers.   We would add that readers may wish to consult and old and classic text entitled “The Rise and Fall of Great Powers” by Paul Kennedy.   We still peek into it from time to time.   2009 is one of those times.