Should the BRussiaICs Become the BICs?

At Cumberland Advisors, our answer, from the perspective of a global portfolio manager, is a strong “Yes.”  As we write, President Obama is in Moscow for his first Russian-American summit with his counterpart, President Dmitri Medvedev, along with Prime Minister Vladimir Putin.  The stated objective of both sides is to “reset” American-Russian relations. The agreements reached on slashing nuclear arsenals and military cooperation are certainly positive developments. But we have not seen anything that would make us more willing to invest our clients’ funds in the Russian economy and equity market. Below we summarize the various reasons behind our negative evaluation of Russian equities in comparison with those of China, Brazil, and India.

In 2001 Goldman Sachs coined the acronym BRIC to refer to the large and rapidly developing economies of Brazil, Russia, India, and China. The equity markets of these four economies have indeed outperformed others in the emerging-market asset class. The MSCI BRIC Index, through the end of the first half of this year, advanced at an average annual rate of 20.4% over the past 5 years in comparison with the 12% average annual increase for the MSCI Emerging Market Index. This outperformance was maintained over the past 10 years as well, with the corresponding annual rates being 11.6% versus 6.3%.  And in the first half of the current year the BRICs continued to lead, registering a 45.76% increase, as compared with a 34.26% increase for the emerging markets index.

Ever since Russia’s invasion of Georgia, and particularly in the past month, strong doubts have arisen as to whether Russia should continue to be considered to be in the front rank of emerging market economies along with China, Brazil, and India. The Russian equity market has become increasingly decoupled from the other BRICs and emerging markets. From a peak on June 3, the Russian Trading System Index (RTSI$: IND) tumbled 21% by June 23, as investor confidence in the economy weakened and the upward advance in oil prices encountered headwinds. The Russian economy is facing a steep decline this year.  The economy plunged by 10.2% in the first 5 months of 2009.  A decline of 8.5% for the full year is projected by the Russian Economic Development Ministry (we had been expecting a 7% drop).  In marked contrast, the decline for Brazil is likely to be only 1.5%, while the Indian economy should advance by 8% and the Chinese economy looks to be on track for annual growth approaching 9%.

Unlike the diverse Chinese, Brazilian, and Indian economies, that of Russia is heavily dependent on the oil and gas sector and other raw materials.  This is evident from the sector composition of the DAX Global Russia Index, which is tracked by the Market Vectors Russia ETF, RSX. Oil and Gas account for 38.5%, Other Energy 6.9%, and Iron and Steel 18%.  We particularly do not like the dominant position of Gazprom, the leading holding of RSX, accounting for 12.6% of the ETF’s holdings.  Granted, investors in Gazprom have done well.  But this firm, majority-owned by the Russian state, has a quasipolitical profile and is spending its dwindling cash flow excessively. This spending is focused on expansion abroad, while huge domestic investment requirements remain unmet.  Other major positions are in Surgutneftegaz, 8%, Rosneft Oil Co., 7.8%, and LUKOIL 7.8%.  An investment in this ETF is essential a play on the global oil price. We would prefer to do this in a way that avoids the country risk presented by Russia.

One of the factors behind the steeper fall of the Russian economy compared with the other BRICs is a huge debt restructuring problem. Russian companies and banks face a $200 billion refinancing requirement over the next 12 months. The Russian Central Bank is seeking to recapitalize a banking sector that has all but ceased to lend. The steep recession is moving this year into a substantial deficit, amounting to more than 8% of GDP.

We were pleased to see President Medvedev signal a new initiative to “strengthen the rule of law” in Russia and call corruption a threat to national security, but we remain skeptical that meaningful steps to reform serious deficiencies in this area will be taken. A new trial with strong political overtones – of Mikhail Khodorsky, the former head of Yukos Oil Co., once Russia’s richest man and political opponent to Putin, along with his former business partner Platon Lebedev, has been underway since March. As the Economist magazine said in its July 2, 2009 issue, Russia is “courting disaster” with its “dismal investment climate.”  The CFA Institute’s report, “Shareholder Rights Across the Markets,” summarizes the situation in Russia as follows:  “Shareholders face various challenges to their rights in Russia.  Inconsistent law enforcement, growing state intervention in business, and challenges in corporate transparency are among the obstacles to stronger shareholder rights in the Russian market.”  IKEA has announced that it is suspending its operations in Russia because of the “unpredictable character of administrative procedures.”  This is not surprising when one refers to the 2008 Corruption Perception Index, calculated by Transparency International. Russia ranks 147, just one place above Syria and one below Kenya.  In contrast, China ranks 72, Brazil, 80, and India, 85.

In sum, we are continuing to invest our International, Emerging Market, and Global Multi-Asset Class portfolios in the three BIC markets (Brazil, India, and China). We sold our Russian holdings when Russia invaded Georgia and do not expect to invest our clients’ assets in such a market until conditions there improve.


What if the Fed were a bank?

Abstract:  Our joint commentary identifies two risk measures—capital ratios and duration—which may be helpful in assessing outcomes of the Fed’s exit strategy.  We have avoided a fully prepared technical paper and admit that the issues are complex for many of our readers.  To assist readers, we have divided this paper into two parts.  The first part describes the Fed’s balance sheet in terms that are more commonly understood because they are applied to banks.  Of course, we know that the Fed is not a bank.  We choose the bank as a reference since it is the basis now for many federal programs.  We demonstrate that if the Fed were a bank it would be capital constrained.  In the second and more technical part, we use McCauley duration to measure the risk building in the Fed’s new balance sheet construction.  We estimate that a 1% upward parallel shift in the yield curve could render the Fed technically insolvent, if it had to mark to market as a bank is required to do.

If the Fed were a bank and had to live up to the same capital requirements as the institutions it regulates, would it be adequately capitalized?  This may seem like an absurd question.  After all, a central bank can’t go bankrupt.  This is especially true for the Federal Reserve, whose balance sheet historically has been quite simple compared to even that of a moderately sized bank.

Until recently, the Fed’s assets consisted primarily of US Treasury debt, typically with relatively short maturities.  There was no credit risk and the Fed usually didn’t engage in the buying and selling of those assets.  Rather, it bought and held them to maturity.  This strategy provided the justification for the Fed not to mark those assets to market as interest rates changed.

Open market operations were usually conducted using repurchase agreements (RP) and reverse repurchase agreements (RRP), where securities were temporarily sold (bought) with an agreement to buy (sell) them back to the holder at an agreed-upon price.  These RP transactions were normally done for overnight or for three-day maturities.  They served to decrease or (increase) the outstanding supply of Federal Funds, which are the cash reserves banks trade among themselves.  Most importantly, they determined the overnight Fed Funds rate, which was the primary instrument of Fed policy.  They also linked the Treasury securities market to the Federal Funds market, because Treasury securities were used in the RP transactions.

Until the recent crisis, the Fed’s liability structure consisted mainly of currency held by the public (Federal Reserve notes), deposits held by member banks in the form of excess and required reserves, and deposits of the US Treasury.  Currency accounted for about 90% of the Fed’s outstanding liabilities.  Individual notes roll over as they wear out, but they are simply replaced with new ones.  The total currency outstanding volumes fluctuated slightly with changes in the demand for cash.  Cash demanded by the public includes foreign demand and what was needed in automated teller machines (ATMs).

Currency is effectively a permanent source of funding for the Fed, and its maturity is nearly infinite.  Until just recently, none of the reserve deposits paid interest.  Of course, cash pays no interest.  So the currency component of the Fed’s balance sheet has a zero cost of carry.

Today, the Fed holds a wide range of loans and other assets acquired as part of its efforts to combat the financial crisis.  The financing of those assets has also changed.  As a result, the Fed’s balance sheet is not so simple and is now exposed to a significant amount of both credit and interest-rate risk.

The Fed just released a consolidated balance sheet as of May 27, as part of a new monthly report on “Credit and Liquidity Programs.”1    The report lists consolidated Federal Reserve System assets at $ 2.082 trillion and total capital at $45 billion.  This implies a capital-to-assets ratio of 2.16%., which would also be the Fed’s tangible equity capital ratio.  Keep in mind that the Fed’s target tangible equity capital ratio for banks is 4%.

Of course, the Fed’s tangible equity capital ratio isn’t its risk-based capital ratio.  If the Fed were a bank, the government securities portion would require a 0% risk weight.  That means no capital would have to be held against those assets.  As a bank, the Fed’s mortgage-related holdings would require a 50% risk weight under current standards.  If one considers all the other lending of the Fed to be equivalent to assets that require a 100% risk weight, the Fed, as a bank, would have a Tier 1 capital ratio of approximately 4.9%.

Now, we know that the Fed is committed to expanding its mortgage portfolio to about $ 1.2 trillion from its current size of $428 billion.  This would increase the Fed’s risk-based assets by another $386 billion and reduce its Tier 1 capital ratio to 3.6%, assuming a 50% risk weight.  The Fed has virtually no options to increase its capital account, except to retain more of its earnings rather than return those funds to the Treasury.  The Fed cannot engage in a stock offering.

Its current capital base provides precious little margin to absorb any additional losses on its AIG- and Bear Stearns-related portfolios or to deal with substantial write downs in asset values.  Furthermore, there is virtually no cushion to absorb the capital losses that might have to accompany any upward movement in interest rates.  An increase in inflation expectations may require the Fed to raise policy rates needed to fight inflation.  This could trigger losses on long-term, lower-rate assets as the Fed’s attempts to exit from its quantitative easing strategy.

Finally, comparing the published financial statements in the Fed’s H.1 report with its new monthly disclosures on its lending programs suggests that the Fed has not yet recognized the embedded losses in the Maiden Lane portfolios in its capital account.  Currently, those portfolios are under water by $13 billion.  Loss recognition would reduce the Fed’s estimated capital-to-total-assets ratio to 1.5% and reduce its estimated Tier 1 capital ratio to 3.5%.  Should the Fed’s mortgage related assets expand to their targeted level and Maiden Lane losses be recognized, this combination would reduce its Tier 1 capital ratio to 2.5%.

It is hard to believe that in today’s environment mortgage loans and mortgage-related assets would be regarded as half as risky as traditional bank lending.  If mortgage loans were considered on par with commercial and industrial loans, then the Fed’s Tier 1 capital ratio would be about 3.9% without recognition of these losses and about 2.8% after recognizing the embedded Maiden Lane losses.  In short, by its own standards, the Fed is arguably not adequately capitalized and would be perilously close to being turned over to the FDIC – if the Fed were a bank.

This view of the Fed’s capital adequacy is obviously somewhat tongue –in cheek, but the issues raised are important for two reasons.  First, possible asset sales have featured prominently in the exit strategy that the Fed has put forward as a means to reduce the outstanding liquidity it had injected into markets previously.  Secondly, the Fed has accumulated a much larger portfolio of longer-term Treasuries and mortgage-related and other longer-term assets whose liquidity may be problematic and whose changes in market value may be substantial if longer-term interest rates increase.

(Note to readers.  What follows is a more technical discussion of the Fed’s balance sheet and risk exposure.)

The Fed’s report provides some information on the maturity of those assets.  Over half of its outstanding loans and other asset holdings have a maturity of over one year, and over 32% have a maturity of five years or more.  This means that the durations of the Fed’s assets have increased substantially during the crisis period and are likely to increase even more as its mortgage-related holdings continue to expand.  The increase in duration plus expansion of its mortgage-related assets to potentially $1.2 trillion means that the Fed’s interest-rate and credit risk exposure has increased substantially.

This would not necessarily be a problem because of the unusual nature of the Fed’s liability structure, which until recently consisted mainly of approximately infinite-duration non-interest-bearing liabilities (namely currency).  However, this too has changed as the Fed has responded to the financial crisis.  In particular, the Fed’s liabilities are now nearly half overnight reserve deposits held by member banks and half in Federal Reserve Notes.  Reserve deposits have a near-zero duration, while Federal Reserve Notes have nearly an infinite duration.  Thus the Fed’s liability structure is a “barbell” shape whose average portfolio duration has shortened significantly at the same time the duration of its assets has increased.  Assuming the mortgage-related portion of the portfolio continues to expand as promised and is financed through the creation of bank reserves, the trend towards a widening asset/liability mismatch will persist.  If the Fed were to expand its mortgage holdings to $1.2 trillion and finance it with short-term reserves, then short-term liabilities would account for over 60% of its liabilities.

At some point in the process, the risk of even small changes in interest rates will wipe out the Fed’s capital if it marks assets to market.  For example, if one assumed an average asset duration of five years and that duration of its liabilities shrank as low as eight years, then back-of-the-envelope calculations using McCauley duration suggest that a 1% increase in interest rates would reduce the Fed’s capital by 38% if assets were marked to market. 2  If the Fed were a bank, this would be sufficient to trigger liquidation by the FDIC.

The first point of this illustration is simply that asset sales or other policies to exit from the Fed’s quantitative easing strategy have a risk if interest rates move by even a relatively small amount.  This poses significant risks to the Fed’s capital structure and the public’s perception of its solvency.

The second point is that the duration calculation has suddenly become an important test of the Fed’s ability to achieve an exit strategy.  The Fed will remain technically solvent as long as the duration of its liabilities is substantially greater than the duration of its assets.  As a practical matter, because of their prepayment feature, mortgage instruments complicate the calculation of their duration, which increases as interest rates rise, other factors being equal.  This means that policies designed to fight inflation by raising interest rates will also narrow the gap between the duration of the Fed’s assets and liabilities and increase the risk that its capital will fall below acceptable levels.  An examination of the Fed’s balance sheet suggests that the Fed is getting close to failing this test.

Third, because of its interest-rate risk exposure and its likely impact on Fed exit strategies and credibility, we expect that there will be great interest in the Fed’s balance sheet duration.  If the Fed truly seeks transparency and discloses its internal calculations of duration, it will also have to estimate how the duration of the mortgage portfolio changes as interest rates change and what impact this will have on its capital structure.  So far we have not seen any Fed computations of duration made public.

One final note is needed to be technically correct.  If the Fed were a bank and if the Fed were marking its assets and liabilities to market, it would also have to mark its gold hoard to market.  Such a change would add about $150 billion to the carried book value of the Fed’s gold.  That addition could also be reflected in the Fed’s capital account.  It would also open the Fed to scrutiny as the gold price fluctuated.  And it would certainly enhance the market’s view of precious metals.

The authors are not advocating a revaluation of gold.  In our view, gold trades just like any other commodity.  It has no place in a fiat-currency world of monetary policy making.  Any one who wishes to use it as a hedge or a store of value may do so on their own.  Furthermore, basing US monetary policy on revaluing gold on the Fed’s balance sheet borders on lunacy.  Remember, the largest hoards of gold are found in the ground in Russia and South Africa.

1 See “Federal Reserve System Monthly Report on Credit and Liquidity Programs and the Balance Sheet,” Board of Governors of the Federal Reserve System, June 2009.

2 The method used here is based upon Bierwag, G.O. and George G. Kaufman, “Duration Gap for Financial Institutions,” Financial Analysts Journal 41, March/April 1985, pp 68-71.

The ABCs of California IOUs

The state of California – the lowest-rated state in the union – has embarked on a program of issuing IOUs to vendors who are owed money by the state. This is a result of the budget stalemate in the California legislature and their inability to agree with the governor on the course of action to fix the state’s finances. State workers, by law, cannot be paid in IOUs, but essentially anyone else owed money by the state will be paid with them. There is no question that this financially hurts vendors.

California had their long-term general-obligation debt rating cut by Fitch Rating Services to “A-” from “A” on June 25th. The Moody’s rating is at A2 and the Standard and Poor’s rating is A. Both the Moody’s and the S&P ratings are on negative credit watch.

There is a precedent for this action. In 1992, lawmakers were also deadlocked on getting a budget passed under then-governor Pete Wilson. Result: the state issued IOUs. The question is how to view today’s circumstances from an investment standpoint. The IOUs are just one part of the large effort being made to solve California’s $24-billion budget deficit. Furloughs for state employees, closing certain state offices, and delaying tax refunds are all part of the ammunition that is being used by the governor to save cash until the budget impasse is resolved. The IOUs carry an interest rate of 3.75% and cannot be cashed until October 1, 2009. Banks have said they will accept the IOUs until July 10th. We expect other financial institutions to be trading in these IOUs.

While it is clear that there is a huge financial problem to be solved, this is, at its heart, a political problem. The governor and state lawmakers will need to come together on the cuts in spending and increases in revenues that are needed to solve the budget problems.

While likely to be downgraded, the state’s general-obligation rating was actually lower in the 2001-02 crisis, when it was lowered to BBB by the rating agencies. There are many resources available to a state to raise revenues and clear avenues to cut spending. The key is the legislature working to solve the problem. The ratings agencies review the economy, debt, finances, and overall management of the state in assigning ratings. An A rating is considered by the rating agencies as representing a strong ability to pay debts. Long-maturity California general-obligation debt is trading at approximately 6.0-6.10%. If bonds were to trade down closer to 6.5% they would represent excellent value, in our opinion. Ten-year bonds significantly cheaper than 5% would also represent value.

California is by no means the only state facing budget woes but the nature of its legislature makes it tougher to come to agreement. Illinois, Connecticut, New York, Ohio, and Mississippi are among other states that are also facing severe current fiscal problems.

We have no reason to believe that states – including California – won’t do all they can to avoid missing any debt-service payments. There is no question that this is the toughest economic environment the states (as well as other municipal entities) have faced in a long time. They will adapt to the leaner world because they will have to.

One endnote: the late and great Will Rogers said “during the Depression half the population of Oklahoma moved to California and the intelligence level in both states went up.” What Rogers forgot to note is that all the migrants are now in the legislature.

Happy Birthday America

As we celebrate the nation’s birthday, we may wish to be mindful of the stress that many in our country are under.  We may try to be gracious in the face of adversity.  We can pause.  And reflect.  And give aid. 

On Friday, in New York, I watched a caring person take 15 minutes to escort a blind woman to her home.  They were strangers.  There was construction on the street and the blind person needed some guidance.  Many passed her by, but thankfully not all.  Kindness to a stranger is a value that doesn’t get measured in our national GDP.  It gets counted when each of us looks in the mirror.

Two close personal friends sent me the email that I will quote below.  It is sourced to a Washington Post story; that link is below as well. It will inspire us as the grill is lighted and the chicken sizzles.  America will weather this economic storm if it does not lose its humanity.  The risk of that loss is a far greater threat than the federal deficit. 

The email story follows:

"Washington, DC Metro Station on a cold January morning in 2007. The man with a violin played six Bach pieces for about 45 minutes. During that time approx. 2 thousand people went through the station, most of them on their way to work. After 3 minutes a middle-aged man noticed there was a musician playing. He slowed his pace and stopped for a few seconds and then hurried to meet his schedule.

4 minutes later:

The violinist received his first dollar: a woman threw money in the hat and, without stopping, continued to walk.

6 minutes:

A young man leaned against the wall to listen, then looked at his watch and walked on.

10 minutes:

A 3-year-old boy stopped, but his mother tugged him along hurriedly.  The kid stopped to look at the violinist again, but the mother pushed hard and the child continued to walk, turning his head all the time. This action was repeated by several other children. Every parent, without exception, forced their children to move on quickly.

45 minutes:

The musician played continuously.  Only 6 people stopped and listened for a short while. About 20 gave money but continued to walk at their normal pace.  The man collected a total of $32.

1 hour:

He finished playing and silence took over. No one noticed. No one applauded, nor was there any recognition.

No one knew this, but the violinist was Joshua Bell, one of the greatest musicians in the world. He played one of the most intricate pieces ever written, with a violin worth $3.5 million dollars. Two days before Joshua Bell sold out a theater in Boston where the seats averaged $100.

This is a true story. Joshua Bell playing incognito in the metro station was organized by the Washington Post as part of a social experiment about perception, taste, and people’s priorities. The questions raised: In a commonplace environment at an inappropriate hour, are we able to perceive beauty? Do we stop to appreciate it? Do we recognize talent in an unexpected context?  One possible conclusion reached from this experiment could be this:  If we do not have a moment to stop and listen to one of the best musicians in the world, playing some of the finest music ever written, with one of the most beautiful instruments ever made, how many other things are we missing?"

For details see the story by Gene Weingarten, Washington Post staff writer, Sunday, April 8, 2007; page W10.  The link is: .

Now to some economics as we celebrate America’s birthday.

The United States has been debt-free in only two years of its existence, 1834-5.  We experienced hyperinflation as a fledgling republic. The phrase “not worth a Continental” referred to the continental dollar used to finance the Revolutionary War, and not to a car manufactured by Ford Motor Company.  We have also had deflation in double digits during the Depression era.  Neither hyperinflation nor severe deflation is currently in the forecast horizon. 

At a level of about $11.5 trillion, we are presently trending to a debt/GDP ratio of 85%.  At the end of World War II that measure of debt burden peaked at 120%.  If current trends of net new borrowing of over $100 billion a month continue, we are likely to exceed that wartime record.  The annual interest burden is approaching a half a trillion dollars and grows as the debt ratio grows.  This will intensify once higher interest rates occur.  

In sum, the debt burden is large and growing.  It may not be inflationary in the short term because of the recession.  It will be inflationary in the longer term unless the Fed exits its massively stimulative strategy in a precisely executed process.  History says central banks do not do these things with precision.  That means there is a high risk of a policy failure, because the Fed may either move too soon or wait too long.  Members of the Fed are required to operate with forecasts.  And they, too, are human.

On this birthday weekend, one in ten workers is looking for a job and cannot find one.  One in six is underemployed, which means many have some job but at much less income than in their previous experience.  The average hourly work week is stagnant.  While the unemployment rate is a lagging indicator, the work week is a contemporaneous one.  It will have to rise in order for things to start improving.  So will measures of labor income.  Neither is happening, so the turnaround is not yet at hand. 

In a provocative research comment on July 3, 2009, David Woo of Barclays Capital uses three data series to derive a model of the impact of the growing federal deficits on the US dollar/euro exchange rate (EUR/USD).  He ends with a forecast that a “5% increase in the outstanding stock of US Treasuries relative to eurozone government bonds is associated with an 8% depreciation of the USD on average.”  Woo studied the period of 1999 to present.  The euro started its trading existence on January 1, 1999.

Woo also notes that low “substitutability between eurozone government bonds and Treasuries” is indicative of a market now driven by “central banks” and government institutions. That means interest rate differentials between these two groups are now a less powerful factor in determining the outcome of the EUR/USD exchange rate.  His math supports this conclusion and suggests the forthcoming and ongoing large US federal deficits will weaken the US dollar.  Woo’s one-year forecast is for a EUR/USD exchange rate of 1.50.

Impressive within Woo’s work is how he estimated the temporary effect of a flight to quality into the US dollar.  He used the VIX as a measure to determine when the spread between eurozone government bond yields and Treasury yields widened during crisis response periods.  The VIX effect is temporary but powerful when it happens.  A VIX spike can result in a dollar rally and lower Treasury yields, which seems counterintuitive to many market agents.  Markets may want to pay close attention to this measure offered by Woo, since it is the longer-term trend that prevails.

Since we believe the outlook for US fiscal policy is bleak for the next decade, we extended Woo’s work beyond his one-year time horizon.  We accepted the Congressional Budget Office estimate that the annual Obama deficits will exceed $1 trillion for the next ten years.  In fact, we expect that the cumulative deficit will be higher than the CBO estimates, because we believe that our political system is currently heavily biased towards borrowing instead of taxation.  Those assumptions lead us to a 1.60 to 1.70 EUR/USD in the early part of the next decade and a longer-term level of 2.0 or higher as the decade progresses.

What a way to start the Fourth of July celebration!  Woo titled his piece “USD risk premium, US fiscal profligacy and the ‘portfolio effect’.”

Enjoy your holiday weekend.  Happy Birthday America! 

Today’s lunch with Jim Bullard

In a most forthright and clear Fed statement, St. Louis Fed president James Bullard spoke on Fed exit strategies at a Global Interdependence Center luncheon today at the Philly Fed.    One can find the text of his slides and the videotape at .  

Having some conversation with him and listening to his prepared remarks and the post-speech Q & A, I came away with confidence that this member of the FOMC is deep in his studies of monetary policymaking and can communicate some very complex issues in a way that is understandable by an audience not fully skilled in this subject.   Readers are urged to take a few minutes and visit the St. Louis Fed website for the text and video. 

Jim Bullard was candid.  This is refreshing to see.  He admits to the areas where the Fed is working out new strategies in this turmoil period.   And he also is clear about how the Fed can unwind some of the new tools it put in place and on what timetable it will likely proceed.   He was prepared to and did say “I don’t know” when it came to issues that are not yet resolved.  

More speeches like this by more Fed officials will go a long way to relieve the Fed’s opacity.  One of the things suggested by many has been the Fed’s failure to communicate clearly during the crisis period.   Readers of Cumberland’s missives know we have been critical of this deficiency at the Fed.  We have argued that part of the problem the Fed now has with the country’s political body stems from its lack of transparency and its inability to tell this story with clarity.

Today we saw the opposite at the GIC Central Banking Series event.  It was a pleasant change from the past “fed speak” and most welcome.  Jim Bullard is serving his institution well.

As for the exit strategies he outlined, the world watches closely and waits for execution.   With Bullard’s discourse the path will be more easily understood.   And an easy style of explanation is most helpful.   We suggest that the members of the FOMC consider the use of more video tapes of their speeches and to resort to using this more talkative style.  It is user friendly.  And it is clearer than stiffly read speeches filled with technical jargon. 

Journalists need to rethink their ways, too.  In settings like this they have to work harder.  They are not just handed a text or obtain an embargoed copy.  The nuances become important.  And reporting them requires alertness.   Print media covered this speech closely today.  The absence of TV was apparent.  To me that means CNBC, Bloomberg, and Fox denied their viewers a complete story.  If more Fed speakers adopt this straight talking approach, TV is going to have to rethink its strategies of communicating just as the Fed is doing with its monetary policy strategy.

One technical issue that intrigued this writer is the development of the new Fed policy to pay interest on excess reserves deposited with the Fed.   Currently that rate is 25 basis points.  The effect is to manage the rate on short term treasury bills.   The reason is that banks will buy the t-bill if the market price translates into a rate higher than the rate that the Fed will pay.  Those purchases drive down the yield on the t-bill.  Banks can perform this arbitrage because both the reserve balance at the Fed and the holding of a t-bill have the same impact on the bank’s balance sheet. 

This new Fed policy is distinguishable from a similar one used by the European Central Bank (ECB).  They pay interest on reserve deposits, too.   The difference between the two central banks is that the ECB doesn’t buy and hold the debt issues of the sovereign countries that make up its membership.   And the ECB is capable of doing direct lending operations with many banks.  A recent transaction involved about 1000 banks.   Contrast that with the Fed which is conducting policy through 17 firms known as the primary dealers.  

Lehman was a primary dealers and a member of this very small “club.”  So were Merrill Lynch, Bear Stearns and Countrywide.   This writer wonders if things would have been different had there been many direct banking access operations with the Fed instead of a small concentrated group.  Alas, we will never know and the Fed has not spoken openly about whether or not having a few primary dealers is or was a “good” or “bad” policy. 

Few observers in America focus on these differences between the ECB and the Fed but the operational aspect of them may be very significant.   It will behoove the Fed to explain the differences as it develops the use of this new interest paying deposit reserve vehicle. 

Yupp!  Today was a good lunch meeting.   Jim Bullard made it so.

Global Recovery In Sight, China A Locomotive

June is the month for mid-year revisions to economic forecasts by the major international financial organizations and other forecasters.  The Organization for Economic Cooperation and Development (OECD) released its new forecasts Wednesday, predicting that the deep global recession is nearing a bottom. It’s projections of world real GDP growth of -2.2% for 2009 and +2.3% for 2010 represent the first upward revisions in OECD’s growth projections since June of 2007.  In remarks last week, the First Deputy Managing Director of the IMF, John Lipsky, said he expects that his institution will be revising its projections “modestly upward, mainly with regard to 2010.”  The sister organization of the IMF, the World Bank, took a contrary stance at the beginning of the week, setting back global equity markets with a downward revision of its projection for the global economy this year to -2.9%, coupled with strong negative comments on the effects of the global credit crisis on developing countries.

We are in broad agreement that a turning point in the global economy is likely in the coming months.  This follows a period of particularly sharp contraction (“falling off a cliff”) in the six-month period to March of this year.  A recovery appears to be already underway in many of the emerging-market economies.  Among the advanced economies, the United States and Japan appear likely to begin to recover in the course of the second half, driven by what the OECD characterizes as “massive policy stimulus and progress in stabilizing financial institutions and markets.”  Continued balance-sheet problems for consumers, aggravated by further increases in unemployment, will likely put a damper on the pace of recovery in the US.  Continued heavy deflationary forces will continue to be a challenge to policy makers in Japan, following what was probably that country’s most severe recession in its post-war history.

While there are some “green shoots” also appearing in the euro area, the eventual recovery looks likely to lag that in the US and Japan.  External demand for the region’s exports has collapsed; and tight financial conditions, rising unemployment, and financial-sector problems have constrained domestic demand.  Positive growth probably will not appear until the fourth quarter of this year at the earliest. 

There is broad agreement on the positive economic outlook for the Chinese economy, which appears to be on course for strong growth.  The World Bank raised its 2009 forecast for China from 6.5% to 7.2%.  The OECD expects 7.7% growth for China this year and 9.3% in 2010.  We would not be surprised to see Chinese economic growth top 8% this year and be close to 10% in 2010.  The government’s fiscal stimulus of $590 billion, along with sizable monetary stimulus, has clearly been successful in helping the economy ride out the global recession.  This is quite an achievement in a year in which world trade growth is on track to register a 16% decline.  In May there were notable advances in urban fixed investment (largely government-sponsored), real estate investment, and retail sales.  Industrial production accelerated to an 8.9% rate.  Declining exports have been a depressing factor in the first half.  This trend should reverse with the expected recovery in the global economy.

Global equity markets, as is often the case, anticipated the end of the global financial crisis, the coming recovery and advanced strongly in recent months after bottoming in early March.  International investors’ appetite for risk evidently returned to more normal levels as fears of “worst-case scenarios” lessened substantially.  The very rapid pace of the advance in equity markets over the March through May period has been followed by a modest 6% pullback in global equities since early June.  Markets clearly had gotten somewhat ahead of themselves.  While risk appetite seems to have moderated in this period, there are no indications that it has turned negative.  Investor flows into equity markets, particularly emerging markets, are continuing.  Cumberland’s equity portfolios remain fully invested.

China’s strong performance on the economic front is reflected in its equity markets.  The MSCI Index for China is up 28% year-to-date through June 23rd.  An important reflection of the continuing strength of China’s market is the fact that this index drew back only -1.8% thus far in June while the MSCI Index for Emerging Markets dropped by -6.4%.

We utilize three ETFs to provide exposure to the Chinese market.  The first is the iShares FTSE/XINHUA China 25, FXI.  This ETF is by far the most popular China ETF, and therefore is the most liquid, an important consideration.  It invests in just 25 ultra-large-caps, mostly government-sponsored Chinese firms.  It is heavily concentrated in the financial sector (45.5%) and has 0% in the technology sector.  The second is the SPDR S&P China, GXC.  It has reached an adequate level of liquidity, with net assets of $315 million (although much less than FXI’s $9.2 billion).  It provides considerably more diversified exposure to China than FXI, investing in some 130 firms, mixing large caps and small caps.  It also has a high exposure to financials (32%) and includes some tech exposure (8.1%).  Thirdly, we also use the Claymore/AlphaShare China Small Cap, HAO.  Here we have to limit our position because the net assets of this fund are only $70 million.  We are attracted by the differences in its sector exposure as compared to the previous two ETFs, including 16% exposure to information technology and only 7.7% to financials.

China’s strong performance is an important positive factor for other economies in the region, including Hong Kong (iShares MSCI Hong Kong Index Fund, EWH), Taiwan (iShares MSCI Taiwan Index Fund, EWT), and Singapore (iShares MSCI Singapore Index Fund, EWS), all of which we are overweighting in our International, Global Multi-Asset Class, and Emerging Markets ETF portfolios. China’s huge appetite for commodities is also boosting the markets for commodity-exporting economies, including Australia (iShares MSCI Australia Index Fund, EWA), Canada (iShares MSCI Canada Index Fund, EWC, and the Claymore/SWM Canadian Energy Income Index, ENY), Brazil (iShares MSCI Brazil Index Fund, EWZ) and Chile (iShares MSCI Index Fund, ECH).

Thus far we have not seen any evidence of a reemergence of the previous speculative excesses in China.  Valuations continue to look relatively attractive.  The price-to-trailing 12-month earnings ratio is 14.5, still below its 10-year average of 15.9%, whereas the same measures for Korea, Hong Kong, India, and Brazil are now all higher than their 10-year averages.  Nevertheless, as the last 12 months have amply demonstrated, the Chinese market, like other emerging markets, can be highly volatile and requires careful monitoring.

Personal Savings Rate to Rise. Also, Ask Bob Parker

The current and projected massive annual federal deficits trigger questions.  A big one is: how will the US finance this onslaught of debt and also find the necessary savings to invest in the economy so that growth can resume?  

Don Rissmiller of Strategas argues that “Even if corporate profits rebound, it’s tough to see more than $400 billion in undistributed profits.”  He notes that a personal savings rate (PSR) of 6% (April was 5.7%) would add an additional $600 billion.  Don concludes that the US is still $800 billion short, and that sum will have to be funded by “foreign capital.” 

But what if the Personal Savings Rate (PSR) is higher?  That means the pressure to attract foreign capital flows is not as severe as markets currently assume.

Dean Maki of Barclays Capital compared the PSR estimate from the Flow of Funds (FOF) report with the computation of the PSR that Don is using.  Maki suggests that the PSR estimate will be revised by the Bureau of Economic Analysis (BEA) in July.  He expects it to go higher.  Maki’s work shows an extraordinary gap between FOF data and current savings rate estimates.  Assuming FOF data is a leading indicator of the forthcoming BEA revised estimate, we can look at four decades of history and surmise that the current PSR is much higher than the reported 5.7%.  Our best guess is that it is somewhere between 7% and 9%. 

If we are correct, that would explain why the US deficit is being financed without as much pressure on interest rates as many believe we should be seeing.  Each percentage point shift in the PSR amounts to about $100 billion in cash that is being transferred from spending streams by American consumers into savings vehicles of some type. 

To help us sort through this puzzle we asked a series of questions to Robert Parker.  Bob is a colleague in several organizations, including NBEIC* and NABE*, a trusted friend of many years, a good musician (although he is shy about it) and, more importantly for this commentary, Bob is an expert in federal statistics.  He is the former BEA Chief Statistician and Director of National Accounts.

Our Q & A with Bob Parker follows. 

DRK:  “Bob, what are these forthcoming revisions, so we may inform our readers?”

BP: “At the end of July, the Commerce Department’s Bureau of Economic Analysis will release its first (“advance”) estimate of second-quarter GDP. In addition to this first take at second-quarter economic activity, BEA also will release revised estimates of the complete set of GDP accounts — back to 1929 annually, 1947 quarterly, and 1959 monthly. It makes these massive revisions every five years or so in what it calls a ‘comprehensive revision.’ (Normally they would revise only the past three years.)  Such major revisions are critical to maintaining the reliability of the accounts, because they allow BEA to incorporate the results of the most recent quinquennial economic censuses – this time for 2002.”

DRK: “Are these usually administrative, or can they be substantive?”

BP:  “Such major revisions have occasionally rewritten economic history by showing that GDP fell earlier or later than previously estimated or that personal saving was stronger in the revised estimates. Consequently, most economists are wondering whether any such important revisions are likely this July.”

DRK: “Are there any methods that can estimate the size of the revisions in advance?”

BP:  “Speculating on such revisions is hard to do. On the one hand, BEA has provided lots of detailed information on its Web site ( on how the accounts will be changed, including a few new definitions, a new classification system for consumer spending, and the re-basing of the chained-dollar estimates from 2000 to 2005. In contrast, BEA has released only sketchy information on the size and direction of the revisions: that GDP for 2002 will be revised up $202 billion, or 1.9 percent, with about $150 billion of the revision to consumer spending. We also know from BEA’s published methodology that these revisions will be extrapolated back to 1998 (the last economic censuses were in 1997) and then extrapolated forward to 2005 using essentially the published estimates, and then to 2008 using the published estimates plus whatever new annual surveys have been published since July 2008.”

DRK: “Can you speculate on some changes that may be forthcoming?  We are certainly interested in the personal savings rate.”

BP: “So if we want to speculate about revisions to the personal savings rate – such revisions could give economists a different picture about the recent health of the consumer – we need to speculate about personal outlays and incomes. We can get a reasonably good take on outlays, most of which come from consumer spending, extrapolating the revised 2002 estimate by the currently published data. We extrapolate the revised 2002 estimate by the published consumer spending estimates for 2002-2008 and get an expected upward revision to 2008 consumer spending of some $200 billion. That amount is slightly above the currently published estimate of savings and so savings would be higher.”

DRK: “What about the income side?”

BP:  “Of course, this upward revision to outlays could be more than offset by an upward revision to incomes. As for data on the revisions to incomes, BEA will be using new data for 2007-08, except for wages and salaries, and the new method for handling disasters, like Hurricane Ike that hit in 2008. We also know that BEA will using a new source for estimating income misreported to the IRS, but I have no idea whether it will be more or less. The bottom line is that we know very little, although some followers of these revisions have observed that upward revisions to personal savings are common, so why not again.”

DRK: “Got any sense of the size of the number?”  

BP: “Although not out of the question, given the upward revision to spending, a lot more income would be needed first to offset the upward revision to consumer spending – about $200 billion for 2008 — and then to actually increase savings and the savings rate.”

We thank Bob Parker for his help. And we also thank Don Rissmiller and Dean Maki for their inputs. 

We think the Personal Savings Rate is going to be a surprise when released; Dean Maki has found a clue in the Flow of Funds reports.  Furthermore, a higher savings rate than currently estimated explains some of the other data we are seeing and also helps explain how the large Treasury auctions are able to be absorbed.  It looks like it is not just Chinese and other foreign buyers.  It also looks like the consumer retrenchment is deeper than markets suspect. We will know in a month. 

*NBEIC is the National Business Economics Issues Council; NABE is the National Association for Business Economics.

Florida, Florida, Florida & Clock Restaurant

Besides the oppressive heat and humidity, the most striking thing on my five-city, six-night Florida swing was the lack of traffic on the roads.  North-south interstates on both coasts (I-95 and I-75) flowed easily.  So did Alligator Alley when I drove across the state. 

Florida went into recession nearly a year before the national economy.  It fights the frontline economic battle in the correction of “overbuilding” commercial space and residential housing.  One doesn’t need data to see how Florida’s economics are suffering.  The vacant highway commercial buildings tell part of the story.  The empty condos and “for-sale signs that scream “short sale” tell the rest.

In a reversal of the boom times, rapidly falling house prices are now the Floridian’s widely accepted norm.  Pressured sellers realize that to move a property they must “leapfrog” the selling price downward in order to get “ahead” of the pack of sellers.  In some condo buildings the disparity of pricing can be as much as 40-50%.  That gap demonstrates the impact of short sales.  A “short sale” is when the seller’s listing price is below the face amount of the mortgage. 

Housing prices are normally sticky; they do not change easily.  After decades of a rising price trend, sellers have been reluctant to cut prices at the beginning of a downturn.  That was the case in Florida for 2006 and 2007.  Foreclosures and short sales are now forcing prices lower.  Psychology has changed.  In Florida, no one expects housing prices to rise for years.  At best, they hope for a leveling off. 

Florida’s employment statistics validate this continuing recession outlook.  The unemployment rate is likely to top 11%.  Wachovia economists Mark Vitner and Yasmine Kamaruddin note (June 11) that the rate would be higher “if not for the out-migration of prime working-age adults.”  We have received permission to share their excellent, in-depth report with readers.  You may find it on the Special Section of Cumberland’s website: this document is no longer available.  The report includes ten sections with local area specifics and may interest readers from Jacksonville to Ft. Lauderdale, Tampa to Naples, or Pensacola to Orlando.  Pour yourself a stiff drink and then spend a few minutes on the city of your choice.

Unemployment doesn’t tell the whole story in the Florida labor market.  In this state, as in others, there is a component of underemployment.  There are many folks who still hold jobs but their income is lower now.  They are struggling.  In 2008, personal income gains for the state were the smallest since 1946.  They came from transfer payments, not labor income.  The negative wealth effect in Florida last year was over $1 trillion.

Segue to an anecdote.

Clock Restaurant, 670 Tamiami Trail North (Highway 41), Naples, Florida is the only 24-hour eatery in town.  I had breakfast there at 5:15 AM.  Three policemen were standing outside when I pulled up.  These members of Naples’ finest were finishing a smoke and coffee and heading back to their patrol cars.  “Good morning” I greeted.  “How’s it going?”  It had been a “quiet night” they said.

Inside there were two night owls staring at mugs of coffee.  One sat at the counter; the other one was parked in a booth.  His profile was low and clearly the booth’s seat sagged in the middle from years of use.  I decided not to engage. 

But the waiter was talkative.  He soon would finish his night shift.  I surmised it had been boring.  He’d been at Clock for seven months and had worked as a waiter in Naples for “about” ten years.  He lost his previous job when the “Manatee mall” closed 16 of their 50 stores and their restaurant shut its doors.  I sat through a lecture about retail stores and how the company headquarters decides it is cheaper to close the store and just pay the rent than to keep it open.  This is “ordered” by the “big guys” in New York, he authoritatively opined. 

I sat there, unshaven, in my fishing shirt and pants, with coffee, two eggs over medium, and rye toast, lightly buttered by me from the small rectangular container whose damn aluminum cover I had to peel back with my stiff arthritic fingers at 5 in the morning.  Some day, I am going to meet the guy who invented that monster and tell him how I really feel.  The waiter talked.  I just listened.

His replacement came at quarter to six.  Thank and bless the deity!

She had been a waitress at Clock for 17 years.  This downturn is the “worst” she remembers.  Tips are down; business is down; the winter was slow; her hours have been cut.  “Even the Germans aren’t coming this year” she said.  Naples’ warmth and golf are a tourist attraction for Europeans.  “At least I still have my job,” she said.  “But I may have trouble with the mortgage payment.”  She concluded, “This is really tough. I haven’t ever seen it like this.” 

Later that morning the fishing guide pointed me at a snook that had disdain for the fly at the end of my line.  Even a spinning rod and live bait didn’t work.  I thought, when the recession hits the Florida fishing territory, things must really be bad.  The fishing guide’s business is off a little. “I’m still booked most days,” he said as we worked our way through the mangroves in the Everglades.  Not true for the storekeeper at the marina.  Those sales are “off noticeably.”

Anecdotes and broad statistics tell the same story about Florida.  This state’s recovery doesn’t start for another two or three years.  Details on housing, manufacturing, agriculture, wealth, and income are in the Wachovia report, so I won’t repeat them.  With my own eyes, I have seen them. 

We thank Mark and Yasmine of Wachovia for their excellent report and must also thank John Silvia, my regular fishing partner and W’s chief economist, for obtaining permission to share it with our readers.

Obama’s Financial Regulatory Restructuring is an ‘Industrial Policy’

President Obama’s plan to restructure regulation of America’s financial system has some desirable elements.  It also has great danger.

Eliminating certain banks that were exempted from supervision is appropriate.  So is the elimination of the Office of Thrift Supervision (OTS) one of the regulators of AIG.  Is there really a difference between a thrift charter and a commercial bank in the modern system?  The answer is no. 

The grave risk in the plan is that it politicizes the Federal Reserve and, in certain instances, gives the Treasury a veto over Fed activity.  This is particularly true for the implementing of the emergency powers that the Fed has used during the crisis.  The Fed will have to obtain the Treasury Secretary’s written permission before an emergency action occurs.  Do we really want to have an appointed cabinet officer in our government wield that power over our so-called independent central bank? 

Remember, it is the central bank that is charged with policy making to encourage low inflation and economic growth.  The more politics gets into central banking, the greater the inflation risk.  Politicians do not want to apply restraint.  They tend to discourage higher interest rates as a tool to fight inflation.  History is replete with examples of central bank policy failures while under political influence.

Power over the “review” of the Fed’s structure is also given to Treasury, even as the Fed is charged with drafting a report.  Many Fed watchers expect this to be the basis for an attack on the regional Fed bank system.  The suspected target is to shrink the number of regional banks and also reconstitute the structure of the Fed’s decision making. 

Right now the Federal Open Market Committee sets monetary policy.  It is composed of seven governors (when all seats are filled) and the presidents of the twelve regional Fed banks.  We expect the Congress to change that and, perhaps, reduce the number of regional banks to five.  The survivor banks may have changed roles and even house some of the supervisors under the Fed’s expanded role.  

Once this Obama proposal becomes an introduced, proposed law, the Federal Reserve Act will be reopened for amendment and anything can happen.  That is when the lid on Pandora’s Box will have been lifted.

In the House, the Obama administration has the certain votes to pass a comprehensive revised Federal Reserve Act.  Several key committees will be involved, with Barney Frank’s Financial Services in the forefront.  If the pattern of other legislation is followed, the Pelosi-led House will send the final law to its rules committee, which will vote out a limited-debate, no-amendments structure.  Republicans are emasculated in the House, so the most they can do is bluster for the TV cameras.  House passage is nearly a certainty.

In the Senate there is still room for material change to this proposal, and the debate there is destined to be fierce.  We expect that the Senate version will be markedly different from the House’s.  The rules will require that the differences be hashed out by a House-Senate conference committee.  Then that final proposed law will head back to the House and Senate for straight up or down votes, with no amendments permitted in either chamber.  It will pass.

This Obama proposal is on a fast track.  There will be public hearings, of course, but the decisions are being made in the smoke-filled rooms.  The lobbying is already intense.  We believe that the end result is coming and it is already known.  The United States is extending a social-democratic form of government to the bulk of the US economy.  We are applying an “industrial policy” to finance and banking, just as we are doing to health care and autos. 

We have already done this for years with the agriculture sector.  The result is that we pay farmers not to farm and we get ethanol policies that starve millions of people, and we promote protectionism in sectors like sugar.  That’s how industrial policies end up in social democracies.  We are going to get one in banking and lending and the monetary business.  The outlook is not sanguine.

We will have more to say about the concept of industrial policy as a form of economic policy.  For now we are going to get some rest, having read through this 89-page white paper twice.  Many of its highlights will be seen in newsprint and on TV and heard on radio.  We see no need to be redundant. 

As for the phrase “industrial policy,” we will leave readers to contemplate its meaning, because it will affect every one of us.  One of several definitions from a Google search of economic references is: “An industrial policy is a set of actions executed by interventionist or mixed-economy countries in order to affect the way in which factors of production are being distributed across national industries.  By this definition, it’s logical that industrial policies contain common elements with other types of interventionist practices, such as trade policy and fiscal policy.” 

Welcome to the new America.  Add up finance and banking, agriculture, autos, housing, and health care: you get nearly half the nation’s GDP under an industrial policy.  Larry Kudlow, take note: “free-market capitalism” is dead.

Interest Rates and the Policy Squeeze

As Treasury and mortgage rates have risen, the question arises whether the Federal Reserve will accelerate its purchases of government debt and mortgage-related securities to force interest rates down closer to the 4.5% target that had been announced for mortgage rates some while ago.  But the prospect of purchasing more Treasuries is now exposing significant tensions within the Federal Reserve, for several reasons. 

First, as the Fed’s balance sheet has expanded, the market and others have begun to worry and focus on the Fed’s exit strategy and how it will be executed.  Indeed, Chairman Bernanke has made repeated references to the fact that consideration is being given to various exit strategies, but to date few specifics have been forthcoming, aside from simply listing some of the options available to the Fed.  It is clear, however, that because of the lag effects of monetary policy, the Fed will have to change policy well in advance of clear evidence of actual inflation having taken hold if it is to be successful in containing inflation.  Furthermore, policy action will require a rapid and preemptive sale of assets to mop up the liquidity the Fed has injected into the system in the form of high-powered money.

A Fed policy reversal will have to take place in the presence of higher-than-desired unemployment, and probably a barely recovering housing market and only the glimmer of a resurgence of real economic growth.  Politically, changing policy in that environment will be a difficult sell to both the public and the Congress, and will have to be done well in advance of the actual policy move.  These two key constituents who have to be convinced of the merits of the policy change have demonstrated repeatedly their willingness to tolerate higher inflation in the short run, if it means more jobs.  Unfortunately, the lessons of the 1970s and 1980s are easily forgotten.

Second, as FOMC members talk about the recent rise in Treasury rates in speeches, they don’t point out that most, if not all, of the increase in nominal interest rates has been due to an increase in inflation expectations as inferred from TIPS, and not due to increases in real rates that might signal a recovery in growth prospects.1  This means that we may already be observing the beginnings of the unhinging of inflation expectations.  Therefore, the window for policy action may be closing quickly.

Third, as the Fed’s holdings of Treasuries increases as a proportion of the outstanding supply, some policy makers are concerned about causing volatility in rates and prices should the Fed have to engage in large sales.  This is what the System Open Market Desk seeks to avoid on a day-to-day basis.  In the past the SOMA desk has attempted to spread its holdings of Treasuries out across different issues so as to avoid dominating a large portion of any issue.  This will be more difficult if the Fed continues lengthening the maturities of its holdings, because issue size is smaller at the long end of the maturity spectrum.  Selling into thinner markets means the price effects and increases in interest rates are likely to be larger and the likelihood of capital losses to the Fed will increase.  At some point the perception of the impacts of the potential losses on the Fed’s reported capital structure will become an issue.  Keep in mind that the Fed is not marking its balance sheet to market.

Fourth, market size is a two-edged sword.  If confining Fed purchases to Treasuries is most desirable when the objective is to minimize price effects and volatility of Fed portfolio moves, then this also means that efforts to drive down long-term rates through additional purchases will require huge purchases of securities.  So far, purchases of Treasuries have not resulted in lower rates, and it may be likely that the volume of purchases to accomplish that aim would be sufficiently large that the Fed’s balance sheet might have to increase significantly.  Those securities would then have to be returned to the market at some time in the future.  The Fed’s security purchases will also generate even more high-powered money, further exacerbating both the inflation risks and the exit strategy problem. 

Finally, it is hard to believe that letting existing securities holdings simply run off, selling non-Treasury assets or paying interest on reserves are considered as serious or viable policy alternatives to preemptive sales of Treasuries.  Studies conducted back when the Fed was worried about the disappearance of Treasuries suggested that there were no alternative markets deep enough to substitute effectively for the Treasury market, as far as the Fed was concerned for day-to-day implementation of monetary policy, without its actions having strong effects on asset prices.  This problem has surely become more severe during the current financial crisis.  Hence, one can’t easily rely upon the sale of significant quantities of non-Treasury assets, as Chairman Bernanke has suggested, without seriously disrupting those markets.  As a result, exit strategies that attempt to rely upon either sales of Treasuries or simply passively waiting until the other assets mature will pose a serious threat to the Fed’s ability to pursue as aggressive or anticipatory an exit as it may desire. 

Similarly, the argument that the payment of interest on reserves can be used as an effective tool seems weak.  At present, the rate paid on reserves is ¼ percent on both required and excess reserves, while the Fed Funds Target rate is a range of between 0 and ¼ percent and the discount rate is ½ percent.  Conceptually, the rate paid on reserves should set a floor on the effective Fed Funds rate, since any institution could borrow in the Fed Funds market at between 0 and ¼ percent and set up a riskless arbitrage by keeping those funds at the Fed earning ¼ percent.  However, as the Fed begins to move its funds rate target up to cut off the threat of inflation, it will also have to move both the discount rate and the rate it pays on reserves up in parallel.  But this doesn’t sterilize reserves.  The only way to do that would be to keep pushing up the rate paid on reserves until it met or even exceeded the discount rate, but this would then create an arbitrage incentive for institutions eligible to borrow at the discount window.  For a long time, the discount rate was set above the funds rate target; and to prevent the obvious arbitrage, institutions were discouraged from using the discount window except in dire need, hence the stigma that has been long associated with discount window borrowing.  Pushing the rate paid on reserves above the discount rate would require abandoning the current discount window borrowing environment, which the Fed has been attempting to encourage as a buffer to deal with short-term liquidity needs. 

What does this mean from an investor perspective?  Put it all together and I think we are looking at the sudden realization that the reliance upon anchored inflation expectations is a weak and fleeting reed to rely upon.  Markets aren’t stupid, and attention has already turned to inflation risks and the market has begun to price those risks.  Add to this dilemma the prospects for the flood of Treasuries on the market that will be necessary to fund the huge federal deficits associated with implementation of the stimulus program, and the implications for interest rates seem obvious.  If the market front runs the potential supply of Treasuries, as is likely, then interest-rate increases will accelerate even without the Fed executing its exit strategy, making the withdrawal of liquidity it had injected even more problematic.  If the Fed monetizes the debt in an attempt to keep interest rates low, then they are bound to fail on two fronts – both inflation and interest rates will increase.  The increase in rates and flood of Treasuries will also crowd out private-sector debt.  All in all, it looks like we are in for a period of rising rates, inflation, and slower growth than would have been the case without the heroic rescue.  The only question is when it will start.

1 It is recognized that TIPS are an imperfect indicator of inflation expectations, but the recent trend seems to be clear.