Crisis Note 2011-1: Twist..ing in the Wind, or Nothing has changed
First, the usual disclaimer: THESE ARE ENTIRELY MY OPINIONS. They are not those of any of my employers, present or past. Some of my recommendations are way out there, and their purpose is to hopefully generate some out-of-the-box thinking and discussions of how to solve this crisis, since the conventional thinking is certainly not working.
Quoting from my 4/8/2008 crisis note:
“In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.”
“Attitude is a little thing that makes a big difference.”“If you're going through hell, keep going.”“Success consists of going from failure to failure without loss of enthusiasm. “
“And in doing those purchases, we have succeeded in reducing the national 30-year fixed-rate mortgage rate from about 6-1/2% to about 4.8%. By lowering mortgage rates that way, we have helped to stabilize the housing sector, to help stabilize the housing crisis, and allow people to refinance, to buy homes. And that, obviously, should get construction started again and house prices stabilizing, and people being able to meet their mortgages. That's obviously going to be helpful. “
What's really sad, is that this action by the Fed was totally predictible. I put on a friendly bet with a client that, before Nov 2012, we would see FNMA 3s trade over $100. This was in August 2009, when FNMA 4.5s were the current coupon, and 3s were not even a glimmer in anyone's eyes. This milestone toppled last week.
And, Ben, please don’t bail out home builders one more time (although that may have been Hank Paulson and Tim Geitner’s doing)- they only add to the problem by building more homes.
In the 1/21/2009 Crisis note, I have a section on the implications of Lowering Mortage Rates, reprinted here:
Securitized credit flows through a one way valve. When credit is available, assets get built, especially if there are other considerations - bull markets that never appear to end, low risk premiums, pressure on CEOs from equity analysts to maximize ROE, etc.However, taking securities off financial balance sheets (that are accounted for as assets) and hiding them in acronyms that start with T or P, cannot make the underlying excess assets disappear. You cannot play the securitization film in reverse!!! The various underlying excess assets are still out there, and as long as they are non-economical, their prices will continue to decline. And with them, the prices of the bonds that are collateralized by them.Bonds are like a mirror. The bonds will always reflect the value of the underlying assets. Throwing a towel over the mirror will not change the price of the underlying assets.”
This can be seen in the Fed's own data. Please see this link:
Dead Link: http://www.census.gov/compendia/statab/2012/tables/12s1204.pdf
Please look at the 2nd table - 1204. U.S. Holdings of Foreign Stocks and Bonds by Country 2008-2010.
This does not include 2011. Guess what the amount of stimulus was via SOMA - whereby the Fed drained reserves and injected cash into the banking system. Its currently at $2.6T! Almost all the cash that was put into the US economy by the Fed went overseas, maybe all of it, and more, once we get the 2011 capital export data.
We certainly got exports going by weakening the dollar. But, of the wrong kind - we exported capital!
We’ve been suffering from price inflation, however, in commodities pricing, all from dollar depreciation. It has been offset periodically by safe haven demand for the dollar. And against most fiat currencies, the dollar has held its own, or appreciated. But against (what I call) fungible currencies - those with substantial savings per capita - Yen, Swiss Franc, Norwegian Krone, gold - the dollar has weakened.
What does it take to generate simultaneous wage and price inflation (i.e., old fashioned inflation)? In today’s world, with capital flight available at the click of a button, there are two ways to do so.
Countries that want to ease or even print money need to implement capital controls, so the money does not fly out, to other higher yielding countries. Banks, hedge funds and other shadow finance organizations must be prevented from exporting capital. Only then will money printing lead to domestic price inflation that might generate production and subsequently wage growth, as the theory predicts. (This is working very well in China at the present - they are printing even more money than we are, but it’s all being retained and used domestically, creating GDP growth and inflation). This will be very hard to implement in the US, and I don’t believe there is the political and economic understanding to do so - we have been the champion of open and free markets - and there are certainly many benefits to be accrued from these – and if we reverse course, it will become impossible for us to ever berate China on economic policy or its weak currency. Historically, too, closing of markets has usually led to trade wars and often physical wars - this is discussed in the older Crisis Notes - and this makes WWIII a possible outcome, and no longer an impossibility.
Well, how about RAISING the Fed funds rate simultaneously. Now, I'm not only out on a limb, but over a precipice!The reserve requirement cut will allow banks to find the balance sheet for all the trillions in excess assets that we've created over the past 5 years. And the RATE RISE, will help dampen inflation, and also allow Mrs. Watanabe (and the hedge fund community) to happily continue shorting the yen to support our stock markets. This will defer the yen carry trade liquidity problem for some time, and allow the central banks of the world to deal with it later. In fact, it may allow the BOJ to raise rates, as it has been hinting it wants to do.
When this happens, I suspect we will end up with a single currency and central bank. It will be like restarting a game of monopoly, except with different countries starting off with different amounts of cash. The goal will be to eliminate distortions and leverage from cross border financing and currency mispricing, which have been fundamental in causing this crisis (see my ramblings on the Yen Carry trade).
Since this Crisis Note was so lenghty, I decided to split it up. It is continued here.