Thursday, January 14, 2010

Between Scylla and Charybdis

A number of Wall Street investment banks are calling for a positive year in the US stock market, and many others are calling for a good first half of the year, followed by a weak second half, as the Fed cuts back on its easing. As suspect as Wall Street’s pronouncements may be (who would believe Goldman Sachs?), it must be admitted that the Fed’s accommodation is a very friendly environment for the markets, and a tighter stance would likely end the good times.

Although many commentators say that they are expecting a tighter Fed policy this year, when we look more closely, there is a variety of viewpoints about likelihood and timing. Let’s look at three opposed viewpoints : (1) a declining stock market due to Fed exit, which is the prevalent viewpoint, (2) a prolonged market advance because the Fed finds it impossible to exit, and (3) a new financial bubble in commodities (triggering another economic downturn) once it is understood that the Fed cannot exit.

A Fed Exit in 2010

Bill Gross of PIMCO is one of the most vocal and most visible proponents of the view that the Fed will cut back on quantitative easing this year. As described in his January 2010 commentary, Gross summarized his view this way:
If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector.

If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.

… 2010 will likely witness an attempted exit by the Fed at the end of March, and perhaps even the BOE later in the year.
The reason that 2009 was so dominated by the government sector was the extraordinary amount of fiscal and monetary stimulus, including:

… the global innovation known as “quantitative easing,” where central banks and fiscal agents bought Treasuries, Gilts, and Euroland corporate “covered” bonds approaching two trillion dollars … the Fed and the Bank of England (BOE) alone expanded their balance sheets (bought and guaranteed bonds) up to depressionary 1930s levels of nearly 20% of GDP.
The reason he believes that this stimulus must end in 2010 is that:
… the check writing is ultimately inflationary and central bankers don’t like to get saddled with collateral such as 30-year mortgages that reduce their maneuverability and represent potential maturity mismatches if interest rates go up.

Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance.
Despite the Fed’s apparent plans, Gross thinks that the exit from quantitative easing will not be so graceful:

Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. … foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds.
Although Gross doesn’t say so explicitly, the implication is that, in the absence of further Fed purchases, the market for Agency mortgages will be, to say the least, weak. Also, given that PIMCO and other funds have already loaded up on Treasuries, the US may face problems selling the new Treasury issuance that will be coming to market in 2010. Higher interest rates on mortgage securities and Treasuries would discourage investors, businesses, and consumers, providing strong headwinds against stock and bond markets and the economy.Putting this all together, Gross is predicting a “double whammy” resulting from (1) heavy debt loads in the “spendthrift” nations and (2) the withdrawal of government support from the financial markets:

Gross doesn’t see the Fed exit strategy as the only problem. Like others, he feels that budget deficits already incurred will be a drag on both the economy and the Treasury securities market for years to come. Interestingly, he quantified the impact:

Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward.

Using 2007 as a starting point and 2014 as a near-term destination, the IMF numbers show that the U.S., Japan, and U.K. will experience “structural” deficit increases of 4-5% of GDP over that period of time, whereas Germany will move in the other direction. Germany, in fact, has just passed a constitutional amendment mandating budget balance by 2016.

Putting this all together, Gross sees a "double whammy" of debt loads for many nations plus the end of easy fiscal and monetary policies:

If these trends persist, the simple conclusion is that interest rates will rise on a relative basis in the U.S., U.K., and Japan compared to Germany over the next several years and that the increase could approximate 100 basis points or more.

… the shifting of private investment dollars to more fiscally responsible government bond markets … in 2010 and beyond.

Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009.
I recommend looking at Gross’s commentary for the chart comparing the deficits and debt levels of a number of large economies. It is fascinating that PIMCO is quantifying the impact of the US budget deficit in terms of bond pricing relative to more prudent countries.

Also, it is interesting to compare Gross’s statements to those of another PIMCO executive, Mohammed El Erian. In Fortune’s 2010 investment guide, El Erian expressed great doubts about the US economy’s ability to sustain any kind of recovery this year. That’s hardly the right environment for Fed tightening, but maybe PIMCO thinks that the Fed has run out of ammunition.  Credit rating agencies have warned that the US must cut back spending or else risk a downgrade.

 No Fed Exit in 2010

The RGE Monitor, Nouriel Roubini’s website recently published an article that argued against any tightening during 2010. The core of their prediction was:

But we expect carry trades to resume in 2010 as policy rates stay at or near zero in the major economies and inflation leads to further EM and commodity-country rate hikes …. We expect the Fed to stay on hold throughout 2010 ...
This is a complete turnabout for Roubini, since not long ago he was writing about the danger that accommodative monetary policies would fuel a continued carry trade on the US dollar and fuel dangerous bubbles in financial markets around the world.

Perhaps Roubini has a point about near zero rates. With unemployment running around 10%, will the Fed dare to tighten ahead of the November midterm elections? With fiscal stimulus running out in the second half of the year, monetary tightening may be out of the question.

In contrast to Roubini, Gross’s prediction is based on Fed and Administration expectations of a self-sustaining economy (do we believe that?) and the supposition that the Fed is being forced to clean up its own balance sheet.  Given the extent to which much of the world is dependent on the US economy, it hardly seems likely that anyone would encourage the Fed to tighten when the economy is at best fragile.  Thewarnings of Fitch et al. hardly matter compared to the stances taken by the central bankers of the world.

No Fed Exit and a Commodities Bubble

In "Roubini v. Gross on Outlook for 2010", Yves at the Naked Capitalist blog points out that if Roubini is correct and the Fed does not tighten in 2010, the markets will create their own organic problems. The reasoning is that continued accommodation will encourage risk-seeking trades (carry trade in the US dollar) that will push money into “hot” assets. In this view, the most dangerous recipient of these flows is commodities. As we saw during the last oil bubble, rising commodity prices produce a drag on the economy – a drag that 2010’s fragile economy can hardly afford.

Warnings about rising commodity prices are already appearing in the press, such as this recent article this recent article  in the Wall Street Journal, and a growing global asset price bubble is depicted on the latest cover of The Economist.  There is some justification for these warnings, because the valuation of the US stock market is approaching historical highs on fundamental measures, and a number of emerging stock and real estate markets are looking overheated.  As we have seen during the past decade, inflating bubbles can persist for a quite some time before they burst.

Negative feedback from a slowing economy would eventually burst the bubble – but damage would already have been done to both the economy and financial markets.

The Fundamental Problems Remain

I don’t know which, if any, of these views will turn out to be correct, but the Fed is in a dilemma. Despite massive quantitative easing last year, the underlying problems weren’t solved, they were only postponed. We still have heavy public and private debt loads, banks holding impaired financial assets, and unaffordable home prices. Remove the lax monetary and fiscal policies and the financial markets will dry up, credit will tighten, and the economy will suffer. Continue the laxity and money will flow where it can find a return, into bubbles, not into the basic US economy.

Whether the Fed tightens or not in 2010, the financial markets and the economy are still caught between the Scylla of crushing debt and the Charybdis of unbridled speculation.