Tuesday, May 17, 2011
Hiatus
The lack of new posts on Caliban's Market is only temporary, to allow time for travel, genealogical research, and other activities. Look for new posts in a few weeks.
Wednesday, March 30, 2011
The Coming End of Quantitative Easing
For the past few weeks there has been talk in the press that QE II will pause at the end of June, and last week several Federal Reserve Bank Presidents made statements supportive of this view. As we will see below, there is good reason to believe that the government's extraordinary programs of support are coming to an end. We should seriously consider this, because the implications appear to be serious for market liquidity, rate expectations, and the dollar.
Accommodation Is Already Being Removed
Recent Fed pronouncements about ending QE should not be unexpected, because both the Fed and the Treasury have been cutting back for some time on other programs of financial and economic support. In "Crisis Era Props Are Fading Away" the Wall Street Journal last week reported on other support programs that both Treasury and the Federal Reserve have already started to roll back.
The Treasury Department has already announced plans to sell its $142 billion portfolio of federal agency mortgage-backed securities bought at the worst of the crisis. The Federal Reserve moved to the next stage of a plan to drain liquidity from the financial system through reverse repurchase agreements, or "reverse repos." Some of these moves have been going on for months. The Fed started testing reverse repos in the fall of 2009, and it has been some time since the Treasury ended several emergency-lending programs that eased the credit markets through the crisis.
More moves are being contemplated. The Fed is considering an auction for some of the subprime-mortgage securities acquired in the bailout of American International Group Inc.
Reasons for Policy Change at This Time
As pointed out by Glenview Capital in the blog Pragmatic Capitalism, there are some fundamental reasons for QE to pause: (1) the economy has rebounded (at least by some accounts), (2) the risk of immediate deflation has receded, (3) rapidly rising prices of oil, food, and other commodities provide some indication of incipient price inflation, and (4) Fed commentary has grown more cognizant of the risks of inflation.
In addition to the reasons cited in that article, the Fed probably wants to normalize policy so as to leave some "dry powder" ready to counteract the next recession or financial panic. Also, private financial institutions have stabilized to some extent, although much of their problems are being hidden at present by Treasury and Fed programs and by official tolerance of mark-to-fantasy accounting.
Recent Federal Reserve Comments
Based on recent statements, the Fed appears now to be in favor of putting an end of QE, if conditions continue stable or improve. Not long ago, St. Louis Federal Reserve Bank President Bullard said this quite plainly: "If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we're going to start withdrawing our stimulus, and I'd start by pulling up a little bit short on the QE2 program." Then last Friday a parade of Federal Reserve Bank Presidents made well-coordinated statements like these:
Speaking at a conference in Marseilles, Bullard said “The economy is looking pretty good. It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short.”
Speaking at the same conference, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said: "If the economy evolves the way I've forecast, I would not foresee us doing further accommodation." He added that the U.S. economy would need to worsen “materially” for the bank to consider further bond-buying.
Atlanta Fed President Dennis Lockhart said in a speech last Friday that "it's a high bar" for the Fed to pursue more QE. He told reporters after his speech that he favors completing the present round of asset purchases as scheduled but opposes additional moves based on his current economic forecast.
At a speech in New York a speech in New York last Friday, Charles Plosser, President of the Philadelphia Fed, said: "If this forecast is broadly accurate, then monetary policy will have to reverse course in the not-too-distant future and begin to remove the massive amount of accommodation it has supplied to the economy." He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.
Charles Evans, President of the Federal Reserve Bank of Chicago, said to reporters at a meeting at the bank that the current program of QE was enough: "Following through on that to the tune of $600 billion, like we've said, I think is appropriate. I personally don't see as many needs for a further amount, as I probably thought last fall."
The rhetoric has continued this week. Richard Fisher, President of the Dallas Fed, said today in an interview on Fox Business that he would vote against any further monetary easing by the central bank after the current program is finished in June. He was definite about this: "I cannot foresee a circumstance where I can support any further liquidity in the economy."
Pressures on the Fed to End QE
A stabilizing economy and a stable financial system have been cited as reasons for taking a pause in QE soon. These are not the only reasons why the Fed might end QE -- or say that it is going to end QE. There are other possible motives that include both real-world finances and Washington politics.
Another reason to consider ending QE in the future, if not right now, is the dollar. The ability of this country to remain solvent depends on maintaining at least some value for the dollar. So far, the dollar has declined only gradually in reaction to the government's extraordinary support for the financial system and the economy, but many of our creditors have complained about the trend. Naturally, dollar weakness is a big issue with the Fed, and they need to do something about it before heretofore modest dollar weakness turns into panic.
Partly, the problem can be seen in the continuing flow of dollars into commodities. When consumers and investors see commodity prices rising suddenly, they try to preserve wealth by exchanging dollars for commodities. This is not what the Fed wants. They want you to hold dollars and other US financial assets, not barrels of oil or gold ingots. A related view is that the Fed needs to forestall the incipient inflation seen in rising commodity prices. In addition, all of this speculation is destabilizing to the markets.
Many observers (such as Bill Gross of PIMCO) worry that the Fed is taking a big risk by tightening policy while it has been buying one-third of all US Treasury issuance. This may be a risk, but others point out that the Fed may already have enough securities on its balance sheet to control rates, and that it doesn't have to depend on incremental purchases.
Maybe the most persuasive explanation for the Fed's recent statements is that it needs to placate the fiscal hawks in Congress. According to this point of view, the Fed is just biding its time until forecasts of robust economic growth are proven wrong. At signs of a faltering economy, the Fed can rein in talk of pursuing QE and start preparing the markets for QE III. Signs of a faltering economy may not be long in coming, considering that the most recent economic data are not uniformly encouraging, and many economic forecasts are being cut back.
Problems with Pausing QE
Unfortunately, a pause in QE would happen at a time when overall economic and financial conditions are hardly conducive to monetary tightening. As Glenview Capital wrote in the blog Pragmatic Capitalism, "a renewed emphasis on deficit reduction in Congress ... will likely slow the growth of both Federal and State/Local spending that has played a key role in reinforcing the economy to prevent a double-dip recession." This austerity-induced fiscal drag seems likely to add its own burden on the weak economy.
If they come to pass, these domestic drags on the economy will happen against a global backdrop of economic negatives. These include high oil prices induced by fears of continuing political unrest in the Middle East, financial instabilities induced by the continuing debt crises on the periphery of the European Union, and the possibility of tightening by China to rein in inflation pressures and rein in an unbalanced and overheated economy.
Pausing QE would tend to raise interest rates, which is a situation that the financial system may not be ready to face. As Bill Gross asked: "Who will buy Treasuries when the Fed doesn't?" This raises the additional question of how high rates might go when the artificial foundation of QE II credit is removed. There is also the question of how well the economy and the financial system can withstand higher rates. The economy hardly seems robust enough to withstand sharply higher borrowing costs. The financial system gives appearances of having stabilized to some extent, but that leaves the question of how dependent is has become on the continuance of rock-bottom interest rates.
There is also a risk that fiscal austerity, induced by fears about government deficits, might actually worsen that situation. This is because the stabilization of the economy has been dependent on stimulus through growth in Federal expenditures. With reductions in Federal, state, and local budgets, there is a higher risk that growth will falter, and that lower economic growth will reduce tax revenues and increase the deficit.
Barbara Stevenson, Apple Vendor, 1933-1934.
All of this paints a picture of a financial and economic environment that is hardly appropriate for monetary tightening in the US. As noted above, recent economic news is not encouraging, and continuing signs of weakness could easily raise new fears of another recession. We have to wonder if QE would not need to be quickly resumed if this uncertain economic climate resumes a downward course.
Tightening to fight inflation runs the risk of undercutting the recovering economy, a situation which would place the Fed and Congress between a rock and a hard place with respect to policy choices. This could lead to a real dilemma for policy, that perhaps deficits cannot be reduced without further weakening the economy. Perhaps we should not be surprised to see such a dilemma, given that this country has seen decades of Fed policies and national budgets sending false signals to the markets that induced economic participants to misallocate resources into consumption rather than productive investment.
QE and the Markets
One of the best discussions about pausing QE that I have read was John Hussman's March 28 commentary. His argument is based on the fact that "the primary factor behind the market's recent advance has been speculation based on the belief, explicitly encouraged by Bernanke, that the Fed would provide a backstop for risk-taking." The implication for the markets is clear. If the Fed does not enter into another round of QE (and certainly if the Fed unwinds past QE), it risks an "an increase in risk aversion" and "a decline in speculative enthusiasm."
Given the momentum-like behavior of the markets, Hussman believes that investors have not priced in "the extent to which this [the market advance] has been reliant on various stimulus measures that are now drawing to a close." In fact, low market returns were almost guaranteed by the nature of QE. This is because by "increasing the stock of non-interest bearing money in the economy toward $2.4 trillion, all of which has to be held by somebody, the Fed has created a market environment that has raised the prices and lowered the returns on all competing assets." [My emphasis]
There is no way of knowing where the market will go in the short-term, but poor long-term returns are indicated by present market valuations. This is borne out by Hussman's quantitative models, which are definitely long-term and fundamental in their valuation approach. These models assume that "long-term growth in GDP and earnings will persist at the same roughly 6.3% peak-to-peak growth rate across economic cycles," which is the average rate observed over nearly the past century. Based on the level of stock valuations to normalized earnings, "our present 10-year total return estimate for the S&P 500 is only about 3.4% annually," and "the historical skew to these returns easily includes zero in the confidence interval."
Bill Gross's has warned that the end of QE will mean the end of the bull market in bonds and, as we discussed above, there is good reason to worry that the removal of extraordinary monetary accommodation may also drive down the prices riskier asset classes, like stocks and commodities. Whether we agree with all of these arguments or not, it is always a good time to review the asset allocations in our portfolios.
Accommodation Is Already Being Removed
Recent Fed pronouncements about ending QE should not be unexpected, because both the Fed and the Treasury have been cutting back for some time on other programs of financial and economic support. In "Crisis Era Props Are Fading Away" the Wall Street Journal last week reported on other support programs that both Treasury and the Federal Reserve have already started to roll back.
The Treasury Department has already announced plans to sell its $142 billion portfolio of federal agency mortgage-backed securities bought at the worst of the crisis. The Federal Reserve moved to the next stage of a plan to drain liquidity from the financial system through reverse repurchase agreements, or "reverse repos." Some of these moves have been going on for months. The Fed started testing reverse repos in the fall of 2009, and it has been some time since the Treasury ended several emergency-lending programs that eased the credit markets through the crisis.
More moves are being contemplated. The Fed is considering an auction for some of the subprime-mortgage securities acquired in the bailout of American International Group Inc.
Reasons for Policy Change at This Time
As pointed out by Glenview Capital in the blog Pragmatic Capitalism, there are some fundamental reasons for QE to pause: (1) the economy has rebounded (at least by some accounts), (2) the risk of immediate deflation has receded, (3) rapidly rising prices of oil, food, and other commodities provide some indication of incipient price inflation, and (4) Fed commentary has grown more cognizant of the risks of inflation.
In addition to the reasons cited in that article, the Fed probably wants to normalize policy so as to leave some "dry powder" ready to counteract the next recession or financial panic. Also, private financial institutions have stabilized to some extent, although much of their problems are being hidden at present by Treasury and Fed programs and by official tolerance of mark-to-fantasy accounting.
Recent Federal Reserve Comments
Based on recent statements, the Fed appears now to be in favor of putting an end of QE, if conditions continue stable or improve. Not long ago, St. Louis Federal Reserve Bank President Bullard said this quite plainly: "If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we're going to start withdrawing our stimulus, and I'd start by pulling up a little bit short on the QE2 program." Then last Friday a parade of Federal Reserve Bank Presidents made well-coordinated statements like these:
Speaking at a conference in Marseilles, Bullard said “The economy is looking pretty good. It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short.”
Speaking at the same conference, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said: "If the economy evolves the way I've forecast, I would not foresee us doing further accommodation." He added that the U.S. economy would need to worsen “materially” for the bank to consider further bond-buying.
Atlanta Fed President Dennis Lockhart said in a speech last Friday that "it's a high bar" for the Fed to pursue more QE. He told reporters after his speech that he favors completing the present round of asset purchases as scheduled but opposes additional moves based on his current economic forecast.
At a speech in New York a speech in New York last Friday, Charles Plosser, President of the Philadelphia Fed, said: "If this forecast is broadly accurate, then monetary policy will have to reverse course in the not-too-distant future and begin to remove the massive amount of accommodation it has supplied to the economy." He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.
Charles Evans, President of the Federal Reserve Bank of Chicago, said to reporters at a meeting at the bank that the current program of QE was enough: "Following through on that to the tune of $600 billion, like we've said, I think is appropriate. I personally don't see as many needs for a further amount, as I probably thought last fall."
The rhetoric has continued this week. Richard Fisher, President of the Dallas Fed, said today in an interview on Fox Business that he would vote against any further monetary easing by the central bank after the current program is finished in June. He was definite about this: "I cannot foresee a circumstance where I can support any further liquidity in the economy."
Pressures on the Fed to End QE
A stabilizing economy and a stable financial system have been cited as reasons for taking a pause in QE soon. These are not the only reasons why the Fed might end QE -- or say that it is going to end QE. There are other possible motives that include both real-world finances and Washington politics.
Another reason to consider ending QE in the future, if not right now, is the dollar. The ability of this country to remain solvent depends on maintaining at least some value for the dollar. So far, the dollar has declined only gradually in reaction to the government's extraordinary support for the financial system and the economy, but many of our creditors have complained about the trend. Naturally, dollar weakness is a big issue with the Fed, and they need to do something about it before heretofore modest dollar weakness turns into panic.
Partly, the problem can be seen in the continuing flow of dollars into commodities. When consumers and investors see commodity prices rising suddenly, they try to preserve wealth by exchanging dollars for commodities. This is not what the Fed wants. They want you to hold dollars and other US financial assets, not barrels of oil or gold ingots. A related view is that the Fed needs to forestall the incipient inflation seen in rising commodity prices. In addition, all of this speculation is destabilizing to the markets.
Many observers (such as Bill Gross of PIMCO) worry that the Fed is taking a big risk by tightening policy while it has been buying one-third of all US Treasury issuance. This may be a risk, but others point out that the Fed may already have enough securities on its balance sheet to control rates, and that it doesn't have to depend on incremental purchases.
Maybe the most persuasive explanation for the Fed's recent statements is that it needs to placate the fiscal hawks in Congress. According to this point of view, the Fed is just biding its time until forecasts of robust economic growth are proven wrong. At signs of a faltering economy, the Fed can rein in talk of pursuing QE and start preparing the markets for QE III. Signs of a faltering economy may not be long in coming, considering that the most recent economic data are not uniformly encouraging, and many economic forecasts are being cut back.
Problems with Pausing QE
Unfortunately, a pause in QE would happen at a time when overall economic and financial conditions are hardly conducive to monetary tightening. As Glenview Capital wrote in the blog Pragmatic Capitalism, "a renewed emphasis on deficit reduction in Congress ... will likely slow the growth of both Federal and State/Local spending that has played a key role in reinforcing the economy to prevent a double-dip recession." This austerity-induced fiscal drag seems likely to add its own burden on the weak economy.
If they come to pass, these domestic drags on the economy will happen against a global backdrop of economic negatives. These include high oil prices induced by fears of continuing political unrest in the Middle East, financial instabilities induced by the continuing debt crises on the periphery of the European Union, and the possibility of tightening by China to rein in inflation pressures and rein in an unbalanced and overheated economy.
Pausing QE would tend to raise interest rates, which is a situation that the financial system may not be ready to face. As Bill Gross asked: "Who will buy Treasuries when the Fed doesn't?" This raises the additional question of how high rates might go when the artificial foundation of QE II credit is removed. There is also the question of how well the economy and the financial system can withstand higher rates. The economy hardly seems robust enough to withstand sharply higher borrowing costs. The financial system gives appearances of having stabilized to some extent, but that leaves the question of how dependent is has become on the continuance of rock-bottom interest rates.
There is also a risk that fiscal austerity, induced by fears about government deficits, might actually worsen that situation. This is because the stabilization of the economy has been dependent on stimulus through growth in Federal expenditures. With reductions in Federal, state, and local budgets, there is a higher risk that growth will falter, and that lower economic growth will reduce tax revenues and increase the deficit.
All of this paints a picture of a financial and economic environment that is hardly appropriate for monetary tightening in the US. As noted above, recent economic news is not encouraging, and continuing signs of weakness could easily raise new fears of another recession. We have to wonder if QE would not need to be quickly resumed if this uncertain economic climate resumes a downward course.
Tightening to fight inflation runs the risk of undercutting the recovering economy, a situation which would place the Fed and Congress between a rock and a hard place with respect to policy choices. This could lead to a real dilemma for policy, that perhaps deficits cannot be reduced without further weakening the economy. Perhaps we should not be surprised to see such a dilemma, given that this country has seen decades of Fed policies and national budgets sending false signals to the markets that induced economic participants to misallocate resources into consumption rather than productive investment.
QE and the Markets
One of the best discussions about pausing QE that I have read was John Hussman's March 28 commentary. His argument is based on the fact that "the primary factor behind the market's recent advance has been speculation based on the belief, explicitly encouraged by Bernanke, that the Fed would provide a backstop for risk-taking." The implication for the markets is clear. If the Fed does not enter into another round of QE (and certainly if the Fed unwinds past QE), it risks an "an increase in risk aversion" and "a decline in speculative enthusiasm."
Given the momentum-like behavior of the markets, Hussman believes that investors have not priced in "the extent to which this [the market advance] has been reliant on various stimulus measures that are now drawing to a close." In fact, low market returns were almost guaranteed by the nature of QE. This is because by "increasing the stock of non-interest bearing money in the economy toward $2.4 trillion, all of which has to be held by somebody, the Fed has created a market environment that has raised the prices and lowered the returns on all competing assets." [My emphasis]
There is no way of knowing where the market will go in the short-term, but poor long-term returns are indicated by present market valuations. This is borne out by Hussman's quantitative models, which are definitely long-term and fundamental in their valuation approach. These models assume that "long-term growth in GDP and earnings will persist at the same roughly 6.3% peak-to-peak growth rate across economic cycles," which is the average rate observed over nearly the past century. Based on the level of stock valuations to normalized earnings, "our present 10-year total return estimate for the S&P 500 is only about 3.4% annually," and "the historical skew to these returns easily includes zero in the confidence interval."
Bill Gross's has warned that the end of QE will mean the end of the bull market in bonds and, as we discussed above, there is good reason to worry that the removal of extraordinary monetary accommodation may also drive down the prices riskier asset classes, like stocks and commodities. Whether we agree with all of these arguments or not, it is always a good time to review the asset allocations in our portfolios.
Tuesday, March 22, 2011
Not Yet the End of the Bull Market in Bonds
PIMCO Total Return Eliminates Government Bonds
A couple of weeks ago there was considerable angst in the press over the announcement that the PIMCO Total Return Fund had totally eliminated its exposure to US government bonds during the month of January. Total Return raised its cash position by a corresponding amount.
In an interview on Yahoo Tech Ticker, PIMCO guru Bill Gross advised investors to stay clear of “bonds in dollar denominated terms” and to be “wary of higher interest rates going forward.” Bloomberg reported: "Gross believes that interest rates on U.S. Treasuries are way too low right now and that they will start going up when the Federal Reserve ends the current round of quantitative easing in June."
Should We Be Worried?
Well, if you believe that rates will rise precipitously when QE II ends, I don't blame you for selling bonds and going to cash. You might even believe, as Zero Hedge wrote, that the "cost of capital could go up by at least 150bps while input costs are rising, margins are compressing and liquidity drying up." In that situation, it might even make sense to "get the hell out of Dodge in all asset classes."
But is there reason to be so greatly worried about rising rates, especially at the end of QE II in June? I certainly agree that the US faces persistent, multi-year problems with interest rates and the dollar. However, it isn't exactly clear that we should have a particularly elevated level of worry about the purported forthcoming event "when the Federal Reserve ends the current round of quantitative easing in June," as Gross says we should. There are differing opinions about the market impact that the end of QE II may have, if it does end then, and we might profit by at least listening to some other opinions.
What Happened to Bond Yields the Last Time?
Cullen Roche, the author of the blog Pragmatic Capitalism, looked at Gross's track record and concluded: "I am not sure there is much, if anything, that we can read into this move by Mr. Gross. He has been talking about some form of bear market in bonds for over 10 years now." For example, ten years ago Gross wrote in 2001 "We are at the end of the secular bull market in bonds," which hardly turned out to be the case then.
Roche also pointed out that Federal Reserve history is against Gross's pronouncement that QE II will lead to a rise in bond rates. When QE I ended last year, and the Fed contracted its balance sheet, interest rates did the opposite of what Gross expected, that is, they dropped.
Of course, the Fed's move was advertised in advance, and bond yields did rise during much of the lead-up to the event. Also, the context is different this time. There is more public awareness now of the risks of a declining dollar, and attention to the growing US government debt has also increased in the past year. Perhaps it is best to admit that argument from a single anecdote is impossible, and not dismiss Gross's worries simply on that basis.
What Else Happened Last Time?
If we want to use historical analogies, the only time that the Fed previously cut back on a program of quantitative easing was last year. Interest rates fell after that cutback, but what else happened? A full examination of the historical record shouldn't be restricted to a single dimension, bond yields, even if that is the issue that Bill Gross focused on.
In John Maldin's latest column, he quoted from a list that was originally published by David Rosenberg. To quote those two, during the period from late April to late August last year, when the Fed contracted its balance sheet by 12 percent, the markets saw asset price changes that included the following:
Among commodities, the exception to the overall decline was gold which "acted as a refuge at a time of intensifying economic and financial uncertainty" by rising to $1,235 an ounce from $1,140.
If the end of QE II follows the same pattern as the end of QE I, perhaps there is reason to worry about the short-term impact, because there were price drops across a wide range of asset classes. But the price declines last time did not include the one that Gross identified, namely a drop in bond prices.
The Difficulty of Interpreting History and Statistics
In his Yahoo Tech Ticker interview, Gross said that America's debt level is nearing a breaking point after years of reckless spending, and that we can no longer depend on foreigners for funding. A critical question, of course, is when the breaking point will arrive. Gross cited the work of Ken Rogoff and Carmen Reinhart in This Time Is Different when he said: “When a country reaches a certain debt level, confidence in that country’s ability to repay that debt becomes jeopardized.”
Now, we must be careful here, because timing is everything in investing. Certainly, high national debt levels can be dangerous, but has the US reached a critical level of debt? Do we expect the US to experience a major bond market dislocation this year, as Gross seems to imply?
The really big problem with Gross's appeal to Rogoff and Reinhart is of course that, when he refers to "a certain debt level," he is referring to average results over a sample of national experiences. Referring a a sample average is misleading. The outstanding aspect of the data used by Rogoff and Reinhart is the variability in the experiences of different nations with respect to the conditions under which they had difficulties paying their debts. There is no way of saying that a nation will default when it reaches a given level of debt, however one defines the debt.
Also, it is myopic to focus attention on only a single variable, the nation's level of debt (presumably as a fraction of gross economic product). Other factors are also critical in determining a nation's ability to pay its debts, including its level of economic activity, prospects for growth, currency convertibility, trade relationships with creditors, and many others. There are good reasons that US creditors are willing to tolerate present debt levels and that the US currently experiences interest rates that are low to moderate in historical terms over the maturity span of the yield curve.
In fact, predicting a nation's ability to repay its debt is not a matter than anyone can achieve with any certainty. Is there risk to the US dollar? You bet. Could the dollar fall more this year? Sure. But will American's ability to repay its debt suddenly end this year? There are risks, but QE II does not seem especially likely to be the trigger for a massive event.
Years, Not Months
Setting a time for a bond blowup is impossible, but the real problem is probably more likely to lie sometime in the next decade, not over the next few months. That is because the big problem is the current high level of US government debt and the likely future growth of that debt, seemingly without limit. Current budgets are heavily in deficit, and entitlement programs —Social Security, Medicare and Medicaid—are set to add ever-increasing burdens that will throw the budget even more into the red. Given the reluctance of politicians to raise taxes to pay for these programs, or to cut entitlements, the national debt seems fixed on a doomsday trajectory that will grow without bound until disaster strikes.
A chart at The Economist is a good place to see the proportion of GDP spent on entitlements and interest, compared with the proportion of GDP that the government is expected to raise in the form of revenues. The data come from the Congressional Budget Office's "alternative fiscal scenario", which is based on today's underlying fiscal policy but also incorporates some widely expected changes, such as an increase in the threshold for the alternative minimum tax rate. The expansion of entitlements to take up an ever-expanding proportion of the US budget is very striking.
The Economist pointed out that, according to this graph, entitlements and interest will absorb all government spending by 2025. Of course, a crisis will arise well before we reach that point. Not only will there be resistance to letting entitlements crowd other government programs, but the government budget will expand well before that time to comprise an unacceptably large percentage of our GDP. Other economic activity would be crowded out, but markets are certain to react well before that point to demand higher interest rates and pernicious currency exchange rates from the US. As confidence is lost in the US, the point will be reached where the economy falls into depression and the national debt cannot be serviced.
Clearly, the government debt situation poses a very big risk for bonds, interest rates, and the dollar. In this respect Gross and PIMCO seem perfectly on track in their warnings, although that still leaves the question of timing.
When will the crisis be seen in the markets? Hard to tell, but it seems more likely that the real trouble will be a few years off, say, in the latter half of this decade, rather than at the end of QE II, if it ends this summer. Of course, there are many uncertainties. Determined political action could lead to meaningful cutbacks in government spending, or unexpected economic growth could bring greater tax revenues to the government to reduce annual deficits. Whether a crisis occurs or not, half a decade seems a more plausible period of uncertainty for an American interest rate crisis than does a restricted period like the few months attending the end of QE II, whenever that event actually comes.
Bill Gross's Argument
Gross's stated position on QE II is much more alarmist than the aforementioned historical interpretations would seem to support. He reminded readers in his March letter that the Fed is currently buying about 70 percent of all new US government debt, and he then asked: "Who will buy Treasuries when the Fed doesn't?"
There is no argument with Gross's recognition that "Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets." Without this "handoff and stability" the private sector may indeed be unable to issue debt at the low yields and narrow credit spreads seen in the markets at present. It is difficult to disagree that this point.
As for the magnitude of the problem that the financial markets might experience if QE ends, we have Gross's estimate" that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%." Of course, in order to be really worried that QE II will end soon, you have to accept Gross's estimate of expected nominal GDP growth. Not everyone would agree that the economic prospect is so rosy.
Perhaps the biggest problem with Gross's alarm is that it posits an event that may not occur. Given the weakness of the economy and the reluctance of Congress engage in fiscal stimulation, it would seem more likely that the Fed will find it necessary to continue a policy of extraordinary monetary easing, rather than discontinue it. Current optimism about the economy seems overdone, and the Fed probably knows that.
There is no denying the existence of near-term risks, but the question is the magnitude of the risk and how it will evolve over time. Based on this analysis, risks to the dollar and Treasuries should rise as deficit difficulties increase over time. This isn't exactly the message of Gross's comments, but at least he has stated his arguments publicly, so that we can judge the extent to which we would like to share them.
A couple of weeks ago there was considerable angst in the press over the announcement that the PIMCO Total Return Fund had totally eliminated its exposure to US government bonds during the month of January. Total Return raised its cash position by a corresponding amount.
In an interview on Yahoo Tech Ticker, PIMCO guru Bill Gross advised investors to stay clear of “bonds in dollar denominated terms” and to be “wary of higher interest rates going forward.” Bloomberg reported: "Gross believes that interest rates on U.S. Treasuries are way too low right now and that they will start going up when the Federal Reserve ends the current round of quantitative easing in June."
Should We Be Worried?
Well, if you believe that rates will rise precipitously when QE II ends, I don't blame you for selling bonds and going to cash. You might even believe, as Zero Hedge wrote, that the "cost of capital could go up by at least 150bps while input costs are rising, margins are compressing and liquidity drying up." In that situation, it might even make sense to "get the hell out of Dodge in all asset classes."
But is there reason to be so greatly worried about rising rates, especially at the end of QE II in June? I certainly agree that the US faces persistent, multi-year problems with interest rates and the dollar. However, it isn't exactly clear that we should have a particularly elevated level of worry about the purported forthcoming event "when the Federal Reserve ends the current round of quantitative easing in June," as Gross says we should. There are differing opinions about the market impact that the end of QE II may have, if it does end then, and we might profit by at least listening to some other opinions.
What Happened to Bond Yields the Last Time?
Cullen Roche, the author of the blog Pragmatic Capitalism, looked at Gross's track record and concluded: "I am not sure there is much, if anything, that we can read into this move by Mr. Gross. He has been talking about some form of bear market in bonds for over 10 years now." For example, ten years ago Gross wrote in 2001 "We are at the end of the secular bull market in bonds," which hardly turned out to be the case then.
Roche also pointed out that Federal Reserve history is against Gross's pronouncement that QE II will lead to a rise in bond rates. When QE I ended last year, and the Fed contracted its balance sheet, interest rates did the opposite of what Gross expected, that is, they dropped.
Of course, the Fed's move was advertised in advance, and bond yields did rise during much of the lead-up to the event. Also, the context is different this time. There is more public awareness now of the risks of a declining dollar, and attention to the growing US government debt has also increased in the past year. Perhaps it is best to admit that argument from a single anecdote is impossible, and not dismiss Gross's worries simply on that basis.
What Else Happened Last Time?
If we want to use historical analogies, the only time that the Fed previously cut back on a program of quantitative easing was last year. Interest rates fell after that cutback, but what else happened? A full examination of the historical record shouldn't be restricted to a single dimension, bond yields, even if that is the issue that Bill Gross focused on.
In John Maldin's latest column, he quoted from a list that was originally published by David Rosenberg. To quote those two, during the period from late April to late August last year, when the Fed contracted its balance sheet by 12 percent, the markets saw asset price changes that included the following:
The S&P 500 sagged from 1,217 to 1,064….
The S&P 600 small caps fell from 394 to 330….
Baa spreads widened +56bps from 237bps to 296bps…
CRB futures dropped from 279 to 267….
Oil went from $84.30 a barrel to $75.20….
The VIX index jumped from 16.6 to 24.5….
The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5….
The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…
Among commodities, the exception to the overall decline was gold which "acted as a refuge at a time of intensifying economic and financial uncertainty" by rising to $1,235 an ounce from $1,140.
If the end of QE II follows the same pattern as the end of QE I, perhaps there is reason to worry about the short-term impact, because there were price drops across a wide range of asset classes. But the price declines last time did not include the one that Gross identified, namely a drop in bond prices.
The Difficulty of Interpreting History and Statistics
In his Yahoo Tech Ticker interview, Gross said that America's debt level is nearing a breaking point after years of reckless spending, and that we can no longer depend on foreigners for funding. A critical question, of course, is when the breaking point will arrive. Gross cited the work of Ken Rogoff and Carmen Reinhart in This Time Is Different when he said: “When a country reaches a certain debt level, confidence in that country’s ability to repay that debt becomes jeopardized.”
Now, we must be careful here, because timing is everything in investing. Certainly, high national debt levels can be dangerous, but has the US reached a critical level of debt? Do we expect the US to experience a major bond market dislocation this year, as Gross seems to imply?
The really big problem with Gross's appeal to Rogoff and Reinhart is of course that, when he refers to "a certain debt level," he is referring to average results over a sample of national experiences. Referring a a sample average is misleading. The outstanding aspect of the data used by Rogoff and Reinhart is the variability in the experiences of different nations with respect to the conditions under which they had difficulties paying their debts. There is no way of saying that a nation will default when it reaches a given level of debt, however one defines the debt.
Also, it is myopic to focus attention on only a single variable, the nation's level of debt (presumably as a fraction of gross economic product). Other factors are also critical in determining a nation's ability to pay its debts, including its level of economic activity, prospects for growth, currency convertibility, trade relationships with creditors, and many others. There are good reasons that US creditors are willing to tolerate present debt levels and that the US currently experiences interest rates that are low to moderate in historical terms over the maturity span of the yield curve.
In fact, predicting a nation's ability to repay its debt is not a matter than anyone can achieve with any certainty. Is there risk to the US dollar? You bet. Could the dollar fall more this year? Sure. But will American's ability to repay its debt suddenly end this year? There are risks, but QE II does not seem especially likely to be the trigger for a massive event.
Years, Not Months
Setting a time for a bond blowup is impossible, but the real problem is probably more likely to lie sometime in the next decade, not over the next few months. That is because the big problem is the current high level of US government debt and the likely future growth of that debt, seemingly without limit. Current budgets are heavily in deficit, and entitlement programs —Social Security, Medicare and Medicaid—are set to add ever-increasing burdens that will throw the budget even more into the red. Given the reluctance of politicians to raise taxes to pay for these programs, or to cut entitlements, the national debt seems fixed on a doomsday trajectory that will grow without bound until disaster strikes.
A chart at The Economist is a good place to see the proportion of GDP spent on entitlements and interest, compared with the proportion of GDP that the government is expected to raise in the form of revenues. The data come from the Congressional Budget Office's "alternative fiscal scenario", which is based on today's underlying fiscal policy but also incorporates some widely expected changes, such as an increase in the threshold for the alternative minimum tax rate. The expansion of entitlements to take up an ever-expanding proportion of the US budget is very striking.
The Economist pointed out that, according to this graph, entitlements and interest will absorb all government spending by 2025. Of course, a crisis will arise well before we reach that point. Not only will there be resistance to letting entitlements crowd other government programs, but the government budget will expand well before that time to comprise an unacceptably large percentage of our GDP. Other economic activity would be crowded out, but markets are certain to react well before that point to demand higher interest rates and pernicious currency exchange rates from the US. As confidence is lost in the US, the point will be reached where the economy falls into depression and the national debt cannot be serviced.
Clearly, the government debt situation poses a very big risk for bonds, interest rates, and the dollar. In this respect Gross and PIMCO seem perfectly on track in their warnings, although that still leaves the question of timing.
When will the crisis be seen in the markets? Hard to tell, but it seems more likely that the real trouble will be a few years off, say, in the latter half of this decade, rather than at the end of QE II, if it ends this summer. Of course, there are many uncertainties. Determined political action could lead to meaningful cutbacks in government spending, or unexpected economic growth could bring greater tax revenues to the government to reduce annual deficits. Whether a crisis occurs or not, half a decade seems a more plausible period of uncertainty for an American interest rate crisis than does a restricted period like the few months attending the end of QE II, whenever that event actually comes.
Bill Gross's Argument
Gross's stated position on QE II is much more alarmist than the aforementioned historical interpretations would seem to support. He reminded readers in his March letter that the Fed is currently buying about 70 percent of all new US government debt, and he then asked: "Who will buy Treasuries when the Fed doesn't?"
There is no argument with Gross's recognition that "Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets." Without this "handoff and stability" the private sector may indeed be unable to issue debt at the low yields and narrow credit spreads seen in the markets at present. It is difficult to disagree that this point.
As for the magnitude of the problem that the financial markets might experience if QE ends, we have Gross's estimate" that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%." Of course, in order to be really worried that QE II will end soon, you have to accept Gross's estimate of expected nominal GDP growth. Not everyone would agree that the economic prospect is so rosy.
Perhaps the biggest problem with Gross's alarm is that it posits an event that may not occur. Given the weakness of the economy and the reluctance of Congress engage in fiscal stimulation, it would seem more likely that the Fed will find it necessary to continue a policy of extraordinary monetary easing, rather than discontinue it. Current optimism about the economy seems overdone, and the Fed probably knows that.
There is no denying the existence of near-term risks, but the question is the magnitude of the risk and how it will evolve over time. Based on this analysis, risks to the dollar and Treasuries should rise as deficit difficulties increase over time. This isn't exactly the message of Gross's comments, but at least he has stated his arguments publicly, so that we can judge the extent to which we would like to share them.
Saturday, February 26, 2011
The Down Staircase
The Stairway to Poverty
Several times I’ve said in this blog that I don’t expect the imminent collapse of the dollar. This isn’t because I’m blind to the dollar’s fatal flaws, but because of the time required for the unfolding of this nation’s budgetary and economic problems, and because the dollar is only one of a number of troubled currencies of declining developed nations.
But I don’t want to give the impression that the dollar is safe. We know that the dollar is on an unsustainable trajectory, and its decline seems inevitable. It’s just that the path isn’t necessarily straight down, and the timing of the dollar’s decline is highly uncertain.
The Dollar Cascade
There is no doubt that the direction is down. Even Chairman Bernanke has said that the US needs to reduce debt, and that the process of deleveraging will involve high rates of bankruptcy and unemployment. In such a spare environment, low rates of economic growth will force governments and individual citizens to adjust their expectations and economic activities downward. Because governments and citizens do not willingly adjust their expectations to reduced circumstances, we cannot expect the process to be a smooth one.
Until the financial crisis hit, the risk of financial collapse because of rising levels of private and public debt was met with official denial. When collapse became imminent, the official response was a bailout of key financial players, a policy of rock-bottom interest rates, and quantitative easing – all temporary measures that left the underlying issues untouched. Private debt was partially transformed into public debt, but the debt remained. The system was stabilized temporarily, but this was only the first step in a multi-year process of deleveraging and economic adjustment.
For these reasons, I see the continuing decline of the dollar as a sequence of stair steps. After falling down a step, the US finds ways to arrest its decline partially and sustain itself at a lower level for a few years. Eventually, the pressure on the US (declining economic competitiveness, value of the dollar, political influence) builds up to a point that resistance gives way and we fall down another step. Over a period of decades, some of the steps may be small and others large and catastrophic. However long we may loiter on any single step, the direction is down.
Printing Money Is Not the Answer, It Is a Symptom
There is a school of thought, based on Modern Monetary Theory, that the US cannot become insolvent. The thesis is that the Fed is not monetizing the debt, and a truly sovereign currency can not be debased into hyperinflation. This position posits that the government does not print money, but rather pushes buttons to create amounts in bank accounts or remove amounts from bank accounts. The blog Pragmatic Capitalism has published a number of articles supporting this position, which might be summarized as: “a sovereign government with monopoly supply of currency in a floating exchange rate system has no solvency issue.”
In my opinion the main problem with discussions of this point of view is that they discuss the wrong problem. The real issues are this country's ballooning federal debt and its persistent negative balance of payments. Those are the main forces driving this country to penury, not monetary policy.
Easy monetary policy, however, exacerbates the problem because it distorts market prices, resulting is the allocation of resources into speculation rather than productive activities. Nevertheless, I was still interested to read a critique of modern monetary theory in a recent series of articles in another blog that I enjoy, Jesse’s Crossroads Café (Jesse Part 1, Jesse Part 2, Jesse Part 3). To quote Jesse, the critique might be summarized as “I can print money, therefore I can never go broke.”
A government with a monopoly supply of currency may remain solvent in the limited sense that it can pay its debts in its own currency, but that is such a myopic issue as to be meaningless. What is that currency worth in real terms? Not much, if that government’s debts expand without limit. If debt grows uncontrollably, no sovereign government can escape the consequences.
Theoretical solvency is a false issue if your currency declines against all others, and if everyone understands that the trend is going to continue indefinitely.
If debt grows uncontrollably, relative to the size of an economy, citizens and creditors will notice. What exchange rates will foreign trading partners demand, what interest rates will foreign creditors demand, and what rate of price inflation will domestic consumers experience? As Jesse put it: “The limit of the Fed's and Treasury's ability to create money is the value and acceptance of the dollar and the bond in market transactions.”
And at some point, after exchange rates, interest rates, and price inflation have escalated to the point that the people are mostly in penury, who will accept that currency in exchange for any service or real good? At that point such a government really does become insolvent.
The Runaway Fiscal Trajectory
The US and other advanced nations seem unlikely to take significant steps to bring their houses into fiscal order until catastrophe is staring them in the face, and by that time it will be too late. It may already be too late. Even holding social entitlements (such as Social Security and Medicare) at current levels (as a percent of GDP) may be insufficient, according to a study by the Bank of International Settlements.
Both monetary and fiscal policy now appear to be impotent, and there is an increasing risk that government policies may be unable to avoid financial collapse. As Charles Hughes Smith recently wrote in “Beyond the False Dawn: Global Crisis 2020-2022” in his blog Of Two Minds, the policy of easy money is a trap, because we cannot reverse it without catastrophe: “… the status quo is now addicted to unlimited flows of free money. If the flow continues, then inflation will destabilize it; if it's cut off, then rising interest payments will destabilize it.”
Although I mentioned inflation as a problem, this does not mean that every step forward will be inflationary. Government budget cuts, recession, and falling real income are among the strong deflationary forces that lie in our future at some point. Different steps on the down stairway will bring different conditions, whether inflationary and deflationary, whether in the price sense or the monetary sense. The overall direction is toward economic decline and monetary devaluation, however.
Despite political rhetoric, US fiscal policy is still on a runaway trajectory. Recently The Economist reported in its Daily Chart feature, "I O USA" that neither the Republicans or the Democrats are serious about the deficit:
Stumbling Down the Stairs
At some point people will not accept dollars without a suitable discount, or else they will not accept them at all. I agree with those who argue that the dollar is already unstable and that the present conditions supporting the dollar are unlikely to continue forever. As Jesse stated: “the question is when markets will start putting pressure on governments, not if.”
Apparently, people are catching on to this idea. Mohammed El Erian recently commented ominously about the failure of the dollar to rise in reaction to the crisis in Egypt, Libya, Bahrain, and other countries in the Middle East (my emphasis):
It does not matter whether the US dollar is or is not the world's reserve currency, as long as the world has confidence in the dollar. Losing the dollar's status as the reserve currency does matter, however, because it signals that the world has recognized lost confidence in the US. It signals that our underlying problems of debt and lack of competitiveness have become unmanageable.
As recognition of the fiscal and economic problems of the US become widely accepted, there will be little to restrain the fall of our currency. The debt has been accumulated, the industrial system has been eroded, and government policies are not being meaningfully directed to remedy the fundamental problems underlying the crisis. This mantra quoted from Jesse’s Crossroads Café is an insightful comment on the need for new solutions:
Several times I’ve said in this blog that I don’t expect the imminent collapse of the dollar. This isn’t because I’m blind to the dollar’s fatal flaws, but because of the time required for the unfolding of this nation’s budgetary and economic problems, and because the dollar is only one of a number of troubled currencies of declining developed nations.
But I don’t want to give the impression that the dollar is safe. We know that the dollar is on an unsustainable trajectory, and its decline seems inevitable. It’s just that the path isn’t necessarily straight down, and the timing of the dollar’s decline is highly uncertain.
The Dollar Cascade
There is no doubt that the direction is down. Even Chairman Bernanke has said that the US needs to reduce debt, and that the process of deleveraging will involve high rates of bankruptcy and unemployment. In such a spare environment, low rates of economic growth will force governments and individual citizens to adjust their expectations and economic activities downward. Because governments and citizens do not willingly adjust their expectations to reduced circumstances, we cannot expect the process to be a smooth one.
Until the financial crisis hit, the risk of financial collapse because of rising levels of private and public debt was met with official denial. When collapse became imminent, the official response was a bailout of key financial players, a policy of rock-bottom interest rates, and quantitative easing – all temporary measures that left the underlying issues untouched. Private debt was partially transformed into public debt, but the debt remained. The system was stabilized temporarily, but this was only the first step in a multi-year process of deleveraging and economic adjustment.
For these reasons, I see the continuing decline of the dollar as a sequence of stair steps. After falling down a step, the US finds ways to arrest its decline partially and sustain itself at a lower level for a few years. Eventually, the pressure on the US (declining economic competitiveness, value of the dollar, political influence) builds up to a point that resistance gives way and we fall down another step. Over a period of decades, some of the steps may be small and others large and catastrophic. However long we may loiter on any single step, the direction is down.
Printing Money Is Not the Answer, It Is a Symptom
There is a school of thought, based on Modern Monetary Theory, that the US cannot become insolvent. The thesis is that the Fed is not monetizing the debt, and a truly sovereign currency can not be debased into hyperinflation. This position posits that the government does not print money, but rather pushes buttons to create amounts in bank accounts or remove amounts from bank accounts. The blog Pragmatic Capitalism has published a number of articles supporting this position, which might be summarized as: “a sovereign government with monopoly supply of currency in a floating exchange rate system has no solvency issue.”
In my opinion the main problem with discussions of this point of view is that they discuss the wrong problem. The real issues are this country's ballooning federal debt and its persistent negative balance of payments. Those are the main forces driving this country to penury, not monetary policy.
Easy monetary policy, however, exacerbates the problem because it distorts market prices, resulting is the allocation of resources into speculation rather than productive activities. Nevertheless, I was still interested to read a critique of modern monetary theory in a recent series of articles in another blog that I enjoy, Jesse’s Crossroads Café (Jesse Part 1, Jesse Part 2, Jesse Part 3). To quote Jesse, the critique might be summarized as “I can print money, therefore I can never go broke.”
A government with a monopoly supply of currency may remain solvent in the limited sense that it can pay its debts in its own currency, but that is such a myopic issue as to be meaningless. What is that currency worth in real terms? Not much, if that government’s debts expand without limit. If debt grows uncontrollably, no sovereign government can escape the consequences.
Theoretical solvency is a false issue if your currency declines against all others, and if everyone understands that the trend is going to continue indefinitely.
If debt grows uncontrollably, relative to the size of an economy, citizens and creditors will notice. What exchange rates will foreign trading partners demand, what interest rates will foreign creditors demand, and what rate of price inflation will domestic consumers experience? As Jesse put it: “The limit of the Fed's and Treasury's ability to create money is the value and acceptance of the dollar and the bond in market transactions.”
And at some point, after exchange rates, interest rates, and price inflation have escalated to the point that the people are mostly in penury, who will accept that currency in exchange for any service or real good? At that point such a government really does become insolvent.
The Runaway Fiscal Trajectory
The US and other advanced nations seem unlikely to take significant steps to bring their houses into fiscal order until catastrophe is staring them in the face, and by that time it will be too late. It may already be too late. Even holding social entitlements (such as Social Security and Medicare) at current levels (as a percent of GDP) may be insufficient, according to a study by the Bank of International Settlements.
Both monetary and fiscal policy now appear to be impotent, and there is an increasing risk that government policies may be unable to avoid financial collapse. As Charles Hughes Smith recently wrote in “Beyond the False Dawn: Global Crisis 2020-2022” in his blog Of Two Minds, the policy of easy money is a trap, because we cannot reverse it without catastrophe: “… the status quo is now addicted to unlimited flows of free money. If the flow continues, then inflation will destabilize it; if it's cut off, then rising interest payments will destabilize it.”
Although I mentioned inflation as a problem, this does not mean that every step forward will be inflationary. Government budget cuts, recession, and falling real income are among the strong deflationary forces that lie in our future at some point. Different steps on the down stairway will bring different conditions, whether inflationary and deflationary, whether in the price sense or the monetary sense. The overall direction is toward economic decline and monetary devaluation, however.
Despite political rhetoric, US fiscal policy is still on a runaway trajectory. Recently The Economist reported in its Daily Chart feature, "I O USA" that neither the Republicans or the Democrats are serious about the deficit:
“Both sides talk about cutting the deficit but are unwilling to risk losing voters by trimming the big budget items: pensions, Medicare, Medicaid and defence. Republicans, who were initially pushed to talk tough on cutting spending by the Tea Partiers, have backed away from what plans they had to take on entitlements since gaining control of the House.”
Stumbling Down the Stairs
At some point people will not accept dollars without a suitable discount, or else they will not accept them at all. I agree with those who argue that the dollar is already unstable and that the present conditions supporting the dollar are unlikely to continue forever. As Jesse stated: “the question is when markets will start putting pressure on governments, not if.”
Apparently, people are catching on to this idea. Mohammed El Erian recently commented ominously about the failure of the dollar to rise in reaction to the crisis in Egypt, Libya, Bahrain, and other countries in the Middle East (my emphasis):
"It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S., worrying about the level of debt and what they're hearing about states and municipalities. I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past."
It does not matter whether the US dollar is or is not the world's reserve currency, as long as the world has confidence in the dollar. Losing the dollar's status as the reserve currency does matter, however, because it signals that the world has recognized lost confidence in the US. It signals that our underlying problems of debt and lack of competitiveness have become unmanageable.
As recognition of the fiscal and economic problems of the US become widely accepted, there will be little to restrain the fall of our currency. The debt has been accumulated, the industrial system has been eroded, and government policies are not being meaningfully directed to remedy the fundamental problems underlying the crisis. This mantra quoted from Jesse’s Crossroads Café is an insightful comment on the need for new solutions:
“Both austerity and stimulus will falter in the mire of imbalanced, broken systems and corruption. The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery.”
Sunday, January 23, 2011
The Old Always
The thing that hath been, it is that which shall be; and that which is done is that which shall be done; and there is no new thing under the sun.
Ecclesiastes 1:9
Last month, James Montier of GMO wrote a piece, In Defense of the “Old Always", questioning the concept of the "new normal" and what it means for the way we invest these days. Perhaps not surprisingly for a value investor, his conclusion was that there is nothing new under the sun and that "old always" value investing principles still apply. I especially liked his observation that the value investing concept of mean reversion still applies, contrary to what some "new normal" proponents have proposed.
What Is the "New Normal"?
Discussing the "new normal" is complicated by the variety of meanings that different writers have attached to the term. Perhaps the most common interpretation is that the "new normal" refers to the current period of low economic growth in the developed world and the likelihood that this period will continue for years. This interpretation makes a lot of sense, because low growth seems likely to be with us for years, thanks to the unsustainably high levels of debt in the private and public spheres. Indeed, the growing convergence of the developed and developing worlds makes it unlikely that the "old normal" economic proposition will return.
Is the "New Normal" in Investing Returns?
To other observers the "new normal" refers to a shift in investing returns from a distribution with thin tails and more likely outcomes close to the middle to a more uniform distribution with fat tails, or more frequent extreme outcomes. Bill Gross of PIMCO offered this interpretation in one of his monthly commentaries last year.
I find this "fat tail" interpretation very hard to give credibility to, because the world has experienced high variance outcomes in the financial markets historically and with a frequency that is much higher than has generally been appreciated. Bubbles, bankruptcies, and the ruin of old regimes have been fairly frequent companions of financial markets for centuries. With samples taken over long enough periods of time or across enough kinds of markets, financial returns have always looked non-normal with fat tails.
Is the "New Normal" in Mean Reversion?
Another PIMCO manager, Richard Clarida, went even further and attacked the very basis of value investing, which is that one buys when a thing is cheap and sells when it is dear. Clarida wrote, “Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.”
Come on now, who could really believe that mean reversion is dead? Not only does this statement ignore the historical fact that extreme outcomes are not that rare, but it also makes the logical mistake of saying that high variance is inconsistent with the mean reversion. When markets go to extremes, they eventually revert to the mean and beyond, and patient value investors will profit if they wait for the bubble to burst. This increases the chances for profit when reversion occurs.
Mean Reversion Is Alive and Well
I have to agree with Montier when he says "the concept of the new normal confuses the distribution of economic outcomes (and forecasts thereof) with the distribution of asset markets ... From the perspective of mean reversion, fat tails help to create some of the best opportunities." Montier's letter also included a chart that illustrates his point very graphically.
History is littered with the remains of proclaimed, but unfulfilled, new eras. Exhibit 6 shows the long-run history for the Graham and Dodd P/E for the U.S. market. Over this time, we have witnessed some quite remarkable, and quite appalling, things – the deaths of empires, the births of nations, waves of globalization, periods of deregulation, periods of re-regulation, World Wars, revolutions, plagues, and huge technological and medical advances – and yet one thing has remained true throughout history: none of these events mattered from the perspective of value!
No One Says That It Is Going to Be Easy
None of this means that it is EASY to apply value principles to mean reversion. No one can predict the future, which means that no one knows when the top or the bottom will occur. You have to understand the investing world, and you need to apply valuation metrics, but is this possible today? Zero Hedge suggested that the metrics have changed:
Yet in a universe in which true asset fair value can no longer be derived, and all valuations are wrapped in the enigma of trillions of monetary and fiscal stimuli, whose stripping is virtually impossible in a world in which everything is centrally planned, we just may have entered... the non-"old always" zone.
I agree that it isn't easy to apply familiar valuation metrics when the Fed has flooded the market with liquidity, but I don't think that it is impossible. You just have to adjust your metrics so that they reflect the determining forces at work in a debt-laden world. If the government assumes private debt to attain financial stability, you need to attend to the political risks as well as the industry fundamentals. But mainly you need patience. I'll let Montier answer in his own words.
It is also worth noting that in order for mean-reversion-based strategies to work, it is not required that the mean be realized for long periods of time, but that markets continue to behave as they always have, swinging pendulumlike between the depths of despair and irrational exuberance, or, from risk-on to risk-off. As long as markets display such bipolar disorder and switch from periods of mania to periods of depression, then mean reversion should continue to merit worth as an investment strategy.
Friday, December 10, 2010
Unstable Equilibrium
Woodblock print by Utagawa Hiroshige
Freeze and Thaw
An increasing number of analysts are forecasting better time ahead for the economy and the stock market. Elaine Garzarelli daid on CNBC that there will be better economic growth and stock market performance next year as a result of the money put into action by QE II. PIMCO's Mohammed El-Erian also raised his US growth forecast for 2011, to between 3.0 and 3.5 percent from an earlier estimate of 2.0 to 2.5 percent, based on the prospect that Bush-era tax cuts will be extended for another two years. However, he added that further stimulus would be needed to sustain growth.
To be sure, not all of the optimism is US-centered or long-term. Byron Wien just came out with a warning that investors need to be invested in emerging markets, and he recommended a portfolio allocation that emphasizes emerging markets, high yield bonds, and hedge funds. Bill Gross just advised fixed-income investors to look to emerging markets like Brazil where they can earn an attractive real interest rate, rather than the pittance offered in the US.
Also, many structural factors are against the US in the longer term. Gross added: “The U.S. is being out-trained, out-educated and out- maneuvered in the global competition for employment.” About his forecast of higher US economic growth, El-Erian wrote: "Maintaining such a growth rate beyond 2011 requires additional measures to enhance competitiveness and achieve medium-term fiscal consolidation."
Risk Probabilities Remain Tilted Toward Recession and Deflation
Despite recent talk in the press about signs of an improving economy, a look at a broader range of evidence shows persistent and underlying economic weakness. Combined with underlying conditions, including high levels of debt in both the private and public sectors, the economic and financial evidence suggests that the way out of this country's troubles will be a long slog and fraught with risks.
Fed Chairman Bernanke said last Sunday that the economy is barely expanding at a sustainable pace and that it’s possible the Fed may expand bond purchases beyond the $600 billion announced last month to spur growth. “We’re not very far from the level where the economy is not self-sustaining,” Bernanke said in an interview broadcast yesterday by CBS Corp.’s “60 Minutes” program. “It’s very close to the border. It takes about 2.5 percent growth just to keep unemployment stable and that’s about what we’re getting.”
Indeed, this country is not alone in its troubles. Around the developed world, financial systems burdened by high levels of debt and stagnant economies are highly dependent on government policies for their maintenance. Certainly, the economies and financial systems of the US, EU, and Japan are supported only by extraordinary monetary policy, and errors in these countries' policies could have negative repercussions that would reverberate around the world. As Hugh Hendry says in his December 2010 Eclectica Fund commentary, "This is an environment rich in policy error contingencies."
Hendry also made the very practical point that serious dislocations can also present serious investment opportunities. In the spirit that our wealth is only as safe as our ability to prepare for an uncertain future, I'd like to review recent commentaries about these risks and uncertainties.
Is Santa Coming to Your House?
In case anyone thinks that the economy and financial system actually are making progress, he or she need look no farther than recent news headlines. As an example, consider the headlines from the news stories reprinted in The Automatic Earth blog, last Saturday, December 4, 2010:
Senate Republicans Defeat Reauthorization Of Jobless Aid, Tax Cuts
4 Million Americans Set To Lose Unemployment Benefits Even If Congress Passes Extension
Here Are The The AWFUL Details Behind Today's Big Jobs Report Miss
Value Sinking Fastest on Homes Priced Low to Start
Homes Prices are Plunging: Let's Talk About the Deficit
Distressed Homes in U.S. Sell at Biggest Discount in Five Years
The con of the century – Federal Reserve made $9 trillion in short-term loans to only 18 financial institutions. Since 2000 the US dollar has fallen by 33 percent. The hidden cost of the bailouts.
ECB bows to German veto on mass bond purchases
Angela Merkel warned that Germany could abandon the euro
The details within these stories are no better than the headlines. For example, consider the imbalance between good and bad news in this list of employment facts from the above-mentioned jobs report article:
1. First, the headline: Nonfarm payrolls barely move upward.
2. And the unemployment rate is now creeping up again.
3. Those unemployed for more than 15 weeks is now near 2010 highs.
4. And those unemployed for more than 27 weeks is moving higher.
5. The civilian employment ratio is back at the post recession low.
6. Civilian employment numbers have given up the past few months' gains.
7. The civilian participation rate is now at a new low.
8. Weekly hours have slipped as well.
9. Now, a look at the industries hardest hit: Manufacturing employment in non durable goods now below 2010 lows.
10. And durable goods manufacturing jobs don't look too much better.
11. Government jobs have dipped again, although only slightly.
12. Construction jobs remain low, and flat.
13. BRIGHT SIGN: Total private industry jobs are still moving higher.
He's Making a List
Maybe we can muddle through with a weak economy, or maybe not. For my part, I'm worried about all the risks we fact before (if ever) we get out of the woods. Pragmatic Capitalism made this point forcefully: "I still believe we are mired in a balance sheet recession that will result in below trend growth, deflationary risks and leaves us extremely vulnerable to exogenous risks that could exacerbate the current malaise."
If the current stagnant situation is being propped up only with extraordinary monetary policy, then surely the situation is actually quite fragile. A world delicately balanced between debt disaster and policy overreach must surely be fraught with numerous, serious risks. Niels Jensen, Managing Partner of Absolute Return Partners LLP listed 12 risk factors for the attention of readers of his latest Absolute Return Letter. Here are the risk factors, each accompanied by my own short exegesis:
High yield priced for perfection? Are spreads getting so tight that one could even talk of a bubble, and could that bubble burst, should the US (and/or European) economy fall back into recession?
The risk of double dipping. Just consider the economic news that I listed earlier.
The sinking ship of Japan. This refers to the high and growing level of government debt, the funding of which is endangered by an old and aging population.
Beggar thy neighbor mentality. Just consider administration talk of devaluing the dollar to increase exports (as if anyone needed our products), complaints from various emerging countries about manipulated interest rates in the US, and China's policy with the Renminbi.
Capital flows too hot to handle. We read every day about the risks of overheating in China and other emerging economies. Capital controls would damage both overseas investors and internal growth. Not imposing controls would risk high inflation and runaway bubbles in commodities and other assets.
Chinese inflation out of control? Although the leadership has said that it is considering price controls on food, lax monetary policy is pushing up prices of a variety of goods and assets.
Food inflation induced civil unrest. Based on the last food price peak in 2008, it may not be too much to expect civil unrest across Asia if food prices continue to climb.
Is India an accident waiting to happen? Although India is financing its external deficit with ease at present, due to the positive capital flows into emerging markets, tighter overseas monetary policies or a change in investor risk perceptions could endanger those flows.
European contagion and solvency risk. Current efforts to avert a crisis are just kicking the can down the road. Banks are in trouble, and the underlying solvency problems are not being solved by adjustments in liquidity.
Massive refinancing program. "This programme poses the biggest risk to my benign outlook for bond yields ...", because of the huge financing needs that are approaching, according to Jensen. Zero Hedge ventured that the problem is even bigger: "Simply put, it's not just fiscally-challenged nations in the eurozone that are suddenly being forced to address the threat posed by too much borrowing. Over the next 12 months, countries across the world, including the United States, will be looking to roll over approximately $10 trillion worth of debt."
Premature withdrawal of monetary support. Not only are the indebted peripheral nations of Europe dependent on continuous support, but the US economy is in danger if Congress follows through on Republican promises to rein in the Federal budget, seemingly without any consideration of the consequences.
Israel launching a pre-emptive strike on Iran’s nuclear facilities. The world is full of political-military risks, and this is just one risk that happens to be a current focus of attention.
I don't know if these are exactly the risks that I would focus on, but they serve to convey the general notion that the present unstable equilibrium could easily be disturbed and send the system sliding off into a new trough of worse conditions.
He's Checking It Twice
Naturally, David Rosenberg has taken his turn listing risks to economic recovery, and out of his list, I think that these two pose particular domestic threats next year:
Massive tightening in U.S. fiscal policy coming via spending cuts and tax hikes. This is the part of the macro forecast that is not given enough attention.
Many goodies will expire at the end of the year and question marks linger over whether they will be extended. These range from the Build America Bond program that subsidized municipal issuance, the Bush-era tax cuts, the extended/emergency jobless benefits, and the little-known Obama tax benefit called the Making Work Pay Credit.
Pragmatic Capitalism reviewed Rosenberg's list and added another domestic risk : "The one major risk that Rosenberg and the market is largely overlooking at this juncture is the housing double dip. This has the potential to be THE most important story of 2011. As I've previously explained, declining asset values are highly destructive during a balance sheet recession."
Tighter fiscal policy will do no good for the economy, and it also brings into question how much money the states might receive from the Federal government should states continue down their present road to budgetary crisis. In "Mounting Debts by States Stoke Fears of Crisis" The New York Times noted just a few examples of how bad the situation has become:
"The State of Illinois is still paying off billions in bills that it got from schools and social service providers last year. Arizona recently stopped paying for certain organ transplants for people in its Medicaid program. States are releasing prisoners early, more to cut expenses than to reward good behavior. And in Newark, the city laid off 13 percent of its police officers last week."
Given continued problems with the national economy, many states could be overwhelmed by debt in a few years, if they are not already at the brink of the precipice. Worries about Federal willingness to aid the states may not be mere fear mongering. The Times added: "Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country."
Felix Rohatyn, the financier who helped save New York City from budget problems in the 1980s warned that while municipal bankruptcies were rare, they appeared increasingly possible. Mr. Rohatyn added that the imbalances are so large in some places that the federal government will probably have to step in at some point, even if that seems unlikely in the current political climate.
In noting the likelihood of legislative deadlock in 2011, David Rosenberg wrote:
Folks, we are on life support. We have been since 2008. Nothing will change in 2011. QE has been extended, the tax cuts will be extended, BABs and the Agency loan limits are being extended. The IV is full and inserted into the arm. The juice that is keeping us alive is still flowing. But make no mistake about this. Without the IV the lights will go out very quickly. 2011 is the last year for these extensions. When we wake up to the fact that we are alive only as a result of medicine we take on a daily basis there is going to be another “event”.
In the current political climate, we have to wonder what kind of price the Republicans might try to exact in exchange for eventual bailouts of the states. Breaking public employee unions would surely please the Republicans, but they might have to provoke a state bankruptcy crisis in order to get their way. Financial systems don't like crises, unfortunately.
In Wednesday’s NYT, David Leonhardt commented: “Mr. Obama effectively traded tax cuts for the affluent, which Republicans were demanding, for a second stimulus bill that seemed improbable a few weeks ago.” It seems likely that any resulting stimulus will be too little to make a difference.
It is to be hoped that the recent extension of tax breaks for the wealthy will prompt those who are often referred to as the "job creators" to get with it and start hiring. Given that the demand for goods from the masses is lacking, there is little reason for more hiring, but we can all hope. At least there are some modest increases in prospective hiring surveys for the first quarter of next year.
The Neighbors Have Been Naughty Too
David Rosenberg has a good way with words, so I'll let him express the nature of the risks with Europe:
"All these “rescue” packages in euroland really do is provide bridge financing — they do not resolve the underlying structural problems in these countries or the deflating asset values in bank balance sheets."
"The massive selloff in government bond markets, even in countries like Belgium and Italy (let alone Portugal and Spain), is a clear sign that the bond vigilantes are now targeting the supposedly stronger governments in the eurozone. These bond vigilantes are also speculating that the national purse will be needed to keep their banks afloat and the relentless widening in CDS spreads is an added suggestion from the markets that these governments may not have the resources to fully repay their creditors once they have moved to support their banking systems."
The Washington Post commented last Tuesday that bond markets are not the only worry with Europe: "A greater danger is that a full-blown debt crisis in Europe could put new pressure on the region's banks, tightening credit and potentially slowing growth in one of the world's largest economic engines. It could also send the euro plunging against the dollar, making the greenback stronger on world markets and undermining the efforts of the Obama administration to boost U.S. exports overseas."
In a guest editorial in Naked Capitalism, the author of Washington's Blog wrote: "...... by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default."
Nouriel Roubini put it this way, “So at some point you need restructuring. At some point you need the creditors of the banks to take a hit —otherwise you put all this debt on the balance sheet of government. And then you break the back of government—and then government is insolvent.” There remains the question of what kind of restructurings will take place, but Europe seems to be kicking the can down the road at present. The transfer of risks onto government balance sheets is already being reflected in the widening of sovereign credit default swaps.
Should there be a systemic breakdown in Europe, it could bring a banking crisis of the same kind that we saw in 2008. Banks in the US, Europe, and elsewhere could face sudden lack of liquidity if European banks take a hit. Investors on the whole are probably not prepared for such an event.
The Bond Vigilantes May Beat Santa to Town
CNBC reported Wednesday that Nouriel Roubini voiced concern over the compromise on extending tax cuts between President Obama and Republican Congressional leaders. Roubini said that the agreement could expose the US to bond vigilantes who will drive up bond yields. The Fed has kept short-term rates as rock-bottom levels to support the fragile economy, and an increase in bond yields could damage any chance of a recovery
Roubini said on Twitter: “Obama-GOP tax deal costs $900 billion over two years. US kicking the can further down the road. Are bond vigilantes starting to wake up?” Bond prices have fallen from the highs of a few weeks ago when speculators were anticipating the Fed's purchases under QE II, and renewed worries about US government debt levels could send Treasury prices even lower.
Worries about the debt positions of other advanced economies, which seem to be in even worse condition, might be a mitigating condition preventing any abrupt break in US bond prices. Nevertheless, given the seeming intractability of the debt problem, it would not be surprising to see recurring periods of worry about US debt levels over the next few years, accompanied by occasional declines in bond prices.
Progress on reducing the national debt will require both steady tax revenues and reduced budget expenditures. The weak economy will make progress on both fronts very difficult, since it will increase demands for fiscal and monetary intervention. As Jesse's Crossroads Cafe put it, "For a nation that is a net debtor, deflation is tantamount to suicide."
Despite criticisms of its monetary policies, the Fed seems unlikely to allow deflationary suicide anytime soon. In his CBS interview, Federal Reserve Chairman Ben Bernanke did not rule out buying more than $600 billion of bonds in further quantitative easing. Once the idea of an imminent QE III gets into the consciousness of Wall Street, we should not be surprised to see even more money piling into commodities, emerging markets, and other "risk" assets. Perhaps this time the weakness of Europe will help to support the dollar ... perhaps. A weaker dollar would help exporting industries in the US, if the Fed could engineer it.
According to the New York Times, financial markets have interpreted the tax cut deal, which was announced this week between the administration and Congress, as contributing to economic growth over the next couple of years but also increasing the federal deficit and raising borrowing costs. Higher borrowing costs would not help in funding extant debts, and the elephantine issue of reducing the federal debt is being pushed off to the future. Whatever happens on the fiscal side, the monetary side of policy seems likely to keep levitating financial asset prices. When that levitation will end it hard to tell, but at some point the bond vigilantes will likely have their say.
An increasing number of analysts is saying that it makes no sense for the Fed to keep monetary conditions so loose when the economy is enjoying growth in excess of 2 percent. They may have a point, because the bond market has responded to better growth prospects, and bond prices have declined recently. Given all of the risks that we have enumerated in this article, we have to wonder if that growth spurt will be short-lived.
Afterword
Pundits who make point predictions about the economy and the markets are absolutely foolish, because any alert observer will admit that the future is a swirling sea of variables. No one knows what is going to happen. On the other hand, we all need to protect our assets and prepare for the future. To do that, we need to consider a range of alternative futures and form judgments about their relative plausibilities. You can tell in which direction I think the probabilities are pointing.
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