Yellen Can't Change Fed Policy

First the good news: Yellen is a monetarist, a dove and an activist. She believes that monetary policy plays an important role in achieving good economic growth, and that the Fed should respect its employment mandate . She is more dovish than Bernanke, and more forceful. She is, in my view, an improvement over Bernanke who placed too much emphasis on consensus.

Now for the bad news: Like Bernanke, Yellen will be faced with the hawkish faction which is likely to tie her hands and prevent her from doing what she believes is right. Were Yellen to advocate more radical policies, such as price-level targeting or nominal growth targeting, she would invite discord and vocal dissent. She would injure the Fed’s “institutional credibility”, and invite Congressional interference, which is anathema.

So here is the bottom line: Yellen will fail as Bernanke has failed. Only radical policies can move the dial on money growth, and radical policies are precluded by the hawks. Indeed, the hawks want to return to orthodoxy as soon as possible. She will have her hands full fighting against this tendency.

Thus, the outlook for the US economy is grim: low money growth, low inflation, low growth, high unemployment, weak fiscal revenue and an ever-growing output gap. That suggests that the bond market should not react to her appointment: she can’t raise the inflation rate any more than Bernanke could.

Forget The Debt Ceiling: Stock Prices Are Very Low

Thesis: Don’t sell, but be prepared to buy aggressively if prices go any lower.

Q: Given the risk of a Treasury default, should the prudent investor sell now and repurchase when it’s all over?

A: I say don’t sell, but be ready to buy if there is a big selloff.

The Dow is down 800 points since mid-September, and is now selling for the same price as in May. The forward earnings yield on the S&P 500 is 6.4% and the current dividend yield is 2.1%.

This compares with a Treasury yield curve of:

1-year: 0.10%

5-year: 1.4%

10-year: 2.6%

20-year: 3.4%

30-year: 3.7%

Aswath Damodaran* at NYU estimates the Equity Risk Premium as of Oct. 1st at 5.73%, which is as high as it’s been since the Carter years. However, if you look at his calculation of the ratio of the ERP to the risk-free rate, now ~3.2x, it is the highest it has ever been, and six times its historical average of 0.5x.

Clearly stocks are deep in value territory by these yardsticks. It is true that Treasury yields could rise, but it almost certain that the earnings yield will rise by more, since corporate earnings continue to grow, and companies continue to reduce their float. 

We are looking today at an historic buying opportunity, similar to the inflationary period of 1977 to 1983, when the Dow was bouncing around 900. If nothing else were to happen except that the ERP/risk-free rate were to normalize at .5x, the Dow today would be ten times its current level. That is the scale of today’s opportunity, at least according to me.

Given that both sides on the Hill appear to be digging in, there is a chance that the risk of a Treasury default could produce a major selloff, which would make equity valuation all the more compelling. Similarly, there is also the risk of a last-minute deal that could produce a rally. My thinking is that one should hold back just a little longer before taking a plunge, but not too long. I assign a very low probability to a default, so my inclination is to start bargain-hunting soon, before it’s too late.

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*http://pages.stern.nyu.edu/~adamodar/

The Debt Ceiling Is Not Lehman

“A default would be unprecedented and has the potential to be catastrophic: credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse.”

--US Treasury, Oct. 2nd, 2013

Yesterday, the Treasury published a paper, “Macroeconomic Effects Of Debt Ceiling Brinkmanship” which lays out the consequences of a government default.  Here are the paper’s assertions:

1. Credit markets could freeze;

2. The dollar could plummet;

3. Interest rates could skyrocket;

4. There could be a financial crisis similar to 2008.

I understand the Treasury’s motivation in publishing this paper. It is the Treasury’s job to protect the credit of the US, and to maintain the Treasury as the gold standard of global credit risk. If I were Secretary of the Treasury, I would publish a paper exactly like this. There is absolutely no reason to run such a dangerous experiment to see if it is survivable. The Republican party is not, or should not be, a bunch of drunken rednecks lighting a match and saying “Watch this!”. Only a reckless fool would allow the US to default, and I trust that Speaker Boehner is not a reckless fool like Ted Cruz and his ilk.

However, as investors we must prepare for any eventuality, including a government default. In yesterday’s post I addressed the first three risk factors above, and concluded that the credit markets would stay open, the dollar would not plummet, and interest rates would not skyrocket.

Today I will address Point Four: the risk of another financial crisis like 2008. That assertion is just preposterous. It could only be suggested by someone who has already forgotten what happened in 2008. Permit me to refresh Jacob Lew’s memory about 2008.

This is what happened then:

1. Overnight, $2 trillion of subprime mortgage-related securities went from being zero risk to being toxic, opaque and of unknowable value.

2. No one knew who was exposed to what securities in what amount.

3. The FASB, at that very moment, chose to change the accounting treatment for such securities from mark-to-model to mark-to-market, just as the market disappeared.

4. In the midst of a crisis in which no counterparty could be sure of another, the Treasury allowed a $700 billion financial institution to go bankrupt, which completely blindsided the markets.

5. The credit markets froze solid because (a) no one knew who was solvent; (b) no one knew who was or wasn’t TBTF; and ( c ) credit committees decided that, given the level of uncertainty, they would only take good names irrespective of the quality of collateral offered by the “question mark” names such as Goldman and Morgan Stanley.

Hence the crisis and hence the bailout.

This scenario is not remotely analogous to a debt ceiling problem:

1. No large asset class will go from being riskless to being risky. This is not a credit event.

2. No one will care who is exposed to defaulted Treasuries because they will be worth 100 cents on the dollar. No one will be rendered insolvent (except maybe some naked ultra-shorts).

3. Treasuries are already carried at market, so the accounting won’t change.

4. No systemically-significant financial institution will fail because of a government default.

5. Counterparty credit lines will remain open because nothing material will have happened.

That’s my view. I don’t buy the Armageddon talk. I don’t see a breach of the debt ceiling as a meaningful economic event, any more than Y2K might have been. Markets can handle events when there is adequate certainty about the implications for all participants. A government debt default would be survivable, like a dirty bomb or another 9/11.

I can’t bring myself to believe that anyone could be so stupid as to run this experiment as a form of political theater. But then again, it never occurred to me that Paulson-Geithner-Bernanke would let Lehman go either. So we must force ourselves to think through such an eventuality. I am staying overweight in US equities.

Investment Implications Of A Government Default

Should you google “debt ceiling default” or its variants, you will discover a substantial literature on the subject. Four sources are particularly interesting.* These publications are quite alarming:

RBC:
“Let us be perfectly clear: crossing the debt ceiling would be catastrophic.”

NY Magazine: 
“Economists and policy experts agree that reaching the X Date

could be the start of financial Armageddon...We don't really know what happens if Treasury bonds default, since it's never happened. What we do know is that it would destroy the market as we know it.”

US Treasury:

"A default would be unprecedented and has the potential to be catastrophic: credit markets could freeze,the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse."

Among the risks cited are:

1. A flight from Treasuries

The thinking here is that, once Treasuries lose their “risk free status”, portfolio adjustments will inevitably ensue. Many investors are not permitted to hold defaulted securities, but cannot discriminate between the defaulted and the undefaulted securities of the same issuer.

2. Disruption of the money market

The Fedwire will not accept defaulted securities, and cannot discriminate between defaulted and nondefaulted securities of the same issuer. Thus, it is conceivable that the Fedwire will not be able to accept any Treasury securities.

3. Disruption at the discount window

Here again, the Fed cannot accept defaulted collateral, but is unable to discriminate between defaulted and undefaulted securities of the same issuer.

4. Loss of reserve currency status

The global perception of the Treasury as a risk free security would be jeopardized by a default, leading to a move out of dollar assets.

5. Ratings downgrades

Rating agencies will react adversely to a default, as they have already cited it as a risk factor.

Let me address these risks in turn:

1. Flight from Treasuries

This is far-fetched. Treasury prices are rising. There is no change in the creditworthiness of the United States. Insofar as anyone is forced to sell, there will be plenty of investors who would be happy to buy Treasuries at a discount. The Treasury market is infinitely efficient.

2. Market disruption

This strikes me as quite likely, given the reasons cited above. A Treasury default would necessitate some extraordinary actions on the part of both the Fed and portfolio managers (and perhaps their clients), which I think would be readily accepted by the market. The simplest fix would be to ignore the defaulted status of Treasuries altogether, since they remain risk-free even in default (aside from the timeliness issue).

3. Loss of reserve currency status

This is a long shot. The factors supporting the dollar as a reserve currency and the Treasuries as reserve assets are unaffected by this event, and the factors weighing against JGBs and Bunds remain.

4. Rating downgrades

Reading the tea leaves, I doubt it. S&P has already downgraded the US to AA+ in part because of this risk. Moody’s did not downgrade the US, and recently changed the rating outlook from negative to stable, citing the declining deficit. I think that S&P would feel that its downgrade was justified by the default, and that Moody’s would not reverse itself because of an event unrelated to underlying creditworthiness. There is no doubt in my mind that a post-default US would remain a AAA credit in both a cardinal and ordinal sense, and that the market’s opinion of the US as a credit would not change either. A technical default is not a credit event. (If a gold mine shuts down for a week, it is still a gold mine.)

With respect to the stock market, I would expect a selloff of a few hundred Dow points in the event of a default. I would view such a selloff as irrational and an opportunity to buy stocks at a discount. I am overweight equities, and I intend to remain so. If there is a default-induced dip, I plan to buy into it.

The best modern analogues are Y2K and 9/11. Y2K was an anticipated financial disaster that didn’t happen. Had it happened, it would have been an example of a noneconomic event with financial implications. Similarly, the U.S. capital market shut down on 9/11, due to mechanical disruption in the Financial District. Bond and stock trading ceased while Wall Street struggled to restore power and communications. The market didn’t do well after it reopened, but I think that was due to the breaking Enron story, which shook the credit markets to a much greater extent than 9/11. 9/11 was a black swan that could be absorbed, whereas Enron was a black swan that shattered market confidence.

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*1. “Here are Some of the Apocalyptic Things That Could Happen If the Debt Ceiling is Breached”, NY Magazine:

http://nymag.com/daily/intelligencer/2013/09/what-happens-if-the-debt-ceiling-is-breached.html

2. “DC: Dysfunction Circus”, RBC Capital Markets via the FT: http://discussions.ft.com/longroom/tables/equity-strategy/rbc-capital-on-the-debt-ceiling-implications?posted=true

3. “Debt Ceiling Analysis” by the Bipartisan Policy Center:

http://bipartisanpolicy.org/sites/default/files/Debt%20Limit%20Analysis%20Sept%202013.pdf

4. "Macroeconomic Implications Of Debt Ceiling Brinkmanship", US Treasury:

http://www.treasury.gov/initiatives/Documents/POTENTIAL%20MACROECONOMIC%20IMPACT%20OF%20DEBT%20CEILING%20BRINKMANSHIP.pdf

Mr. Market Is Yawning

Today’s temperate, thoughtful headline at the Huffington Post reads: “Congress Plunges Nation Into Chaos”. Uh-oh, are we facing Armageddon? Well, not according to the capital markets. Here is the telemetry as of noon on D-Day:

Stocks: up nicely

Bonds: down a bit

Gold: down a lot

Silver: way down

What is Mr. Market telling us? Well, first of all he is telling us that he is a bit confused, because if metals are down (signalling deflation), then bonds should be up. Presumably there are special factors creating this anomaly. Maybe the metallic community is waking up to the fact that hyperinflation is, shall we say, very remote.

In a larger sense, Mr. Market is yawning. He isn’t upset. That’s because he is ignoring the shutdown, as I said he should. The shutdown has zero information content for the equity and bond investor. Mr. Market is rational and doesn’t read the Huffington Post.

What Mr. Market actually cares about is:

1. The economic outlook, as it translates into corporate earnings growth. (Not so good; growth is slowing.)

2. The inflation outlook, as it translates into bond yields. (Good, inflation is very low.)

We will soon get the all the data on the third quarter, which will be brimming with information content. I expect it to show more of the same: weak growth and low inflation. This is not terribly bullish, but it’s no reason to sell stocks and go to cash or bonds. That’s because stocks remain cheap to other asset classes. In other words: you are being paid to own stocks, and you are being charged for holding bonds or cash.

What would make me bearish? Another recession, which I don’t expect, but which is possible given the low level of growth and the current fiscal headwinds. My advice* for now: do nothing, or buy equities on weakness. Don’t sell.

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*Do not rely on my advice; I am not an investment adviser, I am a pundit.

Bank Bailouts Are Healthy And Necessary

As readers know, I am a Tea Party libertarian, at least up to a point. I get off the bus when it comes to monetary and financial policy. I like having a central bank, a lender of last resort, and a financial safety net. Why? Because I don't want the American people to experience another Depression.

There is strong sentiment on the Right (and the Left) to break up the big banks, and to prohibit future bank bailouts. Indeed, there is a push for a Constitutional Amendment to outlaw future financial bailouts (I haven't seen the wording). The view is that, had Paulson and Bernanke allowed Wall Street go bankrupt in October of 2008, excesses would have been squeezed out, and market discipline would have been restored. That, of course, is Mellonism.

Please note that the Great Recession was not caused by the existence of the financial safety net: it was cause by Paulson's inexplicable withdrawal of the net under Lehman. The past five years would have been quite different if the safety net did not have a Lehman-sized hole in it.

Breaking up the big banks is a stupid idea that goes in the wrong direction. Most countries have a few very large banks that are TBTF. The US is unique in that, because of prairie populism, it has thousands of small regional banks that are not TBTF, and a handful of big banks that need to be TBTF. The best run banking systems (Canada, Australia) consist of a few, well-regulated national banks that are subject to strict regulation and which are not permitted to default upon their senior debt or uninsured deposits. That is called "financial stability", which is a predicate for prosperity. (Note also that the "securities firm" is also a dangerous American invention.)

The US experimented with a fragmented banking system with no safety net for 150 years until 1934. Financial stability was not a hallmark of those 15 decades. There were decennial banking panics and decennial depressions, culminating in the Big One. Go back and read an account of the mid-1890s; it wasn't pretty unless you were rich.

Financial capitalism is prone to cycles and panics, as Hyman Minsky has shown. There is a constant repeating of the credit cycle: prosperity, overconfidence, overleverage, panic, collapse, depression, recovery. This cycle may be prophylactic in some Darwinian sense, but it creates a lot of unnecessary suffering, as well as undesirable political consequences. It cannot be legislated out of existence, and it cannot be prevented by repetition.

Market discipline doesn't work because the credit markets have a memory of at most two years. Markets do not learn. How many traders at Goldman have read Friedman's monetary history of the US? How about none. How many traders at Goldman remember LTCM? A handful at most. The Masters of the Universe tend to be about 30 years old and are lucky to remember who Bill Clinton was.

The credit market in general and the banking system in particular need to be protected from themselves. That requires three pillars:

1. High capital requirements for the systemically-significant.

2. Intrusive prudential regulation with an emphasis on risk management and risk tolerance. (London Whales should be punished.)

3. A reliable safety net, such that panics do not occur. That means no more Lehmans, not no more bailouts. It means financial stability.

Let's not relearn the lessons of the 1930s.

Investors Should Ignore The Coming "Debt Crisis"

Thesis: Investors should ignore the coming budget crisis, and leave their asset allocations unchanged.*

The capital markets are now facing the risk that without a budget, the federal government will “shut down” on Tuesday, and that without an increase in the debt ceiling, the US will default on its debt later in the month. I am in no position to handicap either event, although the odds of  shutdown are much greater than of a default.

My advice to investors is to ignore this entire operetta. Whatever economic impact it has will be brief and fleeting. A shutdown is pure theater, since it has very little economic impact. When the government shut down the last time (the winter of 1995-96), the economy kept growing, and the stock market did well. A shutdown is an economic nonevent.

The debt ceiling is a much more serious matter. If the ceiling is reached, and if the Treasury has no more expediencies (or chooses not to avail itself of more expediencies), and if the president allows a Treasury default, then there would be a temporary disruption in the credit market, causing a temporary decline in the bond and stock markets.

However, it should be emphasized that the Treasury/OMB can prioritize debt payments above other spending, and it can continue to roll maturing debt; it just can’t issue new debt above the ceiling. The monthly deficit varies widely but is now averaging $100B, versus around $300B of spending. So about ¼ to ⅓ of monthly spending would need to be postponed or offset with asset sales or other maneuvers. That could be done if the Administration chose to pursue that avenue, although it has said that it won’t.

It may be that both sides will be so dug in that neither will blink, and a default will occur. This is unlikely since Speaker Boehner has said that default is not an option, but his caucus may decide otherwise (or may depose him). A default would be a buying opportunity for both bonds and stocks because it would represent a screw-up, not a real economic problem. (Think of Y2K or 9/11.)

Insofar as a default causes a loss of market confidence that shows up in the capital markets or in the real economy, the Fed can offset the impact with words or actions. In extremis, the Fed can control the nominal economy. Once the default is cleared up, as it would be, bond and stock valuation will return to the fundamentals (which include the fact that the deficit is rapidly declining).

Note that, if the Treasury chooses to assign a low priority to the debt and does choose to default, it would only affect debt maturing during the period affected, not all federal debt. Certain securities would come due and be defaulted upon. Such securities will be “in default” in a technical sense, but are guaranteed a 100% recovery plus interest. The debt is neither excused nor extinguished. In the last ceiling scare, Moody’s put only those affected maturities under review, and indicated that a downgrade would be modest and temporary, as expected loss remained zero. Should such securities decline in value, they would represent a minor buying opportunity.

Both rating agencies have said that the recurring default risk caused by the ceiling is a credit negative. This was one of the reasons for S&P’s downgrade of the US from AAA to AA-. Moody’s has maintained its Aaa, with a stable outlook, but isn’t happy with the prospects of a default. They might react in some way to a default, but in respect of expected loss there is no reason for doing so.

The creditworthiness of the US does not hang by a thread in John Boehner’s fingers. The US is not Spain. The US, given the current trajectory of the deficit, remains a solid AAA in my opinion. I don’t see how any corporate or structured security could be rated higher than the US. The country’s debt burden is quite manageable, as evidenced by the extremely low yields on its obligations. CBO projects that federal debt to GDP will peak in a year or so, and then begin a steady decline for the rest of the decade: no fiscal crisis.

If a default occurs and is disruptive, the Fed will respond which might even spark a rally in stocks and bonds. The fundamentals will be unchanged.

The real challenge to the stock market today is the slowing economy, which may begin to appear in corporate earnings. Keep your eye on nominal growth. That’s the real threat.

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*Note that I am a blogger and not a registered investment advisor. Do not rely upon my opinions.

QE Verdict After Five Years: A Failure

It is now five years since the Lehman crash and the commencement of the Fed’s bond-buying policy known as QE. Since Lehman, the Fed has bought $2.8T trillion of bonds from banks, quadrupling its balance sheet from $800B to $3.6T.

Today’s topic is: How successful has QE been in delivering strong money growth, sustained economic growth, full employment, and 2.0-2.5% inflation? Answer: unsuccesful. Today, the Fed has zero credibility when it comes to market confidence in its ability and commitment to fulfill its twin mandates.

Here is the current data (percent change from year ago):

M1: 7.0%

M2: 6.6%

M3: 4.5%

M4: 3.6%

Core inflation: 1.2%

Nominal GDP: 3.1%

Real GDP: 1.6%

Unemployment rate: 7.3%

We are looking at an economy that has been stuck in second gear for four years, and employment indices that have yet to return to precrash levels. Five years after Lehman, millions of people are unnecessarily out of work and out of the workforce. 

This is because the Fed has not pursued a consistent policy of monetary expansion since 2008. The trillions that the Fed has supposedly “pumped into the economy” are nowhere to be found; they are sitting on deposit at the Fed as sterile and useless excess reserves. They are not "in the economy" and they have had no impact on money growth, inflation expectations or economic growth.

In the 1981-82 recession, Volcker grew M2 by double-digits for a year, and got things moving. Greenspan did the same thing during the 2001-02 recession, and again got things moving. Bernanke did the same thing in in 2009 and again 2011, but stopped in mid-2012, allowing money growth to fall to its current anemic levels.

Five years on, we have persistently high unemployment and very weak growth. Nominal growth at 3.1% is far too low to bring down unemployment, and risks another recession. A deflationary recession at this point in the cycle would be disastrous, and would require heroic policies to reverse.

Bernanke’s half-hearted policies have failed to raise inflation expectations. The fact that expectations remain “anchored” at a low level is a sign of failure, not success. The real funds rate needs to be substantially lower than the current minus 1%. The best way to raise inflation expectations is to explicitly target and deliver 3-4% inflation.

The Fed’s talk of tapering QE was a major policy mistake. Not because QE has worked, but because tapering signals a surrender in terms of the Fed’s commitment to fulfilling its mandate. It signals that the FOMC is OK with high unemployment and low inflation, and that that the Fed’s mandates are aspirational “goals”, which it doesn’t really need to achieve.

The  failure of QE necessitates a bolder policy, not a more timid one. Wars are not won by retreat. The Fed needs to decisively change its focus from inputs (buying $X amount of bonds each month) to economic results: money growth, inflation and nominal growth. This will require a program of shock-and awe in order to make a decisive break in inflation expectations and market behavior:

1. Target 10% money growth, 3-4% inflation, and 6-7% nominal growth.

2. Stop paying interest on excess reserves in order to encourage banks to put them to use in the economy.

3. Double the size of QE and make it open-ended until unemployment returns to a normal level, say 5%.

3. Add to the QE buy-list a trade-weighted basket of foreign government bonds, and physical gold.

4. Commit to raise the price of gold if M2 proves sticky.

5. Permanently redefine “price stability” as 3-4% inflation.

The Fed needs to restore its credibility by meeting its mandates, instead of half-heartedly trying to meet its mandates. There are no points for effort in this exercise. This is a very serious business, given the current level of unemployment and the dismal job prospects for young people.

The Next Black Swans Are Visible

Everyone is now looking under his bed for the next bubble or black swan. Some pundits are pointing to the revival of the market for risky corporate bonds. They worry what will happen when there are defaults. Well I can tell you what will happen when there are defaults: credit spreads will widen and speculators (the people who buy speculative-grade bonds) will suffer MTM losses. Big deal; this happens all the time. No one dies from it. And yes, speculative-grade bonds are speculative.

What people die from is huge positions in low-risk instruments that overnight become toxic. That’s what happened in the subprime fiasco. Here are the criteria for such an event:

Before the event:

1. The security is seen as low risk. It is rated investment grade and is thus eligible for fiduciaries to buy.

2. The security attracts a low capital coefficient under the bank capital regime.

3. The accounting treatment is to carry the security at par.

4. Systemic exposure to the security is massive.

The event:

1. The security is downgraded to speculative grade, forcing fiduciaries to sell.

2. The bank capital regime now requires a higher capital coefficient.

3. The accounting treatment changes from cost to market (MTM).

4. Large MTM losses result, rendering the most exposed players insolvent.

What asset class meets these criteria: Club Med government bonds. In declining order of risk:

1. Spain (Baa3/Negative outlook)

2. Italy (Baa2/Negative outlook)

3. France (Aa1/Negative outlook)

I include France because it has the furthest to fall, like super-senior CDOs. Today French government bonds are a risk-free security. High ratings, zero capital coefficient, carried at par. Imagine if those factors should change: a lower rating, a higher capital coefficient, marked to market. Spain may be the next Lehman, but France could be the next WW1. If French bonds begin to decline in value, there is almost nothing anyone can do about it (besides fiddle with the accounting). It would rip a huge hole in the European banking system which would be impossible to fill without high inflation.

So while we know that Spain is on a bad trajectory, we should worry that France may be too. Spain may be Lehman; but France is civilization as we know it. The next black swans are visible.