A Plan for the Federal Reserve

* What’s the point? – I had an interesting conversation with a couple of clients and long term friends in the business over the last few days about the nature of the blog. On the one hand, a major drawback is that I am persistently negative about the prospects for the economy and the US and global financial system, and who wants to be bombarded by a constant flow of negative information? On the other hand, if I was a mirror of the positive mainstream media, then there would be no point, in my opinion, for papering over the problems with a polyannish view of the world.


The conversation I had reminds me of the time that OJ Simpson dominated the TV during prime time when he was being followed in that white SUV. Every station interrupted their normal program to show the OJ drama as it was unfolding. I remember that this occurred during the spring, and even the network showing the NBA playoff game, went away from the playoff game. Every other station was showing the same, live OJ video. It seems to me that in order for my blog to have value and worth, that I should stick to the idea of not just telling you what everyone else is saying. 


I have been accused of being an alarmist, with the idea that I relish my negativism. That is not the case. The blog was started over 2 years ago as a forum to expand the knowledge base of my bond market clients into topics outside of the bond market, since these other markets were having an increasingly greater impact on the bond market, and in order to do our jobs better, we needed to take other market factors into consideration. Since those humble beginnings, the blog has morphed into a quest for understanding in what shape or form, will the financial world move forward. 


* To summarize my macro view, I do not think that the US will be able to sustain economic growth without causing severe side-effects in other related areas. This comes back to understanding how well the economy can function if the government pares back its deficits to amounts below the growth rate of the economy. And if the government does not pare back its debt and deficits, what will be the negative impact from diverting the world’s capital to financing our consumption based deficits? And at what time will these deficits threaten the ability of the US to maintain its good standing in the world capital markets, and by extension, in  our place of the world’s leading global military andeconomic power? 


Because the answer to these questions has much to do with the government’s response to the economic potholes which are still quite plentiful, the topic has become an inter-twined discussion of domestic and global politics as well. The net of my conclusions is that pain will be forced upon us, as the world re-aligns its over-extended debt marketsto the ability of individual borrowers to repay their debts. Even though we are supposedly past the crisis of 2008-2009, many un-payable debts have not been resolved, and along the way, the reliance on governments to fund economic activity through deficit financed spending, is forcing the global markets to assess the viability of sovereign debtors to make good on their debts. How government’s manage these problems as they arise, will have much to do with what asset classes do well, and which ones do poorly.


* Does the outcome have to be negative? That all depends on how you look at things, and who will wind up paying for the “spend and pretend” policies of Obama and GW Bush. Will the burden of our future deficits fall upon the shoulders of those who acted responsibly, took out affordable mortgages, and are now being forced to pay higher taxes? Or will there be some other consequence which results from the imbalances which still exist?


My contention is that there will be pain and a reduced standard of living in the US. How we get to that point, and in what form the pain is allocated, or camoflouged has much to do with the policy responses of our government.


I would like to expand on a solution which creates the best possible outcome, without damaging the economy too badly. Of course, at this stage of affairs, anything which is done is experimental, since we have never been where we are right now. The best road map for making it through this unfolding crisis can be found in the post world war 2 history. At that point in time, the US’s cumulative deficit was 125% of GDP. In response, the Federal Reserve started buying Treasury notes, which in turn kept interest rates low, and the Fed’s influx of capital into the system helped foster growth while keeping rates low. Of course, this resulted in a 19.7% inflation rate in 1947, followed by a plunge to negative levels, and then another spike above 9% in the early 1950s. Throughout this time period, interest rates on US government debt remained low, although I cannot get my hands on this data over the short term, as Bloomberg data only goes back to 1962.


In 2009, the Fed purchased $1.7 trillion of debt securities, including $300 billion US treasuries, taking over $7 trillion of duration out of the bond market. In my opinion, this had much to do with keeping interest rates low throughout this time period. If the Fed were to embark on a plan to purchase 40% of the treasury deficits, as far as the eye can see, the real challenge will be to see how the markets react. I have not thought through the public relations aspect of this plan, but let me suggest some possible outcomes. The inflationists will be screaming bloody murder upon such an announcements, the dollar will fall, bond yields will fall, and gold and some commodities will do better. The Fed’s purchase of a consistent amount of treasury supply, will guarantee that rates do not rise, since there is demand for treasuries from around the world. Given the deflationary factors at work in the economy, printing all this money, which is what the Fed will be doing, should not have much of an impact on inflation. 


Instead, I suspect that inflation will get exported to those countries which have positive trade surpluses with the US. In the current context, China has experienced rapid growth in their money supply, with inflation running at least 5%. The growth in their money supply has been fueled by US currency, which is held in reserve, and provides backing for the growth of their own domestic money supply. The Chinese government gives their export companies, local currency instead of dollars, which they would otherwise receive when they sell goods to the US. In other words, there is a mechanism in place to convert dollars into Yuan. So, let’s assume that of the $2.6 trillion of FX reserves which China holds, that $2 trillion of this is in US dollars. The fact that this money now sits on China’s central bank’s balance sheet, makes this ‘dead money’ as far as the US economy goes. In other words, so long as the Chinese choose to hold these reserves in dollars, and US treasuries, the concerns that the US’s deficits will create domestic inflation, or a result in a debt crisis will not come into play.


I am not saying that printing more money is a great solution, just a solution which likely has a modest near term set of adverse consequences. Eventually, the Chinese might tell us to take a hike, but with over half their nation’s money supply dependent on the reliability of the US dollar, I am not sure that this will ever happen. Instead the risk will come from every other country which does not hold so many treasuries that they can afford to dump their dollars, and return to a gold standard.


The other reason why I like this plan is that it will keep US interest rates low. In turn, this will help forestall the type of calamity which has undermined the euro, and the peripheral countries whose debt raising abilities were called into question. While ECB efforts to purchase the debt of Greece, Spain and Portugal, have obscured the ability to read the markets concern about the prospects for these countries, if they had purchased this debt before the market took Greek yields into the mid-teens, then the world might never have called the viability of the euro-currency into question. And this is where I come out on the US’s future problems. The last thing the US government wants is to have their credit worthiness called into question by the markets, or bond vigilantes. And buying enough of the US’s new debt would accomplish such an outcome. If the Fed waits for a crisis to develop, amidst rising yields, then it would be no better than the ECB’s actions after the markets took Greek bond yields in the teens. 


I understand that there will be likely be adverse consequences to this sort of strategy, such as inflation in commodities and precious metals. These side-effect are likely to be perceived to be a lesser evil than the negative effects of fiscal discipline, or a crisis in confidence pertaining to the viability of the US dollar and US treasuries, which is inevitable if we continue to run 10% deficits. 


Now I understand that the Fed says that they will not monetize the US deficits, so the real question comes down to what event will force their hand? The trouble with asking this question, is that if the markets are forcing the Fed into such an action, then the viability of the dollar, and treasuries has already been called into question! It would be better for the Fed to embrace this strategy pre-emtively.


* Germany’s failed auction – did anyone see the story two weeks ago, on May 26th,  that Germany conducted a 5 year treasury (also known as Bunds) auction, and did not get enough bids to sell the 7 billion euro issue. Instead, they received bids for 6.1 billion euros, and eventually sold 5.45 billion euros of the issue. Despite the fact that Germany is deemed to be the crown jewel of the Euro-zone, and interest rates on  German 5 year debt is about 0.5% lower than the US’s 5 year treasury note, why would a 5 year Bunds auction fail? The excuse at the time was that there was limited demand for the Bunds, given that the yields were too low. In the new environment in which the ECB is propping up the prices of the debt of peripheral EU members, it is notable that Germany could not issue their desired note size. I am not sure what lasting impact this will have, but even amongst the most desired Euro debt, all is not functioning according to plan.


* Which way did he go George? – Friday’s equity market melt-down took prices to a precarious place on the charts. This happened amidst large volume, with 50 declining stocks on the NY Stock exchange to ever stock gaining. In the S&P, the ratio of losers to gainers was 160:1. In terms of down versus up volume, 99.2% of all volume occurred on a down tick. In short, these are all very bearish numbers. Stock market volatility (VIX) fell well short of the recent May peaks, and this is a bit of a divergence (and bullish) against an otherwise, very bearish day on Friday. The market closed at a support level consistent with levels where a bounce could start from. And last night’s futures low of 1052 is close to another Fibonacci retracement level which could be expected to provide a modicum of support. Nonetheless, the take-away for you is that US stock prices are precariously close to levels, which if taken out to the downside, would bring in new waves of selling, and given the negative day on Friday, that this could usher in a new trading range below 1000 on the S&P. Ultimately I think the S&P goes a lot lower. The question today is does it happen this week, or do we get a reprieve for a brief summer rally before seasonal forces push equity prices lower into the fall.