Since the 2009 lows and the QE-infused bizarro world market where good news is bad news and fundamentals are irrelevant, investors have had no shortage of juxtapositions with which to add to the confusion. But last week we were provided two that may epitomize the post-credit crisis reality.
On Thursday Federal Reserve Chairman Ben Bernanke gave a speech titled Challenges in Housing and Mortgage Markets
where he discussed the obstacles in obtaining credit.
...restrictive mortgage lending conditions do not seem to be linked to any insufficiency of bank capital or to a general unwillingness to lend.
Certainly, some tightening of credit standards was an appropriate response to the lax lending conditions that prevailed in the years leading up to the peak in house prices.
However, it seems likely at this point that the pendulum has swung too far the other way, and that overly tight lending standards may now be preventing creditworthy borrowers from buying homes, thereby slowing the revival in housing and impeding the economic recovery.
On Friday we learned of the results of the FHA’s (Federal Housing Administration) annual audit that showed a net worth deficit of $16.3 billion due to rising mortgage delinquencies. The projected losses raise the prospects of a (nother) tax payer bailout. As reported in the Wall Street Journal:
The FHA is required to maintain enough cash to pay for projected losses on the $1.1 trillion in loans that it guarantees. Last year, the independent audit said the FHA would have $2.6 billion after covering estimated losses.
But the latest forecasts show that while the FHA currently has reserves of $30.4 billion, it expects to lose $46.7 billion on the loans it has guaranteed, resulting in a $16.3 billion deficit. Friday's report was released as part of an annual review required by Congress.
Chairman Bernanke was well aware of the FHA’s solvency issues when he made that speech so it seems odd that he would complain about tight credit conditions in the mortgage market at a time when tax payers may have again foot the bill for home loans gone bad. Nevertheless Bernanke is missing a very critical variable in the lending process, and in doing so, I think he has exposed a fundamental flaw in current Fed policy.
At the Federal Reserve, we have sought to support the economic recovery and maintain price stability -- the two goals given to us by the Congress -- by keeping both short-term and longer-term interest rates historically low. Low interest rates reduce the cost to households of buying homes, cars, and other consumer durables while increasing the attractiveness of new capital investments by firms. Increased demand in turn leads to faster economic growth and more jobs.
So on the one hand Bernanke argues that lending conditions are too tight, inhibiting growth, but on the other hand he extols the virtues of the Fed’s historically low interest rate regime on improving economic activity. Conventional wisdom would have you believe that interest rates are low because credit is tight. I think it could be the opposite. I think at this point in the cycle its possible tight credit is a product of historically low interest rates. There has been much discussion on the intentions and effectiveness of QE. It has been my contention that the main objective is not to reflate asset prices but rather to stimulate credit creation and the velocity of money. According the Fed’s H.8 Release
banks are holding over $2.6 trillion in cash that's sitting idle on their balance sheets in securities portfolios.
Bernanke is trying to flush the banking system out of these bloated securities positions and into extending credit by lowering bond yields to levels where banks can no longer afford to hold them. As banks replace securities with loans credit expands, the velocity of money increases which in turn will increase economic activity, employment, and corporate profitability.
Is it working?
When the Fed launched QE the aggregate loan-to-deposit ratio (LTD) of the US banking system was 90% with most of the balance of their assets in securities. As a comparison, in 2008 the LTD was over 100% and banks held very little in securities. Despite three rounds of QE and Operation Twist that was designed to flatten the yield curve today, the LTD is 79% -- the lowest in over 30 years of tracking it -- and continuing to fall. Not coincidentally, in Q3 2012 the velocity of money (M2) made a 50-year low.
The problems that are impeding the economic recovery
are not due to the lack of federal agency-backed mortgage loans that wind up in securities. What is impeding the recovery is the continued contraction of US bank balance sheets. For lenders to extend credit they must weigh three basic risk variables that make up the total cost of credit: credit risk, interest rate risk, and collateral risk. What Bernanke doesn’t seem to appreciate about this equation is that the benefit of a negative real interest rate to the borrower is the cost to the lender in a negative real return.
The lower interest rates fall, the higher the interest rate risk becomes. By reducing credit risk in the form of low interest rates Bernanke has raised interest rate risk. From a lender’s perspective the balance sheet risk is the same. So perhaps it’s not credit and collateral risk that is holding back lending; it's interest rate risk. Maybe bank balance sheets continue to contract because they can’t earn a positive risk-adjusted real return by making a loan.
Back on October 15 in Precipitous Drop Off in Demand for Money May Signal Repricing of Risk Assets
I went through my various credit market metrics that were all pointing to a contraction. One of the most important indicators I follow is the activity in the Eurodollar pit at the CME. Having traded “euros” in a former life I can tell you this is one of the deepest and most liquid markets in the world.
In the 90 day LIBOR futures market, which is the eurodollar
pit at the CME, the commitment of traders shows commercial hedgers (which are large money center banks) have gone from net long $1 trillion notional at the end of last year to currently being net short $1 trillion. From a historical perspective that is a huge swing. When you are long a Eurodollar contract you are hedging against falling rates and when short you are hedging against rising rates. Therefore the net position of commercial hedgers is indicative of the composition of the banking system’s aggregate balance sheet.
Banks hedge assets from falling interest rates and liabilities from rising rates. The fact that hedgers have seen such a big swing in their net indicates there has been a collapse in the need to hedge credit assets on their balance sheets.
As I wrote back on June 18 In the Parallel Universe, Credit Risk Is Interest Rate Risk Tom McClellan
of McClellan Oscillator
fame has identified a correlation between the Eurodollar commercial hedgers net position and the S&P 500
(INDEXSP:.INX) with a one-year lag. It’s not perfect but the correlation has been remarkably consistent in identifying turns in the stock market. After analyzing the correlation with the S&P I have since identified a couple more correlations both directly and with a lag. I believe these correlations show up because they are related to the extension or lack of extension of credit in the economy. You should understand that the massive reduction in the commercial hedgers’ positions in 2012 portends a severe correction in US stock prices for 2013 and that it also predicted a top in November. This is one reason why I have been looking to fade the consensus QE asset reflation trade and why I concluded in Precipitous Drop
that the various contracting credit market indicators I monitor were pointing to a pending repricing of risk assets:
Was it something cyclical like the fiscal cliff or election that would soon pass, or something secular more akin to a paradigm shift that I had discussed last week? I can’t be sure. We have a lot of indicators that, on their own, could be saying something different, but added together could be saying the same thing.
The consensus trade is to get long the QE asset reflation correlation, however what I am seeing is just the opposite. That big sucking sound you hear might be a precipitous drop off in the demand for money. When that happens, the price of risk assets are soon to follow.
Thus far the equity market has followed the playbook I have outlined since the summer. Not only was fading the QE asset reflation trade the correct call, the September 13 FOMC meeting that announced QE III basically top ticked the market.
The other market top ticker is the hedge fund community which, due to a persistent net short position, had been dramatically underperforming the market. Yet when the S&P finally crossed 1400 in September, they predictably
threw in the towel and got long. Despite heavy liquidation over the past couple of weeks and a 7.8% move off the top it appears hedge funds remain net long this market. I was looking for a short squeeze option expiration bounce last week and the fact that we did not get one suggests that a short base has not yet been developed. Coming into last week large speculators remained long the ES e-mini S&P futures and had in fact increased exposure.
With large specs still long and all the anecdotes of dip buying -- such as perma bear David Rosenberg of hedge fund Gluskin Sheff
apparently looking for an excuse to get long based on “capitulation
” -- I think there is a real danger of a flush. The longer we remain below the critical 1370 pivot I had identified last week in Rally Off 2009 Low Flushed the Hedge Fund Shorts
, the more pressure will be on the downside.
Regardless of how the week plays out you have to realize how important this area on the S&P 500 is from a technical perspective. There is a reason this was the short/long pivot for hedge funds. The 1370 level on the S&P has been a major pivot going back to 2007. To see where this came into play, simply draw a horizontal line on a weekly and you can see how the market has respected this pivot a number of times. You can allow a little wiggle within 10 points, but I would not fade a move from this area in either direction.
This area is so critical that it’s quite possible we vibrate it a bit as to keep the dip buyers in the game. However, despite what may be an attempt to rally this market, investors need to realize that the two primary drivers of bullish price action -- short hedge funds, and the consensus belief that QE is successful in reflating assets -- are no longer on their side. From here the risk/reward of being long and buying dips is very low. It is my belief that an ensuing bear leg in stocks will be very difficult to navigate from either side. I think there is a distinct possibility we just completed a cyclical bullish pattern off the 2009 low and that a retrace is in order that could take the S&P 500 back to the large 1160 pivot at a minimum with the potential for a deeper move that challenges 1000. However unlike the two previous corrections in 2010 and 2011, this will likely not be swift and steep but rather long and choppy.
Chairman Bernanke is scheduled to speak to the Economic Club of New York
this week, which has historically been a venue for which to discuss policy options, and I expect him to telegraph his intentions for the December 13 FOMC meeting. The general expectations are for more of the same buying of MBS and Treasuries in an attempt to stimulate credit creation. Bernanke will try to convince the markets that he will do what is necessary to keep the easy-money spigot open for as long as it takes.
Instead of touting the duel mandate of supporting and economic recovery in the context of price stability, it would be helpful if he could explain just how a continuation of QE and a negative interest rate regime would be successful in stimulating lending. There is a difference between credit creation for refinancing and credit creation for investment, and in order to see velocity rise, we need credit extended for investment. For that to happen the banking system needs to be compensated for not only credit and collateral risk, but also interest rate risk.