Minyan Mailbag: Tight Fed Argument
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.
Hola Prof. Succo,
I know you are convinced that the Fed is still being loose with the printing presses, but I'm going to try and make the opposite case anyway. Attached is my spreadsheet with assorted interest rate things I've been tracking, in case you want to take a look.
As I see it, the Fed has 2 main ways it uses to juice the economy and money supply:
1. Keep short term rates artificially low, so that financial institutions are eager to lend out money to consumers and businesses and score profits off of the carry trade. (Temporary injections are related to this function.)
2. Directly inject money into the system through permanent injections to primary dealers or through auction related treasury purchases directly from the Treasury Department.
While most of the world seems to obsess mostly with the Fed's handling of #1, I see #2 as the more important measure of the Fed's long term objectives. Most money is created in the private banking system, but that money is subject to the whims of the financial sector, and the money can disappear as fast as it is created if lenders get cold feet or borrowers either pay down their debts or default. No matter how loose the Fed is with #1, it takes an appetite among borrowers and lenders to turn that into money creation and economic activity.
Permanent injections, on the other hand, are money created directly by the Fed, not the private banking system. The Fed can force liquidity down people's throats, even if borrowers don't want to borrow and lenders don't want to lend. Take a look at what the Fed has done with permanent injections quarterly since 2000 (totals are close but not
Q1 2000: $3.6 Billion - Still in tightening mode to kill the tech bubble
Q2 2000: $5.3 Billion - OK, looks like we've cooled the Market.
Q3 2000: $17.1 Billion - Hang in there Hoofy! Al Gore needs you!
Q4 2000: $8.9 Billion - Aw, heck with it, let it burn.
Q1 2001: $13.4 Billion - Is it a recession yet?
Q2 2001: $22.8 Billion - Yeah, I think it's a recession. Let's go from 5% to 3.75% on the short end too.
Q3 2001: $12.0 Billion - Ah, heck with it, take 2.
Q4 2001: $1.4 Billion - Maybe going from 3% to 1.75% will fix things.
Q1 2002: $14.8 Billion - Is it a double dip yet?
Q2 2002: $14.9 Billion - Yeah, I think it's a double dip.
Q3 2002: $7.4 Billion - Ah, heck with it, take 3.
Q4 2002: $0 Billion - OK, let's just try 1.25% instead.
Q1 2003: $5.0 Billion - Is it working yet?
Q2 2003: $6.7 Billion - Not yet? Let's try 1%.
Q3 2003: $1.3 Billion - Wahoo! Look at those Refi's go!
Q4 2003: $7.1 Billion - Just to be safe...
Q1 2004: $5.7 Billion - OK, now this economy is cooking!
Q2 2004: $9.3 Billion - Here's some money, now be good boys and prepare for some rate hikes.
Q3 2004: $11.4 Billion - Need some help getting out of that carry trade? Here you go.
Q4 2004: $15.6 Billion - Long rates and the dollar are falling? What a conundrum!
Q1 2005: $0 Billion - What do you mean you won't keep supporting our deficit spending?
There hasn't been a single permanent injection since the December 2004 FOMC meeting. At that time, the Dollar was getting hammered and the Fed may have decided it needed to get tight or face a crisis with the dollar. Central bankers around the world were in a cold sweat about their rising currencies and probably were putting pressure on the Fed to show a little restraint. Meanwhile, the foreign central banks were shifting into buying more Agency debt and fewer treasuries.
You've mentioned that the Fed might still be doing sneaky things behind the scenes because liquidity just keeps on flowing. I'll counter by saying that there is plenty of left over liquidity from the second half of 2004 when the Fed was printing as if we were still in a recession. On top of that, the crazed mortgage lenders have been loaning out money as fast as they can, shrinking spreads and profit margins be damned. 125% equity loans, inflated appraisal values, approving mortgages for children and small pets, and so on, the money just keeps getting created because once the pace of new originations slows, the inflated profit business model of these multi-billion dollar businesses goes Kaboom!
My thesis is that the Fed has gotten tight since the mid-December meeting and they are going to stay tight until these mortgage lenders stop fueling America's excess consumption. If they cause a meltdown in the hedge fund industry, derivative markets or stock markets first, then they'll have to figure out a new course of action. If they go loose again, though, I'll be guessing that the dollar will be toast and a different type of crisis will result.
Over the last quarter, M1 has been in decline, while M2 and M3 keep growing. Consumers aren't keeping as much "money that will soon be spent" because their budgets are shot. However, all that money created by the mortgage industry and other credit providers has to sit in somebody's account, at least until the loans get defaulted on and large amounts of it vaporize.
Looking forward to hearing your thoughts,
You make a fine case and I agree with 95% of your analysis. Under normal times I would agree with 100%.
But these are not normal times. The Fed and our government in coordination with other central banks are conducting a grand experiment, a kind of mad experiment just like Dr. Frankenstein. They both are convinced they can "create" their reality: where Dr. Frankenstein thought he could create life out of nothing, the Feds think they can create economic growth out of nothing. It is Keynesian"ism" gone wild.
There are new countries getting in on the economic act. They want economic growth and the standard of living to go along with it. They are adding capacity to an already over-capacitized world. As cental banks add liquidity, they cause asset and commodity prices to rise, but are doing little to correct the real problem and are actually exacerbating it: world-wide imbalances fueled by fevered consumption and no savings in the U.S. The government's policies encourage even less savings and more debt, which is being created at a momentous pace in order to accommodate the increase in standard of living for other countries (that is what debt does, it borrows the standard of living from the future and lends it to the present).
But the liquidity is fueling non-productive assets, more of what we have. This is and will cause an earnings recession and continue to fuel higher commodity prices. It will continue to fuel higher asset prices as well until eventually higher U.S. interest rates pop those.
I believe that the Fed is monetizing, still printing money but using it to buy long bonds. This is very unconventional and I have little other than circumstantial evidence to back up my claim. One piece is that the Fed said itself it will use means such as this (and even more unconventioanl like buying stocks) if need be. As they raise short term rates it looks to me like they "need be". Another piece are those strange foreign inflows from the Caribbean. They have been showing up for months now and make little sense to really be from hedge funds.
I could be very wrong and all wet, but in my business it is essential to see all angles and attach some probability to them. Once you attach any probability to something it becomes real, no matter how unreal it seems to most people. I put the probability that the Fed is monetizing at around 35%. Even if I am wrong it creates a piece of the puzzle that others may not even consider.
And I believe the Fed can accomplish all this without it showing up in your statistics.
You make a compelling case for your 35% uncertainty as well. As so many of our great corporate and government leaders have shown us, you can't ever trust the numbers 100%, so I never do. Either the Fed is being honest (enough) with its accounting that we can safely say this is the tightest they've been in many years, or it is all an act while they desperately scramble to hold things together in covert ways. I'm glad you are watching the tape in search of the answer.
The layers and layers of risk that have built into our financial system in the name of overstated profits are staggering. Virtually all of our great financial companies are at risk of coming crashing down if things unwind too quickly. As I look at the screen and see Fannie Mae (FNM) and MBIA (MBI) down another 5% this morning, an earnings warning from mortgage banker Irwin Financial (IFC) and the rest of the financial sector also in flames, I have to wonder if it is all unraveling right now before our eyes. And of course it goes far beyond the traditional financials to the industrial companies like General Electric (GE) & General Motors (GM) with their huge finance arms and anyone with a big pension plan.
The Fed has to be aware of this, but I'm not sure there is anything they can do to save all the companies that are rotten to the core or overexposed to other's potential defaults. The Fed will probably try at least once to shock the financial sector back to life, and as investors we'll need to be ready for that, but without permanent support from global banking community (not possible IMO), the blood will just start oozing out of other wounds.
I'm not stockpiling food and ammunition, because in the long run this should only mean a tremendous transfer of wealth, and not the end of civilization or anything like that, but the potential for short term shocks to the economy are great. Companies can continue operating as they change ownership from stockholders to bondholders. Still, I have to think that vast numbers of people will be laid off over time as their unsustainable companies and sectors downsize to sustainable levels or disappear entirely.
Not a pretty thought at all,
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