SINGLE MANDATE LEADS TO DEBT SOLUTIONS
January 8, 2013
Since my last
commentary, the government has been the key driver of financial markets.
First, the Federal Reserve announced the next round of
quantitative easing at its December 12th meeting.
Next, we saw the drama around the Fiscal Cliff and now the focus
has shifted to the upcoming debt limit, which we have already
technically breached.
One of the previous
rounds of easing by the Federal Reserve was called “Operation Twist”
whereby the Fed would add $45 billion of longer-term bonds to its
balance sheet each month while removing the same amount of short-term
bonds. This was viewed as a
“sterilized” monetary action since there was no net change in the
balance sheet. After,
Operation Twist, the Fed added a new round of QE with net new purchases
of $40 billion in bonds per month.
In the December meeting, the Fed announced that it would
essentially extend the purchases of Operation Twist, but would stop the
sterilization part of eliminating the same amount in short-term debt.
As a result, the Fed is now buying $85 billion worth of bonds
each month and adding it to its balance sheet by printing new money.
That is an annual run rate of $1.02 trillion.
It is estimated that the Fed will be buying roughly 90% of the
debt issued by our country in 2013.
Let’s remember the
circular pattern here.
Obama and Congress spend the money, Geithner at the Treasury issues
IOU’s or debt to fund the spending, and then Bernanke prints money out
of thin air and buys the debt or IOU’s – based on this pattern, they are
really IOME’s.
Then, we had all the
drama around the Fiscal Cliff.
After all the daily rumors and TV speeches, nothing changed much
except a slight rise in the tax rates for those earning above $400K
[$450K household] a year.
The Democrats got their piece of flesh from the “rich” and the
Republicans got most of the Bush tax cuts made permanent.
Not surprising, there were essentially no spending cuts and the
net result is an increase in the national debt by an estimated $4.9
trillion over the next 10 years, as identified by the CBO.
Now, we are on to the
fight over the debt limit.
We technically hit the mark at the turn of the New Year, but Geithner
can maneuver the funds around to avoid the spending constraints by
another 2 to 3 months. We
will likely see plenty of drama around this but the net result will
probably be a similar outcome of postponing any real solutions to the
debt problem to avoid short-term pain and kick the can further down the
road.
I think many are
focused on trying to solve the spending and debt problem in Washington
the wrong way. All the
attention is on trying to get Congress and the White House to work
together in coming up with a solution.
I think if we turned the focus to Bernanke and the Fed, we would
have much more success in forcing a longer-term solution.
If we just look at the
recent financial crisis of 2008 we can see parallels.
As long as the credit was cheap and easy, individuals levered up
their personal balance sheets and bought more house and other things
than they could afford and financial institutions did the same by taking
more and more debt onto their balance sheets.
This continued until the housing bubble popped and the easy
credit dried up.
Right now, Congress and
the White House have the easiest credit in history thanks to Bernanke.
He is artificially keeping the cost of capital low for the
government and buying up all the debt the government wants to issue.
It is similar to the over consumption by individuals financed by
cheap and easy credit from the financial institutions.
Without Bernanke, market forces would likely be adding increasing
constraints to the borrowing of the government.
If we shut down the printing press by Bernanke, I think we would
have much more success in forcing more responsible action out of
Washington.
As companies in the
private sector take on more and more debt, the cost of that debt
increases so that the providers of the credit are compensated more for
increasing risk of not getting paid back.
This dynamic is absent from the government as long as Bernanke
creates money out of thin air and directly buys the debt at essentially
no cost.
But, if we look at the
situation for the Chairman of the Federal Reserve, there is no political
support to remove Bernanke - surprise, surprise given that he is the
politician’s banker. And,
the current administration will assuredly appoint another “dove” with
similar views when Bernanke’s term is up.
Therefore, the leadership philosophy and economic world view is
not likely to change anytime soon at the Fed.
So, if we can’t get rid
of Bernanke and we can’t change the likely mentality anytime soon, is
this really an option to address the debt situation?
The one angle that represents the best possible chance of making
a change is to address the mandate at the Fed.
Right now, the Fed has
a dual mandate of price stability and maximum employment.
The Fed controls the supply of dollars, our fiat currency.
Without going into all the issues related to that, the Fed should
really only be concerned with price stability as an indication of
balance in its ongoing monetary actions.
Once it shifts its focus to the second mandate of maximum
employment, it brings in conflicting signals to its basic function.
If we were to change
the Fed mandate to a single mandate of price stability, like a number of
other central banks, then that presents the best opportunity to handcuff
the massive money printing by Bernanke.
At current inflation rates, there would be no justification to
print any money and probably argues for reversing course by the Fed.
Also, recently the Fed has pegged all of its excessive monetary
action to achieving a 6.5% unemployment rate.
If the second mandate relating to employment was removed,
Bernanke would lose his justification for running his printing press.
This is very doable in
that there are many in Congress, such as Sen. Bob Corker, who are
promoting such a change.
If we made that one
change to the Fed mandate, it would seriously constrain the cheap and
easy credit for the government to keep spending.
Then, market forces would essentially put a debt limit on our
government and keep their spending in check and force a longer-term
solution to the entitlements.
If a family or a business is spending way beyond its means, the
credit will eventually get too expensive or dry up and force change.
We saw that in the recent cycle.
If we made this change to the Fed now, it may help force change
in our government spending before it leads to an implosion of greater
magnitude than what we saw in the private sector in 2008.
VISUAL PERSPECTIVE…
Let’s review a few
charts from David Rosenberg of Gluskin Sheff.
The first one shows how households levered their balance sheet to
extremes by overconsumption through easy credit.
They have been working on their balance sheet for the last four
years but still have a ways to go.
Next, let’s look at the
government debt. The first
chart shows interest payments as a share of total revenue and the second
shows debt as a share of GDP.
Now, let’s look at
Bernanke and how he is providing the financing for all this growth in
debt. The first chart is
the Fed Funds rate at zero and the second chart shows all the debt
Bernanke has been buying and adding to its balance sheet.
We can also look at the
chart below to see yields on Treasury Inflation Protected Securities
[TIPS] to see how the Fed is printing money and buying debt to drive
real interest rates across the curve into negative territory.
This is where I think we will see the issues surface whereby the
Fed chases its second mandate of maximum unemployment to the detriment
of its first mandate of price stability.
All this new money creation is not likely to be the driver of
employment anyway and we will see instability surface with prices.
These negative real
interest rates have been a key factor in disconnecting prices in the
financial markets from reality.
As a result of the Fed, price discovery is being artificially
manipulated so that investors are playing the monetary game more so than
focusing on fundamental metrics.
While the media has
been highlighting all the fears around the Fiscal Cliff, you would think
that investors would be positioned very conservatively with their
investments. However, if we
look at a variety of indicators we see the opposite.
SURPRISINGLY, RISK IS ON…
The first chart is by
The Leuthold Group. It
shows their risk aversion index which is a combination of market based
indicators, including credit and swap spreads, implied volatility,
currency moves and commodity prices.
Currently, it is showing that risk aversion is extremely low.
Some of these indicators included in the index are being
artificially skewed by the Fed but nonetheless it gives an indication of
essentially no fear in the market.
The next chart by JP
Morgan shows their speculative position indicator which combines
positioning by investors in 8 risky and 7 safe asset classes.
It is another way of indicating whether investors are positioning
aggressively or conservatively in the market.
You can see how it is at the highest level we have seen in the
last six years.
It is interesting to
note that NYSE margin debt is at four year highs, VIX future traders are
extremely net short and speculators as indicated in the commitment of
traders report are the most net long on equities in six years.
All this points to very high complacency in the market now.
MORE ECONOMIC AND MARKET
DIVERGENCES…
Recently, the economic
data have been mixed.
However, many of the leading indicators are still pointing to economic
weakness. Let’s take a look
at a few charts to illustrate how stock prices are disconnected to the
economic reality. The first
shows an update on global manufacturing PMI indexes in blue relative to
global stock prices in gold.
The next chart shows
the NFIB Small Business Optimism Index in red and the S&P 500 in green.
We are also starting to
see the Citigroup Economic Surprise Index top out, which means that
economic reports should increasingly miss to the downside in upcoming
data. The chart below shows
the S&P 500 in green and the Economic Surprise Index in the dashed gray
line in the upper pane. In
the lower pane, it shows the 3-month rate of change in the Economic
Surprise Index. The rate of
change line in red shows a recent loss of momentum in the Surprise Index
which indicates that the absolute line is topping out.
If you look back through the chart it highlights how the rate of
change line rolls over ahead of stock prices.
The next chart shows
total U.S. package shipments [year-over-year growth] by Federal Express
in the blue line and year-over-year % change in GDP in orange.
This is helpful since it picks up the shift to online purchases
as well. It suggests
increased pressure on upcoming economic growth.
Finally, let’s look at
earnings and revenue expectations for S&P 500 companies over the next
year. The chart below shows
the trend over the last year in the blue bars and the expected trend in
the red bars for this year.
Looking back at the previous economic charts as well as the ones in my
recent commentaries, it appears likely that expectations for earnings
and revenue for 2013 are way ahead of reality.
DISTORTIONS ABOUND…
Let’s wrap up.
Economic growth is likely to remain very weak in the period
ahead. However,
expectations by market participants of company earnings and revenues are
that they will start to reaccelerate once again.
Also, as shown in the sentiment charts above, investors are
positioned aggressively in the market and are very complacent about
risk.
While the continued
deleveraging in the household sector subdues potential economic growth,
investors have positioned their portfolios toward risk assets, partly as
a result of the negative real interest rates caused by the Fed.
Penalizing savers, pushing them out on the risk curve where they
are not being compensated for the amount of risk they are taking, and
financing the spending by the politicians is not a recipe for a solid
foundation of a healthy economy.
The longer we let Bernanke continue down this path, the more
distorted and unbalanced our economic and investment environment will
be. The point of
reconnection, as we have seen twice in the last twelve years, is
generally for most not worth the temporary high off the Fed’s money
creation.
What may seem like an
insignificant step by most would go a long way in reigning in the
excessive monetary policy by the Fed.
Go to a single mandate of price stability for the Federal Reserve
and we may actually realize the second mandate of maximum employment
much sooner and begin to force real solutions to our country’s debt
issues!
Joseph R. Gregory, Jr.