International Perspective, by Marshall Auerback
[dangerous times for bond markets, revolt in progress
thanks to UD for the info]
prudentbear.com
Can The Fed Afford To Call Its Own Bluff?
July 29, 2003
A couple of weeks ago, Chairman Greenspan announced the removal of the unconventional policy bluff in the following terms:
"...given the now highly stimulative stance of monetary and fiscal policy and well anchored inflation expectations, the Committee concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise...substantial further conventional easings could be implemented if the FOMC judged such policy actions warranted."
Is the Fed chairman’s newly found confidence justified? True, there is a decidedly better tone to the US economy as of late. With the latest PCE report the second quarter trend in consumption now appears to be 3%+ at an annual rate, up from a previous indication of 2%+. Durable goods orders were up a strong 2.1% in June. The service sector ISM has improved markedly, to the highest index reading in over two years. Significant fiscal stimulus is also forthcoming, but it will not impact demand until the latter part of the summer and early autumn. Therefore, most of the effects from the several sources of stimulus are likely to be manifested more fully as we come into the third quarter of this year.
Having gazed into the abyss of unconventional policy measures, it now appears that the Fed has concluded that the cure offers more problems then the disease. We have cited some of these difficulties previously. In offering to yield cap longer dated paper, as Governor Bernanke first did last November, the Fed risked having to peg the entire debt spectrum – private and public – in order to fulfill this objective. Grep Ip of the Wall Street Journal has elaborated on these very points in a recent article, which gave vent to the concerns of various Fed staffers thought to oppose a move down the unconventional route:
“…The more the Fed has studied targeting bond yields, the more difficult it has looked…Buying bonds might be a useful signal to the markets, much like intervention in foreign-exchange markets. But it might fail if the markets viewed the world differently than the Fed. Furthermore, the Treasury market is now inextricably linked to other markets, such as for interest-rate derivatives, mortgage-backed securities and foreign exchange. Nobody knows how an artificial target yield enforced by the Fed would ripple through those markets.”
As Ip’s article suggests, in holding bond yields constant, the Fed would ultimately have to buy all the bonds, which of course in the end they would be very unlikely to do. Above all else, there is the issue of capital flight by foreigners, as they begin to understand the full implications of recourse to unconventional policy measures. Such a move poses tremendous risks for the dollar in particular, because of the increased likelihood of currency debauchment through excess liquidity creation. This is a highly germane consideration for an economy on the threshold of emerging market style debt trap dynamics.
So the Fed has apparently called its own bluff and backed off in the process. Many market pundits have taken the line that, having done no more than send up a trial balloon in respect of unconventional measures (whilst refraining from actually resorting to extremely unorthodox policy), the Fed’s decision not to go down this route creates minimal problems. A debate was had and the issue has been resolved; no harm, no foul.
The problem of course is that the Fed’s persistent threat (promise?) to embrace the unorthodox and unconventional has until recently unleashed a speculative frenzy in the bond market. Messrs. Greenspan, Bernanke, Reinhart, and others have induced market participants employing leverage to bid up bond prices in a way they would not have done if there was not a promise of a Bernanke put to peg bond prices indefinitely. Today’s bond market has therefore been a cynical leveraged trade. The leveraged participants are therefore very weak hands. The very abrupt and deep reversal in the bond market that has occurred in recent weeks amidst only a slight improvement in the tone of the economy testifies to this: the 10-yr. U.S. Treasury now yields 4.15% to maturity, down from a peak of 3.7% -- and investors are beginning to exit their bond mutual funds, according to the latest weekly data from AMG. This marks the first phase of bond redemptions since December 2002.
A number of market commentators have begun to appreciate this underlying speculative reality. In a column last month in the Times of London, economics commentator Anatole Kaletsky made the following point:
The Fed’s May 6 statement effectively guaranteed to continue reducing interest rates to support the bond market, even if there were no further signs of economic weakness. It was also hinting strongly that it would enter the bond market directly, if this seemed necessary to keep long-term interest rates down. With the Fed promising to manipulate the markets in favour of bond investors, there seemed to be no risk in chasing long-term interest rates ever-lower, regardless of the true state of the economy. When the economy is weak, at the low point of the cycle, Americans understand that the central bank’s job is to stimulate growth and to forget about inflation. The time to worry about inflation is when unemployment starts dropping and growth accelerates above trend. At that point, the Fed will surely tighten policy quite severely, interest rates will rise sharply and bond prices will collapse.
The question is when bond investors will start to anticipate this disaster. The Fed’s game of blowing bubbles is not like the Caucus Race in Alice, where the rule was “winners and losers, all must have prizes”.
When US economic recovery becomes self-sustaining, Greenspan will suddenly blow the whistle — and the losers will be the Bigger Fools still holding long bonds.”
(“A Story of the Fed in Wonderland as Greenspan puts Emphasis on Growth”, Anatole Kaletsky, Times of London, 24 June, 2003)
To be sure, the average American consumer has little conception of a “Bernanke Put”, and is therefore unlikely to recognize the impact of Mr Greenspan’s recent testimony. The problem lies more in the real economic impact of sharply rising bond yields. The recent bond rally occurred, less because of genuine fears of deflation, more because cynical professionals felt that they could exit the market, perhaps with some help from the Fed, before the inevitable decline in bond prices materialized. The whole bond rally became another variant of the Greater Fool Theory, but in contrast to Kaletsky, we believe it is the leveraged American consumer who remains the biggest loser here, rather than the Bigger Fools still holding long bonds.
For a time this manipulation of market expectations suited Fed objectives. They chose to manage expectations in the hope that the leveraged speculative community would do the work of lifting asset prices for them because they recognized that they themselves could not actually succeed in carrying out the intervention action on the scale that would actually be required for the policy to work.
But can the Fed really afford to withdraw the unconventional policy card so abruptly, given the recent collapse in bond prices? The message the Fed is now attempting to drive home, is that although abandoning its deflation watch, the incipient economic acceleration is just beginning, but it will not be accompanied by accelerating product price inflation. In this regard, it is important to note Mr Greenspan’s repeatedly assertions that private sector balance sheet repair has been completed by households and firms, most recently last week before the House Committee on Financial Services.
“The prospects for a resumption of strong economic growth have been enhanced by steps taken in the private sector over the past couple of years to restructure and strengthen balance sheets… Nowhere has this process of balance sheet adjustment been more evident than in the household sector. On the asset side of the balance sheet, the decline in longer-term interest rates and diminished perceptions of credit risk in recent months have provided a substantial lift to the market value of nearly all major categories of household assets. Most notably, historically low mortgage interest rates have helped to propel a solid advance in the value of the owner-occupied housing stock… On the liability side of the balance sheet, despite the significant increase in debt encouraged by higher asset values, lower interest rates have facilitated a restructuring of existing debt.”
This is patently false: debt/income ratios have continued to climb in the household sector since 1997. Despite 3 years of sub-par growth since 2000, there has been nothing in the way of balance sheet repair which could justify this statement of Greenspan. Indeed, the Fed chairman has gone further; in language reminiscent of his days as champion of the cheerleader of the New Economy, he openly applauds the fact “households have been shifting the composition of their portfolios in favor of riskier assets”, hardly the sort of language designed to promote a build up of savings. The overall picture is one of little improvement in interest expense to income ratios, which is surprising given the volume of mortgage and corporate debt refinancing, and given the historically low nominal interest rates of late. Hy Minsky’s “Ponzi financing” seems alive and well.
Given this continued prevalence of debt, therefore, a back up in US long term rates is potentially devastating for the economy. Outside of telecoms, corporate debt has not been paid down. Household savings are virtually non-existent. The current fiscal stimulus is probably a one off event. There are many financial and real sector imbalances that will impede any recovery. But perhaps of greatest importance is our belief that signs of a significant economic recovery will damage the bond market further, which could in turn precipitate a major decline in the stock and housing markets. This could easily short circuit the economic expansion. Above all else, the bond market reversal underscores the unreliability of the expectations management efforts that have been such a pervasive hallmark of the Greenspan Fed.
Consequently, we are not surprised to see signs of Fed backtracking. Consider Governor Bernanke’s recent speech at Princeton University, “An Unwelcome Fall in Inflation”. In the speech, Bernanke reiterates a point made by Greenspan during Congressional testimony a week earlier: namely, that even if we were to see a robust rebound in the economy in the second half of this year and through 2004, the “ongoing slack in the economy may still lead to continuing disinflation” . But Bernanke argues that strong growth forecast by his chairman--3% to 4%--and low inflation--about 1%--does not pose a problem. Moreover, according to Bernanke, there are mitigating factors on the deflation front: The dollar’s weakness will trigger a further rise in import prices, increasing the pricing power of business; inflation expectations are unlikely to remain low with the Fed pumping money at a robust pace and threatening to lower short-term interest rates once again; energy prices could well move higher this winter, especially natural gas; and the global economy is also likely to rebound given the concerted effort of central banks towards stimulus.
In short, Bernanke promises us a return to the Goldilocks economy: not too much deflation, not too much inflation. Therefore, he concludes that an extended period of monetary ease is warranted. He is willing to cut the federal funds rate to zero, if necessary, despite the difficulties it might pose for certain financial institution--like banks and money market mutual funds where net interest margins are already razor thin.
He then goes on to suggest, that should the funds rate approach zero, nontraditional measures might be considered. These would include, amongst other measures, “increased purchases of longer-term government bonds by the Fed, an announced program of oversupplying bank reserves, term lending through the discount window at very low rates, and the issuance of options to borrow from the Fed at low rates.”
No doubt stung by the reaction of the markets to his last major speech, Bernanke gives no further details regarding these measures, and carefully leaves the impression that they are unlikely to be needed. But no doubt the Fed was disturbed by the severity of the recent sell-off in bonds, and raising the specter of these possible measures, however improbable, might well have been expected to calm the bond market.
The problem, however, is that Greenspan’s earlier withdrawal of the “Bernanke Put” will now make it harder for expectations management to succeed in the future. Many of the leveraged speculators herded into the bond market by Fed intimations of a “Bernanke bailout”, are now sitting on big losses. Once burned, twice shy. Higher bond yields going forward will frustrate Fed efforts to herd investors into the stock market by making yields paltry all along the curve. Market participants now suspect that bond prices were way above levels consistent with the prevailing short run equilibrium and were buyers of bonds only because of Fed intimations of a bailout. The bailout was apparently removed two weeks ago: now it appears to be back on the table again. The Fed is still backed into a corner by multiple bubbles of its own creation. Its mixed messages evince a combination of cynicism and desperation that is beginning to be picked up by the bond market. If the stock market buckles later this year, we shall see truly see whether the Fed has repudiated the unconventional once and for all. |
