It's a bit of an important week this week, and for a reason largely absent from the market calculus of the past few months. Wednesday sees the Federal Reserve announce its policy decision; while no one expects any change in actual policy, the statement will be parsed even more closely than usual for signs that the policy winds may be shifting.
That Big Ben essentially declared the recession to be over recently, in advance of the official data release, may simply have been an acknowledgement of the obvious- current quarter GDP will deliver a positive print when released towards the end of next month. Yet there may be some concerns that the Fed may start to guide the market's gaze towards its exit strategy; having been excoriated in some circles for its "free money giveaway", some Fed voters-particularly the regional presidents-may wish to signal that they do not intend to repeat Easy Al's mistake of taking forever and a day to withdraw stimulus.
The jitters caused by the "paid advisory report" last week suggest that the patient will not enjoy coming off the methadone. That equities have stumbled out of the gate so far this week does not suggest a willingness to look past a possible exit strategy, either.
That having been said, it does seem as if markets are pricing at least some degree of risk premium as to the development of an exit strategy. Using the front two eurodollar contracts, we can develop a "constant maturity" estimate of where 3 month LIBOR will be, say, three months into the future.
As the chart below indicates, markets have priced 3 month forward LIBOR higher than the spot fixing rate for the past several months after pricing it at or under the spot fixing for most of the first half of the year.
If we look at the gap, it's at the high end of the 2009 range; the peak just shy of 30 bps came on June 5, when "strong" payrolls were released and front ends went into free-fall.
What does it all mean? Frankly, Macro Man isn't positive. The rise in the forward-LIBOR risk premium suggests that the market is a touch nervous about what the Fed might come up with; as of Friday, this hadn't meaningfully impacted either equities or the dollar, though today they have reversed recent price action.
By the same token, the opening up of this little risk premium suggests that if the Fed delivers an unchanged message, a relief rally could ensue- particularly in the front eurdollar contract, where positioning is admittedly heavy but there's a bit more "juice" than in the EUR or GBP equivalents.
From Macro Man's perch, it's probably a bit early to be publicly discussing exit strategies- sure, markets have priced in a bit of reflation, but the SPX is still down 15% y/y and the dollar's largely unched over the same horizon. From the Fed's perspective, they are still at the point of adopting a "minimax" strategy- i.e., trying to minimize the losses in a worst-case scenario.
If, after a quarter or two, private demand looks resilient (and bear in mind, Macro Man is highly sceptical on this count), then the Fed will feel comfortable. But to Macro Man's mind, that's a 2010 story, not a 4Q09 one. Of course, he could be wrong...in which case it could be a big week, but not in the way that he might like.
That Big Ben essentially declared the recession to be over recently, in advance of the official data release, may simply have been an acknowledgement of the obvious- current quarter GDP will deliver a positive print when released towards the end of next month. Yet there may be some concerns that the Fed may start to guide the market's gaze towards its exit strategy; having been excoriated in some circles for its "free money giveaway", some Fed voters-particularly the regional presidents-may wish to signal that they do not intend to repeat Easy Al's mistake of taking forever and a day to withdraw stimulus.
The jitters caused by the "paid advisory report" last week suggest that the patient will not enjoy coming off the methadone. That equities have stumbled out of the gate so far this week does not suggest a willingness to look past a possible exit strategy, either.
That having been said, it does seem as if markets are pricing at least some degree of risk premium as to the development of an exit strategy. Using the front two eurodollar contracts, we can develop a "constant maturity" estimate of where 3 month LIBOR will be, say, three months into the future.
As the chart below indicates, markets have priced 3 month forward LIBOR higher than the spot fixing rate for the past several months after pricing it at or under the spot fixing for most of the first half of the year.
If we look at the gap, it's at the high end of the 2009 range; the peak just shy of 30 bps came on June 5, when "strong" payrolls were released and front ends went into free-fall.
What does it all mean? Frankly, Macro Man isn't positive. The rise in the forward-LIBOR risk premium suggests that the market is a touch nervous about what the Fed might come up with; as of Friday, this hadn't meaningfully impacted either equities or the dollar, though today they have reversed recent price action.By the same token, the opening up of this little risk premium suggests that if the Fed delivers an unchanged message, a relief rally could ensue- particularly in the front eurdollar contract, where positioning is admittedly heavy but there's a bit more "juice" than in the EUR or GBP equivalents.
From Macro Man's perch, it's probably a bit early to be publicly discussing exit strategies- sure, markets have priced in a bit of reflation, but the SPX is still down 15% y/y and the dollar's largely unched over the same horizon. From the Fed's perspective, they are still at the point of adopting a "minimax" strategy- i.e., trying to minimize the losses in a worst-case scenario.
If, after a quarter or two, private demand looks resilient (and bear in mind, Macro Man is highly sceptical on this count), then the Fed will feel comfortable. But to Macro Man's mind, that's a 2010 story, not a 4Q09 one. Of course, he could be wrong...in which case it could be a big week, but not in the way that he might like.
43 comments
Click here for commentsBut to Macro Man's mind, that's a 2010 story, not a 4Q09 one...
ReplyAbsolutely. The positive GDP print is just arithmetic, nothing more. Arithmetically pro-GDP changes in inventory and possibly positive foreign trade - imports falling faster than exports.
But in the real world total consumer debt is steadily falling and that says it all - deflation.
Donlast, M1 is growing 18% YoY. Only broad credit supply, the old M3, is deflating. Problem with deflationism, fond as I am of Hugh Hendry, is that it's essentially a prophesy of what politicans and central bankers will do in the future.
ReplyIf deflation were to be allowed to run its course, the whole system would obviously freeze up at some point. Paulson's warning that your ATM would no longer despense cash was actually probably true.
How can anyone say for certain what the Fed will do with their database which is the dollar? After all it's theirs, not yours.
M1 is meaningless as it is highly distorted by the Federal Reserve's establishment of a hedge fund (borrowing short-term from the banks, buying long-term risky assets). Currency in circulation, an undistorted look at base money, is up 10.7% yoy but only 4% annualized over the last 3 months. This is not unusual for a recession.
ReplyFed policy has not been exceptionally anti-deflationary/inflationary except in risk asset markets where its trillion-dollar purchases have bid up asset prices.
Meanwhile, trillion-dollar-plus deficits have kept overall debt, and aggregate demand, positive. How long can these be sustained?
In time, therefore, I expect Donlast to be proven right - deflationary pressures will return, and deleveraging will have to occur.
Of course there are alternatives -- a dollar collapse, chiefly -- but those would have even more severe knock-on effects than deflation. Pray the Fed doesn't turn to them.
>> How long can these be sustained?
ReplyAd infinitum for all I know. We've got the guns and the troops to invade other countries at will. Therefore we get petrodollars and Chinese slave-dollars recycled into the Treasury market.
What are China/GCC going to do instead, purchase copper and bunds? For the moment they're essentially in check and everyone knows it.
Ben Bernanke says the recession is over. Pop quiz: Bernanke is...
ReplyA) the guy who didn't see the recession coming
B) the guy who assured us we were all seeing things when we saw the recession starting
C) the guy who assured us the subprime contagion was well contained
D) one of several guys who assured us that the Bear Stearns failure was a one off event
E) All of the above
If you answered anything other than (E), you may be qualified to work for a bank
CM - I agree that China has little choice but to buy bonds. However ... China is not the alpha and omega of the global economy.
ReplyDeficit-driven stimulus can hold back the tide no more than 2-3 years more. Every year with a $2 trillion deficit adds ~$600 bn to the annual refunding requirement. The US is already refunding $2.5 trn per year plus the deficit.
Add to that the bill for the bank bailouts - FDIC will need ~$500 bn from the Treasury, various guarantees on bank assets will come due as they default, FHA will need a huge bailout, Fannie/Freddie/GNMA will post new losses, other off-budget enterprises will need bailouts. All these will create demands on the Treasury which will all come due at the same time.
Continuing $trn deficits at that point would potentially trigger a funding crisis, Treasury default, and a huge run on the dollar and spike in interest rates. To assuage the markets they would have to cut the deficit.
Meanwhile the Fed will be tapped out soon. US banks don't have the huge deposit surplus Japanese banks had, they can't lend much more to the Fed than the $1 trn they already have. And the Fed can't fund market support operations by printing currency without triggering a run on the dollar.
Maybe your time horizon is much shorter than 2 years ... but the market could start discounting these limits at any time.
If the US is going to be running $trillion plus deficits year after year forever (a decade at least), that means the rest of the world (in aggregate) must run surpluses of a similar amount.
ReplyWhen the US deficit was something close to its trade deficit, this was possible -- it was just a question of price / yield.
But now, the recession is making the trade deficit smaller and there are no countries running trillion dollar surpluses. China runs about $25 billion surplus per month, or $300 billion per year -- way short of a trillion even if one assumes that 100% is recycled into USD. Add in OPEC, make the same 100% assumption and you are still well short
Add to this that most other G-7 countries are basket cases themselves, and also running significant deficits
Investors can shift money from "other" into US Treasuries in the short term, but long term the deficits are not sustainable
Heads, they start withdrawing stimulus now/soon and we have a double dip recession -- the Fed is so politicized now that this seems possible but unlikely
Tails, they wait "too long" and there is a USD crisis as there isn't enough real money in the world to make $trillion deficits work -- the Fed prints the difference for the next year or two before investors realize the inflation problem. Then its a mad scramble not to be the last one out the door.
The US is too big of an economy to behave like Italy. The world will have to cut off the US government sooner than markets think
In other words you're concerned that maybe MGA was right.
ReplyI think the real risk here is that the following things happen:
Reply1) We have a rise in protectionism, reducing trade deficits with non oil producers like China, thus reducing their demand for dollars directly, but also perhaps making them realize that dollar pegs ain't so hot in a protectionist world.
2) Everyone get scared for a bit, then things go great. US Steel rallies like a mofo.
3) Bernanke raises rates and - SHOCK! - it turns out that the buyers of treasuries have been all those banks that buy 30 yr, borrow at 0, and build back your equity. But now, they are solvent or close to it and the 30 yr beta on fed funds is close to 1.
4) Long term rates go to 6-7%, inflation kicks up, and we double dip as America faces the whole insolvency thing.
"If deflation were to be allowed to run its course, the whole system would obviously freeze up at some point. Paulson's warning that your ATM would no longer despense cash was actually probably true."
ReplyLB was in Argentina in 2001, and can verify that this did in fact happen as currency was hoarded, and the government ran out of bills to pay wages and salaries. The resulting deflation was deep and ugly, but also over in 1-2 years.
If the FOMC statement discusses extending QE we will see a sharp break higher at the long end. The public statements of Bill Gross suggest to LB that this will not occur.
The resulting action in gold and silver will resemble 25,000 Millwall fans trying to get out of a phone box outside Upton Park, all at the same time.
Nemo-
ReplyAgree except for 2nd half of #3 ... banks still have another trillion or so of "unrecognized" losses to write off. They can't rebuild equity until after they finish "recognizing" all the mistakes / losses from yester-year. They probably won't be able to do this "in time" (before the Fed is forced to raise rates to finance the $trillion deficits in a world that doesn't have a spare trillion)
In addition, the big banks are now effectively long mortgage IOs in massive size. Supposedly 85% of US mtges this year were done by JPMorgan, Wells Fargo and BofA. All three of those companies have said they are dumping -- whoops, "selling" -- the new mortgages (mostly refi's) to government entities (FNM, FRE and increasingly GNMA).
The banks service the loans -- with a risk exposure much like being long IOs
GNMA sits on the losses until it needs a bailout similar to Fannie and Freddie (and adding to the $trillion deficits)
Good point Igor, though if the banks have their equity base back by selling turds to the government the point is the same. The government of quasi-government agencies will be long turds, short cash and need a refi that the banks won't want to give them, let alone anyone offshore.
ReplyLeftback, funny, I was there in 2001 as well. I even remember witnessing a few of the protests where the bank facades were routinely smashed, and the authorities looked the other way, I guess to allow people to vent their anger without killing anyone.
ReplyBut there are two sides to that coin. Anyone who had a mortgage in pesos suddenly had 2/3rds slashed off in real terms. Those who were well connected probably got tipped off and made a killing on the "devaluation trade."
Frankly this overnight devaluation would probably fix the US problems quicker than the current scheme. I just don't buy your view on gold, look at the 1930's, with real deflation gold went up 75% in dollar terms, more like 85-90% in real terms.
Crisis, I'm not sure how relevant the Depression analogue is for gold...after all, the dollar (and others) were formally pegged to gold back then, so that "rally" in gold was the product of administrative diktat rather than supple and demand. In any event, notions of supply and demand back then are skewed by the fact that private ownership of gold (in the US at least) was banned.
ReplyMaybe gold would have gone up anyways....but the point is, we'll never know!
An interesting thought experiment is this:
Reply- US goes bk or devalues as per my theory
BUT
- China is broke as per Michael Pettis
Who is the tallest midget, the Yen or the Euro? There aren't a lot of really obvious trades once the turd hits the fan in USD. I know everyone says "gold" but there is a very very finite amount of that you can use for cash holdings.
Devaluations are pretty obvious opportunities once identified unless of course its the world's reserve currency.
Nemo, for crying out loud, do you really think that this govt wants to be the one that makes US go BK, or that other CBs would allow that? There will have to be a repeated set of centrally-managed deflations and reflations of our "free markets" from here, as the only other alternatives are taking the elevator straight down or the default scenario. Not going to happen. The path to profit lies in rejecting the extremes here.
ReplyThat's the point LB - its so absurd and has so much collateral damage that nobody wants it to happen. Perhaps thats what the Dr Strangelove story should be about.
ReplyOh, but at some point then we either have to deal with really high rates, or, the US has to talk CBs into buying their debt again, which would require a staredown on budget policy something that most American politicians would not have much success grasping on the first pass.
ReplyCrisis ... how does "deflation" result in real losses that exceed nominal losses?
ReplyDid you mean inflation?
MM, I've learned through the years that it's nearly impossible to convince gold non-believers so to speak.
ReplyI see it as a psychological phenomena which is tied to the roots of Western/Semitic culture, whether it's logical or not is in the eye of the beholder.
"Gold is not neccesary. I have no interest in gold. We will build a solid state, without an ounce of gold behind it. Anyone who sells above the set prices, let him be marched off to a concentration camp. That's the bastion of money." - Adolf Hitler
"Gold still represents the ultimate form of payment in the world. [...] Fiat money, in extremis, is accepted by nobody. Gold is always accepted." - Alan Greenspan
Igor -- GNMA bonds (which have 100% US government backing) already yield substantially more than similar duration IG corporate bonds (which have no such backing, and already trade about 200bp above US Treasuries)
ReplyGNMAs have prepay risk, but given the recession and the sorts of borrowers that qualify for FHA loans, prepay risk doesn't seem much of an issue -- certainly should be less than the 200bp spread built into IG corporates
Its either excess supply (requiring higher yields to clear) or concern about the credit risk (the full faith and credit of the US government needs to be tempered with the fact that politicians are the government)
Anonymous @ 4:42
ReplyI meant "real terms" in relation to prices. Prices fell in dollars and even more so in gold.
Crisis Management, it is a cultural bias. I'm sure Marc Faber is hoarding silver, drugs and nubile young women or the karaoke bars that employ them since all those have been good stores of value in bad times in Asia.
ReplyLB: "Nemo, for crying out loud, do you really think that this govt wants to be the one that makes US go BK, or that other CBs would allow that?"
ReplyI seriously doubt the Soviet Union wanted to "allow" its collapse.
I seriously doubt African / Latin American dictators want to "allow" black markets to flourish while the government taxed economy languishes
I seriously doubt the US government wants to "allow" drug smuggling or illegal immigrants to enter the US (without paying taxes)
I doubt the US government wanted to "allow" all the mortgage / property bubble to pop -- politicians love extra tax revenues to buy more votes
I know the British government didn't want to "allow" George Soros to make billions from the GBP's absurd and uneconomic tie to the ECU.
Governments are not omnipotent.
Nemo, lol, me and him both...
Reply"Governments are not omnipotent."
ReplyThat's true, but we are far from the end game, as yet. The US is more omnipotent (and more inter-connected) than Argentina or Japan. This is not to say that painful adjustments will not have to be made - they must. I am not an optimist or a doomsday merchant, just a pragmatist.
Reduction of debt, re-pricing of risk, reduction of leverage, reorganization of compensation, price discovery and reallocation of capital away from mal-investments (sometimes referred to herein as "turds") are all necessary, and will no doubt be a Good thing, but no-one should ever expect virtue to have an easy time of it, especially when bankers are involved. They will cede power only slowly.
"Problem with deflationism, fond as I am of Hugh Hendry, is that it's essentially a prophesy of what politicans and central bankers will do in the future."
ReplyI think you'll find that is the basis of the argument for inflation...not deflation
As Donlast said, consumer debt is falling; maybe people don't want more debt. Maybe their time preference for consumption has changed. Obviously we don;t know until after the fact, but the amount of consumer debt out there is at such an extreme level I think it is worth betting on deflation.
ReplyLB -- it took the Soviet Union less than 10yrs to go from global superpower to perestroika to IMF basket case. Much like the USA today, the Soviet's power was more on paper than reality.
ReplyThe British Empire was undisputed world power (military and economic) at the end of the 1800s. 15-20 years later, they essentially lost World War I. Officially they "won", much like RBS "won" the acquisition of ABN Amro. The price was too high, and the assets gained essentially worthless.
Another 20 years later, and the mighty British Empire was weeks away from total defeat (according to Winston Churchill's diary)
Most (all?) of the "growth" in the US since 1970 has been debt based, not real growth- the debt is never amortized, just perpetually refinanced. The manufacturing complex is rusting. The cost of the education and healthcare systems unmanageable and getting worse.
All of that could be overcome, but the nail in the coffin is the terrible leadership (or lack thereof). Obama, Bush, Pelosi, Paulson/Geithner, the CEOs of major corporations ... These "leaders" are clearly not up to the task
I hope the US power bubble hisses instead of violently popping, but history suggests we should be ready for a fairly sudden readjustment
Ah all those gold riddles…
ReplyOne point in gold is that it has been rigged so much in aggregate past that its price would be falling right now if one removed (from PoG) the combined effect of all the non existing accumulated many times oversold position that is getting bigger by the second. But we can not do any such thing can we? And after, all what is not manipulated, oversold and missing these days?
So, if no manipulation needs to be »corrected« with regard to all the non existing bullion (as is with shares and treasuries and all »insurance« e.g. missing bonds or "words"), then the PoG is quite a handy tool indeed to stop or slow a slip or even a slide from becoming waterfall is it not?
One other point is that all that newly found demand for “the product” from the east and elsewhere where pegs inflict inflation (expectations) due to wrong »policy mix« against their »situation« could try and match supply from west. The thing here is - the west will try & sell the paper whereas east expects the thing.
And MM, if I hoard / confiscate /corner an »asset« that is considered »reserve« through »agreement« / »a contract« if you will - and then revalue it upwards - what did I accomplish?
If I now change such an »asset« that is no one’s liability for debt (being mine) and call it »reserve« still, unilaterally this time around but back that terminology by virtue, force, determination and the new religion all together and then find myself in similar situation as back then – what would now revaluation of such a »reserve« do to me and what to those that have hoarder/cornered it in between?
The other “asset” that in between is not “reserve” anymore, sitting at +/- 500 of my 70s bananas.
Anonymous @ 5:56/59, consumers try to get out of debt, but the government is massively levering up and force-feeding debt to consumers.
ReplyWhen the government gives 3% down low interest home loans, plus a free $8K essentially for no reason, you're almost foolish not to take it. Hey, while you're at it might as well take the free $4.5K to buy a car on credit.
And if you default on your home loan, the government will rewrite it, or even let you stay in the house for a year or more. Yes, it's wrong, but who is going to stop them?
Crisis Management, that is a fair point, and it is one I have pondered over for a while. But, you still have to take the debt. I just wonder if society has had enough; if they view debt as a negative rather than a positive then you can't force feed them anymore.
Reply>> if they view debt as a negative rather than a positive then you can't force feed them anymore.
ReplyConsider this, in California the federal government now offers many months of "extended unemployment benefits," which were funded by one of the stimulus bills.
How can you convince a unemployed man that taking these benefits is bad, because it's increasing the leverage in the system? Small example but illustrative of the problem. (Sorry for so much rambling MM!)
Leftback - ‘The Americans will always do the right thing after they have exhausted all the alternatives.’ How many alternatives will the administration try before they accept a reduction in debt, and the weak economy that goes with it?
Reply"How many alternatives will the administration try before they accept a reduction in debt, and the weak economy that goes with it?"
ReplyPJ - A good question. I believe we may now be at that point. The risk posed to the economy by higher interest rates and a second oil shock is highly significant. This is the liquidity trap. If they don't turn off the pump, then BB knows it will be turned off for him by external forces.
In fact, LB assumes that the time sequence of major CB moves in terms of QE was actually scripted some time ago by G20, and is now being followed to the letter. Right now it is the turn of Europe and the UK to ease. LB hopes he is right about this, because further QE here would be a big mistake.
You can bet that additional QE and stimulus will be coming down the pike (Spring 2010 as we print a Q1 double-dip?), but right now the priority will be to ensure there is a market for US government and corporate debt, and to get through the winter without an oil spike. Anything else would be folly.
"How can you convince a unemployed man that taking these benefits is bad, because it's increasing the leverage in the system? Small example but illustrative of the problem."
ReplyNot sure what that has to do with consumer debt. Taking unemployment benefits is a debt on society not the individual, and is subject to the usual free-riding abuses that plagues all public goods.
Anyway, most unemployed would rather have a job than benefits. That is illustrated by the frequent surveys from the US where people say they would take 30-50% pay cuts to work again.
The leverage in the system (I presume you mean govt) will be controlled by the treasury market. As for private sector leverage, that is only heading in one direction. Down.
When does this become a currency crisis? the dollar continues to get sold across the board each and every day. Shouldn't US T-Notes trade heavy on this?
ReplySeriously. Thought I'd be oh so clever and short some Yen and gold. I'm right back where I started minus some theta. Something's got to give.
ReplyAdditionally, Shanghai is getting slapped back down so I thought I'd short some HSI. Also going nowhere. Either I should wait or I've got this all wrong and need to go back to the drawing board. Not Happy Ben.
ReplyAnonymous @ 8:29, if one takes on a new $700K home loan courtesy of FNM/FRE that counts as consumer debt. The situation with the government playing Santa has gone far beyond simple abuses as you put it.
Reply"If the US is going to be running $trillion plus deficits year after year forever (a decade at least), that means the rest of the world (in aggregate) must run surpluses of a similar amount."
ReplyWhy? Trade surpluses and deficits must axiomatically add up to zero, but budget deficits can add up to any arbitrarily large number. Budget deficits can always be financed out of consumer savings (a quaint idea in the U.S., but common in other areas of the world, especially Asia).
Talking Treasuries, if one might mention another website in this context, take a look at Bruce Krasting's assessment of Fed deficit and funding over the next decade. The outlook is ghastly. Whatever one might make of "go with the flow" today, looking down the road Treasury bonds are about as certain a loser as a three-legged mare in the Derby.
ReplyWhoever is running the portfolio in Beijing will need a lot of concubine support to see him through.
Hello and thank you for you post. I definitely agree that the deficit of the US is alarming. And what is even more alarming is how many people take loads and live on dept. The more loans we take, the more serious the crisis is.
ReplyTake care,
Elli