Where's the pain?

It's a day of returns today. The US workforce is returning to work from a long Labor Day weekend. Macro Man's kids are returning to school. And financial markets are returning to fully-staffed trading desks and, one would presume, more normal trading volumes.

One thing that has not returned to normal is the money market, where rates and uncertainty both remain high. Markets are abuzz with talk of the enormous CP rollovers to be done this month and left wondering what will happen if there is no bid. The widely held conclusion, of course, is that the Fed will cut rates to ensure that there is a bid.

There is plenty of "real" news this week as well. The US sees ISM, the Beige Book, and payrolls. Weak readings will cement the notion of rate cuts, while strong readings...well, will strong readings mean anything at all? At Jackson Hole, Big Ben noted that economic data will offer less guidance than usual, given the uncertainty of the times. He may as well have just queued up the old Rolling Stones song, ably covered by the Soup Dragons: "I'm free to do what I want/ Any old time".

Of course, it's not all about the US. An early warning signal of how seriously CBs are taking the current market turmoil may be observed from the BOE and especially the ECB meetings on Thursday. The BOE should be a non-event, though the turmoil in the UK money market is just as pronounced as in the US. No, the real info will come from the ECB.

A month ago, Jean-Claude Trichet used his little word games to signal a rate hike this month. And while the ECB subsequuently issued a statement suggesting that the outlook had not changed, at the same time the ECB has provided mammoth amounts of money market liquidity via short and medium term repos over the past few weeks. What would be the use of providing liquidity with one hand and then withdrawing it with another? An unchanged decision would appear likely. The really interesting bit is likely to come in the press conference, where for the first time since the crisis began a central banker will field questions directly from the fourth estate. The degree of medium-term (or lack thereof) concern over the functioning of markets expressed may give us an insight into what the Fed is also thinking behind closed doors, given that the world's central banks confer closely during times of financial distress.

Macro Man retains the view that easing rates would be a mistake for the Fed. Yes, house prices in some markets are falling, in a few cases precipitously. But in most of those cases, these markets are drastically unaffordabe relative to local incomes, and a degree of normalization should not be the end of the world. Yes, some householders will suffer a hit to their wealth. But policymakers (in aggregate) cannot complain about the unaffordablity of housing on the one hand and then act to buoy prices as soon as they start falling! (Well, they can, of course, but not if they wish to maintain internal consistency.)

Moreover, Macro Man would view the current turmoil in the ABCP market as a long-overdue normalization. The chart below shows the amount of CP outstanding by issuer type. Note the explosion in ABCP over the last two and a half years; can there really be any doubt that this represented a bubble? It seems quite clear (as it did in real time to many people) that the expected excess returns to be generated by the assets purchased by ABCP had dwindled to the point of being negative.

A reduction in the "issue short term paper to buy long-term turds" business model is not an event that will cause Macro Man to lose much sleep at night, he has to say. What's interesting to note is that the amount of non-financial, non-asset backed CP has barely budged thoughout this event. If there's contagion, Macro Man doesn't see it here.

Similarly, the yields on CP suggest that markets are charging a higher rate for crap (ABCP and low-quality non-financial CP), while yields on high-grade CP not backed by turds have not budged.
Now, Macro Man will readily admit that credit rationing, should it occur, would prove detrimental to the economy. But he has yet to see evidence that it is occuring. In addition to the steady rates on high-quality CP, borrowing rates for corporates of decent but not sterling credit quality are also showing zero signs of distress. While it's true that spreads have widened since the early summer, that widening has all come from the rally in Treasuries.
The actual borrowing cost of investment grade corporates, proxied below by the Moody's BAA yield index, actually fell in August and is near its lowest level since the beginning of the summer. If there were real signs of the real economy being denied access to credit, shouldn't we see at least some rise in these yields, rather than a modest decline?Finally, and as most readers probably know very well indeed, global equities aren't exactly on a straight line to zero. Of the 18 equity indices on the Bloomberg WEI default page, exactly two are negative year-to-date: perennial basket case Japan, shunned by Mrs. Watanabe for the "safety" of online FX punting, and Italy, which cannot be enjoying the drastically overvalued euro.
While there's certainly no guarantee that equities are properly discounting future macroeconomic developments, that they have yet to fall anywhere near as much as in prior "financial accident" episodes must surely raise the question as to why a monetary tonic is so desperately needed.

So what should the Fed do? For starters, it could cut the discount rate to the level of the funds rate, so at least banks can lock in positive carry by borrowing from the Fed to lend in the interbank market. It could reduce the haircut on asset-backed collateral- or is that 60% margin the Fed's way of saying what that stuff is worth?
Macro Man will humbly offer a prediction here. In 1998, the third Fed rate cut after the LTCM mess helped spur an equity rally of such vehemence that it swiftly morphed into a bubble. When equities collapsed, Greenspan and co. eased rates so aggressively (even before 9/11) that a housing and, ultimately, credit bubble emerged in place of the equity bubble.
If the Fed moves to cut rates by, say, 0.50% of more by the end of the year, Macro Man is pretty sure that this will, in the fullness of time, be seen as the genesis of the next financial-market bubble. And in Macro Man 's view, that bubble could take the form, at long last, of widespread and catastrophic dollar weakness.

After all, if America's greatest export turns out to have, ahem, quality control issues, why should anyone in their right mind, including VIG, RIG, et al., show a bid?

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Click here for comments
September 4, 2007 at 2:11 PM ×

Excellent post. Thanks.

But one question: why do so many people point to the Greenspan Fed’s 1% rate as the impetus for subsequent credit/housing bubbles? I wouldn’t dismiss the factor, but as the Fed continued the discount rate’s (perhaps too) slow march upward, long-term rates did not follow. Does that suggest flows from the PBOC, other central banks, and the GCC may matter at least as much for any resulting bubbles?

Macro Man
September 4, 2007 at 2:28 PM ×

Ross, I'd concur that FX reserve managers have contributed to the bond bubble via their hijacking of the US yield curve through their deployment of their reseves.

However, I'd suggest that the conditions which allow them to do so were partially put in place by over-easy Fed policy which was kept much too low for much too long. By offering investors the propsect of negative real return on US cash, the Fec encouraged a) consumers to spend...a LOT, thereby exacerbating the trad deficit, and b) capital to be deployed out of the US and towards countries offerign a higher rate of return.

That the Fed subsequently complained about the size of the US current account deficit and enouraged homeowners to take out ARMs early in the tightening cycle is particularly galling.

But let's not forget that housing NEVER went into recession when the business sector did, which is pretty unique historically. (I'm still bitter that I sold my place in Hilton Head Island in the summer of 2000 on the expectation that the US was headed for recession...)

September 4, 2007 at 6:09 PM ×

I think for some reason peculiar to the human being, a cut at the next FOMC (if it should happen) will not have the FEDs desired impact.

I think after the "second serving" starting in ernest in 2000 most consumers, investors, speculators are pretty much fed up.

Could this be the start of massive deflation, could Japan be a case in point?

Macro Man
September 4, 2007 at 8:05 PM ×

Hmm.. I wonder if a more likely outcome might not be the opposite- e.g. inflation caused by high commodity prices, a weak dollar, and a tilt towards protectionism. Call it the 1970's UK model!

September 5, 2007 at 8:44 AM ×

Macro Man: With the US making up 28% of world GDP (in nominal terms), could emerging market growth really prop up commodity prices? Sure, Chinese commodity demand has skyrocketed, but can it keep growing at a healthy clip if the US enters recession?

During the three latest US recessions, as well as during the Asian crisis in 98, the CRB commodity index fell.

With regards to USD weakness, the USD is weak compared with both 10 or even 15 years averages. (Both in real and nominal terms). Of the G10 USD crosses, only USD/JPY seem fairly aligned with the 10-year average.

Any thoughts on this?

Macro Man
September 5, 2007 at 1:35 PM ×

Martin, while the US does indeed make up a substantial portion of world economic growth, its prominence as a source of marginalcommodity supply/demand is much lower, I think.

I feel quite sure in thinking, for example, that the US does not consume 28% of the world's foodstuffs, despite its repuation for obesity.

And while some energy demand would no doubt ebb in the result of a recession, bear in mind that demand for energy is also much less income and price elastic than, say , the demand for Bentleys or flat screen HDTVs.

On a more secular basis, the enrichening of the erstwhile third world means that the billion s of citizens there a) want to eat better food and b) want to buy more consumer goods.

I'm not sure that a US recession, even if we get one, will dent that secular demand sufficiently to drive ommodity prices back to where they were a few years ago.

And if I'm right that the US will avoid recession, then even further upside awaits, particularly if commodities also receive the 'bubble treatment'.

And while I'd heartily concur that the USD is cheap against all G10 currencies bar the yen, in a bubble that won;t matter a whit; people are pretty imaginative, and I'm sure someone can come up with a rationale for EUR/USD to trade at 2.