Green shoots everywhere! The credit crisis is over; an economic recovery is
just around the corner! Hold your horses - there may not be enough water to
nourish them at the next pit stop. Hold on - isn't a bad decision supposed to
turn into good policy when you back it by trillions of freshly printed US
dollars?
Conventional wisdom suggests that when you lower interest rates, splatter lots
of money onto the economy through spending programs and credit facilities, the
economy will recover. There are a couple of problems with that view. For
starters, given the magnitude of the credit bust the world has just seen,
"conventional wisdom" may no longer hold up. But wait - we have seen nascent
signs of a recovery - the touted green shoots! Let's
examine some of these:
the stock market has bounced substantially from its lows.
policy makers tell us that the economy is improving.
banks report strong earnings.
Do you notice a theme here? The first two reference expectations of things
improving (arguably the view of policymakers should be taken with a grain of
salt, as their own policies contributed to the present mess). Furthermore, it
should be no surprise that when a financial institution has access to
essentially free money and all losses are guaranteed that they manage to report
"better than expected" earnings.
Wait, there is another one: Intel tells us that chip shipments are up again;
yet Dell and others continue to warn about the reluctance of consumers and
businesses to buy their products. Could it be that refilling depleted
inventories is not a harbinger of an economic recovery?
There are other indicators that have shown signs of improvements; those
searching for a glass half full have been able to find it. To be sure, an
improvement in sentiment is essential to any recovery as consumer confidence
influences spending and investment decisions. So with trillions of dollars
committed, with fiscal and monetary spending put into high gear, what is a
policy maker to do? Let's take a peek behind the scenes at the Federal Reserve
and look at the growth of the Fed's balance sheet.
As a rule of thumb, the Fed's balance sheet can be viewed as the money that has
been printed out of thin air, even if that "printing" is done electronically
and no dollar bills are created. When the Fed increases its balance sheet, an
uptick in economic activity may result as more credit is made available to the
economy; think of the Fed's balance sheet as "super money" as there is a high
multiplier effect between the money the Fed makes available to the banking
system and the economic activity that may be created.
However, this only works if first banks indeed make the cheap money available,
but then individuals and businesses take the "bait", that is, take out more
loans. Rather than risking that banks may not pass on the money, the Fed has
engaged in various "credit easing" programs, essentially bypassing the banks to
extend credit to specific sectors of the economy.
In mid-September last year, the Fed's balance sheet stood at about US$1
trillion; since then it has more than doubled, but the growth has tapered off.
Charts you may see showing a decline in recent weeks do not reflect the net
commitments to buy mortgage-backed securities. Indeed, we would not be
surprised if the Fed were to employ more derivatives to provide the illusion of
a more conservative balance sheet; the New York Fed, for example, has been very
interested in moving assets into special purpose investment vehicles (SIVs) to
remove them from its balance sheet.
This isn't so different from companies delivering what investors are asking
for: You want sales? We give you top-line growth (read mail-in rebate programs
that appear as liabilities while reported sales are high). You want margins? We
give you margins (read stuffing inventory channels and the periodic write-down
of unsold inventory). You want a strong balance sheet? We give you a strong
balance sheet (read off-balance sheet vehicles).
Everyone wants to be appreciated and the Fed is no different in trying to
please the market. Except that it is not the role of the Fed to be loved but to
foster an environment that promotes price stability (low inflation).
Incidentally, it is well established that the Fed's secondary mandate to
promote maximum sustainable growth is best achieved in an environment that
fosters price stability.
The Fed may want to see the impact of the current initiatives before ramping up
its programs. It generally takes about six to nine months for Fed policy
changes to work their way through the economy. There are a couple of factors
why the Fed's balance sheet has plateaued in recent months:
Seasonal factors influence the Fed's balance sheet and are responsible for a
fall early in the year.
Some of the Fed's programs are indeed fading out. Amongst them are support for
the commercial paper market as the panic has abated, as well as certain
liquidity facilities that are not cost effective to the borrowers.
Some of the Fed's purchase programs have been off to a slow start. Some, like
the Public Private Investment Partnership program (PPIP) because they are
ill-designed; others because the Fed may want to influence the market by the
simple announcement that it intends to become active but then saves its firing
power. The mere announcement can move a market - at least in the short-term.
However, this "active communication" strategy is risky as it jeopardizes the
credibility of the Fed.
We don't think the Fed is done printing money - indeed, the Fed has committed
to printing substantially more, for amongst other reasons, to purchase a
further $600 billion worth of mortgage-backed securities.
The purpose of this discussion, however, is that the Fed's actions in recent
months have hovered sideways. If all the money that has been thrown at the
system does not stick, the Fed, in our assessment, is likely to print more.
The stock market rally coincided with the typical lag time to the initial boost
of the Fed's printing press and when the green-shoot theories begun to spring
up. But those green shoots are wilting; the "conventional wisdom" is not
playing out as planned. There are many reasons for this, amongst them:
Market forces are stronger than the Fed and the credit contraction has not run
its course.
Inefficiencies in how the Fed's programs have been designed: the Fed may be
able to prop up financial institutions, but it does so by substituting rather
than encouraging private sector activities. That's because rational market
participants may have no interest in extending credit at artificially low
rates. Warren Buffett, amongst others, has complained his firm cannot compete
at the terms offered by government subsidized programs or companies.
Inefficiencies in how the administration's programs have been designed: when
you give a break to someone who has been shocked by the credit crisis and is
deeply in debt, that person is likely to save a good portion of any government
handout. In contrast, had the stimulus plan provided an incentive to small
businesses to invest, a positive economic snowball effect may have been
created. Instead, the most recent proposals suggest a tax increase for small
businesses to finance more government spending (think healthcare reform,
amongst others).
Looking forward, there are more headwinds in the pipeline:
CIT, the troubled small-business lender that serves 950,000 mostly small and
midsize businesses including 300,000 retailers and 1,900 manufacturers, is
struggling to survive. As of this writing, it seems possible that CIT may be
able to avert bankruptcy, but is likely to become more conservative and thus
make less credit available to small business.
The federal government will need to issue an enormous amount of debt in the
coming months. Given that the summer months are typically slower months to
raise debt, there may be an unprecedented supply of new government debt in the
fall, which will likely put upward pressure on rates.
Corporate America also needs to go back to the financial markets in the autumn
with massive funding needs. On a related note, in Europe, the European Central
Bank (ECB) recently provided an unlimited supply of one-year financing to the
banking system - the equivalent of over $600 billion was handed out. The
connection: the ECB may foresee a crunch in the autumn and may be taking
advantage of a relatively calm period in the market to create a buffer against
a possible funding shortfall.
California's first round of IOUs are due October 2. Of course Sacramento will
have resolved all of its budget issues by then and tax revenue will have
stabilized. And pigs might fly. California, for now, as well as other states,
will need to raise a lot more money. In that case, as many want to access the
credit markets at the same time, don't be surprised if the appetite to finance
local, state, federal, corporate and international needs will be low.
Before we get too excited about the reflation that is said to take place around
the world, consider that the Fed's been pausing to wait out market reaction to
its policies. Given the typical lag time of Fed intervention, the green shoots
may have wilted and died in the absence of fresh liquidity, just as massive
financing requirements hit the markets. Call it credit crunch, part two.
We shall note that we don't have a crystal ball. However, it's a possible
scenario and investors who believe that there's a reasonable probability that
it may play out that way may consider taking it into account in their portfolio
allocation. What does this mean for the markets? For starters, we believe the
equity markets may have got ahead of themselves. In addition to what we mention
above, the business model of corporations that rely on cheap financing is
fundamentally broken - CIT is a prime, but by far not the only example of that
- and won't come back anytime soon.
Will we see a flight to panic, a flight back into the US dollar and Treasuries?
If it does, we believe the pendulum will swing less than last year. Consider in
particular that the balance sheet of the US has deteriorated over the past 12
months. While the US may still be considered a safe haven, it is not the safe
haven it was a year ago.
Governments around the world have also not been sitting idle, making a flight
to the US less likely. Panic may not evolve as the US and other governments
have made it clear that they may do whatever it takes to keep the financial
system together - read: print money, lower the barrier to what may be too big
to fail and provide liquidity.
The massive supply of debt to be issued should push up the cost of borrowing
(raise yields, lower prices of debt securities). However, that scenario is
exactly the opposite of what the Fed wants to achieve. The Fed wants to keep
the cost of borrowing low - especially for the housing market.
As a result, we believe the Fed will ramp up its intervention in the bond
markets if and when credit deteriorates once again. This time around, many
tools will be in place that were not available last year, allowing policymakers
to react more promptly. While this may appease those in desperate need of
funding, it again means that the securities targeted may no longer be
attractive to rational buyers, as they won't be adequately compensated for the
risks they are taking.
More specifically, if the Fed buys Treasury Bonds or mortgage-backed securities
(MBS) to lower interest rates, why would rational buyers - be that foreigners
or private domestic investors - buy these? This abstract concept is nothing but
the Fed printing money to finance government spending, even if the Fed denies
that it is "monetizing the debt" as this is called.
By the way, while it is not the Fed's job to monetize the debt, it is in the
Fed's interest to provide the perception that it is not monetizing the debt for
as long as possible so as to - once again - lower the cost of borrowing.
Needless to say, the US dollar may come under considerable pressure if the
public were to agree to what seems obvious to us. The fact that a weaker dollar
may not be in the interest of US creditors may not be enough to prop up the
greenback should this transpire.
A brief word on other regions: China's stimulus package has been more effective
(and China can afford its stimulus); in Asia, China may not only be best
positioned to allow its currency to appreciate, but China will also find that a
stronger currency may be the most effective tool to counter inflationary
pressures that have been building as a result of its highly expansionary
policies.
Europe may see its share of suffering, but it won't be as "efficient" in
creating government debt (because of the decentralized nature of the European
Union that makes bailouts and fiscal stimuli more difficult to coordinate); we
believe that the less aggressive actions should continue to make the euro more
attractive than the US dollar. Please read our past Merk Insights for a
discussion of specific currencies and regions.
Gold continues to be true money that cannot be printed and thus something to
consider for those who lose their confidence in all fiat currencies. Overall,
don't expect smooth sailing in the months ahead - those familiar with gold know
that, relative to the US dollar, gold can be a rather rocky ride, even if it
may ultimately be profitable for those who have the stomach to bear the
volatility. As the US dollar in particular is at risk of losing its function as
a store of value, investors may want to consider a diversified approach to
something as mundane as cash.
Axel Merk is manager of the Merk Hard and Asian Currency Funds. Merk
Insights provide the Merk perspective on currencies, global imbalances, the
trade deficit, the socio-economic impact of the US administration's policies
and more. To learn more about the Funds, or to subscribe to our free
newsletter, please visitwww.merkfund.com.
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