19 Jul 2010 12:07:38
Fed concerns are misplaced
There is no liquidity problem for the Fed to fix and there will be no need for an exit strategy for a long time.
The minutes of the last Fed meeting showed that it’s looking at (1) ways to provide more stimulation and (2) ways to exit from the abnormal liquidity measures taken since the Bear Stearns bailout. Three of the main four liquidity indicators are positive. Steeper yield curves show greater liquidity – the yield spread between 3 month Treasury Bills and 10 year Treasury Bonds is now close to the widest ever. Narrower yield spreads between high yield bonds and Treasuries show greater liquidity. This spread is now far closer to the narrow end than the wide end of its range. Bigger ratios of Treasuries to loans and investments on bank balance sheets show greater liquidity. This ratio has risen very close to its 40 year average. In contrast, the rate of change of business loans plus commercial paper is near its all time low. Under normal circumstances, this would show extremely tight liquidity but, with the credit bubble having burst and the other liquidity measures indicating ample liquidity, it shows solvency problems rather than liquidity problems.
The bursting of the credit bubble has created enough (1) hidden loan losses that still need to be written off and (2) expectations of higher mandated capitalization ratios to make banks hoard capital. Bank hoarding of capital has disabled the system that turns ample bank reserves and low interest rates into rising private sector borrowing. More monetary stimulation (read higher excess reserves) will accomplish nothing – especially as Fannie Mae and Freddie Mac debt are the most likely assets for the Fed to buy to create the additional reserves. Current estimates of Fannie’s and Freddie’s total losses ranging up to $ 1 trillion, excessive mortgage debt now outstanding, and mortgage rates far too close to Treasury yields mean adding to the Fed’s holding of Fannie and Freddie debt makes little sense. The Fed is already pushing on a string. Pushing harder won’t help.
Looking in the other direction, the Fed’s exit strategy so far has been to let its mortgage backed securities mature. Maturing all of them would take five years. The Fed is unlikely to take overt action until the recovery is firm, unemployment is falling, inflation is threatening, markets have settled down and the election is over. Its first action is likely to be pegging the Fed funds rate at 0.25% and the next probably will be to freeze excess reserves with reverse repos and term deposits. It will auction the term deposits, which can be funded at discount window at a lower rate (yet another subsidy to bankers). Only after policy rates began to rise would the Fed gradually sell assets – and it will announce sales well in advance.
Overt Fed action is unlikely in the foreseeable future as the recovery first must overcome three major impediments; excessive fiscal deficits, over indebtedness and tax increases. Government indifference to interest rates gives fiscal deficits first call on savings. Business trying to utilize its full capital consumption allowances would just drive up interest rates. However, business is not competing for saving because over indebtedness has created a stock of redundant capital that must shrink to employ idled labour. Fitch ratings forecasts US capital expenditures to rise only 4½% in 2010 – compared to the 16.9% drop in 2009 – so investment is unlikely to contribute much to the recovery. In addition, tax increases already in the pipeline will hinder both consumption and investment. Falling risk markets are another factor that will delay overt action by the Fed.
The corrections of the over valuations of risk assets in recent years are far from over. The function of private sector debt liquidation is to reduce bloated asset prices to levels consistent with output prices and incomes. For example, the current level of housing would not be affordable for most people at realistic levels of mortgage rates. The spectrum of commodities, now (wrongly) considered an asset class, contains some of worst examples of bloated prices, such as oil and copper which have been selling about double their marginal costs of production. The S&P 500 is hardly a bargain at 22 times trailing four quarter reported earnings and 21 times 10 year average earnings. Tobin’s Q (the ratio of non-financial market capitalization to replacement value) should be significantly less than one because new plant and equipment is more efficient than older facilities. That makes the most recent reading of 1.04 distinctly high. Risk asset prices are not discounting the creative destruction that is an essential part of the correction of debt financed asset bubbles.
Leigh.skene@lombardstreetresearch.com
The views expressed in these articles are those of the writer. They may not necessarily be those of Lombard Street Research Ltd (LSR) and other LSR economists may from time to time hold different views
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